What Leads Companies to Betray Their Own Principles

ADI IGNATIUS: I’m Adi Ignatius.

ALISON BEARD: I’m Alison Beard and this is the HBR IdeaCast.

ADI IGNATIUS: Allison, there is a phenomenon that we see over and over again where founders create companies with a purpose, with a noble mission, maybe a don’t be evil motto, and then over time, it all gets lost. Short-term financial pressure makes companies cut corners, lose conviction, and in some cases, the founder visionary themself is even forced out.

ALISON BEARD: Yeah, I can think off the top of my head of lots of examples. Apple, when Steve Jobs wasn’t in charge. Starbucks when Howard Schultz stepped down before he came back. Google, which was your don’t be evil reference, now Alphabet. And even my friend’s company, a healthy, fast casual food chain that went downhill because private equity came in and he left to start another business.

ADI IGNATIUS: Eric Ries, today’s guest, has thought a lot about all of this. You might know him as the author of the book, The Lean Startup. In recent years, he has turned his attention to how and why companies lose their way over time. And while he blames a system that excessively prioritizes short-term shareholders’ needs, he also says companies themselves are somewhat complicit. In other words, there are things they could do to hold onto their mission and purpose, but they too often are not doing so and he suggests some alternative paths.

ALISON BEARD: I feel like a few years ago, all the talk was about being mission-driven and stakeholder capitalism, and it seems to have shifted back to more of a focus on shareholders. So I’m excited for someone to present a counterpoint.

ADI IGNATIUS: Yeah. Look, you make a good point. I think the conversation is continuing. So Ries’s new book is Incorruptible: Why Good Companies Go Bad and How Great Companies Stay Great. Here is our conversation.

Great companies often start in founder’s mode. There’s a mission, a purpose, a product, unlimited potential. Then what happens?

ERIC RIES: So much of the management and leadership literature is about the superficial aspects of an organization, the things we can see and control easily. Business model, strategy, org chart, even culture. But this book is about what I call the underlying forces, the physics that act on organizations, whether they want to or not, whether we imagine we can control that or not.

And I have witnessed this firsthand. I’ve helped so many people start so many companies where, as you say, that initial spark, the thing that really made the organization special gets eroded over time. In the book I describe it like watching organizations be surgically deboned by this force that no one controls, but everyone obeys.

In retrospect, I wish someone had told me that the more successful an organization becomes, the more valuable it will be as a target because someone will want to steal it, to take it over, to control it. And I just feel like I and a whole generation of founders and leaders … And this has been going on for a long time, have been horribly naive about the fact that these forces are real and extremely powerful.

ADI IGNATIUS: So some of the forces that you’re talking about are well known that can complicate leaders’ ability to drive long-term success. And for listed companies, that’s quarterly expectations, et cetera, et cetera. It sounds like you’re suggesting that companies are in some ways inadvertently complicit in agreeing to going along with some of these things that hold them back. There’s a quote in the book, I love it. Most organizations operate as sophisticated zombies. Talk about what you mean by that.

ERIC RIES: You hear people talk about companies this way all the time, including founders and leaders. They don’t talk this way in the boardroom, but if you have a drink afterwards, this is how we talk. That often these companies have a lumbering or out of control feeling to them. And it’s interesting to me that customers talk about it this way, like go on the Reddit Panera Bread and watch the customers be absolutely melting down about what private equity has done to that brand or pick hundreds of other brands where you’ve seen this happen. It comes up all the time that these are like creatures or zombies.

John Steinbeck described the bank this way in The Grapes of Wrath. This is not some new thing. But what’s interesting to me is to see it now from the leader’s point of view and see how many leaders feel the same way about their own organization.

ADI IGNATIUS: So I would think there would be executives who would listen to this and say, “Hey, I would love to think for the long term, but my shareholders won’t let me.” So what’s going on here?

ERIC RIES: Yeah. It’s really interesting. This dynamic of I want to think long-term, I want to do the right thing, but the people above or below me don’t want to is true at every level. I’ve had people on the factory floor tell me that story, the factory foremen tell me that story, the middle managers tell me that story, the senior managers, the board. I’ve been with CEOs. But I’ve been with the investors themselves and everyone feels like it’s somebody else that is doing it. We’re all pointing the finger at each other.

