A Theory of the Firm: Governance, Residual Claims, and Organizational Forms

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9780674002951: A Theory of the Firm: Governance, Residual Claims, and Organizational Forms

This collection examines the forces, both external and internal, that lead corporations to behave efficiently and to create wealth. Corporations vest control rights in shareholders, the author argues, because they are the constituency that bear business risk and therefore have the appropriate incentives to maximize corporate value. Assigning control to any other group would be tantamount to allowing that group to play poker with someone else's money, and would create inefficiencies. The implicit denial of this proposition is the fallacy of the so-called stakeholder theory of the corporation, which argues that corporations should be run in the interests of all stakeholders. This theory offers no account of how conflicts between different stakeholders are to be resolved, and gives managers no principle on which to base decisions, except to follow their own preferences.

In practice, shareholders delegate their control rights to a board of directors, who hire, fire, and set the compensation of the chief officers of the firm. However, because agents have different incentives than the principals they represent, they can destroy corporate value unless closely monitored. This happened in the 1960s and led to hostile takeovers in the market for corporate control in the 1970s and 1980s. The author argues that the takeover movement generated increases in corporate efficiency that exceeded $1.5 trillion and helped to lay the foundation for the great economic boom of the 1990s.

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About the Author:

Michael C. Jensen is Jesse Isidor Straus Professor of Business Administration Emeritus, Harvard Business School.

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The most careful academic research strongly suggests that takeovers--along with leveraged restructurings prompted by the threat of takeover have generated large gains for shareholders and for the economy as a whole. Our estimates indicate that from 1976 to 1994 over 45,000 control transactions occurred-including mergers, tender offers, divestitures, and LBOs, totaling $3.3 trillion (in 1994 dollars). The premiums paid to selling firms and their shareholders in these transactions totaled $959 billion (1994 dollars) (Mergerstat Review 1994). And this estimate includes neither the gains to the buyers in such transactions nor the value of efficiency improvements by companies pressured by control market activity into reforming without a visible control transaction.

Exit problems appear to be particularly severe in companies that for long periods enjoyed rapid growth, commanding market positions, and high cash flow and profits. In these situations, the culture of the organization and the mindset of managers seem to make it extremely difficult for adjustment to take place until long after the problems have become severe, and in some cases even unsolvable... In industry after industry with excess capacity, managers fail to recognize that they themselves must downsize; instead they leave the exit to others while they continue to invest. When all managers behave this way, exit is significantly delayed at substantial cost of real resources to society.

With the shutdown of the capital markets as an effective mechanism for motivating change, renewal, and exit, we are left to depend on the internal control system to act to preserve organizational assets, both human and nonhuman. Throughout corporate America, the problems that motivated much of the control activity of the 1980s are now reflected in lackluster performance, financial distress, and pressures for restructuring. Kodak, IBM, Xerox, ITT, and many others have faced or are now facing severe challenges in the product markets. We therefore must understand why these internal control systems have failed and learn how to make them work.

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