After reading the attached ‘Value Maximization’ paper, construction a 4-6 page referee report ?in Word format (1,200 to 1,800

Amos Tuck School of Business at Dartmouth College

Working Paper No. 01-09

Negotiation, Organization and Markets Unit Harvard Business School Working Paper No. 01-01

Value Maximization, Stakeholder Theory, and the Corporate Objective Function

Michael C. Jensen The Monitor Company, Harvard Business School, and

Amos Tuck School at Dartmouth College

October 2001

 Monitor Company and M. C. Jensen 2002

This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection at:

http://papers.ssrn.com/abstract=220671

October 29, 2001 © 2001 Michael C. Jensen

Value Maximization, Stakeholder Theory, and the Corporate Objective Function

Michael C. Jensen The Monitor Group and Harvard Business School

[email protected]

Abstract

This paper examines the role of the corporate objective function in corporate productivity and efficiency, social welfare, and the accountability of managers and directors. I argue that since it is logically impossible to maximize in more than one dimension, purposeful behavior requires a single valued objective function. Two hundred years of work in economics and finance implies that in the absence of externalities and monopoly (and when all goods are priced), social welfare is maximized when each firm in an economy maximizes its total market value. Total value is not just the value of the equity but also includes the market values of all other financial claims including debt, preferred stock, and warrants.

In sharp contrast stakeholder theory, argues that managers should make decisions so as to take account of the interests of all stakeholders in a firm (including not only financial claimants, but also employees, customers, communities, governmental officials, and under some interpretations the environment, terrorists, and blackmailers). Because the advocates of stakeholder theory refuse to specify how to make the necessary tradeoffs among these competing interests they leave managers with a theory that makes it impossible for them to make purposeful decisions. With no way to keep score, stakeholder theory makes managers unaccountable for their actions. It seems clear that such a theory can be attractive to the self-interest of managers and directors.

Creating value takes more than acceptance of value maximization as the organizational objective. As a statement of corporate purpose or vision, value maximization is not likely to tap into the energy and enthusiasm of employees and managers to create value. Seen in this light, change in long-term market value becomes the scorecard that managers, directors, and others use to assess success or failure of the organization. The choice of value maximization as the corporate scorecard must be complemented by a corporate vision, strategy and tactics that unite participants in the organization in its struggle for dominance in its competitive arena.

A firm cannot maximize value if it ignores the interest of its stakeholders. I offer a proposal to clarify what I believe is the proper relation between value maximization and stakeholder theory. I call it enlightened value maximization, and it is identical to what I call

enlightened stakeholder theory. Enlightened value maximization utilizes much of the structure of stakeholder theory but accepts maximization of the long run value of the firm as the criterion for making the requisite tradeoffs among its stakeholders. Managers, directors, strategists, and management scientists can benefit from enlightened stakeholder theory. Enlightened stakeholder theory specifies long-term value maximization or value seeking as the firm’s objective and therefore solves the problems that arise from the multiple objectives that accompany traditional stakeholder theory.

I also discuss the Balanced Scorecard, the managerial equivalent of stakeholder theory. The same conclusions hold. Balanced Scorecard theory is flawed because it presents managers with a scorecard which gives no score–that is, no single-valued measure of how they have performed. Thus managers evaluated with such a system (which can easily have two dozen measures and provides no information on the tradeoffs between them) have no way to make principled or purposeful decisions. The solution is to define a true (single dimensional) score for measuring performance for the organization or division (and it must be consistent with the organization's strategy). Given this we then encourage managers to use measures of the drivers of performance to understand better how to maximize their score. And as long as their score is defined properly, (and for lower levels in the organization it will generally not be value) this will enhance their contribution to the firm.

Keywords: Value Maximization, Stakeholder Theory, Balanced Scorecard, Multiple Objectives, Social Welfare, Social Responsibility, Corporate Objective Function, Corporate Purpose, Tradeoffs, Corporate Governance, Strategy, Special Interest Groups, Social Responsibility.

Published in Journal of Applied Corporate Finance, Fall 2001. Forthcoming in Business Ethics Quarterly , Vol. 12, No.1, Jan 2002, and in Unfolding Stakeholder Thinking, edited by Joerg Andriof, Sandra

Waddock, Sandra Rahman and Bryan Husted, Greenleaf Publishing, 2002. Earlier versions published in the European Financial Management Review, 2001, and in Breaking the Code of

Change, Michael Beer and Nithan Norhia, eds, Harvard Business School Press, 2000.

© 2001 Michael C. Jensen

Harvard Business School Working Paper #00-058, revised 10/2001

This paper can be downloaded without charge from the Social Science Research Network Electronic Library at:

http://papers.ssrn.com/abstract_id=220671

8 BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

VALUE MAXIMIZATION, STAKEHOLDER THEORY, AND THE CORPORATE OBJECTIVE FUNCTION

by Michael C. Jensen, The Monitor Group and Harvard Business School*

n most industrialized nations today, economists, management scholars, policy makers, corporate executives, and spe- cial interest groups are engaged in a

*© 2001 Michael C. Jensen. An earlier version of this paper appears in Breaking the Code of Change, Michael Beer and Nithan Norhia, eds, Harvard Business School Press, 2000. This research has been supported by the The Monitor Group and

I question: What are we trying to accomplish? Or, to put the same question in more concrete terms: How do we keep score? When all is said and done, how do we measure better versus worse?

At the economy-wide or social level, the issue is this: If we could dictate the criterion or objective function to be maximized by firms (and thus the performance criterion by which corporate execu- tives choose among alternative policy options), what would it be? Or, to put the issue even more simply: How do we want the firms in our economy to measure their own performance? How do we want them to determine what is better versus worse?

Most economists would answer simply that managers must have a criterion for evaluating perfor- mance and deciding between alternative courses of action, and that the criterion should be maximization of the long-term market value of the firm. (And “firm value,” by the way, means not just the value of the equity, but the sum of the values of all financial claims on the firm—debt, warrants, and preferred stock, as well as equity.) This Value Maximization proposition has its roots in 200 years of research in economics and finance.

The main contender to value maximization as the corporate objective is called “stakeholder theory.” Stakeholder theory says that managers should make decisions that take account of the interests of all the stakeholders in a firm. Stakeholders include all

Harvard Business School Division of Research. I am indebted to Nancy Nichols, Pat Meredith, Don Chew, and Janice Willett for many valuable suggestions.

high-stakes debate over corporate governance. In some scholarly and business circles, the discussion focuses mainly on questions of policies and proce- dures designed to improve oversight of corporate managers by boards of directors. But at the heart of the current global corporate governance debate is a remarkable division of opinion about the fundamen- tal purpose of the corporation. Much of the discord can be traced to the complexity of the issues and to the strength of the conflicting interests that are likely to be affected by the outcome. But also fueling the controversy are political, social, evolutionary, and emotional forces that we don’t usually think of as operating in the domain of business and economics. These forces serve to reinforce a model of corporate behavior that draws on concepts of “family” and “tribe.” And as I argue in this paper, this model is an anachronism—a holdover from an earlier period of human development that nevertheless continues to cause much confusion among corporate managers about what it is that they and their organizations are supposed to do.

At the level of the individual organization, the most basic issue of governance is the following. Every organization has to ask and answer the

9 VOLUME 14 NUMBER 3 FALL 2001

individuals or groups who can substantially affect, or be affected by, the welfare of the firm—a category that includes not only the financial claimholders, but also employees, customers, communities, and gov- ernment officials.1 In contrast to the grounding of value maximization in economics, stakeholder theory has its roots in sociology, organizational behavior, the politics of special interests, and, as I will discuss below, managerial self-interest. The theory is now popular and has received the formal endorsement of many professional organizations, special interest groups, and governmental bodies, including the current British government.2

But, as I argue in this paper, stakeholder theory should not be viewed as a legitimate contender to value maximization because it fails to provide a complete specification of the corpo- rate purpose or objective function. To put the matter more concretely, whereas value maximiza- tion provides corporate managers with a single objective, stakeholder theory directs corporate managers to serve “many masters.” And, to para- phrase the old adage, when there are many masters, all end up being shortchanged. Without the clarity of mission provided by a single-valued objective function, companies embracing stake- holder theory will experience managerial confu- sion, conflict, inefficiency, and perhaps even competitive failure. And the same fate is likely to be visited on those companies that use the so- called “Balanced Scorecard” approach—the mana- gerial equivalent of stakeholder theory—as a performance measurement system.

