An Inflection Point for Stakeholder Capitalism

Seymour Burchman and Seamus O’Toole are managing directors at Semler Brossy Consulting Group, LLC. This post is based on their Semler Brossy memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here) and Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here).

From the Business Roundtable to BlackRock, there’s growing pressure on companies to respect all major stakeholders—employees, customers, suppliers and local communities, as well as investors. Meanwhile, a variety of innovations are effectively making these stakeholders central to long-term company success. Digital technologies, new ways of organizing work and transactions, and the shift to the service economy have forced businesses to prioritize the interests of all stakeholders—adding significant opportunities and risks.

As a result, unless the company’s survival is in question, stakeholder-centricity is becoming essential to its overall management. Even under short-term pressures such as pandemics, executives and directors will need to view the company as operating within an integrated ecosystem. Only by supporting all major stakeholders, through calibrated and balanced incentives, will companies achieve sustained success.

The rise of stakeholders

Employees: Central to competitive advantage. Workers have always been essential for producing goods and services, but now companies need more from them. As software and automation replace low-skilled labor, firms are relying increasingly on the talents of their employees, and they need to compete to attract that talent. As companies invest more in training, turnover is becoming ever costlier.

On the positive end, companies that invest aggressively in their culture and human capital—beyond the usual onboarding and training—will outcompete rivals focused on financial capital. They’ll give employees ever greater responsibilities that deliver higher levels of value to customers.

Customers: Individualized needs. Throughout the 20th century, especially in consumer goods, customers were often distant constituents. But the internet, big data, embedded sensors and artificial intelligence have given retailers and even manufacturers a flood of information. By tracking search habits and purchase patterns, companies can discern individual customer preferences and curate experiences accordingly.

Netflix carefully monitors what its customers watch on the site, so it can personalize its marketing, offerings and user experiences. The aggregated data also enables Netflix to improve its future content. These deep insights make it hard for rivals to pry customers away, and it increases customers’ usage of Netflix. Those are Netflix’s main motives, but along the way the company has to attend to its customers in ways entertainment providers didn’t in the past. And this stickiness is now extending to most products through the Internet of Things.

If companies don’t orient themselves toward their customers, they’re likely to hear about it from social media as well as through lost sales. Sites such as TripAdvisor and Yelp will add to the pressure to use this deep access to information wisely. The need to get feedback from customers, and please them, will rise steadily.

Suppliers: Integrated Partners. Supply chains might seem to be running in the opposite direction of connectedness. The Human Capital Management Coalition notes major shifts in “the organization of work over the past several decades, including the rise of outsourcing, subcontracting, franchising and complex global supply chains. As employment relationships are increasingly supplanted by contractual ones, there is a growing concern that the incentives of the company’s contracting partners are not necessarily aligned with those of the company.” This change has enabled companies to reduce costs, but with less control comes more risk.

But here, as well, technology is reconnecting companies to their supply chains. Outsourcing isn’t going away, but companies are integrating suppliers into tightly-managed value chains. Amazon carefully monitors and works with suppliers to deliver just-in-time inventory; Apple does likewise to ensure that components meet its demanding requirements. It also has strong relationships with app developers to ensure not just quality but also seamless operation with the overall operating system.

Perhaps the most tightly integrated business models are in the sharing economy. Firms such as Uber and Lyft require close connections with suppliers (drivers) and customers. Neglecting any group of contributors is dangerous.

Communities: Key Constituencies. Companies’ responsibilities to their local communities have always been there, but not always acted on. Here as well, technology is focusing companies’ attention. Social media enables local residents and activists to quickly mobilize around issues from privacy and diversity to climate change. Younger generations have heightened social sensitivities and will keep companies on their toes. With disinformation, cyberattacks, pandemics, and climate change, along with positive but risky advances such as autonomous vehicles, communities have plenty to watch for. But they can also help local businesses overcome challenges, if they see those businesses meeting community needs.

In the past, society expected companies only to abide by laws and work cooperatively with government. Now the table stakes are much greater. Companies that neglect their communities will risk their license to operate.

Stakeholder centrism in action

Boards were already beginning to pay more attention to stakeholders, but with the rise of integrated ecosystems, they will be compelled to accelerate this move. Now the challenge is to better understand stakeholders’ interests, resolve tradeoffs, and create accountability.

“Acme” is a publicly traded, high-growth consumer marketplace company that takes pride in its stakeholder-centric approach. It works to balance the interests of customers, suppliers, employees, local communities and investors in its strategic decisions and communications—which it believes will optimize the value creation for each over the long term.

Acme’s mission-driven business and culture have made it an employer of choice, allowing it to attract top talent. Its community outreach programs and commitment to full transparency have given it license to operate where competitors have faced pushback from communities and regulators. And its commitment to customer experience and customer-friendly policies have boosted its market share and customer loyalty.

