Sercu, Piet

Vinaimont, Tom

English

Research Papers in Economics

One Share One Vote?
by
Piet Sercu (KU. Leuven, BE)
and Tom Vinaimont (City University of Hong Kong, HK)
Introduction
Grossman and Hart (1988) and Harris and Raviv (1989) (GH-HR) study the optimality of
1S1V from the perspective of an entrepreneur writing a charter. Specifically, they figure
out how a founder/entrepreneur, if perfectly informed about a bidder’s characteristics,
would allocate the firm’s security benefits and voting rights to different classes of shares
so as to maximize the firm’s IPO value.
Their conclusion that 1S1V is optimal, by and large, is too sweeping, for two reasons.
First, in reality there is no perfect foresight: at best, the founder knows, say, the mean and
variance for a future bidder’s characteristics rather the exact details. Second, only a
restricted set of cases is really analyzed. In their model, the total value consists of
security benefits that accrue to shareholders and private benefits appropriated by the
controlling management; and GH-HR mostly consider cases where only one player has
the potential to extract private benefits (situations 1 and 2 in Figure 1), mentioning area
(3) merely as an uninteresting exception.
Accordingly, our own objectives are to study situations where any winning contender
can reap private benefits from control (area (3)) and to add uncertainty about the bidder’s
characteristics. We also study the relation between private and social value. We find that
GH-HR  miss  cases  where  dual-class  charters  outperform  1S1V  even  with  perfect
foresight about the bidder's characteristics, and therefore overstate the private optimality
of 1S1V. Consistent with this, our imperfect-foresight analysis fails to produce even a
Private
Benefits
Rival
Private Benefits
Incumbent
(1)
(3)
(2)
Figure 1: GH(1988) and HR(1989) claim optimality of 1S1V by analyzing
takeovers  with  player’s  characteristics  on  (1)  and  (2).  We  address  the
optimality issue in the larger area (3)
single case where 1S1V does better than the two competing dual-class charters that enter
the race. We nevertheless find that deviations between social and private values remain
modest and that complicated charters may even be desirable.
Model Set-up
As in GH (1988), an entrepreneur with no financial resources has started up a firm. Part
of the cash flow is captured as private benefits by management, and the remainder are
security benefits assigned to the shareholders. The entrepreneur appoints a management
team i, the incumbent, under whose control the firm generates security cash flows yi and
private benefits zi. The entrepreneur also issues class-A and -B shares with voting powers
va and vb=1-va, and cash-flow rights say and sby=(1-sa)y, respectively. Without losing
generality we assume va   vb. The entrepreneur also sets a level for the proportion of
votes needed to oust i. Lastly, he sells all claims to atomistic, risk-neutral investors.
Neither the incumbent management nor any potential rival owns any of these securities.
A rival management team, r, then attempts to dismiss the incumbent managers and
take control. If successful, the cash flow would change to levels yr for the security holders
and zr for r. These numbers are known to all investors. This rival publicly announces her
bid, taking into account that the incumbent may counterbid. We limit ourselves to bids
that are conditional offers for all shares: take-over codes typically do prescribe that a
change of control should lead to a bid for all outstanding shares. After r's final bid (and i's
Management Team
(i)
Security Benefits yi
Private Benefits
zi
Rival Management Team (r)
Security Benefits yr
Private Benefits zr
Entrepreneur Chart
er
 : fraction of votes
to assume control
Share
structure
Class
A shares
Class
B shares
 Voting Rights              vA         +       vB   = 1
Security Benefits        sA         +       sB   = 1
sAyi  +          sByi =
yi
sAyr  +          sByr
= yr
Figure 2: The Model Set Upfinal counterbid, if any), investors choose to tender shares or votes to either i or r. A
change of control occurs when enough votes are in favor of the change.
The bidding war
The possible bidding games come in two kinds: in a double bid, r either needs the votes
from both A and B shareholders to obtain enough votes, while in a single bid those from
the A class suffice.
Single bidding
The maximum a player would rationally pay for the A shares (his reservation value)
consists of the shares’ security value under that player’s rule, plus the player’s private
benefits. For r to win, the bid prices needs to be at least the larger of two numbers: (a) i’s