But if stakeholder theory and the Balanced Scorecard can destroy value by obscuring the over- riding corporate goal, does that mean they have no legitimate corporate uses? And can corporate man- agers succeed by simply holding up value maximi- zation as the goal and ignoring their stakeholders? The answer to both is an emphatic no. In order to maximize value, corporate managers must not only satisfy, but enlist the support of, all corporate

stakeholders—customers, employees, managers, suppliers, local communities. Top management plays a critical role in this function through its leadership and effectiveness in creating, projecting, and sustain- ing the company’s strategic vision. And even if the Balanced Scorecard is likely to be counterproductive as a performance evaluation and reward system, the process of creating the scorecard can add significant value by helping managers understand both the company’s strategy and the drivers of value in their businesses.

With this in mind, I clarify what I believe is the proper relation between value maximization and stakeholder theory by proposing a (somewhat) new corporate objective function. I call it enlightened value maximization, and it is identical to what I call enlightened stakeholder theory. Enlightened value maximization uses much of the structure of stake- holder theory but accepts maximization of the long- run value of the firm as the criterion for making the requisite tradeoffs among its stakeholders. Enlight- ened stakeholder theory, while focusing attention on meeting the demands of all important corporate constituencies, specifies long-term value maximiza- tion as the firm’s objective. In so doing, it solves the problems arising from the multiple objectives that accompany traditional stakeholder theory by giving managers a clear way to think about and make the tradeoffs among corporate stakeholders.

The answers to the questions of how managers should define better vs. worse, and how managers in fact do define it, have important implications for social welfare. Indeed, the answers provide the business equivalent of the medical profession’s Hippocratic Oath. It is an indication of the infancy of the science of management that so many in the world’s business schools, as well as in professional business organizations, seem to understand so little of the fundamental issues in contention.

With this introduction of the issues, let me now move to a detailed examination of value maximiza- tion and stakeholder theory.

1. Under some interpretations, stakeholders also include the environ- ment, terrorists, blackmailers, and thieves. Edward Freeman, for example, writes: “The…definition of ‘stakeholder’ [is] any group or individual who can affect or is affected by the achievement of an organization’s purpose.…For instance, some corporations must count ‘terrorist groups’ as stakeholders.” (Edward R. Freeman, Strategic Management: A Stakeholder Approach, Pittman Books Limited, 1984, p. 53.)

2. See, for example, Principles of Stakeholder Management: The Clarkson Principles: The Clarkson Centre for Business Ethics, Joseph L. Rotman School of Management, Univ. of Toronto, Canada. For a critical analysis of stakeholder theory, I especially recommend the following articles by Elaine Sternberg:

“Stakeholder Theory Exposed,” The Corporate Governance Quarterly 2, no. 1 (1996); “The Stakeholder Concept: A Mistaken Doctrine,” London: Foundation for Business Responsibilities, Issue Paper No.4 (November, 1999) (also available from the Social Science Research Network at: http://papers.ssrn.com/paper=263144). See also Sternberg’s recent book, Just Business: Business Ethics in Action: Oxford University Press, 2000, which surveys the acceptance of stakeholder theory by the Business Roundtable and the Financial Times, and its recognition by law in 38 American states. On the latter issue, see also James L. Hanks, “From the Hustings: The Role of States with Takeover Control Laws.” Mergers & Acquisitions 29, no. 2 (1994), September-October.

10 JOURNAL OF APPLIED CORPORATE FINANCE

THE LOGICAL STRUCTURE OF THE PROBLEM

In discussing whether firms should maximize value or not, we must separate two distinct issues:

1. Should the firm have a single-valued objective? 2. And, if so, should that objective be value

maximization or something else (for example, main- taining employment or improving the environment)?

The debate over whether corporations should maximize value or act in the interests of their stakeholders is generally couched in terms of the second issue, and is often mistakenly framed as stockholders versus stakeholders. The real conflict here, though this is rarely stated or even recognized, is over the first issue—that is, whether the firm should have a single-valued objective function or scorecard. The failure to frame the problem in this way has contributed greatly to widespread misun- derstanding and contentiousness.

What is commonly known as stakeholder theory, while not totally without content, is fundamentally flawed because it violates the proposition that a single-valued objective is a prerequisite for purpose- ful or rational behavior by any organization. In particular a firm that adopts stakeholder theory will be handicapped in the competition for survival because, as a basis for action, stakeholder theory politicizes the corporation and leaves its managers empowered to exercise their own preferences in spending the firm’s resources.

Issue #1: Purposeful Behavior Requires the Existence of a Single-Valued Objective Function.

