Dissertation: A Thematic Independent Study

Shareholder Value and Stakeholder Value In Modern Business

Richard Alan Stephen Robertson

This essay will examine weather global macro economic and social events have caused a shift in the effectiveness of both shareholder value and stakeholder value models in modern business. The essay will focus on macro economic and macro social events within the last twenty years and will attempt to identify which model reacts and better prepares businesses for these macro events when seemingly repeated. For example instances such as the Wall Street crash of 1987 and the 2008 financial crisis. Do these economic events affect where a business places its priorities in terms of its stakeholders? Which value model is superior in modern business, shareholder or stakeholder value?

The essay will also attempt to identify if one approach or model is more likely to ensure longevity and success in a business or if this differs according to the sector in which the business operates and the current macro environment; in which case examples of appropriate models in each sector will be identified.

Shareholder Value

The definition of shareholder value, shareholder value model or shareholder value framework, is a business model which focuses above all else, on creating profit for the shareholders. The model is not concerned with creating value for wider stakeholders such as the employees and wider community, but with increasing profits for the owners of the company. The idea of shareholder value as discussed in essay 1, goes back to the infamous text; An Inquiry into the Nature and Causes of the Wealth of Nations written in 1776 by one of the most recognised, celebrated and critiqued economists, Adam Smith (Pferrer 2010, cited Smith 1776). According to Denning (2013), shareholder value has been taught in business schools as an economic and managerial primary approach and is now outdated.

Stakeholder Value

The new economic and managerial approach being considered as primary in creating value and long term business success by man theorists, is stakeholder value. Stakeholder value is the idea of taking into account more than just the shareholder, but multiple stakeholders as a way of improving a companies performance. The model was proposed as an alternative to shareholder theory by economists and business theorists such as Freeman (2013) who concluded that “The idea that business is about maximizing profits for shareholders is out-dated”). They proposed that the performance of companies would be improved by taking into account all stakeholders such as employees, suppliers and the wider community. There are multiple approaches to stakeholder value theory such as the narrow enterprise and basic five’s approach that wee discussed in essay one, but each theory stresses that the shareholder is not the only stakeholder for which a company should be creating value.

Macro Environment

When discussing the macro environment in business, macroeconomics is usually assumed to be the point of discussion. Macroeconomics can be defined as “the study of structure and performance of national economies and of the policies that government use to try to affect economic performance” (Andrew B. Abel et al 2008).

Macro factors that will be investigated to consider their impact on the decision of whether a firm should use stakeholder value or shareholder value theory have been presented below under the subheadings associated with a PESTEL analysis.

Also included in the discussion below are internal factors that affect the decision of whether to implement a shareholder or stakeholder value approach.

Political

Increased regulations that harm operations of a business may result in a need to take measures that focus less on creating stakeholder value and more on creating profit for shareholders.

Trade sanctions for example are decided upon and enforced by government and can seriously impact many sectors that trade with the nation being sanctioned, as a result businesses may have to seek alternative nations to trade with, cut staff that were involved in that nations trades and engage in trade that might seem unethical in an attempt to stay profitable. For example recent trade sanctions imposed by the EU and enforced by the UK government (Gov.uk 2014) in response to the illegal annexation of Crimea include restrictions that will have a direct impact on a number of industries including, arms trading, energy and oil, investment in capital markets and real estate, high tech goods and any goods with military application as an end user.

Regulations enforced by governments and government pressure on policies such as a business’s contributions to pension plans, health care and other benefits cost the business profits. Shareholder value theorists would argue that this is unethical towards the shareholders as the business has a responsibility to maximize profits for its owners. These policies and benefits are seen as creating value for employees and stakeholder theorists propose that providing these services makes employees feel more valued and increases productivity and in turn, profits as a result.