reservation value—otherwise i will trump r’s offer; and (b) the post-bid security value—
otherwise the atomistic shareholders will free-ride, preferring to keep the shares instead
of tendering them. The rival will make such a bid only if its cost is below her own
reservation value; if not, the value of the target company remains at yi.
Single bid Double bid
No free riding (A) pa,r   sa yr pa,r   sa yr
No trumping by i (A) pa,r   sa yi +zi pa,r   sa yi + zi
Cost of cheapest bid (A) pa,r = sa yi + Max(sa (yi–zi)+zi, 0) pa,r = sa yi + Max(sa (yi–zi)+zi, 0)
No free riding (B) — pb,r   (1-sa) yr
No trumping by i (B) — Pb,r   (1-sa) yi + zi
Cost of cheapest bid (B) — pb,r = (1-sa) yi + Max((1-sa)(yi–zi)+zi, 0)
Total cost pa,r = sa yr + Max(sa (yi–yr)+zi, 0) pa,r +pb,r = yi + Max(sa(yi–zi)+zi, 0)
                      + Max((1-sa)(yi–zi)+zi, 0)
r’s reservation value sa yr + zr (for A) yr + zr (for A and B)
The double-bid game
There is an interesting asymmetry in the double-bid situation. For i to win, it suffices to
buy either the A or the B shares, while both are needed for r to win. Thus, r now needs to
ensure that i cannot trump her bid on either class even when i would spend his entire
private benefits on buying one type of shares. For these bids to be possible, r's rationally
spendable resources must exceed the sum of i's alternative reservation prices. If the above
condition is met, r takes over the shares at the lowest prices that meet the free-rider
bounds and i’s reservation values. The security value of the firm as a whole then follows
easily.
The above implies two advantages of the incumbent over r. First, while r needs the
votes from both classes of shares to make a successful bid, i can block this bid by
focusing on only one class. Second, r makes the first move, so i can afford to wait and
decide on the target class for its counterbid after seeing r’s bid. Thus, r’s first move must
block  each  of  the  two  possible  counterbids,  meaning  high  bids  for  both  classes.
Compared to the single bid case, to i a dollar of private benefits now provides twice as
much firepower as it does to r. Stated differently, with a double-bid charter r often has to
pay more.
Privately optimal sharing & voting structure
In GH-HR style, we can assess what charter the founder would choose if the exact
characteristics of the rival management team were fully known already. Although we
relax this unrealistic situation in the next paragraph, it is useful to see under what
conditions the formally dual structure optimally collapses into a virtual 1S1V. This GH-
HR type analysis is quite negative about 1S1V, from the founder’s perspective. A
pseudo-1S1V arises when the optimal dual-class charter is of the single-bid type and all
security benefits are optimally assigned to the A shares. But such a quasi-1S1V is never
strictly optimal; only if security benefits are smaller under r’s rule there is one domain
where  quasi-1S1V  matches  a  non-1S1V  charter.  A  double-bid  charter,  lastly,  is
unambiguously optimal under certain circumstances; and this type can never collapse to a
virtual 1S1V as the B shares always have vital votes.
The  above  assumes  the  founder  is  perfectly
informed. This may be reasonable for the values of
yi and zi: after all, the initial management is known
to the entrepreneur. But the bidder’s abilities are not
really known at the time of writing the charter. So
we now take yr and zr to be random variables at the
time the charter is designed. Market values are then
based on expectations. In a simulation setting, we
let the entrepreneur maximize the proceeds from an
IPO by having him choose the optimal sa and va in a
dual class structure. We then compare this to the
1S1V structure.
Values for yr  and zr, are drawn from a wide
range of normal distributions. For compactness we
show just the results for cases where r’s expected
security  benefits  equal  i’s  and  only  the  private
benefits  are  different.  Security  benefits  yi   are
normalized to unity for the incumbent management
team  and  private  benefits zi  are  set  to  0.1.  The
expected  security  benefits  from r y r  also  equal
unity, and the expected zr then varies along the x-
axis  from  0.05  to  0.25  covering  five  different
simulation runs. The optimized IPO values of the
firm are illustrated in Figure 3.
 The figure shows that an entrepreneur strictly prefers a dual-class charter to a 1S1V
structure. Generally, the double-bid dual-class charter seems to do especially better than
the single-bid one when relatively more private benefits (on average) can be extracted by
the rival management team. In simulations where r also offers a higher security value yr
