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Dual Class Shares: How do they impact Investors?

Stocks, US

Written by:

Alvin Chow

You might have seen listed companies with Class A and Class B shares and were wondering what the differences are. Here, I explain what dual class shares, the key principles you need to know about dual class shares as an investor, whether its good or bad, and the potential risks you must note when investing in dual class stocks.

What are Dual Class Shares?

Dual class shares refer to stocks with two share classes that come with different voting rights.

Dual class shares allow founders and executives to maintain control over the company while raising funds via the stock market. Usually, one class (share A) with lower voting rights is offered to the general public while another class (share B) comes with greater voting rights and are usually owned by the company founders, executives and/or family.

Often times, the different share classes are also entitled to different dividend payment levels.

Why do listed companies adopt the Dual Class Share Scheme?

Imagine Facebook without Mark Zuckerberg, or Tesla without Elon Musk.

Founders are synonymous with their companies. Founders bring vision, drive and passion to the company. They are the reason for the companies’ growth and success. Having them at the helm gives investors the confidence that the companies will continue to do well.

In fact, Bain & Co. consultants have found that founder-led companies among the index of S&P 500 companies performed 3.1 times better than the rest over the a period of 15 years.

W160316_ZOOK_FOUNDERLED

During the initial stages, founders typically own the majority share in their companies. With their personal fortunes tied to the company, they are both willing and able to make sound business decisions to grow and scale.

The struggle arises when the company requires massive funding to scale fast. A large equity raise would dilute the ownership and control of the founder.

While the value of the founder’s shares would increase due to an increase in the valuation of the company, the percentage of the founder’s share would have correspondingly decreased.

The founder is no longer able to make the final decisions on the company’s direction.

Here is where a Dual Class Shares scheme would solve this dilemma.

Take Facebook as an example. Mark Zuckerberg retains control of Facebook even though he is not a majority shareholder.

This is because most of his shares are Class B where each share is worth 10 voting rights as compared to a Class A share of 1 vote per share.

Class B shares are not traded and hence there is no way a shareholder activist or any ill-intent investor can collect enough ownership to oust him. This could assure the rest of the shareholders that Zuckerberg would stick around for a long time regardless of the shareholder concentration or makeup.

In a single share class situation, the shareholder with the majority shares could exert tremendous control of the company. You can see that the ownership and control of the company become delinked in a Dual Class Shares arrangement.

What is the difference between class A and class B shares?

When a listed company offers more than 1 class of stock, these stocks are usually designated as Class A and Class B stocks and come with different voting rights.

Class A shares usually carry less voting rights than Class B and are usually traded publicly. That said, you should read the company’s annual reports to find out the exact voting rights.

In Facebook (now Meta Platforms) case, their Class B shares entitle holders to 10 voting rights per share while their Class A shares which trade publicly entitle holders to 1 voting right per share.

Are dual class shares good or bad?

There are always two sides to every situation. Likewise, dual class shares have their proponents and critics.

On the one hand, they give investors confidence that founders will stay on long-term to guide the company; on the other hand, there is a risk that the company will be solely controlled by these same shareholders, putting the smaller investors on the risk of being on the ‘losing’ end should the interest between shareholders and founders not be aligned.

What are the advantages and disadvantages of dual class shares?

Advantage of Dual Class Shares – Enabling an Intangible Economy

Our world has changed from atoms to bits and the intangible economy requires a totally different funding framework.

Debt financing by banks would play a lesser role in technology companies unless their lending rules are reviewed. Equity will remain the main source of funding for these asset-light companies.

Angel investors and venture capitalists would play their funding roles when the technology companies are in their early phases. Subsequently, public shareholders would provide the funding for technology behemoths when they go for listing.

Good and trusted founders should retain the control of their companies even when they no longer hold a majority equity stake due to massive fundraising required to scale and keep their innovation alive.

Dual Class Shares enable this to happen.

Disadvantages of Investing In Dual Class Shares

However, every investment comes with risks. Dual Class Shares are no exception.

Founders have strong control over company

The first risk is that given the founders’ strong control over the company, they could abuse their powers against the interests of the shareholders.

For example, Conrad Black overpaid himself and his associates with money from Hollinger International. He was able to do it because he had 68% control despite holding only 18% ownership due to the Dual Class Shares structure.

Hence, we must be able to ascertain the intent and ethics of the founders who have control under a Dual Class Shares structure. Warren Buffet’s wisdom rings true for this,

“Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you. You think about it; it’s true.”

It could become the limiting factor to a startup’s growth

The second risk you must be aware of is that companies require different leadership and management skills at various stages. Running a startup and a listed company are different.

A founder may excel in leading the startup in its early days or even up until the IPO stage.

As the business complexity and organisational layers increased, the founder may find himself stretched beyond his capability. In such situations, a better candidate to head the organisation may be needed.

Travis Kalanick, the co-founder of Uber, is a good example.

Image result for Travis Kalanick

He was successful in scaling Uber to a behemoth but started to have a lot of trouble running the bigger entity. He eventually resigned under tremendous pressure.

