By Shawn Tully
February 22, 2017

Making money on Snap stock increasingly figures to be a long shot, not a snap.

Analysts and pundits have been rightly warning about numerous dangers lurking in the upcoming public offering for the parent company of popular photo-sharing app Snapchat. Among the most worrisome are the company’s $676 million in negative cash flow for 2016, and a super-voting rights arrangement allowing Snap’s co-founders to control all major decisions while owning just 19% of the shares.

Here’s another obstacle that’s been mostly ignored: The Big D. Looming dilution of Snap’s stock will force investors to share a lot more of their profits with CEO Evan Spiegel and his lieutenants in the years ahead, because the company plans to reward them with huge grants of shares.

In its most recent SEC filing for its IPO, dated Feb. 17, Snap announced plans to raise approximately $2.3 billion by selling 153 million shares to the public, in an offering underwritten by a group of banks that includes Goldman Sachs, JPMorgan Chase and Morgan Stanley, at between $14 and $16 a share. After the IPO is completed, Snap reckons that its shares outstanding will total 1.187 billion.

But the prospectus also reveals that Snap is making a series of large equity grants to its co-founder, employees, consultants, and even its own foundation. Those awards are “excluded” from the official grand total of over 1.1 billion shares because they haven’t yet vested and hence been exercised, but they will add hugely to the share count, starting as early as this year.

In fact, Snap’s extreme generosity to employees has already swelled the existing share count. In 2016, it awarded 105 million new restricted share units (RSUs). All of those units, plus around 80 million awarded in previous years, will vest with the IPO. Those grants will represent one in six of Snap’s shares. At $16 a share–the estimated high end for the price paid by the underwriters–those grants will enrich its 1,859 employees by $2.9 billion, averaging $1.5 million per person, although the rewards are, as usual, heavily skewed towards the top brass. And that’s just a taste of what’s coming.

Here’s a summary of the grants in the pipeline. Snap is awarding 230 million options and RSUs under a new comp plan and expansion of earlier programs. Thirteen million shares are earmarked for donations to the “Snap Foundation” over “a period of 15 to 20 years.” Another 2.5 million shares are reserved for “employees and consultants in France.” The biggest windfall goes to co-founder and CEO Spiegel. He’ll receive a grant of approximately 37 million shares (worth almost $600 million at $16), no performance requirements attached, that will be distributed over three years. The grand total of new shares arising from these awards: approximately 270 million. And almost all of that dilution should hit in the next three to four years.

What does the Big D mean for investors intrigued by Snap, and its thriving flagship Snapchat? Let’s say you’re expecting 10% annual returns from Snap–a reasonable target, since this is an extremely risky investment. If Snap opens at $16, its market cap will stand at around $18.5 billion. Over five years, its stock would need to gain 61%, or rise from $16 to almost $26, to deliver a 10% annualized return. But its market cap will need to grow much faster than 10% a year, because far more shares will be outstanding.

As the prospectus reveals, 270 million new shares are about to swell the float (that’s excluding part of the shares going to the foundation over an extended period). So by March of 2022, Snap will have at least 1.46 billion shares outstanding. That means its market cap would need to rise from $18.5 billion to $38 billion, or more than double. To justify that kind of market cap, at a towering P/E of 40, Snap would need to earn around $950 million in 2022. At a Google-sized margin of net income to revenues of 33%, it would need sales of almost $3 billion. That means growing sales 48% a year from the current level of $404 million in 2016.

All of this assumes that the projected dilution stops at 250 million new shares. If Snap is successful, the count is likely to reach far higher, since (according to its prospectus) it has reserved an additional 372 million shares for possible equity grants in the future that will be awarded and vest if the stock price rises and management hits benchmarks for performance. And don’t forget that this glamor stock could surge past the underwriters’ price of $16, handing big gains to their institutional customers, a favorite Wall Street tactic. If that happens, members of the investing public who buy at a higher price on the post-IPO market will be starting their adventure in an even deeper valley.

Many tech icons, from Facebook to Google, started as public companies with market caps so gigantic that growing into them seemed highly unlikely. Yet they proved great investments. It’s easier to believe, to love the product and bask in the excitement, than to be convinced by the numbers. Still, for Snap, the Big D may be the downer no investor should ignore.

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