When is a private company ready to go public? Most would agree IPO readiness requires a plan and a strategic niche; a competent team of managers and employees; a meaningful, growing revenue stream; and profitability or a path to profitability. Large institutional investors holding more than $3 trillion in combined assets that are members of the Council of Institutional Investors (CII) recently added another critical hurdle: a fair shake for the company’s public, non-affiliated shareholders (link: http://www.cii.org/ipo_policy).
At the heart of this fair shake is an equity structure that fairly aligns and investors’ voting power to an investor’s capital at risk. Some companies have multiple classes of shares with differential voting rights, usually to enable insiders or founders to control the board of directors despite owning a minority of equity.
With a “one share, one vote” structure, in contrast, incumbent corporate directors—and the chief executive who reports to them—have two paths to retain control of the company in its public form: holding a majority of outstanding shares or securing the confidence of the company’s broad ownership base.
The vast majority of recent IPO companies embrace “one share, one vote,” like most publicly held U.S. companies. However, about 7 percent opt for multiple classes of stock with unequal voting rights, including some significant players. In 2015, more than twice as much capital was raised in IPOs launched with these multiple-class structures than in 2014. These differential voting rights serve to protect control of the company by management or a controlling holder and can leave little recourse for outside investors if issues arise.
For many years, multiple-class structures have been particularly popular among media companies, with Viacom a prominent example. Some of the pitfalls of multiple-class structures are suggested by the challenges Viacom faces in generational transition, with lack of accountability to shareholders generally even as there are fights over the controlling shareholder’s role.
More recently, these structures have been in fashion among certain high-profile technology companies. Google (now, Alphabet) went public with a dual class structure in 2004, and subsequently added an additional non-voting class. Alibaba, First Data, Groupon, LinkedIn, Square and Zynga are among companies with differential voting rights. Some of these companies are highly successful, but others have suffered significant setbacks. This mixed record is not unlike other tech companies, but without the same responsiveness to markets to correct poor strategy or management.
CEOs of multiple-class structures often justify them as necessary to preserve the ability of management to pursue long-term strategy in the face of short-term market pressures. But the misalignment of voting rights and economic interest tends to have certain negative effects in the longer term.
A 2016 study commissioned by the IRRC Institute (link: http://irrcinstitute.org/wp-content/uploads/2016/03/Controlled-Companies-IRRCI-2015-FINAL-3-16-16.pdf) found that controlled multi-class companies overall underperformed non-controlled companies in delivering total return to shareholders (TSR) over all periods reviewed (one-, three-, five- and 10-year periods). Over 10 years, the average total TSR was 7.4 percent at controlled companies with multi-class structures, compared with 8.5 percent for non-controlled companies, a substantial difference in outcomes for shareholders.
Despite this underperformance, there was less change in board composition at controlled multi-class companies. The IRRCi study found that more than 23 percent of such companies had average board tenure in excess of 15 years, compared with just 7 percent at non-controlled companies. The study also found that at multi-class controlled companies, the proportion of directors designated as financial experts was lower, board diversity was lower (which may relate to long board tenure) and CEO pay was higher.
CII’s institutional investor members argue that when a company goes to the capital markets to raise money from the public, investors should have certain protections and basic rights, including a vote that is proportional to the size of their investment. Companies that have differential voting rights at IPO should “sunset” those provisions over a reasonable period of time. Such a structure is likely to be an impediment to needed change at some point in the company’s future, even if company insiders believe it is justified initially.
It is no surprise that private company insiders, anticipating the scrutiny of public investors after the IPO, find these multi-class structures that are personal entrenchment to be a comfortable option. That is why it is critically important for market participants involved in the IPO process, including IPO investors themselves, to advocate their concerns about the long-term risks when equity is structured to preserve control in favor of company insiders regardless of economic interest of investors.