Whether meant as a compliment, as an insult, or perhaps more
commonly as some combination of both, Europeans I meet often talk about
American business’ exclusive focus on profitmaking to the detriment of
long-term strategic planning. While this
commentary has grains of truth, it is really only a caricature of American
business strategy, in that it points out the most noticeable features while
underplaying, or completely ignoring, the surrounding context. However, when European businesses set out to
form partnerships with American businesses, although it is not necessary to
perfectly align strategic goals across the Atlantic, it is important to
understand the underlying strategic motivations of potential partners. Without this mutual understanding of
motivations, both parties in any partnership are likely to come away feeling
fundamentally unsatisfied by their experience together.
Background
Through much of the period between the Great Depression and
the late 1960s, American business management was largely guided by the thinking
of Adolf Berle and Gardiner Means in their 1932 magnum opus The Modern Corporation and Private Property.[1] In this volume, which became a foundational
text for American business leaders for almost two generations, Berle and Means
pointed to what was then a relatively new situation, where the immense growth
of publicly-owned companies led to a fundamental disconnect between
shareholders and professional corporate management. The problem with American management as they saw
it was the incredible size and reach of many publicly-held companies. Because of this size, managers could no
longer be substantial equity holders in their own companies, and without
adequate shareholder input and public oversight, these managers were
essentially free to feather their own nests with company profits, while
contributing nothing positive to the societies that their products had come to
dominate. Their prescription for this disconnect
was for the establishment of a social contract of a sort between corporations
and the public. Corporations would work
in the public interest while maintaining transparency surrounding corporate
governance. In exchange, corporate
management would be compensated in proportion to the success of their
businesses.
The practical effect of these prescriptions was that
corporate managers focused their attentions on making their corporations as
large and as stable as they possibly could.
Corporations would diversify among a large number of different products
as part of an effort to mitigate risk to any single enterprise within the
corporation. As long as the corporation
continued to expand, corporate managers were well-compensated.
However, after more than 25 years of unmatched growth in the
American economy after World War II, the deep and enduring recession of the
1970s indicated to many that there was a flaw in the conventional wisdom of
corporate governance. This is where we
get into the modern era of American management strategy.
Shareholder Value
Even before the recession of the 1970s, economists had begun
to question the value of The Modern
Corporation and Private Property as a model for how to run a modern
American corporation. University of
Chicago economist Milton Friedman posited in his 1962 book Capitalism and Freedom that,
There is only one social responsibility of business – to use
its resources and engage in activities designed to increase its profits so long
as it stays within the rules of the game, which is to say, engages in open and
free competition without deception or fraud.[2]
While it took time, Friedman’s theory that business’ sole
role in society is to produce wealth for its shareholders began to gain
traction as the American economy weakened and then faltered, matched by the
seemingly inexorable rise of Japan as a competing world economic power. This notion of shareholder primacy (otherwise
known as “Agency Theory”) ultimately caught fire with the publication of
Michael Jensen’s and William Meckling’s paper, “Theory of the Firm: Managerial
Behavior, Agency Costs and Ownership Structure,” in the October 1976 edition of
the Journal of Financial Economics. In this wildly influential paper, Jensen and
Meckling argued, much as Berle and Means had, that there was a fundamental
disconnect between the interests of corporate shareholders and corporate
managers. However, times had changed
since the publication of Berle’s and Means’ book in 1932. Because corporate managers were typically
compensated on the basis of size and growth, many American corporations had
grown into massive diversified conglomerates.
The benefit of the conglomerate model was that diversification mitigated
cyclical downturns to individual business units, because other business units
unaffected by these same downturns could keep the entire corporation viable
through the difficult times. The problem
with this model, as Jensen and Meckling saw it, was that these diversified
conglomerates were underperforming their potential because things like
efficiency, industry expertise, and managerial focus had been sacrificed on the
altar of growth and stability for its own sake.
Managers were receiving their substantial salaries, while shareholders
(the true “owners” of the corporation) were earning less than they could or
should from ownership of their shares.
Meckling’s and Berle’s prescription for curing this problem
was fourfold.
1.
Managers should be compensated as much as
possible through the issuance of stock options.
Under this scenario, a manager would receive the option to buy stock at
a future date at a value specified as of their issuance date – the idea being
that the more the value of stock rises during the period that this manager
holds these options, the more that manager earns. Additionally, compensation packages would be
designed to encourage managers to retain equity in the company. Together, these pay incentives were designed
to ensure that managers retained focus on increasing shareholder value (through
stock options) and on long-term sustainability (through equity holding).
2.
