Is Google Using Shareholder Capital Properly?

Investing expert Benjamin Graham, Warren Buffett's mentor, warns shareholders to pay careful attention to whether their companies give proper recognition to the interests of average outside shareholders.

I fear that Google (NASDAQ: GOOG  ) may not pass this test. Here's why.

Questionable investments
According to its 2013 proxy, Google has now invested almost $12 million in 23andMe, a private personal genetics company co-founded and led by Google co-founder Sergey Brin's wife, Anne Wojcicki. The proxy also indicates that Google leases office space to 23andme.

Investors should also note that the 2007 8-K disclosing Google's initial investment also clarifies that Brin provided about $2.6 million of interim debt financing to 23andMe, and that Google's investment was used to repay this debt. In other words, Brin had at least two personal reasons to favor Google's investment -- the fact that it would help his wife's company and the fact that it would help him get his $2.6 million back. And Google's average outside investors do not share in these interests.

As shady as I think this looks, investors should note several disclaimers made by Google management surrounding this investment, including:

The transaction was approved by Google's audit committee as required by the company's policy for related-party transactions. The audit committee's decision-making process included advice from independent counsel and an independent valuation of 23andMe. Sergey Brin recused himself from discussions in which Google evaluated 23andMe as a potential investment.

However, these disclaimers do not eliminate my concerns. For starters, neither the 8-K announcing Google's initial investment in 23andMe, nor Google's subsequent proxy, share relevant details about the advice given by the independent counsel they consulted or the independent advisor's report on 23andMe's valuation. In other words, while these filings made it clear that management considered outside advice, they didn't clarify what that advice was so shareholders could verify that these transactions were in their best interests.

Also, as Google's 2012 proxy points out, Brin controls almost 28% of the voting power associated with Google's outstanding stock. This means he has an overwhelming say in which directors will be re-elected. This could put significant pressure on the directors who sit on the audit committee to push through decisions that please Brin.

A broader trend
Other founder-led businesses have also reported a large number of related-party transactions in their 2013 proxies. As I pointed out in a previous article, Las Vegas Sands was involved in a number of questionable transactions with CEO/Chairman Sheldon Adelson's family members, and with other businesses Adelson owned. Wynn Resorts and Boyd Gaming also reported several related-party transactions in their most recent proxies, such as employee use of company services and company-owned property and employment of relatives.

In all of these cases, insiders control a large percentage of shareholder votes.

Adelson, his family, and entities established for his family's benefit own about 52% of the Las Vegas Sands' company stock CEO/Chairman Stephen Wynn of Wynn Resorts, along with his ex-wife and fellow director Elaine Wynn, own nearly 20%  of the company's stock Boyd Gaming's CEO/Chair William Boyd, and fellow board members Marianne Boyd Johnson and William R. Boyd, together own around 37% of the company stock.

Other issues
The concentration of ownership may create other risks to outside shareholders apart from the potential for related-party transactions that can put insiders' interests above those of average shareholders.

Along with Brin, fellow co-founder and Google CEO Larry Page and Google chairman Eric Schmidt controlled about 64% of Google's voting power as of its last 10-Q filing. In a proposal pushing for Google to give all shares equal voting power, one shareholder suggested that the current power structure allows the company to offer compensation packages that cannot be justified in terms of long-term shareholder value, including Schmidt's 2011 $100 million equity compensation package that had no job performance requirements.

The Foolish bottom line
While related-party transactions can be legitimate, they also create the potential for conflicts of interest and can create a situation in which insiders' interests are put ahead of the average outside shareholder. For this reason, I believe companies should avoid engaging in related-party transactions unless they can offer a clear and convincing argument that demonstrates to shareholders that their capital is being used wisely.

Unfortunately, I don't believe Google's management has offered a sufficient justification of its continued investment in 23andMe.

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