However, a founder who has majority control over a company may not give up the seat so readily and shareholders would not have much power to vote him out under a Dual Class Shares structure.

Dual class stock examples

Although I’ve used Facebook/Meta Platforms as the main example, dual class stocks are fairly common, especially in the U.S. stock market.

You should have heard of these companies with dual class shares:

  • Berkshire Hathaway
  • Alphabet (Google)
  • Square

Why do young, high growth tech companies prefer the dual class share scheme?

We stand at the edge of a new era.

Decades ago, when the Marriott hotel chain was still a fledgeling company, founder John Willard Marriott was thinking about how to grow the company at a faster pace.

Buying another building to house another hotel is a very capital intensive endeavour and it would have taken too long for the current hotels to make enough profits to fund the next property.

JW Marriott understood that his company was known for hospitality. Not for ownership of properties.

Who cared anyway?

So he reached out to building owners who were interested in converting their building to a hotel. Marriott offered the hospitality brand and management expertise while the other party provided the location and space.

The result?

Marriott now runs hotels all over the world. In Singapore, the iconic pagoda Marriott Hotel is right in the heart of Orchard Road and is in fact owned by the retailer CK Tang.

The shift in perspective was crucial to Marriott’s success today. With this business model, Marriott avoided the need to own buildings.

They did not have to borrow to fund their acquisitions. And Marriott thus got onto the rocketship for scale, rapidly expanding to the juggernaut it is today.

Today, we look at a similar shift on a global scale.

Technology – The Dawn of a New Era

Fast forward to today.

  • Airbnb is the world’s largest ‘hotel chain’, but it does not own any hotels.
  • Uber is the world’s largest transportation company, but it does not own a single-vehicle.
  • Alibaba is the world’s largest retailer, but it holds no inventory.
  • Facebook is the world’s largest content producer, but it produces no content of its own.

They grew to their size today not by acquiring and owning more cars, more buildings or more physical stores.

These companies achieved their success by creating successful platforms. Platforms that served as a tool for other asset owners and allowed them to scale with lightning speed.

Like Marriott, technology companies do not need to own huge amounts of tangible assets. They do not need to own another building before they can start their next hotel. They do not require heavy investments in machinery or raw materials to grow their business.

Technology companies, therefore, are inherently scaleable – they can scale fast once they have achieved a product-market fit.

We are now at a stage where technology companies are disrupting businesses around the world. We can no longer ignore technological companies on the pretext that we do not understand them.

Funding Intangible Assets

You might ask: since technology companies are asset-light in nature, why would they need to raise money at all?

Technology companies build invisible enablers in our daily lives.

As the famous venture capitalist, Marc Andreessen once remarked, “Software eats the world.”

Facebook is not a tangible product. It is a software that lives on the internet and harvests the network effect of human relationships.

Similarly, the Google search engine that we use is just a software with nothing but lines after lines of code. The Airbnb platform is yet another example of successful software.

To build all the software, tech companies need to hire talented developers, product managers, designers, community managers and more staff with job roles that were not in existence just two decades ago.

Tech companies need to pay the salaries of these creators and to retain them. Funds are also needed to explore new ideas and to continue pushing the technological frontier. Patents and copyrights are intangible assets resulting from the research and development process.

In Capitalism without Capital, authors Jonathan Heskel and Stian Westlake noticed a trend where businesses around the world are reporting more and more intangible assets.

This creates a problem when these businesses seek funding.

Banks prefer tangible assets that could be collateralised – this would reduce the banks’ risks as they could seize the collaterals and sell them in the event that the businesses could not pay up.

Heskel and Westlake argued that the banks are unlikely to fund technology companies who own intangibles because they will be worth very little when the company folds and also because the intangibles are very difficult to value.

“Even those intangibles that can be sold, like patents or copyrights, present problems to creditors: they are typically difficult to value because a patent or a copyright is unique in a way that a van or a building or many types of machine tools are not. The liquid markets that exist for assets like vans and office blocks, or the professional advisers who will value your mine or your chemical tanker, have fewer equivalents in the world of intellectual property: it is a newer and less developed field and is conceptually more difficult. The result is that it is much harder to offer even well-specified intangibles as security on a loan.”

As a result, technology companies are usually funded by equity and not debt.

This is where angel investors and venture capitalists play an increasingly important funding role for tech startups and companies. As the companies grow to a certain size, they could consider tapping the public capital markets to fund further growth.

Dual class shares allow shareholders to gain exposure to the intangible economy

Shareholders will play increasingly important roles in this intangible economy. As with all forms of investing, there are bound to be risks.

However, if we all agree that this is an inevitable change for companies and shareholders alike, we should be shifting the conversation to how we can better manage these risks as we progress into the future.

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2 thoughts on “Dual Class Shares: How do they impact Investors?”

  1. Agree that Venture Capitalists and Seed Funding plays a role into scaling tech companies without a bank’s help. But one can’t help to realize, that angel investors hard push and high valuation as of recent cases has done more harm than good. It started with Uber. Now WeWork is the next one.
    And the list has just started..

    Reply

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