The Continuing Support for Dual-Class Stock by Companies and Investors

David J. Berger, Katharine Martin and Amy Simmerman are partners at Wilson Sonsini Goodrich & Rosati. This post is based on a WSGR publication by Ms. Martin and Ms. Simmerman. Related research from the Program on Corporate Governance includes The Untenable Case for Perpetual Dual-Class Stock by Lucian Bebchuk and Kobi Kastiel (discussed on the Forum here).

The reported demise of dual-class stock appears to be, to paraphrase Mark Twain, “greatly exaggerated.” The end of dual-class stock was predicted following the decisions this summer by the major indices, including FTSE Russell (who operates the Russell 3000 index) and S&P Dow Jones (who manages the Dow Jones 500 index) to ban most companies that went public with multi-class stock. The decisions by the indices came at the behest of numerous institutional investors, especially passive funds, who argued that only companies with a single class of stock should be included in the most prominent indexes. The decisions by the major indexes led many market observers to conclude that companies going public would no longer adopt multi-class stock since it created the risk that these companies would be excluded from the indexes.

To the extent institutional investors expected that promising companies, especially technology companies, would choose being listed in one of the indexes rather than implementing governance structures that these companies (and their boards and earliest investors) believed better suited their businesses in the long-term, the institutions have clearly been disappointed. Indeed, in just the few weeks since the indexes announced their decision, there have been several prominent—and very successful—IPOs by tech companies with dual-class stock. Examples of such recent offerings include Roku and CarGurus, which have both benefited from substantial stock increases since the first day of trading; and data center operator Switch, which also continues to trade nicely above its IPO price.

In addition to these companies, several tech IPOs expected to occur in the fourth quarter include companies that have dual-class stock. Such companies include cloud database company MongoDB, as well as Chinese search engine company Sogou and Chinese financial services firm Qudian—both of which are expected to list in the U.S. at least in part because both Nasdaq and the NYSE allow for the listing of dual-class companies.

Several recent academic studies offer new support for dual-class stock, while also continuing to raise serious questions about the benefits of activist campaigns. For example, University of Chicago Professor Dorothy Shapiro Lund’s recent paper, titled Nonvoting Shares and Efficient Corporate Governance, describes how dual-class stock may be used to “lessen agency and transaction costs in a corporation by dividing voting power between shareholders who are informed about the company and its performance and those who are not.” Lund suggests that companies can lower their costs of capital by issuing low-vote stock to passive index funds and other “weakly motivated” investors who may not value their voting rights and/or may lack full information about the company. Lund even questions whether passive index funds have the incentive to vote in a manner that will be value-enhancing for the corporation. [1]

The benefits from activist campaigns have also come under increased scrutiny in recent weeks. For example, FactSet issued a highly publicized report that studied a total of 175 activist campaigns launched between 2012 and 2016, and compared the subsequent returns of two groups: companies where the dissident shareholders won and companies where they withdrew their demands. The result: the shares of companies where the dissident won the campaign had a median loss of 0.7 percent after one year, and a median loss of 2.4 percent after two years. In contrast, companies where the activist withdrew their demands had a median gain of nine percent after one year and the gap widened even further in the second year, with the median gain growing to 10.9 percent for the successful resisters. [2]

This does not mean, of course, that all companies planning an IPO should (or will) have dual-class stock, or that all activist campaigns harm companies and/or investors. Nor does it even mean that all dual-class stock is alike; to the contrary, the structures of many of the companies with dual- or multi-class stock are often quite different. What it does mean is that the support for dual-class stock among entrepreneurs and investors continues, notwithstanding the objections of some institutional investors and index funds.

One reason markets continue to support dual-class stock, especially (but not exclusively) in founder-led companies, is out of a general recognition that absent such protections, at least some of these companies will simply choose not to go public. Indeed, one entrepreneur described the IPO process as “a way of living in hell without dying,” as part of his explanation as to why he chose to support a sale of the company he founded rather than taking it public. [3] Scott Kupor, the CEO and Managing Partner of VC firm Andreessen Horowitz, told the SEC that it simply “does not pay to be a small-cap company in today’s [public] capital markets” given the lack of liquidity and research coverage, while mid- to large-cap technology companies find it increasingly difficult to “balance long-term growth goals with the increasingly short-term orientation in public markets.” [4]

The reluctance of companies to go public can be seen as part of a broader trend in our capital markets. The number of publicly listed stocks in the U.S. declined by about 50 percent from 1996-2016, while the number of IPOs in the U.S. fell from an average of about 300 per year during the period of 1980-2000 to less than 110 per year from 2000-2016.

The successful IPOs of such companies as Roku and CarGurus, as well as the challenges faced by newly public companies in today’s capital markets, all lead to the conclusion that multi-class stock structures will continue to be adopted by emerging growth companies. While it is questionable whether more companies will choose to go public exclusively with non-voting stock, the use of dual-class stock seems likely to continue so long as other options, such as tenure-voting, are not easily available to companies who wish to encourage long-term ownership among their investors. Thus the supposed death-knell of dual-class stock that was supposed to result from the decisions by the indices appears thus far to have had little effect on either companies or investors.

Endnotes

1Dorothy Shapiro Lund, “Nonvoting Shares and Efficient Corporate Governance,” August 29, 2017, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3028173. In another recent paper, Professor Lund has proposed that passive funds be restricted from voting at shareholder meetings. See Dorothy Shapiro Lund, “The Case Against Passive Shareholder Voting,” August 19, 2017, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2992046.(go back)

2See Ryan Derousseau, “Do Shareholders Win When Activists Win,” Fortune, September 25, 2017.(go back)

3See Andrew Ross Sorkin, “Fixing the Brain Damage Caused by the IPO Process,” The New York Times, September 18, 2017.(go back)

4See Testimony of Scott Kupor to the Securities & Exchange Commission Investor Advisory Committee, June 22, 2017, available at https://www.sec.gov/spotlight/investor-advisory-committee-2012/kupor-sec-testimony.pdf. Kupor urged the SEC to consider amending its rules to allow companies to adopt tenure voting as a way of encouraging investors to have a longer-term focus. Id.(go back)

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