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5i Research Blog

May 02, 2017 When Dual Class Shares Donít Work

By Ryan

When dual class shares don't work

Months back when there seemed to be a sizable backlog of IPOs coming online in Canada, the issue of dual class shares started to come to the forefront. We took a high level look at the performance of dual-class shares compared to the broad market and found some interesting results.

But what is a dual class share? Simply, it is a share structure where one class of holder has more rights than another. It could be in the form of one class having partial votes or one class having 'super voting' rights. So while a subordinate share may get one vote per share, the other class of shares may get 10 votes. Typically, these structures render the subordinate votes as moot and these shareholders get little say in how the company is run.

Almost a year later and we are seeing some this issue start to come up again, first with Freshii and next with the Canada Goose IPO. We think these two companies offer an interesting dichotomy and a good case study for where a dual class share structure may be more acceptable than when it is not.

Founder-led company

It is hard to imagine a scenario where a founder who has built a business from the ground up and brought it public while remaining at the helm has anything aside from the best interests in the firm in mind.

On one hand, they are likely quite wealthy at this stage, so money becomes less of a motivator while building a lasting ‘empire’ becomes more of the concern. Additionally, you are likely hard pressed to find a single individual that knows the company and industry better, given that they have been there from day one, slogging through, and then been there at day ‘t+1’ when it is a much more mature version of itself.

In the case of Freshii, we have a founder who built the company from a single franchise to what it is today. In the case of Canada Goose, we have a private equity firm (Bain Capital) who is the majority shareholder. While Bain Capital has a group of very motivated and intelligent operators, it is hard to see why their group deserves a super-voting right over the likes of other managers who could just as easilly own shares in GOOS, such as the CPP, OMERs. 

Large competitors

While this can come down to a free market argument, it is a bigger issue in Canada where on average the companies are smaller than competitors to the South. If a company is just getting started on the public markets, it can be understandable to allow a company to protect itself from larger competitors that would not think twice about gobbling up smaller incumbents.

This is a great way to stifle innovation. If there is a new threat entering the market, Google can just buy it and shut it down. Maybe they continue to operate the firm, but it is hard to imagine that the company operates with the same drive or innovation as when it did not have a de-facto sugar daddy supporting it.  A super voting structure can allow a company an opportunity to become the next Facebook, Shopify, or Exxon.

A sub-point to this is that it helps protect investors from themselves. Everyone loves a takeover. It locks in gains often at a premium and it is a short-term win, something that humans love psychologically (opposed to a 10 year slow-burn but high return).

The problem with it though, is that these can get pushed through at smaller companies and it is hard to argue against it. Two companies we cover were recently taken over. Both TIO Networks (TNC) and RDM Corp (RC) were purchased by US companies at what are likely premiums on the lower end of the average.

While it is hard to not be happy about this, in the case of TIO, you have a company that seemed to just be getting started on its journey. The future is always uncertain, but the returns this company could have generated for investors had potential to be substantially larger than the short-term premium offered.

However, a bird in the hand is often viewed as better than two in the bush and when your suitor is PayPal, there are not likely to be many companies willing to get into a bidding war for the company, leaving investors happy but with not a whole lot of choice in the matter. While this specific outcome would not have been different under a dual-class structure, it could help companies that do not want to sell out to a larger competitor.

In the case of RDM Corp, a 13.5% premium is probably ‘fair’, but with a dividend that was growing handsomely on an annual basis and a decent valuation, that ~13% one-year return may have started to look less enticing over a three or five year period (RDM returned 417% over five years!).

The point here is that investors of all shapes and sizes overweight the importance of short-term returns over long-term ones and it is hard for a company to argue when an ok premium comes along even if the longer-term prospects could be multiples of the premium. This does not even get into the issue that an investor needs to now find another great company to invest that money in! 

Taking this back to Freshii and Canada Goose, Freshii could be easily swallowed by Restaurant Brands International or Chipotle to name just two. In the case of Canada Goose, it is a bit tougher to imagine a company that would be itching to take them over in order to eliminate a threat or a scenario where the style of the clothing could not be imitated at a lower cost.

Operates in a cutting edge or innovative business where long-term vision is key 

The best example of this is Facebook and how many times it could have been bought. Essentially the more cutting edge or innovative a company is, the more likely large firms will try to buy the upstart out.

Ironically, in most cases if any of the potential companies had purchased a company like Facebook, it could very well never have evolved into what it is today. Simply put, sometimes the vision of an innovative company needs to be believed in and there will be many distractions along the company’s journey as it charts its own path and a path that most probably cannot see clearly.

If the management team always needs to be worried about others wrestling power and direction away from them, they will never be able to invest and take risks today for the longer-term big picture.

Reverting back to Freshii and Canada Goose, while calling Freshii innovative may be a bit of a stretch depending on how one looks at it, it remains a unique offering with creative menu items that no other restaurants seem to be doing on a larger scale. Being able to move fast and remain flexible could remain a key factor in keeping Freshii competitive.

While we don’t mean to knock on the business of Canada Goose, it is a bit more difficult to view clothing as a particularly innovative industry or company whose vision needs to be protected so it can grow and evolve.

So while an investment case can be made for dual class share structures, there are probably scenarios where the structure makes more sense than others. In the end, capital markets will likely do what they always tend to do and find an equilibrium where the companies that justify such a share structure are rewarded and those that do not, see poor share performance or a discounted valuation.

No one has to buy the dual class company that has little business having dual class shares, and if Canadian IPOs aren’t careful, that might just be what happens.

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Post a New Comment 1 comment
May 2, 2017
By Elliott
Great article Ryan

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