Most people would probably be very keen to invest in a company that is growing at a great pace and has good prospects. One key question you should ask yourself, though, before doing so is : How much do I really know about this company’s shareholding structure and if there are any governing rules that affect how the board operates?
Carefully reviewing the shareholding structure can sometimes determine a profit or a loss on an investment. This is because some companies, knowing full well that they are attractive to investors, put in place internal roadblocks that strip shareholders of significant rights. You may think that this is not possible given the regulatory rules that are in place.
We recently reviewed a company which clearly showed that the internal structures set up ensured that its founder controlled all board nominations and could never be removed. The upshot of this power, is that the founder is able to run the company any way he sees fit which includes remuneration.
You may assume that such control is par for the course for any founder of a company. In this case, however, the control is an issue because the founder in question and the company’s management team have a combined stake of only 10% in the company. To be precise, the founder held only 7% of the company, the management had 3% while the remaining 90% were in the hands of various other shareholders.
In most listed companies, the rule is that all minority shareholders have equal rights; one share, one vote. In fact, since the 1997 Asian Financial Crisis, market regulators have gone to great lengths to improve corporate governance, whose main thrust is to ensure that all minority shareholders are treated fairly.
So how did the minority shareholders of this particular company come to wield so much power over it? We followed this company’s story closely because it was so heavily sought after by investors and there were indications that the company would list only in countries that would accept its approach, that is, to control the company tightly despite having only a 10% stake in it.
This 10% pool of minority shareholders were able to control the company because of what is known as a dual class shareholding structure. This is an old way to structure companies and has been dying out since B-shares were banned altogether in the late 1980s. The ban came after the widespread view that all shareholders should be treated equally. A new threshold was formulated, that is, once a shareholder of a company has a 30% stake in it (or 33% in some jurisdictions), it would be mandatory for the company to offer the same price to all other shareholders.
In this case where a company’s founder and management team can control it despite having only a 10% stake in it, an investor with a 30% stake in it would not be required to make a general offer, be able to control the board or determine the strategies for the company. In fact, in such a company, an investor with a 30% stake would, despite investing a large amount of capital in it, has absolutely no say in how the company is being run.
Let us now consider this dual share structure, which is something that some regional stock market regulators are reviewing at present. A dual class shareholding structure is also known as a “non-standard” shareholding structure. Some argue for this type of structure because it encourages innovative companies to list and raise capital. The argument for this type of structure is that it allows a founder to dictate the strategy for the company and despite the small shareholding, will still be motivated to stay with it. Otherwise, the argument goes, is that a company’s founder with little say might be less interested in developing it. And if founders leave companies, those companies may languish as they lose the founders’ spirit and drive.
The more astute investors may question however, why a company’s founder would want to realise a considerable amount of value in his company if there were such bright prospects. And, why any founder should continue to set the strategy, still maintain control (which includes remuneration) despite having such a small vested interest. One could certainly argue that there would not be the same alignment of interest if a founder has much smaller invested amount of capital.
Many observers say that to operate a dual class shareholding structure, one should first review all the laws that govern the corporations. Otherwise, the repercussions of maintaining such a structure could be very damaging to the investment landscape as many other companies whose founders are minority shareholders might demand such privileges. As regulators debate this new dual shareholding structure, one of the hardest areas will be to determine what exactly constitutes an “innovative company”.
Our advice for those who want to invest in companies with dual class shareholding structures is to ensure that you are well-versed in how limited your rights are in such a company.
That is because, if the company’s direction veers from what you knew of it originally, there is very little that you as a minority shareholder can do to stop that. You have now lost that vote despite committing your capital and being an owner of shares.
© CORSTON-SMITH ASSET MANAGEMENT SDN BHD 2014