Changes in policy and legislation such as closing of tax loopholes are an issue of current debate in parliament and in the media. Tax loopholes are clever ways of avoiding tax that take advantage of non specific legislation, ambiguous language and outdates laws so that a company or individual can pay less tax on their revenue or earnings. There are literally thousands of devised strategies to avoid tax and many of them are taken advantage of by large corporations and individuals. The closing of these tax holes will mean that companies will be forced to pay higher tax on their income and as a result, net profits will suffer, as will the shareholder. Stake holders on the other hand, in this instance everyone but the shareholder, benefit from these loophole closures as the revenue generated from taxing companies contributes to the countries budget for public services such as the NHS. A higher budget means a better service. As well as these loop holes being utilized by companies such as Vodaphone, Amazon, Starbucks and Facebook to note a few high profile cases, individuals such as CEO’s of large companies are also evading taxes. The recent HSBC scandal has revealed that the Swiss

arm of the British bank has helped individuals hide millions of pounds in both cash and assets, and has enabled them to avoid taxes (Leigh et al.2015) (Hodge 2015). Time will reveal the extent of the damage in terms of public image, and the economic effect it will have as a result. HSBC will likely now make attempts to reconcile with stakeholders such as customers, to avoid loosing business to rival banks as customers deem them unethical.

Economic

Recession or economic disparity creates a climate of fear in which consumers stop buying in order to save money in case of redundancies etc, businesses revenues begin to drop and businesses then begin to fail. Competitiveness of firms that survive is increased and as such profits at this time are paramount; shareholder value is often the preferred model in this instance due to the perception of its ability to create sort term profits. There are multiple examples of this in the UK economy between the start of the financial crisis in 2008 and the six years that followed until growth reached pre recession figures in 2014 (West 2014). Many businesses that seemed to be high street giants seemingly too big to close, were devastated by the recession after facing massive declines in sales and increased competition from rival companies, many of which were online based and thus lower overheads afforded them the opportunity to cut prices and take advantage of the struggling positions of their high street rivals.

If we look at the UK electronics business Comet as an example, according to credit management expert Eddie Pacey (2012), comet showed a pre tax profit of £56m in 2007 which tumbled to £25m in 2008. In the years following it announced losses of £8m, £3m and finally £39m in 2011. The recession caused not only a fear in consumers but also a fear in company credit providers, insurers and suppliers. Firms that offered credit to Comet became increasingly nervous about the companies ability to repay loans and as a result demanded higher fees or refused to engage in business altogether. The escalation of this along with other business failures that have been cited such as not being able to compete with online prices from rivals and not adjusting to changes in business as well as their high street rival curry’s, eventually led to the business being placed into administration under the monitoring of Deloitte. Deloitte adopted a shareholder value approach at saving the company that included mass redundancies of nearly 7000 employees in such a way that shareholders, in this case venture capital firm OpCapital, were able to pass the cost of redundancy fee’s on to the government as they declared there was insufficient funds remaining after debts were repaid to creditors, however Op Capita were able to pay themselves approximately £11.5m through their vehicle Hailey Acquisitions limited whilst Deloitte also collected over £10m in monitoring fees (Ruddick 2012).

Social

Social awareness is something that businesses now realise can greatly impact their business and they will often adopt a shareholder value or stakeholder value approach in response to social matters and public opinion. For example large companies will often have schemes or programmes set up to give back to their communities and other stakeholders such as employees at their shareholders expense as a means of improving their public relations. Programmes implemented by companies to improve their public relations and company image may also include philanthropy, social mobility schemes, employment diversification schemes and minimum wage and equal pay schemes. Corporate philanthropy as pointed out by Heasman (2009), must however be scrutinized as it can often be for a purpose other than charity. Companies engaging in philanthropy improve the company image and can profit as a result, but this can also place them in a position of having negotiating power with

government bodies. For example Coca Cola’s RAIN initiative in which they aim to bring safe drinking water and sanitation to two million Africans by 2015 is on the surface a very charitable act that will incur the company a cost of $30m. Coca cola have however openly admitted that this process is also a way of retuning the water that they have taken from communities to manufacture their product from which they generate billion of dollars in revenue each year (Heasman 2009). Many would see this act not as philanthropy, but rather as basic stakeholder value and cooperate responsibility, which is deserving of no praise.

