Share And Share, But Not Alike
By Gillian TerzisJuly 17, 2012
Dual-class share structures allow some CEOs to take the money and run — run the company, that is, according to their own vision.
In May this year, Mark Zuckerberg rankled Wall Street's prickly sensibilities when he embarked on his pre-float promotion of Facebook in a hoodie and loose jeans, sporting a cavalier grin. Shortly thereafter, it became apparent — at least to journalists on the financial beat — that his languid approximation of the Unabomber was an affront to the genteel old guard of American corporate wealth. Michael Pachter, the managing director of Wedbush Securities, had no reservations about expressing his disdain, telling Bloomberg TV that the 28-year-old tech titan's casual outerwear just wasn't going to cut it on Wall Street. (It seems nascent profitability is more digestible when cloaked in a Zegna suit.) "I think he's got to show them the respect that they deserve because he's asking them for their money," Pachter said, in an interview that would soon generate an inexplicablemedia storm.
The takeaway from Wall Street was mostly confusion and incomprehension: they really do things differently over in Silicon Valley. But the ensuing frenzy over Zuckerberg's fashion statement had, unfortunately, detracted from more urgent questions about Facebook's initial public offering (IPO) — and intriguing questions about corporate practice among start-up technology firms.
In the lead-up to the event, many observers murmured that Facebook was massively overvalued. And sure enough, the float was a flop, with the social network's share price falling 23 per cent from its listing price of USD38 by May 29. By June 6, the share value had declined by 30 per cent. No less than a week after the event, Facebook found itself being sued by its own investors. State authorities in Massachusetts had also subpoenaed lead underwriter Morgan Stanley about its communications with the company's institutional investors; the federal regulator, the Securities and Exchange Commission (SEC), had vowed to launch its own investigation; and it was revealed that more than 4 per cent of Facebook's public share was being held by loan traders looking to short the stock in the event of a share-price plunge.
Sam Hamadeh, the founder and CEO of New York research firm PrivCo, was blunt in his assessment: he alternated between calling Facebook's IPO a "debacle" and a "fiasco" that had rattled the confidence of an already frail IPO market.
There's been much oinking about Facebook's IPO. But of more profound concern in the long run is the way Zuckerberg has solidified his grip on the company, particularly in the aftermath of the IPO. Zuckerberg has set up a dual-class share structure at Facebook which gives Class B shares (the shares he owns) 10 times the voting power of ordinary Class A shares. As a result, he owns 18 per cent of stock in the company, but solely controls 57.1 per cent of the voting power.
The implications for corporate governance of this brand-new public company are ominous. Facebook has listed itself under the "controlled company" exception to corporate governance rules for publicly listed companies. Unlike other publicly listed companies, a controlled company is not required to have an independent board. It is not required to have independent directors, who are responsible for determining remuneration for executives. Instead, it is Zuckerberg who is in charge of appointing directors to the board. In Facebook's registration statement to the SEC, it is noted that in the event he controls the company at the time of his death, "control may be transferred to a person or entity that he designates as his successor". The filings further state that the structure "provides Mr Zuckerberg with the ability to control the outcome of matters requiring stockholder approval, even if he owns significantly less than a majority of the shares".
What's more, Facebook's dual-class share structure is increasingly becoming the norm for start-ups hailing from Silicon Valley. LinkedIn, Zynga, Yelp and Zillow are all publicly listed tech companies with a dual-class arrangement, and it is anticipated that the next crop of hot companies — Twitter, Dropbox and Pinterest — will follow suit.
That said, the concept of granting some shareholders more voting rights than others is hardly new: the first instance of multiple-class structures reportedly occurred in 1918. But it was in the late 1980s, a halcyon era of junk bonds, senior leveraged lending, and hostile takeovers, when split-stock structures began to surface — most prominently in the media sector. (As Morrison Foerster senior partner Bruce Alan Mann notes, prior to 1987, the New York Stock Exchange would not even list dual-class companies.) Certainly, companies such as the Washington Post, Viacom, The New York Times and News Corporation have — for better or worse — clung to their split-stock arrangements to concentrate control in dynastic bloodlines.
