The Perils of Lyft’s Dual-Class Structure

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 a Research Fellow at the Harvard Law School Program on Corporate Governance. This post is the second in which they analyze the terms of dual-class IPOs by major companies, following their earlier post on The Perils of Dell’s Low-Voting Stock (discussed on the Forum here).

Related research from the Program on Corporate Governance 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, and the keynote presentation on The Lifecycle Theory of Dual-Class Structures.

Lyft, Inc. (“Lyft”) went public on March 29, 2019, with a dual-class structure in a well-subscribed IPO valuating it at over $23 billion. This post focuses on the governance costs and risks that Lyft’s public investors should expect to face down the road.

Our analysis builds on our earlier research work on multiclass structures, including The Untenable Case for Perpetual Dual-Class Stock (Virginia Law Review 2017) and The Perils of Small-Minority Controllers (Georgetown Law Journal 2019). Below we identify and analyze in turn two significant problems:

  • Tiny-minority controllers: Lyft’s IPO structure enables its co-founders to have a practically absolute lock on control (about 49% of the voting power) while holding only a very small stake (less than 5%) of the company’s equity capital; and
  • Extremely long-lasting lock on control: Lyft’s co-founders will be able to retain control for an extremely long period, which could well last for five or six decades, even if they become value-decreasing leaders.

Each of these governance risks can be expected to both (i) decrease the expected per share future value of Lyft by increasing agency costs and distortions, and (ii) increase the discount to a per-share value of Lyft at which low-voting shares of Lyft will trade. Each of these effects would operate over time to reduce the market price at which the low-voting shares of public investors would trade. These effects should thus be taken into account by any public investors that consider holding Lyft shares.

Tiny-Minority Shareholders in Control

Post-IPO, Lyft is a publicly traded dual-class company in which public investors hold low-voting shares entitling them to one vote per share. Lyft’s co-founders, Logan Green and John Zimmer, hold high-voting shares entitling them to twenty votes per share. In the case of Lyft, the design of its governance structure gives rise to what we define as tiny-minority controllers (see the typology we introduced in The Perils of Small-Minority Controllers).

The Expected Tiny Equity Stake of Lyft’s Co-founders: Based on the amended registration statement that Lyft issued, we provide below the post-IPO distribution of ownership and voting power. As Table 1 indicates, Lyft’s co-founders have practically absolute control over the company’s decision making, holding about 49% of the votes, while holding together less than 5% of the equity capital.

Table 1: Lyft’s Cash-Flow and Voting Rights Post-IPO

Shareholder Class A Shares (millions) Class B Shares  (millions) Cash-Flow % Voting %
Co-founders 1.4 12.8 4.96% 48.6%
Others 271.6 0 95.04% 51.4%

Furthermore, Lyft’s co-founders might be able to reduce somewhat the fraction of votes that they own and still retain effective control. To illustrate, suppose that ownership of 35% of Lyft’s voting rights would still ensure effective control. As Table 2 below indicates, in this scenario, Lyft’s co-founders would be able to reduce their combined tiny-minority equity stake to 2.65% and still retain effective control.

Table 2: Minimum Cash-Flow Rights Necessary to Retain 35% of the Votes

Shareholder Class A Shares (millions) Class B Shares  (millions) Cash-Flow % Voting %
Co-founders 0 7.5 2.65% 35%
Others 278.3 0 97.35% 65%

The Costs of Tiny-Minority Controllers: In The Perils of Small-Minority Controllers, we identify and analyze the severe governance issues that are expected to arise in companies with a controller that owns only a small- or tiny-minority stake. Controllers in companies with dual-class structures pose special governance risks because they present a problematic combination. On the one hand, because the controller is fully insulated from the disciplinary force of the control market, this force cannot address problems of underperformance and opportunism. On the other hand, when a controller holds a minority equity stake, the controller does not have the strong ownership incentives that come from owning a majority equity stake. Most importantly for our purpose, we demonstrate that, as the controller’s equity stake declines, the expected governance costs increase and, furthermore, the expected costs go up at an increasing rate.

Moreover, in The Perils of Small-Minority Controllers, we show that, in companies with tiny-minority controllers, significant agency distortions can be expected to arise in a wide array of corporate decisions. To illustrate, consider the possibility that a potential strategic acquirer would be interested in acquiring Lyft. In such an acquisition, the acquisition consideration would be divided among shareholders pro-rata and the control by Lyft’s co-founders would end. As a result, we show, there is a wide range of acquisition offers with high premiums that the co-founders of Lyft would have private incentives to block even though acceptance of the offer would make all other shareholders substantially better off.

Finally, as we demonstrate in The Perils of Small-Minority Controllers, this analysis of the expected governance costs of tiny-minority controllers is consistent with a substantial body of empirical evidence. We can thus conclude that, given that Lyft’s governance structure currently enables the co-founders to have an absolute lock on control with only about 5% of the equity capital and to have an effective control in the future with as little as 2.65% of the equity capital, this structure is expected to generate agency costs and governance distortions of significant magnitude that public investors should recognize.