Increased social awareness puts increased pressures on business to act in an ethical manner. The reality of this current era is that news of a big business engaging in unethical behaviour is not just business news, it is world news that can dominate the front page of news papers as well as news broadcasts and even go viral with social media. The public, often views many practices that could fall under shareholder value such as forced redundancy, downsizing and the exportation or outsourcing of production, negatively as they have a detrimental impact on stakeholders. One sector that has perhaps suffered the most as a result of the increased public awareness and media coverage, is the financial sector. The financial crisis of 2008 saw the spotlight of the media, government and the public fall on to the financial sector in an unprecedented manner since the wall street crash of 1987. Some journalists such as Will Hutton (2008) have criticized the slack approach to reporting in the financial sector in the years leading up to the financial crisis, stating that reporters “should have been better at whistleblowing than we were,”. Hedge fund managers, traders, investors and apparent banking experts were making millions of pounds a year in performance bonuses each year without investigation as to how this money was being earned. Now that the light has been shone on the deals that were resulting in these bonuses, this period of big bonuses and no questions has changed. The anger felt by the public towards the banking industry in particular for reckless investment was increased further when reports such as that from the Ney York Times journalist’s Louise Story and Eric Dash (2009) revealed that “nine of the financial firms that were among the largest recipients of federal bailout money paid about 5,000 of their traders and bankers bonuses of more than $1 million apiece for 2008, according to a report released Thursday by Andrew M. Cuomo, the New York attorney general.”

Legal

This behaviour has not only resulted in public cries for a stop to banker bonus culture, but also for EU legislation to be written and enforced as of 1st January 2015 that will impose a cap on bankers bonuses and remuneration pay. The new legislation enacts a ratio rule of 1:1 which means that if a banker has a salary of £100,000 they can not receive a bonus in excess of £100,000. There is an exception however where this ratio can be increased to 1:2 is shareholders give permission on an individual case.

This second rule is very interesting in that it enforces and yet contradicts shareholder value theory at the same time. The fact that shareholders now have power over an employee or stakeholders bonus pay is clearly shareholder value theory as they can choose to restrict the bonus to a 1:1 ratio which means more profit for the shareholders as less expense is incurred in the payment to employees. The fact however that this rule has been enforced by the EU and governments is in contradiction to a principle of shareholder value that was discussed in essay 1; laissez-faire capitalism.

Laissez-faire capitalism suggest that the deregulation of business practices and limited government involvement will allow the markets to regulate themselves whilst promoting free enterprise and a

free capitalist market. Essay one also discussed the link with shareholder value theory and capitalist theory as well as the bail out of the banks by government being in contradiction to both of these theories and laissez-faire capitalism. It is still too early to analyze the actual effects of this approach and how shareholders will decide to award bonuses in regards to raising the bonus pay ratio to 1:2 as opposed to capping at 1:1, however predictions will be made in the conclusion of this essay.

Technological

Technological advances can influence many decisions in a business, effecting areas such as manufacturing, shipping and even customer service. Examples of technology effecting a company’s decision to either follow shareholder or stake holder value could influence multiple stakeholders. For example a supermarket making use of checkout technology for serving customers is potentially saving money on salary expenses in the long term and thus creating profits for shareholders, however they are also potentially making employees redundant as their positions are filled with technology. Businesses can approach technology with both a shareholder and stakeholder value approach.

Environmental

The environment is not considered by most as a stakeholder when discussing a firms practices, but it is directly affected by the business practices. The argument by stakeholder theorists such as Sharma and Starik is that the environments usefulness at providing resources to businesses could be a reason for its consideration as a stakeholder. They make clear however that it is “the organisations mortality that is at stake, not that of the environment” (Sharma and Starik 2004). This point further enforces the point that the environments role is to supply the business with resources, which the business depends on, however the success and profits of the business has no baring on the environment other than perhaps the number of resources needed. The effect of business practices on the environment has strong links to the social aspect of this pest analysis as public perception of companies that are detrimental to the environment is very negative and can directly affect sales. Organisations exist that rally members of the public and consumers together to boycott companies that they fell are acting in a detrimental way and are causing harm the environment and its ecosystems. For example the boycott organisation known as ethical consumer, played an integral role in a consumer boycott of Adidas when it was discovered that they were using kangaroo skins in there products which could soon be listed as extinct. The group also attempts to apply pressure to organisations such as BP for their role in the Deep Water Horizon oil spill that the group claims is “one of the worst environmental disasters ever to befall the United states” (Ethicalconsumer.org 2015).

Organisations that operate in certain sectors that immediately raise red flags when considering their affect on the environment include that of the paper industry, manufacturing industry, motoring industry and the airline industry. These companies must take particular care in managing their public relations as well and their business operations in order to cause as little an environmental impact as they can whilst still carrying out their day to day operations and creating profits for shareholders. Shareholder value may not be an option for these companies as increased pressure on government to enact legislation can limit their profitability in many ways if they push the limits of their effect on the environment.

