The governance of the new enterprise

New rules for the changing business world

Jun 01, 2000

Sections Strategy

Following several years of lackluster performance, U.S. fund managers in 1994 opposed the award of a generous option package to Maurice Saatchi, the chairman of Saatchi & Saatchi. Along with his brother Charles, Maurice had founded the company in the early 1970s, and through mergers built it into the world's largest advertising agency.

The fund managers' opposition to the award led to Maurice Saatchi's departure, which quickly was followed by the resignation of several key executives. These executives, together with the Saatchi brothers, started a rival agency, M&C Saatchi, which soon captured many important accounts from the original Saatchi & Saatchi. One of the departing executives wrote in his resignation letter, "I am not leaving the company. The company has left me." The original firm, which later changed its name to Cordiant, was seriously damaged.

In hindsight, the mistake the U.S. fund managers made was to treat Saatchi & Saatchi as a traditional company, with clear boundaries defined by its assets. They had an ownership stake through their 30 percent control of the shares and simply attempted to exercise their rights. However, instead of accepting the funds' decision, those managers who disagreed left the company, taking with them their human capital and valuable relationships. The directors realized, perhaps a little late, that the employees actually owned the firm and took home every day the company's primary asset -- human capital.

Corporate governance today is much more complex than ever before. In a recent paper, "The Governance of the New Enterprise," finance professors Raghuram G. Rajan and Luigi Zingales of the University of Chicago Graduate School of Business argue that the greatest governance challenge firms face today is the demise of traditional sources of authority. As firms become increasingly human-capital intensive, the professors offer new directions for managing in today's business environment.

Diminishing Control

The old corporate governance rules, developed in the early part of the 20th century, grew out of an environment where top management had unquestioned authority. An employee obeyed because he had little choice. A few large, vertically integrated corporations dominated industry after industry (a vertically integrated firm is one that spans the entire process of production, from extracting or growing the raw material to distributing the finished product to the consumer). Each firm had its own distinctive culture and style, its own set of physical assets, and its own unique set of positions for employees. Once an employee specialized to a firm's business, there were few competitors who could hire him. Human capital became tied to the firm simply because there were few alternatives.

In this environment, employees did not specialize much, either to the industry (what Rajan and Zingales call technical specialization) or to the firm. Technical specialization was not rewarded because competitors could not lure the technically qualified employee away, while firm specialization simply tied the employee closer to the firm without any commensurate rewards.

Scale and scope were of paramount importance, so the first movers-firms who accumulated the large amounts of capital needed to set up the vertically integrated behemoths-occupied unassailable positions. Potential entrants who sought to become vertically integrated would have to obtain large amounts of capital to pose a competitive threat. Who would be foolhardy enough to finance them against the entrenched incumbents? These entrants could produce an intermediate product, which would require much lower quantities of capital, but they would still face integrated producers, whom they would have to buy from and sell to.

As national markets became more open, however, new sources of competition and financing emerged. Firms abroad were not necessarily integrated to the same extent, and therefore provided a market for intermediate goods. It became more viable for firms to become specialized producers, in only one segment of the production chain, without full integration. Former employees of the old vertically integrated structures ran many of these new entrants.

The presence of viable, competitive alternatives has had other effects, placing strong constraints on the ability of top management in vertically integrated hierarchies in U.S. firms to exercise command and control. First, the importance of human capital relative to inanimate assets has increased. Easy access to capital has made ownership of physical assets less of a competitive advantage, and firms acquire an edge largely because of their human capital (and the associated relationships and intellectual assets). Moreover, with competition within the industry raising wages for specialists, there is more of an incentive to become technically specialized. People, in general, have become better skilled and more valuable.

Second, an employee who feels management is too heavy handed can simply quit to join a competitor or startup on his own, making control at a distance much more difficult. Ownership of physical capital is no longer a sufficient means of control.

As a result, immense pressure has built to restructure the vertically integrated firm. With the ability to control diminishing, and competition highlighting the cross-subsidies being given to inefficient units, there has been both internal and external pressure to dismantle these integrated firms. This has further increased competition in the marketplace.

So what then holds a firm, albeit diminished in size, together today? A whole new set of assets has arisen. Most importantly, knowledge-based assets such as databases and patents, have replaced physical assets. Nevertheless, the enterprise in today's competitive marketplace needs more than simply ownership of these new assets to exercise control over employees, say Rajan and Zingales.

