Shareholder value

During the 1970s, there was an economic crisis caused by stagflation. The stock market had been flat for nearly 12 years and inflation levels had reached double-digits. The Japanese had taken the top spot as the dominant force in auto and high technology manufacturing, a title historically held by American companies.[18] This, coupled with the economic changes noted by Mizruchi and Kimeldorf, brought about the question as to how to fix the current model of management. Though there were contending solutions to resolve these problems (e.g.Theodore Levitt's focus on customer value creation and R. Edward Feeman's stakeholder management framework),[19] the winner was the Agency Theory developed by Jensen and Meckling.

Mark Mizruchi and Howard Kimeldorf offer an explanation of the rise in prominence of institutional investors and securities analysts as a function of the changing political economy throughout the late 20th century. The crux of their argument is based upon one main idea. The rise in prominence of institutional investors can be credited to three significant forces, namely organized labor, the state and the banks. The roles of these three forces shifted, or were abdicated, in an effort to keep corporate abuse in check. However, “without the internal discipline provided by the banks and external discipline provided by the state and labor, the corporate world has been left to the professionals who have the ability to manipulate the vital information about corporate performance on which investors depend”.[20] This allowed institutional investors and securities analysts from the outside to manipulate information for their own benefit rather than for that of the corporation as a whole.

Though Ashan and Kimeldorf (1990) admit that their analysis of what historically led to the shareholder value model is speculative, their work is well regarded and is built upon the works of some of the premier scholars in the field, namely Frank Dobbin and Dirk Zorn.

As a result of the political and economic changes of the late 20th century, the balance of power in the economy began to shift. Today, "...power depends on the capacity of one group of business experts to alter the incentives of another, and on the capacity of one group to define the interests of another".[21] As stated earlier, what made the shift to the shareholder value model unique was the ability of those outside the firm to influence the perceived interests of corporate managers and shareholders.

However, Dobbin and Zorn argue that those outside the firm were not operating with malicious intentions. "They conned themselves first and foremost. Takeover specialists convinced themselves that they were ousting inept CEOs. Institutional investors convinced themselves that CEOs should be paid for performance. Analysts convinced themselves that forecasts were a better metric for judging stock price than current profits".[22] Overall, it was the political and economic landscape of the time that offered the perfect opportunity for professionals outside of firms to gain power and exert their influence in order to drastically change corporate strategy.

Within the 80's and 90's, numerous companies faced lawsuits from current and former employees alike for reducing or withholding workers from accessing benefits in the present or during retirement. The SV model has led to reduced pension support as a means of maximizing profits at the cost of the employees. Some companies have switched matching pension plans monthly to once a year.[44] Critics remain alarmed at the nature of cutting out or underestimating the value of the labor a worker produces for maintaining or raising the value of stock. The reduced benefits are attributed to the trend of the corporate world's reduction in investing in non-shareholder constituents because it is not an immediate money producer—the main goal of SV theory.[45]

The aforementioned status of workers faces criticism when looking at how this “reduced pension matching” loophole becomes manipulated. If laid off before the pre-pension matching period is complete, there is no compensation. Furthermore, mass layoffs have affected companies in the home headquarters with many jobs either going overseas or being hired out to contractors from similar positions to those that were laid off for lower benefits and protections as critics and experts have noted.[46] According to economic experts and critics alike, the downsize-and-distribute model invoked by SV theory extracts value and then further ingrains employee instability and greater income inequality.[43][47][48]

In Milton Friedman’s seminal piece advocating for shareholder value titled “The Social Responsibility of Business Is to Increase Its Profits” makes the argument that the business of business is its business. Friedman’s postulation suggests that if social responsibility and profit run counterintuitive, pick the latter. By prioritizing the accumulation of wealth by all means, it uncomplicated other responsibilities that may have a hindrance to achieving this goal. Some responsibilities include, but are not limited to: community development, employee investment, worker benefits, research and development, and more. These responsibilities are attributed to being long term and do not immediately satisfy the short term -- and mainstream -- interpretation of shareholder value.[45]

Stock buyback is criticized for its extractive nature which takes profit and uses it to make stocks look more profitable than they might be in the name of shareholder value. In 1982, the U.S. Securities and Exchange Commission (SEC) implemented Rule 10b-18 of the Securities Exchange Act, thus allowing for corporations to buy back stock under certain thresholds and circumstances. With low investigation and consequence rates for breaches, as well as loopholes, this opened up opportunity to legal stock price manipulation. With SV theory incentivizing the shareholder and tying executive pay, the stock price became intrinsically tied with success as critics note. One notable effect of this practice includes reduced investment. From 2003 to 2012, of the 449 firms in the S&P 500, 54% of earnings went to stock buyback and 37% to dividends. This leaves 9% of earnings to go elsewhere, a reduction from the previous rates of investment in past decades.[48] Economists like Lenore Palladino point out the eventual consequence when this bubble will burst, the majority of Americans will face the consequence, not the ones leading the firms.[47]

