Monday, October 26, 2015

Changing Nature of the Corporation

The latest issue of the Economist carries two columns (here and here) that analyze the significant changes that have occurred in the nature of the modern corporation, particularly with respect to ownership. This is an addition to an earlier column in September. These columns highlight the more recent developments relating to the nature of the corporation, and question whether the diffused shareholding model that has been prevalent in countries such as the US and UK is likely to be prominent in the future.

According to the Economist, the anonymity in the large listed corporation with diffused shareholding creates several problems. The first is in the typical agency problem between the managers and the shareholders, which tends to be prevalent in such companies. Other problems include the lack of clarity over who controls the company. More recent concerns relate to phenomenon of short-termism due to the pressure of maintaining strong quarterly financial performance. While over the years tighter regulation has been introduced as a measure to curb the excesses of managers, it has also had the unintended effect of increasing the costs of regulation due to which more companies are either not entering the public capital markets or, if already listed, are going private. Furthermore, there is a drastic change in the nature of shareholding even in listed companies. For instance, institutional shareholding has become much more prominent in the US, and has overtaken shareholdings held by individuals.[1]

For this reason, it has been found that a new type of corporation is becoming more prominent in the contemporary business world, which is focused on technology and disruptive innovations. The columns refer to the increasing presence of start-ups, which operate with a clearer ownership structure, due to which some of the problems present in the large corporations with diffused shareholding may not exist. They note that in this “novel type of corporate arrangement … [i]nvestors, founders, managers and, often, employees have stakes that are delineated by carefully drawn contracts, rather than shares of the sort that trade on exchanges”. The role of lawyers too has attracted attention not only in terms of their role in structuring these arrangements, but also in the manner in which they themselves are incentivized. As one column notes:

Lawyers in the startup world play a vastly different role from those who advise—or sue—large companies. This is in part because of the nature of their clients; often tottering between failure and success they rely more heavily on outside advice. But it is also because lawyers, in the early stages, have replaced banks as the key intermediary for financing. But most importantly they negotiate directly with investors and physically maintain the “cap structure”—the all-important legal contract noting who owns what.

The ambiguities and obfuscation of public companies contrast sharply with the new corporate structures set out by legal contracts that make the rights of both investors and owners more explicit. These legal agreements tackle two fundamental difficulties. The first is the need to mitigate agency problems. This is handled by detailed agreements that include control issues, such as the allocation of board seats. Investors usually insist that management, and often employees, own large stakes to ensure their interests are aligned to the success of the venture.

The second difficulty concerns enabling investment in the absence of an important detail: a plausible valuation. Startups are pioneering a novel answer: an agreement at the early investment stages that enables an investor to buy a proportion of the venture, but at a price determined at a subsequent round of fund-raising, typically a year or two in the future.

Even if the modern startups subsequently access the capital markets, they may structure their offerings differently on the lines adopted by firms such as Google, Facebook and Alibaba whereby the founders will continue to maintain strong control over the firms so as to provide clarity to the investors on this count.

Although the columns in the Economist do not discuss these in detail, they refer to another alternative to the Western corporation, being companies from the emerging markets that are gaining influence on the global scene. Such companies tend to be either family-owned companies or state-owned enterprises (SOEs). In these cases, while the question of control is rather clear and categorical, they give rise to the agency problems between controllers and minority shareholders. Typical problems with such companies tend to be governance issues such as related party transactions and tunneling. However, arguably the issues associated with dispersedly held companies such as short-termism may operate to a lesser extent given the longer term interests and outlook of the controlling shareholders (whether the business family or the state) who are in the business in the longer run. A lot more effort is now being spent in understanding and analyzing the benefits and disadvantages of such companies which carry concentrated shareholdings.

In all, there appears to be a radical change in the outlook among analysts and commentators. It was only at the turn of this century that arguments were proffered about the supremacy of the American shareholder-centric model with dispersed shareholding that should form the paradigm for companies from other countries to follow, resulting in a convergence of corporate governance around the world on the lines of the U.S. model.[2] Just over a decade later, serious doubts are being raised regarding the efficacy of the model, especially when alternative models are beginning to look attractive.

[1] See, Ronald J. Gilson & Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights (2013), available at

[2] Henry Hansmann & Reinier Kraakman, The End of History for Corporate Law (2000), available at

No comments: