The Perils of Dell’s Low-Voting Stock

Lucian Bebchuk is the James Barr Ames Professor of Law, Economics, and Finance and Director of the Program on Corporate Governance, Harvard Law School. Kobi Kastiel is Assistant Professor of Law at Tel Aviv University, and Senior Fellow at Harvard Law School Program on Corporate Governance. This post is based on their recent paper, The Perils of Dell’s Low-Voting Stock. The paper is part of the work of the Research Project on Controlling Shareholders of the Harvard Law School Program on Corporate Governance. The Project’s related work includes The Untenable Case for Perpetual Dual-Class Stock (discussed on the Forum here), and The Perils of Small-Minority Controllers (discussed on the Forum here), both by Lucian Bebchuk and Kobi Kastiel.

Dell Technologies Inc. (“Dell”) is planning a “backdoor-IPO” transaction that would bring it back to the public market with a multiclass structure. In a short paper we recently placed on SSRN, The Perils of Dell’s Low-Voting Stock, we identify and analyze three governance risks and costs that Dell’s IPO structure would create for public investors holding Dell’s low-voting stock:

  • Lifetime entrenchment of Michael Dell (“MD”): He would be able to retain control indefinitely even after he ceases to be a fitting leader and even if he becomes disabled or incompetent.
  • Small-minority controller: Although MD would initially hold a majority of the equity capital, Dell’s structure would enable him to unload most of his shares and still retain control even with a small equity stake, and his status as small-minority controller would be expected to produce substantial governance risks and costs.
  • Midstream changes: Dell’s governance structure would enable MD to adopt subsequent changes in governance arrangements, without any support from public investors, which would increase Dell’s governance risks beyond the risks associated with a small-minority controller.

Each of these governance risks can be expected to both (i) decrease the expected future value of Dell by increasing agency costs and distortions, and (ii) increase the discount to a per-share value of Dell at which low-voting shares of Dell can be expected to trade. Both types of effects would operate to reduce the value at which the low-voting shares of public investors would trade and therefore should be taken into account in assessing the risks to such investors posed by Dell’s planned structure.

Below is a more detailed account of our analysis:

About five years after it went private, Dell Technologies Inc. (“Dell”) is planning to return to the public market with a multiclass structure. The company estimates its market cap to be about $70 billion when it starts trading. This would make it one of the ten largest companies with a multiclass structure.

In two earlier articles that we co-authored, we analyzed the substantial governance risks and costs produced by multiclass structures. In The Untenable Case for Perpetual Dual-class Stock, we show how such structures are likely to become inefficient and value reducing over time—even if they are efficient at the outset—and explain the value of sunsets to address this risk for public investors. In The Perils of Small-Minority Controllers, we analyze the additional substantial costs that should be expected when the governance provisions of a multiclass IPO enable the controller to unload most of its shares and retain control even with a small (or tiny) equity stake. Building on the analytical framework we put forward in this earlier work, the current paper analyzes the governance risks and costs posed by Dell’s planned multiclass structure, which nicely illustrates some of the basic problems arising from such structures and shows how Dell’s specific design choices introduce additional problems.

Dell’s current plan is to return to the public market through a “back-door” IPO in which the company will convert some of its tracking stock (Class V Common Stock) into a new class of publicly traded low-voting shares (Class C Common Stock). Its Class V Common Stock is a special stock that tracks Dell’s 80% stake in VMware Inc. and was created in connection with Dell’s 2016 buyout of the data-storage company EMC Corp. This exchange will take place only if a majority of the holders of the tracking stock (excluding shares held by Dell and its affiliates) approve the transaction in a special meeting currently scheduled for December 11, 2018. Once approved and finalized, this transaction will create a market for Dell’s low-voting shares.

Dell also indicated that, if the holders of the tracking stock vote this plan down, Dell will proceed with an alternative plan to return to the public market: it will conduct a traditional initial public offering in which low-voting shares are sold for cash. Dell’s charter provides that, once the company’s low-voting shares are publicly traded, its board of directors is authorized (at any time and without any other approval) to convert all the outstanding shares of tracking stock into low-voting shares pursuant to a conversion formula set out in the charter. Because MD is the CEO and chairman of the board, owns a majority of Dell’s shares, and has seven votes on the board, representing a majority of votes on the board, MD would, for all intents and purposes, yield significant power over the conversion decision and timing.

