Internet firms' dual-class shares are best avoided
Ownership without voting rights makes it too easy for bad managers to avoid accountability
When a company goes public, it must tell shareholders how it plans to govern itself. The new owners are promised a piece of the profits and a say in how the company is run. The standard arrangement for apportioning control is "one share, one vote". That is a good, tried-and-tested design, but it seems to be going out of fashion.
Upcoming initial public offerings by two large internet companies, Twitter and Alibaba, are putting a spotlight on dual-class ownership, which gives certain shareholders less voting rights, or none.
Dual shares, often known as Class A and Class B stock, until recently were out of favour, but they have been making a spectacular comeback, especially among technology companies.
Google led the way with its 2004 flotation, followed by LinkedIn, Groupon, Zynga and Facebook, which all have two or more share classes.
It is a trend investors would be wise to resist.
True, shares with inferior voting rights may cost less (the market's way of compensating owners for their lack of control). And when disgruntled shareholders cannot oust top managers, it is often argued, they are better able to deflect the pressure to sacrifice long-term performance for short-term return. Technology companies especially like that protective shield in the early years of their public life, when ideas are more plentiful than profits.
And it has worked well elsewhere: Berkshire Hathaway has two share classes, and its investors are not complaining. But for most firms, these arguments are outweighed by the fact that limited-voting shares make it too easy for bad managers to avoid accountability.
Martin Lipton, the corporate lawyer best known for helping managers stay in control with so-called poison pills, says dual-class shares ward off "myopic activists" - hedge-fund managers and buyout specialists who aim to drive up share prices in the short term, yet harm the company's long-term interests.
Recent studies call this view into question. Harvard Law School's Professor Lucian Bebchuk studied about 2,000 companies for five years after takeover attempts, buyouts and other activists' interventions from 1994 to 2007. He found that their performance improved - and kept on improving over five years - when compared with their peers.
Institutional Shareholder Services found that, from 2002 to last year, companies with multiple share classes underperformed their peers.
They also showed greater stock-price volatility, weaker accounting controls and more conflicts in business dealings.
Alibaba, the Chinese e-commerce giant whose value could exceed US$100 billion, unfortunately will keep the trend towards second-class shareholders going. Its founder at first wanted to list on the Hong Kong stock exchange, but it does not allow dual-class shares, so Alibaba is going to New York.
Both the New York Stock Exchange and Nasdaq allow companies to have unequal voting rights.
For now, Twitter will go against the grain and offer a single class of shares. Buried in its prospectus, however, the company says it reserves the right to switch to two classes.
Besides Hong Kong, only Singapore among the major exchanges bars dual-class shares - and it is considering relaxing that rule. Britain strongly discourages them, while other European bourses allow them.
Google, Facebook and the rest are not likely to return to "one share, one vote" anytime soon. That should not stop exchanges concerned about their reputations and corporate governance standards from leaning against the fashion - perhaps by limiting dual classes to the first five years of public ownership, or capping nonvoting stock at, say, 25 per cent of all shares.
Meanwhile, for investors, the best advice is the same as always: buyer beware.