Booking First Class, Stuck In Steerage: Beware The Dangers Of Dual-Class Stocks

by: Analytical Chemist

One of the fundamental rights of shareholders is the ability to vote at annual meetings. For most public companies, there is only one class of common stock, and each share of stock possesses an equal voting interest. However, a growing number of companies are, from their initial public offering (NYSEARCA:IPO), issuing multiple classes of stock where the economic and voting interests are unequal. Facebook (NASDAQ:FB) is the latest of such companies. Class A shares were the ones issued by the company in its IPO, while insiders hold the class B shares, which have 10 times the power of class A shares. This means that insiders hold 96% of the voting power, and CEO Mark Zuckerberg alone holds over 57% of the voting power. Facebook is effectively a privately held company with class A shareholders thrust into the position of silent partners, earning their share but having no say.

This strategy allows the management and/or founders of a company to maintain control of the company even when they do not own an economic majority of the company. It is a common strategy of recent technology companies. Google (NASDAQ:GOOG) has three classes of shares: class A are voting and public, class C are nonvoting and public, and class B have 10 votes per share. Google's co-founders Sergey Brin and Larry Page control the super-voting class B shares, and the two men control more than 50% of the voting power of Google.

Newer IPOs than Google also have super-voting stock designed to give control to their founders. These include Manchester United (NYSE:MANU), LinkedIn (LNKD), Zynga (NASDAQ:ZNGA) and Groupon (NASDAQ:GRPN). Groupon co-founders Brad Keywell, CEO Andrew Mason, and chairman Eric Lefkofsky own about a third of the publicly traded class A shares, but their 100% ownership of class B shares means they control about 57% of the company's votes. Despite accounting restatements and "material weakness in the company's internal controls," shareholders who own an economic majority cannot vote to replace the CEO or CFO without the approval of one of the co-founders.

Shareholders have little recourse when they have a permanent minority vote even when Groupon makes accounting restatements. Or when Zynga issues stock options to its employees to prevent an exodus of employees whose pay was in restricted stock that has plummeted in value since its IPO, even when that plummet is due to a large earnings miss. Or when Electronic Arts (NASDAQ:EA) sues Zynga for copyright infringement alleging its competitive strategy is "Steal someone else's game. Change its name."

In the case of Facebook, significant questions abound over its management. Facebook has long been under fire for its privacy practices and has settled with the FTC, agreeing to audits of its privacy practices every other year for the next 20 years. High-profile advertisers such as General Motors (NYSE:GM) have publicly stopped advertising on Facebook. There are reports that a significant number of clicks come from bots, to which Facebook responded by identifying and reporting 83 million fake accounts. It is entirely possible that Mark Zuckerberg and his management team are up to the challenges, but if they are not Facebook shareholders have no recourse.

Despite the dangers of dual-class stock structures, the structures exist in large part to avoid the fate of Job(s), i.e. founders being forced out of companies to the detriment of both the founders and shareholders. The best example of this is probably Apple (NASDAQ:AAPL), whose founder Steve Jobs lost a power struggle with the board of directors in 1985 and was forced out of the company. More than a decade later Apple acquired NeXT, another Steve Jobs-founded company, and it was only under Jobs' guidance that Apple returned from near bankruptcy to profitability in 1998, and set in motion the steps that took Apple to the highest market capitalization of any publicly owned company.

About 6% of US companies have this type of dual-class structure, representing about 8% of the total market capitalization. In general management ownership of stock is good for stock performance. Having skin in the game, so to speak, more closely aligns the interests of management and shareholders. One study reports that "firm value is positively associated with insiders' cash-flow rights, negatively associated with insiders' voting rights, and negatively associated with the wedge between the two."

In conclusion, owning Facebook is not quite like owning 94% of U.S. companies in which shareholders have voting interests proportional to their economic interests. Owning Facebook stock is also a referendum and vote of confidence in Mark Zuckerberg's leadership, like Manchester United and the Glazer family, Groupon and its co-founders Brad Keywell, CEO Andrew Mason, and chairman Eric Lefkofsky, and Google and its co-founders Sergey Brin and Larry Page. In every case, a business analysis is not enough. Each of these stocks requires an analysis of its controlling stockholders for proper due diligence. Do yours.

Disclosure: I am long AAPL.

Additional disclosure: In addition to owning Apple common stock, I own a small number of short term Facecbook puts.