What Drives All Businesses, and as an Employee, Why Should I Care?
When I was a freshman in college, one of my first business classes was Finance 101, and the first day, the professor introduced himself and started his first lecture:
“The overriding purpose of any business is to maximize shareholder wealth.”
He went on with the rest of his lecture, but I was completely shocked at his first words and just sat there getting angry about what he said. Business is not about satisfying customers? It is not about providing good services or products? It is not about providing jobs and being active in the community? It is not about treating employees fairly and compensating them appropriately?
I was about to raise my hand and put him in his place, as clearly, he was off base here. He must have made a mistake. Or maybe he was an assistant professor (he was young, after all) working on his master’s degree, and he didn’t really understand and misread his notes.
For some reason, I decided to just sit there and continue to be angry. I never did challenge him or talk to him after class about what he said. This just stuck in my craw for the rest of my college career, and I never really agreed with that statement.
Well, it took quite a few years in the business world to really understand this and frame it correctly. It turned out that my professor was on target, but what he said was an oversimplification.
There has been academic research on the over-riding corporate goal of maximizing shareholder wealth, debating all those points I thought about in that class. The bottom line is this:
Companies that do not put ‘shareholder wealth’ or the more in-vogue ‘shareholder value’ as their first priority will eventually get into trouble and likely go out of business.
For public companies, this is a mandate as I will explain below. For private companies, shareholder value may or may not be communicated as the over-riding objective, as individual owners have the right to prioritize whatever they like for the organization. Nonetheless, any owner wants to see a return on the investment they made in owning or partially owning a business, whether that return in regular dividends, or growth and increasing value should they choose to sell the business at some point, or increasing compensation for the owner(s).
Let’s walk through this logically. Let’s say you go to work for a large, publicly-traded company (meaning their stock trades actively on one of the exchanges such as the New York Stock Exchange) and they have been in business for some time. Let’s call them Jones Manufacturing.
Let’s say that Jones takes the approach that the overriding goal for their business is to have completely satisfied customers. So, they focus on that, have success, and grow over time, but find that as they grow, their costs increase and profit margins shrink. Normally companies would raise their prices to cover their cost increases, but since Jones wants customers to be 100 percent satisfied, they cannot raise prices or will see their customer satisfaction numbers fall. So, they continue to see profits shrink, and eventually, they start to lose money; that is, they spend more than they get from customers. Soon, they find that they cannot pay their bills from suppliers, cannot make payroll, and their employees quit, their suppliers stop supplying, and they go out of business.
In reality, well before Jones went out of business, the board of directors would see what was happening, fire the CEO and others on the executive team, and hire someone else to run the company who would change the overriding priority.
Okay, so that example is clear, but why not instead make the overriding priority to take good care of employees, pay them well, train them well, provide pensions and good benefits, etc.? Surely, with great employees, customers will be happy, and the employees will be smart enough to raise prices when costs increase, right? Well, yes, let’s assume they will. But what happens when those great employees demand even more pay because they know that customers are very satisfied, profits are good, etc.
Well, let’s assume that Jones increases their salaries or hourly compensation per the employees’ requests, but of course, that causes profits to fall. Won’t employees see the fall in profits and realize that they need to go back to their old lower compensation? They might understand the need to do that, but most employees see their own part of the company only, do not really understand the big picture, and find it very difficult to see their lifestyle take a hit by having less money to take home. Since the overriding goal of Jones, in this example, is to satisfy employees, they keep paying them more and see profits go negative, since customers will not pay higher prices just so Jones can pay employees more than their competitors. They eventually go out of business. But again, in reality, before that ever happened, the board of directors would question the head of human resources or the CEO, force them to change or fire one of them or both, and hire someone who would have a different belief about employees being the most important priority.
So, maybe we can all agree that profitability is a good thing. But customers don’t really care all that much if the company is profitable, and most employees care more about their job and their pay than the level of company profitability, right? Probably. But why is shareholder value the overriding goal of any business? Simply because any other priority will result, in the long run, in most cases, with the business ceasing to exist. We can all agree that jobs are good, good products and services are needed in society, customers need to be serviced. I think it follows that it is a societal positive for businesses to endure for decades.
But why not have the overarching goal be to generate a reasonable profit, instead of the goal of ‘maximizing shareholder wealth?’ Businesses need profits. Shareholders want to see higher profits because that will mean that their stock is worth more and may see higher dividends paid to them. Businesses need profits to reinvest into their business; otherwise, they have to borrow more and more money from banks, and there is a limit to what a bank will loan a company that does not earn sufficient profits.
Businesses occasionally need more capital than the banks will loan or that they can get from their own profits. In these cases, they only have the option of asking existing or potential company owners (shareholders) for cash, and in exchange, the company gives them additional stock. Would anyone with available cash to invest buy more stock in a company that is barely profitable? Maybe, but most investors would rather invest their capital in a company that is very profitable with great growth prospects, because that stock would then become more valuable in the stock market. They would see a greater return.
