Since I traveled to Pittsburgh this week, I had the chance to read a story in the Pittsburgh Post-Gazette on the pros and cons of allowing employees to participate in office bracket pools.  Indeed, some offices have sought to ban such pools.  Apparently not because they may be illegal.  But rather because they may have a negative impact on employees and the workplace.  To be sure, one research firm estimates that the distraction created by basketball office pools will cost employers some $1.7 billion in wasted work time.  This estimate is based on wasted time spent on bracket-related activities from "trash talking at the water cooler" to "watching live videos of the games during business hours."  In addition, to the wasted time, one employment lawyer notes that bracket pools in the office invite trouble because things may go awry.  Such as when someone believes they should have taken first prize and instead gets third place, or worse, when the CEO wins first prize, after having pooled money with "the people in the mailroom and the messenger."  If this happens, the advice is that the CEO should buy everyone lunch instead of pocketing the money.  To be sure, despite the potential loss in productivity, most companies either encourage or do not discourage bracket pools in the office.   Such companies find that allowing employees to participate in brackets is good for employee morale, fostering a sense of community and healthy competition.  So for now, most employees are free to fill out and agonize over their brackets, even on company time.  Given the many students that participate in bracket pools, it is probably a pastime that would be very difficult for companies to disrupt.

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I know we are trying to move on, but I have heard several news sources and commentators point out that Bear Stearns employees own some 1/3 of the company's stock.  That number seems striking and a bit surprising, particularly given all of the hoopla surrounding Enron and the fact that its employees held so much of the company's stock when it collapsed.  Indeed, I thought one important lesson from Enron, at least for employees, was to diversify.  Apparently not.  To be sure, there are many good reasons to invest in your company's stock.  Then too, a short while ago Bear Stearns did not appear like it was heading for disaster (but then again neither did Enron).  Moreover, it is not clear that Bear Stearns employees have not diversified and hence perhaps there are employees who did not have their entire nest egg in the Bear Stearns basket.   Unfortunately, it seems more likely that employees have once again found themselves in a situation in which they not only face potential job loss, but also the loss of their retirement.   

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Over the past few weeks, I have heard several condemnations of French employment law prompted by the well-publicized inability of Société Générale to terminate Jerome Kerviel for his trading activities. The suggested lesson for Americans: we are lucky to have employment at will as the default rule because it encourages employment (and, thus, economic development).

Certainly, one of the oft-cited impediments to entrepreneurship in Europe is employment law, but it turns out that the facts underlying Kerviel's activities are messier than first presented. We have emails showing that Kerviel had an accomplice, right? Not so fast ... the purported accomplice now says that the emails were altered to make him look more involved with Kerviel than he actually was. And Kerviel's lawyer says that the accomplice is a fabrication designed to keep Kerviel locked up.

Of course, Kerviel's position remains that SocGen was complicit in the fraud. Or, in the words of Kerviel's lawyer, "everyone knew what Jérôme was doing." Which means, interestingly, that one of the live questions in the case is whether Kerviel is entitled to his year-end bonus! (French version. HT Alan Hyde)

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Wouldn’t it be wonderful if you could discharge your debts by paying 50 cents on the dollar? You’d have something in common with General Motors in its bargain with the United Auto Workers union.

The GM-UAW deal adapts an old vehicle, the VEBA (voluntary employee benefit association), in a radically voguish way. Traditional VEBAs, dating to 1928 and used by tens of thousands of US companies, are tax-advantaged vehicles that companies use to manage and fund employee benefits. The new twist, in the GM-UAW deal and others, makes the VEBA a vehicle that unions use to manage and fund those benefits.

GM will transfer to the VEBA $29.9 billion of assets (including a $4.37 billion note convertible into GM stock whose exercise would make the VEBA a 16% shareholder of GM); extinguish from its balance sheet $46.7 billion in liabilities for post-retirement health benefits; and forego further obligations for such benefits. The union assumes all duties from there, including managing and funding the trust and administering benefits—perhaps with some official GM oversight or input.

This new vogue in VEBAs shows the dire straits of some companies burdened by enormous financial legacy costs, due, in part, to bad old accounting rules and curious health care policies.

Until 1993, US accounting rules (GAAP) did not require companies to book a balance sheet liability for promises to employees to pay post-retirement health benefits. The results were bountiful—but often worthless—corporate promises to provide these benefits, contributing to the bankruptcy of some companies. Under the 1993 rule, huge balance sheet liabilities sprouted. This (along with increased costs and other factors) tended to curtail company promises (and reduced the number of companies with 200+ employees who provide such benefits from 66% before the change to 33% today).

Even so, 14 years later, enormous benefit liabilities appear on balance sheets of dozens of US companies, especially manufacturing companies with unionized work forces. For many, the obligation exceeds $1 billion and 5% of total assets (at GM, the figure is nearly $70 billion). These costs impair US competitiveness with foreign companies where national health services foot the bill.