Extremely Long-Lasting Lock on Control

Lyft IPO structure will secure extremely long-lasting lock on control for Lyft’s co-founders. If Lyft were to go public with a standard one-share-one-vote structure, the 5% ownership stake of Lyft’s co-founders would not provide them with insulation from removal regardless of performance. In such a case, if Lyft’s co-founders eventually became value-reducing leaders, public investors would be able to facilitate a leadership change. However, with the dual-class structure now in place, Lyft’s co-founders would be able to retain a lock on control far into the distant future even if they became value-reducing leaders.

Some companies with a dual-class structure have sought to limit such a risk by adopting a sunset provision that would be triggered, and would automatically dismantle the multiclass structure, after a fixed period of time or upon the occurrence of a specified event. Lyft also adopted a sunset provision, but a careful examination of the terms of this provision shows that it has little practical significance. Under Lyft’s sunset provision, the dual-class structure would be dismantled if Lyft’s co-founders were to sell 80% of the high-voting shares they held at the IPO. However, if Lyft’s co-founders were to sell such a large majority of their shares, they would forgo their lock on control even if the dual-class structure were to remain in place. Thus, applying a sunset provision to the scenario of a sale of 80% or more of the co-founders’ shares is not practically significant.

Lyft’s sunset arrangements will also convert its structure to one-share-one-vote after both co-founders pass away. However, Lyft’s co-founders are currently 34 and 35 years old. Given that the life expectancy of a person in the 99th percentile of income is currently 87 years, one or both of them could well be alive for more than five more decades. Thus, investors face the risk of having control locked in the hands of a tiny-minority controller for fifty or more years. Thus, public investors should expect to be remain controlled by a tiny-minority controller far into the distant future.

In The Untenable Case for Perpetual Dual-Class Stock, we analyze the major costs and risks arising from such an extremely long lock on control. Changes in Lyft, its circumstances and its business environment, might well change the type of leader that would be most appropriate for the company. Lyft operates in a dynamic business environment with disruptive innovations and significant changes over time. In such an environment, even highly talented and successful founders can lose their “golden touch” after many years of leading their companies. They might also lose their leadership energy and drive over time. Therefore, even those who view Lyft’s co-founders as the best leaders for Lyft at the present time or even for the next several years should recognize the existence of a major risk, which likely would grow over time: that down the road Lyft’s co-founders would cease to be fitting leaders and might even turn into value-destroying ones.

In The Untenable Case for Perpetual Dual-Class Stock, we put forward a dynamic, lifecycle theory of dual-class structures. Our analysis shows that, as time passes, the potential costs of a dual-class structure tend to increase while the potential benefits tend to erode, and that the risk that the dual-class structure would cease to be efficient would keep increasing as time passes. We also show that controllers have strong incentives to retain a dual-class structure even when that structure becomes inefficient over time. This implies that, over time, there will be a growing risk that Lyft’s structure would lead to its having inefficient, value-reducing leadership.

We should note that subsequent empirical work confirms the predictions of our economic analysis and conclusions. In our article, we put forward an economic prediction that the performance and valuation of dual-class companies will decline as the time from the IPO passes, and we called for empirical work that will test this prediction. Subsequently, as reviewed in our presentation on the Lifecycle Theory of Dual-Class Structures, these predictions were confirmed by three empirical studies (Cremers-Lauterbach-Pajuste (2018), Kim-Michaeli (2018) and Jackson (2018)). This body of empirical work confirms our concern that providing Lyft’s co-founders with secure lifetime control, without an effective time-based sunset, produces an economically substantial risk for public investors.

We wish to conclude the discussion of the expected long period of entrenched control by noting two problematic aspects of Lyft’s structure. First, once one of the co-founders dies or becomes incapacitated, Lyft’s sunset clause enables the remaining co-founder to control the votes of the deceased co-founder. During the period in which only one co-founder will be alive, then, control will be entrenched in the hands of a controller with an especially small economic stake. Second, rather than ending the dual-class structure shortly upon the occurrence of a triggering event resulting in both co-founders being deceased or incapacitated, the sunset provision produces a “transition” period of 9 or 18 months during which the high-voting shares will be voted by a previously-designated trustee who will retain their full voting powers. Having a material period in which Lyft is in such a limbo would be costly for Lyft’s public investors.

Conclusion

Lyft’s IPO introduced into the public market another major company with a multi-class structure posing governance costs and risks. In this post, we analyzed the costs and risks that Lyft’s IPO structure generates, and we concluded that they are substantial. These problems are expected to decrease the economic value of the low-voting shares that public investors hold (and thus the price at which such shares are expected to trade). Each of the effects that we analyzed can be expected to significantly decrease the economic value of Lyft’s low-voting shares that public investors will hold – and should be fully recognized by these investors.

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