Regardless of which of the two routes Dell ends up pursuing, the resultant outcome would have certain basic features. First, Dell’s tracking stock, which is currently held by public investors, would be converted—at least to some extent—to low-voting shares. Second, Dell would become a publicly traded multiclass company in which public investors would hold the low-voting shares (entitling them to one vote per share); and MD, his affiliates, and his investment partner, the private equity firm Silver Lake Partners, would hold high-voting shares (entitling them to ten votes per share). Third, Dell would be governed by an amended and restated charter that it filed on October 19, 2018, as an exhibit to its prospectus form. We shall refer to both routes through which Dell might produce this state of affairs as the “Dell IPO”; to the period following the Dell IPO as “post-IPO”; and to the governance structure established by the provisions of Dell’s amended and restated charter and the initial distribution of Dell shares post-IPO as the “Dell IPO structure.”

In analyzing the post-IPO risks, it is important to recognize that the number of low-voting shares held by public investors can be expected to expand greatly over time for two reasons. First, Silver Lake Partners is expected to liquidate all or most of its holdings over the coming decade or even over the next several years. Second, as discussed in detail in Part III, because the IPO structure would enable MD to unload most of his shares without relinquishing his lock on control, it would be economically rational for him to take substantial advantage of this freedom to diversify by unloading shares. Under Dell’s IPO structure, shares sold by Silver Lake or MD would convert to low-voting shares. Eventually, the low-voting shares held by public investors would likely represent a substantial majority of Dell’s equity capital and have an aggregate value in the dozens of billions of dollars. Thus, the governance risks and costs that holders of low-voting shares would face, and the value implications of these risks, are economically important.

In our paper, we analyze these risks and costs that Dell’s IPO structure would create, and we conclude that they are substantial. The costs are expected to decrease the economic value of the low-voting shares that public investors would hold (and thus the price at which such shares would be expected to trade) in two key ways. First, because the multiclass structure would be expected to produce an array of distortions and thereby efficiency costs, it would also be expected to reduce the per-share value of Dell relative to a benchmark in which Dell would return to the public market with a one-share-one-vote structure that would not produce such problems. Second, the identified governance problems can be expected to increase the gap between the per-share value created by Dell and the per-share value of low-voting shares.

Our analysis proceeds as follows. Part II analyzes the risk associated with the lifetime entrenchment of MD. Because Dell’s IPO structure does not include any time limitation or sunset arrangement, this structure would enable MD to retain a lock on control even if—and after—he ceases to be a fitting leader of the company. Indeed, MD would be able to remain in control even if he should become incompetent, incapacitated, or very old and out of touch with the business and technology landscape. Because having an ill-fitting controller can be significantly value reducing, the risks arising from the lifetime entrenchment of MD are expected to be substantial.

Part III analyzes the risk of having a small-minority controller. For any given controller, the smaller the controller’s equity stake, the greater the expected agency distortions and costs. Therefore, even if MD remains a fitting controller over time, an assessment of governance risks should pay close attention to the risk that the Dell IPO structure would lead to a massive reduction in his ownership stake and thereby his ownership-based incentives. In particular, we show that the Dell IPO structure would enable MD to cash out a large majority of his shares, retaining only a small-minority equity stake, without relinquishing his lock on control. Furthermore, we explain that, consistent with a substantial body of empirical evidence, such an increase in the “wedge” between equity stake and majority control can be expected to produce substantial agency costs and value reduction.

Part IV analyzes the risk associated with midstream changes to the post-IPO governance arrangements. Even if public investors were to find these governance arrangements somewhat acceptable, it is important for them to recognize and assess the risk that MD would change these arrangements to their detriment down the road. Whereas the holders of Dell’s tracking stock currently have veto power over important governance changes, post-IPO charter amendments would not require approval by public investors. As a result, even if MD becomes a small-minority controller, he would be able to use his control to pass changes in the “rules-of-the-game” that would benefit him without support from affected public investors.

Part V states our conclusion regarding the substantial governance problems that public investors holding low-voting shares would face. We hope that our analysis, as well as the analysis in our earlier articles on the perils of dual-class structures, will contribute to any subsequent examination of Dell’s multiclass structure and its considerable risks for public investors.

The complete paper is available here. Comments would be most welcome.

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  1. Thomas Shohfi
    Posted Friday, November 16, 2018 at 8:57 am | Permalink

    Great analysis, but really not surprising. Dell’s hubris led to repurchasing $39.6B worth of stock from 1997 to 2012 before the company went private at a valuation of only $24.8B. A poor steward of shareholder capital certainly doesn’t want to be disciplined by public markets for a second time.

  2. Bernard S. Sharfman
    Posted Saturday, November 17, 2018 at 11:27 am | Permalink

    For an underwriter or investor in the IPO, this analysis must be a gift from heaven. Yet, this analysis can only go so far as I assume the authors do not have a financial stake in the offering. So, it is now up to market participates to decide how relevant this analysis is to the pricing and placement of the newly offered securities. That is why we have capital markets. The markets figure out what works over time. The regulation of dual class shares is not necessary.