The Perils of Pinterest’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 third in which they analyze the terms of dual-class IPOs by major companies, following their earlier posts on The Perils of Dell’s Low-Voting Stock and The Perils of Lyft’s Dual-Class Structure (discussed on the Forum here and 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.

Pinterest, Inc. (“Pinterest”), the digital pin board company, is about to go public with a dual-class structure in an IPO valuating it at over $10 billion. This post focuses on the governance costs and risks that Pinterest’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: Although Pinterest’s co-founders will hold together only a minority of voting power immediately following the IPO, the company’s IPO structure will enable them to become majority controllers over time, and to retain such a lock on control while holding only a tiny ownership stake of the company’s equity capital (less than 5%); and
  • Extremely long-lasting lock on control: Pinterest’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 Pinterest by increasing agency costs and distortions, and (ii) increase the discount to a per-share value of Pinterest at which low-voting shares of Pinterest 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 Pinterest shares.

Expected Emergence of Tiny-Minority Controllers

Post-IPO, Pinterest will be a publicly traded dual-class company in which public investors hold low-voting shares entitling them to one vote per share. Pinterest’s three co-founders, as well as a host of venture capital investors, will hold high-voting shares entitling them to 20 votes per share. In the case of Pinterest, the design of its governance structure can be expected to produce 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 Pinterest’s Co-founders: Based on the amended registration statement that Pinterest issued, we provide below the post-IPO distribution of ownership and voting power. As Table 1 indicates, immediately following the IPO, the two co-founders who manage Pinterest, Benjamin Silbermann and Evan Sharp, will hold 13.4% of the company voting power and 11.5% of its equity capital. In conducting our calculation, we assumed that they vote together, as in the cases of the co-founders of Google or Snap. The third co-founder, Paul Sciarra, will hold additional 9.3% of the company voting power, but he left the company seven years ago and has not been playing a role in leading the company during this long period. Therefore, we assume that his interest is largely as an investor who does not derive private control benefits and can be expected to cash out over time.

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

Shareholder Class A Shares (millions) Class B Shares (millions) Cash-Flow % Voting %
Co-founders 61.1 11.5% 13.4%
Others 75 393.4 88.5% 86.6%

Although post-IPO Silbermann and Sharp will hold together only 13.4% of the company voting rights, far below a majority control, their combined voting power is likely to increase significantly down the road. This outcome is expected to result from the “automatic conversion” provision in Pinterest’s capital structure that automatically converts high-voting shares into low voting shares upon their sale. This conversion mechanism has a strong entrenchment effect. It would enable the co-founders to obtain, over time, a lock on control as other holders of high-voting shares, such as the venture capital funds, cash out by selling their shares to others. Such an evolution can be expected because, whereas the co-founders have incentives to obtain and retain control, the venture capital business model generally requires funds to liquidate their positions within a certain period of time.

We next calculate the extent to which, over time, Silbermann and Sharp would be able to reduce equity ownership without relinquishing their lock on control. In examining this issue, we assume that Pinterest’s total number of shares of common stock outstanding is 529.3 million as indicated in the company’s most recent disclosure. We also assume that the venture capital investors and Sciarra will liquidate their positions over time, which would result in converting all their high-voting shares into low-voting shares.

With these assumptions, we calculate the minimum ownership stake that would enable Silbermann and Sharp to have control. We find that, once the venture capital funds and other holders of high-voting shares cash out their post-IPO holdings of high-voting shares, Silbermann and Sharp will be able to hold 50% of the company’s voting power with approximately 4.76% of the company’s outstanding equity capital.

Finally, we consider whether and how the company’s sunset arrangements affect the equity stake that the co-founders will have to retain in the long term to ensure their lock on control. In the Untenable Case we advocated the general use of sunset provisions that would dismantle dual-class structures after a fixed period of time, and the Council for Institutional Investors (CII) adopted the approach we put forward in a petition to the stock exchanges. Pinterest has adopted a sunset provision, which at first glance seems to be responsive to the long-term entrenchment problem. Under certain conditions, the provision would dismantle the dual-class structure after seven years, which is the time period recommended for sunsets by the CII.