And I think that’s because we tend to see this as a personal drama. Whose decision is it? Who’s providing the pressure instead of seeing it as a systemic or structural issue. And so yes, I do think that the way we construct most companies today, the best practices tend to really favor what I would call a weak structure, a structure that is easy to influence from the outside and so very easy for such companies to become addicted to quarterly reporting, quarterly earnings, guidance, short-term metrics.

You don’t even have to be a public company to see this happening. This happens in lots of private companies too. Notice how many startups are all about what they’re going to have to do to raise the next round of funding so much so that the product, the quality, the employees, the community, the things that they originally cared about goes by the wayside. But the critical thing for me about this book was it’s kind of a mystery. A lot of these practices, these short-term practices we have really good evidence are value destroying. So how can it be people say, “I want to do the right thing but my investors don’t want me to.” I used to ask them, “What? Your investors want you to lose money?” That can’t be right.

ADI IGNATIUS: The Milton Friedman observation – his credo for shareholder primacy has basically held sway for more than 50 years. A few years ago, it seemed like something else was maybe taking shape; that there was a consensus in business in policy that there should be, there needs to be a broader sense of stakeholder capitalism. What happened to that?

ERIC RIES: I watched it totally baffled. My friends and I in Silicon Valley called it the Fakeholder Movement. It just didn’t seem real to me. I think the stakeholder capitalism idea was responding to a real market need. And obviously you see the massive capital inflows to ESG and purpose aligned investment products, even though a lot of them were fake. The fact that people were so hungry to buy that marketing promise tells you a lot about where the demand side of this is.

But I do not think we should be talking about stakeholders because the problem with the stakeholder framing is like, what do you do when the stakeholders have a conflict? So employees want higher wages, but customers want lower prices. Now what? Where we went wrong, we were making a movement based on a critique of shareholder primacy without being able to lay out much of an affirmative vision for what comes next.

If you look at the data, financialization has come with this degradation of non-financial values. It just has. It’s just true in almost every sphere of our life, not just in business. We see it in the civic sphere, we see it in journalism, you see it in sports. The cultural mores have changed in ways that we don’t always fully grapple with.

What I say to people in business is if you care about anything at all, like you tell me you care about making high quality products, you tell me you care about the health of your customers, you tell me you care about the environment or whatever you’re committed to. It could be something simple and humble, like, I just want to bring a little beauty into my customer’s lives. It could be something really dramatic and high concept like I want to fix one of the world’s largest problems. If you believe in any non-financial goal, you’re already a business revolutionary.

Shareholder primacy holds that an organization is not a beautiful, living, dynamic thing that makes high quality products. It is merely a financial instrument for the enrichment of shareholders, which means that it will inevitably, unless structured a different way, it will inevitably betray whatever values or promises you think it has made to you, whether you’re an investor, employee, a customer, or community, anybody. I include investors here because the evidence is in now that this way of working, although it’s being enacted in the name of shareholders, is not actually benefiting shareholders.

ADI IGNATIUS: So to be fair, some founders are not actually good at growing and sustaining the businesses that they created. So it doesn’t seem wrong to me that there might be a mechanism that can move out a founder visionary if he or she is ineffective at running a company.

ERIC RIES: Today we’re trapped in this false dichotomy between founder-controlled companies and investor controlled companies. The data shows that both of those ideas are very flawed. I propose a new system I call mission-controlled companies, which I really think we have the data to support is a better way. But I would like to point out that even among founder controlled companies, people talk about how it’s very important that the founder makes a mistake that there’d be accountability for the founder. Okay. Maybe that’s true. But we have in the documentary record now so many companies where the ousting of the founder, even if justified, was still the death knell of the company’s ability to innovate. It’s very frequent that after the founder’s gone … Like after Edwin Land was ousted from Polaroid, Polaroid never launched another invention of any kind despite at the time that he was fired, having like 1,500 research scientists. They were a huge research organization; that ethos was basically instantly lost. We saw the same thing at SAIC another research organization. Obviously Steve Jobs very famously at Apple. We’ve seen this over and over and over again, yet people don’t have a plan B. So there’s like accountability for founder, the person. We’re seeing this as a moral drama where if someone makes a mistake, they have to be ousted.

