Rethinking the Purpose of Business: Why 'Maximize Shareholder Value' Hasn't Worked

Last Updated Jun 7, 2011 11:15 AM EDT

In 1976, an influential paper redefined the purpose of business for decades to come. "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure," by Michael Jensen and William Meckling, argued that executive compensation and perks motivated CEOs and other top officers to feather their own nests at the expense of the business itself.

Wouldn't it be better, Jensen and Meckling offered, if executive pay was tied with the interests of shareholders -- the people who actually put their money at risk. If the company's stock did well, executive pay would rise in concert. And thus was born the idea that CEOs serve to maximize shareholder value, the slogan that has defined the business landscape ever since.

And led to two economic collapses in just 10 years, after 70 years of relative stability; that led to an ever increasing number of execs paraded on perp walks; that led to CEOs over-inflating their own company's shares to drive up the price; and that led to decreasing rather than increasing returns to investors.

Clearly, maximizing shareholder value is not working and needs to be replaced. That's the argument of Roger Martin, the Dean of the Rotman School of Management at the University of Toronto, in his new book, Fixing the Game. The problem as he sees it is that CEOs game the system to prop up the share price, what Martin calls the world of expectations, rather than managing the business itself, the world of reality.

The needed repair: Put customers first, rather than shareholders. Companies that do this, such as Apple, such as Johnson & Johnson, manage their businesses much differently. They think long term, rather than quarter by quarter. They are cognizant of their impact on society and the environment. They try to bring out the best in their employees. When you do these things correctly, the companies reason, the share price will follow.

A number of interesting thinkers in addition to Martin are using the current economic crisis to rethink capitalism and the nature of the contract between business and society. Michael Porter and Rosabeth Moss Kanter, two of Harvard Business School's most influential thinkers, argue independently that companies are locked in an outdated approach to creating value. Instead of just focusing on short-term profit, execs should steer their companies to benefit society by improving the communities they live in and the world they operate in.

Says Porter in an influential Harvard Business Review article earlier this year: "Businesses must reconnect company success with social progress. Shared value is not social responsibility, philanthropy, or even sustainability, but a new way to achieve economic success. It is not on the margin of what companies do but at the center."

Other thinkers argue that it is the employee that must be at the forefront of all things companies do. An empowered, energized employee makes customers happy and drives ever increasing profits by doing so.

Umair Haque takes perhaps the most revolutionary view of how to modernize capitalism, just short of those who would tip the whole thing into socialism. In his new book The New Capitalist Manifesto: Building a Disruptively Better Business, the author argues world economies are breaking down because they rely on institutions such as schools, banks and governments developed in the industrial age. Companies, he writes, deplete natural resources, exploit workers, harm consumers and produce only "thin value" for a very few people. His manifesto demands a new set of ideals for business including sustainable use of resources, promotion of non-violence and creation of industries that make the least well off better off.

We do seem to have arrived at a point in America where we are ready to challenge past assumptions. When you have government leaders who are at least acknowledging that debt is out of control, that so-called entitlement benefit such as Social Security may need modifications, that the country can no longer afford to be the world's policeman, then you have a time where change is possible.

Should we rethink the purpose of business. If not maximize shareholder value, what then?

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(Image by Flickr user photosteve101, CC 2.0)
  • Sean Silverthorne

    Sean Silverthorne is the editor of HBS Working Knowledge, which provides a first look at the research and ideas of Harvard Business School faculty. Working Knowledge, which won a Webby award in 2007, currently records 4 million unique visitors a year. He has been with HBS since 2001.

    Silverthorne has 28 years experience in print and online journalism. Before arriving at HBS, he was a senior editor at CNET and executive editor of ZDNET News. While at At Ziff-Davis, Silverthorne also worked on the daily technology TV show The Site, and was a senior editor at PC Week Inside, which chronicled the business of the technology industry. He has held several reporting and editing roles on a variety of newspapers, and was Investor Business Daily's first journalist based in Silicon Valley.