The freest enterprise - unbeholden to Wall Street, privately held companies can behave more responsibly

Washington Monthly, Feb, 1987 by Paul Glastris

the FREEST ENTERPRISE

One of the forgotten tragedies of World War II was a precipitous declines in the quality of candy. With government rationing of sugar, cocoa, and other key ingredients, many candy firms used cheap substitutes, and made windfall profits. But the people who walked into Fannie May shops in Chicago got the real thing: pure delectable candy. The company's owners decided that instead of adulterating their product they would simply sell less of it and make less money.

It was not the first, or the last, time Fannie May Candy Shops, Inc. skipped a chance to get fat. The company has, for example, always stayed away from making candy for others to sell under different brand names. "We have no idea what they might be doing with the product once it's out the door,' Richard Peritz, the firm's presient, told The Chicago Tribune. A longstanding refusal to use preservatives meant Fannie May could expand only slowly to ensure delivery of fresh merchandise weekly to company-owned shops. "We're not desperate to do business at any cost,' says Peritz.

Fannie May can operate this way because it is privately owned and thus free of the pressures to pursue profits that the stock market imposes on companies whose shares trade publicly. Most private business owners, of course, do not purposely avoid profit opportunities. But the fact that they can is an underappreciated freedom. Private business owners are also freer to pursue worthwhile ventures aggressively, even if it means large short-term sacrifices. Most important, they can spend every penny of company profits as they see fit: on higher wages and benefits, on philanthropy, on research for new and better products and services, or on new equipment that is more efficient, safer to work with, and easier on the environment.

This is no small privilege, considering their impact on the country. One hundred and seventy-five of the Fortune 500 companies are family owned or controlled; privately owned firms of 100 or more employees make up one-fifth of the U.S. economy. While corporate reformers talk about shareholder democracy, management accountability, and other issues involving publicly traded companies, privately held companies are in the best position to create models of capitalism at its best.

Betraying the faith

Taking a company public can be unavoidable if a firm needs capital to expand and cannot secure it any other way. But the usual motivation for going public is the self-interest of the owner. Turning a fixed investment like a company into liquid assets by selling some or all of it, then reinvesting the assets in diversified portfolios, has always been the way to secure a life of leisured wealth.

The prospect to wealth, however, can be outweighed by the loss of control. "When you go public and sell the majority of the firm, you've essentially made the marketplace your partner,' says Columbia University law professor John Coffee. "It's a very finicky partner.' Decisions concerning ethics or the future health of the company can upset Wall Street and drive a company's stock price down. And there's nothing like a low stock price to put the manager who wants to do the right thing on the defensive. His proposals-- whether they are to reduce the plant's pollution emissions, use sturdier materials in the product, or increase worker salaries--can be voted down or his own position at the firm terminated by a board of directors made skittish by worried investors. The ultimate threat to his job, a corporate takeover, becomes likely when a stock's price dips below the value of the firm's assets.

Wall Street isn't stupid; a share price is as good a measure as any of a firm's long-term prospects. The financial markets will reward a company for a long-term investment, like R&D spending, by bidding up its share price, assuming such spending doesn't cut into short-term earnings. But that's where the problem is. There are innumerable occasions when a firm should sacrifice earnings now--even if it means some red ink-- for future payoffs.

That's where private companies have the advantage, if they choose to use it. Without shareholder demands on company earnings, the owner-manager can spend those earnings on what's best for the firm and its customers and employees. Why should a public company executive risk his job by plowing money into new plants and equipment to make products that may or may not sell as well as those made in Japan, when he can sell existing plants, buy an insurance company, and give his stockholders all-but-guaranteed returns? This is one reason privately held companies often thrive in industries public companies have abandoned. Perhaps the brightest spot in America's otherwise dismal machine tool industry, for instance, is the privately held Ingersoll Milling Machine Co. of Rockford, Illinois, one of the most prosperous and technologically up-to-date machine tool manufacturers in the world.

A public corporation manager has more than his job on the line when making decisions on the crucial trade-offs between his company, his conscience, and his shareholders. A manager who fails to convince shareholders that he acted to enhance the long-term value of their investments can be sued for "waste and dissipation' of a firm's assets. The "business judgment' rule in corporate case law gives managers and directors great leeway in deciding how the interests of the shareholders are served. But the fear of such lawsuits quietly fences in the range of the public company manager's options. One could make a good case, for instance, that AT&T would best serve itself and the nation by slashing its dividends and devoting the money to R&D. But "if AT&T did that,' says Georgetown University law professor Donald Schwartz, "it would be a betrayal of faith to the millions of investors who have historically depended on those dividends. The money managers, out of fiduciary duty to those investors, could sue, and I think they'd win.'