Looking Beyond Shareholders: What Is Stakeholder Theory?
Looking Beyond Shareholders: What Is Stakeholder Theory?
Edward Freeman has heard it all.
When he tells a stranger that he teaches business ethics, he receives predictable responses:
- “Must be a short course.”
- “I didn’t know business had any.”
- Or his favorite: “Oh, that’s a theoretical subject.”
The cynicism doesn’t faze Freeman, who is in his 33rd year as a professor at the University of Virginia’s Darden School of Business. He approaches lectures with a joyful disposition that cuts through his bushy white beard. (“I think I’m the only libertarian that might look like Karl Marx,” jokes Freeman, who defies simple ideological labels.)
Freeman is quick to acknowledge the thinkers that came before him, but he has earned a title that has stuck over the last four decades. Freeman is the Father of the Stakeholder Theory.
Stakeholder Theory Definition
What is stakeholder theory? Stakeholder theory holds that company leaders must understand and account for all of their company’s stakeholders — the constituencies that impact its operations and are impacted by its operations.
Stakeholders include employees, shareholders, customers, suppliers, creditors, the government, and society at large. Most stakeholders do not hold stock or shares in a company. Rather, they are invested in a different way.
Shareholder vs Stakeholder Theory
As a philosophy PhD student in the late 1970s, Freeman did not know much about business or business theory. From his outsider’s perspective, it seemed obvious that businesses should care about groups beyond their investors, particularly in an increasingly complex and interconnected world. But the more he observed businesses in the real world, the more he worried.
“It seemed to me complete common sense that you ought to worry about those groups and individuals that could affect you, or that you could affect. This just seemed to me to be logic,” Freeman says. “And I started to worry about that because it looked like there were a lot of companies out there who weren’t doing that. They were not worried about groups that really could affect them, or that they could affect.”
Freeman published Strategic Management: A Stakeholder Approach in 1984. The textbook frames business as a system to create value for stakeholders. Freeman presents a worldview in which capitalism and ethics are closely intertwined.
Freeman’s book cut against the orthodoxy of the times, which held Milton Friedman’s shareholder theory as the gold standard. Shareholder theory suggests that a firm should prioritize investor return to the exclusion of other goals. Friedman argued that the only moral obligation of a business was to its shareholders. Freeman pushes back on the latter idea with evangelistic zeal.
“What sense would it make to say, I have an economic responsibility to my children, but I have no moral responsibility to them?” Freeman asks. “Seeing businesses set outside of society, in this sort of moral no-fly zone…seems to me to be crazy.”
Freeman uses his lectures to untangle dogma from reality. He observes that the traditional language of business can lead to a false distinction between economic and social activity. Commonplace actions—from purchasing a phone to planting a tree—have real and inseparable economic and social consequences.
Freeman’s critique of Friedman builds on a simple idea: reality is messy. Human beings are complicated. Taken to its logical extreme, shareholder theory ignores these complexities and treats human capital as just another input to maximize profits. In Freeman’s estimation, such thinking reduces employees to beasts motivated by rewards and punishments, carrots and sticks.
“We’re fully complex human beings. And businesses can’t ask us to check that complexity at the door and become one-dimensional maximizers,” Freeman says. “That doesn’t work. There’s a disconnect, a mismatch between the story that we tell about business and what it takes to be successful in business.”
Stakeholder Theory Helps Businesses Find a Purpose
“I need red blood cells to live…but it doesn’t follow that the purpose of my life is to make red blood cells,” Freeman says. “Business must have profits to exist…but it doesn’t follow that the purpose of business is to make as much money as you can. The main purpose is something else.”
“Purpose” is a keyword for Freeman. Any entrepreneur, Freeman believes, must draw on a higher purpose than profit to find success. He struggles to name a single entrepreneur who started a business just to make money. Successful entrepreneurs, Freeman says, start businesses because they want to change the world. He recalls his friend John Mackey, the founder of Whole Foods:
“[Mackey] started on fire about bringing organic food to make it more available to people. He’s turned it into a multi-billion dollar business—business, but it has purpose. It has passion. He’s changed the way we think about food in the US.”
Freeman acknowledges that purpose is a challenging concept. A company’s purpose is not a static mission statement that can fit neatly on a poster. Freeman describes corporate purpose as a “living conversation” that drives everything a company does. Companies suffer when employees and other stakeholders are removed from this conversation.
From this perspective, Freeman argues, a company should treat its harshest critics as value-creators.
“[Your critics] are telling you where there’s an opportunity for you to create value,” Freeman says. “It’s not always an easy opportunity to take advantage of, but that’s what they’re saying. Even in an industry like tobacco, the critics are saying until you give us the pleasure of smoking without the health risk, you haven’t done your job as a business. Seeing critics as [value creators] rather than flies to be squatted turns out to be incredibly important.”
