What do you own when you own a share of corporate stock? It's not as clear as it used to be. As recently as the mid-1980s, the stock market value of U.S. nonfinancial companies roughly equaled their book value. Today, market cap is about twice book value. Put differently, a big chunk of what companies are worth today consists of things that don't qualify for inclusion on the balance sheet.
For shareholders, that's a critical problem. For many knowledge-based companies in the New Economy, the most important unmeasured assets aren't really assets at all. They're the company's key employees. They don't qualify as assets because (obviously) they aren't owned by shareholders. The corporate crown jewels are inside their craniums, and if they walk out the door, shareholders can do nothing about it. Many of Chrysler Corp.'s (DCX
) top people left after the Daimler-Benz takeover. Ditto for J.P. Morgan's (JPM
) brains after the Chase Manhattan merger.
So in evaluating companies, today's investors have to do a two-part test. Part one is to calculate how much wealth a corporation is capable of generating with its tool kit of tangible assets, intangible assets, and employees. Part two is to size up how much of that tool kit is well-fastened to the corporation, since companies with a poor record of retaining key employees are a bigger risk.
Corporate finance as it's taught in business schools takes for granted that shareholders are king. Professors teach that in exchange for supplying companies with capital, shareholders are entitled to receive all of a corporation's wealth in excess of what's paid out to contractual claimants--a group that includes customers, bondholders, and salaried employees.
But theory doesn't match reality. At many companies, shareholders are no longer the owners in the conventional sense. That's because key employees are not simply hired help brought in to run the real assets of the company--the mines and mills of an earlier era. They are the company. And under the right circumstances, many would be willing to walk out. Nearly a decade ago, the advertising firm of Saatchi & Saatchi suffered when shareholders blocked a big options grant to Maurice Saatchi, who promptly quit and started a rival agency. Columbia University business professor Amar Bhide calculated one year that 70% of the companies in Inc magazine's Inc 500 were started by entrepreneurs who got the original ideas while working for other employers.
Once shareholders admit that they aren't Louis XIV, they can move on to figuring out where to invest, given their vulnerable position. It won't be easy. Before the capitalist era, craftsmen tried to hang on to promising workers by signing them to indentured apprenticeships. But even then, apprentices frequently fled once they learned enough to go into business for themselves. The 17-year-old printer's apprentice Benjamin Franklin was one such fugitive, notes Bhide. Noncompete clauses aren't much more effective today--especially since judges are reluctant to enforce broad ones.
For shareholders, the carrot hasn't worked much better than the stick. Just look at stock option grants. They're an expensive way to retain key executives and align their interests with those of shareholders. But as the past few years have shown, big option grants hurt shareholders two ways. They dilute investors' ownership. And they give executives a perverse incentive to pump up stock prices to maximize their options' value. The personal payoff for reporting higher profits may have contributed to the rash of accounting scandals that began coming to light last year--and perhaps even to the stock market bubble of the late 1990s.
How, then, can shareholders be sure that there's real, lasting value in the companies in which they invest? Go back to why corporations exist in the first place. Raghuram Rajan and Luigi Zingales, professors at the University of Chicago's Graduate School of Business, point out that every company starts out with some core asset or idea. Over time, the people who come to work for the company develop unique skills that are only partially transferrable to other jobs. That binds them to the company. Think of a chip designer who becomes the world's expert on some particular feature of IBM's RS/6000 computer workstations. Both the employee and IBM (IBM
) benefit from the development of that vital expertise.
For investors, then, the key is to find companies that do a good job of retaining their key employees--not by legal threats and not by overpaying, but by encouraging talented people to make "firm-specific" investments of their time and energy.
Handcuffs? Nope. The reason good people stay with good companies is that they can create more value by staying than by going elsewhere. Of course, they must be paid for their contributions.
Shareholder activists are talking big these days about asserting their rights as owners. But in the New Economy, the stuff that shareholders own isn't what matters. Investors would be better off acknowledging that they aren't in charge anymore, and hunting for companies whose key employees are least likely to hop a crosstown cab.
MARCH 25, 2002
By Peter Coy
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