Imagine a world in which Americans were betting their retirement savings on Apple’s ability to roll out the next killer product, Google’s ability to monetize the mobile Android ecosystem or on Facebook’s ability to become as dominant on mobile phones and tablets as it has become on the desktop.
Now imagine that, instead of Steve Jobs, Larry Page and Mark Zuckerberg at the helms of their respective companies innovating through these product cycles, the California Public Employees’ Retirement System (CalPERS) was calling the shots.
Sound amiss? Well, if CalPERS makes good on its promise to boycott IPOs with dual-class stock, this world could become a reality. In this brave new world, founder-led technology companies that ultimately live (or die) based upon their successful ability to innovate across product cycles will fail to reach their full potential.
According to CalPERS, dual-class stock creates misalignment between a company’s shareholders. (Dual-class stock refers to a company that issues two share classes of stock, each with equal economic rights, but with unequal voting rights. Often the company founders or other insiders have the class of stock with superior voting rights, giving them more control over the direction of the company.) CalPERS argues that dual-class stock destroys shareholder value; she who controls the votes controls the money.
If only the world were so black and white. One-size fits all may work well for Frank Zappa, but it doesn’t work in corporate governance. And it doesn’t work specifically for founder-led tech companies where external shareholders and internal shareholders have aligned economic interests, but deeply divergent skill sets and wildly asymmetric information.
The Short Term Investor Problem
While academics have sparred largely to a draw over the question of whether dual-class stock enhances or destroys shareholder value, this much is clear:
- Some dual-class stock companies perform exceptionally well – e.g., Google, Nike, Comcast, Berkshire Hathaway
- Some dual-class stock companies perform OK, but raise the ire of investors (like CalPERS) agitating for change – e.g., News Corp, The New York Times, Ford Motor Company
- Some dual-class stock companies are led by executives who are alleged to have abused their power – e.g., Hollinger International
- And, by the way, plenty of single-class stock companies do a perfectly fine job of destroying shareholder value – e.g., Worldcom, Enron, Tyco, Healthsouth
While short-term investor behavior destroys shareholder value (Bushee [1998]), it also has never been more prevalent. Average stock holding periods in the US have shrunk 4x since 1985 and today investors on average hold a particular stock for about 4 months (Cremers [2012]).
At the same time, activist investors are alive and well, maybe too much so. (Activist investors purchase public company shares with the goal of effecting a major change in the company, often through obtaining board seats and thereby replacing management.) The number of activist shareholder campaigns and the amount of assets managed by activist hedge funds doubled between 2009 and 2012. And, because the total number of publicly-traded companies has been cut in half since 1997, the weight of the activist investor is bearing down on a much smaller set of available “targets.”
So how is a founder-led, technology company supposed to build long-term shareholder value when we live in a short-term investor world?
Enter dual-class stock.
The Founder’s Dilemma
It’s important to understand how a founder-CEO of a tech company thinks in order to understand the dilemma that a boycott of dual-class stock options would create. My partner, Ben Horowitz, has written extensively on this topic but the logic boils down to this:
- Technology companies are fundamentally in the product innovation business
- Great founders of successful technology companies find and exploit product cycles – e.g., Jeff Bezos (Amazon), Bill Gates (Microsoft), Steve Jobs (Apple) – to the benefit of long-term shareholder appreciation
- Missing a product cycle is tantamount to death – e.g., Apple under John Sculley; Veritas under Gary Bloom
- Great innovators simply see things that mere mortals cannot. As such, they are often out of synch with the wisdom of the crowds.
For example, when Steve Jobs returned to Apple in 1996, the institutional shareholder world thought he was crazy to deploy a vertically integrated hardware/software strategy. When Jeff Bezos doubled down on Amazon’s low-margin direct-to-consumer e-commerce business in 2002, his sanity was similarly called into question. As crazy as they may have seemed at the time, Jobs and Bezos were right – to the tune of 200x long-term stock price increases for their respective companies!
Investing in a product cycle increases short-term R&D expenses and thus reduces near-term earnings. Short-term investors don’t like this – and generally can’t see what the innovator so plainly sees in the future. Rather, the investors in turn put pressure on the company to reduce investment and instead generate near-term earnings growth, encouraging short-term decision-making.
And when that pressure becomes too strong to resist, bad things happen to good companies – and shareholders suffer. Two recent examples:
Workday is the $10 billion (market cap) by-product of Peoplesoft’s investors having exerted short-term control to force a hostile takeover by Oracle in 2004. Peoplesoft had plans to build a modern, SaaS version of the Peoplesoft software but, forced into the Oracle acquisition, they never got the chance. Workday is today the business Peoplesoft could have been. Would Peoplesoft’s investors have been better off had Workday been built inside of Peoplesoft?
Under the leadership of co-founder Alfred Chuang, BEA was extremely well-positioned in 2008 to nail the next product cycle, having successfully navigated two previous product cycles. Yet, before Chuang and team had a chance to do so, activist Carl Icahn forced BEA into the hostile hands of Oracle in 2008 for $8.6 billion.
Inside of Oracle today, the BEA product family is estimated to be a multi-billion annual business. And today, Alfred Chuang has founded a new company (Andreessen Horowitz is an investor) to realize his remaining product vision for BEA. Would BEA’s shareholders have been better listening to the product leadership of Chuang vs. succumbing to the activist pressure of Icahn? Imagine the market cap appreciation that BEA and Peoplesoft shareholders could have enjoyed had dual-class stock provided them the luxury to invest in the next product cycle.
Thus, the solution to the Founder’s Dilemma is dual-class stock. At its core, dual-class stock enables a company to build for the future, without the risk of short-term oriented shareholders forcing the board/CEO to change course.
To be sure, dual-class stock is not a panacea for all. It is, however, particularly well suited for founder-led technology companies where the ability to innovate across product cycles yields success (or failure, as the case may be) and where economic interests between external shareholders and internal management are aligned.
More about the Alignment Factor
But, does dual-class stock give internal management the unfair ability to pillage the corporate coffers at the expense of other shareholders? Not without breaking the law. We have a very well-established set of laws in place to punish bad the bad behavior of directors and officers, whether in dual-class or single-class companies.
More importantly, there are two critical factors in founder-led technology companies that align incentives appropriately to prevent waste:
First, directors and officers receive very significant portions of their overall compensation in the form of stock options. If the stock price goes up, they make money; if not, they don’t. Thus, directors and officers are motivated by their own self-interest to generate long-term stock price appreciation (Castanias and Helfat [1992]).
Second, customers and employees determine whether to remain loyal to a company based in significant part on the company’s stock price. To retain loyalty, managers must be able to articulate why their planned R&D investments will help drive long-term profit appreciation. Failure to do so means that investors, customers and employees will head for the exit, rendering internal management’s stock options worthless.
Bottom line, instead of stripping founder-led companies of the ability to employ a dual-class stock model, institutional investors who don’t like the long-term direction of the business should stick to what they do best and simply vote with their wallets. I.e. sell the stock!
Corporate governance is not one size fits all, so we shouldn’t paint the entire public markets with a broad brush. As appealing as the bell of direct democracy may sound, sometimes it is out of tune.
