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The Firm As a Respected Institution

The chapter opens with remarks from a speaker at a graduation ceremony, Narayana Murthy, founder and co-chairman of Infosys. The key point of his speech was that his goal was not to be the largest company, but the most respected one in India. It had to be profitable, but a company makes a profit because people are willing to do business with it - customers, employees, partners, and communities. People are more interested in interacting with others whom they respect; therefore, the more respected a firm, the more interaction, the greater the profitability.

The way that a firm becomes respected is to provide value to others: design and develop outstanding services for your customers, provide a business model that is profitable and sustainable for your investors, develop and nurture your employees, and be fair with your partners and suppliers. Do not seek to merely to be legal, but to be good in an ethical sense.

There are a few random snippets of the company's values and beliefs: People are free to disagree with their superiors - but disagree without being disagreeable. "In God we trust, but everybody else brings data to the table." Only an argument that has merit wins, regardless of rank or station.

As of 2008, Infosys had become one of the most respected firms, not merely in India, but in the software industry - and it has enjoyed stunning financial success: $4.1B in revenues, 1M in net profits, and over 90K employees worldwide.

The author emphasizes that Infosys is not unique, as most firms begin with similar desires, though few sustain them. Over time, most companies' leaders think about business models and profitability, and believe that respect is the result rather than the cause if financial success.

Where economies are growing or there are few competitors in the market, it's easy to turn a profit, and a firm that is being run by the wrong ideology can survive and even thrive - but when the economy is thought and competition is fierce, respected companies persevere while others collapse.

Respected Organizations

Companies that have built lasting reputations have done so on various foundations: they may have excellent products or services, iconic brands, unique experiences, or reputable management. These foundations can be maintained though financial struggles and can even carry companies through scandal.

By contrast, companies that choose financial performance may be well regarded, but their reputation is tied only to their returns, and when those fail, the company is abandoned. Witness the respect granted to technology and financial firms during the booming 1990's, and how quickly that respect evaporated after many of the innovators went bust.

When a company's financial performance takes a downturn, as happens to every firm at times, the mediocre economic performance is cause for criticism, but the critics do not stop there. Once a company is in doubt, people begin to question its reputation, good judgment, and ethical behavior. Audits and financial investigations expose incidents of poor risk management, irresponsible investment, negligence, and stunning incompetence. The scandals mount, and people flee the firm: customers, investors, partners, and employees do not wish to be associated with the firm and cease to interact with it.

(EN: What the author seems to be hinting at, but doesn't say outright, is that public opinion tends to the extremes: a company is a hero or a villain. A single scandal may be aggrandized to portray a firm as a villain, or dismissed as a minor misstep of an otherwise heroic firm. It may seem superficial, but it is not inconsequential: people choose to buy from, work for, and invest in one firm or another based on reputation. A good reputation can sustain a firm, a bad one can sink it.)

Negative public image can lead some firms to atone and change their ways, but many are (rightly) skeptical that it is a temporary measure. A company rocked by scandal might apologize and take actions to appear more ethical and socially responsible, but this is often short-lived and, as soon as the economic conditions improve or the spotlight of public attention moves elsewhere, it's back to business as usual.

A firm may change its behaviors, but not its values: if a business leader places primary value on profit maximization and is skeptical about ethics, he may do what is necessary to appear to be ethical without actually becoming ethical, so long as it seems to contribute to profitability. Ultimately, values will drive behaviors, and if the values of a person or group of people are deficient, they will not and cannot long maintain a facade of ethics.

Society's expectations of a firm evolve over time. During the industrial revolution, firms were seen as the means to achieve economic goals - wealth and prosperity for its investors. In the twentieth century, this perspective shifted to consider the firm as a necessity to the livelihood of the people who worked for it - the wealth and prosperity of its employees. The fall of socialist regimes in the late twentieth century confirmed the superior efficiency or the market economy and the role of private enterprise in not only creating wealth, but in achieving social progress. Naturally, this led to the assumption that the former method had been the correct one, and the consequences have been unsatisfactory: a strong of economic crises, each worse than the previous one.

As such, it is necessary not merely to return to the old perspective, but to question: what is the purpose of a company? Is it merely to profit its investors? Is it merely to profit its employees?

The author's argument is that the first purpose of a business is to deliver value to its customers. A company is organized for the purpose of creating a product or service that they are willing to buy - it is financially sustained only if it successful in that purpose. The ethical dimensions of a firm must be derived from that purpose.

