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The price of rights

22 October 2013 By John Foley

New York and Hong Kong differ on shareholder democracy. Alibaba, China’s biggest e-commerce company, has received approval from U.S. stock exchanges to let a partnership of senior executives nominate most of its directors. Hong Kong rebuffed the idea on principle. Investors in a future initial public offering must now decide what that principle is worth.

Shareholder democracy, as an absolute, is overrated. Many companies have thrived despite giving some investors more votes than others. Google, Ford, Hennes & Mauritz and Warren Buffett’s Berkshire Hathaway have all achieved greatness while having different classes of shares with different voting powers, shielding them from unwanted takeovers and corporate raiders. It’s hard to find conclusive evidence that voting power affects company performance either way.

The U.S. system focuses on disclosure. As long as companies provide full information, they can ask investors to make a trade-off. Facebook shareholders have apparently decided that keeping founder Mark Zuckerberg in charge is worth more than an equal right to vote. Google’s shareholders have made a similar call. Twitter has no super-voting shares, but reserves the right to issue them. Sometimes, non-voting shares even carry a premium for being easier to trade.

China’s internet companies already compromise foreign shareholders’ rights. All, including Alibaba, rely on a little-tested legal structure called a “variable interest entity” that conveys the economic benefits of being an investor, but no actual ownership of the underlying business. That’s a necessary workaround for being able to invest in a government-restricted sector. Investors, forewarned, have bought into companies like Tencent and Baidu anyway.

Alibaba’s proposal is subtle. It wants a group of executives who currently control around 13 percent of the shares to nominate the majority of board directors. These candidates would then be put to shareholders for approval. Shares in Alibaba would still bring one vote each, and other shareholders could vote down directors if they choose. The plan doesn’t protect Alibaba from a takeover. But it undercuts the principle that a board should have a free hand in naming new members to best serve all shareholders’ interests.

There are many unknowns. Will partners always propose directors that investors like? Will their nominees get along with the rest of the board? Would the partnership structure have an expiry date? The notion perplexes, which is why Hong Kong’s listing committee wisely decided to stick with its democratic norms rather than make a snap decision.

Future investors have two reasons to accept Alibaba’s model. First, it purports to protect the company from volatility. Vice Chairman Joe Tsai argued on a company blog on Sept. 27 that the board’s proposal would shield the company’s culture from stock market short-termism. Second, since the company doesn’t urgently need cash from an IPO, it can offer investors an ultimatum: like it or lump it.

The problem is that even successful cultures can go astray. Complacency can set in. Without the full checks and balances of outsiders who can force change, creating sustainable value for shareholders can stop being the driving force. Tsai argued that who Alibaba is “cannot, and will not, change.” But that isn’t reassuring. Companies often have to rethink their strategy when the market shifts.

It’s not unthinkable that the wishes of founder Jack Ma, his peers or their successors, might diverge from those of regular investors. The company is already creeping into new lines of business, from software that powers TV set-top boxes to money management, which may not always be driven by shareholder value. Ma himself is a controversial and outspoken figure. That could become a liability if China’s political winds change.

How can investors weigh the risks? One way of thinking about it might be the traditional discount applied to IPO companies – typically around 15 percent – to compensate for the risks of investing in an untested company. Hot tech stocks often ignore such discounts. In Alibaba’s case, it might be sensible insurance.

What’s certain is that the stakes will get higher. Alibaba’s revenue increased 61 percent year-on-year in the second quarter of 2013. As the company expands, so will the value of any rights investors chose to forfeit. IPO investors are likely to give Ma and Tsai what they want, but they should be wary of giving it up cheaply.


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