Ownership, Investment and Governance: The Costs and Benefits of Dual Class Shares

In this paper we show that dual-class shares can be an answer to agency conflicts rather than a result of agency conflicts. When a firm issues voting shares to raise funds, an incumbent manager?s control rights are diluted. This increases the risk that an incumbent could lose control of the firm and therefore, could lose the associated benefits of control. Thus, the incumbent may forgo positive NPV investments in an effort to maximize his expected wealth. Non-voting shares allow a firm to raise funds without diluting manager?s control rights; hence, it can alleviate the underinvestment problem. But non-voting shares facilitate entrenchment and therefore, reduces value-enhancing takeover activities. Also, non-voting shares dilute dividends per share. We obtain conditions under which the benefit of using non-voting shares, that is, higher firm value due to higher investment outweighs the entrenchment and dividend dilution costs. Others have shown that deviations from ?one share-one vote? can be optimal, but our study is the first to integrate the dualclass decision into the rich body of research on capital structure and underinvestment.