Okay, so you are starting to see the link between the importance of wealth of the owners of a business and the overarching goal of the business. How do companies ensure that this overriding goal of ‘shareholder value’ is aligned with the behavior of the management and employees in the company?
This is where the board of directors comes into play. The board of directors, or board of trustees, has the responsibility to represent the interests of all shareholders. In large (and most small) companies, these boards hold tremendous power. Their primary responsibility is to ensure that the CEO/President is running the business in the best way to maximize the long-term wealth of the shareholders, meaning that they are keeping costs under control, treating employees fairly, satisfying customers, and generating sufficient profits. They also assess the rest of the senior management team to ensure that they have the best talent running the company and making good decisions that the shareholders would be aligned to. If not, they have the responsibility (as individual shareholders elect the board members to serve the interests of shareholders) to terminate those executives and appoint someone better.
The board member that does not represent the shareholders well will eventually lose their board seat in the next, or following, election. This whole structure of boards, shareholders, and management exists in all publicly traded businesses, and nearly all privately-held businesses have a board of directors. The structure works well and truly ensures that most companies behave in ways that help ensure that shareholders are getting a solid return on their investment and helps ensure that the company will sustain and continue to be in existence for decades. Shareholders want a good return but also understand that their investment will be worthless if the company goes out of business. So, companies cannot, for example, pay all of their profits out in dividends just to make the shareholders happy. In effect, shareholders care about long-term shareholder value. (At least long-term shareholders will, but that is a topic for a different chapter.)
Why should I care about this as an employee? You will find that once you understand this fundamental of business, many things will make a lot of sense to you in the business world. You will understand about board meetings, you will understand the importance of quarterly financial reporting, the annual report, and other strange events and activities that go on in business. Most important, you should attune your thinking to align with the interests of the shareholders. When debating between solutions to a problem, ask yourself, ‘If I had a board member here and I explained the problem to them, how would they want to see this resolved given that they want to see long term shareholder value maximized?’
You will find that few employees you encounter truly understand this.
So, if you are one of the few that DO understand all of this, you are at an advantage. You will understand how the wheels of the business turn, why they turn, and why management behaves the way they do and what they want to see from employees. You will understand that in 99 percent of the situations you are involved in, behaving in a way that keeps the interests of shareholders in the forefront will be the best for you and the business longer term.
It also helps you to understand why some companies, at times, take actions that seem irrational or not great for customer service. For instance, let’s assume that a successful company is seeing its employment costs rising 10-15 percent per year due to healthcare costs rising, as well as labor rates rising. With some analysis, they can see that if this trend continues, their profitability might drop from healthy levels to zero in five years or less. If they allow the status quo to continue, before too long, the reduction in profits will be a discussion topic for the board. No CEO wants to have his or her board be the ones to bring such a topic to light as the board would expect the CEO to be proactive to solve these sorts of problems. So, the CEO convenes a task force or small group to study the problem. The team recommends that investments be made to improve employee productivity and ultimately to reduce employment costs. Once approved and then implemented, current employees who will be affected will be notified, layoffs occur, departments get restructured, etc.
All the while, that company will likely get negative press coverage, and employees and the community will speak negatively about the company, the CEO, other decision-makers, etc. But you can see that if the CEO did not take action to stem the tide of rising costs, he or she would be fired and replaced by the board. More importantly, lack of action might result in the company going out of business.
I used the example of labor cost increases because we are seeing this in the news recently. Other threats to a company could be competitive threats with competitor companies stealing market share, competitors reducing their prices, competitors offering new sorts of value for customers, governmental threats, quality problems with suppliers, etc.
But the important thing to understand is that ALL businesses will and must take some sort of action when faced with these sorts of threats. And it all boils down to the goal that boards have for long-term shareholder value. They will do all that is required to ensure that occurs. This sounds tough, but it is sort of like ‘survival of the fittest’ in the animal world. Companies, like animals, must do what is required to adapt and survive.
I leave you with one important qualifier to the corporate goal of maximizing shareholder wealth. In my opinion, the best companies do this of course, but they also create an excellent overarching mission or vision. These mission or vision statements align with, and support, maximizing shareholder wealth, but the mission or vision is a better way to talk about the driving force of a company, since most investors already understand the shareholder value priority. For example, Southwest Airlines talks about an overriding mission to give more Americans the ability to see the world. Google used to talk about organizing the world’s information so that it is universally accessible. Whole Foods strives to help people lead longer, healthier lives through better food choices. These mission or vision statements helps the entire organization by providing guidance as to what sorts of business activities are core, and which are not.
But once you enter the white-collar world, do not ever misunderstand that the priority of public companies, and of most private companies, is to maximize shareholder wealth.