Introduction
Shareholders are the owners of a company in legal terms. Therefore, like any owner, shareholders also try to maximize their profit interests in any organization. In the past, organizations were more focused on balancing the wealth generation and distribution among different stakeholders such as shareholders, employees, management, and society. However, since the 1970s, private companies turned to maximize the profit of shareholders ignoring the interest of other stakeholders of the company. This has generated a huge profit for the share market, which, in the last 40 years, has expanded by almost ten times. Other stakeholders, especially the employees, have suffered in this renewed focus for wealth maximization process. In a Capitalist society, pursuing shareholders’ wealth maximization is an appropriate goal for any business firm (Donadelli, Fasan and Magnanelli, 2014). However, this wealth maximization goal may not always be sustainable for the organization in the long run. This essay will discuss how registered private companies maximize their wealth, how the wealth maximization of shareholders conflict with the interest of other stakeholders in the organization, how the goal of managers significantly differs from that of shareholders, and how this agency problem can be resolved.
Definition
Before delving into the discussion on wealth maximization, it is important to understand a few concepts that will be used frequently in this paper.
A registered company is a company that has filed paperwork with the regulatory authority of a country to allow it to issue stocks and bonds. In the USA, a registered company should file its paperwork with the Securities and Exchange Commission (SEC). A registered company should provide a prospectus and detailed financial information to the SEC during the registration process (Worstall, 2011). A registered company should also furnish information regularly on its business and financial condition as part of the SEC regulations.
Wealth maximization of an organization refers to the increase in profit, increase in revenue, and increased social impact. An organization can set to be trying to maximize its wealth if it is pursuing any one of the above three criteria. Wealth maximization can also create conflicts among different stakeholders (Worstall, 2011). Therefore, it is important to understand wealth maximization from the perspective of stakeholders.
Why Maximize Profit for Shareholders?
Till the 1970s, organizations often tried to balance wealth maximization among different stakeholders. After the World War II and till the 1970s, employee benefit and giving a percentage back to the society was a norm for almost any private organization. However, in the 1970s, in the wake of agency theory, the focus shifted towards maximizing profit for shareholders only (Donadelli, Fasan and Magnanelli, 2014). As per agency theory, shareholders are the owners of the company and managers are employed by the owners to protect their interests. As per this theory, if an organization tries to maximize the interest of the shareholders, then wealth maximization works perfectly. In the initial versions of agency theory, the basic underlined assumption is that as owners, shareholders not only try to maximize their profit goals but also try to maximize the wealth of the organization (Smith, 2003). However, in reality, it was found that shareholders were only interested in their short term profit and often ignored the long term goals of growth and balanced wealth distribution. As managers were the principle agents of shareholders, shareholders were only interested in paying the managers based on the company performance. During this time, the remuneration for managers started increasing exponentially. As shareholders thought that managers would be protecting the wealth maximization goal, they were only interested in managers and ignored other stakeholders. This created a narrowed down focus for the registered companies from the 1980s onwards (Donadelli, Fasan and Magnanelli, 2014).
Types of Stakeholders in a Registered Firm
There are different types of stakeholders in an organization. However, only the major stakeholder groups will be discussed in this section.
It has already been discussed above that shareholders are the primary stakeholders of any registered company. By holding stocks of the company, they become the legal owners of the company (Worstall, 2011). Shareholders not only have the right to access the net earnings from the company operations, but also have the decision making power about the operational and strategic initiatives of the organization. They further have the right to recruit and retrench the management responsible for running the organization.
The top management, mainly the C cadre management, is another major stakeholder of an organization. The top management is responsible for running the organization in a way that not only it generates short term profit but also continues to generate increased profit in the coming days (Bebchuk and Fried, n.d.). The top management is answerable to the shareholders for each of their actions. Unlike shareholders, the main aim of the management is to protect their own jobs through superior performance of the company and creation of dependencies.
Employees or workers are another major stakeholder group that has a huge impact on the performance of an organization. Employees are responsible for performing day to day activities to deliver products and services to their customers in a manner that generates profit and increases customer satisfaction. Like managers, employees are also paid salaries for their jobs in an organization (Bebchuk and Fried, n.d.). However, as the remuneration of employees is much lower than that of the top management, employees need other types of securities such as health insurance, pension, and bonus.
Financiers are stakeholders who provide capital in the company for new projects and initiatives (Donadelli, Fasan and Magnanelli, 2014). Financiers are mainly interested in getting the capital back on time with an interest rate. Financiers are also interested in the good performance of the company as that will ensure that they get their back money on time in full.
Societies are indirect stakeholders. Local communities get directly impacted by the company operation. For example, Microsoft by operating in Seattle generates a lot of jobs in the local community. Microsoft spends a substantial amount of money in social community development in and around Seattle, which also contributes to the economic activity of the region. Apart from local communities, the government is also a stakeholder in an organization as based on the performance of a company, the government may collect tax. The government is also responsible for the welfare of workers and protect their basic interests.
