In October 2021, Founder and CEO Mark Zuckerberg announced Facebook would change its name to Meta and committed to investing $10 billion into R&D over the next 12 months into the metaverse. In 2022, as macroeconomic fortunes changed, the pressure on Zuckerberg to change his strategy, and pivot away from the metaverse grew. In October 2022, Zuckerberg even received an open letter calling on him to change course (more on this later). Meta’s corporate governance structure allowed for such strategic change of directon – aerospace and defense primes do not have this benefit.
Corporate governance 101
Shareholders appoint board members to manage the company. In turn, the board picks the CEO and other executives. The election of board members is straightforward: each share has one vote and each member is voted on by shareholders. In a way, he who controls the board controls the company. For a typical US public company, the shareholder base is diffused with no one shareholder holding a majority of votes.
Meta, however, has 2 classes of shares – Class A (publicly traded) and Class B (not publicly traded). Both share classes are identical except that Class B has 10 votes per share. This structure, common for Founder-lead companies, allows Zuckerberg to effectively control the board of the company without being a majority shareholder.
Interestingly, corporate governance that is meant to instill accountability, leads to a lack of accountability when management needs to make big moves to sustain for the long-term horizon.
Happy shareholders, happy life
According to a study commissioned by the Department of Defense (DoD), shareholders for defense companies are happy – they have industry-leading performance as shown in the diagram below. While the DoD might want aerospace primes to be more innovative and take more risks, their shareholders are quite content with the current state of the business. Furthermore, shareholders will continue to be satisfied as long as share buybacks and dividends continue.
Source: Examination of the Financial Health of the Defense Industry
Activist investors as change agents
When shareholders become unhappy, often activist investors set in. Activist investors make their money by accumulating shares in a publicly traded company and then appointing their preferred candidates to the board. As part of the process activists try to publicly pressure the company into instituting changes. If the board doesn’t agree with the proposed changes, activists try to gain the support of the majority of shareholders to vote to change the makeup of the board and install new candidates. Once in control of the board, activists take control of the strategic direction of the company.
Activists as status quo agents
In October 2022, Altimeter Capital in an open letter called on Meta CEO to cut costs, reduce spending on the metaverse initiative, and focus on its core business. This is a typical activist investor playbook: cut costs, buy back shares, focus on core business, etc. Activists are not big believers in companies making big bold moves that are going to take time to pay off. In fact, public markets with their focus on quarterly results are not a good place for a company trying to make radical changes. While Zuckerberg did cut costs, he ignored public pleas for change because the corporate governance structure allowed him to follow his conviction. This is a sign of a great entrepreneur – set and execute on vision that the rest of the world does not yet see. Were it not for the dual-share structure, it is a good bet that activist investors would have taken over Meta and killed its pivot into the metaverse. It is also a safe bet that if management from any of the primes stopped buybacks and dividends to execute a strategy, they would be replaced.
Innovation stagnation as a function of public markets
If the management of a prime wanted to completely change the business model where the company is going to fund the bulk of R&D from its balance sheet, it would be reasonable to expect increased costs with revenue growth probably lagging a few years. Those increased costs would likely lead to reduced dividends and share buybacks – two key parameters for shareholders who invest in aerospace primes. Self-inflicted reduction of earnings would attract the attention of activists, creating a push to replace the CEO and return to the “old” strategy.
During diligence, we used to ask ourselves if the primes could build the same technology that a start-up is building. Strictly focusing on engineering, most of the time the answer would be yes – given enough time and money primes could replicate. However, even when it is clear what products are needed, the primes fail to respond. Case and point - SpaceX. SpaceX landed Falcon 9 rocket in December 2015. Reusable rockets offer huge savings. If a company wants to be in the rocket launch business it needs to have reusable rockets. Yet eight years later, major primes do not have reusable rockets on their drawing boards. Business models dependent on government financing of R&D efforts, combined with public shareholders demanding dividends and share buybacks limit the management’s ability to invest in bold new efforts. Interestingly, corporate governance that is meant to instill accountability, leads to a lack of accountability when management needs to make big moves to sustain for the long-term horizon.
The only way forward is to increase investment capital into startup companies because the only way startups can be successful is by doing things differently from incumbents. If successful, new champions will arise and old ones will dividend into the sunset.
I agree with the core point of the article, however I think the example chosen will actually show the downside of individual control. Zuckerberg abandoned his own lesson from building facebook: Test your hypothesis with the customer early and often. Metaverse, while developing great tech, will go onto the dust pile of history. It is reality that we want to transform and make like a computer game. Nobody wants to move into a computer game. Second Life, Metaverse ...
The market rewards them buying product lines through M&A- it punishes them for near term investments in their own products. They are just doing what markets reward them to do, which is turn into technology equivalent of REITs