By Bernard Sharfman
Originally posted on the Oxford Business Law Blog.
The use of dual class shares (shares with unequal voting rights) in initial public offerings (IPOs) allows for founders and insiders to maintain voting control of the company without having to own a majority of the company’s common stock outstanding. Sometimes, these dual class share structures allow founders and insiders to remain in control without any time limitations, thereby allowing for the theoretical possibility that control of a company can be passed on from generation to generation. In a recent speech at the UC Berkeley School of Law, newly appointed SEC Commissioner Robert Jackson, in expressing his own views, asks whether companies going public should be allowed to utilize such capital structures, commonly referred to as perpetual dual-class share structures.
His answer, a resounding no, begins by warning us that such structures will burden investors for generations with managers of public companies who have inherited the mantle of control through family ties, not merit. By doing so, we will have created a new class of corporate royalty anathema to our democratic principles.
My response is that the elimination of perpetual dual class shares in IPOs is a solution without a real problem to solve. Of the 19 companies that utilized dual class shares in their IPOs in 2015 (14% of 133 according to Jackson; yes, we are only talking about 19 companies in a banner year for dual class shares) perhaps 50% used a perpetual structure. This percentage may be high given that Andrew Winden reported a steady decline in the annual percentage of dual class share structures without sunset provisions (a fixed time or event where the dual class shares must be converted) starting in the year 2000. This means we are talking about the 2015 listing of maybe 10 new companies with perpetual dual class shares.
Moreover, of those relatively few companies with perpetual shares, it is safe to predict that some will eventually be acquired (remember the purchase of LinkedIn by Microsoft), some will have a mid-stream conversion where they drop their perpetual dual class share structure, and some will even decide to go into bankruptcy and, if lucky, will be reorganized and be back in action without dual class shares of any kind. These events represent the optionality built into perpetual dual class shares, an optionality that when its value is high enough, will incentivize founders and their families to voluntarily give up their dual class shares, making the time period of their holdings much less than ‘forever’.
So, even if you are corporate royalty, this optionality will at various points in the life cycle of your firm incentivize you to give up your dual class shares. In sum, our long term future will most likely be filled with a de minimis number of firms that are led by corporate royalty spawned by the issuance of perpetual dual class shares.
Jackson also provides statistical analysis to argue that perpetual dual class shares, relative to dual class shares with sunset provisions (a fixed time or event where the dual class shares must be converted), are a bad deal for investors; a bad deal that becomes noticeable after only a couple of years after issuance. Unfortunately, I believe the release of this statistical analysis was very premature and, hence, of no value at this time. The major reason is the one that he admits to in footnote 20 of his speech, his staff’s use of the ‘much-maligned measure of corporate performance: Tobin’s Q’. Unfortunately, it is not even Tobin’s Q that his staff uses in their analysis but a bastardized version that is referred as ‘Simple Q’. According to Robert P. Bartlett & Frank Partnoy, in their powerfully persuasive article which Jackson references in footnote 20, ‘The Misuse of Tobin’s Q’:
In sum, q—especially Simple q—does not mean what many scholars seem to think it means. Absent more robust testing, the conclusions in the empirical finance literature that rely on q as a dependent variable are unsound and should not be the basis for academic inquiry or policy decisions. Instead, scholars and policy makers should approach studies based on q with caution, and should seek alternative methodologies to assess the correlates of firm value.
Yet, Jackson still uses the results of this analysis in his speech and has even published a data appendix which provides the results of this Simple Q analysis. The rationalization for publishing these dubious results is that his staff, in acknowledging the criticism of Simple Q, used a different methodology and got similar results. So, according to Jackson, it appears the problem with the statistical analysis has been overcome. Perhaps it has, but until his staff publishes a new data appendix with the results using the new methodology, we cannot say for sure.
But the premature publication of the results is not the only issue with the analysis. What Jackson is trying to argue is that the use of perpetual dual class shares will lead, in the long-term, to financial disaster for investors. Yet, the IPO data that his staff uses only starts from 2001, a year too recent to make any real conclusions about how the creation of corporate royalty has impacted corporate governance. It is extremely doubtful that any of the next generation is even close to taking over. Moreover, the sample is over-weighted with firms that went public since 2013. Therefore, it doesn’t seem possible that much can be said about the long-term effects on these firms until many more years go by, if ever.
Second, how much market value reduction can possibly be caused by perpetual dual class shares after the first few years of a company’s life when it is being compared to firms like Google (a firm coded in the staff’s data spreadsheet as being non-perpetual), where the sunset provision kicks in upon the death of the founders? That is, if the firms included in the staff’s database have, on average, sunset provisions that kick in many years after going public, how is it possible that the so-call perpetual premium starts declining almost immediately or that there even exists a premium in the favor of perpetuals in the first couple of years? Why would there be a significant difference in either case? To help answer these questions, if the issue is not just methodological, much more description is needed of the sunset provisions found in the staff’s sample and how the sample’s perpetual dual class shares are actually structured.
Moreover, what is completely missing from Jackson’s argument, besides useful statistical analysis, is an acknowledgement that the use of perpetual dual class shares in an initial public offering, in the relatively small number of cases where it is actually used, is a voluntary choice that encourages founders and initial stockholders to go public in the first place. In an era where the U.S. stock markets are in rapid decline in terms of the number of companies listed, and where private companies are no longer clamoring to go public, finding life as a private company to be just fine, this understanding is of fundamental importance.
Moreover, to call for the elimination of perpetual dual class shares in IPOs is anathema to what many believe to be the great strength of our system of corporate governance, the private ordering of corporate governance arrangements with dual class share structures, perpetual or not, being an optimal result of that ordering. Consistent with this understanding, I would like to once again refer to a statement by the Nasdaq, Inc.:
One of America’s greatest strengths is that we are a magnet for entrepreneurship and innovation. Central to cultivating this strength is establishing multiple paths entrepreneurs can take to public markets. Each publicly-traded company should have flexibility to determine a class structure that is most appropriate and beneficial for them, so long as this structure is transparent and disclosed up front so that investors have complete visibility into the company. Dual class structures allow investors to invest side-by-side with innovators and high growth companies, enjoying the financial benefits of these companies’ success.
The New York Times reported that the number of unicorns (private companies with valuations greater than $1 billion) have increased from 197 in May of 2017 to a current number of 228. The ability to use dual class shares structures, including the perpetual variety, encourages the most valuable private companies to go public, providing increased opportunities for the ordinary investor, including those who simply buy index funds, to diversify their portfolios and realize increased gains from investing. Shouldn’t Commissioner Jackson be cheering, not discouraging their use?
Bernard S. Sharfman is Visiting Assistant Professor at the University of Maryland School of Law, an Associate Fellow of the R Street Institute, and a member of the Journal of Corporation Law’s editorial advisory board. His article A Private Ordering Defense of a Company’s Right to Use Dual Class Share Structures in IPOs is available here.