Why Investors Pay So Much for Dual Class Firms

Professor Coffee makes the insightful point that if founders receive a lower price for their stock when they retain voting control, it does not seem fair to allow other shareholders to take away that control without compensation.  But, Professor Coffee argues, if shareholders can take away founders’ control without compensation, then founders should not receive less when they retain voting control, because such control is largely “illusory” in his words.  Of course, this argument may bring back memories of the economist’s admonition not to pick up the (obviously fake) $100 bill on the floor.  Clearly, markets can get out of equilibrium.  And Professor Coffee’s majority-voting proposal makes a great deal of sense.  However, one might worry that the founder genuinely disagrees with the then-shareholder majority as to the value of control.

The concern that disagreement is hard to value was articulated by Zohar Goshen and Assaf Hamdani in their article on corporate control and idiosyncratic vision.  Dual class stock insulates founders from the market’s failure to understand how they see the future.  The perennial question that remains unanswered by the literature is simply this: Why are investors willing to pay so much for dual class firms?  A recent study found that “at the IPO year-end the market valuation of dual class firms is, on average, 11% higher than that of matched single class firms.”  To be sure, this difference dissipates to some extent but remains statistically insignificant as long as nine years after the IPO.

One possibility is that investors prefer to bet on idiosyncratic vision.  The upside from the entrepreneur’s vision coming to pass may exceed the agency costs of control.  If disagreement is a kind of risk (a point I explore in a forthcoming theoretical essay), then holding dual class firms can be a form of insurance.  And if that’s the case, there seems to be little justification for sunsetting dual class stock to begin with.  Founders were paid by investors for the chance to bet on the next great American success story.  On that view, the Council of Institutional Investors’ proposal that super-voting rights on dual class stock expire within at least seven years is a misguided interference with a healthy form of private ordering.

This post comes to us from Professor Joshua Mitts at Columbia University Law School.