We live in a world where the answer to the question
Why do companies exist?
is almost always
To make their owners* lots and lots of money.
Which seems to make sense.
It may surprise you to hear that the concept of “shareholder value maximisation” as a life-purpose for companies is actually a new one – something that only really came about in the 1970s.
- the average return on holding shares (using the S&P500 as a proxy) in the years prior to the 1970s was around 7.5% per annum.
- since then, it’s been about 6.5% per annum.
- make of that what you will.
Where Does It All Come From?*
*I’m about to simplify a fairly complex web of patterns in, like, a crazy way – so apologies in advance for the broad generalisation.
When the world of business was younger and less-technologically-connected, it was not so easy to run large corporations. It was the era of mom-and-pop stores, where businesses were owner-run and cokes were still sold for a nickel from a soda fountain the world over.
But as in the manner of all things that grow, businesses began to get bigger. Mom and pop started pooling their money and resources with other moms and pops to create bigger and better stores (and factories and farming projects and so the list goes on). This created a small problem, because as all moms and pops know, when you have many cooks nursing a broth, it ends up too spicy to eat.
So the traditional role of “owner” began to split into two:
- shareholder (being the one with legal rights to the assets of the company after all debts had been settled); and
- director (being the one charged with the operation and management of the company assets)
The shareholders would meet annually to appoint a board of directors. The directors would report to the shareholders on what was happening, as well as appoint managers (which could include themselves) to run the business.
Enter: Agency Theory
So while this made sense from a pragmatic point of view, there were some problems that shareholders began to encounter:
- lazy directors – who realised that their paycheck was their paycheck, so why work harder if you don’t need to?
- couldn’t-be-bothered directors – who realised that their paycheck was their paycheck, so why do anything better if you can just maintain the status quo?
- extremely-well-paid directors – who realised that their paycheck was their paycheck, but that they got to set their paycheck (and layer the company with corporate jets and such), so why not extract what you can extract?
- traitorous directors – who realised that their paycheck was their paycheck, but why not disappear with the client list and negotiate a higher paycheck with the competition?
- embezzling directors – who realised that their paycheck was their paycheck, but if it’s your signature on the bank account, why not do a little borrowing?
- amongst others.
So the academic question that was posed: if directors are the agents of shareholders (the principals), how do you get the agent’s interests to align with those of the principal?
The answer, according to Messrs Jensen and Meckling at the University of Rochester in 1976, was to make the agents principals in their own right. And so stock options became the flavour of executive compensation of the day.
A deconstruction of the rationale:
Premise 1: goal of shareholders = maximise shareholder value
Premise 2: goal of directors = maximise compensation + minimise effort
Premise 3: maximised shareholder value = maximised director effort*
*shareholder value will be maximised when director effort is maximised.
Conclusion: make directors = shareholders
Does anyone else see the rational flaws here?
- What about the “maximise compensation” goal of directors?
- What about the “minimise effort” goal of directors?
- Where is the consideration for the role of time in all of this?
The trouble is this:
- Directors under this model do not own the entire company. When you give people the option of either maximising for the whole group or maximising for themselves… The thought goes something along the lines of “why shouldn’t I get a greater share seeing as after all I do all of the work and the rest of these clowns are just free-riding on my mad skills”.
- Directors will still try to minimise effort relative to their return. It’s called “being efficient”. And if that means that they spend more time trying to push the share price higher so that they can make their return sooner and then get out – then that’s what they do.
- Time. In extremes: if I have 10 days to maximise a return versus 10 years to do it – my managerial decisions are going to be quite different. In the first, I’d argue to sell off everything asap and distribute the profits and be done with it. In the second, I’d be building and growing things.
So it comes as no surprise that the ascendancy of “shareholder value maximisation” has coincided with lower returns for shareholders and higher compensation for directors.
But that aside, I think that the biggest flaw in the argument is that, somehow, the interests of shareholders and the interests of the business itself have somehow become conflated.
I mean: shareholders are nothing more than a provider of financing. In general, they are not the entrepreneur that started the business. To be honest, there is no real difference between a shareholder and the bank providing the company with a loan.
In fact, the only difference between them is the order in which the bank and the shareholder will be repaid if the company decides to liquidate.
So why should shareholders get this sacrosanct position in the hierarchy of goals?
They shouldn’t. After all, if shareholders don’t like the return they’re getting, they can just sell their shares and take their money elsewhere. Shareholders (especially of listed shares) are some of the most mobile stakeholders in a business.
What Is The Goal Of A Business?
A business, at its core, is an organic combination of labour, capital and intellectual know-how working toward the provision of some kind of good or service. Think of it as a node of livelihood, like a watering hole in the centre of a nature reserve.
An ecosystem grows around it:
- Customers – who are often dependent on the product for their business and/or way of life.
- Suppliers – who are dependent on the business for their business.
- The labour force – who are dependent on the business for their wages
- The families of the labour force – who are dependent on the breadwinners
- The labour force of the suppliers and customers – who are dependent on the continuation of those businesses which are in turn dependent on the business continuing
- The families of the labour forces of suppliers and customers – refer to point 4.
- Providers of finance (shareholders and creditors) – who are wanting a return.
To be honest, I think that the perfect business is one that economically breaks even. And bear in mind that “breaks even” is not a synonym for “makes no profit”. “Breaking even” includes a reasonable profit for shareholders (which compensates them for the money that they put in), just like the concept of “breaking even” includes enough money to pay interest on any loans.
And this is not an ethical point: the emphasis is on sustainability. When you elevate the goals of a small group of interested parties/stakeholders, what you end up with is a breaking down* of the ecosystem. It’s why I dislike Trade Unions so intensely – they are just as guilty of elevating the interests of the few over those of the many.
*Excuse the pun.
The point is: I think that there is a paradox at play here. Shareholder value is not maximised when shareholder value maximisation is the explicit purpose of a corporation. That principle is a short-term one. Long-term shareholder value is maximised when the explicit goal of the business is cognisant of all interests (I think that the term for it is “shared value”).
It’s just something to think about.
And if you want more on this, I’ve written two posts about it previously:
Alex F.W. McCall November 6, 2013 at 13:50
Broadly-speaking, King III envisages the inclusive stakeholder approach, which sees companies as representing the collective interests of stakeholders over and above the shareholders (including employees). Although it is not a legislated requirement, companies listed on the JSE are by and large required to comply with King III on a “apply or explain” basis by virtue of the Listings Requirements. Private companies are not required to apply the principles of King III (although this is best practice from a governance perspective and is certainly recommended to the extent possible in the particular context). However, the common law in South Africa still views the interests of the company as synonymous with that of the general body of the shareholders – a view that may be somewhat archaic. Ultimately, it does seem that our company law is moving towards the sustainable, inclusive stakeholder approach – indeed, one of the stated over-arching principles informing the new Companies Act, 2008, is “to reaffirm the concept of the company as a means of achieving economic and social benefits” etc. I think we are well under way in a mind-set shift, at least as far as the more well-governed listed companies are concerned.Reply