3 Reasons a Snapchat IPO Is a Smart Move

By Markets Fool.com

Image source: Snapchat.

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We may be close to one of the most highly anticipated IPOs of the last few years. The Wall Street Journal reports Snap, Inc. -- formerly known as Snapchat -- could make its IPO as early as March.

Snap is one of the most highly valued private companies. Its last round of funding valued the company at $18 billion. The Journal says the company is eyeing a value of $25 billion or more for its IPO.

Snap's decision to use the public market to raise capital is a smart move for several reasons. Here's a glimpse at Snap's possible rationale for its planned IPO.

Its competition is much better capitalized

Snap entered the digital advertising market just a couple years ago, and two of its biggest competitors happen to have mountains of cash on their balance sheets. Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) -- the parent company of Google -- has $78.5 billion on its balance sheet. Facebook (NASDAQ: FB) has $23.3 billion.

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For Snap to compete with the two biggest names in digital advertising, it will need to continue to innovate in both ad technology and its ad formats. That takes investments in engineers and other creatives to bring new products to market.

Snap has also shown an interest in developing products outside of Snapchat. The most recent example are its Spectacles glasses, which may act as a loss leader for Snap. Snap could also use the proceeds to help acquire smaller technology companies in augmented reality.

Snapchat's $25 billion valuation is likely its best way to raise capital at this point. The price represents nearly a 27 times multiple of its expected 2017 revenue. By comparison, Facebook's $81 billion IPO valued it at just 13.5 times its expected revenue. Google's $23 billion valuation at its IPO ended up being just seven times its 2004 revenue.

For investors, that may be a sign that Snap will be overvalued when it makes its initial offering. However, history has shown that both Facebook and Google were dramatically undervalued, and investors would have made excellent returns by investing at their respective IPO prices.

Attracting talent with stock-based compensation

Love it or hate it, stock-based compensation is an important tactic used by a lot of companies that aren't yet producing tons of cash to pay their employees. Even with their significant cash flows, Facebook and Google still use a significant amount of stock-based compensation.

Employees are much more attracted to company stock options that are traded on public markets. Not only are they able to see the exact market value of their stock holdings, it's easily liquidated if need be. As such, an IPO could help Snap attract more and better talent to its company in order to compete with the Facebooks and Googles of the world.

There's something to be said for over-reliance on stock-based compensation, though, and investors will want to pay attention to Snapchat's numbers when it releases detailed financial reports. Relying on stock-based compensation works fine if the stock price rises, but employees aren't happy when the stock declines. They're effectively getting a pay cut when that happens, and it can cause a lot of top talent to look for work elsewhere.

Attracting bigger and better customers

Becoming a publicly traded company brings an air of trust that a privately held start-up just doesn't have. Publicly traded companies are required to disclose a lot more information than private companies, and give a sense that the company is much more established -- even though there are tons of well-established companies that aren't publicly traded.

That's important for Snap considering it's going after the big fish in advertising. In fact, Snap is practically exclusively reliant on big-brand advertising for its ad revenue. Google and Facebook, by comparison, count millions of small businesses as active advertisers. Going public will help Snap open those wallets by giving the advertisers a sense of stability in the ad platform on which they're spending millions of dollars.

That's also important because Facebook has been copying some of Snapchat's best features across several of its products. The most obvious example is Instagram's new Stories feature, which Instagram CEO Kevin Systrom even admitted was a copy. The feature already has 100 million active users. If and when Instagram decides to insert ads into stories, advertisers may be more likely to buy into it because it's backed by Facebook and its well-established reputation in the digital advertising space. Snap needs to develop a similarly strong brand and reputation.

The move to take Snap public is certainly no snap decision. The company will have to disclose a lot more information as a publicly traded company, which could be beneficial to its competition. But the benefits certainly outweigh that small downside for Snap.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fools board of directors. Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.