Sunrise, Sunset: An Empirical and Theoretical Assessment of Dual-Class Stock Structures

The decades-old debate on dual-class stock structures in the United States has recently come to a head again as entrepreneurs are adopting such structures with increasing frequency and institutional investors are mounting a concerted effort to have them prohibited, abandoned or excluded from equity indexes. The debate is ill-informed, however, as the actual terms of dual-class stock structures have been remarkably understudied. When Snap, Inc. debuted with non-voting shares, for instance, many pundits stated the listing was unprecedented, but several companies had already issued non-voting shares in previous IPOs over the years, including Dodge Brothers and Industrial Rayon in 1925. My paper presents the first detailed empirical analysis of the initial, or sunrise and terminal, or sunset provisions found in the charters of dual-class companies, based on a data set of 123 U.S. public companies with dual-class structures. After reviewing the terms of the dual-class structures and arguments for and against them, I conclude that careful selection of sunrise and sunset provisions can satisfy both entrepreneurs’ desire to pursue their visions for value creation without fear of interference or dismissal and investors’ need for a voice to ensure management accountability. Private law firms representing entrepreneurs in initial public offerings play a critical role in the selection of charter provisions, so the onus is on such firms to ensure that private ordering produces a satisfactory resolution to the dual-class debate before momentum builds for a regulatory solution to investors’ concerns.

The adoption of dual-class share structures among companies conducting initial public offerings in the United States has rapidly accelerated in recent years, from a couple of companies a year in the 1990s and early 2000s to many times that number in the last seven years. The data set of dual-class companies described in my paper identifies 56 companies that adopted a dual-class structure between 2010 and 2016, including some of the largest IPOs and most familiar names in America: Facebook, GoPro, Groupon, LinkedIn, Square, TripAdvisor, Yelp, Zillow and Zynga.

Alarmed by the increase in dual-class companies, but unable to prevent successful companies from utilizing dual-class structures when they come to market, institutional investors and proxy advisors have mounted a concerted campaign to pressure regulators to prohibit dual-class structures and companies to abandon them. T. Rowe Price announced in March, 2016 that it will vote shares held by its mutual funds against the independent directors and nominating committee members of companies with dual-class share structures in future annual meetings. Institutional Shareholder Services announced in November 2016 that for the 2017 proxy season it would encourage investors to vote against the boards of directors of companies with dual-class share structures unless they have a “reasonable” sunset mechanism, and requested comments from investors as to what constitutes a reasonable sunset mechanism. On January 31, 2017, the Investor Stewardship Group, an organization of influential institutional investors holding an aggregate of $17 trillion in assets under management, announced its new Corporate Governance Principles, which require the directors of public companies with dual-class shares to “end or phase out controlling structures at the appropriate time”.

There is a fundamental tension, or tradeoff, between entrepreneurs’ freedom to pursue idiosyncratic visions for value creation and investors’ need for protection from agency costs. This tension is particularly acute in the context of dual-class companies, where the entrepreneur’s uncontestable and indefinite control, coupled with the entrepreneur’s smaller equity interest, leaves investors with comparatively high exposure to agency costs. It is not surprising, then, that institutional investors have responded to recent increases in the number of dual-class IPOs with calls for prohibition, termination or strict limitation, while entrepreneurs and the lawyers representing them insist on maintaining the private ordering status quo.

There is an urgent need for American lawyers to consider how the respective needs of entrepreneurs and investors can be satisfied to end this impasse. It is difficult to have an informed and productive conversation about how to respond to the dual-class phenomenon, however, without a thorough understanding of the actual terms of dual-class stock structures. Even the most lopsided dual-class structure with non-voting public shares might be acceptable, for instance, if it ends after a short period of years or once the stock price performance falls below a certain level for a pre-set period of time.

In Part I of my paper, I describe the hand collected data set I created to analyze the existing dual-class sunrise and sunset provisions among public companies in the U.S. Part II describes the sunrise provisions of dual-class structures—such as the respective voting rights of the high vote and low vote shares. Part III describes the sunset provisions of the companies in the data set. My review of dual-class terms reveals that there are myriad possibilities for satisfying the needs of both founders and investors in the dual-class form. As described in the paper, a variety of sunrise and sunset provisions have been utilized by companies adopting dual-class structures in the past, and dual-class stock structures have become more investor-friendly over time, particularly in the last decade as use of the structure has proliferated among technology companies, which have incorporated a broader variety of sunsets with greater frequency than dual-class companies in other industries. Part IV of the paper explains how certain law firms acting as issuer’s counsel in initial public offerings have influenced these trends in the development of dual-class sunrise and sunset provisions.

Part V discusses standards for evaluating dual-class stock structures, describing the theoretical background to the positions taken by entrepreneurs and investors and suggesting alternative standards for evaluating dual-class stock structures based on the fundamental bargain between the parties—money for vision—and the interests underlying their respective bids for control: entrepreneurs seek control in order to pursue their idiosyncratic visions for creating value, while investors seek control for influence, voice and management accountability in order to minimize diminutions in corporate value caused by management agency costs.

Finally, Part VI discusses optimal dual-class share structures, evaluating the various structures in use today and suggesting possible modifications in light of the standards discussed in Part V. When the terms of dual-class share structures are considered in detail, we can identify creative ways to give entrepreneurs the control they seek without compromising accountability. It should not be necessary, and would not be consistent with the fundamental vision-based bargain between founders and investors, however, to arbitrarily or prematurely terminate a dual-class structure that has been accepted by investors as a basis for investment. Given the diversity among entrepreneurs and companies in terms of vision, execution, industry and competition, this is not a one-size-fits-all exercise. While in some cases it should be possible to negotiate a set of sunset provisions that satisfy investor concerns, in other cases it may be necessary to resort to sunrise provisions that enhance investor influence, such as a public investor right to nominate and elect a minority of the board of directors. If, as suggested by Wilson, Sonsini, Goodrich & Rosati’s response to institutional investor calls for prohibition or limitation of dual-class stock structures, law firms wish to preserve the current system of private ordering, they have a responsibility to be more creative and proactive in designing structures that respond more effectively to investors’ concerns while retaining founders’ ability to pursue their visions for value creation without undue interference or dismissal. As explained in Part VI of my paper, there are several ways to achieve that result.

The complete paper is available for download here.