Friday, February 15, 2013

Proof that minority share positions are worth less than majority interests

So many people refuse to believe this basic truth of finance, I will make this article devoted only to proving it as simply as possible, then towards the end show how lies against this truth are abused:  A minority share in a corporation is worth much less than a majority share.

Definition of a corporation and shareholder
A corporation is like a box that holds assets (like cash and equipment) and may owe liabilities (debts).

Shareholders "own" a portion of the net assets (assets - liabilities) based on the proportion of total shares that they own.  If a shareholder owns 1 share, and there are 100 total shares, then that shareholder has 1% of the 3 core shareholder rights ("own" is in scare quotes because you will see that it doesn't conform to its common meaning)

The 3 core shareholder rights
For each % of shares the shareholder owns, he can:

  1. Vote on corporate decisions.  Each share is entitled to one vote, and so a majority shareholder is effectively a dictator.
  2. If an offer to buy the company is accepted (through above vote), then the proceeds must be shared among all shareholders, according to their respective percentage ownership
  3. If a decision to disburse funds from the box as dividends is made (through vote) then the dividend amount must be equal for each share.
The lie that the financial industry would have you believe is that these rules are fair to all shareholders.  The main proof that it is a lie is that dividends and buyouts are not the only way that a controlling member of the corporation can extract proceeds from it, and so shareholder rights are meaningless if a shareholder has no decision power.

Let's you and I make a corporation to hold $10k
The box will hold $10k at the start.  You will put in $4k and own 40% of shares.  I will put in $6k and own 60% of shares.  The minute after our corporation is formed we will have a series of votes, the results of which will be that I manage/hold the box, and I am to receive a management/security fee for holding the box.

I know that all of the boxes contents will eventually be transferred to me through management fees.  I would never vote in favour of a dividend because that would mean some of the funds in the box would go to you.  In order for me to accept a buyout offer for the box, it must be $16700 or higher, because only an offer that high nets me (my 60% share) more than the $10k I will eventually get from the box if I don't accept a buyout.  There is no rational reason for any buyer to offer more than $10k for the box, so there is no expectation the box will ever be bought.

Your 40% share in the box is worthless because you will never receive any proceeds from the box, because the decision to do so is entirely within my controlling interest.

Let's buy a car to use for taxi/shipping services with the $10k
I have Good news.  If we buy a car with the money in the box, then with the proceeds of taxi/shipping services more money could go into the box, and so your 40% might be worth more, according to this finance textbook.  Let's vote on it.  Yay! I win again.  After more votes, it is decided that the car will be kept in my drive way, and I will receive a reasonable salary for driving the car and looking for business.  Hopefully, I will actually look for business and actually put all the revenue in the box.  Repairs and gas money comes out of the box of course.

Wow the taxi service has put $20k in the box
You are as surprised as anyone else, and suggest that we should both take dividends out of the box.  I have a better idea.  We vote to get a nicer car for my driveway, and deservedly increase my driving salary.  The finance textbooks say I deserve more money for my successful management of the company.  This is much better for me because I get a nice car, and if the business does not enjoy continued success, I will still be able to drain the full $20K for myself.

Taxi service a big success.  Time to go public
My entire extended family now has a car in their driveways, and the business appears to be successful enough that stock market investors could be convinced to buy shares into the company.  Although, you have learned the hard way that a minority interest in my (I mean our) corporation is worthless because I have no intention of ever letting you be paid anything from the company, you have a definite interest in pretending that the company is successful, and will remain successful, and pretending that your shares are worth something.  If the general public believes that shares in our corporation have value, then you will be able to dump your shares to those idiots at a nice price.  It's in your clear interest to go along with the lie.  Your grandma and her friends end up with 40% of the company due to your skillful sales efforts.

Dual class shares
I have run out of family members to give cars to, and I am pushing the limits of what a reasonable salary is, but I would still like to get more of the money out of our corporation for myself.  The answer, is that we will vote to make a new share class in our corporation:  Non-voting shares have the 2nd and 3rd shareholder right to dividends and buyout proceeds, but no voting right.  The non voting share class will be the one traded publicly on the stock markets.  I will choose an executive compensation committee, and a new employee stock program will be implemented, where most employees receive a few non voting shares, the members of the compensation committee a few extra, and I will be showered in bonus shares.

Extra non voting shares is fantastic for the employees and me.  We get to turn the shares into cash without taking that cash out of the/my box.  We get the cash from stock market idiots.  By keeping the cash in the box, the stock market idiots will think that the non voting shares are worth something, and so pay more for them, and keeping money in the box means that I can find additional ways of diverting it to myself later.

Borrowing against shares
Another way for me to get cash without paying dividends or letting anyone else in the company make money is to borrow against the shares.  Although there is an interest cost, it is tax deductible, and if shares go up in perceived value by more than the after tax cost of the borrowing, then it has no cost.