According to Freeman, companies also fail when they engage in zero-sum thinking about stakeholder value. Purpose-driven companies see opportunities instead of trade-offs.
A company should not seek to reduce the value it provides to suppliers in order to increase the value it provides to customers. Rather, it is the company’s responsibility to innovate.
Executives must strive to make customers, suppliers, employees, and communities simultaneously better over time. When trade-offs are necessary, companies should seek the best trade for all parties.
Stakeholder Theory Starts a Movement
Freeman has his own set of critics. Some commentators have derided stakeholder theory as “corporate socialism” that allows companies to shirk their moral responsibility to shareholders. Freeman, meanwhile, sees himself as capitalism’s new publicist.
“I think capitalism must have the worst PR in the history of the galaxy,” Freeman says. “Capitalism is the greatest system of social cooperation we have ever invented. It’s about how we create value and trade for each other.”
Freeman does not see the same tradeoff as his detractors. He believes that companies that focus on stakeholder value maximize shareholder value in the long run.
“Do you know people who really spend all their waking hours trying to be happy?” Freeman asks students. “They’re the most miserable people on the face of the earth, right? Because they spend all of their time trying to be happy as an outcome. Profits are an outcome of doing other things.”
Why is Stakeholder Theory Important
Stakeholder theory has laid the framework for organizations’ approach to corporate social responsibility and community engagement. Freeman’s vocabulary has made its way into the investor briefings, public statements, and private boardrooms of the world’s most powerful companies.
Since 2004, Freeman has served as the Academic Director for the Business Roundtable Institute for Corporate Ethics. The Business Roundtable is America’s largest CEO trade association.
In April 2019, the Business Roundtable released a new “Statement on the Purpose of a Corporation” signed by 181 chief executives, including Amazon’s Jeff Bezos, Apple’s Tim Cook, and JP Morgan Chase’s Jamie Dimon. The statement echoed many of the points Freeman made in his seminal textbook 35 years earlier.
“CEOs work to generate profits and return value to shareholders, but the best-run companies do more,” read the statement. “They put the customer first and invest in their employees and communities.”
Titans of industry like BlackRock’s Larry Fink have adopted Freeman’s language in investor letters and public statements. Stakeholder theory took center stage at Davos. Freeman believes that bold commitments like these have the power to change the popular narrative about business’s role in society. Business ethics is not a theoretical subject. Stakeholder theory pragmatically describes what successful businesses do and need to do. From the classroom and the boardroom, Freeman continues to lead his capitalist revolution.
“There’s a mismatch, a disconnect, between the story we tell about business and society and what great businesses do and need to do,” Freeman says. “We need a revolution. We need a new story. I’m optimistic because I think that story is being realized in the world even as we speak.”
Practical Advice for Business Leaders Applying Stakeholder Theory
Executives can begin to follow Freeman’s practical advice today. As a first step, leaders should reflect on their stakeholders: Which groups and individuals does their organization effect, both externally and internally? How does their organization affect these groups?
To answer these questions, a firm would benefit from examining its employees and the community surrounding its employees, its supply chain and the community surrounding its supply chain, and its customers and the community surrounding its customers. Companies should also evaluate their ESG strategy or corporate social responsibility initiatives. Through this examination, a firm will refine its hypotheses about its overarching purpose.
After an organization identifies its stakeholders, it can begin to listen. Leaders should reflect on their organizations’ communication channels. How are their organizations soliciting feedback from employees, shareholders, community members, and critics? How are their organizations treating those voices as value creators?
Organizations should invest in diversity and inclusion training for reliable managers and strengthen communication channels to field questions and concerns from employees, customers, community members, and government officials. A large firm would benefit from hosting internal and external town halls with employees and community members. Large and small firms would also benefit from smaller roundtables with these stakeholders.
These conversations should pressure-test the firm’s hypotheses about its purpose. For example, company leaders might enter an internal conversation with the hypothesis that the company’s primary duty toward employees is to help put food on their tables, yet the conversation might reveal higher-level concerns among employees, such as workplace safety, community, recognition, and skill development.
Drawing on this communication, a company should implement policies and programs that provide value directly to stakeholders. These initiatives should resonate with the company’s overarching purpose as well as with its duties to individual stakeholders. One-off volunteer days and detached donations can often lack resonance. A company can maintain credibility with stakeholders through long-term, programmatic planning that leverages an iterative process of reflection and communication.
Stakeholder theory demands constant and determined engagement from business leaders. Applying the principles of stakeholder theory can help lead your business to a more engaged workforce and improve returns on corporate social responsibility programs.
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