Corporations should “de-diversify” in order to
focus on their core business. This idea
was particularly attractive to external professional fund managers and
institutional investors because it allowed them to manage their own portfolio
diversity, while allowing corporations to maximize their value by paying their
full attention to their core businesses which they best understood.
3.
Corporations should use debt for new projects,
and should leverage equity for future expansion. In theory, this would allow corporations to
continue to grow – but only where absolutely necessary – while allowing them to
retain cash to reward shareholders with dividend payments. The use of debt was particularly useful as a
signal to potential investors that the company was so optimistic in its future
ability to repay its debts, and that it was so confident in its new projects,
that was willing to take the risk of new debt.
4.
Corporations should expand board oversight by
bringing in independent members who are not beholden to current
management. Smaller, more flexible, and
more accountable boards would reign in managerial excess, and would ensure that
managers are not taking excessive risks.
Behind these independent boards would be an explicit threat that they could
remove managers if they did not believe those managers were working in the best
interests of shareholders.[3]
While it took somewhat longer to catch on with actual
American managers than it did to catch on with American economists, the Agency
Theory of shareholder value maximization model espoused by Jensen and Meckling
offered a number of substantial incentives over Berle’s and Means’ model. First, it offered corporate managers an
easily definable and measurable strategic goal.
While “growth” and “social benefits” are worthy goals, when designing a
compensation package for executives, they are notoriously difficult to quantify
in any sort of consistent or meaningful way. On the other hand, shareholder
value is an easy goal to quantify, and is an easy goal to manage toward. Second,
fund managers and institutional investors were strongly in favor of this model
for management, and they used their strong influence to reward companies that
followed this management model and punished companies that remained wedded to
the old management model. These outside
actors were attracted by this focus on shareholder value because their own
compensation was based on the increase in value of the funds under their
management and, because of the focus on corporate de-diversification, it
allowed them much greater control over their own portfolio risk profiles.
So dominant is the primacy of the shareholder value model
that when I attended business school as recently as 2003-2005, nearly every
management, accounting, and economics course repeated the mantra that “a
manager’s job is to maximize shareholder value” ad nauseum to the point where I would repeat it in my sleep. So deeply is this management theory embedded
in American popular management culture that, while it is not actually legally
true, even many economists and business school professors who should know
better will say that a manager has a fiduciary responsibility to maximize
shareholder value. While a manager does
have a fiduciary responsibility to manage his or her corporation with the
highest levels of care, competence, and loyalty, that fiduciary responsibility
does not extend to maximizing the value of shareholders’ stock.[4]
Unfortunately, as even Jensen himself has admitted on
numerous occasions over the years, despite its incredible success between 1976
and today, the Agency Theory of shareholder value maximization has been
unevenly applied by its practitioners, ultimately to the detriment of both
shareholders and corporations.[5] While corporate managers have indeed become
compensated largely through the issuance of stock options (with the added
benefit that long-term capital gains are taxed at 20% in the highest tax
bracket, compared to a 39.6% tax rate on other earned income)[6],
while corporations have indeed de-diversified, and while corporations have
indeed turned toward debt-financing for new projects, the measures intended by
Jensen and Meckling to control for excessive risk and managerial malfeasance
have largely been ignored. While
corporate managers are now largely compensated through stock options, few
corporate managers are required by their compensation agreements to carry
long-term equity in the corporations that they manage, nor are they typically
required to return value gains on stock options should share value later fall. This incentivizes managers to manage toward
short-term increases in share value – thus maximizing their current and
near-term earnings – while minimizing the downside potential should this
short-term focus lead to a long-term destruction of value. At the same time, while corporate boards have
indeed become more streamlined, they have typically not maintained the
independence or the initiative to retain control over managerial excess. While the reasons for this are numerous,
perhaps the unifying reason is that the same underlying motivations for
managers to take excessive risk for short-term gain often correspond with the
underlying motivations for board members: the motivation to increase
shareholder value above all else.
Other Models
Just as it had become apparent to many that Berle’s and
Means’ management theories from 1932 had outlived their usefulness, there are
currently movements within academic and professional circles in the United
States to adopt an alternative management theory to Jensen’s and Meckling’s
Agency Theory of maximizing shareholder value.
As indicated above, perhaps the greatest problem with Jensen and
Meckling as implemented is that it sets up a conflict between short-term
investors (including corporate managers, fund managers, and institutional investors)
and the long-term viability of a corporation.
Instead of focusing on maximizing shareholder value, there are two other
management theories that are gaining traction in the United States, and are
worth watching closely.
Stakeholder Value: As originally outlined by R. Edward Freeman
in his 1984 book Strategic Management: A
Stakeholder Approach, a successful corporation is responsible to more than
just its owners (or shareholders).
