It sounds too good to be true: own a small portion of a company's total stock, but get most of the voting power. That's the truth behind dual-class shares. They allow shareholders of non-traded stock to control terms of the company in excess of the financial stake.
While many investors would like to eliminate dual-class shares, there are several hundred companies in the United States with dual Class A shares and Class B shares, or even multiple class listed shares. So, the question is, what's the impact of dual-class ownership on a company's fundamentals and performance?
- Dual-class share structures give specific shareholders voting control unequal to the amount of equity they hold in the company.
- This is to satisfy owners who don't want to give up control of their company, but do want to tap the public equity markets for financing.
- Proponents of dual-class shares say they allow founders to pursue a long-term vision, rather than face pressure to focus on short-term results.
- Detractors say dual-class shares creates an entrenched class of shareholder who is free to make bad decisions with few consequences.
What Are Dual-Class Shares?
When Google went public, a lot of investors were upset that it issued a second class of shares to ensure that the firm's founders and top executives maintained control. Each of the Class B shares reserved for Google insiders carry 10 votes. Meanwhile, ordinary Class A shares (GOOGL) sold to the public get just one vote, and Class C shares (GOOG) have no voting rights.
Designed to give specific shareholders voting control, unequal voting shares are primarily created to satisfy owners who don't want to give up control, but do want the public equity market to provide financing. In most cases, these super-voting shares are not publicly traded and company founders and their families are most commonly the controlling groups in dual-class companies.
Who Lists Them?
Many companies list dual-class shares. The dual-class stock structure at Ford (F), for instance, allows the Ford family to control 40% of shareholder voting power with only about 4% of the total equity in the company.
EchoStar (SATS) demonstrates the extreme power that can be had through dual-class shares: founder and CEO Charlie Ergen controls nearly 91% of his company's voting power via a combination of his Class A and Class B holdings.
Some companies have attempted to dilute the voting rights of existing shareholders by issuing new non-voting shares. Examples include Google, Facebook (FB) and IAC/Interactive Corp (IAC). However, these dilution attempts have been met with allegations of breach of fidicuiary duty and investor lawsuits. This has led companies to establish multi-class share structures with non-voting shares during the IPO phase.
Good or Bad?
It's easy to dislike companies with dual-class share structures, but the idea behind it has its defenders. They say the practice insulates managers from Wall Street's short-term mindset. Founders often have a longer term vision than investors focused on the most recent quarterly figures. Since stock that provides extra voting rights often cannot be traded, it ensures the company will have a set of loyal investors during rough patches. In these cases, company performance may benefit from the existence of dual-class shares.
With that said, there are plenty of reasons to dislike these shares. They can be seen as downright unfair. They create an inferior class of shareholders and hand over power to a select few, who are then allowed to pass the financial risk onto others. With few constraints placed upon them, managers holding super-class stock can spin out of control. Families and senior managers can entrench themselves into the operations of the company, regardless of their abilities and performance. Finally, dual-class structures may allow management to make bad decisions with few consequences.
Hollinger International presents a good example of the negative effects of dual-class shares. Former CEO Conrad Black controlled all of the company's class-B shares, which gave him 30% of the equity and 73% of the voting power. He ran the company as if he were the sole owner, exacting huge management fees, consulting payments and personal dividends. Hollinger's board of directors was filled with Black's friends who were unlikely to forcefully oppose his authority. Holders of publicly traded shares of Hollinger had almost no power to make any decisions in terms of executive compensation, mergers and acquisitions, board construction poison pills or anything else for that matter. Hollinger's financial and share performance suffered under Black's control.
Academic research offers strong evidence that dual-class share structures hinder corporate performance. A study from the National Bureau of Economic Research found that while large ownership stakes in managers' hands tend to improve corporate performance, heavy voting control by insiders weakens it. Shareholders with super-voting rights are reluctant to raise cash by selling additional shares—that could dilute these shareholders' influence. The study also shows that dual-class companies tend to be burdened with more debt than single-class companies. Even worse, dual-class stocks tend to under-perform the stock market.
The Bottom Line
Not every dual-class company is destined to perform poorly. Berkshire Hathaway, for one, has consistently delivered great fundamentals and shareholder value. Controlling shareholders normally have an interest in maintaining a good reputation with investors. Insofar as family members wield voting power, they have an emotional incentive to vote in a manner that enhances performance. All the same, investors should keep in mind the effects of dual-class ownership on company fundamentals.