There is also the notion that companies exist within a society: everyone who interacts with a firm is part of a society, which has a culture and shared values. The firm cannot stand aloof of these values.

In terms of economics, a firm survives or fails because its purpose and values are aligned with those of a society. If it makes a product that delivers adequate value for the price demanded, and does so in a manner that does not destroy more value than it creates, it survives. If it does so more effectively or efficiently than its competitors, it succeeds.

As such, a respected company must be remarkable for its success in a variety of areas, not merely for short-term financial performance. Its reputation is an amalgam of what other people think of it, and each group of people have their own ideas about the qualities a firm must demonstrate. Shareholders, customers, employees, partners, competitors, regulators, and society at large each have different values that are sometimes in conflict. To persevere, the business must pursue the values that are most critical to its survival and its success.

Nestle is considered and example of a firm that does this well. It defines its mission thus: "Nestle's business objective, and that of management and employees at all levels, is to manufacture and market the company's products in such a way as to create value that can be sustained over the long term for shareholders, employees, consumers, business partners and the large number of national economies in which Nestle operates."

The Firm As an Institution

The economic view of a company maintains that the goal of a firm is to be economically efficient, and that all attention is focused exclusively on that dimension - as if there is no other consideration or, at best, as if all other considerations were secondary. While the goal of earning a profit serves the interests of investors, its investors are interested in the firm. But this is only one faction, and the remainder of society, including many groups upon whom the firm depends for its survival, are disinterested or even reluctant to interact with it.

The firm, like any other organization, has a set of norms and values and a body of knowledge that guides its behavior, and as such the firm undertakes activities according to certain expected patterns. For an institution to work properly, and to sustain itself, it must become respected and earn trust from external parties whose interests in the firm are not driven merely be economic efficiency.

(EN: The author does not directly state, but seems to understand, that values result in reliable, consistent, and predictable behavior - which is essential to earning trust, as people interact with an eye toward achieving a specific outcome. Where a firm is inconstant or erratic, there is uncertainty of what the result of an interaction will be.)

For a firm to be successful in its transactions with multiple parties, its culture and value must be aligned to the interest of each party: its economic efficiency will attract investors, the quality of its products will attract customers, its honesty and fairness will attract employees and partners, etc.

The author obliquely suggests that the legitimacy of respected institutions arises from adhering to acceptable standards of behavior over a course of time. If it is consistent in is behavior, people feel they can rely upon it to do a certain thing. If it is correct in its behavior, people feel they can rely upon it to do the right thing. A firm must do both to become respected.

The company's management team must keep watch over its economic effectiveness and efficiency because these factors enable the firm to meet its financial obligations - but this should not be to the exclusion of other and more long-term obligations, which are often not economic in nature.

It's also true that serving non-economic objectives may cause the firm to have less than optimal economic performance - it may be inefficient in its allocation of resources. This is inevitable, and the task of a manager is ensuring that the firm has adequate (not optimal) economic performance, while at the same time serving all its long-term obligations.

Daniel Vasella of Novartis, who presented reasons why his firm should not be evaluated exclusively by economic criteria, particularly by quarterly reports of economic perspective: they do not provide a broad enough perspective of the firm's long-term strength. A firm that focuses on financials tends to focus exclusively on financials, whereas its long-term survival depends on many other factors: its people, culture, values and the way it helps to solve the problems of the society to which it belongs. Economic reality is inescapable, and clearly important, but it is less important over the long term than the short.

Bill George of Medtronic considers that "real leadership" is not based on the ability to achieve short-term economic goals, but about commitment to the long-term growth of the organization. It balances the demand to serve the financial desires of the shareholders against the company's value to other members of society.

These business leaders' reflections do not dismiss the importance of generating economic value, but stressed the key importance of taking the interests of third parties and society at large into account when setting the values to be maintained and the goals to be achieved by the company's day-to-day operations.

The Firm As a Respected Institution

A company becomes respected because it has been successful in multiple dimensions over an extended period of time. Financial performance alone will not cause a firm to become respected, nor do periodic acts of conspicuous charity. A firm must have a clear sense of purpose that distinguishes it from others, and the means by which it achieves that purpose must be honorable and ethical.

A company's first duty is to its customers: to provide "reasonable quality at reasonable prices" and to seek to understand its clients needs and seek ways to make clients happier with the firm's offerings. He finds it "interesting" that it is often not the largest or most profitable firms that offer the best products, but smaller companies that offer premium-quality at premium prices. Their customers tend to be fewer in number, but have fanatical loyalty.

