Innovative Enterprise Solves the Agency Problem: The Theory of the Firm, Financial Flows, and Economic Performance

By William Lazonick

Since the late 1980s, the dominant ideology of corporate governance in the United States has been that, for the sake of superior economic performance, companies should “maximize shareholder value” (MSV). As promulgated by agency theorists, however, MSV is an ideology of value extraction that lacks a theory of value creation. As a theory of value creation, I have constructed “The Theory of Innovative Enterprise”—an analytical framework for understanding how a business enterprise can generate a good or service that is of higher quality and lower cost than products previously available. In this essay, I use innovation theory to provide both a general theoretical critique and a selective empirical critique of agency theory. In Section 2, reviewing Bebchuk and Fried, Pay Without Performance (2004), I argue that the authors fail in their objective to demonstrate that U.S.-style stock-based pay undermines “shareholder value,” while I contend that, from the perspective of innovation theory, shareholder value is an illegitimate measure of corporate performance. In Section 3, focusing on Bebchuk, Brav, and Jiang, “The Long-Term Effects of Hedge-Fund Activism” (2015), which purports to demonstrate empirically that the exercise of shareholder power improves corporate operating performance, return on assets, and stock returns over periods of as long as five years, I argue that innovation theory casts serious doubt on their findings because the supposed long-term improvements in corporate performance could very well have resulted from cost-cutting that increased profits at the expense of the labor force rather than from productivity gains from the generation of higher quality products at lower unit costs—gains of innovative enterprise that are typically shared with the firm’s employees. In Section 4, I turn to a step-by-step critique of Fried and Wang, “Short-Termism and Capital Flows” (2017), which, taking issue with the central argument in my article “Profits Without Prosperity” (2104) that massive distributions to shareholders in the forms of dividends and buybacks have come at the expense of investment in innovation and higher wages, claims that a number of other sources of funds (debt issues, stock issues) and uses of funds (remuneration, R&D, acquisitions, venture capital) result in innovation and good wages. I demonstrate that Fried and Wang make a series of assertions about the economic impacts of financial flows—which they incorrectly call “capital flows”—that lack substance. I conclude the essay by arguing that, for analyzing the operation and performance of the economy, innovation theory should replace agency theory. Agency theorists do not address, let alone explain, why since the 1980s, the United States has experienced extreme concentration of income among the richest households and the erosion of middle-class employment opportunities. I contend that the ideology that corporations should be run to “maximize shareholder value” as promulgated by agency theorists has contributed to inferior economic performance. I argue that the critical issue for understanding the role of corporate governance in supporting or undermining economic performance is the relation between value creation and value extraction for those “stakeholders” engaged in the development and utilization of the company’s productive capabilities. Innovative enterprise solves the agency problem. By incentivizing and rewarding the real value creators, the innovative enterprise can mobilize the skill, effort, and finance that, by generating high-quality, low-cost products, can improve the performance of the economy—defined in terms of stable and equitable economic growth.