Consider a firm that wishes to increase both its current-year profits and its market share. Assume, as shown in Figure 1, that over some range of values of market share, profits increase. But, at some point, increases in market share come only at the expense of reduced current-year profits—say, because increased expenditures on R&D and advertising, or price reduc- tions to increase market share, reduce this year’s profit. Therefore, it is not logically possible to speak of maximizing both market share and profits.

In this situation, it is impossible for a manager to decide on the level of R&D, advertising, or price reductions because he or she is faced with the need to make tradeoffs between the two “goods”—profits and market share—but has no way to do so. While the manager knows that the firm should be at the point of maximum profits or maximum market share (or somewhere between them), there is no purpose- ful way to decide where to be in the area in which the firm can obtain more of one good only by giving up some of the other.

Multiple Objectives Is No Objective

It is logically impossible to maximize in more than one dimension at the same time unless the

FIGURE 1 TRADEOFF BETWEEN PROFITS AND MARKET SHARE

Market Share

P ro

fi ts

Maximum Profits

Maximum Market Share

11 VOLUME 14 NUMBER 3 FALL 2001

dimensions are what are known as “monotonic transformations” of one another. Thus, telling a manager to maximize current profits, market share, future growth in profits, and anything else one pleases will leave that manager with no way to make a reasoned decision. In effect, it leaves the manager with no objective. The result will be confusion and a lack of purpose that will handicap the firm in its competition for survival.3

A company can resolve this ambiguity by speci- fying the tradeoffs among the various dimensions, and doing so amounts to specifying an overall objective such as V= f(x, y, …) that explicitly incor- porates the effects of decisions on all the perfor- mance criteria—all the goods or bads (denoted by (x, y, …)) that can affect the firm (such as cash flow, risk, and so on). At this point, the logic above does not specify what V is. It could be anything the board of directors chooses, such as employment, sales, or growth in output. But, as I argue below, social welfare and survival will severely constrain the boards’ choices.

Nothing in the analysis so far has said that the objective function f must be well behaved and easy to maximize. If the function is non-monotonic, or even chaotic, it makes it more difficult for managers to find the overall maximum. (For example, as I discuss later, the relationship between the value of the firm and a company’s current earnings and investors’ expectations about its future earnings and investment expenditures will often be difficult to formulate with much precision.) But even in these situations, the meaning of “better” or “worse” is defined, and managers and their monitors have a “principled”—that is, an objective and theoretically consistent—basis for choosing and auditing decisions. Their choices are not just a matter of their own personal preferences among various goods and bads.

Given managers’ uncertainty about the exact specification of the objective function f, it is perhaps better to call the objective function “value seeking” rather than value maximization. This way one avoids the confusion that arises when some argue that

maximizing is difficult or impossible if the world is structured in sufficiently complicated ways.4 It is not necessary that we be able to maximize, only that we can tell when we are getting better—that is moving in the right direction.

Issue #2: Total Firm Value Maximization Makes Society Better Off.

Given that a firm must have a single objective that tells us what is better and what is worse, we then must face the issue of what that definition of better is. Even though the single objective will always be a complicated function of many different goods or bads, the short answer to the question is that 200 years’ worth of work in economics and finance indicate that social welfare is maximized when all firms in an economy attempt to maximize their own total firm value. The intuition behind this criterion is simple: that value is created—and when I say “value” I mean “social” value—whenever a firm produces an output, or set of outputs, that is valued by its customers at more than the value of the inputs it consumes (as valued by their suppli- ers) in the production of the outputs. Firm value is simply the long-term market value of this expected stream of benefits.

To be sure, there are circumstances when the value-maximizing criterion does not maximize social welfare—notably, when there are monopolies or “externalities.” Monopolies tend to charge prices that are too high, resulting in less than the socially optimal levels of production. By “externalities,” economists mean situations in which decision-mak- ers do not bear the full cost or benefit consequences of their choices or actions. Examples are cases of air or water pollution in which a firm adds pollution to the environment without having to purchase the right to do so from the parties giving up the clean air or water. There can be no externalities as long as alienable property rights in all physical assets are defined and assigned to some private individual or firm. Thus, the solution to these problems lies not in

