Sunday 20 October 2013

Is maximising shareholder value a good enough purpose for being in business or has it ended up slowing progress towards something far more nobler?

I was having a conversation with an entrepreneur (based in the middle-east) and was attempting to understand his rationale for having chosen entrepreneurship after many years of ‘corporate servitude’. He gave me a number of reasons for becoming an entrepreneur but I did not get the feeling that he got into business with the intent to "maximise his return on investment." Being profitable was definitely part of his agenda as he had to substitute the salary he had foregone but he also placed emphasis on philanthropy on his part. I must concede that such flexibility is far easier for an entrepreneur but very difficult for a listed company’s board of directors to undertake without being questioned on the 'perceived' trade-off between softer intangibles (i.e. ‘social benefits’) vs. hard tangibles (i.e. ‘economic benefits’).

My own experience coming from the background of a family owned business (but working in the corporate world) finds resonance with Ajaero Tony Martins who highlights – “I am sorry to say but when it comes to starting and building businesses, those with money as a primary aim are majority. Everybody wants to be the next Bill Gates or John D. Rockefeller. Whenever I ask an entrepreneur the question: “Why do you want to start your own business? The usual answer I get is, “I want to be my own boss and make a lot of money.” Please I want to clearly state that there is nothing wrong with making money alongside building your business but the wrong comes when making money becomes your primary aim.”

I was then struck by the incongruity of this as one of the precepts conditioned into the mind of most students of management is that the goal of an organisation is to maximise shareholder value, therefore, ensuring that economic benefits are always valued over social benefits! When I mentioned this to another entrepreneur (who owns a franchise for a fast food brand) he smiled and mocked - “That is like saying that breathing is the purpose of life. Being profitable and having a positive cash-flow are the basics of any business unless it is a non-profit but even they must recover their costs and not run at a loss!. An entrepreneur better pay off what he has borrowed fast so that they can enjoy the fruits of his or her labour!”

I then thought of the parallel with a listed company that has a multitude of share-holders. These investors buy shares and if a company is not delivering optimal returns then the directors of the company come under tremendous pressure to deliver on the fundamental notion of maximising shareholder value implying that “the ultimate measure of a company's success is the extent to which it enriches shareholders.” Such enrichment takes two forms, through the constant pay-out of dividends and the on-going rise in price of the value of shares held by an investor. But how does this purpose inspire employees? As David Langstaff cautions – “If you are the sole proprietor of a business, do you think that you can motivate your employees for maximum performance by encouraging them simply to make more money for you? Of course not. But that is effectively what an enterprise is saying when it states that its purpose is to maximise profit for its investors.” I must point out that along the way corporations have aimed for a balance by linking senior management remuneration to share price growth and other financial metrics that boost dividend and share price. 

When I first came across the concept of the stock market I realised that the fundamental intent to invest in an organisation is what drives an investor in the market but as I got exposed to shares and options for management I was faced with a dilemma (which all entrepreneurs will relate to) what behaviour would a management team display when they find that they are getting shares that provide tremendous upside but negligible down-side! Where is the true essence of risk? Most companies have worked on this element to ensure that managers feel the hurt to their wallets but the 'opportunity cost' of losing an upside for a manager cannot compete with the actual cost of loss to a true investor and an entrepreneur. So now comes the real test of this attempt to create entrepreneurs of managers – “Whose money is really being lost?” or "Is any money being lost?"

The goal of offering shares and options to managers (and also to key or selected employees in most companies today) is driven by three primary reasons. First, to retain employees; secondly, to provide incentive remuneration that inflates the market value of the overall remuneration offered (making it more attractive than that offered by other employers; and thirdly, an attempt to identify optimistic employees to remain with the firm (as they would believe that the value of their shares/options will go up and perhaps have some linkage to employee engagement with key talent?) The entire basis is to ensure that the organisation mitigates for agency cost and to keep the focus on actions that are in the firm's interest. [An agency cost is an economic concept concerning the cost to a "principal" (an organisation, person or group of persons), when the principal chooses or hires an "agent" to act on its behalf. Because the two parties have different interests and the agent has more information, the principal cannot directly ensure that its agent is always acting in its (the principals') best interests]. Clearly there is a lot still left out despite these attempts otherwise why would shareholder activism be needed for those organisations where a model to manage agency costs exists! My own opinion is that most shareholder activism is driven by a select few who feel entitled to represent the vast majority who would otherwise remain ‘mute spectators’ but at the heart is crass capitalism (apologies if this is a bit harsh!). Everyone wants their pound of flesh; some in “earthly” terms and the typical “shareholder activist” in “jupiterian” terms where 1 pound would be equal to 2.3 pounds in weight (but not necessarily volume)!].

