How Dual-Class Share Structures Create Agency Costs

A number of companies have recently gone public with dual-class share structures, allowing founders to retain control. Most of these companies’ articles of incorporation contain a provision that requires any merger consideration to be distributed pro rata among all shareholders. These equal treatment clauses, in effect, give away founders’ control premium to minority shareholders. On first glance, these clauses seem to provide some protection to minority shareholders, who know that, in the event of a change-of-control, they will be compensated at the same rate as founders. But, as my recent paper explores, there are agency costs lurking beneath the surface of these clauses.

Control is valuable. It allows controllers to direct the corporation free from interference by others, permitting controllers to pursue a long-term idiosyncratic strategy or extract private benefits. Regardless of the reason for maintaining control, having it without also having full rights to cash flow creates agency costs—the controller is unwilling to permit a socially efficient sale, because it is not beneficial to her. For example, assume a firm’s market value (the amount rational market participants are willing to pay for the firm) is $1,000, and the controller owns 30 percent of the equity of this firm but, through high-voting stock, controls the firm. Although the market views the controller’s stake as worth only $300, she may well view her stake as worth $450, because she believes, perhaps irrationally, that her vision for the company will be successful.[1]

To purchase the firm, a buyer (say, a company that can wring synergies out of a combination) needs to value the firm at more than 15 percent of its current market value—that is, the buyer needs to value the firm at $1,150. In this way, the founder’s idiosyncratic vision forces the buyer to pay the controller’s price rather than the market price. The same problem exists if the founder is extracting private benefits from the company.

The multi-class share structure is almost ubiquitous among public technology companies. Blue Apron, Facebook, Google, and others have all gone public with a multi-class share structure. But two unique features stand out in recent multiclass IPOs: automatic conversion, in which high-voting shares convert to low-voting shares when sold or otherwise transferred by the original holders, and equal treatment clauses. So, a future buyer now must purchase the entire company and must do so by paying equal consideration to all shareholders.

These new features exacerbate the agency problem when a controller does not possess full cash-flow rights. Once those structural features are included, our hypothetical buyer (for the firm valued at $1,000) must now value the firm at 50 percent over its market value. The controller can block a sale and will only sell at her value. The buyer cannot just purchase the controller’s shares, because she won’t have control once they convert to low-voting shares, and the buyer must pay everyone the same price—the founder’s reservation price.

This feature can prevent efficient change-of-control sales, and this risk is not just hypothetical. For example, Yelp Chief Executive Jeremy Stoppelman has turned down offers for the company, because a sale would conflict with his long-term goals. In 2015, Google made overtures to Yelp, which had a dual-class stock structure and an equal treatment clause. The merger discussions eventually ended, likely in part because of Stoppelman’s idiosyncratic vision. And Stoppelman’s gamble did not pay off for Yelp shareholders. Since the discussions with Google started, Yelp’s market value has declined by about 20 percent.

This issue may seem relatively minor now, but more companies will probably go public with this structure, and the market for corporate control may eventually pressure them to sell. Standing in the way of these market forces will be structural impediments that deal lawyers will have to reckon with. Unless the buyer is willing to pay the founder’s reservation price, it will have to violate the equal treatment clause by paying more to the controller than to the minority shareholders. Doing so will require a majority-of-the-minority vote. This allows activists to hold any potential transaction hostage by purchasing a small percentage of the minority stock and agitating for a higher price. And even without activist pressure, obtaining a majority-of-the-minority vote is not always easy—Dell failed to win a majority-of-the-minority vote at its first shareholders meeting to approve its 2013 management buyout.

My recent essay, “The Agency Costs of Equal Treatment Clauses,” tries to grapple with these issues and proposes some alternatives, such as embedding a control premium in the articles of incorporation. The aim is to further the debate over the structure of control arrangements to ensure that they do not limit efficient transactions.


[1] See generally Zohar Goshen & Assaf Hamdani, Corporate Control and Idiosyncratic Vision, 125 Yale L.J. 560 (2016) (arguing that control is valuable because it allows controllers to pursue their visions).

This post comes to us from Kirby Smith, a recent graduate of the University of Chicago Law School. It is based on his article, “The Agency Costs of Equal Treatment Clauses,” available here.