Alibaba’s Stock Structure: Love It or Hate It?

The listing of Alibaba in New York not only raised many an eyebrow in terms of the amount of capital it amassed at its IPO, but also the question of whether its stock structure is good or bad for shareholders

By Fang Ying, Senior Writer, China Business Knowledge @ CUHK 

Alibaba Group was successfully listed on the New York Stock Exchange this past September and raised a record-breaking US$25 billion, making this the largest initial public offering (IPO) in history.

The Chinese e-commerce giant chose New York for its IPO because of Hong Kong Stock Exchange (HKEx)’s reluctance to allow the listing of a company with such a stock structure that would give its management different voting rights from that of its public shareholders—and the Alibaba stock structure does exactly that. HKEx insisted that all shareholders should receive voting rights proportional to the number of shares they hold.

Alibaba calls its own stock structure “Alibaba partnership,” which was originally designed to allow a group of 27 managers to stay in control. In other words, the group has the right to name the majority of Alibaba’s directors, giving them effective control of the board and of the company’s strategic direction. Essentially, Alibaba’s partnership structure has the same effect as a dual-class stock structure, which gives some shareholders more voting rights than others, allowing the company’s founders to maintain control and power, according to Prof. Wang Cong, an associate professor at the Department of Finance of the CUHK Business School, who specializes in corporate finance.

Jack Ma, founder and Executive Chairman of Alibaba, has said that his company’s “partnership structure” aims to preserve the firm’s culture shaped by the founders and can help the company avoid short-term behavior at the expense of long-term growth.

For those founder-led technology companies, such as Alibaba, the founders have tremendous influence on company operations, according to Prof. Zhang Tianyu, an associate professor at the School of Accountancy of CUHK Business School, who specializes in corporate governance. He points out that these firms are usually led by leaders with a vision, who know very well the development trends of the entire industry and are able to bring their companies to the next level.

Prof. Zhang believes this is one of the most important reasons why Alibaba insists on its partnership structure. “Obviously, Jack Ma is important to Alibaba while Alibaba also needs a leader who is capable of creating cohesion within the company in the current stage of development,” he comments. “Such a stock structure can ensure Jack Ma has the possibility to assert a major influence on how the company is run. At the same time, for Ma, he needs to make sure he still has the power to make decisions for the entire company. ”

The Pros of Dual-Class Structure

Unlike the Hong Kong Stock Exchange, the New York Stock Exchange allows companies to list dual-class voting shares. Many companies, including some Silicon Valley companies like Google, Facebook and LinkedIn, have also favored the dual-class stock structure, a structure similar to Alibaba’s partnership structure.

“The benefit of allowing founders to have absolute control of their company is that they can focus on the long-term strategic development of their company without worrying about the pressure on short-term earnings from investors, especially as investors have become ever more focused on short-term gains,” Prof. Wang points out.

He explains that the success of these high-tech firms like Google often depends on whether they can continuously launch innovative new products and services. Therefore, they usually have to take huge risks in their R&D expenditures. This is something that short-term shareholders may not like, since it is highly uncertain whether these R&D expenditures can eventually become successfully innovations. As such, compared with traditional industry firms, a technology company has greater incentives to adopt a stock structure that gives the founders outsized control of the company and allows them to focus on long-term value creation.

Double-Edged Sword

Despite its benefits, the dual-class stock structure can easily lead to agency problems by founders or managers, according to Prof. Wang, who has conducted a research1 on agency problems in dual-class companies. Agency problems refer to the conflicts of interests between a company’s management and its stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth. However, in reality, the manager often acts in a way to maximize his or her own wealth.

In the research, Prof. Wang and his collaborators Ronald Masulis from the University of New South Wales (Australia) and Xie Fei from Clemson University (USA) have documented several pieces of evidence on the downsides of dual-class companies. They found that compared with managers at companies with the single-class stock structure, those at dual-class companies are more likely to pursue private benefits at the expense of outside shareholders. For example, CEOs generally receive higher compensations; managers make shareholder value-destroying acquisitions more often; and capital expenditure contributes less to shareholder value.

According to Prof. Wang, the dual-class stock structure enables company founders to hold a large chunk of voting rights while having a disproportionally smaller equity stake. This often creates a significant divergence between founders’ voting rights and cash flow rights. Such divergence exacerbates the agency conflicts between managers and shareholders, because if founders do something at the expense of outside shareholders’ interests, they would not be subject to disciplinary control from these shareholders. On the other hand, they bear a small portion of the financial consequences of their decisions as they only hold a small equity stake in their companies.

So, how do such companies avoid becoming a liability in the eye of investors? According to Prof. Wang, it is imperative for them to have other corporate governance mechanisms that can constrain the shortcomings of the dual-class stock structure. For example, media coverage, monitoring by analysts and participation in corporate governance by active large outside investors are important channels to make sure that the managers in these companies do not pursue private interests at the expense of outside shareholders.

“In companies without enough monitoring mechanisms, the future prospect would only be bright if the founders or managers are making the right decisions and doing the right things. However, one should not merely rely on managers’ moral standards to run a company. There should be a mechanism to restrain their power,” says Prof. Zhang, concurring with Prof. Wang’s views.

References
Masulis, W. Ronald, Wang, Cong and Xie, Fei, “Agency Problems at Dual-Class Companies”, Journal of Finance, 2009.