Google and its co-founders, Sergey Brin and Larry Page, settled a shareholder lawsuit earlier this summer that most likely clears the way for Google to issue new nonvoting Class C shares. The settlement perpetuates the co-founders’ control, which is good for them, but it may not do much for Google’s shareholders, the majority of whom voted to oppose the maneuver.
When Google went public in 2004, it had a dual-class structure. Mr. Brin and Mr. Page were issued Class B shares with 10 votes apiece, while public shareholders received Class A shares with only one vote. The idea was to ensure that the co-founders kept control of Google even if they did not own a majority of the company.
But over time, Google has issued more Class A stock, and the two co-founders have sold Class B shares, bringing them closer to the threshold of losing control of Google.
So Mr. Brin and Mr. Page and their advisers approached Google’s board and proposed that Google issue new nonvoting Class C shares that would allow them to keep their grip on the company. These shares would then be issued for acquisitions, employee stock incentive plans and other stock sales.
Google’s board eventually voted to go along. But Google’s shareholders disagreed, protesting the move.
Only about 12.7 percent of Google’s Class A stockholders â€" other than Mr. Brin, Mr. Page and other Google directors and employees â€" voted in support of issuing the Class C stock. That’s a pretty poor showing by any measure. With little regard for the shareholders’ opinion, Google continued with the plan.
The only barrier to the plan thus became a shareholder class-action lawsuit filed in Delaware Chancery Court asserting that Google’s directors had breached their fiduciary duties in deciding to issue the Class C shares. The lawsuit argued that the directors were conflicted in deciding to issue this Class C stock because, among other reasons, their jobs depended on the continued good will of Mr. Brin and Mr. Page.
The plaintiffs may have a point, but more important, there is a principle in Delaware that control of a company is something of value that presumably should be paid for. Yet the Class C plan allows Mr. Brin and Mr. Page to maintain control for a longer period of time than they otherwise would have â€" and they were paying nothing for it.
The case had traction, but on the eve of trial, Google and the lawyers representing the plaintiffs settled.
It’s an odd settlement. Not only does it not really address the big issue involving the Class C shares â€" that they perpetuate the co-founders’ control â€" it also stretches the laws of corporate finance. The heart of the settlement is a mechanism intended to compensate Google shareholders for any difference in the value of the Class C shares and their Class A shares. The idea, no doubt, is that nonvoting shares typically trade at a discount to voting shares and so Google will pay the difference.
Let me explain. The heart of settlement is a mechanism intended to compensate Google shareholders for any difference in the value of the Class C shares and their Class A shares.
The settlement requires Google to pay the following amounts if, one year from the issuance of the Class C shares, the value diverges according to the following formula:
- If the C share price is equal to or more than 1 percent, but less than 2 percent, below the A share price, 20 percent of the difference;
- If the C share price is equal to or more than 2 percent, but less than 3 percent, below the A share price, 40 percent of the difference;
- If the C share price is equal to or more than 3 percent, but less than 4 percent, below the A share price, 60 percent of the difference;
- If the C share price is equal to or more than 4 percent, but less than 5 percent, below the A share price, 80 percent of the difference.â€
- If the C share price is equal to or more than 5 percent below the A share price, 100 percent of the difference, up to 5 percent.
If you just skimmed through this, the idea is to pay some percentage of the difference in the price of the Class C shares and Class A shares after one year, with the amount capped at a difference of 5 percent.
There are multiple problems with this formula. Matt Levine at Dealbreaker highlighted one, noting that it is possible â€" though probably not practical â€" to use volume-weighted average trading prices to set up an arbitrage opportunity as the volume of the Class A and C shares differs.
But there’s also the issue that the formula is a finance puzzle. The best way to understand this puzzle is to use an example given to me by a finance professor.
If the Class A shares trade around $450 (after the split/C issuance) and the C shares trade at a 4.5 percent discount during the year (or $429.75 per share), then investors expect a payment of: 80 percent times $450 times 4.5 percent = $16.20. The value of C shares would then be $445.95 ($429.75 plus $16.20). But if this is the new trading value during the year, that’s only a discount of less than 1 percent to the A shares. So no payment would be made. But if no payment is made, we are back to the full discount and this continues ad infinitum.
In other words, the Class C formula appears designed not to pay out. I spoke with Jeffrey C. Block of Block & Leviton LLP, co-counsel for the plaintiffs, who confirmed this intention. Acknowledging that the plaintiffs were also wondering where the stock would trade, he said that the idea was to keep the Class C and Class A shares trading at the same value for the year so that investors could have time to decide which to sell of keep the shares.
But the Class C payout is a one-time-only affair after a year. Nonvoting stock tends to trade at a discount of 4 to 10 percent below voting stock. So after day 365, it should simply drop to that discount. But the market will price this in and push the Class C lower as the one-year mark approaches. That probably means some payment but one that is much lower than this formula would seemingly provide.
Of course, this assumes the discount ranges apply. It may be, as Mr. Levine noted, that because Google’s voting shares already don’t count since the co-founders control the votes, the nonvoting shares may not trade at the typical discount.
In any event, if there is a finance professor who would like to have a class look at this problem and forecast the trading, I’d be happy to post the results.
But the settlement does not make clear what, if any, value it gives to Google shareholders.
Nor does it address the issue that Mr. Brin and Mr. Page are getting firmer control of the company and not fully paying for it, if they end up paying anything. And let’s face it, control of Google is worth lots.
The rest of the settlement is similarly weak and favorable to Google, requiring the board to “consider†things but not actually do anything. The settlement, for example, requires that the Google board consider the best interests of the shareholders before issuing more than 10 million Class C shares. That’s fine but they’re already required to do this, and this provision only lasts for three years. Perhaps the strongest provision of the settlement is one that makes it harder for Mr. Brin and Mr. Page to sell Class C shares without selling a corresponding number of Class B shares, thereby ensuring that if they sold down their shares, they would at least reduce their voting control.
The question now is whether the Delaware court approves this settlement at a hearing scheduled for Oct. 28.
It is extremely rare for a Delaware court to reject a proposed settlement. But still, the court must find the settlement fair to Google’s shareholders. The judge could force the parties to explain what this formula is intended to do and what it is forecast to pay. There is also the possibility of objectors. Such objections are also rare, but given the prominence of this case, it may be more likely than normal.
When it reached the settlement, Google asserted that it “always believed our founder-led approach gives us the freedom to make long-term bets, like Android, Chrome and YouTube, that benefit consumers and shareholders alike.â€
Ultimately, dual-class stock is often justified because all shareholders buy into it at the initial public offering. But that is not what is going on here. It may indeed be that this Class C proposal is a good thing. But it goes against the fundamentals of dual-class stock.
In the end, the real issue is not whether Google’s co-founders can do this. One would hope they wouldn’t without shareholder approval, but that is clearly an afterthought. Rather, the question is whether they can do this without having to paying for the privilege. That’s the real issue in this settlement, and it’s now in the judge’s hands.
