Shares with differential voting rights [“DVR”], internationally known as dual class shares [“DCS”], are shares which have rights disproportionate to their economic ownership. DVRs include shares with superior voting rights [“SR Shares”] and shares with inferior voting rights. SR Shareholders get more than one vote per share on a poll. SEBI released a consultation paper in 2019 and subsequently, it approved a framework for the issuance of DVR shares within the approved framework. It has recently released another consultation paper to review some provisions. In sum, the SEBI has allowed public issue of ordinary shares by tech companies having promoters with superior voting rights, subject to some conditions. This has been done because tech firms tend to prefer raising equity over debt capital. However, this leads to dilution of the founder’s stake. As discussed under “The Innovation Argument” by Yiming Sun, the success of such firms depends greatly on their innovative potential and their ability to explore avant-garde, disruptive ideas. Therefore, it becomes important to allow the founders/promoters to retain their decision making powers. Further, tech companies may not be immediately profitable as they need to focus on research and development in their initial years. As a result, they are more prone to minority shareholders eyeing at short term profitmaking by, say, reducing investments in research. For these reasons perhaps, many well-known tech companies like Facebook, Google, Pinterest, TripAdvisor, Snap, Dropbox, Zoom have opted for a dual-class structure as can be seen here. Mark Zuckerberg, for instance, enjoys 58% control through voting shares, with a 22% equity stake.
As discussed in the 2019 consultation paper, the desirability of DVR/DCS has been a longstanding debate but with time, it has shifted from calling for an outright ban to finding out ways to counteract its perceived harms such as management entrenchment, misalignment of shareholder interests and other corporate governance issues. Insertion of sunset clauses has emerged as a possible third alternative. They trigger the conversion of a DVR structure into one with equal voting rights. This post attempts to explore the ideal form and nature of a sunset clause.
Sunset clauses are not to be seen as a compromise to appease both the sides. They should only be seen as a way to blunt the drawbacks.
The approved framework has adopted two types of sunset clauses namely, time based, and event based sunset.
Under the approved framework, SR Shares shall automatically convert to ordinary shares after five years from listing, subject to a one-time extension of further five years through a resolution in which the SR shareholders cannot vote. Notably, the 2019 consultation paper did not envisage a restriction on the number of times the sunset timeframe could be extended, but the approved framework deviated from this.
a. Benefits of Time-based Sunsets
Some of the reasons behind setting a timer on the superiority of shares are:
i. Erosion of Idiosyncratic Vision
One of the major arguments in favour of DVR has been that the entrepreneur possesses “idiosyncratic vision”. The term signifies two things: firstly, that the entrepreneur’s ideas may not be able to be understood or verified by the outsiders, and secondly, it has a subjective potential to bring above-market pecuniary returns which, if realized, will be shared by the investors and the entrepreneurs. DVR help the visionary exercise her vision without the undue interference of ignorant shareholders. Bernard S. Sharfman discusses Mark Zuckerberg’s decision to acquire Instagram for USD 1 billion, which was then just a 13-employee app with zero revenue. Facebook launched its IPO with a DCS structure just one month after this acquisition. Subsequently, Facebook’s stock price fell down 54% just after four months of trading. In the absence of DCS, Zuckerberg may have had to face pressure to justify his decision to acquire Instagram because quarterly results were disappointing. He may have even lost his operational control. However, the success of Instagram in the longer term seems to justify his decision.
It has been shown by Bebchuk and Kastiel that this founders’ vision is susceptible to erosion with time. Further, the consultation paper also mentions that recent academic research shows that while DCS companies on average have a valuation premium at the time of IPO. This tends to erode from six to nine years after IPO, and the gap between share ownership and voting power, i.e., the “wedge” also tends to widen. After a point, the wedge starts impacting the quality of governance and heightens the risk of self-serving decisions.
ii. Undue Control
Sunset clauses ensure that the leaders do not unduly delay unification of the DVR share structure just to preserve their voting control. It may be the controller’s strategy to sell most of her shares with time. In that case, it may again benefit her to retain the structure so that she can continue to exercise control through voting. To do so, she may continue to sell her ordinary shares while retaining the SR shares, which would only further widen the “wedge”. Further, a perpetual DVR structure would permanently hinder the possibility of change in control via takeover as the acquirer wouldn’t get the controlling number of votes despite buying a majority of equity shares. The threat of a takeover is important to avoid complacency in leadership.
b. Drawbacks of Time-based Sunsets
Time-based sunsets do come with their set of benefits. However, these benefits do not appear compelling enough to make such clauses mandatory. Their drawbacks are listed below:
i. Arbitrary timeframe
The approved framework proposes a one-size fits all approach, i.e., a mandatory sunset clause of five years. It appears to be more of a compromise to appease both the sides than an actual expiry date of the founder’s idiosyncratic vision. The structure does need to collapse at an appropriate time, i.e., when it loses its value, but that appropriate time is difficult to be ascertained. If we look at companies who have included time-based sunsets, there is little consistency in the timeframe chosen. It ranges from three years to twenty years, with the most common being seven or ten years.