Corporate share buybacks
Corporations may buy shares from the stock market.  The finance industry and textbooks tell us that this is a great sign for the stock, as the company must believe that its shares are undervalued, and the extra demand for the shares will push up its price, and reducing the shares outstanding means that future earnings and dividends per share will be increased.  The finance industry also tells us that corporate share buybacks count as giving back to shareholders, because there is flow out of the box.  But technically, that money is only going to shareholders who are unhappy and selling out.  No one that continues holding their shares is paid.

For me (as controlling owner of the corporation), corporate share buybacks are a useful use of the funds in the box if it is effective in convincing stock market idiots that the shares are worth more.  That belief allows me to sell voting and non voting shares at a higher price while continuing to maintain a controlling interest.  Even if the funds in the box don't directly flow to me, different stock market idiot buyers will pay me a higher amount, than if I didn't compete with them with the money from the box.

In fact, the more fearful I am about the worthlessness of the stock, or the deterioration of the value of the box, the more useful it is to me to use corporate share buybacks to help me cash out at a reasonable level.  I necessarily have better information on the future of the company than anyone else.

Maintaining controlling interest without a majority of shares
Even without a total majority of shares, buyouts can still be prevented by management.  Poison pills and golden parachutes are corporate bylaws that can be created for the sole purpose of making buyouts more expensive, and thus less likely, and protecting management's compensation.  Laws that prevent institutional investors from voting for board members, and manipulation of democratic process and voter apathy, can allow management to appoint loyal board members with industry experience, while returning the favour and serving as board members on their companies.

Loyalty to management by the financial industry that promotes their shares, and industry leaders that share a desire to maintain the corporate gravy train for management conspire against paying dividends or sufficiently high dividends.  The core lie that justifies this behaviour is that management deserves to keep your money because they will invest it wisely.  This misleads society by denying investors the choice to give back their dividend earnings to the company only when the investors agree that management deserves to reinvest it.

The harm that is created
The stock market price a stock trades for reflects the value of the minority shareholder stake.  Trades occur  a small number of shares at a time.  When a company trades its controlling interests those trades happen behind closed boardroom doors.  Controlling stakes in the company are worth the value of the box.  Minority stakes are worth less.

When a company is difficult or impossible to take over, and when it refuses to pay dividends, then the shares that minority stake holders are trading on the stock market are worth far less than the value of the company, and cannot justify their trading price.  The increasing corruption of shareholder value is partially responsible for poor stock market returns in the last decade, but it ensures future dismal investment performance.  Society also loses significantly when businesses hoard cash because businesses will only invest when consumer markets have the cash needed to buy their products, and keeping the cash to themselves necessarily reduces the cash available to consumers.

Dividends also significantly reduce risk of investment.  There is no possible way of knowing what will happen to a company in 20 years.  A 5% per year dividend for 20 years ensures that no matter what happens after that time, the investor cannot lose money.

Calling this a pyramid or ponzi scheme
When a share in stock will never receive sufficient compensation in the form of dividends or a buyout, then it is necessarily a scam.  That you have the power to sell that share to a greater fool is simply the power to make a different victim of the scam.  While its easy to argue that ponzi and pyramid schemes are a different scam than worthless stock shares, there is a core commonality:  Trading financial instruments that are determined mathematically to be worth less than their traded value.

Who is to blame for the lie
While I've implicated finance academia in the lies that permit corporations' abuse of minority shareholders, they would defend themselves by claiming that finance academics only speak of the value of the box.  They are still culpable through their silence on the issue and cosy loyalty to the financial industry, and the propaganda and brainwashing force that comes with rewarding 20 year olds with good test scores when they  internalize the lies.  For most people, it seems, lies that were created for them by their first year college teachers are some of the most passionately defended and internalized.

The financial industry and their client stock issuing firms are the most responsible for misleading the investing public that some company shares have value.  There is no excuse for valuing shares based only on the value of the box, when that box has no direct relevance to a share's returns.

Investors that go along with the lie, just because it is more believed than the truth, and hope the belief will stay common long enough for them to flip the stock have some responsibility as well.  They should be staying away from companies that can not compensate their shares rather than hope the truth stays hidden.

The biggest single issue that assures shareholder abuse is dual class shares.  That is what makes dividends impossible.  What makes buyouts impossible.  The tech and social media companies that went public with dual share structures did so because they could.  They did not need extra capital, and so did not need to go public.  The tech companies were great vehicles for the financial industry to sell an investment story, and that is why their stocks turned into a scam.  The financial industry was confident in being able to sell that scam.

Solutions
My original essay on the topic contains solutions at the end.  I still believe they are all needed.  An additional solution would be to threaten supporters of worthless stock with legal consequences.  The same common sense basis for Bernie Maddoff being liable for selling worthless investments should apply to others who lie about the value of shares.

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