What If You Could Choose Your Shareholders?

Private companies have a fair amount of control over the composition of their shareholder base–at least for the time being, if the market for private shares continues to grow, that may not always be the case.

Public companies, on the other hand, have very little, if any, control. Buying and selling listed or quoted securities is so easy that it’s been compared child’s play:

So, as a public company you have to simply accept that your shareholders choose you, and not the other way around. Correct? Perhaps; but maybe not.

A recent paper by University of Pennsylvania Law School Professor Edward B. Rock, questions the preceding notion by examining the extent to which a public company (or a soon/intended-to-be public company) can influence the composition of its shareholder base using two types of strategies, what he calls: direct or recruitment strategies, and shaping or socializing strategies.

What Does Your Ideal Shareholder Base Look Like?

But before getting into the details of the various strategies, you have to answer the question: what does your ideal shareholder base look like? What are the characteristics of a good shareholder? What about a bad one?

The answer, of course, largely depends on who you are, or as Professor Rock puts it: “one person’s ‘active monitor’ is another person’s ‘intrusive busy-body’ or ‘speculator,’ and shareholders who may be good from a shareholder perspective may be bad from a manager’s perspective.”

Generally, however, from a company’s perspective, a good shareholder is defined as one that provides long-term capital at an attractive price. A good shareholder contributes to the development of a well-functioning secondary market, leading to a reasonably accurate price for your securities, and, in turn, increasing their value as a form of corporate currency. A good shareholder is also defined as one that evaluates management “according to long-term fundamental value rather than short-term earnings” and contributes to an overall increase in company value.

In contrast, a bad shareholder is defined as the opposite of a good one. A bad shareholder is one that seeks personal or short-term gains at the expense of other shareholders or long-term value.

Strategies for Influencing the Composition of Your Shareholder Base

Direct or recruitment strategies are categorized as those that are used to identify good investors and bring them into your shareholder base or, conversely, to identify bad shareholders or investors and oust or discourage them from becoming a part of your shareholder base.

Shaping or socializing strategies are categorized as those that are used to transform your existing shareholders into good shareholders.

The paper goes on at length analyzing the different strategies in each category, but here I’m only going to touch on what I think are the three most operable:

Pursue Relational Investments 

Relationship investing, which gained a degree of popularity in the United States in the early ’90s, comes in many forms, but is typically characterized by a large investor taking a long-term position in a company and playing the role of active monitor.

Pursuing a relationship investment strategy involves identifying virtuous relational investors and recruiting them as shareholders in a negotiated, arm’s-length transaction, such as in a PIPE transaction, with contractual or other incentives put into place to align the relational investors’ interests with those of management and of the remaining shareholders. By way of example, the paper cites Warren Buffet’s $5 billion investment in Goldman Sachs at the height of the financial crisis (Warren Buffet and Berkshire Hathaway are used quite often as examples throughout the paper).

Collaborate with Investor Relations

Investor relations, as defined by the National Investor Relations Institute, is “a strategic management responsibility that integrates finance, communication, marketing and securities law compliance to enable the most effective two-way communication between a company, the financial community, and other constituencies, which ultimately contributes to a company’s securities achieving fair valuation.”

Investor relations should be an integral part of any strategy that looks to influence the composition of your shareholder base, and, at minimum, your investor relations department, team or designee should play a role in:

• defining your ideal shareholder base;

• identifying good investors, relational or otherwise, and recruiting them as shareholders;

• educating shareholders about company policies and practices that will ultimately shape their role as shareholders; and

• building relationships with key shareholders around issues of strategy and policy in an effort to move those relationships “into a more cooperative and productive” direction.

Cited examples of the potential for shareholder education include Prudential Financial’s “Letter from the Board of Directors to Our Shareholders” and Berkshire Hathaway’s “owner’s manual.” One approach for building relationships with key shareholders is to increase communications by, for example, incorporating a “directors’ discussion and analysis” into your proxy materials or by holding regular meetings with key shareholders around issues of “strategy, risk control, compensation, ethics, CEO succession, [environmental, social and corporate governance]” and so on (similar to the meetings contemplated by the somewhat contentious fifth analyst call).

Also noteworthy, and I’m not going to recap it here, is that the paper touches on, and you should really consider, the implications of Regulation FD on an investor relations strategy.

Consider Clientele Effects

Clientele effects describe the propensity of a group of similarly situated investors to buy and hold the securities of those companies that have policies or practices corresponding to their own investment preferences. Such as the propensity of investors in lower tax brackets (or who are tax-exempt) and in need of current cash flows to hold the securities of companies that pay higher dividends.

Pursuing a strategy based on clientele effects requires that you first consider whether and to what extent clientele effects play a role in the composition of your existing shareholder base, and then whether changes to certain of your policies or practices would encourage shareholders of a good type to acquire, or discourage shareholders of a bad type from holding, your securities.

Beyond your dividend policy, you should consider whether and to what extent your corporate governance policies, polices on stock splits and reverse stock splits as they pertain to share price and liquidity, policies on earnings guidance, and even where you list your securities, will  influence clientele effects.

A Few Honorable Mentions

Finally, some of the other strategies worth mentioning include the influence of: your choice of domicile, such as Delaware as compared to an offshore jurisdiction, the exchange on which you list your securities, such as Nasdaq or NYSE as compared to the LSE, and, if you’re a soon/intended-to-be public company, alternative capital structures, such as the ever polarizing dual-class structure.