Chewy (CHWY) is one of the more popular names to hit the NYSE in recent memory, seizing upon the obviously expanding market for pet-driven e-commerce. However, the company's peculiar stock structure could keep long-term buyers leashed.
Chewy opened at $36 on Friday, (much higher than the IPO price of $22), but questions will remain over its equity class structure that will favor controlling stakeholder PetSmart significantly over anyone entering a position on IPO day.
PetSmart in Pole Position
"PetSmart controls the direction of our business and PetSmart's concentrated ownership of our common stock will prevent you and other stockholders from influencing significant decisions," the company's S-1 states. "As long as PetSmart continues to control a majority of the voting power of our outstanding common stock, it will generally be able to determine the outcome of all corporate actions requiring stockholder approval, including the election and removal of directors."
Post-IPO, PetSmart will hang on to 70% of the shares in Chewy overall and 77% of voting shares.
Following this offering, each share of Chewy Class A common stock is entitled to one vote, while each share of Class B common stock is entitled to 10 votes. PetSmart's 278.4 million shares of Class B stock will thus remain dominant.
"PetSmart's control over Chewy should raise significant concerns for public shareholders due to the intertwined nature of the two companies," the filing warns. "Chewy sells PetSmart branded products online, and PetSmart sells Chewy's private label brands in its stores. If PetSmart continues to struggle, it may use its control over Chewy to subsidize the brick and mortar operations in a way that would disadvantage CHWY shareholders."
Meanwhile, the dual-class structure makes the stock ineligible for inclusion in notable indices such as the Russell 2000, the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600. Additionally, institutions generally stay away from investing in an entity that would offer them such little say over governance.
So, while the partnership does provide immediate scale and supply to the newly public entity, it comes with significant drawbacks in terms of stock attractiveness.
Harvard Has Qualms
Academics analyzing these arrangements have been highly critical in recent memory.
"The potential advantages of dual-class structures (such as those resulting from founders' superior leadership skills) tend to recede, and the potential costs tend to rise, as time passes from the IPO," Lucian Bebchuk, Director of Harvard College's Corporate Governance wrote in a research paper entitled The Untenable Case for Perpetual Dual-Class Stock. "Controllers have perverse incentives to retain dual-class structures even when those structures become inefficient over time. Accordingly, even those who believe that dual-class structures are in many cases efficient at the time of the IPO should recognize the substantial risk that their efficiency may decline and disappear over time."
Further, the report criticizes the nature of dual-class stock structures without "sunset" arrangements that allow for the retirement of the arrangement and a release of withheld shares to the open market. The paper adds that these companies cannot be expected to comply with proper governance or shareholder activism as they have no reason to heed criticism. Facebook (FB) CEO and chairman Mark Zuckerberg provides a strong example. The company's system of 10 votes per class B share and 1 vote per class A share is identical to Chewy's and has allowed Zuckerberg to largely ignore calls to either break up, rearrange the board, or step down from his own dual roles.
"Controllers in companies with dual-class structures pose special governance risks because they present a problematic combination," Bebchuk argues. "On the one hand, because the controller is fully insulated from the disciplinary force of the control market, this force cannot address problems of underperformance and opportunism."
For a corollary to the 2019 IPO schedule, Bebchuk authored a subsequent critique of IPO-day disaster Lyft (LYFT) ahead of its listing.
"We analyzed the costs and risks that Lyft's IPO structure generates, and we concluded that they are substantial. These problems are expected to decrease the economic value of the low-voting shares that public investors hold (and thus the price at which such shares are expected to trade)," he wrote in a piece entitled The Perils of Lyft's Dual-Class Structure. "Each of the effects that we analyzed can be expected to significantly decrease the economic value of Lyft's low-voting shares that public investors will hold - and should be fully recognized by these investors."
Similar criticisms can be laid at the feat of Pinterest (PINS) , which also sought to take advantage of the structural arrangement.
For Chewy, the disparate nature of voting power and ownership is even more pronounced than these names. As such, while investors may love their pets and getting them what they need through Chewy, investors shouldn't ignore the deal they're getting on the shares.