A firm can be financially successful in the short term without having a strong reputation, merely by offering products at the cheapest prices. Consider the rise and fall of airlines in the last few decades - those who slashed prices to attract customers, sacrificing quality of service and even the safety of their passengers to do so. Their profitability and sustainability was short-lived.

The source of a firm's revenue is sale of its product or service, and as such the customers' willingness to purchase from the firm is its prime, if not its only, source of profit. Shareholders and investors may want profit, lots and fast, but their wishes do not cause the firm to be profitable. Management must manage their demands, not merely obey them.

A respected company must also be efficient. Efficiency is valued for financial performance, but its importance goes beyond mere cost-savings. The firm must have a clear definition of goals and an orderly and efficient way to achieve them, which not only reduces waste but eliminates conflict among employees, suppliers, and any other party that participates in its operations. Efficiency enables these individuals to perform at their best, to have a clear sense of purpose, and to act confidently and without ambiguity.

A respected company must also serve a worthwhile purpose. Its products must be a solution to a basic challenge that society faces. A firm doesn't have the resources to address every want and fulfill every wish, but instead must choose one, or a small number, among these challenges that it has the resources to address efficiently.

Aside of producing a product that directly addresses a social challenge, a firm must strive to have a positive impact on society in other ways. The way a firm treats its employees, which locations it decides to operate in, which partners it works with, which technologies it invests in, and the like all have to do with the impact the firm has on society.

Some firms have developed a "balanced scorecard" to develop strategy that goes beyond economic performance - the author suggests that this is "useful but not enough." Firms must consider their reputation and impact as a component of their strategy - such that acting in a responsible and ethical manner is not done merely to make a positive impression or avoid negative publicity, but in order to achieve its own purpose.

A table is presented that shows various dimensions of performance, according to two basic criteria. First, whether the perspective is internal or external; second, whether it is quantitative or qualitative. (EN: The point of this exercise is entirely lost in its fussiness.)

Institutional Structure: Key Foundations

For long-term success, firms need more than a simple business model: an "institutional structure" defines a broader purpose for an organization that enables leaders to pursue broader and more long-range goals. It should contain the following elements: an idea, a mission, committed people, a customer-service organization, an executive team and board of directors that organize the firm's decision-making, a financial structure for shareholders and investors, and a governance structure.

The idea

Each company begins with a founder, an entrepreneur with an idea for a business that generally revolves around providing goods or services to customers. If the idea is different to what other firms are doing and customers find it valuable, the firm has the potential to succeed.

An idea alone is not enough for the firm to succeed: it depends on the founder's competence - his ability to organize a firm and position the firm in a way that appeals to others whose assistance is needed: employees and investors. He must marshal these resources to make his idea into a reality, and adapt it over time in order for it to be sustained.

An idea may be well conceived but poorly executed, and it will fail. If the idea is poor at its conception but improved upon execution, it may struggle and eventually find success. And over time, the original idea must be adapted as circumstances change.

A good idea must also connect with a need perceived by a sufficient number of customers to make its production viable. It must suit their needs better than other alternatives and continue to refine and improve upon its advantages to remain competitive.

It's also noted that while a single idea or project is the beginning of every company, the continuity and growth of most firms requires them to continue to develop ideas over its lifetime.

Mission and values

A company's mission explains why the company exists and what it intends to do. A strong mission speaks to all constituents: it is not merely boilerplate for investors, but also informs customers of what they should expect and employees of what they are expected to do. It should be embodied by its management and used to clarify the purpose of any activity, project, or business unit. The real test of a mission statement is whether it serves as a point of reference for the company.

The author mentions Johnson and Johnson, whose mission statement is lengthy and defines not only what the firm intends to do, but what it will refrain from doing. (EN: The J&J mission is often used as an example, praised for its specificity and criticized for its length.)

The author then turns to Bertelsmann, which has a more reasonable mission statement:, that indicates the services the firm provides, its desire to contribute to society, to have financial performance as necessary to the "growth and continuity" of the organization, a focus on maintaining customer relationship, equitable compensation and development for employees, and a commitment to the continuity and ongoing progress of the corporation.

A strong sense of mission does not guarantee success - per the earlier points, the mission may not be sustainable, and it does not guarantee efficiency. What it does, however, is promote a clear vision that sets the expectations of and gives direction to every constituent - and with this, it can more easily be determined whether a given decision or activity helps or hinders the company's pursuit of its purpose.

