4 Business Ideas That Changed the World: Shareholder Value

There are four business ideas that changed the world. The debate over how much control to give to shareholders has been going on for many years. The Dutch East India Company, the first firm with publicly traded shares, received complaints from angry stock owners who felt that the company was being run counter to their wishes. Managers and owners would argue over control and ownership.

The idea that maximizing shareholder value takes legal and practical precedence over other things came to prominence in the 70s. The person who did the most to advance the idea was Michael Jensen, a professor at the University of Rochester Business School and later a Harvard Business School professor.

Maximizing shareholder value encourages CEOs and shareholders to feather their own nest at the expense of everything else, according to critics. There has been a backlash against shareholder capitalism and the rise of stakeholder capitalism.

We are going to explore 4 business ideas that changed the world. We will be talking to scholars and experts on the most important ideas of HBR's first 100 years. It's shareholder value this week. Lynn, Mihir, and Carola are professors at Harvard Business School, and they are with me to discuss the issue. The editor in chief of Harvard Business Review is here.

Carola is the historian. You had a boom in business at the time HBR was founded. There were more people in the business. There were more people who owned shares. What was happening between the shareholders and the management?

Let's go further back to set the stage. If you were to go back in time to the 1850s, you would find that every local town had at least one firm that produced almost everything. Setting the stage up to the 1920s is about the economy getting bigger and firms getting bigger. The railroad has changed a lot. These firms need a lot of money. Lots of shareholders are starting to fund these firms because one person can't provide all the financing. The structure of firms has changed from having a single owner to having lots and lots of owners and professional managers.

There is a separation of ownership from control. The people who make the day-to-day decisions for those firms are no longer the same people. In the 1920s, that is how it is. There is a big rise in the stock market. About 15% of households had at least one share by the late 1920s, according to my estimate. They don't have a lot of information about what the firms are doing. We began to see tension between shareholders and management. The stage is set for what is going to happen later in the 20th century.

Lynn, what interests were served by companies then? There was a way to prioritize these interests back then.

It is so fascinating to listen to Carola talk about the rise of the big corporation. There was a debate about who the corporation should serve. The concern was about the power of the capital.

The debate between Columbia Professor Berle and Harvard Law School Professor Dodd was published in the early 1930s. Berle said that managers were the attorneys for the shareholders. Dodd said that managers are trustees of the corporate institution, and they have responsibilities to multiple stakeholders. We didn't have the word stakeholder at the time. He named them as well as the general public.

Professor Berle wrote a book in which he said the argument had been settled in favor of Professor Dodd. Managers were trustees of the institution with more than one responsibility. He says that the debate has been settled for now. It wasn't long before the debate was reopened.

That is really fascinating. As business grows, Mihir, what is happening to the idea of share ownership and the understanding of what power and authority that gives to the shareholders?

I agree with Carola and Lynn that there are great advantages to having ownership. Carola said that it enabled scale. You no longer own your firm and are subject to the decisions of the firm, you own shares of many things. The main issue is the separation of ownership and control. That is a deep problem, and it is worth less than you think.

The degree to which the collective action problem needs to be solved is now being debated. Now we have diffuse owners, that's a collective action problem. Who will be looking at the managers? That is where the problem of corporate governance is today. How do I make sure that the people I have hired to do the work will do the job correctly?

Lynn suggested that it might have gotten settled for some in the ’50s and ’60s. We saw the rise of conglomerates as the nature of economic activities changed. The rise of managerial power is one of the consequences of the separation of ownership and control.

These larger entities are really remarkable. We have forgotten about them, but things like ITT and Gulf and Western, which were able to create empires out of that. ITT started out in a base of telecommunications, but then branched out into Wonder bread, rental cars, and hotels. The underlying premise was that the managers knew what they were doing and they were able to manage capital broadly for their shareholders. People who become worried that shareholders are not being served will react.

I would like to get to that reaction in a second. If I can bring you back. There is an idea that corporations were more paternal than they would be later in life. Lynn said that the companies were more focused on stakeholders than they were on shareholders. Is that an accurate depiction of the time between the 1920s and the 1970s?

Carola Friedman is not completely. There are a lot of forces that are changing that are putting pressure on managers to behave in certain ways. One of the changes that starts putting a lot of pressure on managers is unions that grow larger and become more powerful as time goes on. There was a shortage of labor during World War II.

