Limit, Don’t Ban, Dual-Class Share Structures

A fight is raging between chief executives and big investors over “dual” (or multi) class share structures, which give disproportionate voting rights to corporate founders and leaders at companies including Google, Facebook, Dropbox, and Snap.

Pension funds and asset managers, who want to preserve the principle of one vote per share at all costs, have tried and failed to get these structures banned from stock market exchanges. Now they have taken the fight to stock indices and are trampling on individual retail investors in the process.

Institutional investors have convinced index operators to put hurdles in the way of companies that do not conform to their views on the subject. MSCI has reduced the weighting of companies with multiple share classes and S&P plans to exclude new ones entirely.

For investors and workers who rely on gains from index funds to fund their retirement, this is a nail in the coffin. Many of the biggest tech companies — as well as some of the most recent floats — use tiered voting classes to give founders the power to steer their companies towards their long-term goals.

Nearly a quarter of the global market capitalization of dual-class stocks is in the high-growth tech sector. And even though only one in five initial public offerings in 2017 were dual-class they outperformed all IPOs by about 500 basis points.

The moves by the indices have far-reaching impact. Not only do they provide the benchmarks that other investments are measured against, but also because so much money flows into funds that track them. In the U.S., index funds own about 40 percent of stocks. Facebook and Google shares alone more than doubled in the past five years. Excluding them from the indices would depress overall returns.

When this is coupled with the trend of startups staying private longer and going public at much higher valuations, retail investors face a double hit. Not only does more of the appreciation in stocks go to private investors but, when those companies do go public, they increasingly use dual-class shares. In 2017, 25 percent of IPOs had dual-class shares, up from 1 percent in 2005.

Institutional investors and the U.S. Securities and Exchange Commission are right to be wary that dual-class voting structures could become a form of “corporate royalty” — but excluding such companies from the indices only exacerbates the growing gap between markets and ordinary investors. Instead we should adopt two proposals that would change dual-class shares from a blunt tool into a sharpened scalpel.

First, limit how long these structures can last. Get rid of perpetual dual-class structures, by putting limits on them. Media companies were among the first to adopt dual-class structures — they cited press freedom concerns but also were motivated by dynastic reasons.

Tech companies argue they need strong founder control to allow long product development cycles to mature. We can strike a middle ground between the founders’ desire for a long-term view and investors’ wishes for more say in governance by insisting the structure expire after a specific amount of time, or after the founder or chief executive leaves the company. Just one in four of the 2017 and 2018 IPOs with dual-class shares included such “sunset” provisions.

Second, introduce tenure-based voting, allowing shareholders to accumulate voting control over time. That gives longer-term investors, including founders, relatively more say than those who choose to trade quickly in and out. This approach would also address concerns about extractive activist investors who agitate for short-term rewards such as stock buybacks at the expense of long-term gain. Tenure voting is a more precise way to align incentives between shareholders and company builders.

We must stop seeing this battle between chief executives and institutional investors as a zero-sum game. Instead, let’s set up a system that gives company leaders the chance to build long-term value and investors a fair say in governance.

Rote adherence to a one-vote-per-share rule comes at the expense of the broad principle of equality. Depriving ordinary people of potential gains from long-term stock market investing will not help level the playing field.

This article originally appeared in the Financial Times.