As it has already been discussed above that the interest of different types of stakeholders varies significantly. Stakeholders are more interested in maximizing profit, stock growth, and dividend payout so that they get their money back whereas managers are interested in protecting their jobs and creating dependencies. Their interest may significantly vary. The detailed discussion of the conflict of interests between shareholders and the managers will be held in the next section. Employees require job security, good remuneration and pension benefits. Giving employees more remuneration means less profit for the shareholders. Therefore, employee remuneration and shareholders’ wealth maximization directly conflict with each other, because shareholders think that increasing the salary of employees will not necessarily boost up the performance of the employees, generating more profit for the organization (Donadelli, Fasan and Magnanelli, 2014). Till the 1980s, IBM was focused on taking care of its employees, but in the 1990s when IBM started losing market share to major competitors such as Dell, HP and Compaq, IBM started a huge layoff program retrenching about 60,000 employees, one of the highest in the history (Yang, 2013). IBM continues to use this method to reduce manpower costs. IBM has also outsourced several thousand jobs from the US to other locations for reducing the overall salary burden (Yang, 2013). In 1994, IBM also introduced a new 401K policy in which IBM only matched the employee contribution once per year, which was every month previously. All these initiatives were taken to maximize the profit for shareholders, ignoring the interest of employees. During the 1990s, due to new policies in 401K, a lot of employees lost a lot of money in the 401K account (Yang, 2013). This was a classic case of wealth maximization for the shareholders at the cost of other stakeholders.
Similarly, the government is another stakeholder ignored often by companies if they find better opportunity elsewhere. For instance, in the 15 years, many US companies have shifted their corporate headquarters to tax havens such as Ireland, Luxemburg, and Cyprus. These companies are often controlled by the majority American stakeholders. By moving their headquarters in other tax favorable countries, these companies are able to increase their profit by paying less tax, whereas the government of the USA is on the loss for not receiving tax from the profit of these organizations (Donadelli, Fasan and Magnanelli, 2014).
Conflict of Interest between Shareholders and Managers
Although apparently it may seem that shareholders and managers work together to maximize the wealth of an organization so that all the stakeholders are positively impacted, this is not always true. As per the SEC, owners do not have the absolute control on running the firms, because of their lack of knowledge of the operations and strategic decisions. Shareholders have only the voting rights and the right to appoint the Board of Directors, who, on their behalf, appoint managers capable of running the company. Therefore, shareholders are dependent on managers in running the organization. This limited power of shareholders was created as a regulation by the SEC to ensure a balance of power between shareholders and other stakeholders in the organization (Donadelli, Fasan and Magnanelli, 2014). The goal of the SEC was to create a structure in which managers would be balancing the interest of all the stakeholders, including the shareholders. The SEC took away the power from the shareholders because they thought that shareholders’ interest may not always benefit other stakeholders. However, it has created a structure in which managers have excessive power and often they exploit this power to their advantage. Corporate scandals such as Enron, WorldCom, Tyco International, and Global Crossing are landmark examples of the managers working to further their interest only without considering the interests of the shareholders and other stakeholders (Donadelli, Fasan and Magnanelli, 2014).
Agency theory highlights this problem that if shareholders are allowed the absolute power, then they might use it for their own benefit only (Smith, 2003). Two recent theories, shareholder theory and stakeholder theory, also highlight similar issues. Shareholder theory claims that shareholders’ wealth maximization goal can actually take care of the interests of all the stakeholders. Therefore, stakeholders’ wealth maximization should be the ultimate aim for any organization. To corroborate their point, shareholder theorists have cited several examples of successful private organizations and family run businesses. Companies such as Cargill, Dell, and SC Johnson were successful when they were fully family owned with the management being totally under the control of the owners. Stakeholder theorists, on the other hand, claim that giving full power to shareholders will make matters worse for some of the stakeholders. In fact, there are a few examples that show that shareholders’ decision has negatively impacted the employees and workers. For example, companies such as GE, IBM, and HP shareholders in collaboration with the top management (also shareholders in the company) made massive job cuts, reduced salary, and created unfavorable incentive packages for the employees (Yang, 2013). Another classic example of the management and shareholder conflict is the case of making investment in new projects. If the investment in a new project is risky, then managers often avoid taking risk by making investment in the new project, whereas investment in new projects often increases the stock value of the firm. Therefore, shareholders will be interested in pursuing the project. This will create a conflict of interest between the two, which will add to the agency cost and conflict.
Possible Ways to Resolve Agency Conflict
There are four primary mechanisms suggested by the agency theory for resolving the conflict between shareholders and managers so that both work towards maximizing the wealth of the organization (Smith, 2003). These four mechanisms are managerial compensation, threat of firing, threat of takeovers, and direct intervention.
In classical organizations, managers receive fixed salaries often loosely tied to company performance. As per the agency theory, if managerial compensation can be tied to company performance directly and managers are given stock options, then the conflict of interest is somewhat resolved (Smith, 2003). Managers also become shareholders of the company. Thus they try to protect the shareholders’ interest like the shareholders themselves. Almost all the modern organizations, including Apple, Microsoft, Google, GE, Boeing, and Dell, provide stock options to their senior executives.
Although shareholders have other mechanisms, such as direct intervention, firing of managers, and takeover of managerial responsibilities from the managers, to resolve agency conflicts, relating the salaries to managerial performance and providing stock options to managers are the best of all (Worstall, 2011).
Conclusion
A registered company consists of different types of stakeholders, such as shareholders, managers, employees, government and society. Shareholders are the proprietors of the organization while employees and managers work for shareholders in exchange for salary. Shareholders as owners try to maximize the wealth of the organization to their advantage, whereas that may not fulfill the interests of other stakeholders. Employees suffer the most when shareholders are focused on only maximizing the profit, ignoring the interests of other stakeholders. Managers and shareholders are the two strongest stakeholders in an organization. Shareholders have the ownership, whereas managers have the knowhow of running an organization profitably. Often giving too much independence to the managers can ruin the overall purpose of the organization. Enron and WorldCom scandals are some of the examples of such phenomenon. Almost all the literature concur that fulfilling the interests of the business owners satisfies the needs of all the stakeholders. Therefore, if the interests of the managers and the shareholders can be brought together, then that organization will function efficiently towards the wealth maximization goal. This can be achieved through the implementations of mechanisms such as tying salaries with organizational performance and giving company share options to the managers.
References
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