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Dual or multi-class capitalization structures generally allow companies to sell large amounts of shares to the public while maintaining control in the hands of the founders and early investors. Popularized by the Google IPO in 2004, weighted voting rights have since been featured in the high profile IPOs of LinkedIn, Groupon, Zynga, Facebook, Fitbit and Blue Apron.  Snap then took them to a new level last year when it acknowledged (or boasted) that it was the first company to launch an IPO with shares having zero voting rights.  I blogged about Snap’s IPO here.

Dropbox, Inc. is now the latest to go public with a multi-class structure. Having submitted its registration statement confidentially in early January, Dropbox finally filed its S-1 publicly on February 23. Dropbox’s S-1 shows that its capital structure consists of three classes of authorized common – Class A, Class B and Class C – with the rights of the holders of all three classes being identical except with respect to voting. Class A shares (offered to the public) are entitled to one vote per share, Class B shares are entitled to ten votes per share and Class C shares have no voting rights, except as otherwise required by law.  Although the general rule in Delaware is that each share receives one vote, a corporation may provide in its certificate of incorporation that a particular class or series has limited or no voting rights.

Because of the ten-to-one vote ratio between Dropbox’s Class B and Class A, the Class B stockholders – basically the co-founders and lead VCs Sequoia, Accel and T. Rowe Price — will continue to control a majority of the combined voting power, and therefore be able to control all matters submitted to stockholders for approval. This concentrated control will limit or preclude the Series A holders from having an influence over corporate matters for the foreseeable future, including the election of directors, amendments of the certificate of incorporation and by-laws and any merger, sale of all or substantially all the assets or other major transaction requiring stockholder approval. The concentration of voting power may also discourage unsolicited acquisition proposals.

The concentration of power in the Dropbox founders will likely only grow over time. Under an automatic conversion feature, future transfers of Class B shares will generally result in conversion into the lower voting Class A shares, subject to limited carve-outs for estate planning transfers and transfers between co-founders. The conversion of Class B shares to Class A will have the effect, over time, of increasing the relative voting power of those Class B holders who retain their shares.  Moreover, any future offerings of Class C shares will increase the concentration of ownership and control by the founders even further than would be the case in an offering of A shares because the C shares carry no voting rights at all (except as otherwise required by law). Consequently, the cumulative effect of the disproportionate voting power of the B shares, the automatic conversion feature upon transfer of B shares and the possibility of issuance of C shares is that the founders may be able to elect all of Dropbox’s directors and to determine the outcome of most matters submitted to a stockholder vote indefinitely.

Dual-class structures have been the subject of a great deal of controversy.  Some stock exchanges had banned them, only to reverse course because of stiff competition for listings. See here for case in point regarding Hong Kong, the NYSE and Ali Baba.  Investors have loudly objected to this structure, both through the SEC’s Investor Advisory Committee and the Council of Institutional Investors.  As a result of that opposition, FTSE Russell and Standard & Poor’s announced last year that they would cease to allow most newly public companies utilizing dual or multi-class capital structures to be included in their broad stock indices. Affected indices include the Russell 2000 and the S&P 500, S&P MidCap 400 and S&P SmallCap 600.  Consequently, mutual funds, exchange-traded funds and other investment vehicles that attempt to passively track these indices will not be investing in the stock of any company with dual-class shares. Although it’s too early to tell for sure what impact, if any, these new index policies will have on the valuations of Dropbox and other publicly traded companies excluded from the indices, it’s entirely possible that the exclusions may depress these valuations compared to those of similar companies that are included in the indices.  Interestingly, just two weeks ago, SEC Commissioner Robert J. Jackson Jr. gave his first speech since being appointed, entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty“, in which he expressed his opposition to index exclusions despite his serious concerns regarding dual-class stock, calling index exclusion a blunt instrument and worrying that “Main Street investors may lose out on the chance to be a part of the growth of our most innovative companies”.

And how do companies like Dropbox defend dual-class structures? They would assert that weighted voting rights enable management to make long term decisions that are in the best interests of the company and to resist the short-termism that typically results from pressure brought by major stockholders to maximize quarterly results which often means sacrificing long term interests and performance.  They would further argue that efforts to exclude companies with weighted voting rights from stock indices are counter-productive because they serve to discourage those companies from going public in the first place, thus denying public company investors the opportunity to invest in innovative, high growth companies.

