Over the past three decades, there has been increasing concern about how corporate governance structures such as classified boards and dual class stock entrench managers, reduce director effectiveness, and reduce firm value. Likely as a result, mature firms have increasingly eliminated these structures. While almost 60 percent of S&P 1500 companies had classified boards in the 1990s, only 35 percent had them in 2017. The percentage of companies with dual class shares has also dropped, from 12 percent of the S&P 1500 in the 1990s to 7 percent in 2017.
Strikingly, newly public firms’ structures have moved in the opposite direction. The percentage of firms going public with a classified board has nearly doubled, from 40 percent in 1990 to over 70 percent in 2017, and the percentage with dual class stock has more than doubled, from less than 10 percent before 2000 to more than 25 percent in 2017.
Why Might IPO Firms Adopt Classified Boards and Dual Class Stock?
The contrast between mature firms and newly public firms raises challenging questions about corporate governance choices. On the one hand, perhaps young firms adopt classified boards and dual class stock because these types of structures represent optimal governance for them at this point in their life cycle. Newly public firms tend to be characterized by high information asymmetry, meaning managers cannot credibly convey the value of long-term initiatives to external investors. Classified boards and dual class shares are beneficial because they shield such firms from short-term market pressures.Moreover, the costs of these governance structures may be relatively low for many newly public firms: Insiders tend to own large percentages of the stock, and compensation structures tend to be highly incentive based. Such factors motivate managers to maximize shareholder value, thereby mitigating agency costs.
Alternatively, it is possible that IPO firm managers establish classified boards or dual class shares to entrench themselves. Perhaps the heightened attention to governance over recent decades has led managers to increasingly adopt protective measures while they can, i.e., prior to going public. In more recent years, the increased availability of capital to private firms has given entrepreneurs greater bargaining rights, further contributing to the possibility that agency-related factors contribute to the increasing frequency of these structures.
Dual Class Stock Structures – the Devil’s in the Details
Descriptive evidence highlights the heterogeneity of dual class structures, and it suggests varying motivations for firms’ choices of these governance structures. Among dual class firms, 22 percent represent equity carve-outs, in which a parent firm sells a portion of a subsidiary’s stock to the public in an IPO. Compared with other types of firms with dual class stock, carve-outs are five times more likely to convert to a single class stock structure within the first five years of the IPO (30 percent vs 6 percent), and companies with carve-outs are twice as likely to be acquired (32 percent versus 15 percent). These cases arguably represent instances in which the IPO is just the first step in the sale of the company by the parent, rather than evidence of a founder’s striving to maintain control.
More generally, the voting power of those who would benefit most from protecting perquisites varies considerably. Across all IPOs of companies with dual class stock, the CEO controls less than 10 percent of the vote in nearly 60 percent of the cases. Perhaps even more surprising, officers and directors control less than 10 percent of the vote in nearly one-quarter of IPOs involving dual class stock (these cases represent a combination of equity carve-outs and corporate blockholders.)
The types of firms choosing dual class structures have changed over time. Contrasting the 1988-2014 period with the 2015-2017 period, the percentage of dual class firms that represent founder firms in technology or biotech industries increased from 14 percent to 39 percent. The percentage of IPOs of dual class companies backed by venture capital has also increased markedly, from 21 percent to 46 percent. These trends potentially reflect the fact that the increased availability of capital to private firms has weakened VCs’ bargaining rights and strengthened those of founders.
Value of Classified Boards and Dual Class Stock
To understand how shareholders view classified boards and dual class shares, we examine the voting behavior of a large group of firm owners, mutual funds. We focus on the votes of the most engaged mutual funds, which are more likely to evaluate firm-specific governance demands rather than simply follow the recommendations of proxy advisers such as ISS. Strikingly, among firms with high information asymmetry, engaged funds are equally likely to vote for directors of firms with classified boards or annual boards. In sum, classified boards appear to represent optimal governance among the subset of firms with high information asymmetry at this point in their lifecycle.
Findings regarding dual class firms are starkly different. Mutual funds are 7 percent less likely to vote for directors of dual class firms, and this relation is not mitigated by firms’ level of information asymmetry. Moreover, mutual funds’ opposition is significantly greater among firms with higher agency issues and firms with a higher voting-cash flow wedge, in which insiders hold a larger vote relative their ownership stake.
Further findings indicate that mutual funds have become increasingly likely in recent years to vote against directors of firms with dual class shares. In a similar vein, they have also become more likely to oppose directors of firms with classified boards in cases where firm-level information asymmetry is low. These trends are again consistent with the rise in the supply of capital to private firms in recent years and the associated greater bargaining rights of founders, which have contributed to an increase in agency-motivated governance structures.
Recommendations of ISS
The voting patterns of engaged mutual funds contrast starkly with the recommendations of ISS. Mutual funds tend to tailor their votes to the characteristics of each company while ISS typically adopts a one-size-fits-all approach. First, ISS is less likely to recognize that newly public firms’ governance demands may differ from those of their mature counterparts. ISS recommends against a striking 24 percent of the directors of newly public firms, compared to only 6 percent of mature firms’ directors. Second, this opposition is significantly greater among firms with classified boards and firms with dual class shares. Third, ISS recommendations do not vary with firm information asymmetry, firm agency, or the wedge between insider cash flow rights and voting rights within dual class structures.
Another vehicle through which shareholders can exhibit preferences is shareholder proposals. However, we find that newly public firms face fewer shareholder proposals than do mature firms. Within each of the first five years after an IPO, less than 5 percent of firms receive a shareholder proposal. In contrast, approximately 20 percent of mature firms receive at least one shareholder proposal each year. Perhaps because newly public firms face less pressure from shareholders, 56 percent still have a classified board 10 years after the IPO while only 47 percent of mature firms do. Lower information asymmetry later in a firm’s lifecycle suggests that these structures are less likely optimal at that point.
Our findings are consistent with agency concerns being stronger for dual class shares than for classified boards. Because classified boards shield managers from short-term pressures for just two years, i.e., until a majority of directors can be replaced, classified boards represent a compromise between the benefits of a longer-term focus and the benefits of external monitoring, for example in the form of takeovers or activist intervention. In contrast, dual class structures shield the firm from external monitoring more indefinitely, particularly in cases where the superior voting class effectively has complete power.
Our findings highlight the importance of focusing on both firm-specific governance demands and on the details of these governance structures. First, newly public firms’ governance demands differ from those of mature firms. Moreover, among newly public firms, the governance demands of firms with high information asymmetry differ from those with low information asymmetry. Second, dual class share structures are not all equal. The choice of an equity-carve-out firm to have dual class shares is arguably motivated by a very different set of factors than the choice of a founder firm to elect such a structure. Relatedly, a dual class share structure in which the CEO has majority voting control is fundamentally different from one in which the CEO has less than 10 percent control. ISS’ apparent failure to consider such factors raises serious concerns, especially given the large number of mutual funds that follow its recommendations.
 Classified boards make directors less susceptible to short-term market pressures since directors are up for election only once every three years. Dual class stock similarly shields firm insiders from the whims of short-term investors, in this case by separating control rights from cash flow rights.
This post comes to us from professors Laura Field at the University of Delaware’s Alfred Lerner College of Business and Economics and Michelle Lowry at Drexel University. It is based on their recent article, “Bucking the Trend: Why do IPOs Choose Controversial Governance Structures and Why Do Investors Let Them,” available here.