Corporate control and idiosyncratic vision.

Author:Goshen, Zohar
Position::III. Concentrated Ownership Revisited A. Toward a New Theory of Corporate Ownership Structures 2. Dual-Class Firms and Dispersed Ownership through Conclusion, with footnotes, p. 588-617
 
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  1. Dual-Class Firms and Dispersed Ownership

    As our focus here is on the concentrated-ownership structure, we apply our framework only to publicly traded firms. We start with the two ends of the spectrum: dispersed-ownership and dual-class firms. We then show that concentrated ownership represents an optimal solution between these extremes.

    In the dispersed-ownership structure, shareholders hold nearly all residual cash flows, while management receives a salary and a small fraction of residual cash flows through options and bonuses included in its compensation package. (91) Leaving management with only a small fraction of residual cash flows exposes investors to management agency costs. (92) Those costs, however, are curbed by shareholders' control rights, which provide shareholders with the ability to terminate management. (93) At the same time, the threat of replacement curtails management's ability to implement its idiosyncratic vision. (94)

    Control in a dispersed-ownership structure is contestable. The degree of contestability presents a tradeoff between agency costs and idiosyncratic vision: less-entrenched managers expose investors to lower agency costs, but at the expense of the managers having less ability to pursue their idiosyncratic visions. (95)

    In the dual-class structure, the entrepreneur holds shares with superior voting rights, while investors' shares have voting rights that are inferior or nonexistent. (96) Notable examples of corporations with dual-class structures are Facebook (97) and Google. (98) By owning a majority of the voting rights, the entrepreneur retains full control over business decisions and can block any hostile-takeover bids. Uncontestable and indefinite control provides the entrepreneur with maximum ability to realize her idiosyncratic vision, which, under our framework, can ultimately benefit both the entrepreneur and investors (if the entrepreneur turns out to be right). (99) However, the entrepreneur's uncontestable and indefinite control, coupled with the entrepreneur's smaller fraction of residual cash flows, leaves investors with high exposure to both management agency costs (100) and control agency costs (the takings type). (101) Indeed, although prominent technology firms such as Google, Facebook, LinkedIn, Groupon, Yelp, Zynga, and Alibaba adopted the dual-class structure, this ownership structure is used infrequently because of investors' substantial exposure to agency costs. (102)

    1. Concentrated Ownership

      Conventional wisdom links concentrated ownership to private benefits of control. In our framework, however, concentrated ownership, which is situated between the extremes of dispersed-ownership firms (low idiosyncratic vision and low agency costs) and dual-class firms (high idiosyncratic vision and high agency costs), represents yet another way to balance idiosyncratic vision and agency costs. Specifically, by tying the entrepreneur's freedom to pursue her idiosyncratic vision to her large equity stake, concentrated ownership significantly alleviates shareholders' agency costs associated with relinquishing control to the entrepreneur.

      In both the concentrated-ownership and the dual-class structures, the entrepreneur controls the company by virtue of owning the largest share of the company's voting equity. In both structures, the entrepreneur's uncontestable control provides her with the freedom to pursue her idiosyncratic vision. But uncontestable control also provides controllers in both structures with similar ability to exploit minority shareholders and thus aggravate the control agency problem. However, the incentive to expropriate the minority is not similar under both structures. The higher the controller's share of cash-flow rights, the lower her incentive to expropriate the minority. (103) Unlike in the dual-class structure, equity in a concentrated-ownership structure is issued at a ratio of one share to one vote. (104) As control rights are distributed pro rata according to each shareholder's investment, the controller cannot preserve her control without holding a substantial fraction of cash-flow rights. Thus, while the exposure to the control-agency problem is high in a dual-class structure (high incentive due to small equity), it is only moderate in the concentrated-ownership structure (low incentive due to large equity).