Many firms have unions at the time. Many firms don't The firms that don't have unionized workforces start doing what they call "welfare capitalism" at the time. Benefits to the workforce can be provided by building cities. They aren't doing it because they think it's the right thing to do They are doing it because they want to prevent the workforce from being unionized in the first place. It's more expensive.

Managers are aware of the importance of maximizing profits and value when they read business histories. Given the constraints at the time, they need to make investments that will raise wages and give other benefits.

Yes,ADI IGNATIUS. Let's go back to the 70s. The idea of shareholder value maximization was set in motion by what happened. Do you want to be the first one to try that?

Sir Desai, yes, definitely. There was some disappointment with the idea of conglomerates. In the early 1970s, there were a number of economic shocks, oil shocks, and inflation, which is what we have today. There were two to three years of very scarring stock returns. It was 20% down after 25% down. People were forced to ask questions about the degree to which companies in their current form actually serve shareholders and are generating enough wealth.

The ability of pension plans to allocate capital forces people to say, "Well, wait a second, maybe we as shareholders, we want a different structure." We have ideas about how shareholders can bediversified. conglomerates should be doing it for them. Maybe these things should be dismantled because of all of this. We may need to take power back from managers in a way that we haven't done in a long time.

ADI IGNATIUS: Yes, Lynn.

Lynn Pina will jump in there.

ADI IGNATIUS, please.

Competition from Japan and Germany is starting to add to the story.

Sir Desai, right.

There was some disappointment with how U.S. companies responded to that competition. I think it was 1971 when the book Directors: Myth and Reality was published. Powerful managers and weak boards of directors were what he found, little more than rubber stamps for their managers. Mihir pointed out that most of the managers were more focused on building their empires than serving their shareholders. Things were not good at the time.

That was also the beginning of the corporate social responsibility movement.

Mm-hmm, mister desai

I don't know if anyone remembers "Nader's Raiders" or "Campaign GM" There was a group of lawyers in Washington trying to get GM to be more focused on auto safety and minority hiring. There was a sense that everything was collapsing. The title of the article was "The Social Responsibility of Business Is to Increase its Profits." I don't know if he's a man or not. I don't know what his thoughts are. He was worried that the ownership and control problem would get worse because of all of the other demands from society.

There was a piece in the New York Times that moved the debate along. We're here. This is a very exciting time for business in the United States and around the world. Maybe I'll give it to you. Where these ideas come from and how they take root can be discussed.

The ideas were always there. In the 30s and 50s, Harvard Business Review articles try to emphasize how the shareholders want to see returns, and what they want is for the company to do well. Some voices are heard here and there. When it comes to the New York Times and Jensen/Meckling's paper, these are very important figures. They caught fire. They explain the problems well. The problem is clear by them.

This gives a clear metric that firms should be maximizing as an objective because of the context that Mihir and Lynn were describing. What is fascinating is that these ideas take hold very quickly. It isn't a discussion on whether shareholders' value should be the objective if you read random articles in the New York Times or Wall Street Journal in the 1980's. It's true. The shareholder's goal is to maximize value.

I want to add one more piece of context because Carola and Lynn already laid out a lot of it. There is a resurgence of classical economics in the 1980's. At a time when people are dissatisfied with what had been a leftward shift in thinking, Friedman and others argue. Reagan is the epitome of that. There is a political context of a rightward shift in the U.S. and the UK.

Mihir, do you want to discuss what Jensen and his coauthor were attempting to fix and what their arguments were?

Mike Jensen and his co-authors threw a broadside against managers and against the idea of managerial power in the article Eclipse of the Public Corporation. He said that public corporations are dead. They are no longer useful for welfare advancement.

It's a very hyperbolic statement. The ability to say, "Well, wait a second, maybe diffuse ownership isn't required" is one of the things he's getting at. Maybe it won't be the same. It will be better because of Carola's issue of incentive alignment.

Managers and owners need to be on the same page when it comes to incentives. The only way to make that happen is to pay managers with stock. The main issue in modern capitalism is the separation of ownership and control. At a time when rightward shifts in politics and disappointment with the economic growth of the ’70s serve as fertile ground for seeding these ideas, this is again.

Lynn, when did you first hear about this concept and what did you think about it?

Lynn Pina remembers it very well. I was at a conference in the 1980's. A graduate student was very excited about his thesis and I talked to him. He told me that he was writing a thesis on the hot new idea of agency theory. I didn't like it very much as I listened to it. Everything he said was not in line with what I had learned.

