History is often written by reference to "before" and "after." In this blog, we posit that "before" refers to the "bull market" that ended in January 2022, and "after" refers to everything that – happened, is happening, and will happen – next.
In the 13-year bull market that characterized "before," founders of globally scaled technology companies increasingly demanded super-voting stock from venture capital firms in exchange for allocations, board seats, and protective provisions. We saw "super-founders" attributing "super-voting" shares to themselves to ensure long-term consistency of vision when executing a business plan that would require a majority of passive capital. The balance of shareholders would receive a lower class of shares with diminished voting rights. This structure was often implemented by super-founders at company formation, while very often, the dual-class voting structure would be implemented just before an initial public offering. Sometimes the super-voting rights are perpetual, while other times, they are for a limited number of years or expire upon transfer by the holder to a third party or to the public.
To implement this structure, a company's shares are divided into at least two different classes, usually one designated as Class A, and the other designated as Class B, with distinct voting rights (usually Class B has a multiple of votes more than the low voting Class A). Class A shares typically have lower or limited voting power, while Class B shares carry higher voting rights and control over critical decision-making processes. There is not usually any preference for either upon liquidation or for dividends. The preferred stock held by venture capital investors would be convertible into the Class A common. This disparity in voting power creates a hierarchy that can shape the outcome of M&A deals.
While much has been written about dual classes of voting shares in the IPO and public company context, with some high-profile super-voting structures expiring or under pressure from activist stockholders, the next reopening of the IPO window may tell us whether the dual-class voting structure is dead.
Right now, in the "after," the dual-class of voting share is under pressure. Several high-profile public companies have acceded to activist demands that dual-class voting structures be eliminated. In the current environment for venture capital financings, every area of risk is being fleshed out, and dual-class voting structures could be a red flag.
In the "after," or at least in the current environment for privately held venture-backed companies, the action is happening when there is a move to market for a liquidity event, a sale, a merger, or a disposition.
In the context of potential liquidity events, sales, mergers, or dispositions, dual-class voting stock structures can have important implications:
- Control Retention: Dual-class voting structures enable those holding shares with superior voting rights to effectively control major decisions, such as the identity of the acquirer, the type of acquirer (e.g., financial or strategy buyer), the price, the terms, and all other aspects of the deal, irrespective of their economic stake.
- Defense Mechanism: A dual-class voting stock structure serves as a defense mechanism for founders against a deal with a company or business that they do not want to be part of, irrespective of whether it creates a liquidity event for their investors (e.g., the private company version of a hostile takeover or unwanted M&A offer). The concentrated voting power held by a select group of founders enables them to block or reject acquisition proposals that they perceive as unfavorable, regardless of the economic interests of other shareholders.
- Negotiating Leverage: When a company with a dual-class voting structure is involved in an M&A negotiation, the class of shares held by the controlling shareholders may grant them additional leverage. Their concentrated voting power can enable them to negotiate better terms, such as higher acquisition premiums or specific protections, by leveraging their ability to approve or reject the transaction. It can also mean that a buyer will offer that class of super-voting founder sweeter terms, richer or longer retention packages, or other benefits.
- Shareholder Approval: In many jurisdictions, significant corporate transactions, including M&A deals, may require shareholder approval of each class of stock. The dual-class voting structure can affect the voting dynamics during such approvals. The voting power held by the controlling class of shares can heavily influence the outcome, potentially making it more challenging for minority shareholders to block or modify the proposed transaction.
- Shareholder Dissent: Minority shareholders, who typically hold shares with inferior voting rights, may feel disenfranchised or believe that the transaction undervalues their investments. They may argue that the dual-class voting structure unfairly favors the controlling shareholders and dilutes their ability to influence the outcome. Dissenting shareholders may challenge the deal in court or through regulatory channels, leading to delays, increased costs, or even the potential collapse of the transaction.
- Regulatory Scrutiny: Mergers and acquisitions involving companies with dual-class voting structures may attract additional regulatory scrutiny. Regulators may examine whether the transaction is in the best interest of all shareholders and if the controlling shareholders are acting fairly and transparently. Antitrust authorities may also assess whether the transaction could result in an anti-competitive market concentration, particularly if the dual-class voting structure is prevalent in the industry.
For companies with dual-class voting structures to proactively address governance concerns, they will need to attempt to show transparency in decision-making processes and engage in more meaningful dialogue with minority shareholders. Strong communication and fair treatment of all shareholders can help alleviate potential conflicts and improve the chances of successful mergers or acquisitions.
As the landscape of M&A continues to evolve, thoughtful consideration of dual-class voting stock structures becomes increasingly important in achieving successful transactions.
In the "after," or at least in the present, we expect fewer of these structures until the market turns.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.