Do the dynamics of control allocation affect the firms’ performance? Do firms with Dual Class Security Voting Structure (or Multi-Class) tend to perform better than firms with the traditional security voting structure?
Dual class share structure (‘DCS’) is the separation of voting rights from economic rights. DCS structure allows the creation of a gap between the voting rights and economic rights associated with the stock. This wedge allows the founders to issue different classes of shares (usually two), each having the different number of votes per share. Such a structure allows entrepreneurs-founders to have control over the management decisions while raising capital from the public. The debate over the desirability of DCS structure got rejuvenated with the Snap Inc. announcement of Initial Public Offer where it decided to issue shares with no voting rights. The debate has always focused on whether to allow such structure or not. The ‘One-Share, One-Vote’ principle is optimal and is the dominant view in business literature. However, with the advent of more technology-driven firms, the DCS structure is increasingly gaining the approval of entrepreneurs and founders as it allows them to retain control over the management which, in turn, allows them to nurture the firm with more freedom and it also prevents the firm from unwanted hostile takeovers. However, DCS structure comes with some governance issues which has been identified in many studies. For instance, it is found that as the wedge between the voting rights and economic rights increases, there has been increase in the private benefits extraction and more value-destroying acquisitions.
This article would analyse the desirability of DCS structure and would examine its impact on the performance of the firm. At last, the feasibility of the sunset clause would be discussed.
WHY DUAL CLASS SHARE STRUCTURE?
It is argued that the rights of founders of a company are associated with stocks returns, valuation and the firm’s performance. The primary argument in favour of the dual-class stock is that ‘corporate control’ allows the entrepreneurs and founders to pursue their long-term vision, free from short-term market pressure.
In a letter to its investors at the time of Initial Public Offer (‘IPO’), the founders of Google expressed:
“The standard structure of public ownership may jeopardize the independence and focused objectivity that have been most important in Google’s past success and that we consider most fundamental for its future. Therefore, we have implemented a corporate structure that is designed to protect Google’s ability to innovate and retain its most distinctive characteristics. We are confident that, in the long run, this will benefit Google and its shareholders, old and new”
Some proponents of DCS profess that the structure ought to be allowed in the light of the fact that if not, the DCS firms would be left to the impulses of incompetent and uninformed shareholders. An extremely suitable example is that of Mark Zuckerberg, who owns 28.2% of equity capital but has 53.3% of voting rights. When the decision to acquire Instagram for $1 billion was taken by Facebook, Instagram had 13 employees and zero revenue whereas it is now valued over $100 billion which is a hundred times greater than the cost price. Had Mark Zuckerberg consulted the board, the proposal might have got rejected. Goshen and Hamdani have observed that “entrepreneurs value control because it allows them to pursue their idiosyncratic vision, thereby possibly producing above-market returns.” From the economists’ point of view, two people with common knowledge about past events must hold the same view concerning the likelihood of future events and thereby producing above-market returns is very unlikely. However, an entrepreneur and an investor could have different views about investments and this difference of opinion might frustrate the long-term vision of an entrepreneur (ability to gain above-market returns) and only recently economists have gradually started recognizing the pursuit of above-market returns. In the opinion of Raghuram R. Rajan, “To create, the entrepreneur has to go out on a limb, distinguishing herself from the rest of the herd of potential competitors and thus potentially earning sustainable profits”.
Dual Class Share Structure is also being seen as a defence against a hostile takeover. Such structure allows them to grow without any potential threat of their vision being outweighed by the short-term market participants. In an empirical study conducted by Jarrell and Poulsen, they concluded that consolidating control in the hands of insiders, shields them from removal by a hostile takeover. This is evident from the fact that the average age of a DCS firm is 12.86 years which is higher in comparison to a single-class firm whose average age is 9.6 years. As per Gompers’s, this results from resistance against the takeover in the case of DCS firms.
