Stakeholder vs. Shareholder Theories
By Karina Arsenault • 7 min read
Today’s Environment
Globalization and industrial revolutions have generated increased innovation, wealth, and standards of living of advanced economies such as Canada, the United States (U.S.), and the United Kingdom (U.K.). While this development has reduced global poverty levels, the world has witnessed growing income inequalities both within and between nations. It also contributed to environmental degradation as societies became increasingly dependent of fossil fuels.
The most recent proof of this economic divide and environmental decline has been the impact of the COVID-19 pandemic. While some individuals had access to private healthcare, remote employment, and comfortable homes allowing for adequate social isolation, others lost their jobs or risked virus contraction to pay their bills, lived in closed quarters, and lacked appropriate medical care. Despite decades of progress in addressing poverty, COVID-19 caused the first rise in extreme poverty in a generation.
On the climate front, global CO2 emissions from fossil fuels decreased by 5.4% as people were forced to stay home. However, as restrictions lift and the global economy reopens, we are expected to see a 4.9% increase above 2020 levels, not accounting for the 2.9 billion tons of CO2 emissions resulting from deforestation, degradation, and re-vegetation. By 2030, the pandemic will have lowered predicted global temperatures by no more than 0.01C, proving that we lack the tools and infrastructure for a sustained decrease in global emissions. If we are to meet the Paris Climate Agreement of limiting global warming to 1.5C compared to pre-industrial levels, we need rapid and large-scale reduction in greenhouse gas emissions without the economic and social impacts of lockdowns.
While the climate emergency is on most countries’ political agendas, not all voters make it a priority, and public policies are slow to be implemented. That brings in the private sector, a crucial player in achieving these ambitious, yet necessary goals. Research shows businesses and NGOs are more trusted than governments and are expected to be the “face of change”. As we rebuild our post-pandemic economy, private sector companies must be drivers of inclusive, equitable and sustainable development.
As issues regarding inequality and climate became more widely discussed over the past two years, many consumers paused to reflect on the companies with whom they engaged. What is their broader impact on societies? How are they addressing crucial issues our societies face? Despite the array of management theories, there has yet to be a clear definition of a company’s ultimate purpose. Two options have gained prominence: Shareholder theory and Stakeholder theory.
Shareholder Theory
With the 1930s rise in managerial capitalism, where ownership and corporate control separated, shareholder primacy was implemented and mandated executives, “agents” acting on behalf of shareholder, to prioritize shareholder wealth. Executives were still expected to balance the interest of corporate stakeholders, such as employees, consumers, suppliers, communities, shareholders, and societies. In the face of technological advancement, deregulation and globalization, executives required a clearer corporate purpose to keep up with the fast-paced, changing environments. They argued balancing stakeholders interest led to confusing priorities, slower decision-making, and unpredictable outcomes. As such, an intensified version of shareholder primacy, was coined by Nobel Prize winning economist Milton Friedman, stating that a business’ sole purpose was to maximize profits while acting in accordance with laws and avoiding deception or fraud. Gaining prominence in the 1980s Reaganite and Thatcherite eras, shareholder primacy has become the dominant corporate governance focus in economies such as the U.S and UK.
According to Friedman, executives’ social responsibility is limited to economic profit-making terms. If an executive were to spend corporate money on “socially responsible causes”, they would be “taxing” employees through lower wages, customers through higher prices and shareholders through lower returns. In addition, he argued corporate executives were not qualified to appropriately allocate corporate funds for public use. Therefore, if stockholders, customers, or employees wished to spend their wealth on social causes, it is their individual responsibility, not the businesses’.
Evaluating performance based on shareholder return allowed companies to have clear directions, goals, and operational guidelines. As a result, they became increasingly competitive, driven to maximize profits. Stock exchanges saw record numbers, some economies soared, innovation gave birth to life changing products and services, and many relied on governments’ tax system to collect some of this wealth to inject it back into public services.
Executive Compensations
To align executives and shareholder interests for corporate profits, senior executives were increasingly compensated with company shares and stock-options. As part-owners of the firm, executives themselves could benefit from generating shareholder wealth, as, by 2006, 50% of their salary came from stock-options, while only 20% came from their base salary. As C-suites became compensated greatly by current stock prices, “shareholder value” became associated with short-term, increased share price, rather than a long-term risk-adjusted return on sound business investments. Consequently, as BlackRock’s Chief Executive argues, prioritizing share price prevents investments in innovation, skilled workforces, and essential capital expenditures. This narrow focus on short-term value harms long-term performance and sustainable value creation. Declining wages in pursuit of profit, coupled with increasing executive salaries has contributed to rising inequalities, with the top 1% owning 30% of wealth and the bottom 50% owning 1.9%.
Profit-Maximization Consequences
In the 21st century, profit-maximizing actions have led several large corporations to act in questionable ways. For instance, endangering employees while cutting manufacturing costs, or misusing consumer social media data for top line growth. From an environmental standpoint, some companies manipulate emissions calculations to appear in compliance with regulatory agencies, and some have gone as far as propagandizing against climate science to avoid diminishing profitability resulting from public backlash. Research indicates that short-termism increases environmental destruction, as both climate issues themselves and the financial risks associated to them materialize over the long-term. Take, for example, BP’s Deepwater Horizon oil spill, where managers were incentivized to prioritize short-term financial success over the business’ long-term health. Its cost-cutting structure and intentional disregard for safety measures lead to both environmental and financial catastrophes.
While many argue governments are responsible for instilling a social safety net (unemployment benefits, access to health and education, pollution control) and implement external environmental regulations, these problems are too prevalent and urgent to solely rely on political processes, especially as governments are leaning into the private sector for credibility and partnerships to tackle the biggest issues facing our world in 2022.
