Corporate Culture as a Theory of the Firm

Gary B. Gorton is the Frederick Frank Class of 1954 Professor of Finance and Alexander Zentefis is Assistant Professor of Finance, both at the Yale School of Management. This post is based on their recent paper.

Business leaders have long recognized that corporate culture is vital to a company’s identity and success. In one of the more colorful descriptions of culture’s importance, the legendary management author Peter Drucker wrote: “culture eats strategy for breakfast, technology for lunch, and products for dinner, and soon thereafter everything else too.” Similarly, former IBM Chairman and CEO Louis V. Gerstner, Jr. wrote: “I came to see, in my time at IBM, that culture isn’t just one aspect of the game, it is the game.”

And yet, scholars have consistently overlooked corporate culture in their theories of the firm. For the most part, existing theories have focused on the costs and benefits of asset ownership and/or incentive contracts to explain whether a company produces parts and services in house or instead purchases them in a market (the “make-or-buy decision”). Bengt Holmström and John Roberts provide a detailed survey of numerous current theories (Holmström and Roberts 1998) and Robert Gibbons supplies an elegant synthesis of several theories (Gibbons 2005).

In a recent paper (Gorton and Zentefis 2020a), we provide a novel theory of the firm based on corporate culture. We model how corporate culture takes shape and demonstrate how it affects a firm’s internal organization and governance. We then use this framework to explain the make-or-buy decision, why certain parts of production are more likely outsourced than others, and why some mergers fail.

Corporate Culture

Building on our previous work (Gorton and Zentefis 2020b), we define culture as the values, norms, customs, traditions, symbols, and language that are widely shared by members of a group and that govern their collective behavior. Corporate culture begins forming when a CEO communicates her desired values and norms to all employees (i.e., setting a “tone from the top”). For example, she might express views and give directions on fostering innovation, improving safety standards, prioritizing customer needs, or tolerating dissent. Employees then interpret these instructions from their own perspectives and communicate their views to each other and within their teams. All of these interpretations form a corporate culture comprising values, norms, and customs, which together establish tacitly agreed rules for behavior.

Make-or-buy decision

When deciding whether to make or buy a team’s input to production, the CEO can regulate each team’s behavior in one of two ways: through contractual agreements or through corporate culture. The CEO relies on contracts when buying an input in the market, rather than making it in house. In this system, incentives are aligned by the structure of compensation and the threat of litigation for breach of contract. Those contracts will inevitably have gaps, as the parties will have no way of completely anticipating or describing all possible conditions, needs, and contingencies when tailoring the terms of their agreement.

As an alternative to using detailed contracts, the CEO can make the part internally and rely on a corporate culture to fill in the gaps that bedevil contracts (e.g., as the means to make adjustments, provide flexibility, and resolve uncertainty). In this system, by contrast, incentives are aligned by a fixed wage and social pressures to abide by shared norms and values. In deciding whether to make or buy a part of production, a manager chooses which of the two systems achieves the highest output from her perspective.

Mergers & acquisitions

Corporate culture also plays a crucial role in determining the success or failure of mergers and acquisitions. Over the past 35 years, announced M&A transactions in the US have neared $35 trillion in total across over 325,000 deals, equivalent to one deal every hour (Institute for Mergers and Alliances 2020). But overwhelming evidence suggests that M&A activity often leads to disappointing financial performance for acquirers (King et al. 2004; Cartwright and Schoenberg 2006; Haleblian et al. 2009) and targets alike (Ravenscraft and Scherer 1987, 1989). Only half of mergers are considered successful by the managers who undertook them (Schoenberg 2006).

The troubled merger between telecommunication firms Sprint and Nextel in 2005 provides a striking example. The merger was a full integration of the companies’ technology and operations. But Nextel’s entrepreneurial and aggressive style conflicted with Sprint’s top-down bureaucratic approach. Many meetings between the two sides “ended with Nextel employees storming out, leaving the Sprint side baffled.” Meanwhile, Nextel employees “felt their brand and technology had been unfairly dismantled” (Hart 2007). Three years later, Sprint reported a $29.7 billion write-down related to the merger (Holson 2008).

In our paper, we show that cultural conflicts like the one between Sprint and Nextel are the primary cause of failed M&A transactions. Cultural clashes are costlier if the newly acquired company becomes a core piece of the combined firm’s production, or if it does not coordinate well with the acquirer’s existing teams and suppliers.

Conclusion

What causes employees to work together? We propose that it is corporate culture. This culture is the governing force that allocates resources inside firms in place of lengthy contracts, and the corporate culture impacts numerous other key decisions within firms.

Our work significantly departs from the existing literature on theories of the firm by focusing on how individuals form groups and cooperate to succeed. In our setting, employees make decisions to maximize utility, but they do so while taking into account their surrounding social and cultural circumstances. Culture becomes the root of employees’ social cohesion. It regulates internal governance, production decisions, the choice to make or buy, and it is the defining characteristic of firms. Indeed, corporations are cultures.

The complete paper is available for download here.

The paper builds on our previous work about corporate culture that is available for download here.

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