It has also been argued that multiple-class structures insulate media companies from market forces, protecting their editorial integrity and independence. Gina Rinehart's recent raid on Australia's Fairfax Media Limited, a company with one class of stock, stoked fears of an imminent takeover. Comedian Dan Ilic's much-tweeted mock-up of The Sydney Mining Herald is an amusing take on the prospect of a Rinehart-controlled media outlet. Naturally, there's a tradeoff with multiple-class structures, in that it also means ordinary shareholders can't hold company directors to account when necessary. At the height of the Leveson inquiry, James Murdoch surely would have been kicked out of News International's mahogany row by irate shareholders — if not for the voting power of his father.
So, historically, split-stock companies have been a rare occurrence largely confined to the media sector. But Google kickstarted a new wave of split-share structuring when it created a dual-class structure for its IPO in 2004, which gave its co-founders Larry Page and Sergey Brin and then-CEO Larry Schmidt 66 per cent of voting power, despite Page and Brin owning just over 30 per cent of Google's stock. As of June 21 this year, Google's shareholders passed a resolution to create a 'C' class of shares — in addition to the existing classes of 'A' and 'B' shares — which allow investors at that level no voting power whatsoever.
In 2004, Brin and Page justified their strategy on the grounds that it would allow them to pursue long-term goals — a corporate strategy often threatened by the short-termism of the market. In a statement to the SEC and to their shareholders, Page said: "We are creating a corporate structure that is designed for stability over long time horizons. By investing in Google, you are placing an unusual long-term bet on the team, especially Sergey and me … in the transition to public ownership, we have set up a corporate structure that will make it harder for outside parties to take over or influence Google."
Once more in mid-June, Brin and Page echoed this sentiment, saying that a triple-class structure would "prevent outside parties from taking over or unduly influencing our management decisions".
Those with lesser faith in a messianic brand of leadership may well read sentences like these as disquisitions that, in no uncertain terms, tell shareholders that the founder always knows better.
Investments such as Google Chrome and YouTube, Brin and Page argued, would not have progressed past the gestation period if not for the company's hermetic isolation from outsider influence. Certainly, the notion that the vagaries of the modern market encourage shorter cycles for investment has some merit: a study released last year showed that in 1955, the average fund in the US held its stock portfolio for seven years. Five decades later, this had decreased to 11 months.
These figures are reflective of a relentless focus on company performance in quarterly earnings; and companies that perform dismally must work to placate angry shareholders. But many tech start-ups see this kowtowing to investors as a hindrance to innovation and long-term planning. Why would investors — with their minds fixed on short-term capital gains on dividends — agree to potentially big outlays of capital in the short term, with the possibility of a loss in the long term?
In the end, YouTube proved to be a plum purchase for Google: the site has unambiguously asserted itself as the prime destination for viewing video online. No competitor comes close. (Vimeo, anyone?) But it is much harder to make sense of Mark Zuckerberg's decision to purchase Instagram for a cool USD1 billion. Instagram — for those over 30 — is a company with a photo-sharing app as its sole purpose for existence. Before being bought out by Facebook, it was a company that employed 13 people, had 30 million users and made no money in revenue. Was it overvalued, or a shrewd business decision by Zuckerberg?
The thing is, it is impossible to rationalise tech valuations at the time of sale. Take the example of MySpace. Rupert Murdoch bought it in 2005, two years after its creation, for USD580 million. But in June last year, Murdoch was only too keen to offload MySpace to Specific Media — for the less-than-princely sum of USD35 million. MySpace is one of a long list of malinvestments by tech companies: AOL lost USD220 million on instant messenging service ICQ; Microsoft bought Skype for USD8.5 billion four years after eBay had bought it for USD2.7 billion. (It seems unlikely that Microsoft will recoup its money on a service — free internet phone calls — that provides scarce revenue.)
