Feb 3, 2017 ยท 7 minutes

Snap's IPO filing is finally here, along with a reminder to be careful what you wish for.

For much of the past year, Snap had been seen as the startup luminary most likely to revive a sleepy market for tech offerings. In 2016, 21 tech companies went public, raising $3 billion. So far this year, ten IPOs have launched, none in tech. And in January, five US companies filed to go public, down from 17 in January 2016, according to Renaissance Capital.

Then came Snap. The company that somewhat modestly, somewhat quirkily describes itself as a camera company filed confidentially to go public late Thursday. So confidential were Snap's IPO plans before then that some of its underwriters reportedly didn't even get a peek at its financials. When you are the most-sought after IPO, you can demand concessions like that.

The secret about this camera company is that it's really about keeping secrets. Spontaneous moments, the early pitch went, that can be shared without fear of having them preserved indefinitely in the Internet's unforgiving amber. Snap itself cultivated a culture of secrecy, creating a vacuum of information that some business publications filled with breathless coverage of the company.

It was as if CEO Evan Speigel had dug up the mythical Ring of Gyges, capable of becoming invisible at will. Many CEOs wish for and even strive for corporate secrecy themselves, but few have been as successful or as thorough as Speigel. In 2014, when the Sony hack revealed aspects of Snapchat's business plan, he shared a note not just expressing his anger and devastation, but offering a rare glimpse of vulnerability. “Keeping secrets is exhausting,” he said in the note. “Secrets also bring us together. We keep secrets because we love surprising people.”

The public markets are much like a public swimming pool. The SEC demands you disrobe to a certain extent before entering. Leave those veils of secrecy in the locker room. The good news is that some of this exhaustive business of keeping secrets is over for Snap. Speigel can catch up on his much-needed rest. That bad news is that Snap has yet again surprised us. This time with its financials. It's not the good kind of surprise.

Snapchat is like one of those high-pitched sounds you stop being able to hear when you get old. Because old people like me are often at a loss to understand what makes Snapchat work so well, we may have assumed the company was positioning itself to become the next Facebook. Snap's S-1 helpfully included a kind of user manual for its app, as well as odd insights like “we... poop with our smartphones everyday” – for which, um, thanks – but what really shed a light on the company was old-school financials.

The good news was Snap's revenue grew nearly sixfold to $404 million in 2016 as ad revenue began to gain traction. The bad news was that the operating loss also grew to $520 million from $320 million in 2015. You could look at those numbers and say Snap is making progress toward profitability. Or you could look at them and realize it spent $2.29 cents last year for every dollar in revenue it brought in. That's supposed to be okay because in 2015 it spent $7.51 cents for each dollar of revenue.

Of course, many growing tech companies go public with a history of losses. But that's usually because of operating costs like R&D or stock compensation for a sales staff. Snap is the rare IPO candidate that is trying to go public without much of a gross profit. Thanks to the use of Google's cloud servers to serve its photos and videos, the cost of revenue in 2016 exceeded revenue itself. 

It's hard to overstate how unusual this is among tech IPOs, let alone the coveted ones. An IPO with net or operating losses is one thing, an IPO with gross losses is another. Snap did attain gross profitability in last six months, with a gross profit margin of around 7%. Compare that to Facebook, which owns Snapchat's arch-rival Instagram, and which yesterday reported an 86% gross profit margin. Even sectors like digital music, where investors are accustomed to losses and paltry margins, are doing better. Pandora's gross margins were 36%. Groupon, that modern exemplar of a company growing revenue at all costs, filed for an IPO with a 42% gross margin.

Why the big cost of revenue? Snap may be a camera company, but that camera comes equipped with a sizable chunk of a Google datacenter. Snap said it signed on Monday– that's this last Monday, three days before the filing – an agreement to purchase at least $400 million of Google cloud services a year for the next five years. Google's cloud business surely has a gross margin well above 7%, so someone is getting the short end of the stick here.

Remember, Snap made $404 million in revenue last year. To pay Google and cover the costs of its own operations, Snap needs to keep ad revenue growing. If you believe in the revolutionary potential of Snapchat, that it's remaking how we interact all over again, that shouldn't be a problem. But Snap had bad news here as well, in what it called “lumpiness.” This is a bland bit of financial jargon used by companies that keep finding their great expectations sabotaged by gremlins. Sort of like when a fail-whale image shows up in your business plan. 

Snap's lump surfaced in a bad area at a bad time. In the second quarter of 2016, Snap's daily active users grew 17% from the previous quarter. Not bad! In the third quarter that growth rate slowed to 7%. It slowed further in the fourth to 3%. (By contrast, Facebook's DAUs grew 4%, and Facebook has seven times as many users.) Snap blamed this on technical issues related to product launches in the middle of 2016.

Fine, but when your user growth slows to the low single digits, you invoke comparisons to Twitter, which is what happened with Snap today. (Sarah Lacy drew this comparison last July.) But in deference to Twitter, Twitter is in better financial shape than Snap. Snap burned through more cash last year ($611 million) than it made in revenue. Lumps are not always benign when you're losing that much money. Snap might want to have those lumps checked out.

The corker in Snap's S-1 isn't that it's probably the first to use the word poop, or the word sexting, or to define kindness as telling someone they have something stuck in their teeth. No, the corker was reading this on page 19: “we may never achieve or maintain profitability.” That angry rumbling sound you hear is Benjamin Graham, the father of fundamental analysis, rolling over in his grave. A stock's intrinsic value is based on projections of future earnings. Say Snap's risk factor is right and it has permanent losses, how do we value Snap?

Someday, investors in Snap's IPO might want to come to a shareholder meeting and ask Speigel why the company can't make a profit. They won't be able to. Facebook and Alphabet shareholders may not have a deciding voice, but because they have voting rights, they can at least ask questions at annual meetings. Snap won't even allow this. “To our knowledge, no other company has completed an initial public offering of non-voting stock on a U.S. stock exchange,” Snap said in its S-1.

This is a worrisome precedent. Yes, shareholders have for decades neglected their voting power. Yes, tech founders have consolidated this voting power to themselves, in order to avoid battles with so-called activist investors. But there is a difference between ignoring your vote and not having a vote at all. A shareholder base is a democracy in miniature, tawdry as these democracies typically are. The next time a Snap executive decries the rise of authoritarianism or the demise of democracy, you might want to remind them to clean up their own house first.

Snap is a company with enormous promise. We have heard that a lot. We will keep hearing it in coming months. But it's a company with losses that are, by any relative measure, sobering. And by the company's own admission, this may never change. It's having trouble growing users even as it asks the public market for more money. Instagram is cloning its secret DNA to surprising effect. And it wants your money while insisting you forfeit any kind of interaction that has traditionally existed between the people running a company and the ones that share in owning it.

For investors contemplating this IPO, Snap's appeal may prove as ephemeral as, well, a snap. This is probably going to be a good ride at first, because of the allure that remains around Snap and because of the determination of underwriters to stage in 2017 the kind of high-profile, high return IPO like Netscape and Google were in their eras. Unless Snap does prove to be the next revolutionary tech company, be careful not to hang on too long.

Otherwise, well, what's the kind way to say this? Someday you might find yourself with some Snap shares stuck in your teeth.