More and more unicorns are galloping toward the stock exchanges, and it isn’t always a smooth ride.
Short-term volatility may be typical, as Lyft (LYFT shareholders learned last week in the stock’s first full week of trading. But there are deeper tensions beneath the surface, and their implications for investors are coming more clearly into focus.
In Silicon Valley, the land of celestial one-horned beasts, magical growth and inveterate Steve Jobs worship, the legend of the founder reigns supreme. Through sheer genius and determination — plus some spare change in venture capital here and there — the visionary founder wills billions in value into existence, making lots of people rich and advancing human potential in the process.
Yet as recent history shows, founders are far from infallible. Facebook (FB – Get Report) creator Mark Zuckerberg is blamed for failing to contain widespread data misuse and content moderation issues. A onetime wonderkid who built Snapchat at 21, Snap (SNAP – Get Report) founder Evan Spiegel hasn’t inspired much confidence as a public company executive. Perhaps the most extreme example is Tesla (TSLA – Get Report) chief Elon Musk, hailed by fans as a visionary but considered by critics a toxic and untrustworthy steward of investor cash.
What many of these examples have in common are shareholder voting structures that favor the decision-making of company founders. Multi-class voting structures, installed by many of the unicorns taking the markets by storm this year, are both a manifestation of Silicon Valley’s value system and a complicated problem for shareholders.
Much has been written about the advantages and pitfalls of the multi-class system, which grants founders who own relatively small stakes in the company disproportionate control of votes. One one hand, founders can drive growth unencumbered by squabbling activists; on the other, it can be extremely difficult to remove founders who underperform.
In the case of Uber, which had a multi-class structure before later ditching it, it took the dramatic ouster of founder Travis Kalanick by the company’s board in August 2017.
Recent headlines about Pinterest’s forthcoming IPO, which noted that founder Ben Silbermann’s supervoting shares stay in effect up to 540 days after his death, extrapolated the practice to absurd extremes.
Once the founder-knows-best mentality collides with institutional money, companies are increasingly facing pushback from institutional investors or would-be activists whose authority to push for changes is kneecapped.
Once dual-class stocks are traded publicly, unicorns can find themselves “instantly unpopular” among those constituencies, said Wei Jiang, a Chazen Senior Scholar at Columbia Business School.
“I certainly think they will need to get used to it,” Jiang said of the growing pushback, some of which was codified in a 2018 letter co-signed by Blackrock.
To be sure, there are plenty of examples of dual-class stocks that have been an unqualified success for shareholders. The leading example may be Alphabet (GOOGL – Get Report) , which is credited with popularizing the practice after it went public 15 years ago. In a 2004 letter to investors, Google’s founders described their supervoting powers as “designed for stability over long time horizons…By investing in Google, you are placing an unusual long-term bet on the team, especially Sergey and [Larry Page], and on our innovative approach.” Between 2012 and 2016, roughly 20% of U.S. technology companies went public using a similar power structure to Google’s, nearly double that of the previous five-year period.
It’s not just Google’s success that urged more companies to adopt lopsided power structures. Major stock exchanges, namely the NYSE and Nasdaq, have loosened up guidelines in recent years in a bid to attract the top listings, explained Chester Spatt, a former SEC chief economist and current visiting professor of finance at MIT’s Sloan School.
“They’re competing very aggressively for listings, and that’s even more true in the current era,” he said.
Not everyone can be Google, however. And there is evidence that for everyday shareholders, ceding control to founders is only effective for so long. In a study of shareholder returns for dual-class stocks, highlighted in a 2017 speech by SEC commissioner Robert Jackson, the agency found that valuations of dual-class stocks outpace peers for around seven years, at which point the trend reverses.
“Seven or more years out from their IPOs, firms with perpetual dual-class stock trade at a significant discount to those with sunset provisions,” Jackson said in the speech. Accordingly, Jackson urged the adoption of sunset provisions rather than a standard, and exchanges are starting to enact restrictions on dual-class shares.
Regardless of how ownership standards develop, investors need to pay close attention to how companies are governed over the long-term, Spatt added.
“There are valuation consequences for the shares that don’t have control rights … it’s a compensating differential,” he said. “It’s not that every situation is going to be as problematic as an Uber or a Tesla. But checks and balance are valuable; that’s what governance is about.”
After all, unicorns just aren’t as rare as they used to be. And a unicorn that keeps its sparkle for decades is far more precious.
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