Wednesday, 12 October 2011

Firms: Ephemeral or Eternal Institutions?

The development of companies and corporations was essential for the success of capitalism. Without them it would be more difficult to take advantage of its basic innovations - limited liability and shared ownership - indispensible for large scale capital accumulation.

However, when a founder no longer wishes or can control the firm he must decide on selling control, liquidating or continuing the firm. The first two options imply treating the firm as an ephemeral institution. The last option implies finding a successor to exercise control. It can be a family member, a trusted employee or a trustee like a foundation. Whatever the option, the owner is trying to perpetuate the firm.

Is this a reasonable wish? Superficially a founder’s wish to perpetuate his achievement seems reasonable and rationale. However a firm is not a work of art, an ideology or a monument that can be easily transmitted down the generations. A firm is basically a set of contracts used to explore more efficiently a business. But, business opportunities are by nature ephemeral and contract enforcement depends on power struggles whose outcome is always unpredictable. Therefore attempts to perpetuate firms often fail.

Indeed, this is another of the remarkable features of capitalism on which rests its comparative advantage for innovation.

Yet the rise of managerial capitalism seems to suggest that this mechanism is not working or is insufficient. One reason why it might not be sufficient is the alliance between managerial capitalism and government. The power of this alliance rests to a large extent on their ability to control the rising share of institutional investment. The triad - investment banks, asset managers and regulators - needs to be studied to assert its responsibility in the perpetuation of managerial capitalism.

In this regard finance theory plays an important role. Unfortunately it is not always a positive one. For instance, the theory on the weighted average cost of capital has been a tool to disseminate the widespread misrepresentation of the firm as an entity separate from its shareholders (a kind of deus ex machina), which is the foundation of managerial capitalism.

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