Deciding upon which model to use

A number of questions must be asked by directors and members of the board as to which theory is the most effective at creating long term growth, long term value and long term profits. When considering long term business aims and goals, the industry and sector in which the business operates will depend on their approach. The approach will also differ according to the legal status of the company, the number of shares outstanding and the number of stakeholders the business has. The stakeholders in this instance will be counted using a model such as the narrow fives strategy mentioned in essay one and is likely to include shareholders and employees primarily.

Risk

One of the aspects of business that must be analysed both when making a decision as a board as which model to follow, and also when stakeholders question the decision made by those stakeholders, is that of risk.

“According to agency theory board members, CEO’S, and senior staff are inclined to risk-avoiding behaviour because, as stakeholders, they have to depend on the results of their own company (Blanpain et al. cites Eisenhardt 1989)”.

CEO’S, board member and senior staff are stakeholders of a business as they are employees that work for the owners of the company, ie the shareholders. This is a conflict of interest as shareholders want them to engage in behaviour that maximizes the value they receive, where as the employees wish to engage in behaviour that creates value for themselves. This situation creates a paradox. Employees must be seen to engage in creating shareholder value whilst minimizing their risk of loosing employment. This is why it is common practice to reward senior staff heavily when they perform well and take on risk that pays off. Chasing volatility is something that can create profit but at the same could cost stakeholders there job. The approach taken by the senior staff will therefore depend on the rewards on offer. High risk and high reward is something that can be attractive, however high risk and low reward for the employee will encourage stakeholder value.

Small private businesses in the retail sector for example that exist to support a household and small team of employees will be very risk adverse as they are not focused on substantial growth but rather on creating a steady and consistent income. A large public organisation however, operating the same sector with thousands of employees and thousands of shareholders will use strategies that consistently generate revenue to cover overheads and create stable growth, however they may take more risks and enter into new markets, target new demographics and other less risk adverse strategies to remain competitive and attempt to gain market share and increase share price.

A private hedge fund however operating in the financial sector is by its nature an investment company that uses risk management strategies such as hedging investments, to generate high percentage returns on investment and must outperform other investment companies as well as other investment markets to continue to grow.

The financial sector is an exception to many rules that other sectors would follow due to the market in which it operates. It must in many cases chase volatility in order to earn high return on capital employed, whilst also using risk adverse strategies to manage this risk.

Finance is also an exception when it comes to the approach that CEO’S and senior staffs take to risk. The financial incentives for performance, as discussed earlier in this essay, are very high at senior level in banking and finance. A senior trader for example before the EU cap legislation and if utilizing certain loopholes that are still permitted by the bank of England, can receive a bonus in excess of 10x their salary if they generate high returns of capital allocated to them to invest. CEO’S often encourage risky behaviour as if the investment pays of, they receive incredibly lucrative bonuses.

This behaviour however played a large role in the 2008 financial crisis as discussed in essay one, and may be an indicator that this level of risk is not a sustainable strategy for growth. As this strategy does generate short term profits however for the shareholder at the large risk of the stakeholders, in this case investors, it could be argued that this type of behaviour is shareholder theory and is not sustainable.

Shareholder value and it’s short term outlook

This conflict of interest in which senior managements employment at a firm is under pressure when deciding on risk, could be a major flaw in management strategy and has potentially led to the apparent shortsighted approach associated with shareholder value In the modern business environment. As discussed (Denning 2013), an idea by (Clayton Christensen 1997) written in his publication The Innovators Dilemma, Christensen claimed that large organisations with enormous budgets for technological and investment research, had missed out on being a part of some of the most revolutionary technological developments of the 1990’s. The reason for this is not because they are bad managers, but rather that they are following a bad management strategy that seeks only the largest return on investment and promises the largest market share. However these innovations do not apply to this strategy as they are, according to Christensen (1997) market disruptors. These transitions have created new industries that themselves are now worth billions of dollars. They include the transition from landline to mobile telephones, from film, to digital cameras, stock market floors to online trading platforms, dial up Internet to fiber optic broadband and new industries that arose out of nowhere based on new concepts, such as social media. These opportunities were missed because management was not looking into the future, and the possibility for new products and services, but rather on how to improve their current products or services in order to increase their market share.

