Silicon Valley Rejects Shareholder Value Theory: Disrupting the IPO

I’ve written about problems with Shareholder Value Theory (SVT). The constant need to pump an ever-appreciating stock price to anonymous shareholders, the vast majority who contributed nothing to a company, rewards short-term thinking. Buybacks and other financial tricks tower over innovation and growth initiatives.

It looks like Silicon Valley has tired of the nonsense.

Here is an article about a new public company, Social Capital Hedosophia Holdings Corp. (SCH): Fixing the ‘Brain Damage’ Caused by the I.P.O. Process. Their prospectus is here: Social Capital Hedosophia Prospectus.

Missed the IPO? Don’t worry; you were supposed to. Trading on the NYSE the company’s ticker is IPOA.U. Trading opened on September 14 at $10.31; a week later they’re at $10.63. The company has a $600 million pile of cash but no products or services; they exist to buy tech companies.

SCH is a combination of two firms, the well-known Social Capital and stealthy Hedosophia.

Social Capital is founded and managed by Venture Capitalist Chamath Palihapitiya. Their portfolio includes Slack, Forge, Box, Brilliant, and a sizable group of unusually high-quality companies. Palihapitiya sounds like somebody you’d want to stranded on an island with: he’s be interesting company and probably figure a way off. He tends to make a lot of money for himself and the people he works with.

Less is known about co-founder Hedosophia, a venture firm founded in 2012, that filings state has over $1 billion in holdings. The firm’s webpage is retro 1990’s, appearing on the second page of a Google search for the company name and referencing a street address which, on Google Maps, is a nondescript building with no signage. Hedosophia’s founder is 34 year-old Ian Osborne, of Osborne & Associates and Connaught. These firms have apparently acted as financial advisers “for eight of the fifteen most valuable private companies in the technology sector.” It’s unclear why the secrecy is necessary; it gives off a Le Carré vibe.

SCH is a Special Purpose Acquisition Company, or SPAC. The last and only time I came across a SPAC it was used to take the law firm of David J. Stern public. Stern is the crooked foreclosure lawyer who fabricated paperwork to expedite foreclosures, earning himself two yachts, a mansion and, eventually, permanent disbarment. That SPAC initially traded under the ticker CACA (there are some things you can’t make up) then changed to DJSP, David J. Stern Enterprises. DJSP worked out great for the shorts at least: Stern’s firm quickly went bankrupt. Though, I digress…

The purpose of SCH is to to enable flexibility in the cumbersome IPO process. On one hand, it’s impossible to feel bad for 30-something tech executives flying private jets and repeating the same Power Point dozens of times to potential investors. Especially since, absent a disaster, they will reap a fortune at the end of the process. But those rules can also harm ordinary employees who are subject to rules, because of their tiny stock grants, that are meant for Masters of the Universe.

I watched this happen with a number of companies during the first dot-com boom. Regular employees held locked out stock and watched their chance to finally buy a house or pay off student loans vaporize. Many were taxed on phantom income that never materialized under rules I won’t pretend to understand much less explain. These were not top-tier b-school alum; they were writers, computer programmers, online forum moderators — people who knew nothing about capital markets — and ended up owing a fortune. Their bad for not studying the rules more? Maybe, but since the rules exist to protect the clueless those same rules could have done more to protect them.

SCH’s SPAC is supposed to change this. The idea is that one or more companies would be backed into the SPAC and skip the normal IPO process. No roadshow, no lockouts, and fewer worries about pricing. One bucket of capital goes to the company or companies, a controlling batch of stock goes to the SPAC, lawyers prepare lots of paperwork and, voila, the company is public sans IPO.

Another potential model would be multiple businesses put limited shares in the SPAC and it functions more like a publicly traded private equity firm. Social Capital’s hiring of private equity guru Marc Mezvinsky (yes, Hillary’s son-in-law) as vice chairman, and the use of plural verbiage in filings, suggests they might pursue this route. Plus, they explicitly call out purchasing only one firm as a risk factor although that is normally how SPAC’s work.

Like I said, the only time I’ve seen a SPAC in real-life it was a disaster. During it’s short life I communicated daily to DJSP investors, warning them. At first they weren’t thrilled. “I’ll kill you – no, I’ll have you paralyzed from the waist down,” is how one eloquently put it as I explained my data showing DJSP to be garbage. “Knock it off, look at the data, and direct your anger towards Stern,” I answered.