(not shown here) these results are even stronger. When i is able to extract relatively more
private benefits than its rival team, a single-bid charter seems to do better, but it still beats
1S1V.
Figure 3: IPO Value when the
entrepreneur maximizes value. - -
1S1V, -_- optimal single bid, -_-
optimal double bid. yi=E(yr)=1,
zi=0.1. zr on x-axis.Private v social optima
Arguably, society is primarily interested in total value maximization, which 1S1V
achieves by definition. From the companion paper in this volume, a single-bid charter
may be socially suboptimal because of leakages to or cross-subsidies from the B shares.
In a double-bid charter, market failures may arise because i’s private benefits carry twice
as much weight as r’s. With 1S1V never being optimal for the entrepreneur, the issue
now is how significant the resulting conflict between private and social interests may be.
In Figure 4 we plot the social values (i.e.,
inclusive of private benefits) that correspond to
each of the entrepreneur's possible charters. One
comforting observation is that the differences in
social values y+z are nowhere as large as the
differences in IPO security values (Figure 3).
That is, the charter mainly affects how much
private  benefits  can  be  extracted  from  the
bidder, leaving the expected total size of the
cake largely unaffected. We notably observe in
Figure 4 that there seems to be no important link
between the level of r's zr and the size of any
social value lost by the entrepreneur's preferred
charter; apparently, enough of r's private value
is  creamed  off  during  the  take-over  process.
From further simulations we find that for i there
is no such mechanism. For low values of zi the
impact of the founder's choice on social value
similarly  tends  to  be  small  or  insignificant,
irrespective of whether the zr's and yr’s are large
or not; but the potential amount of social value
lost  grows  the  larger  zi,  and  the  effect
strengthens for higher yrs.
True,  all  these  results  depend  on  the
parameters chosen for the simulation, and especially the z levels. While our numbers look
reasonable to us for large listed companies in Western economies, there is no way to
prove this. Subject to this caveat we conclude that for low zi's, ceteris paribus, the social
planner's optimal y+z seems to be closely matched by any charter. Only for higher initial
zis does the charter's impact become noticeable from the social point of view. But, we
repeat, the impact of the charter on social value is far smaller than the impact on post-bid
security value or initial market value.
Conclusions
In a framework comprising control contests when both r and i potentially can enjoy
private benefits or realize synergies from being in control of the target firm we find that
1S1V never comes out as the founder's first choice.
1S1V lacks two privately useful ingredients: the flexibility in sharing rules that
sometimes leads to more complete rent extraction from the bidder, and the extra premia
Figure 4: Social Value for different
charters. - - 1S1V, -_- optimal single
bid, -_- optimal double bid.
Yi=E(yr)=1, zi=0.1. zr on x-axis.
that sometimes have to be paid when r needs votes from two classes of shares while, to i,
one class suffices for the status quo. This may explain why, in practice, deviations from
1S1V are not uncommon. We also address why governments rarely step in: as far as we
can tell by our simulations, the social impact of the charter choice turns out to be far
smaller than the private impact (on IPO value or post-take-over value). If private benefits
are disapproved of, holding constant the cake’s size, a double-bid charter may even be
preferred as it is much better at channeling the rents the bidder would have extracted
towards the founder.
References:
Grossman, S., and O. Hart, “1S1V and the Market for Corporate Control'', Journal of Financial
Economics 20, 1988, pp. 175-202.
Harris, M and A. Raviv, “Corporate Governance: Voting Rights and Majority Rules'', Journal of
Financial Economics 20, 1988, pp. 203-235.
Harris, M and A. Raviv, “The Design of Securities'', Journal of Financial Economics 24, 1989,
pp. 255-287.
Sercu, P. and T.Vinaimont, “Double Bids for Dual-Class shares”, K.U.Leuven, 2006.

1S1V and the Market for Corporate Control'',

and T.Vinaimont, “Double Bids for Dual-Class shares”, K.U.Leuven,

Corporate Governance: Voting Rights and Majority Rules'',

The Design of Securities'',

One share one vote?.

https://lirias.kuleuven.be/bitstream/123456789/217895/1/SercuVinaimont1.pdf

One share one vote?.

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics