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Industry Voices

Commentary: Dual-class structures rob voices of shareholders

Amy Borrus

As Lyft starts its roadshow, investors are salivating at the prospect of buying a piece of the ride-sharing company and other fast-growing, highly valued private companies like Uber, Pinterest, Slack poised to make their public debuts this year.

Many of the hottest young companies are following in the footsteps of an earlier generation of startups that disrupted their way to riches. From Alphabet (Google's parent) to Zillow, young tech companies achieved success by upending traditional business models.

But when it comes to how they govern their companies, too many founders embrace frameworks that are bulwarks against change that are highly hazardous for investors. How? By going public with dual- or even triple-class stock structures with unequal voting rights for investors that guarantee founders and other insiders voting control that can last decades, even as their equity stake shrinks.

At Lyft, for example, the two founders will have Class B shares with 20 votes per share, giving them control of the company even though they will own less than 10% of the stock. Public shareholders will have Class A shares with one vote per share. This will let the founders govern the company as supreme monarchs in perpetuity while taking a "let them eat cake" attitude toward their investors.

Many founders defend dual-class stock as a valuable tool that lets them focus on their long-term vision for their companies without having to worry about pressure for short-term results from activists and other investors. But this "founder knows best" approach challenges the bedrock corporate governance principle of "one share, one vote": providers of capital should have a right to vote in proportion to the size of their ownership. A single class of common stock with equal voting rights makes the board of directors accountable to all of the shareholders — and more likely to respond when management stumbles.

But the reality is that such dual-class structures that grant insiders super-voting shares (typically 10 votes each) rob public shareholders of a meaningful voice in how the company is run. Over time, they can entrench management and blindside top executives to the need for change, even when they stumble.

Even the most promising charismatic entrepreneurs are not infallible. Consider the embarrassing and costly blunders over issues ranging from data privacy to sexual harassment to production snafus at Facebook, Google and Snap, whose founders all have outsize voting power that assures them control. It's worth remembering that Amazon.com, Apple and Microsoft didn't need super-voting shares to succeed over the long term.

But 2019 could be a pivotal year for the dual-class dilemma. Last fall, the Council of Institutional Investors filed petitions at the New York Stock Exchange and the Nasdaq Stock Market seeking rule changes that would require future listed dual-class companies to incorporate time-based "sunset" provisions in their charters that collapse the dual structure to "one share, one vote" within seven years. It is a sensible compromise that exempts Alphabet, Facebook, TripAdvisor and other currently listed multiclass companies.

Many institutional investors have endorsed CII's proposal. Nasdaq held a hearing last week on the issue, and to date, the NYSE has not responded.

Academic research supports time-based sunsets. A recent study, "The Life-Cycle of Dual Class Firm Valuation," found that while multiclass companies have a value premium over single-class counterparts at the time of their initial public offering, that benefit fades to a discount six to nine years after IPO. Other studies show that multiclass companies have a substantially lower total shareholder return compared to single-class companies over 10 years.

Research by two Cornell University professors found that over time, super-voting rights enable insiders to use their control for personal gain or to pursue personal vision at the expense of other shareholders. When these insiders are also top executives, they in effect choose their overseers, the board of directors. The upshot can be entrenched managers impervious to the need for course corrections and boards of directors that are powerless to force leadership change.

Exhibit A is the destruction of shareholder value and turmoil at the top of CBS and Viacom. Both are controlled by National Amusements, the holding company of media mogul Sumner Redstone, through super-voting shares that give NAI nearly 80% of the votes even though it owns just 10% of the equity of CBS and Viacom. Mr. Redstone was once a young, visionary leader. Today at 95, he is reportedly incapacitated and his daughter Shari's efforts to wield his voting power has resulted in costly legal battles at both companies.

There are signs that founder fondness for dual-class capital structures may be cooling. CII's tracking of IPOs shows that of the 140 U.S. companies that went public in 2018, 125, or 89%, debuted with a single class of common stock; just 15, or 11%, had dual-class structures with unequal voting rights. That marks an improvement from 2017 when 19% of U.S.-based IPO companies went public with dual-class structures.

One third of dual-class IPOs in 2018 incorporated time-based sunsets, up from 26% in 2017. Yelp, Fitbit, Kayak and other household-name companies all went public with these provisions. Sunsets are shrinking, too: The average in 2018 was seven years vs 9.5 years in 2018 and 10.3 years in 2016.

America's for-profit stock exchanges are loath to embrace sunsets. The exchanges compete for listings and are not motivated to force the issue with founders of dual class IPO companies who want to hang onto control. If one exchange were to insist on sunset provisions and another didn't, it is not hard to guess which exchange a founder would select.

Global competition for listings is pushing other markets — notably Hong Kong and Singapore — to loosen longstanding prohibitions on dual-class companies. But Asian exchanges are responding to a "race to the bottom" that U.S. stock markets started. It's time for NYSE and Nasdaq to make American listing standards the global leader in corporate governance again.

The SEC lacks the statutory authority to compel U.S. exchanges to amend their listing rules. Over the past year, providers of benchmark indexes — FTSE Russell, MSCI and S&P Dow Jones — have stepped into the breach, with varying curbs on multiclass companies in indexes that are used widely by institutional investors. A listing standard would put all dual-class companies on the same footing.

One of the strengths of the U.S. economy is the dynamism of U.S. companies. Successful American companies are constantly changing — and reinventing the way we do business. Why shouldn't they embrace the possibility of change in their own governance? n

Amy Borrus is deputy director of the Council of Institutional Investors, Washington. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.