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Founders Intend to Retain Control in New Tech IPOs

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- By John Kinsellagh

Lyft, the principal competitor to ride-hailing company Uber, plans to go public this year. John Zimmer and Logan Green, the company's founders, intend to create prior to the offering a class of share that will give them close to total control, despite together holding less than a 10% financial stake in the company. Lyft joins a slew of tech companies, such as Alphabet (GOOGL), Facebook (FB) and Snap (SNAP), in which the founders own a controlling and disproportionate interest in the company through the issuance of super voting shares.

The pitfalls of such corporate governance arrangements are numerous and could be perilous for shareholders. Some defensive investors, or those who have been in the market for decades, must be aghast at such unorthodox and unprecedented corporate governance covenants that effectively reduce the board of directors to a mere showcase role. How are founders able to issue new shares to the public with such onerous provisions?

The ability of founders to issue themselves supra voting shares is due to the dearth of new tech initial public offerings over the past two years. Investors hunger for new cutting-edge tech companies that they hope will evolve into the next Facebook or Google and, at some point, shower them with riches for their tremendous foresight in purchasing shares on the offering. The difficulty in restraining such skewed voting control provisions is that founders of the new tech companies slated to go public in 2019 know there currently exists a pool of investors afflicted with high-tech fever and greed that has caused many to take leave of their senses.

Lyft's unusual arrangement and Facebook's original corporate structure go against the grain of long-held principles of corporate law and conventional business practices of separating ownership from management for public companies. While it may be the general rule in closely-held corporations that a founder or employee owns a controlling interest, there are few S&P 500 companies where original shareholders in a startup company exert disproportionate control by holding supra voting shares. Indeed, there are S&P 500 tech companies where founders relinquished their control either voluntarily or as a condition for taking the company public.

Even if one could make a plausible argument that founders play an indispensable role in managing the corporation and ensuring its success after an IPO due to their unique knowledge and experience, there are other ways of ensuring they remain at the corporation after the company becomes public without ceding control of the corporation in perpetuity. Employment agreements with the company after it goes public accomplish this goal.

The great risk of ceding control to the original founders of a startup company is that in the event they are no longer are capable of acting in the best interests of the company, shareholders are circumscribed. One remedy potentially available would be if the risks of such a supra voting arrangement were not adequately disclosed to IPO purchasers, recourse might be available under sections 11 and 12(2) of the 1933 Act or Securities and Exhange Commission rule 10(b)5 for fraud in connection with the purchase or sale of a security.

Such an action could be filed up to the statute of limitations period. Underwriters could be subject to liability as well as the company. A shareholders' derivative suit may be available, but its viability may depend on the state in which the company was incorporated.

Facebook presents a classic example of the dangers of owning shares of a company where a founder, at the helm, is steering the ship straight into the rocks.

Over the past two years, Mark Zuckerberg has demonstrated colossally poor judgment and business acumen. Far too many shareholders and security analysts alike are oblivious to the danger of resting control in the hands of a 34-year-old who has placed the company deliberately in a confrontational posture with regulators and legislators. Investors and analysts have treated these instances of bad faith with sublime indifference, as they continue to assert and take comfort in the fact Facebook is the largest tech advertising platform in the world.

Before they continue to express their blithe indifference to Zuckerberg's holding all of Facebook's voting Class A shares, analysts would do well to remember his pugnacious response last July when a damning New York Times expose revealed the company had deliberately misled the public, regulators and shareholders. Despite the company's pious public pronouncements about its concern and unwavering dedication to safeguarding users' privacy and limiting the unauthorized sale of private data to third parties, as detailed by The Times report, Chief Operating Officer Sheryl Sandberg and Zuckerberg did nothing and had no intention of doing anything to effect meaningful change.

In the wake of the bombshell article, rather than express remorse or accept responsibility, an unrepentant Zuckerberg decided to go on the attack. Indeed, during the question-and-answer session with employees, he called the Times story, "Bulls---."

Despite calls from prominent management professionals, regulators and shareholder activists that Zuckerberg step down as CEO and that Sandberg be fired, Zuckerberg, in an act of defiance, made it clear they weren't going anywhere. The incident clearly demonstrated the impotence of Facebook's board of directors to restrain the imprudent actions of the company's CEO. Facebook's directors, however esteemed, are merely captive to the whims of the company's young founder.

These same risks for owning Facebook would apply to those purchasing newly issued shares of Lyft, Uber and other companies slated for IPOs in 2019.

Will the attitude of investors as well as captive analysts concerning Zuckerberg's absolute control of a $500 billion company remain one of insouciance when his pugnacity leads to cumbersome, unwieldy and imminent regulations in 2019?

Investors who believe Zuckerberg's voting control is immaterial for the future prospects of the company are so enthralled with Facebook's past rate of growth that, in the words of Graham & Dodd, "their private enthusiasm is running away with their judgment."

Disclosure: I have no positions in any of the securities referenced in this article.

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This article first appeared on GuruFocus.