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Market-Based Solutions to Vital Economic Issues
Kenan Insight
Dec 15, 2021

Is Money Left on the Table When We Don’t Listen to Stakeholders?

In our recent Insight, we asked whether the benchmark set by the ideal shareholder model – an efficient allocation of resources – could be met by the stakeholder model. Our goal in this week’s Insight is to answer that question. We find there is no clear model of stakeholder capitalism that illustrates how to define and balance the needs of all stakeholders, but models that clearly delineate stakeholders have some promise. Meanwhile, empirical evidence suggests mixed results for stakeholder-focused businesses. We believe that incorporating stakeholder needs via the demands of various change agents – employees, consumers, investors and government – can create value for firms and society. Unfortunately, this inclusion may come at a cost as self-interest and management challenges can mean that change agents may trade long-term benefits for short-term gains.

As a starting point, what do we mean by an efficient allocation or resources? This means society’s demand for goods and services are met at the price which produces those goods and services with a minimum amount of waste given finite resources. The allocation of those goods and services is unlikely to be equal: People with greater resources will be able to consume more, but we know that we are producing as much as we can. Unfortunately, the chart below illustrates a large and growing wealth inequality. The bottom 50% of households now own just 2% of wealth, down from 4% in 1990, while the top 1% now owns 31% of wealth, up from 23% seen 30 years ago. Stakeholder capitalism is meant to help address this inequality by proposing to give workers and the community a stake in business decisions and profits. Similarly, the stakeholder model gives the environment a seat at the table. Can it live up to the promise?

Distribution of Household Wealth

No Standard Stakeholder Model

R. Edward Freeman, who is one of the developers of stakeholder theory says, “The task of executives is to create as much value as possible for stakeholders without resorting to tradeoffs.” Unfortunately, there are always trade-offs. Even when businesses are experiencing explosive growth and investing all their returns back into the business, executives have to think about which set of people and priorities they should invest in. Klaus Schwab, founder and executive chairman of the World Economic Forum, acknowledges that at least “in the short run that may mean difficult choices need to be made which benefits one stakeholder or its concerns more than another.” This should be done by “separating the consultative process from the decision-making one. In the consultative stage, all stakeholders should be included… In the decision-making stage, only those mandated to make decisions should be able to do so, which means in the case of companies, respectively the board or the executive management.” Sarah Kaplan believes companies can innovate around many trade-offs, but “even when there aren’t innovative solutions, companies to learn to thrive within the tensions created by intractable trade-offs. These tensions, rather than being confusing or problematic, can actually be a source of organizational adaptability and resilience.” Kaplan and Schwab use specific company cases – for example, how to balance consumerism and sustainability – to illustrate applications of their models. Our read is that you can boil down their models to the following: If businesses work hard enough, they can often create win-win solutions.

From an economic modelling perspective, one way of incorporating stakeholder needs is to create an internal market in which the excess value created by each stakeholder is measured, ascribed to the stakeholder, and then allowed to be traded within the firm. Thus, management has clear metrics of stakeholder benefits. A theoretical model which incorporates this market-based model for three stakeholders whose value are easy to measure – employees, consumers and shareholders – leads to an efficient allocation of resources. However, this outcome is only valid if there is only one firm serving the market and the stakeholders have the same abilities and tastes – i.e., they all are equally productive or care about the environment in the same way. Unfortunately, if you extend this model to multiple firms or individuals with different tastes, the model suggests that non-shareholder claims must be diminished to maximize society’s creation of goods and services.

Another modeling effort considers that “stakeholder firms are more concerned with avoiding bankruptcy to protect their employees and suppliers.” This implies that stakeholder firms are more valuable when cost uncertainty exceeds demand uncertainty. According to the paper, one of the reasons stakeholder orientation succeeds in Germany and Japan is because they have a greater manufacturing orientation, where firms are likely to face more cost versus demand uncertainty — a contrast to heavily service-oriented businesses based in the U.S. The model also incorporates potential competition between stakeholder and shareholder firms and finds stakeholder-oriented firms can thrive as long as the industry faces the right balance of risks, and the firms don’t tilt too far in the stakeholder direction, which is similar to the model discussed above.

Given the intense interest, it is not surprising that stakeholder implementation has become big business. In an article by Vivian Hunt, Robin Nuttall and Yuito Yamada from McKinsey and Company, “From principle to practice: Making stakeholder capitalism work,” the authors lay out five execution steps: understand who the stakeholders are; understand stakeholders’ needs and build trust; define and measure ways to serve stakeholders; define and execute a stakeholder-capitalism strategy; and build an operating model that can sustain long-term value creation for all stakeholders.

The article cites a researcher who identified 435 stakeholders, so the authors bucket the stakeholders into three categories: internal, external who interact directly with the company, and external who define their operating environment, thus putting a limit on how far stakeholders should extend. When thinking about trade-offs, the authors suggest using three attributes to rank the identified ideas, including the extent to which the idea matches the company’s strengths, how well it addresses a specific stakeholder need and how it captures long-term shareholder value. Unfortunately, there are no well-defined metrics or weights to manage conflicting stakeholder needs.