When these gambles go wrong, the outcomes aren't so peachy for investors — particularly those with stock in a dual-class company. One only has to look at the example of Groupon. Valued at USD13 billion at the time of its IPO in November last year, its worth has now sunk to USD8.5 billion, due to "material weakness in its controls". While the company faces a lawsuit by some of its shareholders, the dual-class structure ensures that regardless of the result, control will remain with the founding owners. For investors — whose influence is effectively elbowed into impotence —there is no recourse for a bad bet, a bung product, or an improvident vision. The best an investor can do is vote with their feet: if they hold enough shares, dumping stock can send strong signals of discontent to management.
Given the current financial climate, it seems unlikely that investors would continue to tolerate such brazen autocracy. There was a moment of outrage when JP Morgan CEO Jamie Dimon tried to account for the company's USD2 billion trading loss in front of Congress a fortnight ago by half-heartedly apologising for a credit-default swap gone bad, before making the astonishing declaration that big banks should be allowed to fail. (This from a man whose big bank accepted those very bailouts at the height of the global financial crisis.)
In fact, such seignorial nonchalance is hardly surprising; it merely compounds the antipathy many investors already feel towards company CEOs. But dual-class companies lump founders with even more authority and even less accountability — yet investors can't seem to get enough of them.
Surely a rollback on shareholders' rights has negative consequences for corporate governance? Short answer: it depends.
Professor Jason Harris, a senior lecturer in law at the University of Technology, Sydney, says that companies with dual or triple-class structures can still be guided by principles of good corporate governance — so long as their investors know what they are buying into.
"If companies set up a structure at the start — and [investors] know what they are buying into — then it's not necessarily an indicator of poor corporate-governance practices. Where we see this most typically is in the start-up, venture-capital industries, where people who have set up the business want to maintain some measure of control. Facebook, before it was floated, was a good example of that; Google and Ford are the same."
But relations between shareholders and management can become thorny when a company with an established share structure of one common stock decides to create differential voting rights. This type of decision-making, Harris says, reinforces a perception that "management is keen to entrench their own positions". He gives the example of News Corporation shifting its base from Australia to the US, saying there was "speculation that the shift was because the ASX wouldn't let [News] create non-voting shares — a decision that was granted by the US state of Delaware".
It's crucial, Harris says, for companies to allow equal access to both classes of shares in the long-term, because "it's problematic if management has a complete stranglehold on the super-voting shares and all you have the opportunity to buy is the lower voting class".
So why do investors buy into dual-class companies? For a start, if they are looking to buy into today's hot stock — technology and social-media companies — they don't really have a choice. (A majority of tech start-ups are multiple-class companies.) And given the recent perils of investing in the stockmarket, people seem desperate to grasp at any hint of return on investment. But there's a sort of romanticism, too, that influences tech investors. The rags-to-riches narrative is a seductive one, and it has come to define the history of many technology start-ups. In an industry where failure is not shunned but seen as unavoidable, a struggle suggests perseverance against all odds. Buying shares in dual-class companies allows investors to be part of that story, as well as allowing them to be part of (and benefit from) the company's vision.
However, the jury is still out on whether dual-class companies have poorer returns on investment than single-stock companies. Two studies of American firms by Paul Gompers, Joy Ishii and Andrew Metrick between 1994 to 2002 found that dual-class firms perform worse than comparable firms with one common stock and equal voting rights. But another more recent study by Judith Swisher of Western Michigan University suggests inferior voting shares do not necessarily lead to inferior returns on investment.
Guhan Subramanian, a professor of business law at Harvard Business School summed up the dual-class quandary quite neatly to Smart Money magazine: "the pro of dual-class is that the founder-CEO runs the show, and the con of dual-class is that the founder-CEO runs the show".
It's quite the double bind: it may be true that a multiple share-class structure protects a CEO from meddlesome market forces, but it sure is a pity that it does little to shield investors from what can either be a premium asset or their greatest adversary: hubris.