What Are Dual Class Shares

In the modern financial landscape, companies have numerous ways to structure their shares. One unique structure that has gained prominence, especially in tech companies and startups, is the dual-class share system. This structure allows companies to issue different types of shares, often categorized by their voting rights, creating a distinct balance between ownership and control.

In this blog, we will explore the concept of dual-class shares, their implications for shareholders, the advantages and disadvantages of using such a system, and how they are applied in the Indian stock market.

The Basics of Dual-Class Shares

Dual-class shares refer to a structure where a company issues two or more classes of shares, typically distinguished by voting rights. Class A and Class B shares are common in this system, with one class holding more voting power than the other. In most cases, founders or early investors are given shares with more voting rights, allowing them to retain control over major corporate decisions while offering shares with limited voting rights to the general public or other investors.

This structure deviates from the traditional ‘one share, one vote’ model, which has been the norm in stock markets for decades. With dual-class shares, companies can create a situation where one group retains significant control even when they do not own a majority of the company’s equity.

Key Characteristics of Dual-Class Shares

1. Voting Power: The most significant distinction between the two classes of shares is voting power. Class A shareholders, for instance, may receive one vote per share, while Class B shareholders could receive 10 or even 100 votes per share. This ensures that those holding Class B shares maintain control over major corporate decisions.
2. Dividends: In some cases, different classes of shares may also carry different dividend rights. However, this is not as common as the disparity in voting rights.
3. Ownership and Control: One of the key motivations behind dual-class shares is the separation of ownership and control. Founders can retain decision-making power even after selling a large portion of their equity.
4. Sunset Clauses: To address concerns over long-term governance, some companies include sunset clauses that automatically convert dual-class shares to a single class after a certain period or when specific milestones, such as the founder’s departure, are reached.

Advantages of Dual-Class Shares

1. Founder Control: One of the primary reasons companies opt for a dual-class structure is to allow founders or early investors to maintain control over the company’s strategic decisions. This can be particularly important in the early stages of a company when it needs to make bold, long-term decisions without being hindered by short-term market pressures.
2. Long-Term Vision: By concentrating control in the hands of a few, companies can focus on their long-term growth strategies without having to cater to the whims of public shareholders or activist investors.
3. Protection from Hostile Takeovers: Dual-class shares can shield a company from hostile takeovers, as the concentration of voting power makes it harder for outside investors to gain control.
4. Innovation and Stability: Companies that rely heavily on innovation, such as tech startups, benefit from the stability that dual-class shares provide, allowing them to experiment and pivot without facing resistance from short-term-focused shareholders.

Disadvantages of Dual-Class Shares

1. Reduced Accountability: While dual-class shares can promote long-term stability, they can also reduce accountability. With control concentrated in the hands of a few, those with voting power may make decisions that benefit themselves rather than the company or its shareholders.
2. Misalignment of Interests: There can be a disconnect between the interests of those holding high-voting shares and ordinary shareholders, especially if the former prioritize personal agendas over shareholder value.
3. Risk of Poor Governance: Without the pressure from the general shareholder base, companies with dual-class shares may face governance issues, with leadership making decisions that are not in the best interest of the company’s long-term health.
4. Investor Hesitation: Some investors are hesitant to invest in companies with dual-class shares, as they may feel that their rights as shareholders are diminished, particularly when it comes to influencing corporate governance.

Dual-Class Shares in the Indian Stock Market

The concept of dual-class shares is not new in India, but it has gained more attention in recent years due to the rise of tech startups and innovative companies that seek to retain founder control while raising public capital. While dual-class shares are more prevalent in countries like the United States and China, the Indian stock market is slowly warming to this concept.

In India, the Securities and Exchange Board of India (SEBI) has laid down specific regulations regarding dual-class shares, especially concerning companies looking to list on stock exchanges. One key regulation is the introduction of ‘Superior Voting Rights’ (SVR) shares, which are designed for tech startups. The objective is to allow promoters of innovative startups to retain control, even after going public.

SEBI’s Guidelines for Dual-Class Shares

SEBI’s guidelines allow companies to issue shares with superior voting rights, but with certain restrictions:

1. Eligibility: Only tech companies or startups that have been in operation for at least three years can issue SVR shares.
2. Voting Cap: The voting power of SVR shares cannot exceed 10 times that of ordinary shares.
3. Conversion: SVR shares must convert into ordinary shares after five years of listing, though an extension of an additional five years may be granted in certain circumstances.
4. Sunset Clauses: To address long-term governance concerns, SEBI requires companies to include sunset clauses for SVR shares. These clauses will automatically convert SVR shares into ordinary shares after a defined period or when specific triggers, like a change in management, are met.

Examples of Dual-Class Share Structures

Globally, many well-known companies have adopted a dual-class share structure to ensure that their founders or early investors maintain control. Here are some prominent examples:

• Alphabet (Google): One of the most famous cases of dual-class shares, Alphabet, the parent company of Google, has a three-tier share structure. This ensures that the founders, Larry Page and Sergey Brin, retain control of the company’s strategic decisions.
• Facebook: Mark Zuckerberg controls Facebook through a dual-class structure that gives him majority voting power despite owning only a minority of the company’s total equity.
• Snap Inc.: When Snap Inc. went public, it did so with a unique structure where public shareholders were issued shares with no voting rights, leaving all control in the hands of the founders.

Implications for Investors

Investing in companies with dual-class shares requires careful consideration. Investors must understand that their voting power will likely be limited, and they may have little say in corporate governance decisions. This makes it crucial to trust the management team and their ability to steer the company in the right direction.

For institutional investors, dual-class shares can be even more problematic, as they are often accountable to their own stakeholders and may find it difficult to justify investing in companies where they lack significant voting influence.

Key Considerations for Investors:

1. Trust in Leadership: In companies with dual-class shares, much depends on the leadership’s vision and competence. Investors must assess the management team’s track record and commitment to the company’s growth.
2. Risk of Governance Issues: The risk of poor governance is higher in dual-class share structures, particularly if the controlling shareholders’ interests diverge from those of the general shareholders.
3. Long-Term vs. Short-Term Goals: Investors must be aligned with the company’s long-term goals, as dual-class shares often promote long-term stability over short-term gains.
4. Potential Returns: While dual-class shares limit voting power, they do not necessarily affect financial returns. Investors should consider whether the company has strong growth prospects that can lead to higher returns, regardless of their voting influence.

Conclusion

Dual-class shares represent a significant shift from the traditional stock structure, offering companies the flexibility to retain control while raising capital. While this system has its advantages, particularly for founders and early investors, it also comes with risks, especially concerning corporate governance and shareholder rights.

In the Indian context, the introduction of dual-class shares through SEBI’s Superior Voting Rights guidelines is a promising step towards promoting innovation and protecting founder control. However, as with any investment, it is essential for investors to weigh the potential benefits and risks carefully.

As dual-class shares become more prevalent in India, they will likely play an increasingly important role in shaping the future of corporate governance and shareholder engagement.