Monday, December 2, 2013

Shareholders are Non-Value Added

I never thought studying for an MBA would turn me into a socialist but that's exactly what it has done. I'm impressed with how most fields of business focus on the customer and on treating employees as an asset, and even more by the focus on the system, rather than individuals, as the source of a company's problems. Deming's 14 points in particular strike me as a good way to run anything.

However, as one of my professors has said regularly most companies are badly managed (and some research has backed up his statements) and we will be spending most of our careers pointing out common sense. Most owners and managers remain bound up in cognitive biases, fundamental attribution error appears to be particularly rife in business types.*

Yet, our system has developed a broad set of institutions that serves to increase the power of owners and managers at the expense of other stakeholders. Companies should be focused on their primary stakeholders, employees and customers, but instead they are beholden to their owners who are continuously draining off funds that could be more productively put to use by the company or distributed to the employees who contributed to the company's success and have a far more direct stake in a company's mission than its owners do. The one field taught in my MBA program that diverges from the focus on customer and employees is finance, which explicitly endorses the purpose of the firm as maximizing the current value of the firm's stock.

This results in the most important institutions in our society, private corporations, having a goal that is often at odds with the health and wealth of society as a whole. Companies focused on their customers and employees will have interests that line up very naturally with those of society as a whole, this is far less likely with owners. The malaise effecting America, and much of the rest of the world, has at least some of its origins in the fact that the conflict between owners objectives and companies' missions was decided in favor of the owners; with predictable impacts on corporate success and on income inequality.

Reforming this doesn't seem overly difficult, though it is in direct conflict with the increase in shareholder power which has been occurring since the 1980s as a result of the Friedman doctrine.** All that is really necessary is to change the rules governing corporations so that firms can purchase themselves through stock buybacks. As it stands, buybacks do nothing but concentrate ownership, but there is no good reason the stock should become inactive. A cultural change is also necessary, we are biased in believing companies should be owned, but there is no real need for a company to be owned by anyone.

Rules for composing corporate boards of unowned companies would have to be drafted, but this should be easy enough since their primary stakeholders, customers and employees, are readily identifiable. Boards composed this way would result in companies that have their interests aligned with society as a whole, and incidentally matching up with modern business best practices of having a focus on the customer and on their own personnel. This would also resolve the conflict between stockholders and other stakeholders how it should have been resolved decades ago, in favor of the other stakeholders.

None of this is to say that capital should be shut out. Capital does add value, where I find it problematic is in mature companies where the stock price has become disassociated from any need to raise further capital. Where capital plays a role is in financing start ups and long term projects. The life cycle I imagine is one where venture capitalists and other investors primarily play a role in the early phases of corporate growth. As a company matures it returns the initial investment to stockholders through the form of share buybacks, eventually getting a 51% stake and freeing itself from outside ownership. Provided this becomes an explicit corporate goal it should be easily achieved.

While this is a utopian pipe dream, it's unlikely for cultural and not institutional reasons. For whatever reason Americans have powerful beliefs about ownership and don't seem to be able to shake out of these beliefs even when performance is lackluster. Institutionally, we know that finances tend to shift powerfully in response to even small relative incentives. To achieve corporate independence on a national scale all that would be necessary would be a fairly small tax advantage to encourage firms to compensate their investors through share buy backs rather than through dividends and other means. Most investors are fairly neutral in the form their returns take so provided they don't object on cultural and ideological grounds (which is likely) it shouldn't be difficult for firms to free themselves of the tyranny of ownership.

Unfortunately, other than a very small movement in favor of employee owned firms*** I haven't heard much on this subject. However, like Deming, I believe that systems matter and that systems are responsible for the majority of faults in any organization. Treating the world economic system as this kind of organization I believe that 3rd party ownership is one of the fatal flaws at the heart of many of our social problems. Ending this problem wouldn't be difficult but it would take a revolution in how we think about our economic system. Perhaps momentum will build, this is perfectly congruent with everything I have been reading outside of finance texts with modern business thinking.

[Lest it need be added, while I think freeing firms from ownership is clearly socialistic I see even more problems with state ownership than I do with ownership by investors. Organizations function best when they are independent, while this is a socialist program the state has no role other than in changing institutions to allow for this. I'm going on a tangent but I am very frustrated at how often socialism is confused with the state when the state has nothing to do with socialism in theory or often in practice.]