Acme’s greatest struggle has been resolving short-term tradeoffs, especially with policies that benefit customers but can tax local communities. There’s also the usual tension between customers wanting more benefits, and Acme needing to preserve the business model that supports their many suppliers. Every company faces these tensions, but a commitment to stakeholder-centrism makes them more explicit and raises the stakes.

Acme is working to satisfy each stakeholder group without undermining the value proposition for other groups and without jeopardizing the viability of the business. Getting this right has required the company to rethink many of its core functions—stakeholder communication, governance, philanthropy, and employee performance management. The board has begun adjusting compensation so executives stay committed to this stakeholder-centricity over the long-run. At many companies, pay and incentives are where the rubber meets the road, so getting these right is essential.

Reinforcing stakeholder-centricity through compensation

Through trial and error, Acme has been fine-tuning its approach. In our work with the boards of Acme, and of other companies, we’ve found four principles for making it all work.

Emphasize the long-term. It’s impossible to attend to all stakeholders equally in the short term. Companies are constantly making near-term trade-offs while still optimizing outcomes for all over the long-run. Investments in customer experience today might squeeze suppliers or reduce profitability in the near-term, for example, but boost the value proposition and expand revenues and margins in the future.

Any pay program tied to short-term outcomes will subconsciously influence how leaders balance these trade-offs. Accordingly, Acme has emphasized an ownership culture with greater equity compensation, broad participation, and policies that promote longer employee holding periods. It also steered clear of the usual practice of overlapping three-year performance cycles, as the overlaps effectively create a series of one-year cliffs that emphasize short-term thinking. While Acme has continued to use a short-term, cash-based bonus, it reduced that element’s weight relative to the rest of executive compensation. (Although a clear minority, some companies looking to prioritize long-term, balanced stakeholder outcomes have eliminated bonuses entirely.)

Explicitly tie pay to outcomes for all stakeholders. Acme wanted to keep the cash-based bonus tied to short-term profit and revenue goals, but was concerned that these would keep employees from weighing the stakeholder tradeoffs discussed above. So the company balanced the investor-focused metrics for the bonus with stakeholder-oriented goals such as employee engagement, customer retention, and supplier satisfaction. The simple act of ‘naming’ the priorities and directly tying them to compensation boosted buy-in across the organization.

Balance metrics with discretion. Acme believed that stakeholder dynamics were too fluid to be captured in a typical bonus construct, where ‘hard’ goals were established at the beginning of the year and performance measured formulaically twelve months later. The board set specific priorities and definitions of success, but allowed for discretion in the actual assessments and payouts. They also allowed for the updating of priorities frequently to ensure continued alignment with the strategy.

Stick to your guns. Finally, and perhaps most difficult, boards need to build up the resolve to align compensation outcomes with the stakeholder model. That means letting cash-based incentive awards follow stakeholder outcomes even when short-term financials are weak. And conversely, it means pulling back on pay when stakeholder priorities weren’t achieved, even if financial performance was strong. Note that executives will still be motivated to respect investor interests, as much of their pay will be in stock.

Boards must build the credibility to diverge from the “one-size-fits-all” status quo on pay for today’s U.S. public companies. They have to stand firm in the face of external pressure from impatient investors and shareholder advisory groups to align with their guidelines, most of which are anchored in and promote a shareholder-centric perspective. Some investors won’t agree with this philosophy and decide to select out, but others will take their place if they find the company’s mission, strategy, and execution compelling and in shareholders’ interests long-term. This will require boards to be consistent, symmetrical, proportional, and transparent in their compensation decisions. If the tie always goes to the executive, or if the company applies its philosophy selectively, the board will lose credibility and struggle to operate outside the typical investor-centric norms.

Finally, to sustain and optimize incentives that align with the stakeholder-centric model, boards must be relentless about communication, internal and external. They need to dialogue continually with investors and employees. They can emphasize the mission and strategy, how they’re balancing stakeholder needs over the long-term (even as they make trade-offs in the short term), and how the incentives align.

Making the Transition

The Coronavirus pandemic is likely to speed up the move toward stakeholder-centricity. Companies have realized the fragility of their ecosystems and many will invest in better monitoring their supply and distribution chains. We’ll likely see greater automation—and a greater reliance on the talents of remaining and re-skilled employees, (especially those tasked with monitoring and maintaining systems and robots). The concerns of local communities are also coming to the forefront. But shareholders will need attention too, especially since many will see heightened risks and a year or two of depressed returns.

When the economy regains its footing, boards can communicate a new approach to managing executive pay. Only with revamped incentives can companies effectively serve and balance their ever-more-integrated ecosystems of stakeholders.

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