He told me that managers were the shareholders' agents. An agent is sort of an order taker, whereas a fiduciary is supposed to exercise independence. Judgement on the behalf of the person. A student told me it was for shareholders. You're fiduciary for the corporation and the shareholders, not just the shareholders. I didn't think this theory would go anywhere.

Sir Desai, " (laughs)".

Lynn Pina thought she turned out to be incorrect.

So far.

Carola asked if she could jump in.

Yes,ADI IGNATIUS.

The insight that comes out of these papers is powerful. When we hire managers, professional managers, on their own, they won't run the form to maximize the firm's value. Unless shareholders design the incentives of managers so that they are aligned with the objectives, they will respond to their own personal incentives. That is crucial. The manager will think about her own personal benefits or her own preferences when she makes the day-to- day decisions. Agency costs are the same as other costs. Depending on what we put as the objective in the maximization function, they do not go away.

That is interesting. It is a very interesting argument. Friedman argued that businesses should just worry about making money and that other things would be taken care of if they did that. Jensen and Meckling are trying to find a solution to the problem.

Lynn was a young scholar and had problems with it, but it settled into orthodoxy. For a long time, it is accepted practice, but you talk to CEOs and they say, "Hey, I have no choice." I have to maximize shareholder value or I have to give up my fiduciary responsibility. It's thought to be the only way that CEOs can be responsible. What happened to that? I might ask you to start.

Lynn Pina thinks the point you made about simplicity is important. The idea that shareholders own the corporation is the fundamental idea that it all starts with.

ADI IGNATIUS: Yeah, that's right.

Sir Desai, " (laughs)".

This is a very easy idea. Agency is a very easy idea. The principles give authority to their agents to run the corporation. The premise that shareholders own the corporation is questionable at best. The shareholders don't own the corporation in a traditional sense.

As a shareholder, you are not the owner of the corporation. You don't have to worry about its debts or misdeeds. You are not responsible for injuries that it causes. I can be a shareholder of Apple but I don't have the keys to the building. Whenever I need a phone, I can't pick it up in the store. It is a different concept of ownership than the traditional one.

Mihir Desai is a man.

That theory begins with the fundamental premise. In the 70s and 80s, institutional shareholding was picking up and looking for returns, as Mihir was saying. There was a ready audience that said, "Ah, this can help us," and there was a lot in it for the institutional investors.

That's right, mister desai.

CalPERS was one of the first companies to get involved in shareholder activism in the 1980's. You can see that they were influenced by this theory by looking at their materials. Some of their materials say, "We are owners, we have been asleep at the wheel, we need to wake up and assert our rights." The lobbying power of institutional investors was very strong. This is not just about an idea that people like. There was something happening. Politics was present. There was a lot of power. There was a lot of money to be made from this idea by some groups.

That's right, mister desai. I want to learn more about the rise of institutional investors because I think it's important. There is a change in the way Americans view savings and the way their retirements are funded. The GM pension plan was managed by GM in the 60's. They delegated to the private equity firms and venture capital firms that grew up to manage assets on their behalf.

The idea that our interests need to be served is being crystallized by the new investment management industry. Through the late 1970s and early 1980s, there was a defined contribution revolution that said that retirement savings should be different. There should be portable benefits for us. It makes people think of themselves as investors in a different way.

The mutual fund industry explodes in the 1980's and 70's. Lynn points out that the industry has a reason to spread that idea. Private equity is an asset class. Major asset classes include venture capital. There are a lot of people who are interested in propagating the idea.

How did this affect executive compensation?

It is a significant impact on executive compensation. The idea of stock and stock options aligning incentives is not new. Before the Great Depression, firms used stock and options. Through the ’50s, ’60s, ’70s, the use is very low.

Jensen has another important paper. Kevin Murphy was with this person in 1990. Executives are being paid as bureaucrats. What they mean by that is that most of their pay is fixed. They think that CEOs get $3 for each $1,000 in value that they create. The claim is that they have no incentives to work hard or do right by the shareholders.

The levels of CEO pay go up quickly through the 1990s. A big shift from salaries, relatively fixed bonuses, short-term bonuses, to a very large fraction of compensation comes through stock options and restricted stock. The tax reform of 1993 made it more difficult for firms to pay executives in fixed forms of pay that are not tied to the performance of firms.

The 1990s were the most rapid rise in executive compensation among the largest firms. Since then it has been a lot more stable. Since the early 2000s, there hasn't been such a sharp increase.

ADI IGNATIUS: Yes, the 1990 article is called "CEO Incentives -- It's not how much you pay, but how." I want to know if the idea of shareholder value maximization has influenced corporate systems in other countries.

