What is the purpose of a firm?
Before we answer the question I must start with what in many-ways set the foundation on which a seminal essay written in the 1970 article by Milton Friedman, “The Social Responsibility of Business is to Increase its Profits”, The New York Times Magazine,
September 13, 1970.
“When I hear businessmen speak eloquently about the “social responsibilities of business in a free-enterprise system,” I am reminded of the wonderful line about the Frenchman who discovered at the age of 70 that he had been speaking prose all his life. The businessmen believe that they are defending free enterprise when they declaim that business is not concerned “merely” with profit but also with promoting desirable “social” ends; that business has a “social conscience” and takes seriously its responsibilities for providing employment, eliminating discrimination, avoiding pollution and whatever else may be the catchwords of the contemporary crop of reformers. In fact they are–or would be if they or anyone else took them seriously–preaching pure and unadulterated socialism. Businessmen who talk this way are unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades. ” http://umich.edu/~thecore/doc/Friedman.pdf
It is very lear that the single minded pursuit of profit has failed everything we know today.
Behaviour of executives and boards:
With capital borrowing rates at such all time lows executives and boards have been been rampant in spending borrowed capital. From 2013 to 2019 the stock markets seemed to go up based on some incredible fundamentals. However alas the large part of that driver is the $4.6Trillion of share buyback or greater than 50% of the entire market cap of the DJIA and entire Free Cash Flow of the S&P 500! In addition these companies have over $10T in debt on their balance sheets, which is over 120% of DJIA market cap and 50% of GDP
Post the 2008/09 financial crisis with the availability of zero cost capital, almost every company seems to see no value creation, capture and distribution from their core business and have resulted in value extraction behaviour to look more like fund managers or stock pickers of their own stock, rather than invest their retained earnings into the business itself and not in stock buyback or shareholder dividends just to achieve EPS number and achieve individual bonuses.
What does this indicate? Causality of contracts that reward behaviour of greed which lead to predictably irrational behaviour of executives and boards.
What is the role of a business?
The role of business is to have “Purpose”, around which “Profit” is a derivative and to have a “Conscience” around “Capital” deployed for which the derivative is how value is created, capture and distributed.
The role of an executive in a company is to look at the basics of why the business exists. Its responsibilities lie in the very reason and thus its purpose on which the company or organisation exists.
For example if a business making automobiles is working in how to make the world of mobility have a purpose and conscience and if EVs seem to be the answer than the first question is to ask for the executive is where does the electricity generated come from? For if every car, truck and bus in the world will become an EV and its electricity came from fossil fuels such as coal fired power plants, than the very purpose of the purpose is destroyed for the generations that follow. The capital deployed by conscience should not be just on the battery or the electricity charging points but the ecosystem upstream itself.
So should we address the question of purpose and it may be to have a zero or negative Carbon based mobility ecosystem. Then that would start with the source of power generation and how auto companies would enable that entire ecosystem to play in. So would auto companies become Carbon neutral to negative electricity marketplaces and look like an e-commerce platform with the ability to connect automobiles to a both grid and off-grid? Imagine the value creation and capture in addressing the causality and the resulting behaviour and its effects on a compounding growth ecosystem with an inverse compounding Carbon utilisation and fundamental sequestration model? Would it then mean that EV companies find sources of energy ti sequester Carbon and trade that electricity into a marketplace for its users? Is that the purpose of an EV firm?
Or if local or central governments wake up every morning and apply taxes on products and services just to generate and income and then do not have a clarity on deploying that income, taxed from the common person on the street in to initiatives which would be inclusive in design and generate an ROI and ROE that based on the conscience of the capital in policies or laws, the results over time suffer from the effect Compounding Depreciation.
Profit maximisation has continued to erode the value of a firm’s DNA in the long term with a culture of extract value even if it means in the long term we are all dead. Look across any industry, pharmaceuticals, finance, insurance, healthcare, technology, the list is endless. Instead of optimising for value, every firm’s single pursuit of profit maximisation has ultimately led to chaos from which company mortality is on the rise, poor executive behaviour is on the rise and investor greed is on the rise and with technology the velocity of greed is at the speed of light.
Since the financial crisis banks have been fined an incredible value in fines of over $321 Billion which was from irresponsible behaviour of the methods deployed in getting mortgage backed securities and put into collateralized debt obligations (CDOs), which were really greed packaged and sold off to unsuspecting investors leading to the collapse of the banks and financial system prompting government to step in with a trillion dollar bailout.
The crisis was the worst U.S. economic disaster since the Great Depression. In the United States, the stock market plummeted, wiping out nearly $8 trillion in value between late 2007 and 2009. Unemployment climbed, peaking at 10 percent in October 2009. Americans lost $9.8 trillion in wealth as their home values plummeted and their retirement accounts vaporized. This turmoil lead to over $8T in the stock markets, umeploymnet at 10 percent and almost $10T in wealth due to losses of real estate pricing for home owners and overnight 401k disappeared. In addition the global wipe out was over $2T in economic growth which reflected the staggering scale of losses from USA to UK, Europe and Asia.
