Beware of Facebook’s New C Class?

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Everyone said, “Facebook’s Class C stock is no big deal, don’t worry about”. To the average shareholder, it means more stock. Every Class A and Class B shareholder, receives Class C stock as a dividend. And then there are three: three classes of stock. Only founders and venture capitalists should really care.

Since going public, Facebook used stock in part to acquire three companies: Instagram, Whatsapp, and Oculus. For example, Facebook used Class B stock and cash to get Oculus back in 2014.  The advantage of Class A or B stock to the seller – founder or venture capitalist – is any taxes on the deal are paid later, not now. This is not the case with non-voting stock, such as the Class C stock.

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When voting stock is used, taxes can be delayed. This occurs when the buyer (Facebook) exchanges its voting stock for the assets or stock of the seller (Whatsapp, Instagram, or Oculus). When the non-voting stock is used, there is no tax deferral. So if you want to do the deal, you may need to find another way. And if you can’t, maybe the deal does not get done. Facebook said the following:

Sellers may have a preference for a transaction in which they can defer taxes owed, in which case we may have to structure the acquisition in a different manner or may be precluded from using shares of Class C capital stock to fund the acquisition.

Think about, if Mark Zuckerberg really wants another company, then he may need to issue more Class A or Class B stock. That gives more voting stock to others, as was done with Instagram, Oculus, and Whatsapp. This would defeat the purpose of the Class C stock: maintaining voting control for Mark Zuckerberg.

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Like Facebook’s New Higher EPS

 

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Facebook now thinks stock-compensation is important. Because of stock-compensation’s importance, Facebook will emphasize GAAP over non-GAAP results.  On a recent earnings call, Facebook CFO Dave Wehner declared

“Stock-based compensation plays an important role in how we compensate our employees and therefore we view it as a real expense for the business.”

Facebook must focus on stock-based compensation, not because it wants to, but because it must.  Under new accounting rules starting next year, all public companies must change the reporting of stock-based compensation for financial reporting purposes. Tech companies that use a lot of share-based compensation, the new rules may change amounts reported for net income and consequently earnings per share or EPS.

Going, Going, Gone.  In some situations, EPS is going up, but not for the reason you think. Earnings per share is just that, a comparison of  a company’s earning to its stock outstanding. Earnings are also known as net income and Facebook’s net income could be changing. Next year, public companies must include in net income items, which in some circumstances, increase net income and increase EPS.

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EPS represents the amount of net income you own as a shareholder. In this view, the shares of stock are not pieces of paper, but an actual company. In fact, shares are a fractional interest in the business and here, you own an interest in Facebook. EPS compares the amount of net income to the number shares outstanding. A company can increase EPS by either decreasing the outstanding shares through buy backs or by improving net income.

Bottom’s Up. Facebook’s EPS may automatically increase under  the new rules. Before going further, consider what would have happened if Facebook had use the new rules over the past five years. If that had happened, Facebook’s basic EPS would have increased 30% or more over the past five years (see below). For instance in 2012, instead of a basic EPS of $0.02, the figure becomes $0.97. For last year, instead of a basic EPS of $1.31, the figure now becomes $1.92.

Employee compensation is an expense for financial reporting purposes and a deduction for tax purposes. Tax deductions reduced expenses and increase net income. If the tax deduction increases, the amount of net income increases. When stock-based compensation is granted, companies must estimate the deduction for tax purposes. Often the final tax deduction can change from the one estimated, and under the new rules, can cause more net income.

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Cha-cha, Changes. A company has more net income when the change is more than the tax amount originally estimated. That can happen when the stock price increases from the granted date of a stock option and to the date the option is exercised. For restricted stock, it is the time between the grant date and the date the stock vests.  If the stock price increases, the tax deduction is higher than expected. The extra deduction amount will now be reported as net income under the new accounting rules.  $1.7 Billion was the extra-amount for Facebook in 2015.

For Facebook, the amount is large due in part to Facebook’s success and its use of stock-based compensation especially in acquisitions. For example, Facebook issued 46 million restricted stock units (RSU) to Whatsapp employees in October 2014 which vest over a period of three year. So sometime between now and October 2017, Facebook’s net income could be impacted by those RSUs and the new accounting rules.

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