Above: SEBI must be cautious in allowing dual-class shares’ listing in the stock market
Issuing different classes of shares with differential voting rights results in management being unaccountable to market discipline. SEBI should re-think about allowing such shares to be listed on the exchange
By Sanjiv Bhatia
Companies sometimes issue different classes of common shares with differential rights. Typically, voting rights for common shares are based on the principle of “one share-one vote”, but recently, new-age technology companies have started issuing shares with preferential voting rights for the founders to allow them to raise capital without diluting their ability to run the company.
Dual-class shares with differential voting rights (DVRs) are used by companies to allow promoters and founders to retain management control of the company even when they don’t own a majority of the shares. In 2004, Google went public with a dual-class equity share structure in which stock held by the founders had ten votes per share, while stock held by the public had one vote per share. As a result, Google’s founders collectively held 66.2 percent of shareholders’ total voting power while holding only 31.3 percent of the total shares.
Since Google’s IPO, other companies have gone public with similar capitalisation structures. LinkedIn in 2011, followed by Facebook and Groupon in 2012, and more recently, Lyft and UBER, (and soon to go public Pinterest), have all issued shares with DVRs. The firm Alibaba chose to list in New York instead of the Hong Kong exchange principally because it was allowed to list multiple class of shares with DVRs.
In India, dual-class shares were first used by Tata Motors in 2008, but since then, only five companies have used this equity structure primarily because it was frowned upon by India’s market regulator SEBI. However, in an about-face, SEBI recently issued a White Paper in which it stated that dual-class shares were a practical way for emerging technology companies to raise critical capital without fear of loss of ownership. It proposed that firms be allowed to keep dual-class share structures with DVRs for five years after the initial public offering (IPO). In response, IndiaTech, a lobby of technology-based startups in India backed by founders of Ola and MakeMyTrip, proposed that the sunset period for which companies be allowed to keep stocks with differential voting rights be extended to 20 years.
Academic research supports such time-based sunsets. Stocks of dual-class companies sell at a premium compared to their single-class counterparts at the time of the IPO, but this benefit fades to a discount six to nine years after the IPO. After ten years, multi-class companies have a substantially lower total shareholder return compared to single-class companies.
While the US market regulator, SEC, does not require time-based sunsets, many companies now use them. In 2017 and 2018, of the 38 companies that listed on US exchanges using multi-class structures, 29 percent incorporated simple time-based sunsets. Groupon converted to a single share class after five years, and Facebook shareholders are pushing to eliminate dual-class shares arguing that disproportionate control in the hands of CEO and Chairman Mark Zuckerberg is not in the best interest of the company.
So, should the SEBI regulate the issuance of dual-class shares in India, should it use time-based sunsets and should the sunset period be five years or the 20 years that the industry wants?
There is much debate about both the legality and the efficacy of dual-share classes and DVRs. The most pervasive argument in support of dual-class shares is that management can more easily set long-term goals and innovate. Emerging companies have a critical need for capital, and at every stage of raising capital, founders have to dilute their holdings. Without DVRs they risk losing ownership and managerial control over the company they founded.
Opponents say that dual-class stock structures have no place in today’s marketplace because they carry unequal voting rights which is antithetical to the fair and fundamental principle of a “one-share-one-vote” structure. They argue that control of a corporation should come from owning a majority of shares, not owning shares with special rights. There are legitimate reasons why dual-class shares can be beneficial for a company and its shareholders, but on balance, such structures are undesirable. Shares with DVRs serve as instruments to keep the promoters in control of the company. An investor who wants to invest funds in a company would also want some oversight to ensure that the company utilises the funds judiciously. Such control cannot be exercised if the shares issued to an investor have diminished rights.
A primary focus of corporate governance is to monitor the mismanagement and self-dealing that arises from the separation of economic ownership (shareholders) and control (managers). This is known as the “agency problem” in which managers as agents of the owners make decisions to benefit themselves at the cost of the owners.
