Corporate control and idiosyncratic vision.

• Author: Goshen, Zohar
• Position: Introduction through III. Concentrated Ownership Revisited A. Toward a New Theory of Corporate Ownership Structures 1. The Spectrum of Ownership Structures, p. 560-588

ARTICLE CONTENTS INTRODUCTION I. EXISTING EXPLANATIONS AND THEIR LIMITS A. The Minority-Expropriation View B. The Optimal-Reward View II. A THEORY OF CORPORATE CONTROL A. Idiosyncratic Vision, Agency Costs, and Control 1. The Entrepreneur's Idiosyncratic Vision 2. Outside Investors and the Value of Control B. Control and Cash-Flow Rights 1. The Role of Cash-Flow Rights 2. Control and Cash-Flow Rights as Substitutes 3. Bargaining Power and Competition III. CONCENTRATED OWNERSHIP REVISITED A. Toward a New Theory of Corporate Ownership Structures 1. The Spectrum of Ownership Structures 2. Dual-Class Firms and Dispersed Ownership B. Concentrated Ownership IV. CORPORATE LAW: CONTROLLER RIGHTS AND MINORITY PROTECTION A. The Tradeoff Between Minority Protection and Controller Rights B. Controller Rights 1. Management Rights: The Business-Judgment Rule and Board Composition 2. Property-Rule Protection: Preserving Control 3. Right To Sell Control for a Premium C. Minority Rights 1. Pro Rata Share: Identifying Self-Dealing 2. Midstream Changes 3. Type of Protection D. Difficult Cases 1. Freezeout Transactions 2. Sale to a Third Party CONCLUSION INTRODUCTION

Several prominent technology firms that went public in recent years, including Google (1) and Facebook, (2) adopted the controversial dual-class share structure in which the founders retain shares with superior voting rights. Alibaba, the Chinese company that set the record for the largest ever IPO, decided to list its shares in New York instead of Hong Kong so that it could use this dual-class share structure. (3) Essentially, the goal of this structure is to allow the entrepreneur-controlling shareholder to preserve her indefinite, uncontestable control over the corporation. (4) Commentators have criticized the dual-class structure for creating governance risks. (5) But why do entrepreneurs insist on holding control in the first place?

The answer has important implications for corporate law. Most public corporations around the world have controlling shareholders, (6) and concentrated ownership has a significant presence in the United States as well. (7) For example, Facebook, Google, and Viacom all have controlling shareholders. (8) In the concentrated-ownership structure, a person or an entity--the controlling shareholder--holds an effective majority of the firm's voting and equity rights. (9) The governance concerns raised by firms with controlling shareholders differ from the governance concerns associated with firms with dispersed ownership. Yet, legal scholars have largely overlooked the issues arising from firms with concentrated ownership. (10) Moreover, as we explain below, Delaware's doctrine concerning controlling shareholders has often been puzzling and inconsistent."

Unlike diversified minority shareholders, a controlling shareholder bears the extra costs of being largely undiversified and illiquid. (12) Why, then, does she insist on holding a control block despite having to bear these costs? (13)

The prevailing answer focuses on private benefits of control. (14) According to conventional wisdom, entrepreneurs seek a controlling interest in order to exploit their dominant position and divert value from the company or its investor, thereby capturing private benefits of control. An alternative, and less pessimistic, theory proposes that allowing an entrepreneur to consume some level of private benefits is a necessary cost of incentivizing efficient monitoring and good performance. (15) The controller in this explanation still diverts value to herself at the expense of investors, but on balance, her actions benefit the investors and the corporation as a whole.

Both theories explain corporate control as a function of private benefits. However, the depiction of controlling shareholders as being either motivated or rewarded by private benefits of control is unconvincing from both positive and normative standpoints. On the one hand, there may be good reason to doubt that most controlling shareholders around the world are opportunists whose motivation for control is the prospect of exploiting loopholes in minority-investor protection. On the other hand, it is by no means clear that investors, courts, and lawmakers should actually tolerate some level of value diversion by controlling shareholders in order to incentivize them to monitor management.

This Article offers an alternative explanation for the value of control by entrepreneurs. Under our framework, control allows entrepreneurs to pursue business strategies that they believe will produce above-market returns by securing the ability to implement their vision in the manner they see fit. The entrepreneur values control because it protects her against the possibility of subsequent midstream investor doubt and objections regarding either the entrepreneur's vision or her abilities.

Control matters because business ideas take time to implement. This ongoing process requires numerous decisions, ranging from day-to-day management issues to major strategic choices. Perhaps the most important decision is whether to continue a business, change its course, or close it down. However, investors and entrepreneurs often need to make these decisions under conditions of asymmetric information or differences of opinion. Investors cannot always observe the entrepreneur's efforts, talents, and actions. Therefore, it is hard for investors to determine the real cause of a corporation's poor performance: it could be the entrepreneur's incompetence or laziness, temporary business setbacks, or simply bad luck. Since the entrepreneur commonly knows more about the business and her own efforts and talent than investors, she has the ability to exploit investors by the way she manages the business. Investors will wish to contain this risk of agency costs by maintaining the right to close the business down or fire the entrepreneur. Even when investors and entrepreneurs have the same information, the complexity of the business and the uncertainty of the future might yield different beliefs as to the potential success or failure of the business. Consequently, under conditions of asymmetric information or differences of opinion, entrepreneurs and investors may disagree over whether a business should continue and in what fashion.

Thus, in our framework, both investors and entrepreneurs value control, but for different reasons. The entrepreneur wants to retain control over management decisions to pursue her idiosyncratic vision for producing above-market returns. That is, control enables entrepreneurs to capture the value that they attach to the execution of their idiosyncratic vision. (16) Investors, by contrast, value control because it allows them to minimize agency costs. (17)

Henry Ford's story illustrates our theory well. Ford did not invent the automobile, nor did he own any valuable intellectual property in the technology. He was competing with hundreds of other entrepreneurs attempting to create a "horseless carriage." Ford, however, had a unique vision regarding car production. The Detroit Automobile Company, the first firm that he founded, was controlled by investors. (18) While investors demanded that cars be immediately produced and sold, Ford insisted on perfecting the design prior to production, leading to delays and frustration on both sides. The tension eventually led investors to shut down the firm. (19)

Ford's second attempt, the Henry Ford Company, was also controlled by investors. Again, after designing a car, Ford resisted the investors' pressure to move directly into production. (20) Ultimately, Ford's obstinacy prompted investors to replace him with Henry Leland, who changed the company's name to the Cadillac Automobile Company and successfully produced the car that Ford had designed. (21) In Ford's third attempt-the Ford Motor Company-he insisted on retaining control. This time, with no outside-investor interference, Ford transformed his innovative ideas for car design and production into one of the greatest corporate success stories of all time. (22)

The entrepreneur's idiosyncratic vision has two distinctive features in our framework. First, it reflects the parts of the entrepreneur's business idea that outsiders may be unable to observe or verify. This could be because the entrepreneur cannot persuade investors that she is the best person to continue running the firm or that her business plan will produce superior returns. Second, it reflects the above-market pecuniary return expected by the entrepreneur, which, if the business succeeds, will be shared on a pro rata basis between the entrepreneur and investors. Importantly, idiosyncratic vision need not concern an innovation or new invention: as long as the entrepreneur has a plan that she subjectively believes will result in above-market returns, she has idiosyncratic vision.

While it may seem intuitive that...