On a personal note – Dissonance and Incongruence
My education and formative work years have been in India. There, the capital markets are big, active, IPOs are popular although a difficult and complicated process, and the regulator is strong, with regulations ensuring protection of retail investors. India, however does not allow dual-class shares for listed companies (After further research, I need to add some more colour to this statement. There are DVRs or Differential Voting Rights shares which were allowed from 2001 onward in India. But only a few companies (four) actually used that option. And then again in 2009, the regulations have been changed. India does not allow any more DVRs for listed companies(?). And the ones that are already trading seem to go in and out of favour with investors).
My personal fairness compass finds the concept of dual-class shares with different voting rights quite questionable. I believe that owners of equity are eventual owners of company, and it needs to be a fairly democratic process for all owners in a listed company. Less rights should come with a corresponding benefit (say, preference shares instead of equity so at least they are superior on liquidation waterfall). There is an unevenness or dissonance in calling them equity, and treating them as equity but not giving them equal votes.
This post is my way of trying to understand the picture and the reasoning of dual-class shares better.
Defining Dual-Class Shares (DCS)
The term dual-class stock or shares is normally referred to two or more classes of equity shares of the same company – difference mainly being in the voting powers attached to each class. Often, the class for insiders/founders has significantly higher voting power than the class of shares issued to the general public which may or may not have nominal voting rights. The difference can be significant, often allowing founders with small, minority economic interest a controlling decision-making power in the company. All good in a private company where the shareholders can have an inter-se agreement, but in a public, listed company, courting retail investors, the disproportionate votes can easily become a matter of debate.
The roots and history
Dual-class shares are not a new concept. They have been around for a long time now.
The first company to issue such shares was in 1898, International Silver Company*. After which 1920s was when it gained more popularity in the United States. And during the same decade, given concerns over control of company by minuscule shareholders (Dodge Brothers IPO being case in point), NYSE began to discourage such issues. But there were other exchanges which did allow dual-listing. During 1980s, with increasing competition between exchanges and increasing demand by companies for dual-class shares to protect themselves against hostile takeover attempts, NYSE joined the other major exchanges to allow Dual-class listing.
During the last century, the companies that issued dual-class ordinary shares were either in sectors such as media where they wished to retain integrity (and not be in control of the money), or companies trying to discourage hostile takeover attempts, or family controlled listed companies.
But since 2004, since Google’s IPO, the structure of dual-class shares is being used by many more early stage, loss-making, long term strategy pursuing tech companies that do not want any short-term interference in the pursuit of their stated vision and decision making.
Effectively, those companies which could have stayed private for longer, but they decide to list, to raise money from public markets, and not give commensurate equity rights to the new shareholders.
The two sides of the debate
As I begin to look up the discussion on DCS, I realize that I’ve stepped into a long-standing debate. Because the sense of fairness it challenges is not mine alone. A simple google search will reveal scores of papers and discussion on why or why not dual-class shares, and what they imply for the company’s performance, or the company’s stock’s performance.
Why do founders/ insiders want superior voting rights? To control the direction of the company. To execute a long-term vision (when short term results might push shareholders to seek new management). To detract hostile takeover. To maintain the editorial independence of their products (media).
The why not of Dual Class Shares is perhaps more clear. That all equity should be at the same footing in a listed company. If people need extra powers, then they should contribute with extra capital commitment, or something else, say, go down further in the liquidation waterfall. Another reason is that these rights can be misused. And one of the biggest controversy is around transferable, perpetual rights.
Another personal note – what works in private may not in public
For a little bit more context, I must also add here that all my working life, I have negotiated for superior rights or veto rights or decision-making rights for private equity investments. But the key difference is that where I have sought those minority protection rights, most companies are closely held, and are private, with the key other shareholders being the founders. The investors are not founders. And the rights protect their minority interest. That may not sound democratic and very well so – the rights are an outcome of a negotiated contract or agreement between shareholders of a private company. And all the parties get to have their say, negotiate and agree before the terms can be put in place. The moment those companies go public, and get a wider base of shareholders, the rights generally fall away and equity gets democratic.
So where the private investor in a private company gets to negotiate and agree to the value and rights, the only say that the external investors in listed companies get is that they can choose not to buy (at the quoted price and the disclosed voting rights).
So what works in private companies and private ‘sophisticated’ investors does not really work in public listed companies with external investors ranging from retail investors to institutional investors without really any ability to negotiate for their rights. The investors in public companies rely on their votes, and the regulatory environment, corporate governance standards, and in certain countries and in certain cases, legal recourse.
Even as the debate rages on, one thing worth considering is that until recently, the dual-class represented market cap in the world was minuscule. However, as tech stock themselves become the cornerstone of global equity markets, dual-class stocks share in the market is increasing at an unprecedented rate.
