Opinion | The need for dual-class shares in India
In the absence of a dual-class share structure, raising outside equity would dilute the insider’s ownership stake
By selling two kinds of partnership shares, through the dual-class share system, Indian businesses will actually strengthen corporate governance rather than weaken it. My argument is three-fold. First, outside shareholder control is a myth in Indian firms. Even without dual-class shares, outside shareholders do not enjoy much control. Second, the dual-class share structure makes insider control more transparent. It will signal the firms in which insiders enjoy absolute control. This will put greater onus on outside investors to exercise due diligence before investing. Third, allowing dual-class shares is the only way we can have an Indian-owned unicorn.
Let me reiterate: Outside shareholders do not exercise any meaningful level of control in Indian firms.
When one buys a share, one gets two sets of rights: cashflow rights and control rights. The former refers to the right to obtain dividends, while the latter refers to the right to vote in shareholder meetings to elect the board of directors.
As I highlighted in the previous article, in a majority of listed firms in India, the insiders own a majority of the shares outstanding. This means that outside shareholder votes are in the minority. If all of the outside shareholders do not like something happening in the firm, they can go to the shareholder meeting and express their displeasure by voting against the proposal. But if the insider owns a majority of the shares, then the outside shareholder votes are symbolic.
Apart from voting in shareholder meetings, shareholder governance is usually exercised through an independent board. The lack of real independence among Indian boards is legendary and also impedes the ability of outside shareholders to exercise their control rights. While there is a lot of independence on paper, there is very little real independence. Let me present a few pieces of evidence.
Consider the Satyam Computers scandal. Nobody could fault its board for its quality and independence. It had members who were world-renowned experts in accounting and corporate governance. However, the board was in the dark for an extended period.
There are a number of factors that affect the board’s ability to adequately exercise oversight. First is the presence of a shareholder with majority stake who may also control firm management. Given such a shareholding pattern, it is difficult for any independent director to go against the insider. Second, even in the US, board effectiveness is compromised by the fact that the management identifies new directors who owe their position to the chief executive officer. Furthermore, directors typically depend on the management for information about the firm’s performance and don’t have independent means of verification!
My next argument for a dual-class share structure is transparency. Having a dual-class share structure is a transparent way for the insider to signal the fact that they exercise absolute control over the firm. Given that, it is for the outside shareholders to exercise caution when investing in the firm’s shares. It is interesting that following the Asian financial crisis, both Japan and Korea wanted their large business groups to unwind their complex ownership structures to make them simpler and more transparent. To date, that has exhibited very little impact on the control structure of the firms. Thus, even after unwinding the complex structures, insiders found alternative means to retain control over their firms. So instead of deluding ourselves into thinking that outsider shareholders do have control, it is better to know that outsiders don’t have any control and hence will have to exercise greater due diligence before investing in a stock.
Note that if dual-class shares do worsen governance, then outside shareholders will vote with their feet and refuse to invest in firms with dual-class share structure. This will automatically reduce their attractiveness.
My final argument for dual-class share structure: It is the only way to create Indian-owned unicorns. Let me explain. The new technology firms typically have an asset-light balance sheet. They do not invest in physical assets such as plant and equipment but in intangible assets such as programmes, systems and human capital. This investment pattern has implications for how they can finance their growth. The lack of physical assets limits the firm’s ability to raise debt to finance its growth. That means perforce the firms depend on equity for incremental financing. This equity can either be from retained earnings or from outside investors. The problem with growing through retained earnings is that not only does it put pressure on firms to start generating profits at an early stage, but also limits the rate of growth to the rate of cash generation.
In the absence of a dual-class share structure, raising outside equity would dilute the insider’s ownership stake and risk loss of control. Thus, in the absence of debt finance, the Indian technology firms are caught between a rock and a hard place. Either depend on internal cash generation to grow and settle for slower growth, or depend on outside equity and risk losing control.
To avoid this painful choice, it is important to give them an alternative and that will be to issue dual-class shares. This will enable them to grow fast using outside equity while retaining control.
Radhakrishnan Gopalan is a professor of finance in Olin Business School at Washington University in St Louis.
This is the second in a two-part series.
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