Building Human Links

Rajan and Zingales argue that the way to rebuild authority lies in creating links between a firm and the person or unit that the firm seeks to control. Not any link will do; what is needed are links that cause the person or unit to be better off by voluntarily following the firm's commands. Economists call such a link "complementarity." A complementarity is said to exist when the unit or firm can create more value together than they can independently.

Once complementarity exists, the unit must cooperate with the firm's headquarters for fear that disobedience would jeopardize the joint value they can create together. While ownership legally links an inanimate asset to a firm, complementarities economically link a person or unit that cannot be owned to a firm.

One form of building complementarities is through specialization. But it is useful to distinguish between technical specialization and firm specialization, say Rajan and Zingales. A machinist in the aircraft industry may work with a special kind of lathe and his skills may be valuable only for the high-precision needs of the aircraft industry. Such technical specialization ties the machinist to the industry, but not to a specific firm unless the industry is a monopoly.

Firm-specific specialization occurs with regard to the individual needs of a firm. For example, a supplier may invest so that his software can communicate with the firm's special order processing computer. The most specific investment in a firm, however, is to build ties to the other individuals who belong to it. An individual may build friendships, or may start relying on the skills of other employees of the firm.

The Sum of the Whole is Greater than its Parts

Owners and managers, say Rajan and Zingales, need to create a situation where employees or units know their rewards will be greater if they make firm-specific investments. The firm does this by giving key employees or units privileged access to the enterprise and its critical resources so that they have power if they specialize.

For example, a brokerage firm usually gives brokers leads to new clients. This is a form of access. At the moment a new broker receives leads, his human capital is not very valuable to the firm. Over time, the broker develops the leads into solid client relationships. Now his human capital is very valuable, serving as a crucial link between the firm and its clients. Thus by giving a newcomer access to leads, the brokerage effectively gives him the ability to acquire power over assets (client relationships) that will be valuable to the firm.

This allocation, however, is conditional, according to Rajan and Zingales. If the broker does not invest in the leads and develop fruitful relationships, his human capital does not become valuable. The leads can easily be taken away and given to others. Thus the power that comes from privileged access is contingent on the agent specializing.

If the brokerage provides enough unique value to clients through the broker, the broker needs the firm's backing. By investing in the building of client relationships, the broker builds complementarities between himself and the brokerage, giving it some power over him. But he also has power over the brokerage because he "owns" the client relationships. The brokerage has to commit to relinquish power in order to obtain power. In exchange for committing to share some of the profits from the relationship with the broker, the firm obtains his loyalty, which gives the brokerage power in its interactions with other players.

The ultimate question is whether the brokerage holds any value that the broker could not replace by moving his clients to another brokerage. Unless the brokerage has unique products, up-to-date information systems, a very efficient delivery system, or a rock solid reputation, there is little to tie the broker and his clients to it. But even if it does possess these assets, the broker is really enmeshed when he builds relationships to other people who are part of the brokerage-when he becomes friendly with analysts who pass along hot tips, or when he knows the person in trust services who will respond quickly to a query. The organizational challenge now becomes how to design the formation of these links, such that top management becomes central to the organization again, and can acquire some of the old command-and-control powers.

This requires a fine balancing act. Too little power to employees and subunits provides little reassurance that they will benefit from being loyal to the organization; too much power gives management little ability to coordinate the firm's operations and create value for the owners. Owners and directors need to intervene as the enterprise is assembled and make sure that customers, suppliers or employees are not given the opportunity to accumulate too much power, which would allow them to expropriate a large fraction of the value of the enterprise.

For the Saatchi & Saatchi directors, it was simply too late to intervene. They should have anticipated the problem and ensured the company was not too dependent on the two brothers. The problem they faced is no different from the problem a venture capitalist faces when financing a startup. One of the venture capitalist's jobs is to ensure that the founder gives up his central position and brings in more professional management techniques and managers. Eventually the firm can be taken public to be owned by arm's length investors. As human capital becomes more valuable, many boards will have to take up the task of reining in wayward units and integrating key players into the management hierarchy. And if it is impossible to obtain control, boards will have to consider breaking up the firm.

The nature of business organization in the United States and the world has changed. Governance today requires more than casting a vote. It requires a long period of organizational design. Boards must not just discuss how they will uphold the rights of minority investors but also focus on developing mechanisms to control and retain human capital.