In sum, stylized models suggest stakeholder orientation can be accretive to firm value under certain conditions, as long as the stakeholder benefits or demands are clearly delineated, measured, and not overweighted. While theoretically easy, putting the theory into practice is much harder. Future Insights will explore measurement issues that can inform how these benefits or demands can be calculated and the weights can be incorporated. This study will also be beneficial to the more holistic approaches espoused by Kaplan, McKinsey and Company, and Schwab as it will support ranking efforts.

From Theory to Practice: Mixed Stakeholder Results

Moving away from the proposed ideal model, let us see how things work in practice. As noted above stakeholderism is more of the corporate norm in Europe and Japan. An analysis the 50 most valuable firms in Germany, the Netherlands and France found that the potential benefits of greater environmental (E) and social (S – in the form of labor) focus, was outweighed by the cost of worse governance (G). As a result, the European companies on net had lower equity market valuations than similar U.S. and U.K. counterparts. This begs the question of whether bad governance can be separated from good environmental and social.

Meanwhile, an analysis of 100 private equity transactions in U.S. states – which authorize corporate leaders to give weight to stakeholder interests when considering a sale of their company – indicates that corporate leaders used their discretion to obtain gains for shareholders, executives and directors, rather than stakeholders, such as employees who were a greatest risk from the transaction. Moreover, “in the small minority of cases in which some stakeholder protections were formally included, they were generally cosmetic and practically inconsequential.”

This is not to say that individual companies have not been successful at integrating stakeholder needs and creating strong market success. Salesforce is seen as one of the exemplars. However, the success is often the result of senior leadership focus or because it was always part of the corporate DNA, which in many cases was built into its ownership model. For example, Vanguard is a mutual company which is owned by its investors, while Patagonia is a certified B corporation which must meet certain ESG standards. Senator Elizabeth Warren has proposed converting all U.S. companies with revenues greater than $1 billion into benefit-type companies, we think much more work is needed to assess the scalability of these models.

In general, given the recently renewed interest in stakeholder capitalism, rigorous analyses of the success of stakeholder initiatives are relatively new, and the results discussed above should be seen as preliminary. Over the next year, we will continue to highlight research in this area.

Stakeholder = Shareholder + Change Agents?

Rather than asking management to solve stakeholder issues, we wonder if the stakeholders themselves can and will act as change agents within the shareholder model. We have identified four key potential change agents: employees, investors, consumers and governments. We believe a better understanding of their motivations and tastes can create the win-win situations that the formal and holistic models seek. Future insights will explore how ESG-focused investors can potentially lower the cost of capital for companies and drive governance changes and how employees may be motivated by non-remuneration-based policies such, as paid sick leave mandates which has been shown to increase employment. Insights will also explore how consumer tastes are shifting toward ESG friendly products or companies that have strong ESG-focused cultures, and how some of these might be slow-moving generational shifts.

Incorporating those change agents into the decision process may be value accretive to the firm, but change-agent self-interest may also lead to accretive yet inefficient allocation of resources from a societal standpoint. Returning to the question posed in the last Insight, should an energy company invest in a dirtier power generation facility in its locality, thus creating more jobs in its community, or should it build a greener plant across the country? Society clearly prefers the greener plant (workers should be able to find jobs that are better suited for the locality), while employees are very likely to vote for their community.

Finally, we have to acknowledge the limitations of the change agents, especially on macro issues such as the environment or yawning wealth disparities. While a narrower gap between CEO and cleaning staff pay may motivate employees and spur consumers to buy a company’s products, government policy needs to play an important role through improving educational outcomes, investing in underserved communities, and other motivational progressive tax and spending policies such as the earned income tax credit.

Putting this all together, we believe that stakeholders can and should play an important role in business decisions. However, there is no clear model to help incorporate their interests into corporate governance and real-world examples of stakeholderism have led to mixed outcomes. As a result, we are exploring other ways to incorporate stakeholder influences into business practices that will create win-win solutions and are willing to acknowledge when they don’t meet the challenge.

1 Stakeholder Theory. (n.d.). About the Stakeholder Theory. http://stakeholdertheory.org/about/

2 Schwab, K., & Vanham, P. (2021). Stakeholder capitalism: A global economy that works for progress, people and planet. Wiley.

3 Kaplan, S. (2019). The 360° Corporation: From Stakeholder Trade-offs to Transformation. Stanford Business Books.

4 Magill, M., Quinzii, M., & Rochet, J. (2015). a theory of the stakeholder corporation. Econometrica, 83(5), 1685-1725. https://doi.org/10.3982/ECTA11455

5 Allen, F., Carletti, E., & Marquez, R. (2015). Stakeholder governance, competition, and firm value. Review of Finance, 19(3), 1315-1346. https://doi.org/10.1093/rof/rfu011

6 Rajgopal, S. (2021). Has European Corporatism Delivered? A Survey with Preliminary Evidence (SSRN Working Paper). SSRN. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3907406

7 Bebchuk, L.A., Kastiel, K., & Tallarita, R. (2021). For Whom Corporate Leaders Bargain: Presentation Slides (SSRN Working Paper Series). SSRN. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3881969


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