Reading: Introduction to Financial Deal Making

Many entrepreneurs are reluctant to issue common stock because, as we have seen on the previous page, inviting new shareholders into the company could significantly alter the control structure of the company. In particular in early rounds of financing, where the valuation is still comparatively low (see before), issuing common stock could take control away from the entrepreneurs.

It turns out, however, that common stock is not so "common" after all. Some of the issues discussed before, in particular the dilution of control through additional rounds of financing, could well be addressed with common stock.

To see this, it is important to note that shareholders have two basic rights:

• Cash flow rights: Shareholders are entitled to receive a dividend (if the company decides to pay a dividend).
• Control rights: Shareholders are entitled to vote at the shareholder's meeting (and they have certain information rights).

Control rights and cash flow rights are economically and legally separable. This means that, in principle, a shareholder can enjoy the dividends from his shares of common stocks while giving away his voting rights, or vice-versa. There are various ways to separate economic ownership (cash flow rights) from control (voting rights). For example:

• Most countries' laws allow multiple share classes. So a firm can issue classes of shares with identical cash flow rights but different voting rights. Many of the celebrated companies have this feature, including:
  • Facebook: In 2016, the firm had the following classes of common stock outstanding:
    • 2 billion shares of Class A common stock: 1 share 1 vote
    • 570 million of Class B common stock: 1 share 10 votes
    • Not surprisingly, Zuckerberg mostly owns class B shares. The result is that while he has "only" approximately 18% of the cash flow rights, he controls about 60% of the voting rights. So he factually controls the company, even though, from his economic interest, he is a minority shareholder.
  • Google: In 2016, the firm had three classes of common stock outstanding:
    • Class A: 1 share 1 vote
    • Class B: 1 share 10 votes
    • Class C: 1 share 0 votes.
    • The Google founders mostly hold Class B shares. Note that the Class C shareholders have no voting rights at all. So these shareholders participate in the cash flows of the company but have no say in the shareholders' meeting.

• It is also possible to enter into contractual agreements to transfer the voting rights or the cash flow rights to another party.
  • Warren Buffet, for example, has been a shareholder of the Washington Post for many years. However, he granted the Graham family a proxy to vote his shares at their discretion. So while he held the cash flow rights, he transferred the control rights to the company's controlling family.
  • Total Return Swaps are fairly common instruments to transfer the cash flow rights to another party.

• Finally, it is not uncommon to see structures where individual shareholders are granted disproportionate board representation.
  • The Stulzberg family, for example, is entitled to appointing 70% of the directors of the New York Times even though they only own 20% of the shares. Thereby, they factually control the board of directors.

Consequently, there are ways to finance growth with common stock without losing control over the firm. The trick is to separate the ownership rights (cash flow rights) from the control rights (voting rights).

However, there is no free lunch. Separating ownership and control can give rise to a whole set of new problems. In particular conflicts of interest among the shareholders themselves. Here are some examples using the cases from above:

• What if Google started doing business with a company in which the Google founders own 100% of the cash flow rights? This could give the founders incentives to transfer wealth from Google to the company the control in full, thereby harming the other Google shareholders.
• What if Mark Zuckerberg is no longer the best person to lead Facebook? Given his controlling stake, it will be hard to replace Zuckerberg against his will.
• Or what if Zuckerberg suddenly passes away? Would this lead to an immediate transfer of control? To whom? And would the new controlling shareholders have the same interests as Zuckerberg?
• Etc.

These concerns are very general and particularly relevant among privately held firms under family control. More sophisticated financial contracting allows us to address many of these and related concerns. This is what we will do in the next course sections.