Meanwhile, we have an economy where the people who cut costs are rewarded, but they are never held accountable for the consequences, the brand damage, the quality damage, the consequences of that cost-cutting. So where’s the accountability on that side? And third, the people clamoring for this accountability, this is being done in the name of what’s called shareholder democracy. These are liquid shareholders. They could just sell their shares. They don’t have to own this company. So I think the question is not, should there be accountability for management? Of course, there should be. The question is who should be involved in the driving of that accountability? And one of the key ideas in the book is that accountability decisions should be driven by the citizens of the republic, not the tourists. So those people who have a genuine aligned long-term interest in the health and success of the company are the ones who should be helping to make those decisions, not those who are just passing through.

ADI IGNATIUS: There are famous mission statements like Johnson & Johnson, J&J has its hierarchy, its primary responsibilities to patients, doctors, nurses, families, second to employees, third to the communities where they operate. And then fourth to stockholders. Does that give them any real power legally or practically?

ERIC RIES: No. In fact, Johnson Johnson is one of the negative case studies in the book. And you got to remember this famous credo, Robert Wood Johnson II, an old school corporate titan of the early 20th century type. He took Johnson & Johnson public during World War II. Okay. People today talk about macro uncertainty or whatever, IPO window. This guy took the company public while the Nazis were still rampaging around Europe so I don’t really want to hear it.

And he was so worried that the company would lose its way that he not only developed this famous credo, but he had it carved into the limestone blocks that make up the facade of the lobby of Johnson & Johnson where they stand this day like 10 feet high so that the idea was people would have to walk by the credo every day on their way in and out of work. And yet after he died and later generation of managers got sucked into the best practices of shareholder primacy, this was not enough to defend the company.

The same people that put asbestos in the baby powder and tried to cover it up walked by the credo every day on their way to work. So what we have to be looking for are structural solutions that are deeper than just leadership preference or a nominal mission statement, things that embed the mission into the governance structure of the company.

I really wanted to write a blueprint that shows both the operational side of this: How do we choose what the company’s mission and purpose should be? How do we defend it? How do we install it in our leadership practices? How do we align it with our business model? How do we build a culture that emerges from that connection, but also how do we protect it at the board level with shareholders and in our corporate structures?

ADI IGNATIUS: Okay. So let’s talk about that. So your point I think is it cannot be dependent on a single leader. It needs to be enshrined. There need to be structural protections for this initial or emergent mission, the values. How do you do that?

ERIC RIES: So on the operational side, it’s really a matter of a principle I call harder is easier. Most important decisions a company will make score as ROI negative in the spreadsheet by definition because the returns are intangible but the costs are tangible. So I’ll give an example. In the book we talk about this grocery store in Texas called H-E-B. If you know anybody that’s ever lived in Texas, you ask them about H-E-B, they won’t shut up about it. Trust me. People in Texas think mistakenly that H-E-B stands for here, everything’s better, even though actually it’s just the founder’s son’s initials. Anyway, the company’s been there for a very long time, has this real ethos of having this fiduciary commitment to customers.

So I tell a story about a time in ’20 or ’21 where there was a massive ice storm in Texas and there’s a store where the power goes out and there’s a massive groan that goes up in the store. Why are people so upset? Did I mention it’s an ice storm? You can imagine why they’re in a grocery store and an ice storm, they’re stocking up. Now they won’t be able to get the things they need because the point of sale system is down. A manager steps up on the counter everyone gather around, just take your carts and go home. People say, “Well, how are we going to pay?” You’re not. Just go. So customers were weeping in the aisles. It was a really profound moment for them because here was a company saying, even though we can calculate the costs of this action to the last decimal place and the returns of doing it are very vague, we nonetheless do the right thing. That was not an isolated individual manager being a hero. The company drills for this, not for ice storms in particular, but they teach everybody that this is our mission to take care of these customers in these extremely tangible ways. It’s an operational discipline. So that’s just an example on the operational side.

