Our theories exist to make our lives better. They exist to simplify a complex world and make it easier to act effectively. Yet, sometimes, our theories make our lives worse. Sometimes, our theories produce results exactly the opposite of those we intended.
Take peptic ulcer surgery. For many decades, the prevailing theory held that peptic ulcers were caused by excess stomach acid. Hence, the treatment was a bland diet and antacids to reduce stomach acid. Unfortunately, the treatment wasn’t particularly successful and for many patients, the ulcers just got worse to the point that surgery was prescribed to cut out the most ulcerated portions of the patients’ stomachs. A highly invasive procedure, this permanently damaged the patient’s stomach. And guess what? It didn’t solve the problem.
The real problem was the theory, not the therapy. By and large, peptic ulcer surgery was performed professionally, by caring and attentive doctors. However, their chance of success was minimal. Peptic ulcers are actually caused by h.pylori, a bacterium that does not respond in any favorable way to bland diets, antacids or surgery.
Fortunately for peptic ulcer sufferers, a pair of Australian scientists, Barry Marshall and Robin Warren saw something others didn’t. Marshall and Warren had to overcome an almost impregnable wall of expert resistance to prove that ulcers were actually bacterial and could be treated with antibiotics. After years of frustration, Marshall went so far as to consume h. pylori, which, as he predicted, caused him to develop peptic ulcers. He then cured the ulcers with the use of antibiotics. In due course, the medical world stopped slicing up patients’ stomachs and instead gave them antibiotics—and Marshall and Warren won the Nobel Prize, a full 21 years after Marshall’s h. pylori ingestion. They had finally defeated a dangerous theory and replaced it with an effective one.
The theory behind our current executive compensation system also falls into the dangerous theory category. Since 1976, the business world has embraced the idea that stock-based compensation aligns the interests of shareholders and management—and like antacid, more of it is better than less of it. Sadly, it is a deeply flawed theory. Stock-based compensation generates an incentive for CEOs to focus their attention on manipulating investor expectations—and with them the stock price—rather than on building the real business. As long as CEOs can produce swings in expectations, they can create lots of value from their stock-based compensation. A downdraft in stock price followed by a restoration to its prior value does nothing for shareholders but can result in healthy stock-based compensation gains to CEO stock awards made at the bottom.
Of course, not all CEOs succumb to the temptations of stock manipulation over business building. But sadly, the data are pretty clear—many do. And the result has been that executives are doing just great, while shareholders are doing worse—earning lower returns and enduring higher volatility to get them. In addition, the focus on expectations manipulation saps the authenticity out of the professional lives of CEOs and with it a considerable amount of their moral fiber. None of this is good for shareholders, as their executives spend their time trying to please an expectations market that can’t be satiated.
Business needs a better theory—and fortunately it can borrow a well-tested one. The NFL figured out long ago that to enable its real market—playing the game on the field—to prosper, it needed to enforce a strict separation between it and its associated expectations market—betting on NFL football games. Nobody in any way associated with the real game—players, coaches or managers—is allowed to play in the expectations game. That keeps the real game authentic, which has helped the NFL become America’s most successful sports league, with some very happy, and very wealthy, owners.
Business can learn a big lesson from NFL football: Sequester the expectations game from the real game and the real game gets a chance to prosper; intermingle them and the expectations game has the capacity to irreparably harm the real game.
In “Fixing the Game,” I show how our current theory of stock-based compensation and shareholder-value maximization is damaging capitalism and how an alternative theory has the capacity to restore executive authenticity and protect the best of capitalism. Like peptic ulcer surgery, our current theory is doing real harm. It’s past time to adopt a new and better theory.
Roger Martin has served as Dean of the Rotman School of Management since September 1, 1998. He writes extensively on design and is a regular columnist for BusinessWeek.com’s Innovation and Design Channel. He is also a regular contributor to Washington Post’s On Leadership blog and to Financial Times’ Judgment Call column. He has published several books, including: The Design of Business: Why Design Thinking is the Next Competitive Advantage (2009), The Opposable Mind: How Successful Leaders Win Through Integrative Thinking (2007), The Responsibility Virus: How Control Freaks, Shrinking Violets-and The Rest Of Us-Can Harness The Power Of True Partnership (2002), The Future of the MBA: Designing the Thinker of the Future, (with Mihnea Moldoveanu, 2008) and Dia-Minds (with Moldoveanu, 2010).