Undermining Staying Power

Myriad theories have been bandied about to explain the root cause of the recent carnage in the financial sector that has brought the economy to its knees. While examining lending provisions, banking regulations and derivatives structures can provide some insight, focusing our attention in these areas obscures the real lesson.

The current financial carnage is a product of increasing market volatility and the prime culprit of that volatility is a triumvirate of well-intentioned management theories that is taught in every business school and entrenched in every significant publicly-traded company. Intended to ensure longevity and profitability, these theories have instead contributed mightily to the technology crash of 2001-02 and the financial services crash of 2008.

Neither would have happened if our business and capital markets theories were as robust as those used to govern the American National Football League (NFL). You read that right. In the NFL, definitions of and rewards for success are grounded in the “real market” – the real touchdowns and field goals scored during a 60-minute game that define a real winner. Football also has an associated “expectations market”: betting on football. Bettors place their wagers not on which team will win but rather whether their team will beat the “point spread,” the point differential that reflects bettors’ expectations and balances their bets evenly across the two teams.

In business, the real market is the world in which products are produced, revenues earned, expenses paid and real dollars of profit hit the bottom line. But increasingly that’s not where business bases its definition of success or decisions regarding rewards. For that, business turns to the expectations market – driven entirely by expectations about future events – and reflected in a firm’s stock price.

A stock price in business is the moral equivalent of a point spread in football. However, NFL players are not rewarded for beating the point spread and are strictly forbidden from betting on any game including their own; their incentives are based on how they do on the field. In stark contrast, business executives are encouraged if not required to play in the expectations market.

The first theory that begins executives’ slide down that slippery slope is shareholder value theory which holds that the primary job of executives of publicly-traded companies is to maximize shareholder value — a combination of expectations market (appreciation) and real market (dividends) measures.

The existence of that theory led to the creation of the second theory – principal-agent theory – which held that the interests of executive ‘agents’ are not naturally aligned with those of shareholder ‘principals’, because executives, as human beings, inevitably put their own interests ahead of shareholders’. Hence the agents are inclined to undermine the first theory and not maximize shareholder value.

That in turn led to stock-based compensation alignment theory, which held that in order to re-align management agents with shareholder principals, one has to make executive compensation significantly stock-based so that they would feather the nest of shareholders in order to feather their own.

As a result, unlike NFL players, business executives are compensated primarily on their expectations market performance, through significant stock-based compensation. The theorists missed the logical connection that this makes their primary incentive not to enhance real results but rather to increase expectations. Only if they increase expectations will their incentives pay off; real market performance is secondary.

This creates a pernicious trap. Imagine a football team starts winning every game it plays – like the 2007 New England Patriots. With each win, expectations for the team grow. If expectations keep rising, no team — no matter how good — can beat the point spread every Sunday – like the record 24.5-point spread the Patriots faced in a late-season game against the New York Jets. They clobbered the Jets but didn’t cover the spread, disappointing their bettors.

The identical trap awaits high-performing companies. The very instant expectations rise, the base for new shareholders is a price consistent with the new heightened-expectations level. This is why Google struggles to imagine, while it is dominating its market, how it can return to the expectation level of all those investors who purchased shares at $400.

Increasingly, executives have understood the structure and strictures of the game they are playing. They get compensated highly to the extent that they can raise expectations. However it is impossible for them to keep expectations rising continuously. They understand that expectations will eventually exceed reality, then come crashing down.

So they increasingly define their job as increasing expectations not increasing real performance because improving performance is the hardest way to increase expectations. Easier ways include going to Wall Street to hype expectations or engineering a series of acquisitions to give the appearance of rapid growth or employing aggressive accounting to give the appearance of higher profitability. But because these techniques are impossible to sustain, the crafty executive concentrates on producing one spurt of expectations-raising before cashing in and getting rich — before expectations come tumbling down.

The effect is two-fold: enormous expectations-market volatility and flaccid real-market performance; or more simply a volatile and crappy economy.

And the biggest friends of these volatility-driven executives are the hedge funds. The more volatility, the better it is for these speculators. If they bet right on a big expectations swing, they make giga-bucks and if they bet wrong, they hand the remaining money back to investors and start another hedge fund. Further still, like executives, hedge-fund managers quickly realized that influencing the expectations market was their most powerful money-making tool. If that meant getting together with other hedge funds to organize concerted attacks on target companies to drive down their stock, why not? The extreme form of payoff driving this behavior – where the fund manager is paid two per cent of assets-under management plus 20 per cent of investors’ gain — is itself based on stock-based compensation alignment theory.

The time has come to scrap shareholder value theory. Executives should care about shareholders only with respect to the real market. The goal should be to earn a return on the real dollars given to the company by real shareholders, compensating equity investors in proportion to the degree of risk at which they put their capital. Managers should feel zero responsibility to earn a return on any value other than the book value per share.

As well, we should entirely scrap stock-based compensation alignment theory. Executive compensation should be based entirely on real-market measures such as revenue growth, market share, profits, and book equity return. Incentives should be aligned solely to real market performance.

While these proposals might seem draconian, they are necessary to save corporations from themselves. If a business wants to enjoy staying power, it must become more like the NFL, replacing the troika of current management theories with a theory divorced from the expectations market and embedded in the real market.

This is an excerpt from an article by Roger Martin in the Spring 2009 issue of Rotman Magazine. Roger Martin is dean and professor of strategic management at the Rotman School of Management, and director of the school’s AIC Institute for Corporate Citizenship. His third book, The Design of Business, will be published by Harvard Business School Press in 2009.