1.3.4 Summary

We have learnt the basics of three commonly occurring business structures; sole trader, partnership and corporation. All the structures have advantages and disadvantages, which one suits best depends on your situation. In the next section, we are going to discuss different theories of business purpose.

1.4 Theories of Business Purpose

We have talked a little about how a firm can be structured, but what is the purpose of a firm in society? What should a business value?

First, let’s have a look at what you value yourself, using the Sustainable Development Goals (SDGs). The SDGs are a set of 17 goals, with 169 targets, that are “a blueprint to achieve a better and more sustainable future for all“.^[1] All 193 countries have committed to these goals that are to be achieved by 2030. Below are the 17 goals:

To simplify the goals, we can divide them into environmental (biosphere), social (society) and economic.

For societies and economies to thrive long term and be sustainable, we need a highly functioning natural environment and healthy, equitable social systems to support them.

1.4.1 Sole Traders and Partnerships

As a sole trader, you own the business all by yourself. As a partnership, you own the company with your partners. In both those cases, you have direct control over what happens in the company and the consequences are yours as well. You make the decisions by yourself or with your partners. For example, you can choose how you treat your employees, and you’ll probably realise that you have to create some value for them if you want to retain them. Do you give them part of the profits when you have had a good month? Or do you keep it to yourself?

Let’s consider your coffee shop. You can decide whether you give a discount on takeaway cups, if you sell fair-trade coffee only, etc. Let’s say the cost of a “common” discount is $0.5 for customers using a takeaway cup, but a disposable cup only costs you $0.05. Should you offer the “common” discount? From a purely financial perspective, you may say no, but the reality is that most coffee places now offer this discount. Some may argue that considering the environment (through reducing the billions of coffee cups ending up in landfill) is either “good business”, as you enhance your reputation and customers might be more loyal, whereas others do it simply because it is “the right thing to do”.

1.4.2 The Corporation

To what extent should companies consider the social and environmental impacts of their business? How should they be balanced with financial impacts? This question has been long debated, some are set in law and regulation, others in culture, and can differ across and within countries.

The 20th century gave something unique, which was the rise of the corporation, a separate entity from both its owners and management, which for the first time allowed companies to have dispersed equity ownership.

In most textbooks, you will often see the following argument: shareholders “own” the company (residual claimants of the firm) → management and directors have to do what the shareholders want → shareholders want maximum wealth (as a measure of value) = maximum share price; thus the role of the financial manager is to maximize the value of the shares (share price). This argument was mostly instigated by Milton Friedman (1970), the father of shareholder theory. His idea was further enhanced by Jensen and Meckling (1976) in their work the “Theory of the Firm”^[2], one of the most cited and influential works in finance literature, which discusses the main challenge that needs to be addressed in corporate governance is that the managers and directors act to maximize shareholders’ wealth. This view is discussed in more detail next.

1.4.3 The Shareholder Theory (Friedman, 1970)

Milton Friedman, a Nobel prize-winning economist, wrote an article in the Financial Times in 1970 entitled “ The Social Responsibility of Business”. In this article, he writes about the notion that businesses may have a responsibility beyond just making a profit; a responsibility to achieve some “social goals”. He strongly disagrees with this and quotes from his book “Capitalism and Freedom” (1962) in which he argues:

And

Thus, Friedman concludes that there is one and only one responsibility of a business, which is to increase profits for shareholders. Note, however, that he does not believe that this should occur at all costs; the actions to achieve these profits have to be legal and conform to ethical custom. His main concern about a business manager pursuing anything other than profits is that the manager is spending someone else’s money:

Friedman was not against giving money to any charitable organisation or helping out friends, he just believed that if anyone wanted to give money to charity or anyone that this should be with their own money. A manager sponsoring the local ballet, soccer club or the Red Cross with corporate funds may be something the shareholders do not want to spend money on. Shareholders may want to spend the proceeds of the businesses’ money on other pursuits. Both shareholders and managers themselves are free to give money to charity as well, but with their own money.  Friedman also argued that if managers would spend money on charitable organisations or any other “social” goal, the managers would be acting as a regulator as they are effectively imposing a tax and deciding where the proceeds of the tax would go to, and this should be determined through a democratic process, not a corporate executive.

Let’s go back to your coffee shop for a little bit.

While running the business, you will be both impacted by, and impact, a number of entities in society. Take your customers for example your customers impact whether or not you can stay in business, and at the same time, your service and the quality of the coffee have an impact on the wellbeing of the customers. Your suppliers have an impact on the quality and availability of your coffee, whilst you also impact their ability to be in business. Entities that both affect the firm, and are affected by the firm, are what we call stakeholders. In reality, stakeholders have an impact on the success of a business.