So, the mandatory 5-year period clearly fails to appreciate the unique attributes of a company that may affect the time needed by it to self-actualize. This argument is bolstered by the concept of “private ordering”. If the purpose of corporate governance is the maximization of shareholder wealth, private ordering helps achieve just that without any regulatory intervention. As per an SEC Commissioner Troy Paredes, corporate law grants companies the freedom to tailor their internal affairs to suit their attributes, culture, maturity as a business, and governance practices. As per Adena Friedman, the President and CEO of Nasdaq, Inc., public companies should have the flexibility to opt for a class structure which suits them the best, so long as the structure is transparent and disclosed beforehand to the investors.
In conclusion, a mandatory sunset of five years may result in premature unification of the structure, which may sabotage its entire purpose. Ideally, companies should choose a timeframe most suitable to them as per their characteristics, but this could also lead to imposed dictatorship. Facebook, for instance, still has Zuckerberg leading the company after nine years. Some may argue that he is still creating value for the company, while some may deem it to be entrenchment.
Alphabet, Facebook, Berkshire Hathaway, Nike, and Comcast are all companies without time-based sunsets and it is argued by Sharfman that the downsides of not keeping a time-based sunset are outweighed by the wealth these companies could potentially create. Perhaps, some identifiable companies which are expected to emerge as best performers and deliver positive stock market returns should be granted some flexibility. The leadership guiding these companies should not get hindered by regulations. Instead, the objective of regulations should be to aid them in reaching their optimum levels.
ii. Shift in Attitude
Fisch and Solomon describe it as a moral hazard problem. Sunsets can give rise to problematic incentives. Founders would be incentivized to use their control while they have it, to reap economic benefits at the expense of ordinary shareholders. Further, knowing that the expiry date is nearing, the founder is more likely to engage in short-termism, i.e., short term profit making. So, SR shareholders may shift their focus from pursuing their “idiosyncratic vision” to shareholder appeasement so that their voting control is maintained through a further extension of five years.
iii. Extension of Sunset Period
As per the approved framework, a one-time extension of five years is possible through a resolution. The problem with this is two-fold:
Firstly, it is well recognized that ordinary shareholders are afflicted with information asymmetry and they lack commercial knowledge. They may not be able to recognize situations wherein the company would benefit from continuing with the leader’s idiosyncratic vision. Even though the shareholders now have the knowledge of how the company has performed post its IPO, they cannot miraculously learn to appreciate the leader’s idiosyncratic vision. They may be greatly amiss in prematurely unifying the structure if, say, the company is in the process of pursuing the idiosyncratic vision. This misstep will not only fail the very purpose of DVR, but also have a huge bearing on the future of the company, and its stock market returns.
Second is the problem of “short-termism”. Shareholders who are in it for the long term would want the tech companies to be consistent with their innovation. However, short-term shareholders may only seek to maximize the profits till they cash out. Unification of shares offers a very apparent advantage to ordinary shareholders, i.e., the transfer of control from the leader to the public. Would they be able to objectively weigh the value of obtaining control against the value of retaining DVR is a pertinent question.
Event-based SunsetIt appears that time cannot be the most determinative factor. Event-based sunsets make more sense as they identify events on the occurrence of which, the structure loses its value and therefore, unification is triggered. As per the approved framework, the events are:
- Demise of the promoters holding SR shares
- Resignation of the SR shareholder from the executive position
- Merger or acquisition of the company having SR shareholder where the control would be no longer with SR shareholder.
- Selling of SR shares after the lock-in period but before the time of sunset.
In addition, events such as incapacitation due to medical reasons, misconduct or breach of duty can be included. A dilution-based event can also be added to this list. It would require SR shareholders to maintain a stated percentage of shareholding below which unification would be triggered. It would ensure that the previously discussed “wedge” does not broaden.
There is a clear need to give some more thought to the mandatory time-based sunset of five years. It arbitrarily presupposes that the benefits arising out of founder control would have sufficiently been realized within this timeframe. If anything, they may deter companies from going public to raise funds. In the US, for instance, there is no mandatory requirement of a sunset clause. So, even if it is not viable to let the companies decide the terms of sunsets themselves, the term should at least be extended. IndiaTech, for instance, has sought an extension from five years to 15-20 years. Another alternative is to only mandate event-based sunsets. Finally, as Bernard S. Sharfman has put it, “even if the implementation of a mandatory one-size-fits-all sunset provision only results in inhibiting one company from becoming the next Alphabet or Facebook, it is one company too many”.
– Bhavya Solanki