On the governance side, the problem is we have to find ways to resist shareholder primacy. So for example, most companies today, the leaders have never read their corporate charter and have no idea what it says. That’s a big problem because that’s like your constitution. You need to know what it says. But if you do read it or ask your lawyers to explain it to you, we have this very arcane jargon that makes it very difficult to understand.

For example, most Delaware corporations today, if you read the charter, the first sentence will be, “The Acme Corporation is hereby incorporated to pursue,” and it’s like a mad lib. There’s a blank line and it says, “Any lawful act or activity.”

People hear, “Oh, any lawful act or activity, that doesn’t sound too bad. It’s pretty open-ended.” Wrong, because thanks to the magic of governance class, any lawful act or activity now means maximize shareholder value according to Delaware law. So most people don’t even realize that though they have a mission statement … I tell the story in the book of Silicon Valley Bank, my bank, the bank we loved here in Silicon Valley. After it collapsed, I went digging into why did it collapse? I wanted to know. Well, it had a really awesome mission statement. It was something like to move the innovation economy forward. I was like, oh, that’s a cool mission.

I want to be part of that. Sounds great. But if you read the charter, which is public because they’re a bank, it just says any lawful act or activity, meaning shareholder primacy. So this divergence between a company’s stated mission and its actual legal purpose eventually causes managers to lie to everybody because we say this is what we’re doing, but actually what we’re doing is something else.

So first step would be to reconcile, to put the mission back in the charter and show this is our actual commitment. And then I talk about how to protect that mission at each of the layers of the ownership stack of the company. So how do we make sure that the board is committed to that mission? I think we need a director’s oath, like the equivalent of the Hippocratic oath for doctors, but for boards of directors.

And of course, there are a whole bunch of structures out there in the world. So many that we have a data set to understand them and to see how they perform that change the power dynamics away from shareholder privacy, things like the industrial foundation structure, employee ownership or the perpetual purpose trust. I won’t enumerate them all. There’s quite a few. Together collectively, those give us the evidence that there is a better way, not just morally and ethically, but financially too.

ADI IGNATIUS: So a lot of what you’re talking about sounds ambitious and probably difficult for companies that are thinking about, well, how do I get from where I am to where I might want to be? But I’d love to talk about a real life company that again, we may view as an outlier, but that is living into some of these principles. And Costco comes to mind as with any company, I’m sure that there’s some things they do that are exemplary, some not so much, but Costco does seem to be an outlier in a largely positive way. Talk about what Costco does that’s different and that could be replicable by others.

ERIC RIES: The principles of Costco really illustrate this harder, is easier principle. So for example, they won’t mark up any item in the store more than 14%, 15% for Kirkland’s signature, but 14% is their default rule. Even if they could get away with doing more. You’d ask Jim Sinegal, the founder of Costco, why? He says, most businesses are addicted … He called it the business equivalent of taking heroin. The way he put it to me was, if I take a dollar bottle of ketchup and I sell it for a dollar and three cents, nobody would notice. We’d sell the same number of ketchup. If we did that across the whole store, 3%, we would double our net income. Costco is a $400 billion public company.

So if you double your net income, that’s not an insignificant thing, but we don’t do it. Why? Because once you do it once, you’re going to have to do it again. Now that increased profit is baked into your forecast. Now you got to do it quarter after quarter. Next thing you know, you’re not the low cost leader. Next thing you know, you’re nothing.

So Costco does this thing where they take the harder road. He said, raising prices is the easy way. We like to do it the hard way. The hard way is upfront extra work. You want to have quality. They pay higher wages than they have to pay. They’re always above average in every market that they operate. They don’t have as many SKUs as everybody else. They have this extremely stripped down warehouse format. They just do a lot of things that other companies wouldn’t be willing to do because it’s communicating something very specific about what they stand for.

The most famous of these symbols is of course the famous dollar 50 hotdog. Since 1986, Costco’s been selling a hotdog and soda combo in the restaurant cart outside their stores for $1.50. Just to give you a sense of it, McDonald’s Big Mac in 1986 in California was about $1.60. Today in California, that same Big Mac has crossed $7, I think, in some restaurants. So they could be charging a lot more for this hotdog combo, but they have kept the price at $1.50.