Perhaps the sensible compromise here would be sunset provisions, under which dual-class structures would sunset after a fixed period of time, such as five, ten or fifteen years, unless their extension is approved by stockholders unaffiliated with the controlling group.  Snap’s muti-class structure has no sunset provision; the only way the two founders could ever effectively lose control of Snap is if both died.  By contrast, Google has a sunset provision on its dual-class shares. The Council of Institutional Investors sent a noisy letter to Blue Apron just before its IPO last year urging the company to adopt a five-year sunset.  And Harvard Professor Lucien Bebchuck published a paper last year called “The Untenable Case for Perpetual Dual-Class Stock”, arguing that the potential advantages of dual-class structures tend to recede, and the potential costs tend to rise, as time passes from the IPO, and advocating for finite-term dual-class structures.

A recent Delaware Chancery Court decision provides important guidance on what types of defective corporate acts may be ratified under Section 204 of the Delaware General Corporation Law (the “DGCL”), and what types may not.  Paul Nguyen v. View, Inc. also underscores the importance of focusing on whether to opt out of the class vote required by DGCL Section 242(b)(2) for changes in authorized capital, which effectively gives the common stock a veto over future funding rounds.

The facts of the case are as follows. View, Inc. develops smart windows that allow the light, heat, shade and glare properties of the glass to be controlled manually or electronically, thus enhancing comfort and reducing energy consumption and greenhouse gas emissions. After closing on a Series A round, View replaced its founder, Paul Nguyen, as CEO and CTO. While in mediation over the termination, View proposed a new Series B round of funding, which under Section 242(b)(2) of the DGCL required the consent of Nguyen as holder of a majority of the common. The parties then signed a settlement agreement in which Nguyen consented to the Series B, subject to a seven day revocation right. When Nguyen discovered the terms of the Series B would materially diminish his rights, he revoked his consent within the revocation period. Unbeknownst to him, View had already closed on the Series B. Nguyen then brought an arbitration proceeding against View, seeking a declaration that the revocation was valid and the Series B funding invalid. While the arbitration was pending, View closed on additional rounds C through F in an aggregate amount of over $500 million. After View filed two certificates of validation under DGCL Section 204 seeking to ratify the increase in authorized capital, Nguyen commenced the Chancery Court suit, which the parties agreed to stay pending the arbitrator’s decision on the validity of the consent revocation.

The arbitrator ruled that the revocation was valid and the Series B invalid. The ruling effectively meant that all of the related transaction documents were likewise invalid and void because Nguyen had not consented to them either. And since each of the subsequent rounds of financing rested on the Series B funding, the invalidation of the Series B effectively invalidated the Series C through Series F rounds as well, basically blowing up View’s capital structure. The Series A stockholders responded by seeking to resurrect the funding rounds through the ratification provisions of Section 204, initially by converting their preferred shares into common (thus becoming the majority holders of the class) and then by authorizing the filing of certificates of validation with the Delaware Secretary of State under Section 204.

The key issue in the case was whether an act that the holder of a majority of shares of a class entitled to vote deliberately declined to authorize, but that the corporation nevertheless determined to pursue, may be deemed a “defective corporate act” under Section 204 that is subject to later validation by ratification of the stockholders, an issue of first impression.

In 2014, the Delaware legislature created two alternative pathways for corporations to cure defective corporate acts. Section 204 provides that “no defective corporate act or putative stock shall be void or voidable solely as a result of a failure of authorization if ratified as provided [in Section 204] or validated by the Court of Chancery in a proceeding brought under Section 205.” Previously, acts deemed “voidable” could be subsequently ratified, but acts deemed “void”, such as the issuance of shares beyond what is authorized in a company’s charter, were deemed invalid. Prior to Sections 204 and 205, corporations had no way to remedy “void” corporate acts, even if the failure to properly authorize the act was inadvertent. The ability to cure defective acts is critical. Startups often need to clean up such acts prior to a funding round or acquisition, both to satisfy investor or acquirer due diligence issues and to enable counsel to issue opinion letters.

The court found that the Series B round was not a “defective corporate act” that is subject to ratification under Section 204 and ruled that View should not be allowed to invoke ratification to validate a deliberately unauthorized corporate act. As the holder of a majority of the outstanding common which was entitled to a class vote, Nguyen’s vote was required in order to authorize the Series B. The failure to obtain such authorization was not an oversight; it was the result of an affirmative rejection by Nguyen. Thus, the distinction here is between a defective corporate act that results from an oversight, which is curable under Section 204, and a defective corporate act resulting from an affirmative rejection by the stockholders, which is not curable under Section 204 (or 205).

One obvious takeaway is that companies should respect arbitrators’ rulings and should not proceed with a transaction, let alone a series of transactions, until stockholder authorization has been secured. View’s pursuit of the Series B round during the revocation period, and thereafter of the Series C through F rounds while the arbitrator’s ruling on the consent revocation was pending, was reckless to say the least. As the court put it, “[o]ne must presume that View understood that if the arbitrator found in favor of Nguyen on the consent issue, then the later rounds of financing that rested on the Series B Financing would collapse when that block was removed from the tower of blocks that comprised the Company’s preferred stock offerings”.  One can only presume further that it did so against the advice of counsel or despite counsel’s warning of the risk.

