Before you dive into hot "Web 2.0" companies like LinkedIn (NYSE: LNKD ) , Groupon, and Facebook, make sure you're fully aware of their major corporate governance downside. The insider-centric, shareholder-stifling policy of dual-class ownership plagues some of the market's hottest, most coveted IPOs.
Companies with a dual-class ownership structure have two separate classes of common stock, often dubbed Class A and Class B, which generally carry a different number of votes. From a corporate governance perspective, this signals big-time danger, because the class of shares management owns generally gives them more votes than the shares investors like you buy. In short, dual-class ownership gives insiders much greater control over the company.
This practice is particularly popular at family-owned companies and founder-led corporations. Defenders can certainly rationalize that dual-class ownership preserves management's freedom to pursue long-term goals when outside investors push for short-term performance. Still, from a shareholder perspective, it also stifles dissent and greatly dilutes outsiders' say over important corporate matters.
Just yesterday, corporate governance expert Nell Minow wrote in-depth about the hidden dual-class danger facing LinkedIn shareholders, as well as those who crave a piece of Groupon when it completes its own initial public offering. Minow succinctly summed up why investors should stay on guard: "[Dual-class ownership] gives insiders the best of both worlds -- the access to capital and limited liability of a public company on one hand, and the control offered by a private company. Great for them; lousy for shareholders."
Worse yet, LinkedIn's recent IPO has drummed up even greater investor interest in the prospect that Facebook might go public. Although Facebook has not released any imminent plans for an IPO, in late 2009 it set up -- you guessed it -- a dual-class stock structure, with insiders' Class B shares representing 10 votes each.
Seeing double and seeing red
This issue has a habit of creeping in and out of the spotlight over time. Back in 2004, my Foolish colleague Bill Mann wrote an excellent piece outlining how dual-class shares result in second-class investors -- namely, you and I.
In 2006, Google (Nasdaq: GOOG ) had to defend its own dual-class stock structure. A union pension fund shareholder complained about Google's Class B shares, which only insiders Eric Schmidt, Larry Page, and Sergei Brin own, giving them 10 votes per share to every one vote for Class A shareholders.
Long-struggling newspaper giant New York Times (NYSE: NYT ) also faced a major shareholder revolt over its dual-class ownership structure in 2007. A whopping 42% of shareholders withheld their votes for the company's directors at the time, displeased with the company's leadership and strategy.
Shareholders might not have been so angry had the company been flourishing. New York Times has not reported positive annual revenue growth since the year ended December 2006. In 2009, its sales dropped a staggering 17%. Unfortunately, the company's dual-class share structure gave regular shareholders no way to protest beyond selling their shares -- probably at a loss. If management's more powerful shares hadn't helped it maintain the upper hand, outside shareholders might have enjoyed a much better chance of enacting performance-boosting changes at the company.
Don't get two-timed
I don't believe a dual-class ownership structure must knock a company off a watch list, or out of a portfolio. Still, we regular shareholders should at least sharpen our awareness of such unfriendly policies, and take them into account when searching for stocks.
Two of the stocks I purchased for my Rising Stars portfolio, Timberland (NYSE: TBL ) and the aforementioned Google, have dual-class ownership structures. This is a ding against the strong corporate governance policies I try to promote. However, in the weighing, I concluded that I basically trusted these companies' managements, since both stocks' leaders have a vested financial interest in seeing their companies succeed.
Overall, though, dual-class stock structures represent the significant risk inherent in insiders' concentrated power. If more people know about the dangers of this policy, and speak out against it, perhaps more management teams will begin to pay more respect to the shareholders who provide their firms with capital in the first place.
Check back at Fool.com every Wednesday and Friday for Alyce Lomax's columns on environmental, social, and governance issues.