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Most companies have to worry about what Wall Street thinks — here's why Google doesn't

Google founders Sergey Brin and Larry Page in 2006
Google founders Sergey Brin and Larry Page in 2006
(Chris Hondros/Getty)

Google's share price is down about 3 percent in after-hours trading on Wednesday after the company announced that its first quarter earnings had fallen short of expectations.

Google's critics say the company is paying too much attention to self-driving cars and face computers and not enough attention to the the firm's lucrative search advertising business, where the revenue per ad is declining. And they might have a point. But they have no way to make Google listen to it.

Ultimately it doesn't matter what the pundits or Wall Street analysts think about Google. In fact, with two exceptions, it doesn't even matter what Google's shareholders think. Because Google is structured in a way that gives founders Larry Page and Sergey Brin total control over the company. If the pair wants to squander the shareholders' billions on fanciful, money-losing products there's nothing anyone else can do about it.

Earlier this month, Page and Brin completed a controversial move that further strengthened their control over the company. The maneuver, called a stock split, created a new class of stock that had no voting rights. By issuing additional non-voting shares, the founders can raise vast amounts of money without diluting their majority control over the company.

What's a stock split?

The Google share split is all about control

A stock split is a financial transaction in which a company replaces each share of its stock with two or more shares. The new shares are granted to existing shareholders in proportion to their holdings. So if you had 100 shares of a company prior to a 2-for-1 stock split, you'd have 200 shares afterwards. Of course, doubling the number of shares doesn't actually make the company twice as big, so if the number of shares doubles, the value of each share generally falls by half.

Traditionally, companies do this because it was inconvenient for stock shares to become too expensive. Google's pre-split price of $1,135 made it difficult for people who wanted to purchase small quantities of the stock. Splits are also seen as a way for executives to signal confidence that the stock's value will continue to rise.

So is that why Google wanted to split its stock?

No. This month's split will double the number of Google shares and cut the share price in half. But that's where the similarity to a normal stock split ends.

The Google share split is all about control. Google has an unusual corporate structure designed to ensure that the company's co-founders, Larry Page and Sergey Brin, have complete control over the firm. The company has two types of shares. "Class A" shares are held by the general public and have one vote apiece. "Class B" shares are held by the founders and other corporate insiders and get 10 votes apiece. The result: the founders only own about 14 percent of all Google shares, but that's enough holdings give them 56 percent of the votes. That means that as long as the pair votes together, they have total control over the company.

But Google likes to create additional shares to finance acquisitions or reward star employees. That was gradually eroding Brin and Page's voting power. If their voting power slipped below 50 percent, then they could have been deposed by the other shareholders. Page and Brin argue that that would be bad for Google because pressure from Wall Street would force them to focus too much on short-term profits.

So Google management decided to create a third class of shares, creatively known as "Class C." Where Class A shares get 1 vote and Class B shares get 10 votes, Class C shares get 0 votes. Class C shares allow Google to create as much new stock as it wants without eroding the founders' control over the country.

Is that legal?

Some shareholders didn't think so. After Google's board approved the plan in 2012, shareholders filed a class action lawsuit seeking to stop it. The plaintiffs argued that public shareholders weren't adequately represented in deliberations over the proposal. Indeed, according to the New York Times, only 13 percent of Google's public shareholders voted in favor of the plan.

In their 2012 letter announcing the transaction, the founders promised not to cash out their Class C shares while holding onto the Class B shares—which could lead to them having total control of the company but an even smaller financial stake. They also argued that the deal is consistent with the "clear, well-publicized expectations we established for investors in 2004," when Google stock was first offered for sale to the public: that the co-founders would remain in control of Google for the foreseeable future.

But the plaintiffs counter that there was "no plan announced to perpetuate the Founders’ domination if they lost such dominance due to share sales or otherwise." They contend that Google's public shareholders expected Page and Brin's voting power to erode over time as more Google shares were issued, and the stock split frustrates that expectation.

The courts never had a chance to weigh in on the issue because the case settled shortly before trial.

How did the settlement address the shareholders' concerns?

As far as we can tell, it didn't. Google's biggest concession was that it would compensate holders of the new Class C shares if their value fell significantly below the value of Class A shares. A year from now, Google's board will check to see if Class C shares are worth less than Class A shares. If they are, then Google will compensate Class C shareholders for part of the difference.

But that doesn't seem to address the issues raised in the lawsuit. It does nothing to curb the co-founders' ability to issue more equity without losing control of the company. "This seems to be more about showing that the settlement did something than about actually preserving shareholder value," Matt Levine wrote.

The settlement did accomplish one thing, though: the plaintiffs' lawyers got $9 million for their trouble.

What happens now?

Sergey Brin and Larry Page can continue running Google for as long as they want to. And thanks to the new Class C shares, they can issue an unlimited amount of new stock to compensate employees or finance acquisitions without lessening their control.

That means that Google's public shareholders are completely at Brin and Page's mercy. Overall, the pair's management of the company has been excellent. Google's stock value has risen 10-fold in the last decade. But if this week's disappointing financial results recurs in future quarters, there won't be any way for the public shareholders to force the founders to change how they run the company, or to force them out of power.

How typical is this kind of corporate structure in Silicon Valley?

It's growing increasingly common for publicly-traded technology companies to have a "dual class" structure that gives its founders control. Mark Zuckerberg controls a majority of Facebook voting power all by himself. Other companies with dual-class structures include Zynga, Groupon, and LinkedIn. This structure gives all of these companies' founders disproportionate influence over the companies' direction.