Sunset Provisions for Dual-Class Share Structures?

By Hyunseob Kim, PhD and Roni Michaely, PhD Posted In: Economics, Equity Investments, Performance Measurement & Evaluation, Portfolio Management, Standards, Ethics & Regulations (SER)

Dual-class share structures take a lot of heat from practitioners and academics alike. When Snap Inc. was preparing for its initial public offering (IPO) in 2017, CalPERS and other institutional investors harshly criticized the company’s move to create a new share class with no voting power. Similarly, before Lyft went public this year, a group of institutional investors unsuccessfully lobbied its board to abandon a proposed dual-class structure.

Why are dual-class share structures so controversial? Because, critics contend, they give the insiders who control the firm disproportionate voting rights relative to their cash flow rights and make it easy for them to take advantage of dispersed outside shareholders. This, in turn, is believed to be correlated with less-efficient corporate decision making and poorer performance over the long term. Indeed, research also suggests that “one share, one vote” weighting is the optimal structure.

Nevertheless, many prominent companies, especially in the tech sector — Google, Facebook, and Lyft among them — have embraced dual-class voting in their IPOs. That such pillars of the modern economy would opt for — if the literature is to be believed — the path of self-sabotage gave us pause and led us to look more closely at the potential benefits of the dual-class structure over a firm’s life cycle.

In our paper, “Sticking around Too Long? Dynamics of the Benefits of Dual-Class Voting,” we examine how the influence, both positive and negative, of a dual-class share structure, net of costs, evolves over a company’s existence. We carefully — often manually — construct a database of more than 900 unique dual-class firms in the United States. The sample spanned almost 50 years, from 1971 through 2015.

Using the data, we show that young dual-class firms — those with less than the sample median of 12 years from their IPOs — have about 7% greater valuation than single-class firms of the same maturity, in the same industry and year, and with similar characteristics.

As they mature, dual-class companies experience approximately 9% greater declines in valuations than their single-class counterparts. What explains such diminishing returns? We found that the principal drivers are deteriorating operating performance, slower innovation rates, and increasing systematic risk.

This evidence suggests that the costs of a dual-class share structure increase significantly as firms evolve, while the benefits of shielding firms from capital market pressure decrease. These findings challenge the dominant view that dual-class voting is suboptimal. Rather, dual-class voting is likely to be optimal for young, fast-growing firms.

So rather than precluding dual-class firms altogether, investors and firms should consider embracing dual-class structures — with defined sunset provisions. The dual-class structure could be in place until a particular event — say, the passing of a fixed period of time — triggered their retirement, or minority shareholders could vote on an extension of the structure at a predetermined time post-IPO.

These provisions are simple to understand and easy to implement. They allow firms and investors to enjoy the advantages of dual-class structures when those advantages are clear — when companies are young and growing fast — while providing a time-consistent way to dismantle them after their time is up.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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