Testifying to the Committee on Science and Technology at the U.S. House of Representatives Professor Margaret Blair clarified on the matter that the purpose of an organisation is NOT to maximise shareholder value – “What I hope you will take from my testimony today is that this claim is, at best, a misleading overstatement. At worst, this claim is simply false, but is often asserted as a weapon to try to persuade corporate managers and directors that they should take actions that benefit particular shareholders of a given corporation, regardless of whether those actions may impose high costs on creditors, employees, the communities where corporations have their operations, or other stakeholders, or sometimes even on the long run ability of the corporation itself to compete effectively for market share, or to develop the next technology.”

So now I am a bit confused but let’s come back to the point of how an entrepreneur views investment by others in his firm. In most cases, he would view it as a loan and most likely be personally liable whereas in the case of a company establishing personal liability to any employee or even director is an impossible task. So when someone says that the goal of an organisation is to maximise shareholder value you must wonder out loud as to why that would be critical unless shareholders have engaged in opportunistic behaviour by buying or investing in over-priced shares and paid the price of their eagerness when the buying price fell below the prevailing price at which the market bought from them. In fact, the only time shareholders are actually owed anything is at the time of bankruptcy when assets are being liquidated and the shareholders “share” is being settled after the residual is ascertained.

As I tried to make sense of the academic bias towards economic benefits that was engrained in me I realised that we have progressed to a point where everyone accepts that maximising shareholder value is the only primary objective without realising that the fundamentals driving this objective are not aligned with where we find ourselves today particularly for those organisations that are constantly restructuring or realigning and hence not able to deliver ‘optimal returns’ (as a proxy for maximising share holder value!) and where constant change has weakened the employee employer contract and had negative impact on employee engagement, job satisfaction and organisational commitment and this chase can also contribute to why CEOs in Fortune 500 companies last 4.6 years (on average) in their jobs with many high profile CEOs not even completing 3 years or leaving abruptly (and leaving succession and general planning in abeyance!).

The most critical question (which I intuitively believe in) comes from Steven Pearlstein and though the context is the American worker it still resonates for the global working class  – “These days, in fact, economies have been scrambling to explain the recent slowdown in the pace of innovation and the growth in worker productivity. Is it possible it might have something to do with the fact that American workers now know that any benefit from their ingenuity or increased efficiency is destined to go to shareholders and top executives?”

So are there any answers that come to my mind? Frankly, none! Attempting to make a change seems destined to be thwarted by the deep rooted reliance on maximising shareholder value and the reality that any attack on this notion will be deemed as an attack on shareholders and the basic fundamentals of the stock market! In simple terms, we have got used to the notion of subverting the future by addressing the short-term. Is it really that difficult for a listed corporation to pursue a more elaborate purpose that focuses on the long-term and de-emphasises maximising shareholder value? 

In the long run, how does one address this situation? Clearly the path of being the master of your own destiny i.e. being an entrepreneur does offer some hope but of course at tremendous personal risk and as the old adage goes – “water flows in the direction of least resistance”, therefore, talent will keep going to the large listed corporations as there is too much at stake at a personal level in becoming an entrepreneur. 

Look forward to hearing from the reader on whether we may have lost our way in the process of maximising shareholder value or is my sense of alarm misplaced?


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  2. Maximizing share holder's value, to me, is conducting a business in a responsible manner. Its only fair that the business strives to create wealth to its promoters. Isnt that what a business is for, anyway?
    There are several examples of how, when rightly pursued, this strategy can lead to value creation (I define value as a product/service/solution/process for which a customer would pay for).
    However, some corporations have pursued this objective as the sole objective of their success. Herein lies the issue you have pointed out in your blog. Just as in any other aspect of life, every objective has to be balanced with other competing dimensions and also controlled through defined boundary conditions.
    Such companies see maximizing shareholder profit as value creation. At the heart of value creation lies the identification of a target customer set and creating a product/solution that fulfills a specific need. In fact, relentless focus on value addition to customers and structuring an organization to meet to customer needs has been the only time-tested and proven way for maximizing shareholder return.
    Unilateral focus on this pseudo-value creation concept of shareholder returns has, in many cases, destroyed the capability of an organization to create value to its customers and to the society overall. In pursuit of the this 'holy grail', some companies are put on growth steroids and balance sheets make overs which include reduction in R&D spend, reduction in personnel even in areas where they need to stay invested, resulting in the company to loose relevance in the market place over a longer time period. Typically, either the company sells out to a bigger corporation or has needed to take drastic steps to re-establish relevance in the market. Need I quote examples of such companies: There are a plenty, including our very own HP after the strategies followed in 2007 – 10