Alex Edmans, Professor of Finance, London Business School
How do companies actually pursue purpose in the modern world when there are very real short-term pressures? 
Alex Edmans, Professor of Finance, London Business School
Amsterdam,
27
October
2016
|
12:45
Europe/Amsterdam

ARTICLE - Why purpose is critical for long-term success

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 factory, you can still get a reasonable handle on the benefits – estimate the number of widgets it will produce, and the profit per widget.

But the most important assets in the twenty-first 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, a whole slew of investments would never be 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 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.

But there’s actually no trade-off in the long run. The Purposeful Company Project, released by the UK's 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 insights from companies (C-level executives and directors at the likes of Kingfisher, GSK, Barclays, PwC, 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 (Big Innovation Centre, Innovate UK). We have also launched a call for evidence on the website.

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. 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 short-run profit towards purpose is a huge challenge. But it must not be shied away from – and conquering it is key not only for firms, but also for the success of the economy as a whole. Because the evidence is clear: To reach the land of profit, follow the road of purpose.

 

This article was written for the World Economic Forum 

About the author

Alex Edmans is Professor of Finance at London Business School. Alex graduated from Oxford University and then worked for Morgan Stanley in investment banking (London) and fixed income sales and trading (New York). After a PhD in Finance from MIT Sloan as a Fulbright Scholar, he joined Wharton in 2007 and was tenured in 2013 shortly before moving to LBS.

For more articles, visit alexedmans.com

You can follow Alex on Twitter: @aedmans