Ritter (2018) illustrated that 200 of 3,046 (6.6%) of the technology IPOs between 1980 and 2017 in the United States—and 498 of 5,314 (9.4%) non-tech IPOs—have adopted DCS structures (see Exhibit 7). He suggested that the likelihood of technology IPOs adopting DCS structures has become higher in recent years, with 23.8% and 43.3% of the firms in the sector listing in DCS structures in 2016 and 2017, respectively, compared with 9.4% and 21.8% of those not in the technology sector. Note that Ritter’s dataset was limited to include company listings (i.e., IPOs) with an offer price of US$5 or above, while ADRs, unit offers, closed-end funds, REITs, natural resource limited partnerships, small best efforts offers, banks and S&Ls, and stocks not listed on CRSP [the Center for Research in Security Prices] (CRSP includes AMEX, NYSE, and NASDAQ stocks) were not included.
(Source of Data: Dual Class Shares: The Good, The Bad and The Ugly pg 35, 36 (they source it to Ritter, 2018))
The point which is worth noting from above is the gradually increasing volume of new shares being issued with DCS structure. Where earlier, DCS was more of an exception, gradually, more and more new shares are embracing this structure.
The key stakeholders in this fundamental question
The debate is at a level, quite fundamental and brings up questions around what is right corporate governance, and who gets to say what. There are many parties- founders, investors, the companies act (or corporation act), exchanges which list companies and have their own regulations and listing rules, and then the regulators themselves (for example, SEC).
Since the direct impact is on Exchanges (loss of revenue if companies decide to list elsewhere), founders (superior rights sought if allowed), and investors (who don’t really get to say anything, they are more takers of what gets decided), it is mainly the exchanges and Founders/ Insiders that get to really choose and act. Indirectly and over time, of course, every other party gets affected and gets a say (introducing better governance rules).
Since it is the founders and exchanges which get a say, a quick look on what’s happening there.
Amongst founders, we know that since Google, a lot many companies have come up with disproportionate voting pref shares (Facebook, Snap, Alibaba, Box, Square and then, Viacom, Underarmour, Berkshire Hathaway – the CII website can lead to a complete list).
“These structures have been very controversial. Whereas some countries such as the United States, Canada, Sweden, Denmark and the Netherlands have allowed the use of dual-class shares, other jurisdictions such as the United Kingdom, Singapore or Hong Kong have prohibited or strongly discouraged companies from going public with dual-class shares structures. ”
Eventually, exchanges are also corporate bodies seeking revenue growth. When companies like Alibaba ( US’s largest IPO, raising $25 billion), choose NYSE over HK, debates get raised. And Alibaba is just one of many such companies. Then there is a whole economy of service providers which get a say. HK and Singapore brought out discussion papers. And other exchanges are considering too.
After losing the Alibaba IPO, HK stock exchange contemplated dual-class listings. And so is Singapore.
“In Hong Kong, after frustrations following Alibaba’s choice of NYSE as a listing venue in 2014, HKEX was finally able to amend its listing rules in April 2018 to allow companies to issue shares with unequal voting rights. Xiaomi Corporation, the world’s fourth-largest smartphone maker by shipment, was listed in early July 2018, making it the first DCS IPO listed on the SEHK since therefrom.”
(Page 39, “Dual Class Shares: The Good, The Bad and The Ugly” by CFA Institute)
It is not just HK and Singapore. All over the global capital markets where dual class listings are not allowed, the advisor and service provider group and even investors who wish to participate in such issues for the economic returns irrespective of the voting rights are creating enough noise around opening up the respective exchanges to Dual Class listings. Be it Australia (Listing rules require one class of ordinary shares unless ASX approves terms of additional class), India, China or Tokyo.
Hence, over time, the debate itself has shifted. Where until a few years ago, the discussion was around whether dual-class stocks or not, now the discussion has shifted to how DCS?
Looks like DCS are here to stay. Founders, service providers will be requesting for them and more and more exchanges will perhaps eventually allow them. Hence, if they are here to stay, the focus is on how to put in enough safeguards to make them equitable and fair (or less inequitable, and less unfair).
There is a whole host of suggestions and discussion around corporate governance of DCS companies, but the key one is around making these shares as a temporary solution in the company or a temporary phase in the company’s life rather than a permanent outcome.
For this, rules seeking provision of a sunset on such superior shares. The shares should revert to normal after a time period (such as 5 years or 10 years), assuming that they are needed because the company is going through early stage growth phase. Once the phase changes, so should the powers. Or sunset in case the shares get transferred from the visionary founder to someone else. Or if the visionary founder is not there anymore, and all such similar changes in situation which caused DCS in the first place. Then there is a set of other means of trying to ensure that there is no misuse.
The idea is to make such listings exceptions rather than rule. Exceptions for certain companies in certain sectors and for certain phase in their growth curve, ensuring that over time, they too revert to ‘one share – one vote’.
* Reference materials
For this post, I have referred to several links. But the material I found most useful and relevant are:
- An excellent resource is the comprehensive review “Dual- Class Shares: the good, the bad and the ugly” by CFA Institute.
- Council of Institutional Investors (CII) Website. They represent about $3 trillion of funds and investors.
Both the CFA institute and the CII believe in better standards of Corporate Governance than what DCS make possible.
There are several other online articles which a simple google search should reveal.