Apart from the above justifications to allow DCS, it is also argued that the relationship between the founder and the investor is a matter of contract and it is upon the discretion of parties to dictate the terms of the contract and investors can always choose not to invest if they dislike the bargain. Such a structure should be allowed if it does not violate law and policy.
DCS AND ITS IMPACT ON FIRMS’ PERFORMANCE
The questions related to DCS and its implication on firms’ performance have been raised time and again in business literature. However, findings on the impact of Dual Class Stock on the firms’ performance have been unconvincing. In a study conducted by Martijn Cremers, Beni Lauterbach and Anete Pajuste, it is documented that in the early years after IPO, the dual- class firms tend to outperform single-class firms, usually for 7 to 9 years. Another comprehensive evidence that dual-class firms decline in valuation as they mature is presented by Hyonsoeb Kim and Rony Michaely. Above findings are complemented by Ritter’s finding that the market usually misprices the IPOs and investors may have trouble pricing DCS. It is also noted by Ritter that “if the prices investors pay for IPOs fully reflect differences in corporate governance, then all else equal duals and singles will not exhibit long-run abnormal returns.” It is conclusive from the above observations that the mispricing of IPOs is what causes firms’ over or under performance in the long run. The decline in value, after some time, of DCS firms is caused due to correction in pricing errors. In a study, it is found that the firms with dual class share structure tend to have 13% higher valuation, at the time of IPO, than single class firms, on average. However, it is also noted that with time, the valuation tends to decline and consequently starts trading at a discount relative to comparable single class firms about six to nine years after the IPO. (Refer to Figure 1 and Figure 2). Figure 1 presents the higher valuation of DCS firms at the time of IPO and their performance in the first 5 years and Figure 2 presents waning in their momentum. This data complements the findings of Martijn Cremers, Beni Lauterbach and Anete Pajuste.
On the other hand, there are some studies which document that the DCS structure, in reality, benefits the firm in enhancing shareholders’ wealth. For example, it is argued that the market is efficient to price the Dual Class Stock at the time of IPO by taking into consideration ‘Potential Benefits’ and ‘Potential Costs’ associated with the stock and investors can always choose not to invest in the Dual Class Stocks.
Some researchers have found the Dual Class recapitalization to be value-enhancing for shareholders. It has been noted that the value of stocks upsurges by 23.11 % following the announcement that the firm is opting Dual Class Security Structure and upsurge can go as high as 52.61% for the firms that issue securities.
Apart from above two contrasting views, some studies present that DCS structure neither increases nor decreases the firm’s value or performance. CII Research Analyst concludes “multi-class equity, measured by the percentage of the company’s vote controlled by holders of superior-voting shares, does not affect ROIC, positively or negatively”. Jog and Dutta[i] have concluded that cash flow and the difference in voting rights does not lower the value of firms relative to those with traditional voting structure.
Experts have contended that ‘potential benefits’ and ‘countervailing efficiency’ associated with dual class share structure tend to recede with time and eventually disappear.[ii] For example, in the case of Viacom, in the 1990s, the company came up with DCS structure which allowed its founder, Sumner Redstone to hold approximately 79% of voting rights while having around 10% of equity capital. Sumner Redstone, the controlling shareholder, might, at that time, have had the skills and acumen to take the company forward but as argued ‘potential benefits’ associated with dual class stock tend to recede over time and something similar happened in the case of Viacom. In 2016, Viacom CEO filed a lawsuit against Redstone stating “he is mentally incapacitated and has been unduly influenced by Shari Redstone”.