Shareholder theory does not deny this but rather proposes that stakeholders are a means to an end (maximising wealth for the shareholders, also called shareholder primacy). So for example, if wages can be cut to generate a profit, they should be cut. If dumping waste in a river is cheaper than treating it, the waste should be dumped in the river. If paying liability suits for a defective product is cheaper than making the product safe, then it is best to make the defective product and pay for the lawsuit. The following video shows a debate between Friedman and a student at Cornell University in 1978.

VIDEO: Milton Friedman on Self-Interest and the Profit Motive (YouTube, 6m56s)

Friedman proposes that perhaps the car company should have put a disclaimer on the product saying “this product is $13 cheaper and therefore has an increased chance of x% of exploding under y situation”. Do you think companies should do this? Do you think they do? Do you think people are really “free” if they do not have information on the possible impacts of products on individuals/society when buying a product? Who has a responsibility for providing this information?

1.4.3.1 Enlightened Friedmanite

There is much criticism of Friedman’s view (shareholder primacy), particularly as it is often used to justify focusing on short-term valuations. If managers are putting profit in the next year first, does that mean they are maximising profit for the next 5 years? 10 years? 50 years? Are higher current profits necessarily in the best interest of shareholders who may hold their investment for years or decades?  “Enlightened” Friedmanites take a longer-term perspective. Is it in the best interests of shareholders to clear-cut a forest and maximise current production, without replanting it? Or to sustainably manage the forest resource so that it provides a moderate level of output for decades to come? This long-term perspective can lead to the same result as managing for stakeholders (discussed next), but there is a difference in motive.

1.4.4 Stakeholder Theory (Freeman, 1984)

One of the leading alternatives to shareholder theory is stakeholder theory, proposed by Edward Freeman in 1984.^[4] Stakeholder theory asserts that a manager’s goal should not be to maximise shareholder wealth as a primary purpose, but rather to create value for all stakeholders. Freeman intentionally used the word “value” instead of “wealth,” as value includes (but is also broader than) financial outcomes. It includes human well-being, benefits from collaboration, etc.

Freeman^[6] classifies five primary (most important) stakeholders and their stakes are as follows:

• Financiers (shareholders and debtholders) have a financial stake in the firm and expect a financial return from the firm
• Employees provide human capital to the firm and are impacted by the firm in terms of working conditions. Employees may also be decision-makers in the firm (e.g. if they are managers), or they can also be financiers (e.g. via employee stock options)
• Suppliers and customers have a stake in the firm in terms of exchanging products and services for resources (money)
• Communities grant firms the “right to operate” and can be impacted by the firm’s operations e.g. provision of local services or dumping hazardous waste

There can also be secondary stakeholders.

There may be conflicting interests between groups of stakeholders and the manager’s job is not to trade-off these conflicts, but to work out a way to create value for all parties. Stakeholder theorists, therefore, argue that managing for stakeholders is simply good business practice. If all stakeholders are managed well this will result in a profitable, well-run firm.

CONCEPT CHECK: What is happening in the real world?

The Business Roundtable is an organisation that consists of Chief Executive Officers (CEOs) of more than 181 major companies in the United States. The organisation has been issuing statements on the Purpose of the Corporation since 1978, and since 1987 it has defined the purpose of the corporation to be to serve shareholders first and foremost.

In August 2019, “the Business Roundtable” has changed its statement to:

We commit to:

• Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations.
• Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions.
• Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses.
• Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders.
• Each of our stakeholders is essential. We commit to delivering value to all of them, for the future success of our companies, our communities and our country.

The example above demonstrates that there is a change in business sentiment. CEOs are increasingly realising that creating long-term value for shareholders requires creating value for its stakeholders. Through innovative thinking many co-benefits can be created. In some regions like Europe, there is also increasing regulation on requiring company of their social and environmental impacts, so there is more information and transparency for people to make informed decisions.

1.4.5 Shareholder Value Myth (Stout, 2012)

Cornell Professor of Corporate Law, Lynn Stout wrote a book entitled The shareholder value myth^[7] in which she discusses the history of the role of companies in society and several inaccuracies about shareholder theory. Watch the video below (for more info here is an article too).

The shareholder value myth | Lynn Stout, Cornell University (YouTube, 12m43s):

1.4.6 Shareholder Welfare not Wealth (Hart)

Lynn Stout’s last point regarding shareholders having pro-social concerns is very similar to Oliver Hart’s thesis below.

