John Zimmer and Logan Green, co-founders of ride-hailing company Lyft, ensured that they retained near-majority control of the company after its IPO filing with the SEC.
Now, here’s where it gets interesting.
The co-founders owned only 7% of the stock. So, how could they retain control?
Well, Zimmer and Green chose a dual-class stock structure to retain their powers, which granted them 20 votes for each vote held by other investors.
That’s not all...
Many startups today are opting for this kind of a stock structure, including Snapchat and Dropbox. Moreover, existing giants such as Under Armour, Alphabet, and Blue Apron are known to prefer this dual-class stock structure as well. Even Ford has a dual-class stock structure.
This graph shows the surge in the percentage of newly-listed companies with dual-class share structures in recent years (from 2009 to 2018).
A typical startup company authorizes one class of common stock with simple rights. An instance of such rights is that each share of common stock is entitled to one vote on all matters, subject to stockholder approval.
Founders have always been loath to give away the powers that they’ve earned with their blood, sweat, and tears once investors start taking interest in a startup. However, as venture capitalists compete for deals and as valuations grow, founders of certain startup companies have gained negotiating leverage. They generally bring this leverage to bear by implementing a dual-class common stock structure that provides additional rights to them (i.e., to the founders). This is more familiar as “Class A” and “Class B” common stock.
Read on to find out what a dual-class stock structure means, and why more and more startups are opting for this tongue-twisting financial term.
- What is dual-class stock structure?
- Why use dual-class stock structure?
- Why bother with the high vote shares?
- Why are founders often hesitant to use dual-class stock structure?
- How to convince your investors?
- How can dual-class stock structure work for your company?
What is dual-class stock structure?
A dual-class stock structure is an arrangement where a company has more than one class of stocks and every class has different dividend payments, voting rights or other features. It is a capital structure where founders hold shares of common stock with greater than 1x voting rights, while other common stock stockholders hold shares with standard 1x voting rights.
Dual-class stock companies generally issue one class of shares to the top executives and company founders, and another class of shares to the public in an IPO (Initial Public Offering).
For example:
Let’s assume that the founders own the same number of shares as the public. If the founders’ shares count for ten votes each and the public’s shares count for only one, then the founders automatically become 10x more powerful than the public shareholders (assuming equal number of shares owned).
In fact, when founders raise money through future equity financing, dual-class common stock enables founders to maintain control through “super” voting powers.
A number of companies have implemented dual-class stock structure over the years. This structure was already popular among family-controlled media businesses like the New York Times (where the Sulzberger family controls a majority of the board through dual-class stock). However, more recently, high-growth technology companies (including Google, Facebook, and Zynga, to name a few) have taken to it as well.
Essentially, the idea is as shown below:
- Class A shares, with 1x voting rights, mirror the typical common stock described above.
- Class B shares have greater than 1x voting rights (e.g., 5x or 10x), along with, in some cases, having other rights, privileges and preferences not held by the Class A shares. These may include:
- Automatic conversion into Class A stock upon a sale or transfer; and
- Protective provisions that necessitate Class B stockholder approval for certain material events, such as charter amendments, liquidity events, and dividend payments.
Shareholders who own shares of common stock often feel that the dual-class stock system is unfair. This is because even though they might be the ones who make up the major part of the capital, a group of special shareholders (owning Class B shares) still have the right to overrule the majority.
Why use dual-class stock structure?
It serves as the company’s safety valve against getting caught up in the short-term financial focus that investors are frequently interested in promoting. The founder’s long-term vision of crucial aspects of the business might not make a lot of sense to an investor who has got their eye trained on the upcoming quarterly results.
The best part?
The downside of implementing a dual-class structure is low – at worst, you might need to unwind the arrangement and revert to a single class structure at the time of a financing if you have low leverage but need to get a deal done. In most cases, that’s about it, as far as any major disadvantages are concerned.
But the upside of having long-term control is truly high. We see encouraging real life examples each day in the cases of companies like Google and Facebook where executives have room to focus on long-term growth due to founders retaining high vote shares.
Why bother with the high vote shares?