Dual-class shares with different voting rights aggravate the agency problem by allowing founder managers to control disproportionally more voting rights than economic (cash flow) rights.
As a result, they bear a smaller proportion of the financial risk from poor decisions while still preserving the voting rights to block any changes that could threaten their personal benefits and control of the company. There is evidence that entrenched founders often use their DVRs to demand excessive remuneration, misuse corporate cash reserves and engage in poor capital expenditure and acquisition decisions that destroy shareholder value. As a result, stock returns are lower for companies in which founder promoters control more voting rights relative to cash-flow rights.
A good example of the problems created by decoupling voting rights from economic ownership is Facebook. Through dual-class shares, the CEO and chairman of Facebook Mark Zuckerberg controls about 60 percent of the voting rights while owning only 18 percent of the shares. This has allowed him to entrench himself despite a series of poor decisions and scandals last year which caused Facebook stock to drop by 40 percent. In April this year, when concerned Facebook shareholders, pushed to eliminate dual-class shares, the company’s stock jumped up nine percent. This suggests that investors are willing to pay a premium to invest in companies that do not have multi-class shares. The discipline that the market imposes on management through the voting process is an important aspect of the overall valuation of the firm.
In India, the DVR shares of Tata Motors sell at a discount of between 30 to 40 percent compared to the ordinary shares. Over a ten-year period since the listing of its DVR shares (2008-2018), the ordinary shares of Tata Motors have given a return of approximately 763 percent, whereas its DVR shares have returned only 185 percent. Clearly, the market discounts DVR shares and does not like the idea of management being able to control a company while ignoring the voice of its shareholders.
Another significant problem is that institutional investors like mutual funds, pensions plans, etc., prefer not to invest in companies that use dual-class structures. These investors are crucial to good corporate governance because they seek to influence corporate decisions by using their voting power and exerting pressure for change through board composition. Small dispersed groups of individual investors do not possess this level of clout and are often unable to muster the collective action required to change management behaviour. Recent studies show that institutional ownership in dual-class firms was substantially lower than in single-class firms. In the light of the poor stock performance of the few firms that have issued dual-class shares in India, it is unlikely that institutional investors invest in such companies. This will hamper the liquidity in dual-class shares and eventually hurt the very companies these structures are designed to help.
Proponents of dual-class shares also argue that DVRs protect new emerging companies from hostile takeovers. Founders of new technology companies feel they are vulnerable to capital-sharks and risk losing control over the firms they have founded in their search for capital. But these fears appear to be exaggerated given that there are other ways to prevent such takeovers. LinkedIn and Facebook, for example, have corporate charters with staggered boards which can only be repealed by an 80-percent shareholder vote—a difficult threshold. In staggered boards, the terms of the board of directors are staggered to prevent more than a small fraction of the board being replaced at any one time. These boards provide effective protection against hostile takeovers making the use of dual-class shares redundant. Another effective strategy is the use of a “poison-pill” which involves allowing the founders to buy shares at huge discounts, or having preferred stock that is convertible to common shares should the company be threatened with a hostile takeover.
Experiences of US companies that have had dual-class structures illustrate why such structures can be detrimental to shareholders. In a capitalist system, the primary purpose of a corporation is to produce goods and services that maximise shareholder wealth. In such a system, dual-class share structures with differential voting rights result in disproportionate voting and economic rights. This results in management being unaccountable to market discipline, allowing them to divert funds to benefit themselves and indulging in unprofitable empire building and value-destroying acquisitions.
SEBI should be extremely cautious about permitting dual-class shares to be listed on the exchange. In a rapidly evolving financial economy like India, corporate governance is an area of critical importance. Sustainable businesses are essential for the country’s growth and prosperity, and the discipline and control imposed by outside shareholders on a company’s management are crucial to developing sustainable businesses.
—The writer is a financial economist and founder, contractwithindia.com