The Governance Swing
A storm brewing across the public and private markets
“We have two classes of authorized common stock, Class A common stock and Class B common stock. The rights of the holders of Class A common stock and Class B common stock are identical, except with respect to voting and conversion. Each share of Class A common stock is entitled to one vote per share. Each share of Class B common stock is entitled to ten votes per share and is convertible at any time into one share of Class A common stock.” — Facebook S-1
This week, activist hedge fund Starboard Value disclosed a 7.5% stake in Box ($BOX), on the heels of slow revenue growth and falling share prices for the cloud storage company. As documented in this piece, an activist investor taking a weighty position in a public company is not huge news, but an activist investor taking a position in a tech company sends a bit of a ripple. Since Facebook’s IPO in 2012, tech companies that IPO usually have a dual-class stock structure, meaning that one class of shares has a lot more voting power than the other. The founder(s) and insiders typically own this class of stock, leaving effective control for the direction and vision of the enterprise in the hands of the founder(s).
Facebook’s implementation of the dual-class structure was the logical conclusion of the paradigm of corporate stewardship for technology businesses it paved that way for. We forget this in the current early-stage market, but up until Facebook, venture capitalists owned way too much of companies, pushed management to make hasty decisions with little long-term strategic vision themselves, and had all the leverage in the founder-investor relationship. The success of Facebook and Mark Zuckerberg, as the visionary product leader and founder, flipped the table on this dynamic.
The historical context matters today because last year, Box eliminated the very founder-friendly stock structure it went public with. That elimination provided the opportunity for a firm like Starboard to wrestle away some control from management. It also stirs the pot in a debate I see happening across the public-private market spectrum, and the outcome may give ammunition to either side.
Dual-Class in the Public Markets
As more tech unicorns go public, this conversation sees more steam. Founders and early investors argue that they should have outsized control due to their long-run outlook on the promise of their businesses, which in the current moment, can be largely unprofitable. Here’s a transcript from a Planet Money podcast that sheds some light on the rationale:
LEVINE: Facebook is a good example of the success of this. Mark Zuckerberg did a lot of moves that were kind of - that kind of looked like, you know, weird corporate governance. Like, he just went and bought, you know, Instagram or whatever with, like, relatively little oversight. It just sort of felt like a sort of company that was not, like, run by best principles of corporate governance necessarily. And it turned out to be wildly successful for shareholders, and they made boatloads of money - right? - because he actually was good at it.
VANEK SMITH: Matt says a lot of investors - especially investors in tech companies, you know, with these celebrity genius inventor CEO types - actually started to really like the fact that shares of stock came with no voting muscle. It became kind of like a selling point. Like, don't worry. No schlubby, small-minded investor is going to step in and thwart, you know, the genius's vision.
LEVINE: The pitch is - this is actually - adds value.
VANEK SMITH: It's protecting your investment in a way.
LEVINE: Yeah, this is protecting your investment because, like, what you're really signing up for is Mark Zuckerberg. And the only way to make sure that you're getting Mark Zuckerberg is to give Mark Zuckerberg all the votes.
Nevertheless, public investors are getting irritated with this arrangement. Some indexes won’t add companies with the dual-class stock to their sets. Here’s some thoughts from Andreessen Horowitz’s Scott Kupor:
Pension funds and asset managers, who want to preserve the principle of one vote per share at all costs, have tried and failed to get these structures banned from stock market exchanges. Now they have taken the fight to stock indices and are trampling on individual retail investors in the process. Institutional investors have convinced index operators to put hurdles in the way of companies that do not conform to their views on the subject. MSCI has reduced the weighting of companies with multiple share classes and S&P plans to exclude new ones entirely. For investors and workers who rely on gains from index funds to fund their retirement, this is a nail in the coffin.
It’s a battle from both sides, and I understand why. Founders deal with the historical vestiges of bad actor investors with immediate profits in mind and short-sighted goals. Institutional investors want control — they’re not angels writing uncapped SAFEs. They have fiduciary duty in mind and are contending with the end result of the governance swing, which took place following the dot-com bust and the emergence of Facebook, along with the tenacity of someone like Jeff Bezos and his attitude towards Wall Street.
‘Winning the Deal’ in the Early-Stage Markets
So, if we look to the early-stage private markets where the companies that go public to a decade from now are in the formation stage, what’s the outlook? What’s the relationship like between entrepreneurs and VCs right now that sets the tone for corporate governance throughout these companies’ lifecycles?
I’m not judging the current state of affairs, but rather, observing. The pendulum has swung fully in founders’ favors due to the proliferation of dollars hungry for alpha at the early stage. VCs are focused on ‘winning the deal’ rather than great founders hoping an investor will come from the heavens and select them. There are certainly exceptions to these high-level comments, but it’s largely true, especially for the companies that matter. Founders want to hear that VCs can help with recruiting, BD, fundraising, strategy, etc. No talented founder worth their salt wants to hear, “well, we really care about governance.” The idea of governance is thrown out the door when you’re trying to get an allocation.
To be clear, founders having decisive control over their businesses is a good thing. Many VCs were shitty in the dot-com era. What worries me is the possibility for divisive relationships between investors and entrepreneurs, tied to noise going on in the market. The kernels of that relationship inform the nature of the partnership throughout a company’s trajectory. If there are interpersonal issues with misalignment at the company level, it does not bode well for a broader ecosystem when multiplied across many startups.
Starboard and Box
Starboard’s actions with Box will be ones to keep an eye on because the outcome can help either side rationalize their position. If Box’s management screws things up, and Starboard turns the ship around, proponents of investor-driven governance will have their day. If the opposite occurs and Starboard messes it up, advocates of corporate governance oriented around founders and management can continue with the trajectory of the last decade or so.
I throw the dynamics of early-stage fundraising into the discussion to demonstrate a tendency that may not mix well with what’s going on in the public markets between large tech companies and institutional investors. But then again, see the following from Constellation’s Mark Leonard:
“However, when you are dealing with a high-performance company, I don't think governance should be the key role of the board. Governance is still necessary, but it is not sufficient. Helping extend the extraordinary track record of building intrinsic value should be the board's primary function.” — Mark Leonard, Constellation Software President’s Letter 2017
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