Instead, in addition to shareholders, a successful corporation is
responsible to employees, suppliers, customers, creditors, government, and
society at large – in the form of the local community, the nation, or even the
world (or stakeholders). This corporate
management model is a reaction to the shareholder value maximization model in
which only shareholders – and typically only short-term shareholders – should
be the focus of corporate strategy.
Instead, the stakeholder value theory posits that a company – and
society as a whole – benefits when shareholders earn reasonable returns on
their investments, when employees receive fair compensation for their labor,
when suppliers and creditors are paid on time, when customers receive a quality
product for a reasonable price, when taxes are paid, and when communities are
bolstered by the income generated by all of these transactions.
While an attractive model, critics see this as a return to
the outdated management theories of Berle and Means with its focus on growth
and social responsibility (although supporters counter that there was nothing
wrong with Berle’s and Means’ model in the first place). However, the simple measurement of cause and
effect that is possible in the shareholder value model is replaced by a much
more difficult to quantify model, in which competing and often contradictory
stakeholder interests must be balanced against each other, leading to
incomprehensibly muddled strategic targets.[7]
Customer Value: All
the way back in 1954, in his book The
Practice of Management, renowned management consultant Peter Drucker wrote,
“There is only one valid definition of a business purpose: to create a
customer.”[8]
What seemed to be common sense in the 1950s has by today become
revolutionary. Indeed, it flies in the
face of Milton Friedman’s pronouncement that places profits above all else –
even above, by implication, customers.
But as the failures of the Agency Theory of shareholder value
maximization have become increasingly obvious – or, as former General Electric
CEO Jack Welch called it, “On the face of it, shareholder value is the dumbest
idea in the world. Shareholder value is a result, not a strategy”[9]
– managers and economists have returned to Drucker’s work for inspiration in mapping
a new strategic path forward. If maximizing
stakeholder value fails by not providing a clear enough evaluation mechanism
for success, perhaps what can stand in as a surrogate for stakeholders is
customers. Customer satisfaction and
customer sales are easily measured and, as the argument goes, any corporation
that creates and successfully caters to a market will be profitable. Where customer value maximization overlaps
with stakeholder value maximization is that in order to maintain satisfied
customers, qualified and reasonably paid staff must be retained, and suppliers
and creditors must be paid on time. If
this customer value maximization is achieved, then shareholder value is
maximized as a natural result, not as an end in itself. Indeed, modern American companies that are
becoming known for maximizing customer value are spectacularly profitable industry
leaders such as Apple, Costco, and Whole Foods.
From a pure corporate governance perspective, while shareholder value
can be (and regularly is) manipulated and financial projections can be (and
regularly are) “gamed,” customer value is impossible to fake.
Conclusion
This blog was neither meant to be a comprehensive history
lesson in management theory in the United States over the past century, nor was
it meant to be a polemic on the advantages of certain management theories over
others. However, this decades-long
debate over the purpose for which corporations are formed, in whose interests
they are managed, and how best to motivate corporate management to work to
their corporations’ greatest benefit, has real-world implications for how your
American partners will relate to you and to your product or service. If your own management culture conflicts
fundamentally with the management culture of your American partners, rather
than assigning that conflict to simple greed, it is helpful to consider the very
real theoretical underpinnings of the choices they are making. Your American partners’ strategic goals may
be different from your own, but those strategic goals nevertheless make sense
in the particular environment in which they operate.
For more information on how Geyer Global Partners can help your business to "Go Global," visit our website at www.geyerglobal.de.
For more information on how Geyer Global Partners can help your business to "Go Global," visit our website at www.geyerglobal.de.
[1]
Berle, Adolf and Gardiner Means. The Modern Corporation and Private Property
(2nd Edition). Harcourt,
Brace and World, New York: 1967.
[3] “Theory
of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” by Jensen,
Michael and Meckling, William. Journal
of Financial Economics, October 1976.
[4]
“The Shareholders vs. Stakeholders Debate” by H. Jeff Smith. MIT
Sloan Management Review, Summer 2003.
[5] “CEO
Incentives – It’s Not How Much You Pay, But How,” by Michael Jensen and Kevin
Murphy. Harvard Business Review, 1990.
“An Early Advocate of Stock Options Debunks Himself,”
by Claudia H. Deutsch. The New York Times, April 3, 2005.
“Interview with Michael Jensen,” by Donald Chew. The
American Finance Association, April 25, 2010.
[6]
“Tax Law Changes for 2008-2017.” Kiplinger’s,
March 2009.
[7]
“Can the Dumbest Idea in the World Be Saved?,” by Steve Denning. Forbes,
November 27, 2012.
[9]
“Welch Condemns Share Price Focus,” by Francesco Guerrera. Financial
Times, March 12, 2009.