Usually, upon an IPO, the preferred stock converts to common stock. At this time, investors lose the benefit of:
- The liquidation preference
- Protective provisions; and
- Other rights specific to the outstanding preferred stock.
This can give the investors who hold high vote shares the ability to block significant corporate actions such as:
The high vote shares could easily outvote the low vote shares after the preferred stock has converted to low vote common stock, even if there are significantly more low vote shares outstanding. This depends on the high vote multiplier you use and number of shares outstanding.
Why does this matter?
Holding high vote shares allows founders to maintain voting control in their companies, even in cases where several rounds of venture financing have caused significant dilution and resulted in founders owning a relatively small fraction of their company. In fact, holding high vote shares enables founders to retain voting control even after an IPO.
Why are founders often hesitant to use dual-class stock structure?
Many founders equate using a dual-class stock structure with skating on thin ice. This skepticism originates from certain assumptions harboured by founders about dual-class common stocks.
Primary among such presuppositions is the belief - common to many founders - that while high vote shares are all well and good in the case of super-successful companies like Google or Facebook, the same stock structure won’t be right for their startup. Especially since VCs won’t find it acceptable.
Therefore, most founders reason, they shouldn’t bother implementing the dual-class stock structure in the first place as they will ultimately need to unwind it.
What’s the real story?
This assumption has been found to be untrue on several occasions. As will be discussed in the next section, market conditions are influencing investors to become more and more amenable to dual-class stock options.
Unfortunately, advisors (including company counsel) often perpetuate false assumptions such as the aforementioned one in order to avoid complexity in the present or future.
After all, an analysis of the relation between dual-class stock structure and corporate governance indicates that when compared to other firms, companies with dual-class share systems face more management challenges during their existence. This is because these companies are more likely to demonstrate comparatively questionable corporate governance practices.
That’s not all…
While they do appear to offer a competitive edge in profitability (compared to the profits of other companies), dual-class stock systems do not seem to inherently provide a performance advantage - the findings in this area are inconclusive.
As a result, company counsel might discourage the dual-class stock structure and offer advice in favour of the conventional method of equity distribution.
How to convince your investors?
Generally, many VCs will not take the position that founders’ long-term control over the company is a bad outcome, because VCs are increasingly desiring to be perceived as “founder-friendly”.
With that said:
Some VCs will, regardless, object to a dual-class stock structure. When this happens, they typically point at how they are being disadvantaged by having low vote shares in contrast to founders who have high vote shares.
But this is generally not the case, because VCs will normally require that a startup company agree to certain “protective provisions” in the term sheet as a precondition for the investment.
Specifically, VCs will tend to require investor approval before you can take certain actions such as:
- Amending your certificate of incorporation (which is a step that needs to be taken in order to raise the next financing round)
- A liquidation event (implying that there can be no exit without VC approval either)
Therefore, when VCs raise the objection that they are being disadvantaged because they possess low vote shares, there is an effective way for founders to counter them. Founders can emphasise upon the presence of “protective provisions” (such as the aforementioned ones) and highlight the areas of the business where VCs do (evidently) exercise considerable influence in decision-making.
Another group of shareholders has proposed a middle course. According to them, investors can be convinced and won over by limiting the effects of a dual-class system.
This can be achieved by:
- Imposing a time-bound constraint on dual-class stock structures; and
- Allowing shareholders to accumulate voting interest over time
How can dual-class stock structure work for your company?
Startup founders should at least consider the most basic dual-class common stock structure. This will grant founders greater access to public capital while ensuring that control isn’t compromised.
In such a basic structure, one class of shares has 1x voting power while the other class has about 10x voting power - but otherwise, the two classes are identical.
Of course, founders can always opt for slightly more advanced dual-class stock structures. As we move up from the basic structure, the high vote shares start to have other features, such as:
- Automatic conversion to low vote upon a transfer or sale to a third party
- Optional conversion to low vote shares at the election of the holder
- Protective provisions requiring approval of the holders of high vote shares for certain actions (like mergers and acquisitions)
We can help!
If you have any questions regarding the stock structures, feel free to drop us a line on hello@abstractops.com.
At AbstractOps, we help early stage founders streamline and automate regulatory and legal ops, HR, and finance so you can focus on what matters most.