*I personally believe that this is a large cause of widening income inequality. Compensation seems powerfully skewed towards proximity to ownership and the ability of owners, and the managers beholden to them, to decide on compensation appears to play a large role. Fundamental attribution error leads the people with control over finances to overcompensate those they are personally familiar with far out of proportion to the relative productivity of those within the organization. This error leaves them unable to see that it is the organization itself responsible for the productivity and that the gains should be more evenly distributed throughout.

** I'm aware of the strong theoretical arguments in favor of stockholders maximizing both company and broader social values as a result of market forces. The theory is strong enough that in the 70s and 80s I would have thought it an experiment worth trying. Today, it appears to have been disastrous. American companies have weakened, not strengthened, as management has restricted their view of stakeholders closer to stockholders only. With the exceptions of finance and extractive industries (oil, gas, metals, etc.) the companies that are doing better seem to be mostly those who defy this doctrine and have become more expansive in their missions. The basic problem is that people are just not set up psychologically in a way that allows stock price maximizing to work, it skews power towards owners and owners have interests which conflicts with the firm itself. In a world without fluid capital markets stock price maximization might work, but where individual companies are simply a small part of a portfolio occupying a certain segment of that portfolio the doctrine damages everyone but owners.

*** Current rules have the flaw that corporations need to be owned making emancipation of corporations far more difficult. Current systems involve union ownership, employee stock purchases, or ownership by employee pension or retirement plans. This is unnecessarily convoluted, it would be easier and more intuitive to simply free firms from ownership entirely so they can go about fulfilling their mission and obligations to customers and employees independently. After all, the Supreme Court long ago decided that corporations are people why then should it be required that someone own them?


  1. Hey Tz! Your posting is similar to an idea I had for reform where instead of being given stock that will eventually be bought back, investors would receive debt in the form of bonds or something along those lines; we could then forbid corporate ownership entirely. (Obviously there would be a transitional period here that would need to be worked out.)

    How do you think that would work out compared to the idea you proposed?

    1. I think overall it would work out similarly for large companies, provided we ignore a rough transitional stage. I was just trying to minimize the disruption that any change would make. All I'm really proposing is that shares bought back remain active with the company itself receiving the voting share and then some legislation regarding the composition of boards of companies that own themselves. This wouldn't really disrupt current business practices at all, everything would carry on more or less as usual.

      The trade off would be that groups that don't want to sell, like the Walton's ownership of Walmart, would remain in private hands. Personally I regard this as a plus, I like competing systems and would rely on the market to sort out whether or not independent corporations are really a superior form of organization. Data from employee owned firms hints they would be, bringing customers and suppliers onto the board of directors would likely enhance the positive gains further.

      Another factor is that I think traditional ownership is strongly positive in the growth stages of a corporation and would want to maintain this feature. Smaller businesses, basically under 100 employees, also can be managed effectively by direct ownership. I'd want to maintain this.

      What I am trying to rely on is that people prefer working with their incentives aligned with doing a good job. While people will work to what their incentives are, even if this results in poorer performance (and in my experience is perhaps the greatest source of low employee morale), given the opportunity they will work to change those incentives. From talking with some managers affiliated with the business school I've gotten the impression that many feel that the need to pay attention to stockholders is a strong negative to their businesses. Institute a reform to allow them to use profits to free themselves from shareholders and I believe they would do so. They'd rather answer to employees and customers than a third party and they recognize that this aligns perfectly with management best practices.

    2. Thanks for taking the time to respond with your thoughts! :-)

  2. Replies
    1. I hadn't heard of Mondragon before. Very interesting. I like employee ownership a lot, but with the low share of compensation in the form of wages in the US I think it unlikely that employee ownership will become widespread. My main goal is to give managers an incentive to buy out shareholders and to then bring employees and other stakeholders in through the back door. I believe most managers would prefer to answer to stakeholders with interests better aligned with good business practices than they do shareholders.

    2. One of the main problems you are facing is the multinationals and their ownership structure (arab owners and japanese ones or what not) and the banking system that has captured the polity and is mainly in rent seeking mode nowadays.

    3. I don't seriously see this happening on less than a generational scale. I certainly don't have any influence to push it. The only mechanism I can rely on is that managers don't like answering to shareholders and that modern business best practices emphasize flatter organizations and taking multiple stakeholders into account which contrasts sharply with the old emphasis on ownership. By making this an optional process, though, I do mitigate the problems with foreign owners.

      Also, Japanese keiretsu are a partial inspiration for this so I'm not sure the Japanese would be a problem. The distance from shareholders appears to be an advantage, though this structure has problems of its own.