Weekly Puzzle #2: Dual Class Shares, Boon or Bane?
The essence of buying shares in a publicly traded company is that you are part owner of the company, entitling you to your share of the cash flows and your share of the control. While it is true that your shares in large publicly traded firm may not give much more than a miniscule share of cash flows and control, you are still getting your fair share of both. This is true, however, only if all common shares are equal, both in terms of dividends and voting rights. While that has historically been the case in the United States, there has been a troubling move away from this norm, especially with young technology companies. These companies, following Google's lead, have adopted the practice of giving the founders a class of shares with disproportionately large voting rights, while issuing shares to the public with diluted or no voting rights. While Silicon Valley, with its fixation on Founder Worship, feels that this is appropriate, it raises questions for the rest of us in terms of corporate governance.
For decades, US companies steered away from issuing dual class shares for a simple reason. From 1926 to 1985, the New York Stock Exchange (NYSE) required companies listed on the exchange to issue shares with equal voting rights, though it grandfathered in some companies (like Ford) that had given higher voting rights to some shareholders. Since every successful company, for much of the twentieth century, saw success as being traded on the floor of the NYSE, this served as sufficient incentive for one class of shares. Thus, the tech start ups of the 1970s and 1980s (Apple, Microsoft and Intel, for instance) all had one class of shares. That discipline started to fray in the 1990s, as companies increasingly became comfortable with a NASDAQ listing and the exchanges themselves, including the NYSE, started loosening restrictions on different share classes to compete to get listings. Outside the US, the rules on dual class shares diverge widely. At one extreme, there are many countries, like India, that do not allow shares with different voting rights. At the other, there are some countries, like Brazil, where dual class shares are the exception rather than the rule.
Google's Game Changer
While there were smaller companies that issued dual class shares earlier, it was Google that ultimately upended the old order when it went public in 2004. The company not only decided to bypass the traditional investment banking guaranteed offering price process for a Dutch auction but chose to issue two classes of shares - Class B that would be held primarily by Sergey Brin and Larry Page, the co-founders of the company with ten times the voting rights of the Class A shares, offered to those subscribing on the offering. (If you are interested here ist the original prospectus.) Here is what they said at the time:
Not only was the offering still a success, with investors seemingly sanguine abou their loss of voting rights, but Google's subsequent success in the market opened the door for a new generation of tech companies following its rule book, at least when it came to voting rights.
In the last five years, it is the social media companies that have played this voting game most decisively. The biggest of these was Facebook which followed the Google templste of disproportionate voting rights (thus allowing Mark Zuckerberg to control 57% of the voting rights with 24% of the total outstanding shares). In fact, Google and Facebook went further, by issuing a third class of shares with no voting rights at all. In the next few weeks, we will see the next chapter in this book, as Snap goes public. In its initial public offering, it does look like Snap is planning on doubling down and offering those who will be getting shares in the initial public offering no voting rights at all.
The Trade off
You could spent time and energy on the unfairness of it all but moral outrage is not going to get us anywhere. Instead, it is worth taking a clear-eyed look at the economics of issuing low or non-voting shares, both for investors buying these shares and for the companies issuing them.
The Founders' tradeoff: The plus of issuing tilting voting rights in favor of the shares held by founders is that it gives them control, even as they raise more capital from equity markets. Thus, it seems to provide the best of both worlds for founders, combining the unchecked power of running a private business with the capacity to raise capital of a public company. There is, however, a cost. To the extent that investors value control, they will discount the shares with lesser or no voting rights, thus reducing the capital that can be raised in the market by new stock issues (or as exchange on acquisitions). The magnitude of that discount can vary across firms, but even Google has discovered that there are limits to which shareholders can be pushed with their Class C shares trading at a discount of 4-5% on Class A shares, with a single voting right/share, which probably trade at a discount on Classs B shares (with ten voting rights/share). It is perhaps for this reason that some of the young tech companies are adopting sunset clauses on their voting right differentials, hoping that investors will start paying higher prices for their shares.
The Investors' tradeoff: Investors who buy reduced-voting right shares in companies are presumably doing so with open eyes. On the one hand, it does give them shares in a young, growth company, run by a visionary founder or founders. On the other, these shares come with very little control and if the founder(s) decides to take the company down a path that investors view as value destructive, there is not much that you can do, even as a large stockholder, to stop him or her. While some investors are quick to dismiss these concerns, arguing that founder interests are likely to be congruent with their own, they would be well served reading the horror story (for stockholders) that is Viacom, a company that has had two classes of shares, with a controlling shareholder (Sumner Redstone), and is facing an existential crisis, largely of its own making. In fact, there has been a move by some institutional investors to push back against dual class shares.
Questions/ discussion issues