NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Dual-Class Companies

"Some firms adopt dual-class structures when their original owners are reluctant to cede control... these firms are less likely to tap the capital markets, typically invest less, grow more slowly, and have lower valuations."

Aligning the interests of owners and managers has been a problem ever since stock corporations were invented. In principle, owners can shape managerial incentives in a variety of ways. In practice, most managerial incentive schemes are built around equity ownership. Awarding rights to the cash flow created by equity ownership creates a positive incentive to increase future cash flows. But equity ownership also gives managers more control. If managers use that control to entrench themselves, they may run the company for their own benefit, acting against the interest of other shareholders.

In dual-class companies, there are two classes of common stock offered, one of which has superior voting rights. Because management and other insiders typically hold more of the superior voting class, data from dual-class companies lets researchers assess whether the positive incentives of increased cash flow dominate the negative incentives of increased managerial control.

Studies of companies in emerging markets suggest that firms with two classes of stock neglect the interests of those holding shares lacking the superior voting rights. But unlike emerging markets, in developed countries the capital markets have a framework of legal, regulatory, and institutional protections designed to shield owners of publicly traded stock from managerial fecklessness. In Incentives vs. Control: An Analysis of U.S. Dual-Class Companies (NBER Working Paper No. 10240), authors Paul Gompers, Joy Ishii, and Andrew Metrick consider how cash flow rights and voting control affect managerial behavior in well developed capital markets.

Combining data from the Securities Data Company, the Center for Research in Security Prices, the Investor Responsibility Research Center, and company proxy statements, the authors create a unique collection of information about U.S. dual-class companies. They find that dual-class firms are more common among media-related firms, possibly because such firms offer greater opportunities for non-pecuniary private consumption and their founders "establish a dual-class structure in order to preserve control." On average, managers and directors own an average of 26.7 percent of the cash flow rights and 50.7 percent of the voting rights among firms in the authors' sample. Dual-class firms rely more heavily on debt financing, possibly because investors do not wish to buy stock with inferior voting rights. The median debt-to-assets ratio for dual-class firms is 0.21; for single-class companies it is 0.09.

After examining the effects of insiders' cash flow and voting rights on firm value, performance, and investment behavior, the authors conclude that aligning incentives by increasing managerial ownership of cash flow appears to increase managerial willingness to pursue more rapid growth. Increased cash flow ownership increases capital expenditures and growth in advertising and R&D spending, and firm value increases until managerial ownership of cash flow reaches about 33 percent. Increasing managerial control apparently has the opposite effect, perhaps because "some firms adopt dual-class structures when their original owners are reluctant to cede control" and seeking capital typically dilutes control. As a result these firms are less likely to tap the capital markets, typically invest less, grow more slowly, and have lower valuations.

-- Linda Gorman


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