Corporate Governance: Dictatorships VS Democracy

Before you fall asleep (or worse, hit the “back” button), let me acknowledge that there is no more boring phrase than “corporate governance.” Each individual word is a yawner, and then combined it becomes the auditory equivalent of a horse tranquilizer dart in the neck. I read two unrelated, yet thematically connected, stories this week about corporate governance that collided in my head. And I thought it best to blog it out to explore where they build upon each other.

First story: Facebook’s reported financial performance is breathtaking, and they were the darling of Wall Street this week, but the real Facebook financial news released in the quarterly call was a change in corporate governance. Facebook is creating a new class of stock (Class C) for the purpose of allowing Mark Zuckerberg to give away nearly all of his Facebook-made wealth while still remaining in sole voting control of the company.

This is the second time Facebook’s board has taken measures to ensure Mark retains absolute control of his company. The first time was when Facebook went public, the board established a 10-to-1 voting ratio between Mark’s shares (Class B) and all other investors shares (Class A) back in 2012. Now, the board is creating yet another class of stock that comes with no voting power, very similar to the move Google executed in 2014 in order to ensure Larry Page and Sergey Brin retain control of their company even after their ownership levels dip below normal control thresholds.

The TL;DR on these corporate governance moves is Facebook and Google are both run as monarchies with their founders as kings. And the stock performance over the past 3+ years would indicate that their boards’ decisions to grant such monarchies were smart.

Second Story: The WSJ ran a feature on a ninth grader who took a vocal stand at the most recent Bank of America annual shareholders’ meeting. Natalie Clarke owns 5000 shares of BAC, which she received when she was a baby, and she has attended the last few years of BAC shareholder meetings.

During her ownership since 2002, the stock has dropped significantly (down -55% VS the S&P500 up 122% over the same period). At the meeting Natalie publicly questioned why CEO pay was increased in 2015 (by an additional $3MM) while the stock dropped -6% over the same time period.

The story is a great example youth ambition and I adore Natalie for her stand, but it’s also an example of how most public company shareholder meetings are sadly perfunctory. All the voting on any resolutions is done by proxy before the meetings, so the shareholders that attend typically have no practical impact on governance and the events of the meeting are mostly ceremonial.

The collision of these two stories in my mind results in the following ricocheting shrapnel:

I take issue with the monarchy setup of Facebook and Google. I feel like if you’re actively selling your company’s stock, you deserve exactly as much control of your company as you own. To sell the vast majority of your position while also retaining outright control is to have your cake and eat it too. Founders of successful companies have every right to diversify their wealth, and I’d do the same thing in their shoes (I wish I had that problem…). But that diversification comes at the cost of control, because the buyers of founders stock (who definitionally are bullish and believe in the future of the business) deserve a say in the company that now in part own.

Yet, the success of Google and Facebook under their monarchies is undeniable. Post IPO (and post-dual-class stock issuance) performance has been amazing. These founders make aggressive acquisitions and heavy R&D bets that you could not fathom a successor-CEO making in their place, and the general consensus of Wall Street is these are the right moves.

The company I most admire in this light is Amazon. Jeff Bezos owns around 19% of the company he founded and continues to run today. He doesn’t have outright control and never created a dual class of stock. He has had no shortage of critics on the street over the years. I recall with a smile an accounting class at NYU where my teacher routinely used Amazon’s financials as the punchline to a joke about IPO’ing with retained losses instead of retained earnings. Jeff has been comfortable constantly reinvesting in the business and operating at zero net income for well over a decade, and he never needed corporate governance engineering to have the faith he was doing the right thing for his company. He increased the value of his own minority ownership, and he made everyone who believed in him quite wealthy along side him as AMZN stock appreciated.

In contrast to monarchies, I want to believe that if the investing world had more Natalie Clarkes (our heroine from the WSJ article), we’d all be better off. Instead of passive ownership of the world’s largest companies through index funds, I’d like to believe that the good corporate governance could come from democratic input of the companies’ owners. Something just feels *right* about everyone having a voice commensurate to their ownership in a company.

In the private market, this is exactly the way I strive to behave as an investor. Whenever negotiating term sheets with startups or with other co-investors, corporate governance terms such as protective provisions and board seats should be reflective of the cap table. If an investor does not own a material portion of a company, they shouldn’t be granted these rights, and vice versa.

Unfortunately, as index-based investing has become increasingly popular, most owners of the the companies which comprise the S&P500 are passive because their ownership is through a mutual fund or ETF. I suspect most index fund investors are completely unaware of the names of the individual companies they partly own and the corporate governance responsibility such ownership grants. Instead that responsibility is outsourced to fund managers, juggernauts like Fidelity and Vanguard. If you have invested in Vanguard’s S&P500 index fund, you can see how they have voted on corporate governance on your behalf.

That’s what makes Natalie Clarke’s story so unique: she’s a retail investor with an active stance. Matt Levine at Bloomberg mentioned in his email news letter today that Natalie’s story is a lesson in investment diversification because had baby Natalie taken her 5000 shares and sold them in exchange for shares in the S&P500, she would have done much better. While Matt’s point is true, then Natalie would have been just another passive indexer, relinquishing her vote to fund managers. How sad… and that’s exactly what makes Natalie’s story newsworthy: she’s a bold exception in a world of indexers.

The lesson at the intersection of these two corporate governance stories is probably something like How I Learned to Stop Worrying and Love The Corporate Monarch. Yet, the idealist in me can’t quite embrace this empirically-supported conclusion. So, Go Natalie!

Disclosure: I have economic interest in Facebook, but not Google, Amazon, or Bank of America, aside from my passive indexing. ;)

“Seeing ourselves clearly is the project of a lifetime.” -The Nix

“Seeing ourselves clearly is the project of a lifetime.” -The Nix