Bad ideas don’t die just because they are bad. They hang around until a consensus forms around another idea that is better. This is what’s happening now with a stupid idea has dominated American
business for the last four decades: that the purpose of a firm is to maximize shareholder value. The massive problems that this notion has caused for business and society have been documented. Even Jack Welch has called it “the dumbest idea in the world.” Yet it remains the conventional wisdom throughout much of big business. What’s different now is that a consensus is forming around a better idea.
That’s the big news coming out of a recent
report from the Aspen Institutewhich convened a cross-section of business thought leaders, including both executives and academics. The report’s most important finding is that majority of the thought leaders who participated in the study, particularly corporate executives, agreed that “the primary purpose of the corporation is to serve customers’ interests.” In effect, the best way to serve shareholders’ interests is to deliver value to customers.
It’s true that you have to read the report carefully to discover this key development, which is buried in the middle of page 6. The report doesn’t headline the finding because it frames the debate wrongly and suggests a false compromise that misses the main point.
Wrong framing of the debate
The report begins, “Ask someone, ‘What is the purpose of a corporation?’ and you are likely to hear some variation on maximizing profits for shareholders or creating value for stakeholders.”
This is like saying that the debate over climate change is between those who believe that climate change is caused solely by natural causes (a bad idea) and those who believe it is caused by evil spirits (a discredited idea).
“Creating value for all stakeholders” is the idea that preceded shareholder value. It was Milton Friedman who in 1970 argued that corporations had lost their way by addressing the needs of multiple stakeholders—shareholders, employees, customers and the community. He had a point: having multiple unprioritized goals in an organization is like having no goal at all. When there is no way to measure progress, there is bound to be confusion.
Firms had to decide, Friedman said, on what their primary goal was. He proposed focusing solely on profit. He attacked those who thought differently as “unwitting puppets” of forces that were undermining society, and “stealing the shareholders’ money” (along with other unprofessorial invective). The article drew on the ideology of those who believe that unconstrained pursuit of self-interest is always good.
However the choices are not between focusing on profit (a bad idea) or addressing multiple stakeholders (a discredited idea). The intelligent choice is the goal supported by the majority of the study’s participants, namely, to serve customers’ interests. This is essentially the idea that Peter Drucker articulated back in 1973: “the only valid purpose of a firm is to create a customer.”
The goal was further articulated by Roger Martin in January 2010 in Harvard Business Review as “the age of customer capitalism.” Maximizing shareholder value, Martin wrote, “is a tragically flawed premise, and it is time we abandoned it and made the shift to… customer-driven capitalism “ Now in 2014, the Aspen Institute report shows that thought leaders are in fact converging on customer capitalism as a better idea.
By downplaying this development, and framing the debate as one between a bad idea (shareholder value) and a discredited idea (serving stakeholders), the report creates more confusion then clarity.
In fact, the report spends so much time recounting the opinions for and against shareholder value that it never gets to examine the substantive case for (or against) the idea that the majority of the participants actually support, namely, customer value.
A false compromise: “fighting short-termism”?
Instead the report celebrates the “common ground among all participants,” both those who support shareholder primacy and those who reject it. The common ground is said to be that “short-term decision making is the bane of American business and requires remediation to mitigate its most pernicious effects.”
“What we have here,” the report says, “as the warden in Cool Hand Luke said, is ‘a failure to communicate.’” It claims to have discovered “a viable middle ground,” namely, that short-termism is bad.
This is to confuse the fundamental nature of the disagreement between the defenders of shareholder primacy and the supporters of customer primacy.
The substantive debate is not about short-term versus long-term. It’s about whether organizations should operate as money-making machines solely for the benefit of managers and shareholders or as instruments which add value to society.
One is the internally-oriented self-interested perspective whose essence was captured in the movie,
Wall Street, with the phrase “greed is good.”
The other is a morally-grounded externally focused perspective that a corporation’s primary purpose is to add value to those for whom work is being done.
This is not a difference between short and long term perspectives. In fact, when self-interested shareholder-value thinking is applied in a long-term plan to maximize earnings per share, as in
IBM IBM -0.05%’s Roadmap 2015, it is even more self-destructive than shareholder value operating short-term, quarter by quarter, as explained in my article,
Why IBM Is In Decline.
This is not a “he said, she said” debate
Part of the problem with the report lies in its methodology. “Altogether, 28 one-hour interviews were conducted with men and women who hold an important position in one of three areas: a) in an investment capacity (9 respondents); b) as a senior executive in a large corporation (11 respondents); and c) in an academic setting in which the respondent engages in topics related to business issues (8 respondents).”
The result is a report of 28 separate interviews, but it’s not conversation. There’s no evaluation as to whether what is being said makes sense.
