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Nepotism and corporate goverance

But it’s not just movie stars and musicians who are born with a leg up. In fact, it happens all the time in most industries. But when nepotism occurs in the stock market, it’s wealth that’s being bogarted.

Experts have been expressing concerns about the risk of the “nepo baby” in corporate governance long before the term took hold of the internet. Even if you don’t hold shares, you may want to consider how inherited control could impact the brands you love and rely on — here’s what you need to know.

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Keeping it in the family

Several hundred companies in the U.S. employ dual-class stock ownership structures, which allows them to pass down super-voting shares through the family.

Most public companies have a single-class stock structure, meaning one stock equals one vote.

In contrast, a dual-class stock structure allows for two or more classes of shares, one which can hold comparatively more voting rights than the others. This empowers corporate executives to benefit from public investment in their company while maintaining perpetual control and limiting the investor’s power.

Former SEC commissioner Robert J. Jackson Jr. warned in 2018 that these forever shares “don’t just ask investors to trust a visionary founder. It asks them to trust that founder’s kids. And their kids’ kids. And their grandkid’s kids.”

Since there’s only so much wealth to reap out there, investors continue to trade this eternal trust for a share of fast-growing stocks.

Alphabet subsidiary Google is the most famous example of a company with a dual-class structure. Class B shares reserved for Google insiders carry 10 votes, while ordinary Class A shares (GOOGL) sold to the public get just one vote, and Class C shares (GOOG) have no voting rights.

As of 2021, founders Larry Page and Sergey Brin controlled approximately 51.4% of the company’s voting power via “super-voting” shares, according to Capital.

The risk of disproportionate voting rights

Family businesses have long played an important role in the American Dream — so what’s wrong with continuing that tradition?

The trouble, as Jackson pointed out back in 2018, is that asking investors to put eternal trust in corporate royalty is antithetical to the values of Americans.

“It raises the prospect that control over our public companies, and ultimately of Main Street’s retirement savings, will be forever held by a small, elite group of corporate insiders — who will pass that power down to their heirs,” he said.

However, there are some structures that can mitigate that perpetual control, like sunset provisions stipulating a re-evaluation of the structure after a fixed period of time.

In such a case, the public shareholders of the firm would vote on whether or not to extend the dual class structure, and if they declined it, all shares would be converted into a single class of shares with one vote per share.

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Is dual-class best for performance?

There are upsides to a dual-share structure. Majority ownership allows entrepreneurs to prioritize their long-term goals and unique vision, without having to worry about pressure from investors concerned with the company’s short-term gains. Especially in the early days of a company, a dual-class structure can allow visionary leaders to steer the growth of the business.

And even generations on, family CEOs may act as stewards of their firm to maintain long-term focus on those original goals.

But that advantage starts to erode over time. In fact, a study of dual-class firm valuation from the European Corporate Governance Institute in 2022 found that these companies tend to underperform over time — usually about seven years after the initial public offering (IPO).

Similarly, a 2017 paper found that as time passed from the IPO, the initial efficiencies of the dual-class structure decreased, while controllers developed perverse incentives to retain their power — which found them sometimes working against the company’s economic interest.

And then there’s the matter of merit. What happens when the lock on control is passed to a nepo baby who’s not a fitting leader? Someone who’s not as able, talented, skilled or driven as their predecessor?

A Harvard Law Discussion paper dubbed this the problem of the idiot heir. Citing evidence from another study, researchers have pointed out that competitive contests for top executive roles would rarely result in a family chief executive officer. That’s because they’d be overshadowed by their non-blood-related competition.

What it might mean for you

While a company falling apart at the hands of an idiot heir might seem very much like a “them” problem, investors and consumers alike often get burned in the process too. Just look at WeWork, the famous coworking real estate company. When it filed (unsuccessfully) for IPO in 2019, it was revealed that co-founder Adam Neumann held 20 times the voting power of other shareholders.

Should Neumann be unable to continue his leadership, a committee headed by his wife would select the new CEO. According to Business Insider, he expected to pass control to future generations of Neumanns.

Though the property company flourished in its early years, public disclosure showed it was underperforming. WeWork had been thought to be valued at $47 billion before SEC filings, but in actuality was worth less than $10 billion. And it had lost $1.9 billion the previous year.

To salvage the company, WeWork’s largest investor SoftBank took control and insisted that Neumann step down. According to CNBC, it took an offering of about $1.7 billion in stock, cash and credit to get him to walk away from the company and give up his voting rights.

While WeWork is an extreme example, the once-promising company that was set to dominate the hybrid work industry has watched its value tumble nearly 80% in the last year, demonstrating the cost of perpetual control in the hands of leaders more focused on their own interests than the company’s as a whole.

So as a prospective investor, how do you know if an exciting dual-share company is just one generation away from flushing it all down the toilet? That’s the rub. As with all investing decisions, it comes down to what you’re willing to risk. And sometimes big risks can carry big rewards — just ask Google’s early investors.

But if a successful name is compelling you to invest in a company with disproportionate voting rights that could live on for generations, consider your long-term stake. Blood may be thicker than water, but the yield on your investments is a matter of quantity. In the end, you’re going to want as much liquid as possible.

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