Stakeholder Theory
Stakeholder Theory originated in 1984 with R. Edward Freeman’s book “Strategic Management; A Stakeholder Approach”. The theory is a form of capitalism aiming to create shared value amongst all stakeholders; consumers, suppliers, employees, shareholders, and communities in which the business operates. As each stakeholders’ interests are seen as inter-related, managers must work to have them move cohesively in the same direction.
Stakeholder Theory reflects society’s increased emphasis placed on corporate social responsibility. Forbes studies show 76% of the workforce would prefer to be employed by a company serving various stakeholders’ interests and 85% of consumers are willing to pay a premium for a product or service sold by a purpose-driven company serving all its stakeholders. While many fear that Stakeholder Theory and Shareholder Theory are zero sum games, companies creating shared stakeholder value generated a 6.4% higher return on equity and experienced improved net and operating margins. Furthermore, amongst 615 large-and mid-cap publicly traded corporations, those adopting stakeholder capitalism’s long-term view outperform the rest in earnings, revenue, and investment. Additionally, companies with strong Environmental-Social-Governance (ESG) scores outperformed others on credit ratings through revenue growth, lower costs, fewer legal and regulatory interventions, higher productivity and optimized investment and asset utilization. As Larry Fink argues, “society is demanding that companies, both public and private, serve a social purpose […] To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society.” Our business environment is progressing, especially with the Fourth Industrial Revolution presenting breakthrough technologies smearing the lines between physical, digital, and biological spheres, and companies resisting to adapt will ultimately suffer a competitive disadvantage.
With the current Fourth Industrial Revolution, the private sector, along with governments and policymakers have a responsibility to prevent mistakes witnessed with the last three Industrial Revolutions mentioned at the start of this article: leaving behind certain groups of people and the planet. As such Klaus Schwab, Founder and Chairman of the World Economic Forum presented companies with the Davos Manifesto of 2020, describing “The Universal Purpose of a Company in the Fourth Industrial Revolution”. The statement calls on companies to serve the following stakeholders:
Customers: offer value propositions meeting customer needs, embrace fair competition, maintain a trustworthy and reliable digital ecosystem, have zero tolerance for corruption, and educate customers on their products’ functionality, including adverse implications or negative externalities.
People: honour diversity, continuously improve working conditions, and foster continued employment through upskilling and retraining.
Suppliers: consider them as value-creating entities, provide fair chances to new market entrants, and integrate human rights across their supply chain.
Society: support communities in which the business operates, pay its fair share of taxes, ensure safe, ethical, and efficient use of data. The business is to care for environmental and material use for future generations by protecting our biosphere, fostering a circular, shared, and regenerative economy. It must improve well-being by expanding the frontiers of knowledge, innovation, and technology.
Shareholders: the business provides return on investments that account for entrepreneurial risks and the need for continuous innovation and sustained investments. It creates value for the near-term, medium-term, and long-term and aims for sustainable shareholder returns that do not sacrifice the future for the present.
Measuring Stakeholder Capitalism
Executives have been accustomed to measuring performance on numbers, presenting a challenge to adequately track value created for other stakeholders. As such, the World Economic Forum’s International Business Council created the “Stakeholder Capitalism Metrics”, quantitatively measuring their environmental, social, and governance targets.
Principles of Governance: metrics and disclosures on stated purpose, board composition (experience, gender, membership of underrepresented groups, stakeholder representation), stakeholder engagement, anti-corruption efforts, reporting of unethical or unlawful actions, and risk and opportunities affecting the business.
Planet: metrics on climate change, including greenhouse gas emissions and steps to reduce them to Paris Agreement targets, land use and ecological sensitivity of business activities, water-use, and withdrawal in water-stressed areas.
People: metrics on diversity and inclusion, pay equality among gender and ethnicities, wage level and disparities among CEOs, median income, minimum wage, and compulsory labor, health and safety training provided.
Prosperity: metrics on employee turnover and hires, economic contributions, financial investments, R&D expenditures, and taxes paid.
With 120 of the world’s largest companies, including Big 4 accounting firms and institutional banks, supporting Stakeholder Capitalism metrics, and 181 CEOs of the Business Roundtable reviewing corporate purpose statements to “express a fundamental commitment to all stakeholders”, Stakeholder theory is gaining increasing prominence and endorsement in modern business environments. With increased consumer scrutiny and accelerating corporate commitment to social responsibility, there is significant hope for the private sector to assume its responsibility in battling global challenges such as climate change and socio-economic inequality.
Despite the two theories often being pitted against each other, both agree that profit remains a private sector priority to access resources and capital required for meaningful change. However, Stakeholder theory aims to take a more long-term view, allowing for shared value among all stakeholders, rather than short-term, quarterly shareholder profits.
Sources
https://www.weforum.org/agenda/2022/01/the-davos-agenda-2022-addressing-the-state-of-the-world/
https://public.wmo.int/en/resources/united_in_science
https://gsdrc.org/topic-guides/the-social-impact-of-private-sector-development/
William Lazonick and Mary O’Sullivan, INSEAD, Boulevard de Constance, 77305 Fontainebleau Cedex, France. E-mail: William.Lazonick@insead.fr; Mary.O.Sullivan@insead.fr
https://www.theatlantic.com/ideas/archive/2019/08/milton-friedman-shareholder-wrong/596545/
Fink, L. (2015). BlackRock CEO Larry Fink tells the world’s biggest business leaders to stop worrying about short-term results. Business Insider. Retrieved from: http://www.businessinsider. com/larry-fink-letter-to-ceos-2015-4?IR=T
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http://stakeholdertheory.org/about/
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