However, a careful examination indicates that this provision becomes applicable only in certain circumstances that the co-founders have the power and financial incentive to prevent from occurring, thus rendering this aspect of the sunset practically inapplicable. In particular, the sunset would not be applicable to any holder of high-voting shares that continues to own at least 50% of the high-voting shares he held prior to the IPO. The practical impact of the sunset is thus to limit the sale of high-voting shares by Silbermann to no more than 50% of his initial post-IPO equity holdings – rather than to dismantle the dual-class structure after 7 years.

Therefore, even assuming that Sharp liquidates his position by selling more than 50% of his high-voting shares over time, Silbermann will still be able to circumvent the sunset by retaining over 50% of his high-voting shares he held at the IPO. As indicated in Table 2, in this scenario, Silbermann will be able to decrease his equity stake to 4.87% without triggering the sunset (or to 4.77% once the underwriters exercise their option to purchase additional shares in full at the IPO), thus retaining his status as a tiny-minority controller.

Table 2: Minimum Cash-Flow Rights Necessary to Retain Majority Control

Shareholder Class A Shares (millions) Class B Shares (millions) Cash-Flow % Voting %
Co-founders 25.8 4.87% 50.6%
Others 503.5 95.13% 49.4%

Furthermore, we note that Pinterest also has a large number of authorized low-voting shares (6,666,666,667 shares), and only 75,000,000 of them will be issued at the IPO. In the future, Pinterest could distribute such shares as a dividend, on a prorated basis, to its shareholders. In such a case, Silbermann would be able to further reduce his equity stake without triggering the sunset provision and losing his effective control. To illustrate, suppose that ownership of 35% of Pinterest’s voting rights would still ensure effective control. As Table 3 below indicates, in this scenario, if Pinterest distributes 454.5 million low-voting shares as a dividend, Silbermann would be able to reduce his tiny-minority equity stake to 2.62% and still retain effective control (over 35% of the votes).

Table 3: 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 25.8 2.62% 35%
Others 958.3 97.38% 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 Pinterest. In such an acquisition, the acquisition consideration would be divided among shareholders pro-rata and the control by Pinterest’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 Pinterest 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 Pinterest’s governance structure currently enables the co-founders to have an absolute lock on control in the future with less than 5% 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

Pinterest’s IPO structure will secure extremely long-lasting lock on control for Pinterest’s co-founders. If Pinterest were to go public with a standard one-share-one-vote structure, the 13.4% aggregate ownership stake of Pinterest’s co-founders would not enable them to be insulated from removal in the event of under-performance. In such a case, if Pinterest’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, Pinterest’s co-founders can be expected to obtain over time a lock on control that subsequently would enable them to remain in power even if they became value-reducing leaders.

As indicated above, Pinterest will adopt a sunset provision that has a time-based element. However, this provision becomes applicable only in certain circumstances that the co-founders have the power and financial incentives to prevent from occurring, thus rendering this aspect of the sunset inapplicable. Pinterest’s sunset arrangements will also convert its structure to one-share-one-vote after Silbermann passes away. However, Silbermann is currently 36 years old. Given that the life expectancy of a person in the 99th percentile of income is currently 87 years, Silbermann 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.

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 Pinterest, its circumstances and its business environment, might well change the type of leader that would be most appropriate for the company. Pinterest 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, we argue in the Untenable Case, even those who view Pinterest’s co-founders as the best leaders for Pinterest 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 Pinterest’s co-founders would remain in power even though they would value-reducing leaders.

Our study puts forward a dynamic, lifecycle theory of dual-class structures. The study’s 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 tends to 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 Pinterest’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 teams of researchers (Cremers-Lauterbach-Pajuste (2018), Kim-Michaeli (2018) and Jackson (2018)). This body of empirical work confirms our concern that providing Pinterest’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 an additional problematic aspect of Pinterest’s structure. Rather than ending the dual-class structure shortly upon the occurrence of a triggering event resulting in Silbermann passing away or becoming incapacitated, the sunset provision produces a “transition” period of between 3 to 18 months during which the high-voting shares will be voted by a previously-designated trustee. Having a material period in which Pinterest is in such a limbo would also be costly for Pinterest’s public investors.

Conclusion

Pinterest’s IPO will introduce 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 Pinterest’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 will 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 Pinterest’s low-voting shares that public investors will hold – and should be fully recognized by these investors.

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