In the last two decades, we have seen a convergence on both sides. There were stark differences in what the goal was in the early 1990s. Managers in the U.S., as well as the UK and Canada, all agreed that the only goal was shareholders' value maximization.

Managers in Japan were more likely to prioritize stakeholders. The governance of firms in Germany and Japan has been different in the past. The boards of German corporations are required to have labor representation.

The significance of shareholders' value maximization has influenced other countries as well. In the case of executive compensation, the use of equity-based pay was rare in other countries. They became aware of how much it was used in the US.

This is definitely the beginning of the debate over income disparity.

That's right, mister desai.

The idea that the top earner should not make more than 20 times what the average worker makes seems quaint after this explosion of executive compensation. The backlash to shareholder value maximization will be explored after the break. There is a better way to go. We want you to stay with us.

There are four business ideas that changed the world. I'm a person named Adi. It was an era that lasted for a long time. Would you be willing to look at the positives and negatives of this 50 years that we really subscribe to?

Sir Desai, yes, definitely. My approach to this question is to quote a famous person.

Lynn Pina: (mocks).

It is a terrible form of capitalism, but for everyone else.

Carola Frykman: (sighs).

Sir Desai, which is what he said about democracy? There are many problems with it. The ratio of compensation at the top end of the distribution goes to a lot of people at the bottom of the distribution. There was an obliviousness to the central disaster of our time, which is the environmental disaster, and that could have been fostered by focusing on one metric.

I don't like what people have been suggesting as alternatives. The right way to do this is the Japanese way and we need keiretsu's. That didn't turn out very well. I don't think other people would think of the German model as being much different than it is. State capitalism as pioneered in China is going to be the way to go. That will be the victor. These other examples are not easy to understand.

There is concern about income inequality in the country. The last few decades have seen a reduction in global income inequality. That is quite positive. These high-powered incentives have led to the creation of remarkable technological accomplishments. Including in technology that we praise. The idea of incentive alignment that Carola outlined is what leads to this.

There are a lot of problems. I don't think we should give up on the idea of what it has done for us. Alternative models that were heralded during the last fifty years have not delivered.

It seems fair, but we are in a time where a lot of people are unhappy with the shareholder model. Some of the biggest criticisms of maximizing shareholder value are well known.

There are a few short-termisms. CEOs lead companies to the benefit of the quarterly earnings report over the long-term health of the company. Reductions in R&D spending are one of the things that implies layoffs.

Value creation and value transfer are different things. When hedge funds buy shares, they gain an active role on the board, and then they sell. They are not there for the long term. These are some of the most common gripes. Lynn, what are the other negative and positive impacts of this idea?

Lynn Pina said that the era brought in more discipline and focused on efficiency and accountability. The movement woke up a lot of sleeping boards and they became more active. There were some positives to discuss here.

You are talking about maximizing value for the wealthiest Americans when you talk about maximizing value for shareholders. The wealthiest 10% of Americans own the majority of U.S. public company stock. The majority of Americans get their income from their jobs.

Ignatus: Mm-hmm.

In the U.S., wages for lower- and middle-income workers have not increased. The shareholders have done a great job. It will be hard for us to rebuild the fabric of society unless we think of a better way to share the benefits of the system that we have.

Lynn, where is this push coming from?

This idea that a company should be run for the benefit of all of its stakeholders is what we referred to as this idea. The core idea is that one. Most companies define their core stakeholders as their employees, their customers, their suppliers, their partners, communities, and the public at large. That is a group of people.

The idea of strategic management first appeared in the 1960s, but it was in the mid 1980s that it really took off. Over the last decade, it became a popular imagination.

There are a lot of social and economic problems that we have and a lot of environmental problems that we have. If we keep on with maximization of shareholder value, it won't help solve the problems. It is likely that they will be worse.

Some of the Proponents are experienced business leaders. They are making money. They are looking for how to cope with this world that we will inherit. There is a lot that needs to be worked out. I don't think it's as thought-through as shareholder value maximization

It doesn't have that simplicity.

It doesn't have a simple structure. It doesn't have the full theoretical foundation that's there. There is a lot of confusion when it comes to what it means in practice.

I wonder if the shift is real. I think CEO incentives are stock-based and aligned the same way they always were. There are active investors out there. The rhetoric has changed. You will get booed out of the room if you don't talk about stakeholder capitalism at the World Economic Forum. Is there a change in the way we do things?

