What is a company for?

What is a company for?

(An Essay on the Purpose of Companies)

‘Whereas, previously, the actions of companies could have devastating consequences for their customers, suppliers, employees and investors, now they can destroy economies, societies, communities – and even species. As opportunities for companies seem to increase so do their risk and threats – as do the risks and threat of the company itself! The means of our prosperity is rapidly becoming the weapon of our own potential self-destruction.’ (Colin Mayer)

It is a critical time to revisit the question, “what is the purpose of a company?”

There have been many different ways to answer this question over time

  • A money maker for shareholders
  • An employment mechanism
  • A vehicle for an entrepreneur/founder to realise their vision
  • The creation of a family legacy
  • A tax efficient vehicle
  • A production function – converting inputs of capital and labour into outputs of goods and services
  • A device for diminishing the transaction costs of undertaking certain activities
  • A nexus of contracts between different parties

 

What was the original thinking about the purpose of a company when they were created?

The combination of shareholder interests, contracts, reputation, regulation and state engagement – underpins the structure of economies around the globe. It is within this context that companies developed and matured over time. Companies were created for a number of good reasons. They were conceived of and given birth to at a time of great change and much industrial and economic development. This time was characterised, on one hand, by fragmentation and uncertainty and, on the other hand, by great opportunities and progress. The concept of the company ‘as a separate entity’ come into being to make sense of these two competing tensions. It did so by creating a stable mechanism within which (i) the risks implicit in the fragmented nature of business relationship and the uncertainty of the future could be mitigated whist (ii) the opportunities could be grasped hold of and ‘exploited’ (in the best possible sense of the word). This was probably one of the most significant innovations of the 1700’s and 1800’s – one that has not received the credit due. The creation of a legal entity is something invisible and intangible designed to address the intangibles of uncertainty, relationships and time. The role of the company as a separate legal entity was significant in that it sought to address the incompleteness of the market at that time – and partially solved many of the challenges experienced in the market.

 

In a nutshell, the company facilitated a ‘commitment to the long-term’ that enabled the stabilisation of the inherent set of fragmented contractual relationships to the degree necessary to remove sufficient uncertainty to make the pursuing of opportunities more attractive and achievable. The company exists because markets themselves have clear limits especially where complex long-term commitment is required. In a sense the structure and form of a company imposes a time-based commitment on the various parties or role-players. It does this by facilitating the central control and administration, over time, of the principle costs of operating and managing the vast set of detailed and inter-related contracts and relationships under conditions that often remain inescapably and irreducibly uncertain. The company itself is built upon this set of relationship and contracts that are both implicit and explicit – but these relationships and contracts remain uncertain and often variable or not very specific as they change and adapt over time.

 

In this context the resulting concept of the company was therefore about imagining a mechanism or vehicle for the generation of economic value. As such it comprises a controlling mechanism to facilitate the creation, delivery, and capture of value through appropriate coordination of role players and their relationships. It did this by consolidating or focusing the efforts of these role-players towards a long-term commitment aligned around a singular objective or purpose. The purpose of generating economic value does however come with an important caveat or proviso – that of doing so without inflicting, directly or (as far as is possible) indirectly, a negative impact on the range of stakeholders. In business parlance these impacts are known as ‘externalities’. Society, and law, therefore do provide the company – as a important social mechanism – with a range of important rights and privileges but they also do have, to a comparative degree, the right to demand or require responsibility and obedience to both the law and principles of decency (social or civil norms). The expectation on a company is therefore to add value to all those who engage with it (are impacted by and can influence it). It does so by organising its various ‘parts’ into an effective and flexible whole.

 

The innovation of the company is that the company while being a mechanism for providing commitments to others it ‘stands alone’ and has its own interests, needs and expectations. Its first and foremost objective is not to its shareholders or to its stakeholders but to itself. Its own best interest is to make, develop and deliver things and to service people, communities, and nations. It does this through engaging investors – creditors as well as shareholders – employees, suppliers and communities. In the process, it balances the commitment it makes and the control it exerts over them, and assumes a variety of forms to achieve this. The traditional model of the company – the shareholder orientated corporation  – is one, but only one, such manifestation. The company is therefore in a sense accountable ultimately and primarily, to itself.

 

In summary the company is an innovation that addressed and continues to address three major challenges (i) mitigating uncertainty (ii) coordinating control (iii) imposing long-term commitment. It did this by creating an entity that could house relationships and contracts over time.