A Quick Look Back

The old corporate framework was based on the model of a vertically integrated firm. Vertical integration occurs when one company is responsible for product research, development, design, manufacturing of its components and assembly, as well as purchasing raw materials and providing technical support for the finished products. According to finance professors Raghuram Rajan and Luigi Zingales of the University of Chicago's Graduate School of Business, three main features distinguished the old corporate framework.

  1. Rigidity. The traditional firm was rigidly defined by the ownership of a large set of unique assets. The legal boundaries of the corporation could be drawn around these assets and also coincided with its economic boundaries. When most of the value of a firm was embedded in assets that could be owned, its boundaries were fixed and there was nothing directors could, or were required to, do to guard them. Moreover, these boundaries only changed when ownership changed. The main issue was determining allocation of the surplus generated within the boundaries, and not how to preserve and protect the boundaries. 
  2. Heavy Outside Ownership. Traditional firms required outside investors to finance sizeable assets and to bear risks associated with such large ownership stakes. The economies of scale and scope, which provided the firm its competitive advantage, made the firm too large to have ownership rest only in the hands of management. Once outside owners controlled the assets, they could delegate control to salaried managers. If top managers were not cooperative, the owners could threaten withdrawal of assets, crippling the firm. 
  3. Top-Down Management. Concentration of power at the top of the organizational pyramid and legal claims over assets became the most important power source. Thus the sole problem of corporate governance was how to ensure that top management acted on behalf of shareholders. With the increased significance of human capital, power has moved away from the top of an organization. It is now widely dispersed throughout the firm. The added problem of governance now is how to ensure that the board and its agents, the top management, have the power to govern the firm.

Rise of Human Capital

The increased significance of human capital, and the related difficulty in controlling it, is perhaps the most significant recent change in corporate governance. One area where the relative importance of human capital has increased tremendously is the financial sector. Rebecca S. Demsetz, a research officer formerly with the Federal Reserve Bank of New York, finds that the share of employment of low-skilled workers in banks declined from an average of 60.4 percent in the period 1983 to 1986 to 52.5 percent in the period from 1993 to 1995. Correspondingly, there is a shift in hiring workers with college degrees rather than those without a degree. While Demsetz sees an economy-wide trend in the increasing employment shares of highly skilled workers, the effects are pronounced in banking.

Increased automation in banking is one factor. But finance professors Raghuram Rajan and Luigi Zingales of the University of Chicago Graduate School of Business offer other explanations. In their recent study, "The Governance of the New Enterprise," Rajan and Zingales argue that to a large extent, a bank's primary asset was the ability to raise money from captive depositors and channel credit to customers, who had few alternatives. Outsiders could possess this asset by virtue of ownership of the bank's charter. And top management's control of this asset gave them authority over loan officers. The credit evaluation skills of the loan officer were of secondary importance to the funds that the bank supplied. Without the funds, the officer had little value. Regulatory restrictions on competition also meant there were few banks competing in the same region to which those evaluation skills could be transferred.

Due to competition from markets and other institutions, the ability to channel funding is no longer a critical asset, say the authors. The role of the loan officer has changed as well. Beyond the task of controlling the flow of funds, loan officers now must create new ideas for structured financing for firms in order for their banks to stay competitive. Rather than the plain-vanilla commodity loan, innovative and customized deals are the source of profits. The loan officer's human capital, both in terms of product and industry knowledge and client relationships, is an important source of value to the commercial bank.

Furthermore, it is no longer clear, say Rajan and Zingales, who owns the most critical asset-the client relationship. And, of course, the loan officer, and not the bank, owns his or her human capital. Banks that have attempted to force their officers to share their relationships within the bank in order to cross-sell goods and services often have faced subtle sabotage. Savvier banks have first negotiated client ownership with loan officers. These negotiations would never have been necessary in the past, when the ownership of the bank charter (and as a result, the access to critical funds) gave top managers substantial authority over lower managers and outsiders authority over management. Rajan and Zingales feel that firms must limit discussions on strengthening the rights of dispersed owners and focus on developing mechanisms to control and retain human capital.

Raghuram G. Rajan is Joseph L. Gidwitz Professor of Finance at the University of Chicago Graduate School of Business. Luigi Zingales is professor of finance at the University of Chicago Graduate School of Business.