All of this caused by greed or behaviour. The SARS CoV2 virus has further highlighted the continuation of behaviour of company executives and government leaders in handling of the crisis and the incredible loss of lives and livelihoods.
This comes back to a simple question. What really is the purpose of a firm?
We see this in two parts. The reason of existence of a firm is to have Profit with Purpose and Capital with Conscience. This is what we believe is the sustainable moat and competitive advantage of a firm, organisation or country and thus every person in society and our roles in today and more importantly tomorrow.
A study conducted titled ” Business Model Warfare The Strategy of Business Breakthroughs“, by Langdon Morris Senior Practice Scholar
Ackoff Center for the Advancement of Systems Approaches (A-CASA) The University of Pennsylvania 2003, highlighted the mortality rate of S&P 500, Fortune 500 firms where every month one company died or disappeared. http://www.innovationlabs.com/BusModelWarfare.pdf
Why this may seem alarming today with the advent of technology these rates of failure continue to accelerate due to a single factor, human behaviour.
The role of every person in a company is to look at her or his function and ask a simple question, what is my purpose and what does my conscience ask me to do. Companies that continue to work on this core will continue to exist and thrive and outlive, outperform and out manoeuvre their competitors in their ecosystems for the value they create, the value they distribute and the value they capture. We call this the Value Stream thesis.
If companies and all their employees, executives, boards, investors and ecosystem partners have a single minded view on how to create a greater future with a simple metric of what value is and why having a purpose and a conscience will far outweigh every other short term metrics. The results disguised as purpose end up driving herds of investors in stock markets wild and wilder when they loose all the value they projected to have, will end up being left in the dust in the sands of time.
To quote Charles Mackay and his seminal work Extraordinary Popular Delusions and the Madness of Crowds in 1841 is a must read and a line that describes what has stood and will continue to be is, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.“
Markets and mechanism design:
To ensure that we all live in a free market economy the principles of mechanism design are critical to understanding the role of the actors. So where do policymakers and government leaders begin? The principles of 101 of mechanism design with “behaviour” as the pivot and the algorithm to increase participation between every upstream, midstream and downstream entity in the economy for every industry to creates the circular flow of behaviour and capital.
Every firm is an agent in the free market economy. All economic interactions that connect multiple actors including individuals, governments and other stakeholders, each with there purpose. The goals of mechanism design are to achieve three key principles;
i. Self Interest (SI)
ii. Truthful Sharing (TS) &
iii. Incentive Compatibility (IC)
How do we design mechanisms around quantum rational thinking to create value for all participants where we map the core of the challenge, the behaviour of people and create market-making mechanisms that create a participative and inclusive economy by the design of Self-Interest (SI), Incentive Compatibility (IC) and Truthful Sharing (TS), else watch every single model implode right in front of one’s eyes, Today’s challenges cannot be solved with yesterday’s ideas and we are dealing with a truly wicked problem that needs everyone to understand the principles of a wicked problem first. As multiple actors or agents each with their self interest interact around mechanisms designed to bring out the Truthful Sharing of their behaviour whether it be market prices or service bundling or tax structuring and together Incentive Compatibility to achieve a collective return on decision making, all around private information. These design of mechanisms whether allocation or other further accelerate the need for purpose and conscience. Leonid Hurwicz, Eric Maskin and Roger Myerson were awarded the 2007 Nobel Prize in Economics for their contributions to mechanism design theory. This was a critical inflection point in behavioural economics around behaviour in agents in economic mechanisms, and the analysis of models, agents and markets.
For example companies globally have leveraged structures such as Double Irish and Dutch Sandwich as a market mechanism to optimise for tax, rather than for the product or service offering. Questions from where to register their corporate, their IP, revenue flow, costs and labor, that are the measure of impact in the balance sheet, which may be tens or hundreds of millions of dollars. Tax regimes as incentives at heart may be a critical component to growth of industries from Silicon Valley and Ireland to Israel to India. That’s why from Double Irish and Dutch Sandwich to the STP tax regime in India, structuring your company around a beneficial tax regime framework and meet GAAP compliance as key to companies. According to Reuters, “the large 500 largest American companies hold more than $2.1 trillion in accumulated profits offshore to avoid U.S. taxes and would collectively owe an estimated $620 billion in U.S. taxes if they repatriated the funds”
It’s headlines like these that getting a lot of attention on how to deal with international regulation that enables this flow of capital and IP and drives profitability in balance sheets of a lot of innovative and large corporations. So is the market making mechanism of tax optimisation really value capture or is the purpose of the business in itself the core?
The sense of purpose in the pursuit of profit will create better decision making in where the role of firm’s products or services lie and deploying capital with a conscience create the environment in which every single individual will be rewarded for the sum of their decision making and behaviour of Purpose + Conscience. This is where the real value system lies. Whether in a firm or in government the role of ever member of the organisation is to see how to achieve the core sense of purpose and to achieve the conscience deployment of capital across the ecosystem.
This time it’s not different.