But this is not some loss leader. They have done the extra work to make sure they can do this and keep this promise. And the reason the story is so famous is because of an episode in 2008 when the then COO of the company came to Jim Sinegal and said, “Boss, we’re getting our butts kicked on this hotdog. We need to raise the price.” And Jim said, “Sure, no problem. But just so you know, if you raise the price of the effing hotdog, I will kill you. Figure it out.” That quote is so famous you can buy a T-shirt with it on it. It’s a very famous episode.

But I think what’s really interesting about that story are the questions that nobody ever asks me when I tell it. For example, no one ever asks, why would the COO want to raise prices? Because of course he would. We all just take that for granted that of course that’s how you would do it. In fact, when Wall Street comes for Costco, as they do every couple years, they say stuff like … I quote an analyst who says, “Costco takes money that rightfully belongs to shareholders and instead invests it in the customer experience” as a criticism because in the shareholder primacy theory, customers and employees, communities, these are just resources to be mined for the benefit of shareholders.

So Costco refuses to do this. Again, to give you the scale of it, Costco sells more of those hotdogs than every major league baseball stadium combined. More than 200 million combos a year. So the amount of money they could make by even a small price increase would be a staggering amount, let alone that they could get away with charging $7 for it. Yet they don’t because they understand that the value that they gain by keeping their promises is more valuable than the short-term revenue they could get through acts of betrayal.

And that’s because the most underrated asset in all of business today is trustworthiness. I think it’s very important to see this as a financial asset that most organizations do not account for properly. So when you stockpile all this trustworthiness, this massive asset, of course people will try to steal it from you. No kidding. So that’s where the governance fortress side of it comes in.

Costco was born out of the betrayal by investors of its predecessor company called FedMart, for those that remember FedMart, the original discount retailer. Why was FedMart betrayed while Costco endures? It’s because of the specific governance structure of Costco. It has what I call a governance fortress that protects it from outside influence. And that’s really what we need organizations. If they want to be strong they have to have this ethos, this really specific thing that they stand for and they have to have the governance strength to defend that against both inner temptation and outer pressure.

ADI IGNATIUS: The hotdog example really sounds like it is the power and mission and purpose of the cofounder and former CEO, Jim Sinegal, who says, figure it out. But what’s the structural protection then? What is Costco doing structurally that could be emulated?

ERIC RIES: Yeah. It’s funny. Everyone I tell this story to is always like, “Well, that’s just because Jim Senegal is still around.” No, he’s not. He’s still alive, but he’s not involved in the company. So people assume that Costco has failed the test of succession because every company fails the test of succession. It’s inevitable, right? Wrong. Just give you one example, one of the elements of the fortress. This is a very simple thing. If you want to amend the corporate charter of Costco, you have to get a super majority of shareholders to consent to the amendment. Not just a super majority of shareholders who happen to vote in that election, a super majority of all shareholders and Costco has millions of retail shareholders. So it’s not impossible to get the retail shareholders to vote for something actually.

There was a recent controversy where Costco had a vote where someone tried to force them to do something they didn’t want to do and they had a 98% opposition to the thing people wanted them to do. So their shareholders do vote, but we’ve had a bunch of examples where so called good governance experts have come for Costco and their arguments are, to me, hilarious.

If you look at companies that are rated by governance rating agencies, since 2008, companies that are rated to have bad governance have outperformed companies rated to have good governance. So it’s been very, very difficult to bully Costco into doing things it doesn’t want to do. Whereas most companies are hyper eager to do whatever is going to please the folks who decide what constitutes a best practice.

ADI IGNATIUS: If I’m a founder with a new company or I want to reorient my company along these lines, what are some practical things they can do, particularly in light of the opposition that they’re going to face?

ERIC RIES: Let me just give one data point and then I’ll try to be very specific.

I mentioned the industrial foundation structure. This is one of the recommendations in the book. People who know Novo Nordisk or IKEA or Vanguard or REI or Hershey Chocolate or Patagonia or John Lewis Partnership … There’s a lot of companies in the world that have this two-tiered structure where there’s the for-profit company is governed by a separate entity. In the case of Nova Nordisk, Zeiss, the German optics company, Grundfos, Ikea, this second entity is a nonprofit foundation.