We continued communicating after the failure — they eventually became more friendly — and said it hadn’t worked out well in the past either. Their business model was to use SPAC’s to take Chinese companies public in US markets. But a disproportionate number of the companies turned out, in hindsight, to have elements of fraud. They purchased Stern’s operation because the two-year window to acquire a company was closing and they wanted to avoid fraud by focusing on a US business. Of course, instead of avoiding fraud, they ended up with arguably the worst SPAC in history. There are benefits to SPAC’s but also risks.

Which brings us back to SCH and Social Capital. Chamath Palihapitiya has the magic touch for a VC. He was an early Facebook employee, introduced to Zuckerberg by Sean Parker. His motives, an ability to focus on long-term value, is exactly what we like to hear. He says the right things, has the right history, and sounds like a person you want to trust. As an added benefit there is nothing that I’ve come across which even hints that you shouldn’t. With the market price of their empty SPAC increasing, despite no news, somebody else agrees.

But is it a genuinely good idea to ditch the traditional IPO path? There’s no question the as-is method is disruptive (in the traditional sense), cumbersome, expensive (though SCH charges 20% of the acquisition cost), and lengthy. Great for investment banks and their insiders; not so great for everybody else. Palihapitiya points out the need to disrupt his own VC industry in the same way tech firms have disrupted and upended dinosaurs. Further, an ability to better protect employees and more equitably distribute stock and options sounds like an improvement, especially after seeing those Silicon Valley employees financially drowned in the undertow of upside-down options.

There are a substantial number of companies rejecting the as-is path to an IPO. SCH’s prospectus highlights that there are 150 private tech companies valued at more than $1 billion but only 200 public tech companies. Firms are actively rejecting the as-is solution for initial public offerings though it remains unclear if that is because they wish to avoid investor pressure or whether they want to avoid the hassle of the IPO process. If their concern is investor pressure are they worried about an unwelcome letter from Carl Icahn or worried about turning into the next Snap or Twitter, with a languishing stock price?

I’m not a finance person but there seems to be a math problem. SCH has $600 million cash. They’re required to buy a controlling interest in voting, and at least 50 percent of outstanding shares, of at least one business worth more than $1 billion — their preference is to buy a company valued at $2-3 billion. Normal IPO’s deal with inadequate demand in the capital markets by selling a lower amount of stock. Need to raise $500 million but require a $2.5 billion valuation? Then sell 20 percent of the business to the public. But SPAC’s have different requirements; they must acquire controlling interests so they cannot take this route. I’d imagine somebody has thought this through.

Disrupting the IPO process to enable a long-term focus rather than short-term financial shenanigans seems worth the risk of innovation, though the risk of blindly betting on an acquisition should not be underestimated.

SCH has the potential to grow into a Y-Combinator like entity for mature companies; the premier go-to place for firms that need an exit but don’t want the hassle and expense of a regular IPO. If so, it’s shares are a chance to buy into a Berkshire-Hathaway at $10. Or it can end up like DJSP. While Stern’s demise was spectacular — everything he does seems to be large — SPAC’s do tend to historically underperform. Still, given Palihapitiya’s reputation and history, I’d bet on the former. But his management team must remain wary to ignore demands from the inevitable parasitic “activist investors” (formerly and more accurately known as raiders) to “derive value” with buybacks and other worthless financial gymnastics.

Shareholder Value Theory: History

In 1970 Ralph Nader led a campaign to “Tame G.M.,” in a proxy battle aiming for “social responsibility.”

The Harvard Crimson memorialized their demands. Quoting verbatim:

  • changing GM new car warranties to give more guarantees that the automobile will work;
  • improving health and safety standards for GM;
  • asking GM to “substantially increase” the number of non-white new car dealerships. At present, there are seven non-white franchises out of GM’s total of 13,000 national dealerships;
  • asking the company to meet Health, Education, and Welfare Department anti-pollution standards before the 1975 HEW deadline and to devote more research to study other pollutants in the environment;
  • requiring GM to develop a car by 1974 that can crash into a wall at 60 m. p. h. with no injury to the occupants. The National Safety Bureau has already designed such a car that works at 47 m. p. h.;
  • enlarge GM’s Board of Directors from 24 to 27 seats, adding three representatives of the public;
  • change the GM charter to restrict the corporation to operations which are not “detrimental to the health, safety, or welfare of the citizens of the United States…”;
  • set up a “shareholder’s committee” to study GM’s impact on the country, including an assessment of its efforts to produce pollution-free engines and safe cars, its effect on national transportation policy, and, in general, the manner in which it handles its economic power.

