The Life-Cycle of Dual Class Firms

The Life-Cycle of Dual Class Firms

Martijn Cremers, Beni Lauterbach, Anete Pajuste

March 02 2018

IPOs of dual class shares have become popular in the recent decade, following the lead of some technological "superstars", e.g. Google and Facebook. Firms adopting the dual class equity structure have at least two classes of common shares: high-voting-power shares, owned primarily by firm founders or controlling shareholders, and low-voting-power shares, held primarily by ordinary public investors.

Dual class financing is a controversial and hotly debated issue worldwide. In a recent talk, new SEC commissioner Robert J. Jackson points out that this structure may be useful as it allows visionary entrepreneurs to build for the long term - and even transform entire industries - without being subject to market pressure to increase profits in the short-term. On the other hand, says Jackson "you have a structure that undermines accountability: management can outvote ordinary investors on virtually anything". In other words, public investors fear that the disproportional power allocated to controlling shareholders may corrupt, and may tempt controlling shareholders to try various self-serving behaviors ("private benefits consumption"). The problem of dual class financing is exacerbated because, as Commissioner Jackson notes, "Those companies are asking shareholders to trust management's business judgment – not just for five years, or 10 years, or even 50 years. Forever".

We contribute to the debate on the merit of dual class financing by examining empirically, for the first time, the crucial effect of the firm-age dimension. Bebchuk and Kastiel (2017) have recently argued theoretically that any initial benefits of dual class financing dissipate in the years after the IPO, as founders' vision is largely accomplished. On the other hand, they argue that agency problems tend to aggravate in the years after the IPO, as founders and controlling shareholders gradually dilute their equity holding (and thus pay less for their private benefits consumption). Thus, Bebchuk and Kastiel (2017) conclude that dual class structures become less efficient with time from the IPO. A possible solution is to implement a sunset clause, where non-controlling shareholders vote on whether or not to extend the dual class structure at a pre-determined date (say X years) after the IPO. Examining the potential merit of such a sunset provision is another task of our study.

Our sample comprises all U.S. IPOs in 1980-2015, with special reference to a matched sample of 504 dual- and 504 single-class IPOs. We find that dual class firms exhibit a valuation premium over comparable single class firms at the IPO. However, this valuation premium gradually dissipates with firm's listing age (= time from IPO). Depending on the measure and methodology used, within 6 to 9 years after the IPO, dual class firms drop into lower valuations (lower Tobin's Qs) than comparable single-class firm.

Our evidence on the higher initial valuations of dual class firms suggests that dual class financing should not be banned and dual class stocks should be allowed to trade on exchanges. On the other hand, the eventual valuation discount of mature firms with dual class shares illustrates that sunset provisions deserve serious consideration. Interestingly, our findings and conclusions are consistent with Commissioner Jackson recently expressed position. He argues that allowing visionary entrepreneurs to issue dual class shares is beneficiary as it lets public participate and profit from the rapid growth of companies like Google and Facebook. On balance, Commissioner Jackson also acknowledges that some sort of a sunset provision may be necessary as a protection against managers who may misuse the dual class structure.

Our extensive data and tests also help establish several other differences between dual- and single-class firms, and show how these differences evolve along firm's life-cycle. For example, as hypothesized in previous studies, dual class firms have higher survival rates and are taken over less often, compared to single-class firms. Last, our evidence warns us that what is true for firms at young ages might not hold at older ages. Firm's age and life cycle are dominant factors that studies should incorporate.