Peter Drucker, author of “The Concept of the Corporation”, makes the argument that shareholder value in fact serves to underplay the important social role which corporations occupy in contemporary society. Drucker states “In the social reality of today, shareholders are but one of several groups of people who stand in a special relationship to the corporation.  The corporation is permanent, the share-holder is transitory. It might even be said without much exaggeration that the corporation is really socially and politically a priori, whereas the share-holder’s position is derivative and exists only in contemplation of law".[49] Drucker's argument is expanded upon by anthropologist Karen Ho, who notes that in the immediate period following the second world war, the corporation existed primarily as a social institution which largely accepted its responsibilities to those involved in its operations outside of shareholders, concerning itself with the longevity and well-being of the corporation as an institution even if this meant undertaking actions that may run counter to the immediate concerns of the corporation's shareholders.[49] This post-war outlook is contrasted by the attitude adopted by management of modern-day corporations, which according to former WebTV CEO Randy Komisar see themselves not as institutional stewards but rather as investors themselves.[49] Critics such as Ho believe that the shift of management attitude towards treating corporations as investments has led to the decline of the corporation as a social entity, and allows corporate management to make decisions that may be against the interests of the corporation's social stakeholders or even longevity of the corporation itself.

The failure of the corporation to readily fit within the neo-classical economic model which dominates contemporary economics academia and policy is a frequently-targeted flaw by critics. Anthropologist Karen Ho argues that the concept of shareholders and subsequently shareholder value was developed primarily for the purpose of shoehorning the insertion of the corporation into the neoclassical economic model, and ignores that the neoclassical model, which was originally created in eighteenth and nineteenth century prior to the proliferation of corporate organization, was never designed to operate with number of inputs the modern corporation requires.[49] Ho claims that advocates of neoclassical proprietorship ran directly counter to the limited-input “owner and property” intentions of influential founding figures of neoclassical economics such as Adam Smith, and that the neoclassical economic model hinges on the idea of the owner-entrepreneur being directly involved in the management and operation of their enterprise. As the modern shareholder typically has very limited or no connection to the regular operations of a corporation they have invested in, the shareholder does not fit within the owner-entrepreneur role required by the neoclassical economic model. Adam Smith himself noted his belief that managed corporations were not viable due to this issue, stating “The directors of [joint stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own”.[49] Critics such as Ho and Smith believe that failure of the shareholder model to accurately represent the key neoclassical owner-entrepreneur concept is a foundational issue of the neoclassical economic model, leading to an inaccurate assumption that corporate interest remained identical to shareholder interest.

A common critique of shareholder value is the mystification surrounding its legal validity. It is often espoused that shareholders are the owners.[50] This status as a shareholder comes with an assumed legal claim of all profits after contractual obligations have been fulfilled and that they have the ability to decide the structure of the corporation on the board level however they want.[50] Yet, none of these are rooted in any law because shareholder value is ultimately a management decision, not a legal requirement. Corporations are their own legal entity and shareholders simply hold shares, making them equal stakeholders to employees, suppliers, and more.[51] They only get guaranteed full access to residual funds in the case of liquidation. Otherwise, the firm has all control of how to do things as they please like investing into the company, raising salaries, etc.[51] And when it comes to the shareholder supremacy over structure, the ability is flimsy and hard to use. The few cases in which legal action can be taken is when a director is explicitly stealing.[51] In spite of the reality of shareholder obligation and abilities, corporate America has convinced itself, according to legal critiques, that there is a legal duty to their shareholders.

In the shareholder value model, companies often take on much more risk than they otherwise would. The acquisition of debt makes the company unstable and at risk of bankruptcy. Plentiful debt is conducive to increasing share value because the company has greater potential to increase value when starting at a lower baseline. This however is a detrimental to the stability of the company.

Debt financing, or the purposeful acquisition of debt, causes the debt to equity ratio of the company to rise. Without shareholder value, this would normally be considered negative because it means that the company is not making money. In the shareholder value system, high debt to equity ratios are considered an indicator that the company has confidence to make money in the future.[54] Therefore, debt is not something to avoid but rather something to embrace and having debt will actually gain the company investors. Taking on large risk attracts investors and increases potential value gain, but puts the company in danger of bankruptcy and collapse.

