Why Are Two-Class Shareholder Arrangements Proliferating?

When Facebook first filed its IPO papers, Mark Zuckerberg structured the offering such that even though he was diluting his ownership of the company he was doing nothing to dilute his personal control over it. This is the basic paradox of publicly traded firms with two-class share structures. After all, what does it really mean to say you “own” a share of a business if you don’t have a say in its management? And yet such arrangements are reasonably common. You often see them when you have a family company—like Slate’s parent the Washington Post Company—that’s grown too big to be run on a purely family basis. But with Facebook and Google, we now have what looks like a somewhat different trend. Naturally, financial markets tend to discount the price of shares that don’t come with full voting rights attached, and, equally naturally, firms whose managers are freer to ignore shareholder views are less likely to maximize shareholder value.

But should we care?

Andrew Gelman offers the case for indifference while Felix Salmon and James Surowiecki sound the alarm.

In this case I think it’s primarily important to initially focus on why this is happening in the first place. Surowiecki points to the fact that particularly in the online services industry, firms don’t have especially large needs for capital. “Thanks to things like open-source software and cloud computing,” he writes “the cost of starting and expanding a technology company has fallen dramatically, and Facebook’s operating profit is more than enough to fund its growth.” This is true, but it’s worth noting that if it’s ever been the case that the stock market was there primarily in order to help firms raise money to engage in capital investments it was a long time ago. Here’s Doug Henwood from before anyone had heard of Facebook:

Over the long haul, U.S. corporations have funded about 90% of their capital expenditures with internal funds, profits plus depreciation allowances. This is true of most other economies as well. And when firms do turn outside for cash, they go first to banks, then the bond market, and only last to the stock market. There are individual exceptions to this rule, of course; for some individual companies, a share flotation is a crucial coming-of-age ritual - though typically the proceeds are used to cash out the initial investors rather than funding investment and hiring. Occasionally, there are historical periods, like the late 1990s, when IPOs do channel large amounts of money to corporations. But even in the peak year of the recent gusher, 2000, IPOs totaled just 5% of nonresidential fixed investment. In the less frenzied environments of the 1970s and 1980s, they averaged just 1% of investment. But even during the bubble years, IPOs were massively overshadowed by retirements of shares, through buybacks and takeovers. For example, in the U.S. from 1994 to 2000, one of the most vivid periods in the history of stock markets, buybacks exceeded IPOs by a ratio of nearly five to one. Over the same period, mergers and acquisitions exceeded IPOs by a ratio of twenty-two to one. In other words, U.S. corporations were shoveling out twenty-seven times as much cash to shareholders as investors were supplying to corporations via IPOs. And I’ll bet that more than few of those IPO buyers have come down with severe cases of buyer’s remorse.

So given that IPOs are really about cashing-out early equity holders (both investors and key employees), they’re the ones who clearly lose out if founders don’t structure lucrative offerings. And indeed we do see that venture capital firms don’t earn lucrative returns. It may be that startups no longer need venture capitalists’ money as much as they used to and thus can afford to structure exits in a relatively unfriendly way. That’s especially true if the sort of people startups try to lure as equity-incentivized early employees have a distaste for shareholder value as a concept.

If we’re observing a situation in which capital has become plentiful relative to entrepreneurial ideas, shifting the balance of power between investors and founders, then the natural question to ask is whether we have more capital or fewer ideas. It seems to be fashionable in some quarters to say we have a shortage of ideas, but I think this is hard to quantify. What’s clear is that we have a surge in capital. This has been a bad decade for developed countries, but the world as a whole has gotten dramatically richer over the past 15 years (think China, India, commodity exporters, etc.), and the United States has attracted big inflows of the money that’s resulted.