      In the dispersed-ownership and the dual-class structures, those with de facto control do not necessarily hold a majority of cash-flow rights. (105) Thus, these structures expose investors to management agency costs. The concentrated-ownership structure, however, provides a middle-ground solution: it bundles cash-flow rights and control. Under a "one share, one vote" regime, the entrepreneur can retain control only if she holds cash-flow rights sufficient to give her control. Indeed, holding a control block inflicts costs on the entrepreneur. She needs to put her equity at risk, reducing liquidity and diversification, and to work either directly by serving as a manager or indirectly by monitoring professional managers. Under the conventional view, the entrepreneur is willing to pay this price in order to enjoy the private benefits of control. Under our framework, however, the entrepreneur is willing to bear these costs in order to hold indefinite and uncontestable control, which enables her to pursue her idiosyncratic vision. After all, this is a comparatively small cost, as the entrepreneur herself is (subjectively) confident she will make above-market returns on her investment and costs. (106)

      From the investors' perspective, the entrepreneur's bundling of control and cash-flow rights alleviates both asymmetric information and agency-cost concerns. First, asymmetric information and differences of opinion as to the entrepreneur's idiosyncratic vision are priced differently when the entrepreneur's own equity--for example, the equity investment required to secure a majority of voting rights--is placed at risk (thereby putting a lot of "skin in the game"). Second, substantial equity investment by the entrepreneur strongly aligns her interests with those of the investors, thereby reducing management agency costs. Third, since control blocks are relatively illiquid, bundling control and cash-flow rights restricts the ability of the entrepreneur to quickly walk away from the business. This type of lock-in effect increases the entrepreneur's commitment to the business and in turn reduces agency costs for the investors.

      To be sure, even entrepreneurs with a lot of "skin in the game" might make costly mistakes, such as making the wrong predictions about the market's future direction. Yet, compared to entrepreneurs with relatively insignificant cash-flow rights--under both dispersed-ownership and dual-class structures--they have substantial incentives to avoid these mistakes.

      Our analysis thus shows that concentrated ownership is not necessarily inferior to dispersed ownership. Each ownership structure presents a different balance between agency costs and idiosyncratic vision. The spectrum of ownership structures according to our framework can be summarized as follows:

      In sum, while contestable control constrains the entrepreneur's ability to pursue her idiosyncratic vision under dispersed ownership, the concentrated-ownership structure allows her to enjoy indefinite and uncontestable control without subjecting investors to the high management agency costs associated with the dual-class structure. Control enables the entrepreneur to pursue her idiosyncratic vision for both herself and investors. However, the entrepreneur must pay for her position in the form of lost diversification and liquidity, and increased execution and monitoring costs. While the entrepreneur's large equity stake protects minority shareholders from management agency costs, investors are nevertheless exposed to control agency costs. But, by tying the entrepreneur's freedom to pursue her idiosyncratic vision to her large equity stake, concentrated ownership moderates the control agency cost by decreasing her incentive to exploit the minority shareholders.

      IV. CORPORATE LAW: CONTROLLER RIGHTS AND MINORITY PROTECTION

      In this final Part, we present the principal implications of our theory for corporate law. We offer a blueprint of the policy considerations that should guide lawmakers in the United States and around the world in crafting corporate legal regimes for firms with controlling shareholders. While recognizing the importance of minority protection, our theory also underscores the importance of allowing controllers to pursue their idiosyncratic vision. Thus, we argue that controlling shareholders' rights play, and should play, a critical role in corporate law. We further argue that the interplay of minority protection with controllers' rights sheds light on some of the most puzzling aspects of Delaware case law and jurisprudence concerning firms with controlling shareholders.

      In Section IV.A, we argue that any legal regime governing firms with controlling shareholders encounters an inevitable tradeoff between the goals of protecting investors and allowing controllers to maximize idiosyncratic vision. As we explain in the subsequent Sections, this tradeoff should shape both governance arrangements and corporate doctrine moving forward.

      In Section IV.B, we discuss the rights that controlling shareholders should have, demonstrating that recognition of the controllers' rights may justify legal outcomes that are contrary to the traditional notions of shareholder-value maximization.

      Section IV.C analyzes the main elements of minority protection. We advance two specific points. First, the need to balance idiosyncratic vision and minority protection may undermine the protection against self-dealing. Some self-dealing should be tolerated not because we believe that controllers deserve to be rewarded with private benefits, but because regulation would result in excessive interference with...

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