Field Notes

Fair Share
How much value is lost with dual-class control structure?

By Brian F. Smith, professor of finance, Wilfrid Laurier university; Ben Amoako-Adu, professor of finance,
Wilfrid Laurier university; and Madhu Kalimipalli,associate professor of finance, Wilfrid Laurier university.

Under a dual-class share structure, a small group of shareholder-managers can control a disproportionate amount of votes relative to their equity investment. The relative lack of equity interest suggests that there is weak alignment of interests of managers and outside shareholders. This lack of alignment of interests increases the risk that the controlling group of shareholder-managers will expropriate private benefits from the corporation. This in turn increases the need to monitor management by outside shareholders. The costs of the monitoring are referred to as agency costs. In this way, management voting leverage reduces corporate value.

Under the dual-class structure, there are two groups of outside or minority shareholders. One group comprises those who hold a non-controlling interest in the superior voting shares and the second comprises those who hold restricted shares. Thus, under the dual-class structure, shareholder agency costs, which reflect shareholder disagreement and monitoring costs, will arise among the three groups of shareholders. It can be argued that the more stakeholder groups a company has, the larger are the agency problems and costs.

All is not negative with dual-class companies. The significant equity investment in dollar terms that most controlling shareholder-managers have in such companies may partially offset the negative influence of management voting leverage. Such shareholders will often want to protect their wealth by making sure the company is well managed so that the wealth is preserved for descendants.

Previous research from other countries has found that dual-class structure has either a negative or neutral impact on value. See Lins (2003), Nenova (2003) and Gompers et al. (2004). In this study, we examine the impact of management voting leverage on corporate value in Canada and distinguish this impact from that of concentrated control using a single class without a pyramid.

To test the hypothesis that management voting leverage reduces corporate value, a regression is run with the dependent variable, the Q ratio, and the main explanatory variable, management voting leverage, as well as several control variables. The management voting leverage is the proportion of equity over the proportion of votes held by management. Where a company holds less than 100% of a subsidiary, a pyramid structure exists and the management voting leverage is adjusted accordingly. When the pyramid and dual-class structures are combined, the result is a very high management voting leverage.

We define management as managers and noninstitutional shareholders who directly or indirectly hold more than 10% of the votes of a company. The bigger the management voting leverage, the bigger the difference between voting rights and cash flow rights of management, and hence the larger the agency problems. Based on corporate governance theory and other empirical studies, we control for size, financial leverage, institutional voting block, percentage of outside directors, and type of industry. The variables used in the regression analysis are defined as follows:

We are able to gather complete data on 53 dual-class companies, 78 companies that were closely controlled single-class companies (single shareholder has greater than 20% of votes) and 171 widely held companies. On average, the dual-class firms have management with 66.1% of votes but only 23.9% of equity. The mean (median) management voting leverage for these companies is 6.33 (3.89). In four of these cases, a pyramid structure is used to increase the management voting leverage. The 78 closely held single-class companies have shareholder-managers with 46.3% of the votes on average. Thirteen of these single-class companies use a pyramid structure. In these cases, the average (median) management voting leverage is 5.88 (2.97). This means that the presence of dual-class shares in Canada, and to a lesser extent the use of pyramidal structures, creates an overall divergence between managerial equity ownership and control rights.

Table 1 shows the results of the second stage of a two stage least squares analysis of the relationship between corporate value and voting leverage. Q-ratios are higher for technology companies (reflecting growth opportunities) and lower for highly levered companies (reflecting expected financial distress costs). Institutional votes weakly reduce Q-ratios. Most notably, management voting leverage is found to have a negative and significant effect on Q-ratios at the 1% level under both specifications of the second-stage regression. The finding suggests that if the management voting leverage increases by 1, the marketto- book value should decrease by 0.26. Thus, dual-class companies in Canada, on average, sell at a discount of 1.39 times book value to their single-class counterparts (that did not use pyramid structure) and single-class companies employing pyramid structure sell at a discount of 1.27 times book value. The close ownership and dual-class dummy variables by themselves or multiplied with voting leverage are not significant. The findings indicate that it is not close ownership per se that reduces value but the management voting leverage that comes with dual-class shares and corporate pyramids that leads to lower value.

Amoako-Adu, B., B. Smith, M. Kalimipalli, 2007, “Concentrated Control and Corporate Value: A Comparative Analysis of Single and Dual Class Structures,” Working Paper, Wilfrid Laurier University.
Gompers, Paul, Joy Ishii and Andrew Metrick, 2004, “Incentives vs Control: Analysis of US Dual-Class Companies,” NBER Working Paper Series.
Lins, Karl V., 2003, “Equity Ownership and Firm Value in Emerging Markets”. Journal of Financial and Quantitative Analysis, 38, 159-184.
Nenova, Tatiana, 2003, “The value of corporate voting rights and control: a cross-country analysis.” Journal of Financial Economics, 68, 325-351.

Contex Group Inc.