 

Where do we stand today?

Companies have been a mechanism for creating significant prosperity and stability in society over the past 200 years. There have been many benefits that have flowed from the creation of the concept and the form of the company. However the means of our prosperity has rapidly/is rapidly becoming the weapon of our own self-destruction – and the destruction of many of the benefits that have flowed from it. Over the past 50 years there has been a tipping of the balance from healthy to unhealthy growth and from a wide distribution of economic value to a narrower and narrower concentration of this wealth. Whereas companies existed to meet a wide range of needs, and did so successfully for many years, they have recently become a vehicle or mechanism that meets a very narrow interest of a  a small grouping of stakeholders – namely shareholders.

 

So what went wrong? How did that which provided such prosperity become the driver of so much damage today?

This all started with one set of legitimate interests, amongst the whole range of interests, becoming the sole focus to the exclusion of other focuses. Much of this shift in thinking started with a single statement by an influential economist Milton Friedman who stated in a paper discussing the purpose of companies (1970) that ‘the social responsibility of business is to increase its profits’. After a fairly lengthly discussion of the obligations of individuals, companies and government Friedman end his paper with the following that is seldom quoted in full “there is one and only one social responsibility of business: to use its resources and engage in activities designed to increase its profits as long as it stays within the rules of the game, which is to say, engages in open and free competition without deception and fraud.” The first, best known, portion of the quote – “to increase its profits” has become the mantra of boards and directors and business schools. While one has to understand the quote of Friedman’s within the international context at the time it has been an extremely damaging focus and also illustrates the importance of ensuring that we do not take any development in business thinking and practice out of context.

 

To generate economic value and initiate the bringing together of the conditions for the business to commence does require an ‘economic seed’ – the provision of capital to fund the start-up and expansion of the business. This funding originates with shareholders and creates the concept of shareholding – those who hold a portion of the entity within which the business operates. The return or reward for providing this initial economic seed or seed capital is an entitlement to a stream of the profits generated by the business – in the form of dividends or a share in the growth of economic value. In a well-balanced system this return would be related to the nature of the investment and tied to a long term commitment to the entity. Shareholding has the longest term perspective or interest in the entity.

 

It has been traditionally argued, especially since the 1970’s and 1980’s, that since shareholders are at risk of losing their investment (or economic seed) and that other stakeholders are protected by contracts shareholders should be able to protect their interests by being provided with control over the entity. This argument has been underwritten by the Friedman doctrine of “maximisation of profits”.

 

There are a number of major challenges to this argument

  • Firstly, it is not true that all the interests of other stakeholders are protected by contract. This has become more evident over the past few decades as the concept of stakeholder has grown. Stakeholders were previously viewed primarily as those involved in the ‘supply chain’ of a business – those providing inputs to the business (suppliers), those involved in the processing of these inputs (labour) and those receiving the outputs (customers). Stakeholders are now viewed as any party that is impacted by the company as it pursues it strategic objectives as well as any party that is able to influence the company in the achievement of its strategic objectives. This thinking is far broader than previously and as a result has to recognise that purely formal contractual arrangements do not make up the relationships of a company with its stakeholders – rather the network of relationships forms a relational geography or landscape within which the company operates.

 

  • Asymmetrical information – the flow of information to shareholders legitimately focuses on the nature of their interest in the company. It is generally ‘investment-based’ information and comprises financial information and results that can be measured against the investment objectives or expectations of the shareholders. It is normally expressed as the combination of dividends and share growth/value that delivers or meets these expectations. Shareholders do not generally have access to strategic and operational information. Access to this information could also ‘cloud’ their thinking as investors. The perspective, and level of detail in various types of company information must be recognised and kept separate in order to facilitate the right decision making at the right level, and over the correct time-frame in business.

 

  • Related to this is conflict of Interest – there is most often an inherent conflict of interest between the narrow investment interest of shareholders and the broader interests of other stakeholders – and also the best interests of the company itself. This is especially evident when the range of different interests themselves are not recognised and dealt within the appropriate time-frames or time-scales. By definition the investment interest of shareholders is a long-term interest – this is why the reporting periods to shareholders are generally annual to allow investors to monitor their 10 to 20 year (or more) investment time horizon. The strategic interest of the company – expressed best as the ‘best interests of the company’ and its strategic vision and objectives (and ‘carried’ by the board of the company) – are best viewed as medium-term, the 3 to 8 year picture of the company. This medium-term vision is designed to deliver long-term sustainable results to shareholder. The operations of the company itself – the implementation of plans and budgets aimed at moving the company towards it medium-term vision (and long-term results for shareholders) is the short-term perspective of management. This provides a clear 12 to 18 month focus for management to pay attention to. The right interests must be matched with the right time frame – as must the information flows and decision making framework, otherwise the conflict of interest becomes unmanageable and too often untenable and destructive.

