Should Dual-Class Shares Be Banned?

Voices against dual-class shares, which violate the principles of corporate democracy and the precept of “one share one vote,” have increased over time. An influential 50-member Investor Stewardship Group (ISG), overseeing $22 trillion in assets, demands a total elimination of dual-class stock. Council of Institutional Investors (CII), representing managers of $25 trillion assets, recently demanded limiting any company’s dual-class share structure to seven years. Yet this year, Hong Kong and Singapore stock exchanges, which initially barred the listing of dual-class shares, went the opposite way, by allowing their listing.

Who is right? Influential institutional investors or Hong Kong and Singapore stock exchanges? Should dual-class stock be totally eliminated or, at least, have a mandatory sunset clause?

In our view, while the proposal to ban dual-class shares raises important issues, its implementation would do more harm than good, given the challenges from the digital revolution and the growing imperative for established firms to transform their business models.

For readers who haven’t been following this debate, here’s a quick primer. Companies with dual-class shares have two designations of common stock, typically A shares and B shares, with one class having more powerful voting rights than the other. Holding the more powerful shares allows some group of shareholders—often the founders—to control boardroom decisions even as economic interest in the firm is dispersed more widely. Some of the largest companies of recent times by market capitalization, such as Facebook, Alphabet, and Alibaba, carry dual class-shares. So do some older, family-controlled firms, such as Ford Motor Co. and The New York Times Co.

The use of dual-shares has been growing recently: One-fifth of companies that listed on U.S. stock exchanges last year had dual-class shares. Curiously, Warren Buffet strongly demands the elimination of dual-class shares, but Berkshire Hathaway continues to maintain two classes of voting stock. While most dual-class companies have superior Class B shares, which provide ten times more voting power than the inferior Class A shares, other companies such as Alphabet, Under Armour, Blue Apron, and Snapchat have taken this practice to an extreme by offering common shares with zero voting rights. Yet, investors price Alphabet’s Class C stock, which carries no voting rights, almost no differently than Alphabet’s Class B stock, which carries voting rights. Investors’ continued clamor for inferior-voting shares, even those with zero voting rights, suggests there must be some economic reason for their existence.

Academic research remains divided on the merits of dual-class shares. On one hand, some studies find lower stock returns for dual-class firms as compared to single-class firms, lower trading prices compared to fundamentals, and higher management entrenchment, executive compensation, and value-destroying acquisitions. Other studies, however, show that dual-class structure might be optimal in certain scenarios. Firms with growth opportunities as well as the need for external equity financing often convert to dual-class shares. Aggressive-growth and family-controlled dual-class companies display higher long-term shareholder returns. MSCI’s recent analysis shows that unequal voting stocks outperformed the market over the period from November 2007 to August 2017.

While media companies, such as The New York Times Co., Comcast, DISH Network, AMC holdings, Liberty Media, News Corporation, and Viacom have traditionally had dual-class shares — arguably to maintain news independence — a more important recent development is the widespread adoption of dual-class structure by technology companies. Almost 50% of recent technology listings have a dual-class status. We explored reasons for the growing use of the dual-class structure in an HBS case study among technology companies. Our nickel summary is that their growing popularity is due to the increasing importance of intangible investments, the rise of activist investors, and the decline of other protection mechanisms available to existing management such as staggered boards and poison pills. A dual-class structure, offering immunity against proxy contests initiated by short-term investors, could be optimal if it enables founder-managers to ignore pressures from the capital markets and avoid myopic actions such as cutting research and development and delaying corporate restructuring.

So, in our view, outright ban on dual-class shares would not be costless. For example, one principal reason for decline in the number of initial public offerings is the increasing reluctance of technology companies to list their stock, which is largely caused by rising shareholder activism. At the margin, a ban on dual-class stock would encourage more technology companies to remain private, or motivate listed technology companies to go private, eliminating common investors’ chance to buy even the inferior voting stock. This growing possibility is likely why Hong Kong and Singapore stock exchanges have reversed their earlier stance and allowed dual-class shares.

But how can one argue against a mandatory sunset clause? This clause automatically converts a superior voting share to a low-vote class at a fixed time after IPO. For example, Groupon’s and Texas Roadhouse’s shares converted after five years of listing, and Fitbit, Kayak, and Yelp carry clauses for automatic conversions. This structure allows a dual-class structure for a defined period early in a company’s life to allow founders to pursue risky and bold initiatives without subjecting themselves to the pressures from short-term investors. Research shows that the benefits of dual-class structure dissipate over time. The costs of letting management entrench itself eventually outweigh the benefits of shielding the company from short-term investors. This argument is supported by the decline in the valuation premium of dual-class companies over comparable single-class companies as firms grow older.

In our view, a sunset clause would be ideal if there exists a fixed, predetermined time after which all companies become mature enough to need no further changes in their business models. However, we cannot completely endorse this idea for two reasons. First, the firm age at which sunset clause should kick is far from clear. We calculated the years after IPO when a growth company becomes a mature company in its lifecycle for the stocks listed on U.S. stock exchanges. We find that this age-to-maturity has been declining. In the late 1980s, we estimate it was ten years. It declined to 7.6 years in 1990s and has further declined to five years in the 21^st century. The period to maturity differs based on the firm’s technology and business model. So, a one-size-fits-all policy would not work.

Second, and more important, we are unsure whether any of the today’s companies can bask in their established business models forever, given the increasing pace of creative destruction and the emerging competition from digital companies. Well-established companies, such as Ford, Caterpillar, Walmart, Macy’s, Sears, Boeing, General Electric, and John Deere, Duke Energy, and Thompson Reuters, are facing disruptions that require complete overhaul of their business models. Many large and mature companies, such as Amazon, Alphabet, IBM, and Apple, have had to reinvent themselves multiple times over. To the extent that a dual-class structure facilitates a company’s transformation, the assumption that a company predictably reaches a permanent business-model stage, and therefore does not need further transformation, would be detrimental to the nation’s innovation and shareholder value. For example, Pepsi’s transformation from a purveyor of sugary drinks toward healthy snacks would have been hindered had hedge funds succeeded in their demands.

In sum, instead of recommending a total ban on dual-class shares, or even a mandatory sunset clause, we recommend a more flexible shareholding structure. Companies with dual-class structures could be required, after a period of predetermined years, to gain approval from a majority of all shareholders to continue the dual-class structure. Furthermore, single-class firms should be given an option to convert to dual-class shares through a shareholder vote, in order to carry out significant transformations, instead of having to completely delist in order to achieve that goal.