Shareholder Theory: A Simple Explanation -

Shareholder theory: A simple explanation

20th January, 2023

What is shareholder theory? Theories can often be difficult to wrap your head around. Shareholder theory is another business theory, which I will break down into simple terms in this blog post to help you better understand what it is, how it works and why it is used.

Contents

What is shareholder theory?

Shareholder theory is a business theory established in 1970 by Milton Friedman, an economist. It is sometimes also referred to as the Friedman Doctrine. The main basis of shareholder theory is that it is a business’ main responsibility to increase profits. It says that because shareholders are the ones funding a business, it should be them who the firm has social responsibility towards. According to MITSloan, shareholder theory is an example of a ‘normative theory of corporate social responsibility’, aiming to dictate what a corporation’s role should be.

Friedman proposed the idea in an essay he wrote for the New York Times titled A Friedman Doctrine: The Social Responsibility of Business is to Increase Its Profits. He essentially said that companies have no social responsibility to the (local or general) public or to society, because they are beholden to those initially funding them.

What (or who) is a shareholder?

A shareholder is literally someone who holds (owns) shares in a company’s stock. This is known as equity. Shareholders are essentially joint owners of a business, and profits go back to them as increased stock valuations or payments known as dividends. If there were no profits or profits were to go down, the value of each share would drop.

The Corporate Finance Institute says ‘A shareholder can be a person, company, or organization that holds stock(s) in a given company. A shareholder must own a minimum of one share in a company’s stock or mutual fund to make them a partial owner. Shareholders typically receive declared dividends if the company does well and succeeds. Also called a stockholder, they have the right to vote on certain matters with regard to the company and to be elected to a seat on the board of directors.’

How does shareholder theory work?

The way shareholder theory works is actually quite simple. As mentioned in the definition of what the theory is, it suggests that businesses should only be focused on increasing profits for their shareholders. This, in reality, means not engaging in any form of philanthropy; e.g, no charitable donations, unless the donation would lead to a benefit (to the business or shareholders) equal to or greater than the donation itself.

The whole premise of shareholder theory is basically that the shareholders are more important than other stakeholders, like employees and the local community, all of whom have a stake (interest) in the business.

Read about stakeholder theory and stakeholder analysis HERE, and find out how it opposes shareholder theory.

Benefits of shareholder theory

There are certain advantages and disadvantages of shareholder theory and applying it to the way a business is run. First of all, let’s look at the benefits of shareholder theory and how it can be a good thing for businesses…

The goal of shareholder theory, e.g to increase equity for shareholders, is measurable. This means management can put a plan in place knowing exactly what they need to do in order to achieve this goal.
This goal is a narrow one, which should theoretically make it simpler to achieve.
Responsibility is only towards one set of people – the shareholders – meaning there are usually less people to satisfy than when applying stakeholder theory, where there could be thousands if not millions of people who a business feels responsibility towards.
The theory is over 50 years old, meaning there is a lot of research and information to back it up.

Disadvantages to shareholder theory

As with all theories, there are downsides too. Here are some of the negatives and disadvantages which go along with shareholder theory…

Shareholder theory fails to take into account anyone other than the shareholders. This means that employees, consumers, the local community and so on are not being taken into consideration; this can lead to a negative outlook of the company.
Shareholder theory does not look at sustainability. With natural human resources being limited, a business making no effort to be sustainable because they are only focusing on profit is a business that might not last as long as it could despite the money involved.
The theory mostly ignores the other factors that go into creating a ‘good’ or successful business in favour of focusing on shareholder satisfaction. This means that they end up with unhappy and therefore unproductive employees, for example, due to paying them a low wage in order to drive further wealth to shareholders.
By focusing so much on increasing profits to please shareholders, businesses might be tempted to cut corners and ultimately deliver a below standard end-product to customers and consumers.
Shareholder theory creates a relationship between the corporate world and the political one. Because a government can create a policy or law which reduces shareholder value, businesses will often donate money to political parties or lobby them to ‘get them on side’. This is an obvious negative side to this theory, because it leads to governments acting in the best interest of businesses rather than individuals or a community.

Criticism of shareholder theory

As you can see above there are a variety of disadvantages that go along with shareholder theory. For this reason, the theory has been criticised on a number of occasions by various people and experts.

Naomi Klein

Noami Klein, a left-wing activist and author, is particularly opposed to the theory. She said in her book The Shock Doctrine, that shareholder theory consistently impoverishes communities while actively enriching the lives of the corporate elite. Her book was a criticism of what she calls ‘disaster capitalism’. In it she says “When it comes to paying contractors, the sky is the limit; when it comes to financing the basic functions of the state, the coffers are empty.” This is clear criticism of shareholder theory in itself.

Paul Tudor Jones

Hedge fund manager/investor Paul Tudor Jones is someone who also vehemently opposes shareholder theory, despite being a billionaire and therefore someone who you might think would be in favour of it.

He actually blames shareholder theory and the Friedman doctrine for the famous opioid epidemic across the United States. He says that profit maximisation is what led to Purdue Pharma particularly, along with the Sackler family, engaging in unethical practices. They were encouraging and allowing doctors to dispense prescription opioids for no medical reason – thus leading to so many people becoming addicted to it. This is a real, albeit extreme, example of the negative impact shareholder theory has. At least 400,000 adults have died in the US due to prescription drug overdose.

Lawrence Mishel

Working for the Economic Policy Institute in Washington, Lawrence Mishel blames shareholder theory – and Friedman – for the fact that wages have remained so low in the US. Of course, it is not just the US where wages are criminally low; we can see this from the current cost of living crisis in the UK, for example, where people are being told to simply work more hours or get a second job to make ends meet rather than policies being put into place that ensure wages are enough to live and thrive on.

Mishel wrote about this for the International Monetary Fund, saying that wages are low because businesses and corporations work hand in hand with the government to block reforms that might change this. Of course, this is directly beneficial to the shareholders who get more of the profit. It fails to account for employee dissatisfaction, however. Mishel goes on to say that workers have become disempowered thanks to wage suppression, wage inequality, poor labour standards, changes to the corporate structure and excessive unemployment keeping wages low.