Hong Kong’s stock exchange operator has proposed a bold capital market reform, accepting so-called dual-class share structures that allow entrepreneurs to retain voting power in their companies even after selling most of its economic value.
The controversial stock structure sparked months of fierce debate among the financial community. But with the proposed rules coming into effect as soon as next year, FinanceAsia takes a look at what changes the new structure could bring to Hong Kong.
Some of these changes will be seen as positive and some are undoubtedly negative. In either case, the investment community should be prepared for a changing environment.
Dual-class shares remove a headache that many entrepreneurs suffer from at the early stage of their business – striking a balance between fundraising and maintaining control.
Founding members often need to sacrifice part of their control over the company in order to raise equity to grow the business. This happens both in the private and the public market.
Under the new dual-class share structure, founding members can raise public capital to fund their business while avoiding massive dilution of their interest. This is particularly good news for capital-intensive businesses.
As a result, more early-stage companies will be interested in raising public capital, thus enhancing liquidity and bringing high-quality startups for public investment.
Smaller variety of investors
Companies that adopt dual-class shares are less likely to attract institutional investors, which require a certain level of corporate governance for their portfolio companies.
Government-linked investment funds and pension funds typically set a higher standard of corporate governance among their portfolio companies.
Private equity funds may also be less interested in these companies because they are less likely to gain control over their business directions and strategies.
Weaker boards of directors
The role of the board of directors is likely to become less clear in a company that adopts dual-class shares.
In fact, it is doubtful whether the board can still serve its fiduciary responsibility to protect investor interests, given that all the board members have to be voted in by shareholders.
This is because under the dual-class share structure, founding members with superior voting rights will have full control over who will make up the board of directors. In the event that the founding members' interest goes against those of other shareholders, the board is likely to act in favor of the founding members, to whom they owe their positions on the board.
As such, it is more difficult for dual-class share companies to hire independent boards of directors because they are not as influential as directors working with a company with general shareholding rights.
In terms of composition of the board, the founders will likely avoid selecting board members who represent certain interests that potentially go against the company. For example, a board member that represents the employees or minority shareholders is less likely to be “approved”.
Lower stock market functionality
The capital markets naturally serve the function of regulating companies through market forces. But that function may not apply to dual-class share companies.
When a company does not perform as expected, its share price will suffer and the company will be prone to a hostile takeover. Senior executives need to address the situation through measures such as share buybacks, more generous dividend payments or generally improving the business quickly.
Under the dual-class stock structure, a hostile takeover is almost impossible as long as the founders own a sufficient amount of superior shares. Thus, companies are less likely to take action to address investor concerns over its sub-par performance.
By the same token, shareholder activism – one of the few ways for public investors to challenge the management – is less likely to work on dual-class share companies.
More share pledges
Under the dual-class stock structure, there will be a stronger incentive for company founders to pledge their shares for personal financing.
There are two reasons for this. First, the founding members’ superior voting power means they are no longer required to hold the bulk of shares to maintain control. Second, they will be restrained from selling their shares directly because if they do so the shares will be converted into ordinary shares, making share financing a more practical way of raising money for themselves.
Share pledges are generally perceived as negative because they are often associated with financial difficulties. Under normal circumstances, companies are unlikely to disclose share pledges by their founders.
But with the number of share pledges potentially on the rise, there will be a higher chance that these share pledges are leaked and become public knowledge. For public investors, it implies less transparency and potentially more volatility when such cases are exposed.
More cautious dividend policy
Under dual-class shares, company founders have less incentive to pay dividends, as there is no distinction of dividend payment between the different classes of shares.
This particularly applies to senior executives who take full advantage of the dual-class share structure – keeping the smallest amount of shares sufficient to maintain full control over the company.
In this case, the founders will receive fewer dividends relative to their voting power. A 10% stakeholder could only get a tenth of the overall dividend payment even if he has absolute control over the company (assuming that superior shares have 10 times as much voting power as ordinary shares).
Naturally, senior executives will be more inclined to keep the cash within the company for future development. While shareholders of fast-growing start-ups generally do not expect generous dividends compared to large enterprises, those investing in dual-class share companies may have to further lower their expectations for dividend payments.
Many of the world's most popular dual- or multiple-class stocks such as Alphabet (parent of Google), Facebook and Alibaba never declare dividends. This is the same for Snap, which is the only company that offers shares with no voting rights to public investors.
It is worth noting that the manager of S&P 500 Index has recently banned companies with multiple share classes from inclusion in the US stock index. FTSE Russell, provider of the benchmark FTSE 100 Index, has also proposed to exclude companies whose ordinary shareholders have less than 5% of voting rights.