In response to-be Nobel Laureate Milton Friedman, thought leader of the Chicago School of Economics, wrote a scathing article in the New York Times. I’ve already detailed the article and will not repeat the core criticisms except to focus on one … noncustomer demands balanced against shareholder value.

Friedman begrudgingly admits that “social responsibility” and business practices that eventually increase share price sometimes align. “… it may well be that in the long-run interest of a corporation that is a major employer in a small community to devote resources to providing amenities to that community… That may make it easier to attract desirable employees, it may reduce the wage bill or lessen losses…” He then goes on to label these moves “hypocritical window-dressing because it harms the foundations of a free society.” He backs off telling companies to avoid these moves because “that would be to call on them to exercise a ‘social responsibility!'”

Let’s think about a world where GM ignored Friedman and listened to the reformers.

In our mythical 1970, after expanding their Board of Directors, GM decides to focus on several key areas of competition:

  • Quality & Reliability. Quickly realizing that the cheapest way to extend a warranty is to build more reliable cars, GM tasks their talented engineers with vastly improving reliability. Those engineers find a well regarded expert working in far-flung Japan, W. Edwards Deming, and convince him to come home and apply his methods — that were vastly improving the quality of Japanese products — to GM plants.
  • Safety. GM’s theoretical 1970 safety initiative finds that baby boomers, their largest up-and-coming customer group, prefer safer cars. There is a reason Ralph Nader’s book, “Unsafe At Any Speed,” became a bestseller. GM finds that safer cars cost slightly more to build but provide a competitive advantage and buyers are willing to pay considerably more.
  • Pollution. In 1970 American cities were choking with smog. Los Angeles was especially disgusting. Below is a photo of Los Angeles from that time and a more recent photo.åÊPollution was more than a social concern: it was a quality of life issue, a classic commons problem that Milton Friedman no doubt understood could not be solved with traditional market forces. GM’s early 1970 low-pollution cars sell well in car-crazed LA, a traditional trend setter that pushes them to the rest of the world.

  • GM makes an effort to train and launch dealerships with African American and Hispanic owners. They realize 7 out of 13,000 minority-owned dealerships, .054%, is ludicrously low. GM quickly realizes dealerships owned by African-Americans, staffed by non-racist salespeople, are more likely to be frequented by African-Americans. They sell more cars. Dealerships owned by Hispanic Americans hire Spanish and English speaking salespeople: they also sell more cars.

Every one of these “social responsibilities” that Friedman — and, by extension, followers of Shareholder Value Theory rail against — would have been, in hindsight, moneymakers. The inverse is also true; GM ignored these areas and their business was decimated by Japanese and German automakers.

Friedman’s assertion that “social responsibility” is nonsense is, in itself, nonsense. Despite that Friedman’s view became and, in large part remains, a dominant view it is simply wrong. In hindsight, had GM adopted these demands the business, and the shareholders would have been healthier wealthier. There is oftentimes no genuine conflict between shareholder value and social responsibility. Indeed, the opposite can be true: fulfilling social responsibility can increase shareholder value.

Original Shareholder Value Article – Milton Friedman to GM: Build Clunky Cars

On September 13, 1970, Milton Friedman published one of the most arguably economically destructive articles in history, “The Social Responsibility Of Business Is to Increase Its Profits,” in the New York Times. The article is available, in PDF form, for subscribers from the New York Times website.

Friedman advanced the idea that managers are agents of shareholders and that the only purpose of for-profit businesses is to increase stock price.

Managers have been debating Friedman’s “Shareholder Value Theory” for ages but nobody seems to have found the most obvious flaw from the seminal article. Milton’s sermon was directed at GM management who listened,åÊdecimating their brand, market share, and share price.

Specifically, Friedman raved against the notion that corporations have “social responsibilities” that, in this specific case, meant they should build safer, more fuel efficient and environmentally friendly cars. One can surmise this notion eventually extended, during a time when planned obsolesce was part of a business model, to quality.

In 1970, Friedman insisted businesspeople not concern themselves with issues beyond increasing shareholder value. “Businessmen who talk this way are unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades,” wrote the Nobel laureate. Implicit is the message to GM: keep doing what you’ve been doing: build clunky, crappy cars because that strategy was profitable in the past. The Times, They Weren’t A Changin’ at GM.

In hindsight Milton Friedman was, by any measure, wrong.

