In theory, everyone who owns stock in a company is equal to everyone else who owns the same stock. But in reality, some shareholders are more equal than others.
Newly public firms are increasingly choosing to issue multiple classes of shares, some of which carry more voting privileges than others, even though that restricts them from being included in some major stock-tracking indexes. That may be more consequential than it seems, Goldman Sachs strategists argued in a research note, as it will deny those firms access to the massive amounts of capital flowing from passively managed funds.
Multiple-class share structures aren’t new, but the issue has grabbed headlines recently as high-profile companies like Facebook
made them part of their initial public offerings. When Facebook went public in 2011, for example, Chief Executive Mark Zuckerberg and some early investors were given Class A shares that grant them 10 votes each, compared with one vote for one share for Class B shares.
Advocates of the multiple-class approach say that a “founder-led” management strategy is better for companies: in 2016, Facebook argued that “a large part of Facebook’s success has stemmed from the leadership, creative vision and management of Mark Zuckerberg, and that the company’s future success will depend on Mark’s continued leadership.”
They also argue that corporations that cede too much control to newer investors may fall prey to activists with short-term time horizons. But research published in 2016 finds that companies with unequal voting rights underperform the rest on total shareholder returns, revenue growth, and return on equity, across a variety of time horizons. What’s more, CEO pay at multi-class companies was more than 40% higher than at those with one class.
The practice has faced a backlash. Investors “should have equal protections and rights, including the right to vote in proportion to the size of their holdings,” argues an industry group called the Council of Institutional Investors. “Risks are exacerbated for investors when equity structures skew the alignment of ownership and voting rights, which is why the ‘one share, one vote’ principle has been a core focus for CII since its founding in the 1980s.”
CII was instrumental in getting two major stock indexes to put limits on companies with multiple classes of shares. S&P Dow Jones excludes such companies altogether, although it grandfathered in existing members with that structure. FTSE Russell set some restrictions on member firms with multiple share classes.
Despite that, and against the backdrop of increased interest in corporate governance, seven of the 10 largest IPOs in 2019, including Lyft, Inc.
and Chewy Inc.
included shares with unequal voting rights, the Goldman strategists point out. It was an unconventional share-class structure that preserved most of the voting power for then-CEO Adam Neumann that led to an outcry over the offering for The We Company, parent of WeWork.
The trend may represent precisely the same kind of short-termism the companies say they’re trying to guard against, Goldman argued.
“The debatable benefit of insulating management from its own shareholders comes at a significant long-term cost,” the strategists wrote. “Firms restricted from joining major indices will not fully benefit from the extraordinary flow of capital that continues to surge into passively managed funds.”
More than half of all U.S. mutual fund and ETF assets are made up of “index-objective” passive funds, the Goldman team said. “This year, U.S. passive mutual funds and ETFs have experienced $114 billion of inflows, while active mutual funds have sustained outflows of $193 billion.”
The three largest ETFs, which together hold nearly $600 billion of assets, all passively track the S&P 500: SPDR S&P 500 ETF Trust
iShares Core S&P 500 Trust
and Vanguard S&P 500 ETF
One compromise, the Goldman strategists suggest, might be to allow separate classes for a period, say five to ten years, and then sunset that arrangement.