Another governance issue that comes with DCS structure is ‘Entrenchment’. Numerous investors consider the potential costs of the structure, which are believed to rise with time, and contend that the DCS structure brings about entrenchment and poor long-term returns. Entrenchment refers to the situation when the board gets the power to exploit the firm’s resource for its private benefits. The ‘wedge’ created by decoupling of voting rights from economic rights gives birth to ‘Agency Cost’ which is believed to rise with time. It has been documented that the DCS structure consolidates the agency cost of the firm which is being controlled by managers having low equity capital and of the firm regulated by a manager who is free from influence of other shareholders.[iii] Such structure makes the controlling shareholder unaccountable and untouchable. This is evident from the social networking giant, Facebook’s stock structure which provides its founder Mark Zuckerberg absolute control over any decision. Troy Wolverton says “No matter how poor a job Mark Zuckerberg has done lately running Facebook, he’s almost certainly not going anywhere, because he’s effectively his own boss”. According to a person familiar with the matter related to Zuckerberg’s decision to acquire Instagram, “The Board was told, not consulted”.
Therefore, it can be said that the studies on the relation between firms’ performance and DCS structure are inconclusive so far, and the argument that DCS enables the founders to pursue their long-term vision does not appear to be a satisfactory ground for justifying the everlasting DCS structure.
In short, it is submitted that DCS enhances shareholders’ wealth for six to nine years post IPO and it is beneficial to new age firms such as technology firms and data firms as it acts as an anti-takeover device and encourages controlling shareholders to pursue their long-term idiosyncratic vision. However, after a fixed period, such restricted security structure must be approved by shareholders to continue.
SUNSET CLAUSE: IS THIS THE SOLUTION?
DCS structure is often justified by superior leadership skills and acumen of controlling shareholders but as argued by Bebchuk and Kastiel and evident from the case of Viacom and somewhat Facebook as well, these superior leadership skills tend to erode over time. Therefore, in order to strike a balance between the proponents and opponents of DCS structure, Professor Bebchuk and Kastiel recommend the inclusion of a time-based mandatory sunset provision in the certificate of incorporation of a firm. This provision provides for the sunset of the DCS structure after a fixed period Robert R. Jackson presents (See Figure 3) that the firms with a sunset provision tend to outperform those without it. The study shows that firms with sunset provisions show valuations notably higher than those with perpetual DCS structures after 7 years since the IPO. A large number of studies, Council of Institutional Investors and other institutional investors have recommended the inclusion of a mandatory time-based sunset clause which gets triggered automatically after a fixed period of time which will unify the shares with superior voting with standard shares (unless minority shareholder vote to extend the DCS structure).
On June 27th , 2019, SEBI approved the framework on Differential Voting Rights. The framework has adopted two facets of sunset clause:
- Time-Based Sunset Clause
- Event-Based Sunset Clause
SEBI’s framework, as per para 4.2.5, has identified the period of 5 years when the sunset should get triggered unless extended by shareholders (SR Shareholders would not be permitted to vote) once for another term of 5 years. Para 4.2.6 enumerated the situations in which sunset gets triggered.
However, with the sunset clause, comes the apprehension of premature unification of shares. It is argued, by opponents of Sunset, that the absence of mandatory time-based sunset clause averts the sub-optimal and forced unification of shares which may prove to be value- destroying. Since the nature and characteristics of various firms differ in many aspects, it is a challenging task to identify the time-period when the sunset should get triggered.
In the light of the above discussion, it is submitted that the inclusion of Sunset Clause should be mandatory for the listing, as a DCS firm, as inclusion of Sunset Clause enhances the Corporate Governance and Investors’ confidence in the firm. It is proposed that, for DVR framework to be successful, there is a need to align corporate control with the founders’ vision. There is a need to strike a balance between the founders’ freedom to pursue the ‘idiosyncratic vision’ and investors’ protection.
[i] Vijay et al, Impact of Restricted Voting Structure on Firm Value and Performance, 18(5) Corp. Governance – An Int. Rev. 415 (2010).
[ii] Lucian A. & Kobi Kastiel, The Untenable Case of Perpetual Dual Class, 103 Va. L. Rev. 585 (2017).
[iii] Henrik Cronqvist and Mattias Nllsson, The Agency Cost of Controlling Minority Shareholders, 38 J. Fin. & Quant. Ana. 695 (2003).
The author is a IV Year Law Student at RMLNLU, Lucknow.
Illustrator: Manny Francisco