Snap case shows pursuing an IPO not without risks and challenges for tech scale-ups seeking access to capital, says expert

Out-Law Analysis | 17 May 2017 | 4:05 pm | 4 min. read

ANALYSIS: Pursuing an initial public offering (IPO) is one way for technology 'scale-up' businesses to access the capital they need to grow.

However, as Snap's recent experiences following its IPO show, becoming publicly listed brings new risks and challenges and added scrutiny that scale-ups must be prepared to deal with.

The perennial problem for scale-ups of accessing capital may about to be tackled through changes to UK regulation, according to comments made earlier this year by City regulator the Financial Conduct Authority (FCA).

What makes a business a 'scale-up'?

A scale-up company is a business that has shown promising signs of growth from modest beginnings. Scale-ups are businesses at a more advanced stage of development than start-ups.

There is no set definition for what comprises a scale-up business, but the FCA said it considers scale-ups to be businesses that grow their turnover or number of employees by more than 20% on average each year over a three year period, where they start the period with more than 20 employees.

In the UK there are several mechanisms in place to support the development of fledgling companies, such as tax breaks and entrepreneurial grants, but often businesses that develop beyond the start-up stage find it harder to access the funding they need to take the next step in growth.

The problem in accessing capital was recognised by the FCA earlier this year. In a discussion paper published in February, one of the aims of which was to examine the effectiveness of the UK’s primary equity markets in supporting the growth of science and technology companies, the FCA expressed a willingness to explore changes to primary market regulation if it were felt this could address a perceived shortage of capital for scale-ups.

In the same paper, the FCA also noted that UK technology companies "are disproportionately the subject of merger and acquisition (M&A) activity compared with their international peers".

Taking the IPO route

One of the ways technology companies might look to gain new investment is by seeking an IPO.

An IPO may also be attractive for a variety of other reasons – it is often seen as a sign of prestige to operate a public company, and it also offers enhanced profile and credibility, as well as greater flexibility and ability to fund acquisitions with stock. Another typical driver is the ability of existing shareholders to realise some of the gains their investment has enjoyed, while maintaining an interest in the company.

These benefits come at a certain cost, however. In particular, the increased public scrutiny that attaches to a public listing is something that will require careful preparation on the part of a company. A company in private ownership that has, up to the point of IPO, enjoyed a high degree of control over its own narrative, must be prepared for that narrative to be taken out of its hands and used in ways that its founders may find surprising and even, from time to time, damaging.

Snap's experience with an IPO

Snap Inc. is the company behind popular social messaging app Snapchat. In March this year the company raised a reported $3.4 billion when it conducted an IPO.

Snap's IPO came at a relatively early stage in its cycle. Both Google and Facebook had been around for eight years or so at the time of their IPOs. The Snapchat app was launched just under six years ago. Snap, moreover, had enjoyed something of a reputation for secrecy, prior to its IPO. Both of these factors led to a degree of speculation as to the motivation for the listing. Arguably, this speculation as to rationale has translated into a continuing degree of uncertainty as to Snap’s future intentions.

Uncertainty over the company's future was fuelled by Snap's recent publication of its first quarterly results since its IPO and the market's reaction to those results. Shortly after the results were published, Snap's share price fell 24%, wiping $6bn off its market capitalisation.

The fallout has been surprising for a couple of reasons.

Firstly, the sheer scale of the reaction suggests a high degree of scepticism as to Snap’s future business prospects. Secondly, some of the underlying factors that resulted in this reaction were already known at the time of the IPO. In particular, concerns were expressed at that time as to the level of costs within the business and also as to the slowdown in user growth.

On its call with analysts, Snap focused on a number of positives, including revenue growth. However, that growth had not been as much as the market had anticipated – it was just under $150m as opposed to an anticipated $158m. While it had not missed by much, this difference, along with the other figures, told their own tale and it was to this that the market reacted.

As a privately owned company, the management team would have been dealing with a relatively small group of main investors. Arguably this is also the case with a publicly traded company, which although it has a wider shareholder base, will have a smaller group of significant shareholders. That said, the scrutiny to which a publicly traded company is subject, and the damage to profile that can ensue from negative results, are far harder to manage.

This may have been part of the thinking behind Snap offering only non-voting shares to the market. What better remedy to negative market sentiment than not being immediately answerable for it?

Snap caused some controversy when it announced that it would be the first company to issue only non-voting shares in its IPO. Some investors were said to have been angered by this and perhaps it is, in part, a residue of this anger that is translating into increased negative sentiment now.

Mechanisms to maintain control within the hands of founders following an IPO have been around for some time and are increasingly common within the technology sector. That said, much will depend on the venue chosen for listing.

In the UK, for example, dual class share structures are permissible in a standard listing on the London Stock Exchange, but not in a premium listing. A premium listing gives rise to the potential for inclusion in the FTSE UK series of indices and access to these indices is often seen as one of the central benefits of a premium listing, as many investment mandates are driven by FTSE indexation.

So, there is much for scale-ups to ponder when they consider whether to seek an IPO. It may be that reforms, hinted at in the FCA's discussion paper, could make the IPO process more attractive for tech and science companies in future. The FCA's paper closed to comments on 14 May. The feedback received could potentially shape the FCA's future thinking on the issue.

Andrew McMillan of Pinsent Masons, the law firm behind, is a specialist in corporate transactions in the technology market. A version of this article was first published by TechCityNews.