New Rules for the Changing Business World

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New Rules for the Changing
Business World

• Luigi Zingales

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Outline

• Corporate governance is about the distribution of
  power within firms.
• The nature of firms determines the essence of the
  corporate governance problem and its solutions.
  
• The focus of the existing literature and its
  solutions are based upon the traditional model of
  firm (GM-like).
• The nature of firms is changing.
• So should our corporate governance focus and our
  solutions.

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A Bit of History -1

• The corporate governance debate started in 1932
  with the publication of Berle and Means The
  Modern Corporation and Private Property.
• They lament the separation between ownership and
  control.
• What is the modern corporation?
• Why do they lament the separation between
  ownership and control?

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A Bit of History -2

• The 70 years between 1840 and WWI witnessed a
  dramatic change in the way firms were organized.
• Until 1840 no large firms, no middle
  management, no multiunit enterprises.
• By WWI what Chandler calls the Modern Business
  Enterprise was dominant.
• To a large extent is still dominant today.
• What are the characteristics of the MBE?

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Characteristics of the MBE

• 1) Large enough to exploit potential economies of
  scale and scope in production
• In 1886 Standard Oil refineries were from 3 to 20
  times bigger and had a production cost per barrel
  equal to a third
• 2) Capital intensive
• Between 1869 and 1899 capital invested per worker
  in the United States nearly tripled in constant
  dollars, from 700 to 2000
• 3) Integrated both forward and backward
• 4) Oligopolistic
• 5) Run by professional managers

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Why Did the MBE Emerge?

• Technological change
• enormous increase in productivity associated with
  an increase in the scale of production
• In 1881 Duke installed the Bonsack cigarette
  machines. Two such machines could saturate the
  American market.
• need of a reliable supply and distribution chain
  to sustain high level of throughput
• gt impossibility to find it in the spot market
• market did not support many players
• people will not be willing to specialize
• gt necessity to create a proprietary one
• gt vertical integration

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Why Those Characteristics?

• Vertical integration capital intensity
• Difficult for newcomer to enter
• Oligopolistic
• Vertical integration capital intensity
• Too much risk to be born by a single entrepreneur
  
• Dispersed investors
• Vertical integration
• Too much work to be handled without an
  organization
• Emergence of professional managers (and business
  schools).

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Effects of the MBE

• Large barriers to entry for new firms
• -gt stability of organizations
• of the Fortune 500 firms in 1994 nearly half was
  founded between 1880 and 1930.
• 2) Great control of the firm over the employees
  (lots of specialization, little alternatives)
• command and control system
• unions, other forms of protection
• 3) Clear ownership of the source of value
• -gt dispersed investors possible

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Implications for Corp. Gov. -1

• Vertical integration
• Coincidence between non arms length transactions
  and the legal entity called firm
• corporate governance
• Little competition in intermediate products
• Organizational slack
• Need of a command and control system
• Development of hierarchies
• Compression of wages for skilled workers

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Implications for Corp. Gov. -2

• No competition in intermediate stages internal
  command and control system
• All rents at the top of the organization
• dispersed investors
• Huge agency problems between managers and
  shareholders
• Hence the focus of the corporate governance
  literature
• pay-for-performance
• accountability
• takeovers- proxy fights

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What Is Changing?

• There are powerful forces at play that are
  changing the nature of the firm
• 1) Drop in the cost of information collection
• gt more intense competition
• 2) Reduction in the barriers to trade
• gt bigger markets can support more competition
• gt less need of vertical integration
• 3) Reduction in the role of Government
• gt end of regulated monopolies
• 4) Development of financial markets
• gt facilitates new entry

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Effects on firms

• 1) Improvements in capital markets drop in
  communication costs
• gt Reduced importance of existing assets
• 2) Increased competition gt increased demand for
  process innovation
• gt increased importance of human capital
• 3) Easier access to financing increase in
  competition
• gt human capital less specific to their current
  employer
• Saatchi Saatchi example.

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Macro trends

• Reduction in firm size
• Employees working in firm gt1000 dropped 13
  percent from 1967 to 1973 and 18 percent from
  1974 to 1985
• Increased job mobility
• Increase in the fraction of workers with less
  than ten years tenure, especially in the 1990s
• Increased skill premium
• Between 1979 and 1987 average weekly wage of
  college graduates increased by 30 percent
  relative to that of comparable high school
  graduates

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Changes in Corporate Governance Focus

• Three examples
• 1) Changed role of stock options
• 2) Agency problems from slack to stealing
• 3) Changed nature of the private equity market

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1) Changed Role of Stock Options

• Traditional objective motivate executives
• gt stock option to CEOs
• Current
• ensures employee a share of the rents
• decrease threat of their departure
• without giving away all the control.
• Solution long-term stock option, which vests
  over many years
• gt generalized use of stock options (not just
  for CEO).

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Challenge for Accounting

• Balance sheet measures firm as a corpse
• Joke for Internet firms
• They should measure
• 1) ability to retain human capital
• 2) value of human capital retained
• gt Need to develop new performance parameters,
  such as employees turnover, to verify whether
  generalized stock options work.

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2) Changed Nature of the Agency Problem

• Traditional problem Managerial slack
• Current problem Managerial stealing of growth
  opportunities
• Easier access to financing has made it easier for
  employee to appropriate opportunities that used
  to belong to the firm.
• 71 of firms in the Inc 500 founded by people
  exploiting a growth opportunity created by their
  previous employer
• Intel

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Challenge for Valuation

• Traditional approach
• Value firm Assets in place Growth
• opportunities
• Implicit that firm owns growth opportunities.
• If employees can appropriate them, who owns them?
• How do we value a firm?
• Need for measure of ability to capture growth
  opportunities.

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3) Changed nature of the private equity market -1

• How did the nature of the MBE reflect on the
  Private Equity Market?
• 1) Stability of the MBE -gt
• i) VC rare events
• confined to new technologies
• in industries not very capital intensive
• debt preferred instrument (LBOs)
• ii) Low likelihood of success of new entry
• Low valuations
• iii) MBE can easily support debt (LBOs)

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3) Changed nature of the private equity market -2

• 2) Firms boundaries well defined -gt
• Valuation easier
• Transferability easy
• gt buyouts lions share of the PE market
• Concentrated ownership a temporary phenomenon
• Reverse LBOs

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Effects on the PE Market -1

• 1) Break-down of the MBE and of its barriers to
  entry
• gt likelihood of success of a new entrant
  increases
• gt increase in valuations

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Effects on the PE Market -2

• 2) Opening up of possibility of entry in all
  sectors
• gt increase in VC investments in all areas
• gt even in capital intensive areas
• gt increase in the amount of money invested in
  early phases
• gt more money needed for VC funds
• 3) Loss of stability of the MBE
• future cashflow very unpredictable
• reduction in the use of debt (less LBOs)

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Effects on the PE Market -3

• 4) De-integration of the corporation
• gt suppliers and customers become independent
• gt smart corporations prefer to facilitate rather
  than resist this phenomenon
• gt corporate VC
• 5) Global phenomenon break down of traditional
  way of doing business
• gt model is more easily expandable abroad
• gt opportunity for international VC

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Conclusions

• The firm has changed, we should change the way we
  look at it.
• This forces us to rethink many aspects of
  corporate governance and corporate finance in
  general.
• I provided 3 examples
• 1) Use of stock options
• 2) Nature of the agency problem
• 3) Changing nature of the private equity market