Voting and Power in the Small Firm: Alternatives to the One-Share, One-Vote Rule

The Journal of Entrepreneurial Finance Volume 3 Issue 2 Spring 2004 Article 3 December 1994 Voting and Power in the Small Firm: Alternatives to the One-Share, One-Vote Rule Robert Goon Long Island University John L. Teall Pace University Follow this and additional works at: https://digitalcommons.pepperdine.edu/jef Recommended Citation Goon, Robert and Teall, John L. (1994) "Voting and Power in the Small Firm: Alternatives to the One-Share, One-Vote Rule," Journal of Small Business Finance: Vol. 3: Iss. 2, pp. 127-139. Available at: https://digitalcommons.pepperdine.edu/jef/vol3/iss2/3 This Article is brought to you for free and open access by the Graziadio School of Business and Management at Pepperdine Digital Commons. It has been accepted for inclusion in The Journal of Entrepreneurial Finance by an authorized editor of Pepperdine Digital Commons. For more information, please contact , . Voting and Power in the Small Firm: Alternatives to the One-Share, One-Vote Rule Robert Goon and John L. Teall The one-share, one-vote rule applicable to the governance o f most business firms provides for proportional voting power which differs substantially from propor tional shareholdings o f investors. This problem is particularly acute in small firms where several (or many) shareholders may hold significant proportions o f shares. This paper reviews well-known game theoretic algorithms (weighting or vote assignment schemes) for the alignment of power with proportional sharehold ings. It also provides a simple measure o f the “misalignment o f power from proportional shareholdings” and discusses its applicadon in determining more equitable vote reassignment schemes. I. INTRODUCTION AND LITERATURE REVIEW The one-share, one-vote system of corporate governance is intended to provide a fair distribution of power among shareholders with diverse interests and expectations. However, it can be shown rather easily that the one-share, one-vote system provides a distribution of power that is significantly out of proportion to the distribution of votes am ong shareholders (Dubey & Shapley, 1978; Shapiro 8c Shapley, 1978; and Shapley & Shubik, 1954). This is particularly true for many smaller companies where each of the individual shareholders or partners may hold significant num bers of shares relative to the total num ber outstanding. The distribution of power among investors is particularly im portant in smaller companies for a num ber of reasons: Robert Goon • Department o f Finance, C.W. Post College, Long Island University, Brookviile, Long Island, NY 11548; John L. Teall • Department o f Finance, Lubin Schools of Business, Pace University, NewYork, NY 10038. The Journal o f SmaU Business Finance, 3(2):127-139 ISSN: 1057-2287 Copyright © 1994 byJAI Press, Inc. All rights o f reproduction in any form reserved. 128 JOURNAL OF SMALL BUSINESS nNANCE 3(2) 1994 1. Investors in small companies tend to m aintain less diversified portfo lios. With m ore significant proportions o f their wealth at stake in a particular firm, control and risk m anagem ent is of greater im portance to these investors. 2. Small firms subject themselves to significant shifts in power due to their need to raise capital as they grow. Prospective shareholders in the firm will be sensitive to the possibility o f being exploited by controlling shareholders. This potential for abuse may inhibit the small firm ’s ability to raise capital and grow. The reassignm ent of voting rights may be an excellent means to deal with this problem . 3. Given that smaller firms are likely to have several shareholders holding significant proportions of the firm ’s stock, the power level of each shareholder is likely to be of greater consequence. 4. Shareholders of small firms firequently form readily identifiable coa litions affecting the power structure of the firm. 5. Small firms differ from larger firms in that their securities tend to be less marketable and m ore closely held, rendering the distribution of control and minority discounts difficult to evaluate by owners and prospective purchasers.^ Frequently, valuations are m andated and determ ined by court systems and tax authorities. D ant (1975) dis cusses the increased willingness of the court system to recognize the value of control when establishing minority discounts. Small firms are particularly suitable for various schemes to deviate from one-share, one-vote rules. In addition to the im portance of the distribution of power to small firms discussed above, it is often easy to determ ine how many shares are owned by an investor at a given point in time when shares are transferred and which investors are most likely to vote as blocks. The game theory literature provides substantial inform ation on the meas urem ent of power (e.g, Milnor 8c Shapley, 1978; Owen, 1972; von Neumann 8c M orgenstern, 1944). These and other works have provided a foundation for the m easurem ent and valuation of control in the business and finance literature (Rydqvist, 1987; Robinson & White, 1989). The Shapley value and its “oceanic” variations (for large firms) have been used most extensively in the financial literature (Rydqvist, 1986,1987; Robinson &: W hite, 1989) and there have been occasional references to the Banzhaf index (Rydqvist, 1986). Each of these papers note the discrepancy between investor shareholdings proportions and relative voting power levels. Ratner (1970) argues that the one-share, one-vote rule gives excessive power to holders of large blocks, resulting in significant misallocations of resources and redistributions of wealth. Meeker and Joy (1980) and Meeker, Joy, and Cogger (1983) in their 129 Small Firm Voting and Power studies of closely held banks dem onstrate the im portance of voting and control in the smaller, closely held firm. The firm is regarded here as a set of contracts (the corporate charter, bylaws, bond indentures, m anagerial contracts, etc.) characterizing th ejo in t activities o f and the payoffs to the contracting parties (see Alchian &: Demsetz 1972; Fama, 1980; Jensen Sc Meckling, 1976). This contractual structure specifies a wide range of the firm ’s activities. However, Easterbrook and Fischel (1983) argue that it is impractical, cosdy, or impossible for this set of contracts to fully prespecify all of the activities which may be necessary in reaction to unknown future conditions. Thus, the im portance of the voting mechanism is that it is intended to provide for “fair” reactions to varying conditions on a timely basis. Presumably, the num ber of votes an investor holds is a function of the value of his investment in the firm; therefore, his voting power is based on the im portance of the election to him. Nonetheless, the one-share, one vote rule provides for voting power which is not propor tional to shareholdings (For example, consider the obvious case of two voters, where one has 49 percent o f the votes). Voting reassignm ent sc (...truncated)