October 4, 2012
Not all shareholders are created equal.
That is a truth that has been evident for years to anyone who has invested in a company with a dual or multiple share structure, one that gives them a fraction of the voting rights of a controlling group, or gives them a fraction of the dividend payments. Company founders love the idea, of course; it helps them retain control of their businesses while still being able to attract outside capital. Everyone loves to eat their cake while simultaneously hanging on to it. Institutional investors tend to hate the dual share structure; they don’t like being second-class citizens, giving up rights they believe should go along with owning equity.
Nonetheless, investors still show up when a company goes public with a two-tier share structure – when it’s the right company, that is. Just think of the investor response to Google (GOOG), despite the fact that insiders hung on to 10 votes per share while investors in the newly issued Class A shares received only one vote.
Now the issue is leaping to the fore once more, given that more than 10 percent of the IPOs completed between January 2010 and March 2012 had multiple classes of shares, each having different rights. Moreover, according to a recent study by the Investor Responsibility Research Center Institute, companies with multiple share structures have more stock price volatility, weaker accounting controls, and more transactions with related parties – all big “no-nos” from a corporate governance perspective. Oh, and their stocks also tend to underperform over the long term.
Why does this matter today? Three words: Social networking IPOs. Zynga (ZNGA), LinkedIn (LNKD), Facebook (FB) and Groupon (GRPN) all went public recently, and all of them offered multiple-class share structures. Of the three, only LinkedIn trades above its IPO price. It’s far too premature to attribute the underperformance of the three companies to the share structure, or even to say that that lopsided structure has led to the specific business decisions that have contributed to the dismal market performances of the other three companies. But the new study’s findings, in the wake if these high-profile transactions, offer some food for thought and for debate.
The study examined the performance of “controlled firms” –companies where ownership is concentrated in the hands of a small number of insiders – and found that the returns generated by companies where the control was a function of a multi-class structure lagged those of companies where control was exercised simply through majority ownership of a single class of stock. Over the three, five and ten-year periods ended August 31, 2012, you would have fared better owning stock in a company with just a single class of shares. Companies with multiple classes of shares “materially underperformed,” generating only 7.52 percent in total return over the ten-year period, compared to 9.76 percent for non-controlled companies and 14.26 percent for companies controlled through majority ownership of a single class of shares.
The logic behind this is fairly clear. Owning a majority of a single class of shares squarely aligns the controlling shareholder’s interests with those of other shareholders. If you are getting the same benefits as every other investor, odds are that’s going to make you focus even more intently on both risk and return. If you are shielded from the consequences of poor decisions because your share structure gives you de facto control of the board, or because you earn dividends on your Class A stock while you aren’t obliged to pay them out to holders of Class B shares, well, that’s a different picture.
Some have pointed out that dual share structures can have their upside. New York Times columnist Joe Nocera recently tackled the issue in the wake of the death of the company’s chairman, Arthur Ochs Sulzberger. Raising outside capital but curbing the extent to which those new investors can force the paper to, say, cut back on foreign reporting in order to save money and boost profits amounts to serving a kind of public interest, he argued.
But there aren’t many companies that can legitimately make that kind of pitch, or do so with a straight face. For the most part, this offers insiders a way to maximize their own control – and the portion of the returns that flows directly to them – while still being able to raise capital that, had they used a single-share class structure, would have diluted their ownership to below 50 percent.
If that came with outperformance – or even performance that kept up with the broader market over time – investors might still wince because of the governance implications, but might be more willing to tolerate it. Instead, the Council of Institutional Investors is urging both the New York Stock Exchange and Nasdaq to ban companies that try to list their stock while maintaining two or more share classes with unequal voting rights. (They’re not suggesting de-listing Facebook, but grandfathering in existing multi-class companies and having the rule apply only to new companies.)
Despite the blue-chip credentials of those supporting the proposal, it’s probably a non-starter. Both exchanges are for-profit enterprises, and their response likely will be that since the share structures are clearly spelled out in IPO offering documents it’s up to investors to decide whether or not they want to put up with being second-class corporate citizens. (Although I doubt that either will use that precise phrase....)
So it the question comes right back to you the investor. My suggestion? Do voluntarily what no other agency can or should do for you and avoid investing in companies whose share structure doesn’t offer a level playing field. In particular, steer clear of those where, if all the shares were converted into a single class tomorrow, the individuals or entities that today wield 75 percent of the votes would see that interest diluted to 15 percent.
Americans fought and won a revolution on the basis of defying taxation without representation. A multi-class investment structure strikes me as, in most cases, being little more than a modern twist on that, with companies saying, yes, we’d love to have your investment dollars, but we’re not going to give you as much voice in the running of the company as we give ourselves in exchange for that capital. A majority of these companies may be well run, deliver solid results and otherwise adopt high governance standards. But if they don’t – or if that changes – by owning that restricted-voting class of stock, you’re tacitly acknowledging that you don’t have a right to protest.