By Alex Edmans
How should businesses make decisions?
The textbook answer is to do a calculation – to trade off the costs and benefits. For investment decisions, this is difficult, because the benefits are uncertain. But, for tangible investments, such as building a new factory, you can still get a reasonable handle on the benefits – estimate the number of widgets the factory will produce, and the profit per widget.
But the most important assets in the 21st century firm are intangible – a company’s corporate culture, innovative capability, or environmental sustainability. How can you calculate the benefits of introducing an employee volunteering programme? If every investment had to be justified with a mathematical calculation, then a whole slew of investments would never get made.
There’s another way. To make decisions based on a sense of corporate purpose. A company’s purpose is its intrinsic reason for existing –to use technology to transform customers’ lives for the better, to nurture and develop its employees, or to preserve the environment for future generations. This contrasts profits, which are an extrinsic goal. Purposeful companies will make an investment simply because it is the right thing to do – because it’s consistent with its mission – rather than because it expects an instrumental payoff.
Nice idea, but it sounds totally unrealistic. In the real world, a company needs to make profits to survive – and without profits, you can’t finance investment in the first place. The pursuit of purpose simply distracts you from profit.
But there’s actually no trade-off. The Purposeful Company Project, released yesterday by the Big Innovation Centre, highlights the critical role of purpose to the modern firm. How is this project different from the tons of other white papers on investment? There are two main hallmarks. The first is its evidence-based approach. One could present a case study of one company that pursued purpose and ended up being profitable. But, correlation doesn’t imply causation – it could be that profits led to purpose. Or, we just hand-picked this company because it supports our story. Instead, we study thousands of companies, across dozens of industries and countries, using many different measures of purpose.
The second is its breadth. The Project combines rigorous academic evidence with practitioner insights from companies (C-level executives and directors at the likes of Kingfisher, GSK, Unilever, Barclays, PwC, and EY), investors (e.g. Fidelity, Hermes, Alliance Trust), policymakers (the Bank of England, whose chief economist Andy Haldane serves on the Steering Group), and think tanks (the Big Innovation Centre, Innovate UK). We have also launched a Call for Evidence.
After combining all of these perspectives, what do we find? Compelling evidence that purpose is critical for a firm’s long-term success. In particular, purpose “glues” the different stakeholders of an organisation – customers, employees, suppliers, communities, and investors – towards a common mission. In theory, contracts can provide this glue by specifying what each stakeholder contributes, and what she gets in return. But, stakeholders may simply do the minimum required to satisfy the contract. A sense of purpose encourages stakeholders to go above and beyond – for an employee to mentor subordinates even if not explicitly rewarded by a bonus. For example, a study featured in my TEDx talk “The Social Responsibility of Business” uses 26 years of data to show that ethical treatment of workers is associated with 2-3% higher stock returns per year.
But it’s no good just stopping with the message that purpose is desirable. How do companies actually pursue purpose, in the modern world when there are very real short-term pressures? We present a range of options, while recognising there is no “one-size-fits-all” solution and that any remedy should be tailored to the individual firm. These include changes to executive incentives (longer vesting periods for equity), shareholder structure (encouraging large shareholders who have the incentive to engage with the firms they own), disclosure (communicating purpose in company statements, and accounting for intangibles), and corporate governance (giving firms the flexibility to adopt structures that favour stakeholders rather than only short-term shareholders).
None of these solutions is easy to implement. Reorienting companies away from the decades-old focus on profit towards purpose is a huge challenge. But, it is a critical challenge that must not be shied away from – and conquering it is key not only for individual firms, but also for the success of the UK economy as a whole in international competition. Because the evidence is clear: To reach the land of profit, follow the road of purpose.
Alex Edmans is Professor of Finance at London Business School, an Associate at Oxera, and member of the Purposeful Company Project Steering Group. Twitter: @aedmans.
First cited in CityAM.
This article was written by London Business School Review from Forbes and was legally licensed through the NewsCred publisher network.