In response to investor concerns regarding an increase in the number of technology companies that have been implementing multi-class capital structures, index providers S&P Dow Jones, FTSE Russell and MSCI have adopted or proposed new rules that will likely have a significant impact on technology companies that are contemplating or have implemented these capital structures. Below we summarize recent trends regarding implementation of multi-class capital structures by technology companies, institutional investor reactions to these structures, the new rules adopted or proposed by the major index providers, and how these rules will impact technology companies.
Over the last few years, an increasing number of technology companies have been implementing multi-class capital structures prior to or in connection with their initial public offerings. High-profile technology companies like Alphabet (Google), Facebook, LinkedIn, Square and Box have all implemented these types of capital structures and of the 10 domestic technology companies that went public in the first half of 2017, six had adopted multi-class capital structures. The primary reason that technology companies implement these structures is to protect the long-term vision of their founders and to insulate founders from some of the pressures associated with short-term decreases in stock price, such as activist stockholders.
The most common type of multi-class capital structure utilized by technology companies is a dual-class structure that provides for two classes of stock, Class A common stock and Class B common stock. The classes of stock are identical except the Class B common stock is entitled to 10 votes per share and the Class A common stock is entitled to one vote per share. The Class A common stock is issued to investors in the IPO and is also generally used by a company following its IPO for acquisitions and equity-based compensation issued to employees. The Class B common stock is held by the company’s pre-IPO stockholders, including its founders, directors, executives and employees. Following the IPO, except in limited circumstances, the Class B common stock converts to Class A common stock upon a sale or other transfer. Over time, as Class B stockholders seek liquidity and as venture capital and other institutional investors distribute shares to their limited partners, voting control is further consolidated with the founders since founders often hold their stock for longer periods of time.
Investor Reaction to Multi-Class Capital Structures
Multi-class capital structures have increasingly become the subject of investor scrutiny. In recent years, technology companies with multi-class capital structures have become the target of stockholder proposals urging these companies to unwind these structures. Certain large institutional investors—such as BlackRock, Vanguard, Fidelity and T. Rowe Price—have all noted that they are generally opposed to multi-class structures and will generally vote in favor of proposals to dissolve a multi-class structure and against proposals to establish multi-class structures. Additionally, various investor trade groups such as the Council of Institutional Investors, an organization that represents big pension funds and institutional investors, and ISG, a collective of some of the largest U.S.-based institutional investors and global asset managers, have endorsed the principle of “one share, one vote,” although investors that are part of these groups are not required to adhere to their proposed frameworks. While we have yet to see large investors refuse to buy stock issued by companies with multi-class structures, this may be a position that some investors decide to take in the future.
Snap’s IPO in March 2017, in which the company issued shares to investors that were not entitled to any votes, generated additional publicity regarding multi-class capital structures and was scrutinized by certain institutional investors, investor groups and other shareholders’ rights activists. For example, the Council of Institutional Investors sent a letter to the founders and chairman of Snap urging them to reconsider plans to take the company public with shares that have no voting power. These organizations also lobbied index providers S&P Dow Jones, FTSE Russell and MSCI to change their rules to exclude companies with no-vote stock from their indexes.
Major Index Providers Change Rules
In response to these concerns, S&P Dow Jones, FTSE Russell and MSCI have all recently either adopted or proposed new rules that will impact companies that have, or are contemplating, the implementation of a multi-class structure. These rules are further described below:
S&P Composite 1500 Effective July 31, 2017, companies with multiple share class capital structures are no longer eligible for inclusion in the S&P Composite 1500 and its component indices, the S&P 500, S&P MidCap 400 and S&P SmallCap 600. Companies with multiple share class capital structures will continue to be eligible for inclusion in the S&P Total Market Index and other S&P and Dow Jones branded indices.
Existing S&P Composite 1500 companies with multiple share class capital structures are grandfathered in and are not affected by the above rule changes. The guidance provides that for existing S&P Composite 1500 companies that issue another publicly traded share class to index share class holders, the newly issued class will be “considered for inclusion if the event is mandatory and the market capitalization of the distributed class is not considered to be de minimis.” The newly issued class will also have to meet the traditional requirements for inclusion on the index like liquidity, public float and so forth. Moving forward, this likely presents the possibility that a company could remain in the S&P Composite 1500 but a newly issued class of that company’s stock would not be included in the index, at the S&P’s discretion. The guidance also notes that if an existing S&P Composite 1500 company reorganizes into a multiple share class structure, that company will remain in the S&P Composite 1500 at the discretion of the Index Committee in order to minimize turnover.