The younger generation of employees, consumers and investors have different preferences according to Carola. Climate impact is more important for the younger generation than it was for the older one. Firms are responding to these concerns because that is what is best for shareholders as well.

Institutional investors have different preferences. They express their preferences in a different way than they have in the past. Executives are seeing that if they don't respond it will be bad for their firms.

It is a little early to say what the impact will be in practice.

Mm-hmm, mister desai

It has a question mark for me. Lynn said shareholders' value maximization is a very clear metric. It is easy to measure and comprehend. Corporate social responsibility can be difficult to measure in a consistent way or we don't know what the right measure is. There are many different parts. Some of them don't matter as much as others. When we think about investor preferences, they don't all have the same preferences.

That's right, mister desai.

What does maximization of stakeholder value mean in practice? How do they get to know the different preferences of all of these people? I'm worried that the lack of clarity will allow the agency problem to reappear.

Mm-hmm, mister desai That is very interesting Carola. It is true. I think it's true. Compensation is being linked to metrics. People are thinking a lot about it. I think it's true.

My worry is that it will lead to more agency problems. Adam Neumann said in the WeWork filing documents that he was going to be saving the world with his company, but he was actually lining his pockets.

Lynn said that she was concerned about the displacement of political ambitions and political dissatisfactions from the commercial sphere to the political sphere. The political domain is the vehicle for fixing the world's problems. It could include limiting companies from doing certain things. We have convinced ourselves that giving corporations more latitude to do the things they think are right is the right way to approach this problem. That seems problematic and possibly anti-democratic. I believe it is a real movement. It has a lot to offer. There are some real issues that need to be addressed.

It is a funny period where we are looking to companies and CEOs to solve social problems. We need to have each of you talk a little bit about where we are going. I don't want to say 100 years now because that's nonsense If the last 50 years was a sort of Reagan-esque, Milton Friedman-esque, whatever you want to call it, shareholder first, with all the positives and negatives, that's what it would be. What are we going to do? We are entering a phase, what is it? Do you want to?

Lynn Pina feels like we are in a period of experimentation. The old paradigm has changed a lot. We don't have a new one that's ready to go in place. All of these experiments have encouraged me. We are looking for a new paradigm after the old one broke down.

Some of the advocates of a shareholder focused model are rethinking what shareholder value is. Problems can be found with all of them. I think it is great that we are having this discussion and that we should be working on the ideas that are out there.

I don't have a crystal ball I don't know what it will look like in the next few decades. I don't think anyone on either side of the debate wants to go back to the days when companies dumped their pollution into the community water supply in order to maximize shareholder value

Adi ignatius asked Mihir.

Mister Desai thinks that is correct. I agree with Lynn's statements. We are in a very transitional period and it is exciting to see people come up with new ideas.

The power of shareholder value maximization is one of the bedrocks of what we do. Some genuine successes are part of it. I don't think it's about replacing the shareholder value model with a different idea. Legislation may be possible. With a renewed sense of what the state would do, perhaps. I believe that is the best way to go.

I don't know what's going to happen The bedrock will continue to be a form of shareholder value maximization. Hopefully, with more effective curbs on bad behavior. It would be great if there was a more powerful state that could counter the power of corporations. That would be a great place to end up.

Is Carola included?

Carola Friedman agrees with Mihir. Thankfully the corporate form is not dead and I don't think it will happen. The agency problem is caused by the separation of ownership and control. We're aware of it. We can try to figure out how to fix it.

The advantage goes back to what Mihir said in the past. Firms are able to take on riskier projects. That is a big engine for growth.

We see this constant evolution because we know exactly what we maximize and how we address these problems. There has been a lot of back and forth. Slowly, it moves towards progress. That is part of what we are seeing now. The preferences of other stakeholders will be taken into account.

I don't think that's going to replace the shareholders' value as one of the key things that corporations are going to maximize What history has taught us is very interesting. Sometimes we get it wrong. We try something after learning over time. We try to fix the problem. One step at a time.

I have spoken with Lynn and Mihir of Harvard Business School and Carola Frydman of the Kellogg School of Management.

In the next part of the series, we'll look at emotional intelligence. Alison Beard will speak with experts about how to identify and manage one's own emotions as well as the emotions of others. The HBR IdeaCast feed will show that next Thursday.

The person who produced this episode was CurtNickisch. Rob gives us technical assistance. Ian Fox is our audio product manager. Special thanks to Mrs. Hoch for her assistance.

I would like to thank you for listening to the HBR Ideacast. I'm a person named Adi.