The other takeaway here is that companies should consider carefully whether to opt out of the class vote requirement under DGCL Section 224(b)(2) for changes in capital structure. Section 224(b)(2) requires any increase or decrease in authorized shares to be approved by holders of a majority of each class of stock entitled to vote, but allows corporations to opt out by providing as much in the charter. The National Venture Capital Association’s model amended and restated certificate of incorporation has an optional provision that states that the common and preferred will vote together as a single class on all proposals to increase or decrease the authorized capital, irrespective of the provisions of Section 242(b)(2). Failure to opt out effectively provides the common stockholders with a veto over future capital raises because each subsequent round requires an amendment to the charter not just to create the new series of preferred, but also to increase the number of authorized common to accommodate conversion of the preferred. Failure to eliminate the class vote requirement will force the company to have to seek the consent of holders of a majority of the common, providing them with unintended leverage in connection with a deal that’s presumably in the best interests of the company and its shareholders.

On August 1, 2017, Delaware became the first state to allow corporations to record issuances, transfers and ownership of stock using blockchain technology.  Amendments to the Delaware General Corporation Law authorizing blockchain stock ledgers were passed by the Delaware State Senate and House of Representatives in June, signed by Governor John C. Carney Jr. in July and became law August 1. The amendments have enormous potential advantages for emerging companies, including cost savings, error avoidance, accuracy of ownership records and automation of administrative functions.

Blockchain is essentially an automated, decentralized, distributed database or ledger that allows participants on a given network to create an indelible, secure record of asset ownership and transfers directly and without the additional cost and delay associated with intermediaries. Each transaction is cryptographically signed and time stamped. While conventional transfers of assets typically require verification by third party intermediaries, blockchain based transfers rely on algorithms to confirm transaction authenticity.

Delaware law has required corporations to record stock transfers on a stock ledger and to maintain ownership records on the ledger. Stock ledgers are typically maintained by the corporate secretary or the company’s transfer agent who makes entries on paper or on an excel spreadsheet to reflect all transactions in the company’s stock. Under the current system, the corporate secretary or transfer agent must be notified of a stock issuance or transfer in order for the transfer to be recorded on the ledger and for the transferee to be treated as the record owner of the shares. The requirement for intermediaries to record stock transfers creates friction in the form of delay, expense and potential for error.

Prior to the blockchain amendments, Section 224 of the Delaware General Corporation Law provided that corporate records including stock ledgers could be maintained on any “information storage device”, but didn’t specifically allow for storage or recordation on electronic networks or databases, let alone any distributed electronic network or database. Section 224 has now been amended to provide that the information storage devices on which corporate records including stock ledgers could be stored may include “electronic networks or databases (including one or more distributed electronic networks or databases.”

The State of Delaware published an information sheet outlining the benefits to companies from registering issuances and transfers of shares in blockchain form, identifying three categories of benefits: cost savings, accurate ownership records and automation of administrative tasks. For privately held companies, maintaining a stock ledger on blockchain would:

  • enhance accuracy and ease management of the cap table
  • facilitate direct communications with investors
  • enable option grants to remain in sync with authorized shares
  • increase transparency of the shareholder voting process
  • prevent certain “foot faults” common to administering private companies
  • reduce likelihood of disputes

So if a corporation organizing in Delaware elects to use blockchain technology for its stock ledger, the Division of Corporations would cryptographically transfer to the company on the distributed ledger just those shares identified in the corporation’s certificate of incorporation as authorized. By doing so, the Division of Corporations establishes a perfect record of authorized shares, and the distributed ledger then reliably tracks subsequent issuances by the company and transfers by stockholders to produce a reliable record of issued and outstanding shares.

Under existing methods of share transfer and ownership recordation, an issuance or transfer could easily slip through the cracks. It’s not uncommon to discover gaps in a company’s cap table, often at the most inopportune time such as on the eve of closing a transaction, where the company inadvertently issued a number of shares in excess of the amount authorized, thus triggering the necessity for a filing under Section 204 of the DGCL to cure the defective corporate act. Blockchain based stock ledgers would eliminate this possibility.

Finally, the amendments impose certain requirements on blockchain based stock ledgers. First, electronic corporate records must be capable of being converted into legible paper form within a reasonable period of time. Second, as required of other stock ledger formats, blockchain based ledgers must be able to (i) be used to prepare a list of stockholders entitled to vote, (ii) record information required by the DGCL to be maintained in the ledger and (iii) record transfers of stock pursuant to Article 8 of the Delaware Uniform Commercial Code.