The Problem with Separating Business Owners and Managers

Imagine you own a fantastic bakery. You’re the one who came up with the amazing recipes, built the business from scratch, and poured your heart and soul into it. You’re the owner. But as your bakery grows and becomes incredibly successful, you realize you can’t manage every single detail yourself. You need to bring in professional managers to handle the day-to-day operations, things like staffing, ordering supplies, and making sure everything runs smoothly. This is similar to what happens in large companies: the people who own the company, the shareholders, are often different from the people who actually run the company, the managers. This is what we mean by the separation of ownership and control.

On the surface, this separation seems like a smart idea. Owners, often many individuals or institutions, provide the capital and take on the risk. Managers, who are experts in running businesses, are hired to use that capital effectively and grow the company. It allows for specialization. Think of it like hiring a professional chef to run the kitchen in your bakery while you focus on the overall vision and strategy.

However, this separation isn’t without its potential downsides. One major concern is what’s often called the principal-agent problem. In our bakery example, you, the owner, are the principal, and the hired manager is the agent. Your goal, as the owner, is likely to maximize the profits and long-term value of the bakery. But the manager, while ideally working towards your goal, might have their own goals that don’t perfectly align with yours.

For instance, a manager might be more interested in increasing their own power and prestige. They might decide to build a fancy new headquarters, even if it’s not the most efficient use of the bakery’s money and doesn’t significantly improve the quality of the pastries or increase sales. This is because a larger headquarters makes them feel more important and enhances their reputation, even if it doesn’t directly benefit you, the owner, in terms of higher profits.

Another potential downside is information asymmetry. Managers often have much more information about the day-to-day operations and the true performance of the company than the owners do. Owners, especially those who are not involved in the daily running of the business, rely on reports and summaries provided by management. This information gap can be exploited. Imagine your bakery manager knows that sales of a particular pastry are declining, but they don’t immediately tell you because they are concerned you might question their decisions. They might delay addressing the issue, hoping it will resolve itself, potentially leading to further losses before you become aware of the problem.

Furthermore, there can be conflicts of interest. Managers might be tempted to make decisions that benefit themselves in the short term, even if those decisions harm the long-term interests of the owners. Think about executive bonuses. Managers might be incentivized to focus on short-term profits to boost their bonuses, even if it means cutting corners on quality or neglecting long-term investments that are crucial for the bakery’s future success. They might prioritize maximizing this year’s profits at the expense of building a sustainable and thriving business for years to come.

Monitoring managers effectively can also be challenging for owners, especially in large, publicly traded companies where ownership is dispersed among many shareholders. Each individual shareholder might own only a small fraction of the company, making it difficult and costly for them to individually monitor management’s actions. It’s harder for many dispersed owners to collectively exert influence and ensure managers are acting in their best interests compared to when the owner is directly involved and present in the business every day.

In essence, while separating ownership and control allows for professional management and business growth, it introduces the risk of managers acting in their own self-interest, potentially at the expense of the owners. This can lead to inefficient decisions, wasted resources, and ultimately, a decrease in the value of the company for its owners. Therefore, good corporate governance mechanisms, such as strong boards of directors and transparent reporting, are crucial to mitigate these potential downsides and ensure that managers are accountable to the owners they are supposed to serve.