Governing for genuine profit.

• Author: O'Hara, Michael J.

ABSTRACT

Business corporations can have many purposes. The shareholder wealth maximization goal is the proper one for business. This maximization, however, must look to the long-term as well as the short-term. Terrorism is a major threat to the long-term stability, profitability, and even viability of business corporations. Because of a focus on the short-term to the exclusion of the long-term, businesses are likely to shirk their responsibilities related to terrorism and its causes. A paradigm-shift is necessary to bring business to accept their responsibilities and internalize their costs.

TABLE OF CONTENTS I. INTRODUCTION II. SEEKING PROFIT III. BIASES OF BUSINESS IV. VALUE OF A DOLLAR TODAY V. OLD AND NEW: RISKS AND MANAGEMENT VI. RISK CAN NOT BE ZERO VII. SEEDS AND FRUIT VIII. PARADIGM OF GENUINE PROFIT IX. RECOMMENDATION I. INTRODUCTION

What is the purpose of a business corporation? Because there are many forms of business, that question can have many answers. It is axiomatic in law and economics that a for-profit business exists to maximize profit. For publicly traded firms, profit maximization is rephrased as maximizing shareholder wealth because the discounted present value of all future profit streams equals current shareholder wealth.

Narrowly defined, the goal of shareholder wealth maximization can generate business decisions that are fundamentally flawed. Both critics and corporate mangers lament that corporate governance today is too focused on the next fiscal quarter rather than the long run. (1) An "efficient" market, when populated by day traders who own shares at neither the start of the day nor at the end of day, further compounds the tendency for myopic management. (2)

This Article will not challenge the shareholder wealth maximization goal. Instead, this Article will insist on it. All too often, the shareholder wealth maximization goal is praised in name and ignored in practice. The decisions of business corporations are decisions requiring tradeoffs. All tradeoffs are complex and tinged with uncertainty. Accordingly, the scope of governance discretion must be broad. In practice, rather than in theory, all too often the shareholder wealth maximization goal is ignored. Agents of the principal too narrowly define value streams (when it suits the agent's preference), and both agents and the market misapply discounting to present values.

More fully defining the net that is the business' profit and accurately applying the concept of discounted present value will orient a firm towards sustainability. That sustainable orientation fosters peace.

2. SEEKING PROFIT

   Business corporations are legal persons. (3) Business corporations exist because society wishes to encourage business investment. Society encourages shareholders to place their wealth at risk. The encouragement society offers is liability limited to that investment. (4)

   Each natural person can tolerate only so much risk. Limited liability allows each investor to place at risk only that fraction of the investor's wealth that can be tolerated. (5) Limited liability allows additional natural persons to invest and increases the total pool of wealth available for business formation. Business corporations exist to serve society and society bears the cost of limited liability. Corporations that foster sustainable peace serve society well, and those that defeat peace do not.

   The corporation's Board of Directors and the Officers are fiduciaries. (6) They are economic agents for a principal. Their primary fiduciary duty is to husband their shareholders' investment. (7) The fiduciary duty is to pursue shareholder wealth maximization. The maximization to be pursued is long-run, not short-run, shareholder wealth maximization. (8)

   Business corporations seek profit, which is total revenue minus total cost. That is, after subtracting cost, they maximize net revenue. More narrowly defined, the corporation maximizes net revenues that are internal to the corporation. Accounting tracks transactional values that go through the corporation. (9) Corporations tend to ignore values that are not internalized by the corporation. (10)

   Values not internalized by the market system are known as externalities or spillovers. (11) All market transactions involve spillovers of varying magnitudes and durability. A market failure is said to exist when a spillover's magnitude becomes so large, durable, or predictable that the spillover materially distorts the market's efficiency. (12) For example, education is subsidized because of substantial spillover benefits and pollution is regulated because of substantial spillover costs. (13) The very existence of the firm is a tribute to market failures. The firm exists because the firm is able to assemble the transactions more efficiently than the market by internalizing otherwise external values. (14)

   Profit is a net, but net of what? Governing boards and management must choose which spillovers (both costs and benefits) to internalize. They must make trade-offs. A creative executive compensation package is a bundle of values, both internal and external to the firm. (15) The governing board should be no less creative in pursuing sustainable peace.

3. BIASES OF BUSINESS

   Business is biased towards revenue. Often, this bias is appropriate because a sustainable firm must capture value. Capturing cost tends to be far easier than capturing revenue. (16) However, the true goal is wealth, not revenue.

   Business is biased against cost. This anti-cost bias is greatest against internal costs. In fact, external costs are too often ignored or, worse, are the deliberate consequence of governance. A firm can create the false appearance of increasing profit by externalizing costs. (17) Society, however, sees no profit. Such false profits defeat society's expectations when creating corporations.

   Business corporations have another bias: Today is preferred over tomorrow. Managers of risk soon learn that the future is unpredictable and that a bird in the hand is worth more than one in the bush. The precise value of "now" is calculated using discounted present value. (18) However, all too often, business distorts that calculation and, in effect, eats its seed corn.

   Business focuses upon cash profit in the form of net revenue. That is, business focuses on out-of-pocket total revenue minus out-of-pocket total cost. This cash profit is only one measure of value and wealth. Cash profit fails to account for spillover costs and spillover benefits. Governing boards should govern with an eye on these spillovers, so the board can select the best set of trade-offs for maximization of the shareholders' wealth.

   Markets transactions are transactions between participants who are both willing and able to participate in a particular transaction. (19) If a participant is either unwilling (e.g., theft) or is unable (e.g., poor) to participate, then the market neither sees nor registers that transaction. (20) Such involuntary transactions generate spillovers or externalities. (21) Cash profits based on substantial spillovers are false profits. (22)

   At its essence, board oversight is prioritization in the long run. (23) Prioritization is choosing between options. This choosing requires the acceptance of trade offs. The realm of management is similar in that management also prioritizes and accepts trade-offs. However, the realm of management is the short-term while the realm of the board is the long-term.

   The business bias against tomorrow is greatest in management. The board's governance should counteract this management bias. As certainty diminishes, the role of the board increases. Certainty is diminished by externalities that are difficult to quantify. Also, the magnitude of spillovers often is greatest in the future--the realm of board governance. Spillovers, especially when coupled with clumsy applications of discounted present value, can create a false perception of profit. (24) Accordingly, cash profit can be a gross misstatement of the firm's value generation. Because the board's governance duty is to maximize shareholder wealth, governance includes choosing which external values to internalize.

4. VALUE OF A DOLLAR TODAY

   A dollar tomorrow is worth less than a dollar today. For example, when is $1,000,000 tomorrow only worth $1 today? (25) At a 20 percent interest rate $1,000,000 in 70 years is worth but $1 today; at 10 percent, it's 140 years; at 5 percent, it's 280 years.

   The required rate of return reflects a variety of risks, including inflation and business failure. (26) Venture capitalists face some of the greatest risks and routinely strive for a rate of return equaling 100%. In effect, $1,000,000 a mere 14 years in the future is only worth $1 today. In stark contrast, the Iroquois (27) recommended management decisions that would serve well the seventh generation. (28) Assuming, as Thomas Jefferson did, (29) that a generation is 19 years, then the Iroquois recommend management decisions that valued $1,000,000 in 133 years as worth $1 today (almost 7 percent). If one recognizes that, in the industrialized world of the 21st century, a generation may now be more like 30 years, then managing for the seventh generation would require a focus of 210 years (or about a 11 percent rate of return).

   The key question is: "Will that $1 be dedicated today for tomorrow's use?" If that $1 is not dedicated today, then tomorrow most likely will be hard pressed to pay the piper.

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