In order to facilitate an incentive structure that supports shareholder value, the method of executive compensation has changed toward making a large portion of C-suite pay come from stock. The reasoning behind this decision was that it would bring the interests of CEOs in line with those of shareholders.[45] As a result of this decision, executive compensation has skyrocketed, quadrupling from the rate of compensation in the early 1970s.[44] This change has also shifted the motivations of C-suite managers in the direction of increasing share price over everything else, leaving other goals like long-term growth and stakeholders like employees and customers behind.[55]

The short-term nature of shareholder value theory is one of the features focused on by critics. They argue that this fixation on the short term leads to neglect of more profitable long-term strategies.[46] In this way, shareholder value fails to attain the level of overall capital growth that might otherwise be expected. Given the emphasis on stock price inherent to shareholder value, incentives are created for corporations to inflate their stock price before its value becomes critical for assessment. One such incentive is that the compensation of executives and managers is increasingly tied to stock value through executive bonuses and stock options.[46] Corporations use several gimmicks to increase stock price, perhaps the most infamous being the mass layoffs of employees which creates the appealing image of increased efficiency and lower operating costs, in turn driving up stock price.[44] However, this and other such gimmicks have several negative consequences. Oftentimes, in the wake of mass layoffs, corporations have to refill some of the positions now vacant. This leads to a longer term inefficiency as new employees must be trained and the resources invested into the original employee (provided they were not rehired) are permanently lost.

A related criticism of shareholder value is the reliance on the process of assessing stock, which is itself vulnerable to manipulation and speculation.[46] Speculating on the firm's stock price is in the interest of managers that receive stock compensation and may therefore cause them to focus on speculating on the stock price rather than maximizing real production.[46]

Management experts also cite another criticism of shareholder value's short-term view, namely that it creates a corporate culture more concerned with maximizing revenue than with maintaining relationships with employees, customers, or their surrounding communities.[55]

Business experts have criticized shareholder value for failing to materialize economic growth and increased productivity. Despite decades of research and dozens of studies, there is negligible strong evidence that shareholder value theory has produced better results for businesses (studies that did provide evidence of shareholder value being beneficial generally were not able to be replicated; Stout). Since the inception and widespread application of shareholder value theory, returns on invested capital have steadily decreased.[45] One explanation for this trend is reduced investment in innovation. Studies have shown that publicly traded companies (who have a share price) invest about half as much as privately held companies in the United States.[45] Even shareholders have had disappointing results with poor returns on investment and a reduction in the population of publicly traded companies by 40%.[51]

In addition to reduced growth, critics also point to reduced productivity. Shareholder value can have a negative effect on employee morale as the entire mission of the corporation becomes the generation of wealth for shareholders. Because of this reduction of motivation, corporations need to engage in more top-down and control-oriented management strategies, one such example being the massive rise in the use of non-compete agreements. Despite such efforts (or because of them), low employee morale has negative effects on business. Less motivated employees are less energetic and produce less and are less likely to innovate.[45]

A further inefficiency of shareholder value is the growth of financialization. The financial industry has ballooned in size following the use of shareholder value, largely due to the outsized importance placed upon shareholders by corporations.[56][45] The large financial sector is a drain on the entire United States economy, costing roughly 300 billion dollars per year.[45] This is because the financial sector does not engage in actual production.

The broad idea of "stakeholder value" is the most common basis of alternative frameworks. The intrinsic or extrinsic worth of a business measured by a combination of financial success, usefulness to society, and satisfaction of employees, the priorities determined by the makeup of the individuals and entities that together own the shares and direct the company. This is sometimes referred to as stakeholder value. Stakeholder value heavily relies on corporate social responsibility and long-term financial stability as a core business strategy.[57]

The stakeholder value model is prevalent in regions where limited liability laws are not strong. Some companies, choosing to prioritize social responsibility, elect to prioritize the social and financial welfare of employees and suppliers over shareholders; this, in turn, shields shareholders, the owners of the company, from liability when the law would not be lenient should the company engage in poor behavior.[57]

Despite its high potential social benefit, this concept is difficult to implement in practice because of the difficulty of determining equivalent measures for usefulness to society and satisfaction of employees. For instance, how much additional "usefulness to society" should shareholders expect if they were to give up $100 million in shareholder return? In response to this criticism, defenders of the stakeholder value concept argue that employee satisfaction and usefulness to society will ultimately translate into shareholder value.

Another related criticism is that it is difficult to determine how to equitably distribute value to stakeholders. The question of "who deserves what and how much" is a difficult one to answer.

A company may choose to disregard shareholders completely. A social enterprise instead focuses its objectives on goals other than the profitability of its owners; indeed, the legal body of a social enterprise often precludes issuing dividends to shareholders. Social enterprises require significant investment in financial stability and long-term profitability, in the meantime taking very little risk.[57]

Social enterprises manifest themselves in the UK as community interest companies or limited by guarantee. In the United States, California allows companies to incorporate as flexible purpose corporations.[57]