Values

A company's mission defines what it seeks to do - its values set guidelines for the manner in which it will do it. These values are chiefly directed at the management and employees of a firm as guides to the conduct expected of them, but it is also of value to consumers and investors as to what they should expect from a firm.

The author concedes that values are secondary to mission - a firm with strong values and weak performance will not survive - but this does not mean they are dispensable or should be compromised to pursue a financial opportunity - as a profitable firm without values will not be respected and, in the long run, will fail.

Values are important to the rank-and-file employee in the performance of their daily duties, but are critical to management and decision-making, as it is at this level that the duties of all employees are defined to give the rank and file a strategic objective and tactical guidance that will grant consistency to their actions.

The author names three or four values that a company should extol, conceding that this is an abbreviated list:

Internally, the values of a company contribute to the formulation of its strategy and guide tactical decisions. Externally, the values of a company set the expectations of customers, investors, suppliers, competitors, and the general public of what they should expect. In assessing whether a firm is reputable, people will evaluate the degree to which a firm's actions represent its stated values.

People

Employees are the embodiment of a company, and the essential element that makes it successful: without its people, a firm is merely a mass of capital that generates no economic value. Without committed and competent people, a firm will struggle to succeed.

Respected companies seek to hire the best people: their interview process focuses not merely on technical ability to perform the abilities required, which is important but relatively easy to find, but on the character and motivation of the individuals in question. These are people with a service orientation, who take to heart the mission of the firm and are motivated to contribute to the effort.

The long-term success of a firm depends on the development of its employees to maintain and increase their level of competence and, as a consequence, the quality of service they provide to the firm and its customers. They recognize that people seek from an employer not merely a paycheck, but a sense of purpose and personal growth.

Developing people is important, but more important is treating employees with dignity and respect on a daily basis. Companies that attempt to gain an upper hand by demoralizing and marginalizing their people find that they lose the respect of their employees - and in that sense, the respect employees have is a gauge by which the respectability of the firm can be measured. Employees are the individuals with whom the firm most frequently and closely interacts, and if it regards them with contempt and treats them with disdain, what better can a customer, investor, or any other party expect?

At the same time, respected companies are not soft-hearted organizations that cater and pander to their employees: they expect much from their people, and grant esteem and rewards accordingly. An employee that contributes to the purpose is valued, one that does not is coached and developed to provide value.

Respected firms recognize that its employees are the agents that act to fulfill the purpose of the organization, not merely as resources used by others to achieve their ends.

Governance

The right structure and prudent use of power helps a company to achieve its goals. This includes not only guidelines that grant power to those who require authority to accomplish their objectives, but those that restrain it so that it is not misused or misdirected, and so that they are guided to use their authority in ways that contribute to the function of the organization.

Traditionally, the organization of groups of people within a company has followed closely the organization and flow of authority over certain functional areas. However, the author proposes a broader institutional structure that is more geared toward the achievement of the firm's mission as a whole, not merely the function of each business unit the firm operates.

Fundamentally, a company is a group of people led by a chief executive. The company is driven by an idea - specifically, an idea to offer goods and services that are useful and attractive to customers that can be provided in a manner that creates an economic reward for the firm. Certain activities are necessary to make the idea a reality. These activities are organized into products, which require financial investment is necessary to obtain the capital resources and labor to accomplish. As such, a company is driven by an idea (or several ideas) that are directly pursued by some employees, while others support or coordinate their work.

Where a firm is founded, the entrepreneur may act as the chief executive or he may hire a professional manager. He may use his own resources, or draw on the financial resources provided by other investors. Those who invest their capital resources in a firm expect to gain a financial return, and there is often documentation that describes how they can expect to receive this return as well as the authority they will have pertaining to decision-making. The terms of this agreement can vary greatly, can be simple or complex, and can change over time.

As such, there can be no general or definitive statement about what authority shareholders maintain and what authority is delegated to management. There is generally a constant struggle to assert authority and control but in the best of cases, some balance is achieved.

The experiences of "numerous companies" have shown the disadvantage of placing too much power in the hands of management and leaving the board of directors disempowered. This scenario was seen in a number of firms in the 1990's, particularly during the dot-com boom, in which executives had excessive power, developed initiatives without approval from the board, were plagued by personal scandals, and ran their firms into bankruptcy.

