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More Than Meets the Eye: Reassessing the Empirical Evidence on U.S. Dual-Class Stock

Since Google (now Alphabet) issued dual-class stock at its IPO in 2004, the subject has been vigorously debated throughout the world.  Unlike firms whose shares all have equal voting rights (“one-share, one-vote firms”), companies with dual-class stock allow a founder to attach enhanced voting rights to the shares that he or she holds, while issuing shares with inferior voting rights to public stockholders.  All classes of such stock possess equal rights to share in the cash-flow of the corporation, thereby creating a divergence in voting and cash-flow rights in the capital structure of the company.  Dual-class stock therefore enables a founder to hold a majority of the voting rights in a company while holding only a minority of the cash-flow rights.  In the first half of 2019, 26 per cent of U.S. IPOs adopted dual-class structure, compared with only 1 percent in 2005.

A battle has emerged between institutional investors, which have traditionally derided dual-class stock, and founders, who have long supported the structure.  Institutional investors worry that dual-class stock, by reducing a controller’s exposure to the financial prospects of the business, encourages a controller to act in its own rather than its firms’ best interests – the extraction of so-called “private benefits of control.”  Founders counter that dual-class stock gives them the space to pursue their long-term visions and make long-term investments without succumbing to short-term pressure from public stockholders to maintain a high stock price.  Whether a particular dual-class firm is managed to the benefit or detriment of public stockholders will be determined by the balance between the extraction of private benefits of control and behaviour that promotes long-term value for all stockholders.

Empirical evidence on dual-class stock has been repeatedly used to attack dual-class firms and cited to persuade exchanges and indices to curtail dual-class stock.  Most of the empirical evidence examines how firms’ dual-class structures affect their stock prices, comparing their market capitalizations to the book values of their assets.  Tobin’s Q is a common measure of performance.

In a recent paper, though, I review an array of empirical studies on U.S. dual-class firms, which embrace a range of performance measures – not just Tobin’s Q or derivatives thereof.  I find that, on average, dual-class firms do show lower firm valuations than one-share, one-vote firms.  However, when assessed from the perspective of accounting measures of performance, dual-class firms show greater operating performance than matched one-share, one-vote firms.  Furthermore, investors in notional portfolios of inferior voting stock of dual-class firms earn at least equal, and possibly greater, returns than investors in notional portfolios of similar one-share, one-vote firms.

If dual-class firms are valued less than one-share, one-vote firms, but perform better financially and generate higher buy-and-hold stock returns than one-share, one-vote firms, it would suggest that the market is excessively discounting dual-class firms.  There is no evidence that, on average, dual-class structure is used to exploit public stockholders, at least not to the extent that it outweighs the structure’s positive impact on operating performance.  The market appears to discount dual-class firms on the assumption that public stockholders will be harmed, but that harm is not, on the whole, born out in practice.

Based upon the empirical evidence, the vitriol directed at dual-class firms is largely unjustified.  Rather than focusing on how to deter dual-class firms from listing, policymakers and exchanges should, instead, consider how best to give institutional investors greater comfort that the structure will not be used unfairly, in order to reduce the cost of capital for dual-class firms.  In the paper, I also note that an emerging strand of empirical study takes a more granular approach to dual-class firms, finding that their performance may vary depending upon firm characteristics, controller identity, and the time period studied, and such evidence may be informative to those policy considerations going forward.  Although the debates between founders and institutional investors will continue, it can no longer be assumed that the adoption of dual-class stock inevitably results in harm to public stockholders.

This post comes to us from Bobby V. Reddy, a lecturer in law at the University of Cambridge and a former corporate partner at the law firm of Latham & Watkins LLP.  It is based on his recent paper, “More Than Meets the Eye: Reassessing the Empirical Evidence on US Dual-Class Stock” available here.

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