Why companies?

Posted by Marc Hodak on May 29, 2007 under Invisible trade-offs | Comments are off for this article

I’m putting together a presentation to a group of board members who requested that I start with some basics about the role of directors. So, I’m starting with the most basic question of all: why do companies exist? This is not a philosophy seminar, and we don’t have time for Coasian details, so I have to get right to the point:

– Shareholders create companies with their investment in exchange for a residual claim to the company’s profits
– Shareholders hire managers with the expectation that they will manage the company to legally maximize those profits
– The board’s job is to oversee management to insure that the shareholder’s interests are put first.

Managers, of course, have a zillion trade-offs to make–supplies, labor, new investment, etc.–in their quest to maximize shareholders’ profits. Even for insiders, overseeing the quality of these trade-offs is a very difficult task, but directors should understand in whose favor those trade-offs must ultimately be made.

For most outsiders, including critics, those trade-offs are invisible. But they still criticize. Business critics at least nominally hold the shareholders’ interests at heart when offering advice about new technology or grand strategy, which are sexy when they pay off, but often don’t. Kodak’s critics, for example, as well as their workers and communities, thought the company’s transformation from a chemical to a digital company was long overdue. Kodak’s shareholder’s blanched. They were content to milk the chemical company of whatever cash flow was left from chemical film rather than take that cash and plow it into something their managers had no clear competence in pursuing. Everybody loves a daredevil, as long as it’s not their baby on the ledge. Thus, “harvesting” is a highly underutilized strategy.

Social critics don’t even pretend to have the shareholder’s best interests at heart. And they hate “harvesting.” They would have us consider owners to be just one of many “stakeholders” for whose benefit the firm should be run. These people see the company not as the product of investment and risk-taking, but simply as a given, something to be milked for their own “good” ends based on some nebulous “social contract.” They advocate for “rights” of communities, workers, etc., competing with the rights of shareholders, supported by cash that would otherwise go to the shareholders. And where they have been most successful, they later complain about the decline of their communities and a lack of jobs.

My job is easier. I just have to help directors do their job.