On the other hand, placing too much power in the board can paralyze a firm's management, rendering it incapable of making necessary decisions or reacting swiftly to change. Whereas a board can govern strategic matters, it is impractical for the shareholders to participate in tactical decisions. And worse, the firms can be subject to investors demand for returns that are poisonous to the viability of the firm, effectively dissecting the organization and salvaging it for its asset value.

A sound corporate structure places the board in a position to govern the strategic decisions and management to govern the operational decisions of the firm. Such a structure enables to firm to achieve its mission and ensure its continuity.

(EN: I don't think this is necessarily so - there can be instances in which both the board and the chief executive are wrong-headed and can be cooperatively dysfunctional, or where both are right-minded and can be cooperatively functional. It's not always that they are pulling in opposite directions - but generally, they are focused on the same objective by have different ideas about what actions would effectively achieve the desired outcome.)

As with other elements discussed here, corporate structure is not sufficient to achieve success - it is a method of guiding and controlling the firm in pursuit of its goals, but governance alone does not achieve those goals.

Financial resources

Any business idea requires funding to obtain the resources necessary to pursue a goal. In rare instances, and entrepreneur has the personal wealth to fund his own projects, but in most instances he must obtain funding from others - whether he goes out into the world to obtain capital directly from investors or seeks to fund a project internally, by appealing to fellow employees who manage the funds of the business (which is to say, the funds of the owners that are maintained by the business).

Investors who are committed to and enthusiastic about the idea are a source or financing as well as a beacon to other investors - and it also stands to reason that a dissatisfied investor, like an unhappy customer, are the source of bad publicity that can make the idea, and the firm, unappealing to others.

The author suggests a third class of investor, who is even more damaging: the "inappropriate investor" who is not committed to the idea, who simply demands a financial return, and who wishes to use his influence not to create a stable and long-term source of revenue, but to get maximum short-term returns even at the cost of destabilizing or harming the firm.

This is a particular problem with public companies, whose shares are traded on the open market, and who cannot control or predict which individuals it accepts as investors - but the problem can also exist with privately held firms if they are not judicious in their acceptance of investors. In a family-owned company, the issues can become more complicated because of the contentions relationships between family members and their use of the company to suit non-financial agendas - that is, sibling rivalry creates factions and dissonance within the firm owned by siblings.

Regardless of the structure of the firm, the problems of investor relations remain the same: each investor has his own reasons for investing and his own desires to influence the firm in specific ways: the best investors identify with the firm's mission, seek a reasonable return, and have a long-term commitment. The worst investors oppose the mission, seek the maximum return, and have no long-term commitment. The way in which they govern the firm will differ accordingly - and they will not necessarily act in the best interests of the firm, of other investors, or even their own.

And yet, the firm's challenge is in pleasing the investors, with their myriad of expectations and demands, in order to remain respected in the market.

Some Final Thoughts

In this chapter, the author has presented his ideas about a company: the reason it is created and how it is sustained over time, with a focus on the purpose of the firm as a source of sustainability as a respected institution.

In the present environment, short-term economic performance has dominated the notion of a firm's purpose, but it is clearly not enough to build a strong and lasting organization. Firms need to make money to cover their own expenses and provide a reasonable return to their investors - but they do so by serving customers well. Serving customers well requires competent and loyal employees, reliable suppliers and partners, and positive relationships with the community at large.

Where any of these are sacrificed to generate a short-term profit, the firm's long-term interests suffer. As such, firms that desire success must balance the different and conflicting demands of stakeholders with a long-term perspective. Unless a firm develops a coherent and balanced framework for addressing the various interests, its reputation and sustainability are damaged.

On the other hand, conflicting interests are not always contradictory, nor does making a decision require excluding alternatives: a form must exercise good judgment in serving those objectives and defining the aspects in which they are complementary - because all expectations are based on the same institution, they are often complementary, though it may require some finesse to set expectations so that short-term interests do not undermine the long-term interests of different parties, or even the same party.

The legendary firms, those with solid reputations, can be seen to have done so successfully: their investors are pleased with stable returns over a long period of time, their employees are happy with their compensation and development and maintain a long tenure of service, their suppliers and partners feel they are fairly compensated for services rendered, their customers are delighted with the products and services they receive.

As such, building a respected firm does not require sacrificing one for the sake of the other, but in serving the needs of all with whom it interacts, and getting in return a long-term commitment from them. This is an ongoing process that a company's executives must constantly pursue, not a goal or a destination to be reached.

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