FTSE Russell Effective at the September 2017 index reviews, FTSE Russell will require companies to have greater than 5 percent of their voting rights (aggregated across all equity securities, including those that are not listed or trading) in the hands of unrestricted (free-float) shareholders. “Free float” is defined as the percentage of a company’s shares that are considered freely available for public purchase. Determining the free float requires analysis and classification of a company’s shareholders but generally excludes: shares held by directors, senior executives and their affiliates; shares held within employee share plans; shares held by governmental authorities (excluding shares held by independently managed pension schemes for governments); and shares subject to lock-up. Accordingly, in order to be eligible for inclusion on the FTSE Russell indexes, a company with a typical ten-to-one dual class structure, as described above, will need approximately 34 percent of its total outstanding stock to be held by unrestricted shareholders. For more information regarding FTSE Russell’s calculation of free-float, including a list of companies that will be affected by these new rules, see these tables showing an indicative list of those constituents of the Russell 3000 and FTSE All World Developed indexes that fail to meet certain voting rights hurdles.
This new requirement applies to all standard FTSE Russell indexes, including the Russell US indexes, FTSE Global Equity Index Series (GEIS) and non-cap weighted indexes including the FTSE and Russell RAFITM Index Series and factor indexes.
Existing FTSE Russell companies are afforded a five-year grace period (i.e., until September 2022) to allow such companies time to change their capital structure. To the extent that an existing FTSE Russell company does not meet these requirements following the grace period, it will be removed from the index.
The guidance also noted that the rate at which the voting rights hurdle is set will be reviewed in light of subsequent developments on an annual basis and, if following an annual review, FTSE Russell determines that a more restrictive threshold is appropriate, the grace period will be extended by a further year.
For more information regarding the new rules, please see the “FTSE Russel Voting Rights Consultation – Next Steps.”
MSCI MSCI is seeking feedback on proposed rules regarding non-voting shares until August 31, 2017. It is unclear when, or if, these proposed rules would become effective. The proposed rules provide that with respect to new potential MSCI companies, MSCI will not include non-voting shares in the MSCI GIMI and the MSCI US Equity Indexes in cases when company level “voting power” (defined as the voting rights of listed shares over total voting rights of the company) of listed shares is less than 25 percent.
Under the proposed rules, existing MSCI companies would remain eligible if their listed voting power is above two-thirds of 25 percent (i.e., 16.67 percent) and would have a period of one year to meet the requirement before being removed.
Please see “Consultation on the Treatment of Non-Voting Shares in the MSCI Equity Indexes” for more information regarding the proposed rules.
Impact of New Index Rules on Technology Companies with Multi-Class Capital Structures
These new rules will likely have a significant impact on technology companies that are either contemplating whether to implement a multi-class capital structure in connection with their IPO or are currently public and have previously implemented a multi-class capital structure. As the FTSE Russell noted in its rule release: “The inclusion of such an eligibility hurdle might in addition discourage future tech IPOs should companies prefer to stay private rather than lose a degree of control; this would reduce the opportunity set for investors in public markets.” Inclusion in an index often has a positive impact on a company’s stock price and so technology companies will have to weigh the benefits of inclusion in an index against maintaining founder control through a multi-class capital structure.
With respect to the S&P Composite 1500 and its component indices, these changes will not have an immediate impact on newly public technology companies because these indexes require that IPO companies be traded on an eligible exchange for at least 12 months before being considered for addition. Companies must also meet other requirements before being eligible for the S&P Composite 1500 and its component indices such as market capitalization ($6.1 billion for S&P 500; $1.6 billion for S&P MidCap 400; and $450 million for S&P SmallCap 600), liquidity (required to have adequate liquidity and a reasonable price), float (at least 50 percent public float), and financial viability (sum of most recent four consecutive quarters’ GAAP earnings should be positive as well as the most recent quarter). Therefore, technology companies, which often go public before reaching GAAP profitability, may not be eligible for the S&P Composite 1500 and its component indices for years following an IPO regardless of the new rules. However, once a company meets the seasoning and other requirements of these indexes, it will not be eligible for inclusion if it has a multi-class capital structure. Existing S&P Composite 1500 companies that are contemplating either issuing an additional class of stock or reorganizing into a multi-class capital structure should consult with S&P Dow Jones to ensure that any new classes of stock would be eligible for inclusion.
With respect to the FTSE Russell and the MSCI (assuming the MSCI rules are implemented), both new and existing multi-class capital structure companies will have to closely monitor their float to ensure that they meet the eligibility requirements. Newly public companies will be impacted by these new rules almost immediately following their IPOs because the FTSE Russell and MSCI have more relaxed eligibility requirements and companies are often eligible for inclusion shortly following their IPO. Companies contemplating an IPO may consider variations of the traditional dual class structure, such as lowering the voting power of the high vote stock or including sunset provisions in their charters that would unwind the multi-class capital structure if the requisite index hurdles are not satisfied. Companies should work closely with their bankers and lawyers to assess the impact of these rules on their organizational structure and capitalization.