In recent days, we have learned about an odd financial arrangement at WeWork. As you may know, the office-sharing company doesn’t own much of its real estate; it leases office space and then subleases the use of that office space to its co-working tenants. That’s not the news. The news is that, in some cases, an owner of the space WeWork has leased is WeWork’s founder and CEO, Adam Neumann.
Mr. Neumann has made millions of dollars by leasing multiple properties in which he has an ownership stake back to WeWork, one of the country’s most valuable startups. Multiple investors of the privately held company said the arrangement concerned them as a potential conflict of interest in which the CEO could benefit on rents or other terms with the company.
Now, WeWork clarified to the Wall Street Journal that the conflict of interest is mitigated, because any lease where Neumann owns a piece of a WeWork landlord has to be approved by WeWork’s board. In at least one case, the board rejected a proposed deal where Neumann wanted to take a personal ownership stake in a building WeWork was renting. But that process has looked a little different in recent years, because:
Mr. Neumann effectively gained control over the company. As part of an investment round for WeWork in 2014, he was granted Class B shares that gave him 10 votes per share, and now he has more than 65% of the overall share vote, according to WeWork corporate filings.
WeWork is far from alone in having a multi-class share structure: One in five companies that went public in the United States in 2017 had share structures where some investors are more equal than others. Under such an arrangement, all common shares in a corporation typically have the same claim on the company’s profits (the super-voting shareholders can’t vote themselves higher dividends than the other shareholders) but because some shares get extra votes, managerial control is concentrated in a minority of the company’s equity owners, typically founders or executives or their heirs.
In this instance, Neumann owns less than 50 percent of the company he runs, but because he owns super-voting shares, he controls the company as though he were its majority owner. Among other things, this gives him the power to force approval of deals where he sits on both sides of the table, even if other investors might have qualms about those deals.
An obvious question is: Why did the other investors in WeWork agree to an arrangement where their votes don’t count? Why do investors in any company agree to it? A group of business school professors took a crack at the question last month in the Harvard Business Review, and they have a few answers.
Multi-class share structures have historically been especially popular for media companies, and the HBR authors attribute this to a desire to protect journalistic prerogatives. A founder with a particular journalistic focus might use his voting control to ensure the company refuses deals that would put profits ahead of journalistic integrity, or even to continue operating money-losing aspects of a news organization in the interest of public service. In this case, the dual-class structure reduces profits available to shareholders, but that’s a feature of the design, not a bug: When taking the company public, management chose the dual-class structure explicitly to enable a strategy that will lead to lower profits and a lower share price in order to serve a social mission.
This does not describe why a start-up company like WeWork, whose mission presumably does focus on maximizing profits, would benefit from a dual-class share structure.
The HBR authors also note that dual-class structures may free up managers of high-growth companies to focus on long-term value creation instead of reacting to investors’ desire to see profits generated quickly. This is an example of the long-running debate over “short-termism” and whether companies are systematically failing to invest for the long run. They cite some evidence that dual-class share structures are associated with better performance in the early stages of a company’s life.
Under this theory, the low-power shares exist to protect outside investors from each other, or even from themselves. When you agree to accept a share with few voting rights, you’re also buying into a company where other outside investors have given up their rights. And if you trust management more than you trust your fellow investors, that might be appealing.
On the other hand, WeWork isn’t a public company. WeWork’s outside owners are sophisticated venture capital funds whose specialty is supposed to be investing for long-term value. If these funds’ managers can’t be trusted to be patient and wait for long term value, what are they doing running venture capital funds?
Critics of multi-class structures describe them as being simply what they appear to be: A structure that allows management and other insiders to prioritize their interests over those of other shareholders. For this reason, S&P has started prohibiting new dual-class shares from being listed on S&P indices.
There are also compromise positions. A coalition of corporate and financial management executives including Warren Buffett and JP Morgan CEO Jamie Dimon issued a statement of governance principles in 2018 that says “dual class voting is not a best practice.” They allow that sometimes the structures are used in order to insulate management from short-term profit pressure, but they say in such cases the two-tier structure should be designed to automatically sunset after a specific time or event. That is, if enhanced management control is appropriate during a company’s growth stage, it should end automatically when that stage is over.
But the rise in popularity of dual-class shares may simply reflect a reality in capital markets over the last decade: There’s a lot of capital around that people want to invest, and few opportunities to invest it for high returns. When a founder has a company that investors are excited about, he or she gets to set terms about how investors will get into the deal. It’s a seller’s market.
So the mystery of why WeWork’s investors agreed to hand so much power to the CEO is essentially the same as the mystery of how WeWork could possibly be worth $45 billion. (Chris Lane, an analyst at Bernstein who covers major WeWork investor Softbank, recently took a crack at valuing WeWork under optimistic parameters and couldn’t establish a value higher than $16 billion.)
Investors are desperate to get in on the next big thing, and they’re willing to overpay. Why wouldn’t they also be willing to hand too much power to the CEO?