An overview of stakeholder theory and the three ways people justify adopting its principles.
This post summarizes a 1995 academic paper by Thomas Donaldson and Lee E. Preston, called “The Stakeholder Theory of the Corporation: Concepts, Evidence, and Implications.” From time-to-time, I will highlight important papers like this to make them more easily accessible.
What is a Stakeholder?
Stakeholder theory centers on the idea that companies exist to serve those with a stake in the future of a firm. There are many interpretations of who qualifies as holding a stake. One of the most widely cited definitions is from 1963 when Standford Research Institute referred to stakeholders as “those groups without whose support the organization would cease to exist.”
Flipping that definition a bit, you could also say that stakeholders are those people with a legitimate interest in the firm, which is to say, people who stand to gain from the successful operation of the business. In other words, they have a stake in its success. Using this criterion, it’s easy to see how most interpretations of the term include: shareholders, lenders, employees, suppliers, distributors, customers, and even the members of the communities in which the business operates. Competitors are usually left out of the mix for this reason, but I would argue the growing importance of coopetition is making even this distinction less clear.
The stakeholder perspective differs from the traditional view of business, which is sometimes pictured as an “input-output” model, where investors, suppliers and employees contribute inputs into the firm, with the resulting outputs going out to the customer:
In contrast, the stakeholder model pictures many more players at the table, each contributing and receiving something from the firm’s operations:
Why Care About Stakeholder Theory?
In their paper, Donaldson and Preston note that there are many ways of thinking about stakeholder theory, but that most fall into one of three buckets – each with very different arguments for why it matters.
- Descriptive approaches explain it by showing how it maps to the way business actually works today. It might be opinion research showing that most management believes a sole focus on shareholder interests is unethical. Or it might be studies showing that a growing number of court cases and governmental regulations now give managers greater leeway in taking factors aside shareholder interests into account in their management decisions. With descriptive approaches, you care about stakeholder theory because it better describes the actual way business works.
- Instrumental approaches essentially frame it as a means to increased efficiency, better business performance and ultimately higher profits. With instrumental approaches, you care about stakeholder theory because it will make more money for your business.
- Normative approaches see it as a moral or ethical issue. This frame usually rests on the idea that each stakeholder group has intrinsic value, and that no group’s interests are more or less important than any other. With normative approaches, you care about stakeholder theory because it is just and because it is fair.
What’s Best for Society?
While the instrumental view is widely held, the authors found little empirical evidence that stakeholder principles translate into superior business performance when they wrote the paper in 1995. A more recent study, written up in the book, “Firms of Endearment,” does illustrate a strong connection, however, showing how a select group of firms operating with strong stakeholder principles outperform the S&P 500 by a 9-to-1 ratio.
To Donaldson and Preston, the problem with the descriptive approach is that opinions and behavior change over time. Pinning support for stakeholder principles on the fact that it is widely supported in practice could leave it vulnerable to a day when it is not. Democracy is what we practice in the United States, but if it were to suddenly disappear from American politics, the ideal itself would not somehow disappear.
In the end, the authors argue that the case for stakeholder theory is ultimately best made by normative approaches that focus on what is best for society. Doing that means answering tough questions about the best way to allocate societal resources, or what social scientists refer to as “distributive justice.”
I believe the authors are correct. While the more recent research shows that stakeholder theory is actually quite beneficial to the individual businesses that practice it, the more compelling argument is what it does for society.
Our current brand of capitalism is missing the kind of clear, moral foundation that we find at the root of the US political system. The opening lines of the Declaration of Independence stir the heart because they reach something deeper within us – the sense that we are all created equal. Stakeholder theory takes us closer to these ideal than our current property-centric view of the corporation.
In the end, having the right operating system for business requires that we come to terms with the two competing views of fairness we wrestle with as a society. Our egalitarian notion of fairness says we each have intrinsic worth and dignity that must be protected, while our libertarian notion of fairness tells us effort matters and that we should be better compensated when we work harder or take more risk than others.
This tension is valuable. As a society, we need both understandings of fairness. By better representing the diversity of interests in a firm, I believe stakeholder theory comes closest to a set of practical principles for maintaining this kind of balance in business. Getting that right embeds this healthy tension into the engines that drive our economy, where it can easily scale and create immense good for society.
Liberty image: James Cridland