No serious student of business, economics, law, history, or engineering could argue that Friedman’s business analysis was correct. GM, along with other US automakers, listened to Friedman, ignored the “reformers” (Friedman’s word), and went on to build a series of truly terrible cars. Automobiles that broke, blew up, hurt people, handled terribly, and guzzled gas. These cars were uglier than a Blobfish and polluted “like a 19th century coal-fired factory,” as Wired Magazine eloquently summarized the era.

Besides building awful automobiles those “social responsibilities” that Friedman raved against were important to many baby boomers who, in 1970, were trending to be the largest consumer group. That is, to appease faceless shareholders, Milton Friedman advised that GM and other businesses ignore demands from future customers.

The result was predictable. As my mentor Prof. Robert Ayres recalls, he bought a Honda. I’m younger but remember when my father replaced the family jalopy with a new Corolla. Subaru’s became cool. Japanese cars were fuel efficient, environmentally friendly, relatively safe, and incredibly reliable. They were built by companies that took exceptional care of their workers who, in turn, cared exceptionally about their businesses and the products they build. Japanese executives must have been aware of Friedman’s theory and actively rejected the advice; they took, and continue to take, those “social responsibilities” seriously.

Did Toyota and Honda ignore shareholder value? With booming sales and sterling reputations I imagine their shareholders were pleased. How about those GM shareholders that Friedman praised for voting against exploring social responsibilities? People who purchased GM stock in 1965 — the one’s Friedman praised for voting down social policy considerations — did see their stock increase in value … in 1993. I’m not sure how that constitutes shareholder value.

Milton Friedman’s Exhibit A on shareholder value — the notion that GE must reject a call for “social responsibility” and ignore buyer demands — resulted in one of the worst business disasters in history, the gutting of General Motors.

Others have pointed out that the rest of Friedman’s theory is bunk.

First are the business executives: those who run actual businesses, something Milton Friedman never did. As detailed in this article from Forbes, Jack Welch called it “the dumbest idea in the world.” Paul Polman, CEO of Unilever, referred to followers as a “cult.” Alibaba CEO Jack Ma reminds that “customers are number one; employees are number two and shareholders are number three.” Marc Benioff, founder and CEO of Salesforce, added it is “wrong .. the business of business isn’t just about creating profits for shareholders.”

Great business executives care about social issues. Apple CEO Tim Cook famously told an analyst, when questioned about Apple’s use of renewable energy, “I don’t consider the bloody ROI,” adding that Apple does “a lot of things for reasons besides profit motive. We want to leave the world a better place than we found it.” Google’s founding motto was “Don’t be evil.” They eventually dropped that because it set the bar too low. Facebook actively works on connectivity for poor countries. Well managed businesses are menschkeit, taking care of their customers, employees, and communities while earning a lot of money for shareholders. Lesser businesses, or those driven by short-term activist shareholders, are parasitic, milking their customers, employees, and the organization itself dry until there is little left for shareholders or anybody else.

Legal experts explain that Friedman’s theory, that managers are agents with a responsibility to increase stock returns, is outright wrong. Lynn Stout, distinguished professor of corporate and business law at Cornell Law School, argues Friedman bungled the law; managers are legally not agents of shareholders. She wrote a book on the subject, The Shareholder Value Myth. Prof. Stout writes “the idea of a single shareholder value is intellectually incoherent. No wonder the shift to shareholder value thinking doesn’t seem to be turning out well — especially for shareholders.”

Shareholder Value Theory remains alive and well. Michael Jensen and William Meckling published a 1976 article, “Theory of the Firm,” that repeated the myth managers are agents of shareholders. Despite that by 1976 GM’s struggles were apparent, and that one would think the question of agency is for lawyers rather than economists, their paper became and remains one of the most widely cited in academic literature.

Buybacks (or Corporate Suicide)

Prof. Robert Ayres asked me for help with a data project examining the relationship between buyback and growth in market value. Many have studied the effect on buybacks but rarely on overall market cap growth.

What we found was surprising.

Some items that pop out:

Sears spent $6.92 billion buying stock. The company is now worth $729 million. Over the past five years their market value has contracted by 87 percent.

HP is now worth $30 billion. But HP spent $81.56 billion buying their own it’s stock. The company has contracted 25 percent in market value in the past five years.

Xerox spent $8.6 billion; it is now worth $7.2 billion. The market value contracted 30 percent over the past five years.

Click here for Prof. Ayres thoughts.

Here is a working copy of the paper:

See also: Original Shareholder Value Article – Milton Friedman to GM: Build Clunky Cars