In the video below, Oliver Hart (winner of the 2016 Nobel Prize in economics) discusses the shareholder theory in the economic field and provides a new perspective on what the goal of the firm should be. In his paper, “Shareholders Should Maximize Shareholder Welfare not Market Value (PDF, 674 KB)“^[8], he argues that firms should maximise the welfare of shareholders, which is much broader than wealth. Shareholders are all participants in society and have a range of social and environmental preferences. When a company engages in actions that maximize profits but create externalities that go against a shareholders’ ethical preferences, it is suboptimal to engage in these actions and let the shareholders “mitigate” the externalities with their own money. Firms should therefore actively seek shareholders’ preferences and values, and act consistently with those. Watch the video below.

Shareholders Care about more than just profits (YouTube, 4m12s)

Case Study: Gun Control

Oliver Hart uses the example of Dick’s Sporting Goods, which changed its policy on gun control.

Dick’s Sporting Goods could generate money by selling assault rifles. Friedman would have argued that, if it is a profitable strategy to sell high-powered guns, then the company should do it, pay shareholders the extra dividend, and they might decide individually to support gun control organizations. However, spending money by shareholders to “reverse” the actions of the company would be very inefficient and suboptimal for the shareholders.

Hart argues that it is more efficient than the company refrains from selling guns in the first place. Shareholders are humans, who have pro-social concerns, and it is assumed that if someone is not only interested in the bottom line, they would prefer to invest in companies who are also interested in issues beyond the bottom line. Oliver argues that if a CEO and managers want to show loyalty to their shareholders, their individual concerns should be taken into consideration.

In other words, instead of making money at the expense of all, the pro-social concerns of shareholders should be accounted for when building a strategy.

Discussion on Edge: Case Study: Merck

Watch this video: Merck & co will pay $4.85 billion to end thousands of lawsuits over its painkiller Vioxx (YouTube, 2m7s)

1.5 Business Ethics

In this chapter we have touched upon ethics. Ethics is concerned with what is ethically the “right” thing to do and what is “wrong” or “not right”. Many may consider “Do unto others as you want them to do unto you” as a general ethical principle to live by. In business, sometimes it seems that different ethical rules apply to everyday ethics and a “dog-eat-dog” attitude is acceptable. Billionaire Jeremy Grantham argues the following:

This demonstrates the importance of business culture, it determines the way people behave and make decisions. Different businesses will have different cultures, and you may want to think about what kind of business culture you want to be part of, or want to create when you have the power to do so.

Evidence shows however that lapses in ethics can also be very costly to both shareholders, managers and the general public. For example, the Global Financial Crisis in 2008/09 has caused devastating losses to many through unethical behaviour of a small group of people. Scandals can cause companies to go bankrupt, such as Enron, whilst others cause major losses for shareholders, the general public’s health and loss of trust, such as Volkswagen. In 2018, the big banks in Australia all suffered big share declines as a result of an investigation by the Royal Commission, as they all had been involved in fraudulent and highly unethical practices.

1.6 Summary

In this first chapter, we covered key financial decisions, different forms of business organisations and different business purpose views.

• Key financial decisions a manager has to make include 1) capital budgeting (what long-term assets should I invest in?) (covered further in Chapters 7-9), 2) financing decisions (how do I finance my operations?) (covered further in Chapters 5 & 6), and 3) working capital management (how do I manage my current assets and liabilities?)
• There are different forms of business organisations, which differ in several important aspects, such as control, tax, ease of set-up and liability of members. We discussed 1) Sole Trader (one owner), 2) Partnership: two or more owners of a business, with general – and sometimes also limited – partners and 3) Corporation: an entity separate to its members. Try to list the advantages and disadvantages of each structure and if unsure, revise the respective section. It is also important you are comfortable recommending a business structure in a particular scenario.
• Finally, we discussed four different views on what the role of a business in society is. Philosophizing what the role of a corporation in society ought to be is a question of business ethics. A very influential, but possibly outdated, the view is that of Friedman (1970) who proposed that the only responsibility of a business is to maximize profits for its shareholders (without deception or fraud, adhering to the law and ethical custom). This theory is referred to as Shareholder Theory. Later theories criticise this view and propose alternatives: stakeholder theory (Freeman), shareholder welfare (Hart and Zingales) and “satisficing” one or more objectives (Stout). In the tutorial, we collect ideas from the different theories in miro. This will be a great tool to revise the theories for the workshop (where we will apply the theories to a case) and your final exam.

Before continuing with the course, we would like to point out that the concepts that are going to be learnt in this course can be applied to any organisation (for-profit, not-for-profit, and everything in between!). Decisions are often complex and we encourage you in this course to consider both financial and non-financial factors before arriving at a final decision.