The doctrine of “shareholders come first” has taken a beating in recent years—and rightly so! For decades, this mantra held sway as conventional wisdom. Some people even believed it was a legal requirement to put profits above all, which it isn’t.
The problem isn’t necessarily a focus on shareholder value as a broad concept. The problem is a focus on short-term shareholder value. Yes, shareholder returns are often affected by strong market reactions to quarterly earnings reports. But a slavish focus on meeting quarterly earnings expectations can lead a company to cannibalize its long-term future to feed the short-term earnings machine. Starving the forest to save a few nearby trees, basically. It’s a nasty feedback loop.
So, we’re getting into system dynamics?
Yep! Let’s look at a hypothetical software company that faces increasing pressure from a market leader with a better product. Our company’s sales are falling, jeopardizing next quarter’s earnings results, and we need to respond.
One way to respond is to cut costs to meet earnings expectations and then try to turn the company around. So, our hypothetical company lays off 15% of its staff, primarily in quality assurance and administrative functions, and cuts the budget for marketing and advertising. It also pressures sales teams to increase sales while implementing a company-wide hiring freeze.
After taking these steps, the company meets earnings forecasts for the quarter. But what happens next?
Let’s throw this hypothetical company’s situation into a causal loop diagram and see how the system dynamics might play out (note: this is only one representation out of many possibilities! On a real project, you’d spend weeks or months vetting diagrams and models with stakeholders):
So, how do we trace cause and effect here?
We’ll first describe the causal relationships in this diagram as individual pairs in isolation. Then we’ll trace the effect of the company’s decisions through the loops in the diagram. For a primer on how to read and create causal loop diagrams, visit this Risk Musings article from July.
Looking at our diagram, as we increase each variable, its pair reacts positively or negatively (inversely):
As external pressure from the market leader increases, our company’s market share decreases (an inverse relationship: the two components tend to move in opposite directions, all else held constant).
As management pressure to increase sales increases, our direct sales efforts increase, possibly through overtime (a positive relationship: the two components tend to move in the same direction, all else held constant).
As management pressure to increase sales increases, employee satisfaction decreases.
As direct sales efforts increase, market share increases.
As employee satisfaction increases, staffing levels increase (due to lower turnover).
As staffing levels increase, employee satisfaction increases.
As staffing levels increase, direct sales efforts tend to increase.
As staffing levels increase (e.g., in software development), features added to the product increase.
As staffing levels increase (e.g., in QA teams), product quality increases.
As features added to the product increase, product quality increases.
As product quality increases, market share increases.
As market share increases, earnings increase.
As earnings increase, budget pressure decreases.
As budget pressure increases, employee satisfaction decreases.
As budget pressure increases, funding decreases.
As funding increases, staffing levels increase.
As funding increases, marketing/advertising increases.
As marketing/advertising increases, market share increases.
Okay. For an example, that’s a big list! But all of these factors interact with each other in the causal loop diagram to produce an outcome, which will vary based on which factors and which loops dominate.
Let’s remember what our hypothetical company did to stave off a potential earnings shortfall:
Laid off 15% of its staff, primarily in quality assurance and administrative functions.
Cut the budget for marketing/advertising.
Pressured sales teams to increase sales while implementing a company-wide hiring freeze.
We’ll trace these changes around the causal loop diagram and see their possible effects.
Laid off 15% of Staff, Primarily in QA and Administrative Functions
The company decreased staffing levels, which will decrease employee satisfaction, which will increase turnover, further decreasing employee satisfaction. The decrease in staffing levels also may decrease the direct sales effort (for example, if sales staff now have to perform more administrative functions due to loss of administrative staff), which could decrease market share.
A decrease in QA staffing could reduce product quality and also could reduce the number of features that make it through the QA pipeline at any given time, which in turn could reduce market share.
So, as a result of layoffs, we have downward indirect pressure on our company’s market share for its product. But we’re not done looking at the impact of these changes.
Cut the Budget for Marketing/Advertising
This one’s pretty straightforward: a decrease in funding for marketing and advertising will lead to a decrease in marketing and advertising, which will decrease our company’s market share.
That just adds to the pressure building from the other changes made.
And remember: external pressure from the market leader is continuing during all this! And that’s also reducing market share.
Implement a Company-Wide Hiring Freeze
This action decreases funding for hiring, which will decrease staffing levels (with a delay) as people who leave are not replaced. In turn, decreased staffing levels likely will reduce the number of features added to the product, reduce the product quality, decrease employee satisfaction, decrease the number of people conducting direct sales efforts, and ultimately decrease market share.
So, the end result of our hypothetical company’s actions is downward pressure on market share from several different factors, which likely will decrease earnings, which will increase budget pressure, and voila! Our company has entered a vicious cycle spurred by a focus on short-term shareholder value.
Are you anti-shareholder value?
Not really. Again, it’s not that optimizing shareholder value is inherently bullshit; it’s that our hypothetical company’s decisions prioritized short-term shareholder value over long-term shareholder value.
If our company could stick to optimizing long-term shareholder value, it might do that by focusing on other long-term goals like boosting employee satisfaction, product quality, and customer satisfaction. Which leads to this hypothesis:
Shareholder value is not a primary goal; it’s an end result.
Putting it first is thinking the wrong way around.
So, maybe customers should come first instead of shareholders?
Nope. Bzzzzzt! Customers don’t come first either.
Yes, many business owners adhere to the idea of “customers come first”, but I’d argue that’s also misguided. Of course, customer service is vitally important! But too many businesses sacrifice employee satisfaction on the altar of short-term customer satisfaction.
