Corporate Control and Idiosyncratic Vision

Zohar Goshen is the Alfred W. Bressler Professor of Law, Columbia Law School and Professor of Law at Ono Academic College. Assaf Hamdani is the Wachtell, Lipton, Rosen & Katz Professor of Corporate Law, Hebrew University of Jerusalem. This post is based on an article authored by Professor Goshen and Professor Hamdani.

Prominent technology firms such as Google, Facebook, LinkedIn, Groupon, Yelp, and Alibaba have gone public with the controversial dual-class structure to allow their controlling shareholders to preserve their indefinite, uncontestable control over the corporation. Similarly, in the concentrated ownership structure, a person or entity—the controlling shareholder—holds an effective majority of the firm’s voting and equity rights to preserve control. Indeed, most public corporations around the world have controlling shareholders, and concentrated ownership has a significant presence in the United States as well. Unlike diversified minority shareholders, a controlling shareholder bears the extra costs of being largely undiversified and illiquid. Why, then, does she insist on holding a control block?

The prevailing answer focuses on private benefits of control. According to conventional wisdom, entrepreneurs seek a controlling interest in order to exploit their dominant position and divert value from the company or its investors, thereby capturing private benefits of control. An alternative, less pessimistic, theory proposes that allowing an entrepreneur to consume some level of private benefits is a necessary cost of incentivizing efficient monitoring and good performance. The controller in this explanation still diverts value to herself at the expense of investors, but on balance, her actions benefit the investors and the corporation as a whole.

In our paper, Corporate Control and Idiosyncratic Vision, recently published by the Yale Law Journal, we offer an alternative explanation for the value of control for entrepreneurs. Under our framework, control allows entrepreneurs to pursue business strategies that they believe will produce above-market returns by securing the ability to implement their vision in the manner they see fit. The entrepreneur values control because it protects her against the possibility of subsequent mid-stream investor doubt and objections regarding either the entrepreneur’s vision or her abilities.

In our framework, both investors and entrepreneurs value control, but for different reasons. We identify a fundamental tension that arises whenever entrepreneurs raise funds from investors under the conditions of asymmetric information and differences of opinion: while entrepreneurs want the freedom to pursue their idiosyncratic vision, investors seek protection from agency costs. The entrepreneur wants to retain control over management decisions to pursue her idiosyncratic vision for producing above-market returns in the future. That is, control enables entrepreneurs to capture the value that they attach to the execution of their idiosyncratic vision. Investors, by contrast, value control because it allows them to minimize agency costs.

We show that investors and entrepreneurs can use different combinations of control and cash flow rights to balance the investors’ concern regarding agency costs against the entrepreneurs’ interest in pursuing their idiosyncratic vision.

We use our theory to uncover the essence of the hypothetical bargain between investors and controlling shareholders. We first show that corporate ownership structures can be recast as combinations of cash flow and control rights that entrepreneurs and investors adopt to balance the conflicting objectives of minimizing agency costs and maximizing entrepreneurs’ ability to pursue their vision. We then focus on the spectrum of public-company ownership structures: concentrated ownership, dispersed ownership, and dual-class firms. Concentrated ownership bundles cash flow rights and control together. While dispersed ownership with its contestable control constrains the ability of entrepreneurs to pursue their idiosyncratic vision, an entrepreneur in the concentrated ownership structure enjoys permanent and uncontestable control, much as she does in the dual-class structure. The controller values permanent and uncontestable control because it allows her the freedom of action that is often necessary to realize her idiosyncratic vision. At the same time, the controller’s large equity stake limits investors’ exposure to management agency costs.

Concentrated ownership, therefore, should not be viewed as an unalloyed evil. Our analysis shows that controlling shareholders may hold a control block to increase the pie’s size (pursue idiosyncratic vision) rather than to dictate the pie’s distribution (consume private benefits). Importantly, when the entrepreneur’s idiosyncratic vision is ultimately realized, the benefits will be distributed pro rata to all investors.

Our framework provides important insights for investor protection and corporate law doctrine and policy. We argue that corporate law for publicly-traded firms with controlling shareholders should balance the controller’s need to secure her idiosyncratic vision against the minority’s need for protection. While the existing corporate law scholarship has focused solely on the protection of minority shareholders, we show that it is equally important to pay heed to the rights of the controlling shareholders. The tension between minority protection and controller rights underlies our blueprint of the policy considerations that should guide lawmakers crafting the legal regimes that govern firms with controlling shareholders.

A one-sided theory of corporate control, focusing only on minimizing agency costs, is blind to the cost of minority protection regimes. Our theory, by contrast, uncovers the hidden cost of regulation—that is, interference with the entrepreneur’s freedom to pursue her idiosyncratic vision—and presents the legal challenge of balancing these goals. We also demonstrate that the recognition of controllers’ rights may justify legal outcomes that are contrary to the traditional notions of shareholder-value maximization.

The full paper is available for download here.

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