It allows the supporters of shareholder value to claim that it has been good for business and society without ever being asked how that squares with the known problems of the shareholder value doctrine, namely:
How The West Was Stung
If you are wondering why so many bright highly educated people have gone along with such a bad idea for so long, you could be cynical and say, “Follow the money.” You could note that in the period 1978 to 2013, while the rates of return on assets and invested capital in US firms
declined by around 75 percent,
CEO compensation increased by an astonishing 937 percent, while the typical worker’s compensation grew by a meager 10 percent. As Upton Sinclair noted long ago, “It is hard to get a man to understand something when he is being paid not to understand it.”
But on a more intellectual level,
Roger Martin has been pointing out the rhetorical tricks that were used to sell this bad idea, namely, by presenting it as a matter of tradeoffs between the interests of shareholders versus the interests of society. Why should shareholders get anything less than 100 percent of the benefits of the business’s success?
“Friedman won the way a great debater wins,” says Martin, “by cleverly framing the terms of the debate… Because Friedman was so inflammatory in his call for a 100 percent versus 0 percent handling of the trade-off, his entire opposition …has focused on making arguments for a number lower than 100 percent for shareholders. In doing so, they implicitly… accepted Friedman’s premise that there is a fundamental trade-off between the interests of shareholders on the one hand and other societal actors such as customers, employees and communities on the other hand. Ever since, the Friedmanite defense has been to force the opposition to prove that making a trade-off to any extent whatsoever against shareholders won’t seriously damage capitalism.”
“Had the opposition been cleverer, it would have attacked the premise from the very beginning by asking: what is the proof that there is a trade-off at all? Had they done so, they would have found out that Friedman had not a shred of proof that a trade-off existed prior to 1970. And they would have found out that there still isn’t a single shred of empirical evidence that 100 percent focus on shareholder value to the exclusion of other societal factors actually produces measurably higher value for shareholders.”
In fact, all the evidence that we have since 1970 points the other way: shareholder primacy has been a financial bonanza for the C-suite (the very problem shareholder primacy was meant to solve) but a disaster for the long-term interests of the firms themselves, their shareholders and society.
“If [corporations] make it their purpose to maximize shareholder value, shareholders are likely to suffer because that cravenness turns off customers, employees, and the world in general. If they make it their purpose to serve customers brilliantly, be a fabulous place to work, and contribute meaningfully to the communities in which they operate, chances are their shareholders will be very happy.” The key is to see that it’s not a tradeoff.
“No long-term schism”?
The other rhetorical trick that Roger Martin has identified, by which economists defend shareholder primacy, is to say that in the long term, customer value maximization and shareholder value maximization converge. So there is no long term schism. Thus shareholder primacy is, the argument goes, perfectly reasonable because it will cause enlightened management to make decisions that are good for everybody; today’s stock price is a perfect representation of the future cash flows of the company so using it as your measure of progress toward long-term shareholder value is legitimate; therefore, stock-based compensation, quarterly guidance, and so on, all make sense. QED.
The fundamental flaw in this argument is brought out by the example of IBM, which no one can accuse of being short-term in its focus on shareholder value. For almost ten years, IBM has,
through Roadmap 2010 and Roadmap 2015, been relentlessly focused on increasing earnings per share and so increasing its stock price, by whatever means necessary.
The result? Relentless cost-cutting, automatic culling of more costly experienced staff and a resort to cheaper expertise, declining technical competence, stifling bureaucracy and increased rigidity caused by the effort to make fixed earnings targets no matter what, an inability to innovate and a consequent reliance on acquisitions rather than innovation, resort to financial incentives to induce performance, plummeting staff morale, an imploding business model and a broken future strategy.
As revenues fall, IBM’s higher earnings targets are met through relentless cost cutting, tax reduction gadgets and share buybacks funded by borrowing. While IBM’s share price soars, as the top managers and big investors extract cash from it in a weird kind of reverse-Ponzi-scheme, IBM steadily becomes an increasingly unproductive shell, a mere shadow of its once truly-innovative self. As a triumph of financial engineering, IBM “makes money from money,” while its future is being systematically destroyed. How many more of such disasters will we have to witness before the shareholder primacy idea finally dies?
The death throes may be long and painful
A year ago, in response to a question, I
offered a forecast as to how long it would take for the world’s dumbest idea to die:
“Major thought leaders: end 2014.
All major businesses and business schools: 2020.”
The news contained in the Aspen Institute report suggests that we are on track to achieve the first part of my forecast—major thought leaders will have made the shift by end-2014.
The bigger issue is how to help businesses make the shift and so avoid the economic and financial catastrophe that another six years of pursuing the world’s dumbest idea will cause.