3. For a case study of a small non-profit firm that almost destroyed itself while trying to maximize over a dozen dimensions at the same time, see Michael Jensen, Karen H. Wruck, and Brian Barry, “Fighton, Inc. (A) and (B),” Harvard Business School Case #9-391-056, March 20, 1991; and Karen Wruck, Michael Jensen, and Brian Barry, “Fighton, Inc., (A) and (B) Teaching Note,” Case #5-491-111, Harvard Business School, 1991. For an interesting empirical paper that formally tests the proposition that multiple objectives handicap firms, see Kees Cools and Mirjam van Praag (2000), “The Value Relevance of a Single-Valued Corporate Target: An Empirical Analysis.” Available from the Social Science Research Network eLibrary

at: http://papers.ssrn.com/paper=244788. In their test using 80 Dutch firms in the 1993-1997 period, the authors conclude: “Our findings show the importance of setting one single target for value creation.” (emphasis in original)

4. I’d like to thank David Rose for suggesting this simple and more descriptive term for value maximizing. See David C. Rose, “Teams, Firms, and the Evolution of Profit Seeking Behavior,” May, 1999, Dept. of Economics, University of Missouri- St. Louis, St. Louis, MO, Unpublished Manuscript, available from the Social Science Research Network eLibrary at: http://papers.ssrn.com/paper=224438.

Telling a manager to maximize current profits, market share, future growth in profits, and anything else one pleases will leave that manager with no way to make a

reasoned decision. In effect, it leaves the manager with no objective.

12 JOURNAL OF APPLIED CORPORATE FINANCE

telling firms to maximize something other than profits, but in defining and then assigning to some private entity the alienable decision rights necessary to eliminate the externalities.5 In any case, resolving externality and monopoly problems, as I will discuss later, is the legitimate domain of the government in its rule-setting function.6

Maximizing the total market value of the firm— that is, the sum of the market values of the equity, debt and any other contingent claims outstanding on the firm—is the objective function that will guide managers in making the optimal tradeoffs among multiple constituencies (or stakeholders). It tells the firm to spend an additional dollar of resources to satisfy the desires of each constituency as long as that constituency values the result at more than a dollar. In this case, the payoff to the firm from that invest- ment of resources is at least a dollar (in terms of market value). Although there are many single- valued objective functions that could guide a firm’s managers in their decisions, value maximization is an important one because it leads under most conditions to the maximization of social welfare. But let’s look more closely at this.

VALUE MAXIMIZING AND SOCIAL WELFARE

Much of the discussion in policy circles about the proper corporate objective casts the issue in terms of the conflict among various constituencies, or “stakeholders,” in the corporation. The question then becomes whether shareholders should be held in higher regard than other constituencies, such as employees, customers, creditors, and so on. But it is both unproductive and incorrect to frame the issue in this manner. The real issue is what corporate behavior will get the most out of society’s limited resources—or equivalently, what behavior will re- sult in the least social waste—not whether one group is or should be more privileged than another.

Profit Maximization: A Simplified Case

To see how value maximization leads to a socially efficient solution, let’s first consider an objective function, profit maximization, in a world in which all production runs are infinite and cash flow streams are level and perpetual. This scenario with level and perpetual streams allows us to ignore the complexity introduced by the tradeoffs between current and future-year profits (or, more accurately, cash flows). Consider now the social welfare effects of a firm’s decision to take resources out of the economy in the form of labor hours, capital, or materials purchased voluntarily from their owners in single-price markets. The firm uses these inputs to produce outputs of goods or services that are then sold to consumers through voluntary transactions in single-price markets.

In this simple situation, a company that takes inputs out of the economy and puts its output of goods and services back into the economy increases aggre- gate welfare if the prices at which it sells the goods more than cover the costs it incurs in purchasing the inputs (including, of course, the cost of the capital the firm is using). Clearly the firm should expand its output as long as an additional dollar of resources taken out of the economy is valued by the consumers of the incremental product at more than a dollar. Note that it is precisely because profit is the amount by which revenues exceed costs—by which the value of output exceeds the value of inputs—that profit maximization7

leads to an efficient social outcome.8

Because the transactions are voluntary, we know that the owners of the inputs value them at a level less than or equal to the price the firm pays— otherwise they wouldn’t sell them. Therefore, as long as there are no negative externalities in the input factor markets,9 the opportunity cost to society of those inputs is no higher than the total cost to the firm of acquiring them. I say “no higher” because

5. See Ronald H. Coase, “The Problem of Social Cost,” Journal of Law and Economics 3, no. October 1960: pp. 1-44; and Michael C. Jensen and William H. Meckling, “Specific and General Knowledge, and Organization

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