There are certainly times when meeting customer needs has to come first in the short term. For example, if our hypothetical business signed a contract to deliver a software upgrade to a customer by next month, that deadline must be met, even if it requires overtime and surge hiring. But afterward? If the business repeats the actions that got it into this pickle, and employees feel spread too thin over the long term, the company shouldn’t be surprised if employee dissatisfaction begins affecting customer satisfaction.
Let’s walk through that scenario where employee satisfaction declines due to repeated bouts of overtime required to deliver customer software upgrades on time. Here’s our causal loop diagram again for reference:
In this case, the variable affected first is employee satisfaction. As it declines, overworked employees start to leave, decreasing staffing levels, which further reduces employee satisfaction. The decline in staffing levels begins to reduce the number of features that can be added to the product and thus the overall product quality, which reduces market share.
If enough good and great employees leave, and the replacement employees who come on board tend to be mediocre (because the company is known for last-minute sprints and mismanagement of employees’ time), then product quality will continue to suffer and market share will continue to decline, which will eventually reduce earnings, which will increase budget pressure, which will reduce funding for staffing, which will reduce employee satisfaction, and so on in a vicious cycle.
So, what’s the right approach?
One model used for decades by some highly successful companies goes like this:
Employees come first, then customers, then shareholders.
While not the only way to the top, this approach might be one of the more sustainable ways to gain and maintain industry dominance. Yes, it’s more easily implemented at private companies that don’t face quarterly earnings pressure, but it is possible for public companies to prioritize the long term. It takes commitment, and it’s not easy, but it can work.
How might this work? This sounds idealistic.
Let’s say our company faces the same set of circumstances as in our first example: external pressure from a market leader, falling sales that jeopardize next quarter’s earnings results, and a need to respond. But what if, instead of cutting costs to meet short-term financial metrics, and instead of squeezing employees to meet short-term customer pressures, the company addresses the problem in this counterintuitive way:
Accept and announce that next quarter’s earnings will be lower than anticipated.
Focus on long-term success by identifying an unserved or underserved market niche that the market leader is not addressing, and develop a strategy to serve that niche profitably. (A great example is the Apple iPhone, which upended everything despite Apple’s lagging position in the personal computer market at the time.)
Hire and train so that employee staffing levels and skills are adequate for the challenge.
Compensate employees well (above market average), and create or improve company culture so they feel valued, rewarded, and supported for achieving goals. (This may mean retraining, removing, or sidelining managers who resist transformation.) Confident, motivated, well compensated employees tend to make great products and provide great customer service.
Now that employees are valued, focus on delighting the customer, unhindered by excessive turnover. Adjust strategy as needed based on long-term goals and customer feedback.
Eventually, blast past earnings targets with a great product that delights customers.
Can we track this through the diagram?
You bet, with a few tweaks, so get out the pencil and paper. Let’s take one last, longing look at our original causal loop diagram (yeah, I know this article is long!):
In the employees-first approach, in response to earnings declining, our company does feel budget pressure but counterintuitively increases funding (of course, this assumes they’ve budgeted well in the past or can tap new funding via stock or debt offerings. You’d add this to the diagram as Additional Funding Sources with a negative arrow pointing toward Budget Pressure, because additional funding sources reduce budget pressure). They use that funding to hire new staff and develop not just new features, but possibly entirely new products (which would also be an addition to our diagram—go ahead and draw it in if you want on your own diagram!), expanding the marketplace and aiming to lead in the new segment.
If they’re successful, their new staff will increase the number of new features available, which will increase the company’s market share. Even better, if their new staff successfully create new products, and the company markets those products well, their market share will increase even more. That increased market share will eventually increase earnings, which will reduce budget pressure, which will increase employee satisfaction (via bigger raises, bonuses, and stock option value) and allow for increased hiring of good and great employees (which will further increase employee satisfaction since highly competent people prefer to work with other highly competent people). The increased staffing levels will enable development and delivery of even more features and higher product quality, increasing market share. The company has entered a virtuous spiral.
This isn’t purely idealistic thinking. It’s difficult, but possible: Apple sparked a similarly virtuous spiral with iTunes and with the iPhone.
Note that another factor not shown on this sample diagram is network effects. In short, some products benefit tremendously from word of mouth: the more people who use a product, the more other people hear about it and want to use it, too. Think of Facebook or the iPhone. As an exercise, try drawing this causal loop diagram with network effects included.
Bring on the takeaways!
Consider that shareholder value is not a primary goal, but an end result. By putting employees first and then customers, value will accrue to shareholders not through short-term cost cuts, but through long-term investment and innovation. As always, success is never guaranteed, but a long-term focus and a resilient strategy can increase the chances of achieving it.
Also, an employee-first model doesn’t exist in isolation. For almost all companies, the planet is a stakeholder. It is speaking up loudly now against the harms we’ve inflicted in the last century. And conducting business in a way that acknowledges this all-important stakeholder is fast becoming, well, all-important. You can have the best and happiest employees, delighted customers, and increasingly rich shareholders, but none of them will stay that way if the planet topples into full-on extinction mode.
So, reach for that causal loop diagram and see where and how you might add environmental sustainability as a variable. Many corporations haven’t fully figured out how to prioritize sustainability alongside profit yet, although triple-bottom-line theory explores the concept. Sustainability will be integral to future success, not just for individual businesses but for everyone.
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I think this article is long enough that we don’t need extra links down here. I’ll bring back the links in next week’s newsletter.
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I am going to have to read this many times to appreciate all the details and those diagrams! Awesome post.