I remember the first time I met a company who had this structure, I was giving a lecture to their CEO and top executives and they’d asked me to come in and do a workshop and they told me they had this structure where they’re governed by these nonprofit trustees and I said, “Oh, I’m so sorry to hear that. My condolences, that must be really tough. You’re not going to be able to compete in the ruthless shareholder driven global.” I was a believer in shareholder primacy as anybody. And they all started laughing like I was such a child who didn’t know anything about the world. They said, “We wouldn’t trade this structure for any amount of money in the world. It is why we’re hyper-competitive.” And I thought they must be lying.

So I looked it up. Turns out there’s enough of these companies in the world that we know how they perform. They are dramatically more likely to live to year 50 compared to companies with a conventional structure. They have superior return on assets, return on invested capital, they have better employee morale, they have better Tobin’s Q, if you remember that old finance metric. There’s just so much data that these companies outperform.

So if you’re asking for what are the practical things we can do, definitely number one in the governance checklist for me is to write the company mission into the corporate charter. If you’re a Delaware company, it is a two-page legal filing in Delaware. Your lawyers can have this done for you tomorrow. It’s extremely easy. All you’re doing is writing the actual purpose of the company, what’s called its public benefit into the charter.

Again, this is not some newfangled thing. For the vast majority of time, there have been joint stock corporations on this earth. This would’ve been seen as completely obvious that every company should be incorporated to do a specific thing.

Number two is you have to do something at the director level. Today, the prescription for almost any governance challenge is to add more independent directors, but the evidence shows that independent directors are not actually really independent. They generally tend to be captured by the interests of investors. So independent directors are agents of shareholder primacy. Just like founders need to be held accountable, as you made a very eloquent case for before, I think directors need to be held accountable.

But I think it’s also important … I mentioned before the idea of having a Hippocratic oath, a director’s oath. That’s one of several techniques that we have for how to constrain the judgment of directors to insist that you only become a director of a company if you in fact are prepared to protect and defend its mission. So a mission oriented board would also be a prescription that I recommend. And then yes, the actual ownership structure. There are these alternative structures that we have data for that are really good. I mentioned the industrial foundation structure. Just a word about employee ownership because the advocates of shareholder primacy are very opposed to employee ownership.

I say a bunch of examples of this in the book. They see money spent on employee owners as an expense, an unjustified expense. Again, taking money from shareholders and giving it to the employees. This is the problem with stakeholder stuff, like I mentioned before. It’s just a zero-sum game, but it’s not zero-sum. In one incredible meta study that built a massive data set of all the different studies of employee ownership … I think they built a data set of like 55,000 companies. They found that not only does employee ownership drive commercial outcomes like faster revenue growth and more profitability, it exhibits dose response like a medication like having 10% employee ownership is better than 0%, 50% is better than 10 and 100% is better than 50.

So we see companies like Taylor Guitar, like I’m a Taylor guitar customer. And you see that Eileen Fisher, who’s doing the same thing in fashion. You see it in so many places in the economy. Mondragon in Spain is a really famous example where the whole thing is a series of worker cooperatives. So we have these other structures available to us that are not incompatible with making money. In fact, they are much more likely to create value over the long term.

ADI IGNATIUS: So there’s a great line in the book that sums up everything you just said, which is purpose without power is just poetry, give it teeth and it becomes destiny. Eric, we’re out of time, but thank you very much for being on the IdeaCast.

ERIC RIES: Oh, it’s absolutely my pleasure.

ADI IGNATIUS: That was Eric Reese, author of the new book, Incorruptible: Why Good Companies Go Bad and How Great Companies Stay Great. Next week, Alison speaks with Kelly Clements of the UN Refugee Agency about navigating political uncertainty and reforming legacy institutions.

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And thanks to our team, senior producer, Mary Dooe, audio product manager, Ian Fox, and senior production specialist, Rob Eckhardt. And thanks to you for listening to the HBR IdeaCast. We’ll be back with a new episode on Tuesday. I’m Adi Ignatius.