Dual class share structures: how do they work and what are the pros and cons?
Dual class share structures allow a shareholder, for example the founder, to retain voting control over a company. They are not currently permitted in the case of companies admitted to the premium segment of the Official List of the Financial Conduct Authority but are permissible within the standard segment. Lord Hill, in his UK Listing Review report dated 3 March 2021, has recommended that the listing rules applicable to the premium segment be amended to permit dual class share structures. This is one recommendation of a wide-ranging package of 15 recommendations made by Lord Hill with the objective of improving the attractiveness and competitiveness of London’s equity capital markets.
How do they work?
The most high profile IPO of a company with a dual class structure in the UK is Deliveroo Plc. Deliveroo Plc had two classes of ordinary shares on admission of its shares to the standard segment of the Official List and to trading on the London Stock Exchange’s (LSE) main market (Admission): class A ordinary shares and class B ordinary shares.
In high-level terms, there are two key rights attaching to a company’s shares: their voting rights and their economic rights. Unusually, the rights attaching to the different classes of Deliveroo shares are not set out in the articles of association of the company filed at Companies House. However, based on a review of the IPO prospectus and a return of allotment of shares filed at Companies House, it can be ascertained that:
- Voting rights: on a poll (i.e. a vote at a general meeting of shareholders), holders of the class A ordinary shares have one vote for every class A ordinary shares held and, for so long as the founder, Will Shu, or one of his “permitted transferees” holds class B ordinary shares, the founder, or such permitted transferees, shall have twenty votes for every class B ordinary share held. This gives Mr Shu weighted voting rights, and the net effect is that as at Admission Mr Shu controlled approximately 57% of the voting rights of the company; and
- Economic rights: the class A ordinary shares and the class B ordinary shares rank pari passu with respect to the payment of dividends, on any return of surplus assets on a winding up, and “in all other respects except as set out otherwise in the Articles”. Given that the articles of association do not distinguish between the class A ordinary shares or the class B ordinary shares, this author was unable to identify any exception in the articles as currently adopted- the economic rights therefore appear to be the same.
Interestingly, the class B ordinary shares will automatically convert into class A ordinary shares on a one-for-one basis on the third anniversary of Admission, or if the founder ceases to be a director or employee of the company as a result of voluntary resignation (other than for good reason) or termination for cause. As such, the dual class structure is time limited and is linked to the founder continuing to be a director of the company.
So, in the case of Deliveroo, the dual class structure establishes a weighted voting rights structure designed to empower, and ensure that majority control resides with, the founder (or his permitted transferees) for so long as he holds the shares and is a director. But in terms of economics, the two share classes rank equally. Similarly, both classes are non-redeemable with no conversion rights.
But the Deliveroo model is not the only dual class share structure being used in the UK with standard listings. An alternative structure has been used in the case of THG Holdings Plc, the digital-first consumer brands group, which was admitted to the standard segment of the Official List in the autumn of 2020. In this case, at the time of Admission, the founder, Matthew Moulding, was issued with a “special share” (which is generally a non-voting share with no economic rights). However, pursuant to provisions contained in the articles of association, the holder of the special share will, immediately on a change of control of THG, automatically carry such number of votes on any shareholder resolution as shall be necessary to ensure the effective passing or defeat of that resolution. The stated purpose of the special share is therefore to permit the holder to deter an unwelcome acquisition of THG that would not, in the founder’s opinion, deliver sufficient value when compared with what he considers could be generated by THG in the three years following Admission. (This is almost akin to the sort of “golden share”, as used in privatisations back in the 1980s/1990s.)
As with the Deliveroo structure, the rights attributable to the special share will cease three years after admission. However, and in distinction to Deliveroo, there is no link to the founder continuing to be a director of the company, and indeed there is no particular right enabling the founder to remain a director in the absence of a change of control occurring.
What are the pros?
The idea behind dual class share structures, which are now relatively common place in the US (think Snapchat, Facebook and Linkedin), and facilitating their use and occurrence with UK IPOs, is to make the UK public markets a more attractive fundraising route for founder-led high-growth companies, including those in the hugely important Technology and Life Sciences sectors. The market reality is that the greater flexibility and lesser restrictions in other international financial centres, coupled with the rise of private equity over the past 20 years, mean that (i) the number of listed companies in the UK has fallen by about 40% from a peak in 2008 and (ii) between 2015 and 2020, London accounted for only 5% of IPOs globally.
As Lord Hill explains, two key risks for a founder bringing his/her company to market is their vision being derailed by being removed as a director/CEO and an opportunistic takeover bid at a conventional bid premium to the market price. With this in mind, Lord Hill recommends revisions to the rules relating to the premium segment to enable a “transition period” of up to a maximum of 5 years during which period a limited number of dual class restrictions should be permitted to alleviate these risks and encourage listings of founder-led companies. At the end of this period, such companies would either need to “sunset” the restrictions or move segment at which point they could even expand the scope of their share structure, subject to shareholder approval.
What are the cons?
At the heart of this issue is investor protection and sentiment. The dual class structure is to displace the “one share, one vote” principle which is a fundamental investor protection. It is to entrench a founder and in part disenfranchise and prevent investors from having a say and holding management to account. As Legal & General Investment Management put it when explaining its decision not to participate in the Deliveroo IPO: “We believe in the active ownership of the companies in which we invest, and think change from within can be the most impactful way to influence positive change in a company, for employees and shareholders alike.” This statement touches on the wider push in the UK since the financial crisis to balance the obligations placed on companies under the UK Corporate Governance Code with obligations on investors to comply with the Stewardship Code to create a two way street when it comes to shareholder engagement and effective corporate governance. If investors have no effective vote, will they still be listened to or will engagement be compromised?
Also of concern is founder entrenchment itself. This is relatively common in private equity transactions but it does create issues. What if the strategy is not working? What if there is drift and underperformance? What if a strategic premium is offered for the company and the founder still rejects it? In these circumstance, conflict and discord can quickly arise, but investors’ hands will be tied, and they will be unable to force management change or bring their influence to bear; in short, the main con is the risk that investor comments and concerns fall on deaf ears. It is effectively the other side of the coin to the “long term vision” founder empowerment proposition.
It is because of these concerns that in the case of the premium segment Lord Hill recommends a number of safeguards including a maximum 5 year duration for the dual class restrictions; a maximum weighted voting ratio of 20:1 to ensure that founders must have a minimum economic interest in the company; limitations on transfer such that the ordinary B class will automatically convert to ordinary A class shares on transfer except where the transfer is for estate planning or charitable purposes; limiting B class holdings to founders who are also directors of the company; and limiting the “reserved matters” to just two fundamental items, namely enabling the founder to ensure they remain as a director and being able to block an unwanted takeover.
When you speak to founders and high-growth Technology and Life Sciences companies private equity is often seen as the most attractive “exit” option, with the perception that the US capital markets are “bigger and better” for IPO, despite the increased litigation risk that comes with US exposure. A lot has been done in recent years by the LSE and others to promote the UK public markets and put the IPO route back on the founders’ agenda, but it is clear from the statistics that more needs to be done and that there is now appetite for urgent and wide-ranging reform to “reimagine” the UK capital markets’ regulatory environment. It is an opportunity which the UK can ill afford to miss. As Lord Hill says in his report, his recommendations are not about opening a gap between us and other global centres by proposing radical new departures to try and seize a competitive advantage. No, it is about “closing a gap which has opened up” and now is the time to act.
For more information, please contact Mark Howard or your usual Charles Russell Speechlys contact.
 As per Lord Hill’s UK Listing Review report dated 3 March 2021, page 1.