An argument made management experts such as Denning (2013), is that the shareholder value approach is too focused on short term profit maximization and this will have negative impacts on the long term performance of the company. An example used by Denning (2013) (see figure 1) illustrates the failure from companies and managers to recognise the importance of the customers relationship with the company as well as other factors that should be take into account when for example, generating a product pricing strategy.

(Figure 1)

Denning (2013) argues that this typical question asked of management assumes that managers should –

A) Have the sole goal of profit maximisation B) Assume market response to productsC) Assume competition is non-existent D) Assume customers are not basing their purchase on their relationship with the business

These assumptions ignore stakeholders such as customers and customers as well as ignoring other factors such as market forces. It is this kind of short sighted shareholder value which has hindered large companies from entering new markets at early stages and this approach is increasingly proving itself as a non viable approach in modern business.Bad Profits

The idea of “Bad Profits” is a notion that is not taken into account by shareholder value theorists and implementers. This notion is discussed by Reichheld, Markey and Reichheld (2011) in their book The Ultimate Publication 2.0 in which they describe bad profits being created “whenever a customer feels misled, ignored or coerced, profits from that customer are bad. Bad profits come from unfair or misleading pricing. Bad profits arise when companies shortchange customers the way AOL did, by delivering a lousy experience. Bad profits are about extracting value from customers, not creating value. When sales reps push overpriced or inappropriate products onto trusting customers, the reps are generating bad profits. When complex pricing schemes dupe customers into paying more than necessary to meet their needs, those pricing schemes are contributing to bad profits”. Put simply, bad profits are profits that are generated at the cost of the customer relationship. These types of practices, although designed to increase short term profits through aggressive sales tactics for example, will result in the customer feeling ripped off in the long run. This then results in customers turning to competitors in the long term and as such is an unsustainable business approach.

Conclusion

The Decreasing Viability Of Shareholder Value

The evidence and argument presented in this essay indicates that the viability of shareholder value is decreasing in modern business for a number of reasons.

Public Awareness

As discussed, increased public awareness made possible by increased media coverage of business practices, has led to increased pressure on business to act ethically look after its stakeholders such as

employees and customers. Media coverage exposes negative elements of a businesses operations that have a detrimental effect on matters that are of public concern, these include environmental issues, mistreatment of employees and financial misconduct such as stock price manipulation, price fixing and false performance indication. Companies can no longer ignore the notion of good and bad profits, and customer perception may be the key to longevity.

Necessity of Government Involvement

The shareholder and capitalist notion of laissez-faire capitalism had evidently failed in the modern business world. If this approach is to be taken, it must be applicable in all sectors and industry. However the banking industry has proved itself to be too greedy and inconsiderate of stakeholders for this approach to work. Banks in modern society are deemed too big to fail, as shown in the list produced by the Financial Stability Board (See Appendix 1). This list highlights the banks that would cause serious economic problems if they were to fail and as such must hold extra capital to insure tax payers against more government bailouts. These bailouts were necessary in 2008 in order to save the financial system. If laissez-faire capitalism were viable, these businesses would have been able to fail without government involvement. However as this is no longer the case, this shareholder value approach is another approach that is no longer viable.

Competition

Globalisation has led to a massive increase in competition worldwide. The Internet has not only enabled customers to make informed product choices, but also informed choices about which business to buy from. Competition can no longer be focused on price alone, service is now an important element for customers. Creating good profits that will ensure future business means proving a service that is based on fairness as well as profits. In order to grow, a business must reinvest in its stake holders. Training employees on how to interact with clients and customers is now crucial to longevity and those businesses that do this well will have the upper hand on their competitors.

The Inevitable Rise Of Stakeholder Value

The issues raised in concern with the viability of shareholder value theory do have an apparent answer, stakeholder value theory. In this increasingly volatile business environment, regulation is needed in order to discourage individuals from acting recklessly and endangering stakeholders financially, environmentally and health wise in some cases.

Stakeholders must feel they have a stake in the firm and are looked after if the business expects them to operate at a high level of productivity. Health care, fair wages and job security can be important factors in ensuring that employee’s fulfill their potential.

The wider community favour ethically responsible companies and the media will punish those who firms who do not act in this way by reporting this negative behaviour. Treating stakeholders fairly can prove a competitive edge in this scenario.

Although the purpose of a firm is to create profit, creating value for all stakeholders will ensure continued relationships, which in the long term, result in long-term growth, sustainability, and profits.

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Appendix

Appendix 1

Figure 1

Appendix 2

Mind Map