The perils of investing into tech dictators
The second-quarter earnings announcement by Facebook, the darling of the technology world, on July 25 gained a ‘like’ from very few investors.
On a call, the social media giant revealed disappointing levels of user growth in the US, Canada and Europe. This followed months of bad headlines about Facebook’s struggle with information leaks and the spread of false news on its site.
The combination rattled investors. Facebook’s market capitalisation plunged by $145 billion in aftermarket trading – marking the largest single share valuation drop in stock market history.
And yet, no serious discussions of a change in leadership resulted. There was little point – Mark Zuckerberg, the founder of Facebook, remains its largest shareholder. Indeed, his voting rights outweigh those of every single other shareholder in Facebook.
Tech companies are big business. But they also tend to be dominated by an original founder, or group of founders, who continue to control how their companies are run even after listing – through dual class share structures.
In essence, the founders retain shares with many more votes than those sold to public investors. The concept has been popular with the world’s biggest tech founders. Zuckerberg, as noted, wields absolute power at Facebook despite holding less than 1% of its publicly traded stock, while Jeff Bezos still effectively controls US online retailer Amazon (he holds about 16.17% of outstanding shares).
Similarly, Jack Ma and Joe Tsai, co-founders of Chinese online retail giant Alibaba, control the company (with 7% and 2.5% stakes, respectively, as of June 2017). There are many others: Elon Musk of Tesla (22%); Masayoshi Son of Softbank (21.22%); Larry Page and Sergey Brin of Alphabet (which owns Google – and they own about 11% of it).
“Over the last decade we’ve seen a rise in the number of companies in the US that have gone to market with this structure and got away with it, because a couple of them did outstandingly well for shareholders,” Mary Leung, head of advocacy for Asia at the CFA Institute, told AsianInvestor. “That’s led others to think, rightly or wrongly, that it’s the magic ingredient for success.”
While most such companies are listed in the US (although Softbank is listed in Tokyo), dual-class shares are gaining traction in Asia, too.
In January the Singapore Exchange (SGX) declared it would allow dual-class share structures. The Hong Kong Exchange (HKEX) followed suit in April, in a transparent attempt to convince fast-growing Chinese tech companies to choose it over New York.
As concepts of environmental, social and governance (ESG) principles gain traction in the world, that’s causing some issues. Governance – the ‘G’ of ESG – is a vital component for investors to best assess such risks, but it does not lie easy with autocratic levels of control.
KEEPING CONTROL
Listed companies must undertake many steps to demonstrate good corporate governance, but among the most important are volunteering plentiful information about their practices and decisions, employ a diverse board with several independent directors.
Plus there is the need to respect minority shareholder rights. Indeed, corporate governance advocates typically consider classical share structures to be sacrosanct.
“The CFA Institute believes in one share, one vote; we think that’s the gold standard,” Leung said.
From an ESG perspective, governance is particularly important for asset-light growth companies like technology firms, added Louise Dudley, a global equities portfolio manager at Hermes Asset Management.
“They often don’t have a huge amount of people in the business and their supply chains aren’t usually extraordinarily complex, and therefore governance is more of a focus [for us].”
But tech company founders are often obsessive and controlling, especially over the companies that they have created. They often list their organisations to raise more capital and get rich, but don’t want pesky minority shareholders interfering with how they run them.
That’s where dual-class shares come in. The owners, senior managers and close friends or family often receive special stock with greater voting rights than those that get publicly offered, allowing founders to raise money from a listing, yet keep full control through a minority stake.
“It’s called a wedge; when economic ownership of a company is out of synch with control,” said Leung. “The bigger the wedge, the bigger this proportion is.”
Stock exchanges don’t give companies an entirely free hand with dual-class share structures. The HKEX, for example, insists only “innovative”, newly listed companies can employ the structures. It also puts a maximum 10 votes per share and says regular shareholders must be able to cast at least 10% of the votes for resolutions at a general meeting. Both the HKEX and SGX also require one share, one vote for issues such as changing share voting rights, appointing or removing independent non-executive directors and voluntarily closing the firm.
But with their effective control, founders can override minority shareholders to pursue takeovers or controversial projects that offer little prospect of return, or simply ignore requests for more information disclosure. At worst there is the danger that they conduct fraudulent schemes.
Going hand in hand with this, many tech company founders combine their chairman and chief executive officer roles. That risks creating an echo chamber of their own devising.
“There is no adult in the room; you can call the shots, but it can raise hubris and means you may ignore warning signals that managers in better governed businesses may pick up on,” Leung said.
Jens Peers, CIO for sustainable equities and fixed income at Mirova, said when pondering governance risks he considers a lack of separation of CEO and chairman roles, along with warning signs such as a lack of gender diversity on a company’s board and whether the company employs the same corporate accountant and auditor. “Those are warning signs” of a lack of commitment to good governance, he warned.
ADDRESSING THE ISSUE
The biggest risk of the dual-share model is that it directly links a company’s share performance to the behaviour of the founders. On the plus side, company shares can rapidly benefit when a founder executes a brilliant strategy or unveils clever new products. On the negative, they can quickly suffer if a founder displays erratic judgement.
Tesla’s Elon Musk is a recent example. After picking Twitter fights with journalists who criticised his electric car company, the South African tweeted on August 7 that he could take Tesla private at $420 a share, later adding Saudi Arabia’s sovereign wealth fund had been willing to support the move.
But The New York Times reported Musk wrote the tweet in an outburst, didn’t inform all of Tesla’s directors, and there was little evidence the Saudi fund was preparing such support. Plus the US Securities and Exchange Commission asked Musk why he hadn’t disclosed the plan in an official filing.
As a result, after soaring to $379.57 on the day of his take-private tweet, Tesla’s shares cratered afterwards to close at $308.44 on August 20, below their $311.35 value at the end of 2017. Musk didn't help himself or Tesla's share price in the weeks after that; he smoked marijuana and drank while on the radio, and a rapper friend of his girlfriend alleged that he took class-A drugs while she was visiting his home.
Similarly, Facebook’s Zuckerberg has faced withering political criticism for Facebook letting Russia-affiliated individuals and entities take out adverts and disseminate fictitious social media posts and ‘news’ stories around the 2016 US presidential election. And that was before its earnings announcement.
Mirova’s Peers noted Facebook’s share correction was an example of a company being a victim of its own success.
“People are asking more questions around the governance of Facebook, but ... everybody who liked the stock already holds the maximum they can, so there are basically no buyers – that means the share price reaction will be very volatile [when some people do sell its shares],” he told AsianInvestor.
This is the first in a two-part focus on owner-dominated technology companies, and how asset owners and fund managers can best consider how to invest into them, and is converted from a feature in AsianInvestor August/September 2018 magazine. Look out for part two soon.