 

  • The problem of taking collective action. This is simply because shareholders, as individual shareholders or as blocks of shareholders can legitimately have divergent views and opposing investment objectives and expectations. The ability of shareholders to act as a group is often severely hindered by these differences. The result is too often dominant shareholders who act out of line with the rest of the shareholders and impose their own view. In addition, when these specific shareholders also act in difference capacities within the company – for example as a member of the board or in senior management – their views and expectations as shareholders ‘leak’ into these other roles or positions that they hold – shareholder thinking will generally over-ride director and management thinking. This again is often very destructive.

 

So while shareholders do, to some extent, bear risk in their role as ‘assurers of solvency’ they are not the only stakeholders to do so. The truth is that all stakeholders in an organisation are exposed to and bear risks that cannot be protected or mitigated by contract. This is one of the fundamental reasons for the creation of the company in the first place. In addition shareholders are often in the best position to ‘hedge their risk’ through diversification – many other stakeholders are far more dependent on the success of the company than shareholders. Shareholders should therefore not be placed in a position of control within the company.

 

So what is the way forward?

The twin doctrines of shareholder value maximistaion and shareholder control have dominated thinking about companies for too long and have led to some serious imbalances and issues that if not addressed quickly could create further damage. This is illustrated in the plethora of focus areas in governance ranging from executive compensation, growing income inequality, loss of trust , environmental concerns and climate change and ethics and corporate culture. The dominance of these two thoughts has had a fundamental effect on the way companies are structured and operate but they miss the true point or purpose of the company which is to facilitate the generation of economic value in the long-run for all parties involved in it. To deliver this purpose the company must sustain long-term commitments from all stakeholders – ‘these commitments will only endure is it is costly for parties to be opportunistic’ (Meyer).

 

There is a need for opportunities and constraints to be better aligned. Shareholder value maximisation and shareholder control are, at the very most, radically incomplete goals for companies that create a massive opportunity for opportunism. Ethical constraints must be designed and internalised to be effective in balancing these goals with the legitimate expectations of other parties involved in and impacted by the decisions and activities of the company. This must be done even if these constraints seem to be against or in contradiction to the interests of shareholders and are not easy to address.

 

To mitigate the risk of opportunism by any stakeholder all parties must, to some degree, bind themselves to certain ways of thinking and deciding and acting.  To do so requires both a long-term commitment and a level of trust between them. It is also these constraints that form the foundation of a robust governance model for companies. Governing a company is about recognising the inherent continuing tensions between divergent stakeholders as well as the tension between stakeholder interests over time (short, medium and long). Governance frameworks and structures must be designed to ensured that these tensions do not tear the company apart – and re-fragment the relationships it sought to unite – but ensure the holding together of these relationships over time. This in essence is what sustainability means – the company surviving and thriving as it generates value over time.

 

The conventional and current concerns about the company (or corporation) are too often focused on incentives, ownership and control – these need to be balanced with a concern, and strong viewpoints on, obligations, responsibilities and commitment. In order to refocus and balance the perspectives and viewpoints about companies three critical conversations need to be held

  1. Reviewing, identifying, clarifying the values of the company – within the tension of obligations and incentives
  2. Unpacking the role and ‘positioning’ of the board to ensure appropriate independence of the board from both the shareholder interests as well as from the operational interests of the company in order to ensure an appropriate accountability between the short-term, the medium-term and the long-term. This ensures a balance between control and responsibility.
  3. Revisiting (and re-imagining) the range of appropriate ‘holding’ rights and responsibilities to ensure the correct balance of power and control over time in the best interests of the company – to ensure sustainability of the company over time and manage the tension between ‘ownership’ and commitment.

 

There are a number of books and papers that have fashioned the thinking expressed in this essay but two in particular stand out the book “Firm Commitment” by Colin Mayer and the paper “Opportunistic Shareholders should Embrace Commitment” by Martin Wolf.

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