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What Are Dual-Class Shares, And How Do They Work?
In 2022, Meta founder Mark Zuckerberg oriented his entire company to "the metaverse." A seemingly malaria-induced fever dream became a reality when the Zuck changed the name of one of the most iconic brands in world history to stake his claim in a digital, legless world. He also pumped billions of dollars of research and development into some goofy goggles no one wants. But this might raise the question: with Meta being a public company, and therefore having voting shareholders, how did he manage to pull this off? Well, welcome to the surprisingly fascinating world of dual-class shares.
In recent years, the debate around dual-class share structures has become one of the most captivating narratives in the world of capital markets. Traditionally favored by well-known companies in the media and technology sectors, such structures have been increasingly adopted by a variety of innovative companies, causing a significant increase in their prevalence in public markets. In the United States, the number of initial public offerings (IPOs) featuring dual-class structures has surged. The trend has even spread beyond U.S. borders, with changes to listing rules on stock exchanges as far afield as Hong Kong.
Before delving further, let's lay out what dual-class shares entail. In a dual-class share structure, a public company issues two or more different classes of common stock. Typically, these consist of Class A shares sold to public shareholders and Class B shares held by company founders, family members, or other insiders. While all shares participate in the company's financial successes (or failures), they carry different voting rights. Class B shares, often in the hands of visionary founders, wield superior voting rights compared to the Class A shares held by the general public. This creates a system of unequal voting rights, wherein the holders of Class B stock maintain voting control, thus keeping majority control of the board of directors and significant sway over the company's strategic decisions.
This type of stock structure is no recent innovation. It's been utilized by a host of public companies, from the Ford family at Ford Motors, to Berkshire Hathaway, to tech companies like Snap Inc. and Facebook (err..Meta). The appeal for company founders and their management teams is clear. Dual-class share structures allow them to tap into the capital markets for funding while retaining control of the company. The rationale being that these founder-led companies can keep a long-term perspective, unhindered by the pressure of short-term performance or the threat of hostile takeovers.
The Controversy of Dual-Class Shares
But dual-class shares have not been without controversy, particularly around the issue of corporate governance. The Council of Institutional Investors and other groups advocate for "one share, one vote," arguing that dual-class voting structures can leave minority shareholders underrepresented and undervalued. And there's the crux of the argument against such structures. Public investors, including mutual funds, buy into companies expecting a say proportionate to their ownership. Dual-class shares infringe upon this expectation, with Class B shares wielding voting power disproportionate to their financial stake.
In a perfect world, visionary founders would use their control only for the benefit of the company, but what happens when things go south? For instance, our earlier example about Zuckerberg sending all brand value and billions in shareholder value down a toilet, thanks to his mass stake of Class B shares. In dual-class companies, it becomes difficult to remove board members or a controlling shareholder, even when their decisions seem contrary to the best interests of common shareholders or the company at large.
There have been attempts to temper the potential pitfalls of dual-class share structures. One popular idea has been the use of "sunset provisions," which limit the duration of dual-class voting structures. These time-based sunsets mean that dual-class structures automatically convert to a single-class after a specified period of time, often tied to the life cycle of the company, or when the founders step back from active management. Yet, these are not without their issues. What constitutes an 'appropriate' length of time? A decade? Two? It's a tricky question to answer.
The Securities and Exchange Commission in the U.S., and its counterparts in other jurisdictions, have a tough task balancing investor protection with the appeal of attracting high-profile, often technology companies, to their public markets. While private equity and other forms of private capital offer alternatives to the public markets, there's a recognition that the prestige and liquidity of exchanges like the NYSE are an effective way to facilitate growth.
Recently, the Premium Segment of the London Stock Exchange has relaxed its rules regarding differential voting rights, allowing dual-class companies to join its main market. This move, mirroring a similar shift by the Hong Kong exchange last year, aims to attract innovative companies looking for an IPO but wary of giving up control to public investors.
As we've seen, dual-class share structures present a conundrum. On one side, they offer an avenue for visionary founders of technology companies, among others, to retain control of their creations. Yet, they also expose public shareholders to potential downsides due to unequal voting rights. Like a tool, dual-class structures can be either beneficial or harmful, depending on how they are used.
The debate on dual-class shares won't be settled anytime soon. With the rise of tech startups and founder-led companies in Silicon Valley and elsewhere, we may well see a further increase in dual-class IPOs. What is clear is that, regardless of one's stance, the conversation around dual-class structures, corporate governance, and minority shareholders' rights is not going away.
Ultimately, the dual-class structure is a tool, much like a hammer or a saw. In the right hands, it can be used to build something impressive. In the wrong hands, it can cause significant damage. So, it's essential to look beyond the initial appeal of visionary founders and innovative companies. Take a moment to understand who holds the hammer, how they're using it, and what they plan to build.