Separation of Ownership and Management

Many businesses are owned and managed by the same individual. This simple organization, well-suited to small businesses, in fact was the most common form of business organization before the Industrial Revolution. Today, however, with global markets and large-scale production, the size and capital requirements of firms have skyrocketed. For example, General Electric has property, plant, and equipment worth about $35 billion. Corporations of such size simply could not exist as owner-operated firms. General Electric actually has about one-half million stockholders, whose ownership stake in the firm is proportional to their holdings of shares.

Such a large group of individuals obviously cannot actively participate in the day-to-day management of the firm. Instead, they elect a board of directors, which in turn hires and supervises the management of the firm. This structure means that the owners and managers of the firm are different. This gives the firm a stability that the owner-managed firm cannot achieve. For example, if some stockholders decide they no longer wish to hold shares in the firm, they can sell their shares to other investors, with no impact on the management of the firm. Thus financial assets and the ability to buy and sell those assets in financial markets allow for easy separation of ownership and management.

How can all of the disparate owners of the firm, ranging from large pension funds holding thousands of shares to small investors who may hold only a single share, agree on the objectives of the firm? Again, the financial markets provide some guidance. All may agree that the firm's management should pursue strategies that enhance the value of their shares. Such policies will make all shareholders wealthier and allow them all to better pursue their personal goals, whatever those goals might be.

Do managers really attempt to maximize firm value? It is easy to see how they might be tempted to engage in activities not in the best interest of the shareholders. For example, they might engage in empire building, or avoid risky projects to protect their own jobs, or overconsume luxuries such as corporate jets, reasoning that the cost of such perquisites is largely borne by the shareholders. These potential conflicts of interest are called agency problems because managers, who are hired as agents of the shareholders, may pursue their own interests instead.

Several mechanisms have evolved to mitigate potential agency problems. First, compensation plans tie the income of managers to the success of the firm. A major part of the total compensation of top executives is typically in the form of stock options, which means that the managers will not do well unless the shareholders also do well. Table 1.4 lists the top-earning CEOs in 1999. Notice the importance of stock options in the total compensation package. Second, while boards of directors are sometimes portrayed as defenders of top management, they can, and in recent years increasingly do, force out management teams that are underperforming. Third, outsiders such as security analysts and large institutional

CHAPTER 1 The Investment Environment

Table 1.4 Highest-Earning CEOs in 1999

CHAPTER 1 The Investment Environment

Table 1.4 Highest-Earning CEOs in 1999



Total Earnings (in millions)

Option Component* (in millions)

L. Dennis Kozlowski

Tyco International



David Pottruck

Charles Schwab



John Chambers

Cisco Systems



Steven Case

America Online



Louis Gerstner




John Welch

General Electric



Sanford Weill




Reuben Mark




"Option component is measured by gains from exercise of options during the year. Source: The Wall Street Journal, April 6, 2000, p. R1.

"Option component is measured by gains from exercise of options during the year. Source: The Wall Street Journal, April 6, 2000, p. R1.

investors such as pension funds monitor firms closely and make the life of poor performers at the least uncomfortable.

Finally, bad performers are subject to the threat of takeover. If the board of directors is lax in monitoring management, unhappy shareholders in principle can elect a different board. They do this by launching a proxy contest in which they seek to obtain enough proxies (i.e., rights to vote the shares of other shareholders) to take control of the firm and vote in another board. However, this threat is usually minimal. Shareholders who attempt such a fight have to use their own funds, while management can defend itself using corporate coffers. Most proxy fights fail. The real takeover threat is from other firms. If one firm observes another underperforming, it can acquire the underperforming business and replace management with its own team. The stock price should rise to reflect the prospects of improved performance, which provides incentive for firms to engage in such takeover activity.

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