Dual class shareholding is an idea whose time has not come

13th June, 2018 BUSINESS STANDARD Because of testing protocols, promising food innovations sometimes fail to make it to the market. There needs to be an international protocol for testing innovations that impact Mother Gaia.


R. Gopalakrishnan

Email: rgopal@themindworks.me

*The writer is a corporate advisor and Distinguished Professor of IIT Kharagpur. His new book, “CRASH: lessons from the rise and exit of business leaders” will be published by Penguin India in September 2018.

(Brilliant entrepreneurs can be badly behaved, but badly-behaved entrepreneurs are not necessarily brilliant.)

Startups bear great promise for India, so they must be encouraged in as many ways as possible. Startup founders in India tend to be younger and more inexperienced compared to their counterparts in Silicon Valley, according to studies (https://qz.com and www.yourstory.com). The opinion on whether that is good or bad is divided. Data on trends and facts on startups are ambiguous and packaged in egg shells. Hence one must strongly deploy experience and common sense. In my overall experience, most Indian founders are incredibly immature and inexperienced, in particular their understanding of governance and the board.

The principle of good governance is the separation of ownership and management. Dual class shares work against this principle. Entrepreneurship experts defend dual class shareholding. One admirable Indian entrepreneur, Sachin Bansal, says that building a company is like a long train journey. According to him, the founder is the driver, whereas employees and investors are like passengers. Who is supposed to be the station master or the signal keeper, the person who is charged to prevent accidents? Surely the founder should be accountable, he cannot wreck the train through inadvertence or stupidity! Bansal mentions that Tata and Birla exercised control over their companies when they were short of capital but then, they earned that privilege from shareholders after many years of showing profits; for sure, they did not arrogate the privilege through legislation.

Raghav Behl, another superb Indian entrepreneur, feels that dual class shareholding would help get the foreigner’s money without his control. This is an autarkic view, predicated on the current unsustainable hubris; it may work for awhile, as markets outside of India struggle for growth, and their interest rates are held near zero.

Sometime around 2000, India permitted dual class shares through a section in Company Law, applicable to companies with a three-year profit record. Some listed companies have experience of such shares; the results and benefits are ambiguous.

Startups feel left out of the ‘big boys’ party’. Waiving the three-year profit record has a downside, according to opponents, that it will open a Pandora’s Box. Its merit, according to protagonists, is that it will encourage entrepreneurship. The truth is that there is no cause and effect relationship between dual class shares and entrepreneurship, at best, there may be some evidence of correlation.

Dual class shares (unequal voting) were invented to satisfy owners who did not want to give up control but needed outside equity. The idea got a refreshed visibility in America around the time Facebook, Google and Snapchat went public. The move upset the market players because it was considered downright unfair to other investors. Further, it is with increasing frequency that one encounters founder-managers with super-class shares who spin the company out of control.

Dual-class share structures hinder corporate performance according to academic research (https://www.investopedia.com). The case of Hollinger Inc, a Canadian media company, is often quoted. The company was reputed to have a complex and convoluted holding structure. Former CEO, Conrad Black, held 30% of the equity but controlled 73% of the voting. Mr Black filled his board with friends and his admirers. Hollinger’s financial and share performance suffered under Black’s control and in 2007, he was convicted in the District Court of Chicago.

On the other hand, the move has its supporters. They feel that it protects owners and managers from the short-termism of Wall Street. Frankly, if Wall Street suffers from short-termism to the detriment of the firm and the national economy, then the root cause of that affliction that must be treated rather than create another pill with unintended side effects. After all, there is a dual-class share company like Berkshire Hathaway, which has done very well in all respects. Given the predatory instincts associated with capitalism, it is unrealistic to expect many benign, well-meaning entrepreneurs. The Hollinger variety is more than likely.

If the founder CEO is what the text book requires—a values-based and humble Level 5 leader—then absence of voting power does not prevent him or her from exercising brilliance, creativity and entrepreneurship. Allowing founders to exercise voting control of the board despite diluting their shareholding would be an undesirable adaptation of a capital-accretive American model into Indian business. Even if India wishes to permit it in startups, the privileged voting power should be for a limited time of say 3-5 years with a rigid sunset clause.

Brilliant entrepreneurs can be badly behaved, but badly-behaved entrepreneurs are not necessarily brilliant.