Inherent conflict between owners and management
Owners and managers often find themselves at odds, tangled in what economists call the principal-agent problem. At heart, this is a matter of trust and transparency.
Imagine you are giving your brand-new car keys to a friend. You are the principal; your friend, who is behind the wheel, is the agent. The heart of the matter? While you hope they will treat your car with care, your friend might not show the same respect, especially when you are not around.
In a corporate environment, an owner of a company (principal) hires a CEO (agent) to manage the company. However, the CEO might not always act in the best interests of the company and its owner. The CEO might pursue personal interests that diverge from those of the company or its shareholders. For example, a CEO might choose business strategies that boost short-term profits (and potentially their own bonus) rather than focusing on the long-term health and growth of the company. Or they might conceal crucial information about quality issues and the potential uncompetitiveness of a newly developed product, hoping that these problems will not affect the company's market position before they move on, leaving others to handle the fallout.
And the principal-agent problem does not stop at the top. The CEO, while acting on behalf of shareholders, also oversees other 'agents'—the executives and managers beneath them. Here, the CEO faces a similar challenge as the owners. These lower-level agents might have their own agendas, leading them to sugarcoat information from their teams or put their department's or personal goals ahead of the company's overarching objectives.
The numbers trap
The principal-agent dilemma arises from a simple yet tricky situation: an owner often knows less about their company than the management does. This conundrum was a significant reason behind the financial world's transformation through new rules, regulations, and metrics. One of the goals was to distill a company's health into measurable figures, akin to checking its temperature.
Ideally, these metrics would allow owners to keep a tighter leash on managers. However, over time, this method revealed its flaws, proving to be more harmful than helpful. Financial numbers rarely capture a company's true essence; they only show its financial state at a moment, offering little in terms of long-term insight. The American corporate scene is filled with examples. Under Edward Lampert, Sears became too focused on financial gimmicks and cutting costs, neglecting key areas like store upgrades and online presence, leading to its downfall. Jack Welch's era at General Electric made the company too sensitive to financial market swings at the expense of real innovation and investment in its core industries.
The issue is that financial metrics are too easily manipulated and promote short-termism. Companies can issue dividends by delaying repairs, cutting research budgets, or acquiring another company. Worse yet, the focus on these metrics has drowned out discussions on products and services. Board meetings with CEOs are now almost entirely about financial goals, leaving hardly any room for meaningful conversations. Edward Deming's "Out of the Crisis" captures this problem well. He discusses an organization aiming to boost productivity by 3 percent without a clear plan, relying instead on just "making it happen." Deming points out that if the company is stable, setting such a specific goal is pointless because the result will match the company's existing capacity. Going beyond this is unrealistic. This is why boards should shift their focus to the nature of what a company does, i.e., its products and services, rather than getting hung up on arbitrary targets.
Believing in growth stories
There are companies that are still growing up. For these companies, the traditional yardsticks of financial health are not just inadequate; they are often irrelevant. These companies spend more money than they make, investing in their future. They are trying to stand out, make their products better, and get customers to love them. Here, the narrative shifts almost entirely from balance sheets to pure belief, with company boards placing immense trust in the vision and integrity of their CEOs.
How this can end is starkly illustrated by the saga of Elizabeth Holmes and Theranos. Holmes captured the imaginations of both investors and the public with her bold claim: a revolutionary device capable of conducting a wide array of blood tests swiftly, using just a minuscule sample. This promise of a healthcare transformation led to an avalanche of financial backing for Theranos. Yet, the dream crumbled as investigations unveiled that the technology fell drastically short of these grand assertions. The fallout was severe, encompassing legal battles and the disintegration of the company.
The unseen data
At this point, you might be wondering: why do boards rely so much on simple, straightforward metrics to gauge a company's health?
Well, the core of the issue is that a lot of the information about how a company is really doing is hidden away in text - think reports, memos, emails, and even the everyday chats between people who work there, or with their suppliers and customers. A big chunk of this stuff is not even saved anywhere. But, even when it is, until not too long ago, we did not really have a technology to sift through all that and pull out a clear, concise summary that owners could quickly understand. And let us be real: most board members are not going to wade through thousands of pages of documents to get a clear picture of the company’s situation, nor are they likely to have the time (or maybe the interest) to talk to a ton of employees to get a feel for the company vibe that is any different from what the CEO is telling them. Many board members are on like 5 different boards, and some even juggle between 8 to 15 (that is what they call overboarding), so they and their teams end up depending a lot on what the CEO says, backed up by just a few numbers. That is a big reason why Elizabeth Holmes was able to keep the Theranos scam going for so long.
Workers know first
Before diving deeper into solving the puzzle, it is essential to consider another crucial element: the employees. While owners may have only a superficial understanding of their company's inner workings, and management might present a more optimistic scenario to the board—sometimes even convincing themselves in the process—it is the employees who truly know what is happening day-to-day. They are on the front lines, dealing with the immediate problems: the product bugs not yet trending on social media, the customer frustrations not aired in online reviews, and the supply chain snags being untangled through emails.
In companies that thrive on innovation and heavily rely on their staff, employees are more than just workers; they are the guardians of the company's present and its future possibilities. If they have serious concerns about the products they are building, their insights are often grounded in reality. This was exactly the situation with Theranos. It was whistleblowers Tyler Shultz and Erika Cheung who brought to light the true state of the company's operations and the capabilities of its technology. Employees, especially those directly involved in developing and testing Theranos' products, saw the discrepancy between what was publicly promised and what could actually be delivered. Unfortunately, both Shultz and Cheung faced significant personal and professional repercussions for their bravery, including legal threats and surveillance from Theranos.
Revolution in boardroom insights
Imagine a system where every employee in a company can share what is going right and what is not, anytime they want. This system keeps everything anonymous, collects all these insights, and then distills them into reports that the board members can easily digest. It is like having a direct line to what is buzzing on the ground floor, without anyone worrying about their name getting attached to their feedback.
And we are not talking just about the snapshot. Over time, this system can track whether things are getting better or worse. Are more people starting to grumble about the same thing? That is a red flag. Or maybe there is less chatter about a problem that was a big deal last month, signaling that something has been done about it.
What is really cool here is the way this setup gives a continuous peek into the company’s heartbeat adding a necessary context to the usual financial reports. It is like having your finger on the pulse, catching potential issues before they blow up. Armed with this kind of intel, board members can really zero in on what matters. They can ask sharper questions and make sure management is not just talking the talk, but walking the walk, too.
If Theranos had implemented this form of continuous, transparent feedback, the company as we know it might not have been possible. It would have either been forced to confront and rectify its shortcomings early on or, failing that, faced a much swifter reckoning.
Is it possible today?
The debate on AI's capabilities is alive and kicking. Can these systems be creative like us? Are they capable of deep, logical reasoning that is novel? These questions remain open, signaling we have not reached a consensus on artificial general intelligence (AGI) yet.
Meanwhile, AI's prowess in tasks like text summarization and classification is undisputed. These skills are not just matching but in some cases, even surpassing human capabilities. And this is precisely what we need for our new project aimed at enhancing corporate governance. We want a system that quickly, anonymously and impartially sums up what employees are saying, sorting their feedback into different types of problems and benefits. We are not trying to replace human leaders with computers. We are just trying to give company boards a clearer picture of what is going on inside their organizations, to make the playing field more even between owners and managers. The good news? My company, Culturama, is already offering such a system. Just check our website.