The new vogue in VEBAs may be appealing, but is not free from risk. Two risks are manifest in the GM-UAW deal. First, GM’s initial funding may be insufficient to satisfy the VEBA’s long-term obligations. Second, GM officials may exercise influence over the VEBA. Either way, the risk is that the obligation will remain with GM and not be transferred to the VEBA, as a matter of law or accounting, whatever balance sheet treatment GM adopts now. If so, investors may regret the deal; workers may get two bites at the apple. But there may be no other solution.

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Members of the United Automobile Workers Union began striking today at GM plants across the country in what is apparently the first national strike by the union since 1970.  In a statement on Sunday, UAW told its members that if a deal between GM and the union had not been reached by 11 a.m. today (and unless they heard otherwise), they should consider themselves on strike.  And thus, after 11 today many workers walked off the job to begin striking for what could be weeks or even months.  To be sure, as GM noted, the apparent stalemate between GM and the union involves "complex, difficult issues" such as those related to health care coverage and how to secure jobs in a troubled industry.  Yet, similar to many conversations in the corporate governance arena, a large part of the stalemate appears to center not only around issues of compensation, but also around the gap between executive and employee compensation.  Thus, in criticizing GM, vice president and director of the union's GM department stated "in 2007 company executives continued to award themselves bonuses while demanding that our members accept a reduced standard of living."  This apparent difference in behavior captures the broader sentiment of employees and their mounting frustration with increased executive compensation.  The seeming difference in behavior no doubt only adds to the complex and difficult issues being confronted at the bargaining table. 

Permalink | Corporate Governance| Employees | Comments (2) | TrackBack (0)

A study to be presented at the Academy of Management's annual meeting indicates that bad bosses get promoted rather than punished.  According to the study, nearly two-thirds or 64.2 percent of the 240 people surveyed said that their bad boss was either never censured or was promoted for domineering ways.  The three study authors from Bond University in Australia suggested that the promotion of such leaders has a negative impact on the corporate environment and the bottom-line.  Indeed, despite their apparent success in office, such leaders not only cause workplace strife, but also cause serious malaise for their subordinates including nightmares, insomnia, depression and exhaustion.  Bad bosses also lead to increased employee turnover, which can impact profit.  This is because not only do many employees eventually walk away from workplaces with spiteful supervisors, but such supervisors often develop a reputation that makes it difficult to recruit and retain employees.  The study's authors faulted senior managers for failing to recognize the signs of bad supervisors as well as the leaders above such managers who fail to intervene or otherwise elect to reward the behavior of spiteful bosses.

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I have been traveling a bit lately and, as is apparently inevitable, my most recent flight was delayed.  However, the delay gave me the opportunity to speak with a fellow passenger who happened to own a mid-sized business.  Once he discovered that I was a Corporations professor at a law school, he at first lamented lawyers and the amount of money he had to pay in legal fees each year.  He then said that the fees (and the threat of lawsuits they often represented) were particularly annoying because he was, as he described himself, "one of the most accommodating bosses in the world."  When I guess I appeared skeptical, he explained that he made it a point to have a very flexible work schedule for his employees, and if people needed time off or to come in late to "watch their kids or whatever"--his answer was always that they should take the time, their job would be there when they returned.  He said the answer was the same if the time off was ten minutes or ten months.  When I asked him if he could really run a business with people taking ten months off at a time, he responded that the problem with most people in human resources was that they "forget that resources are things you build up, not something you constantly turn over."  I found the quote so interesting, that I knew I would share it.  The conversation reminded me that while many corporate scholars may debate the wisdom of whether or to what extent corporations should devote time and resources to employees, at least some business owners do not see it as a debate at all.  Thus, while I know that not all employers have the same philosophy as my fellow passenger, I found it refreshing to hear that some not only believe that focusing on employees and their welfare is an integral part of running a business, but also implement that belief through their employment policies.  Alas, I considered my flight delay time well spent.

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Paul Kedrosky raises an interesting possibility about the fallout from John Mackey's excellent internet adventure: "while anti-stock-blogging/posting clauses haven't yet hit CEO/exec contracts, they will. And soon."

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Scott Moss has a very interesting article on Findlaw about the Sullivan & Cromwell associate who is representing himself in a lawsuit against the firm for discriminating against him on the basis of his sexual orientation.  Scott was a plaintiff's-side employment attorney in New York, so he knows the mountain of which he speaks.

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CSM has an interesting piece on credit checks as a civil rights issue.  Apparently, more and more employers perform credit checks as part of their diligence in hiring.  However, some studies show that average credit scores for blacks and Hispanics are worse than for whites, while there is apparently a lack of data supporting a relation between bad credit and poor employee performance.  The story describes a suit against Harvard University by a job applicant whose bad credit history prevented her hire.

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Tuesday a district judge finally weighed in on prosecutors’ practice of seemingly encouraging corporations and other entities to refuse to pay the legal fees of their employees accused of fraud or wrong-doing.  In a case involving tax fraud allegations against several former KPMG partners, U.S. District Judge Lewis Kaplan ruled that prosecutors unconstitutionally pressured KPMG into cutting off legal fees for its employees, apparently interfering with their right to a fair trial.  In a strongly worded opinion, Kaplan noted that the government had let “its zeal get in the way of its judgment.”

In sharply criticizing the legal fee policy, Judge Kaplan also calls into question the viability of the “Thompson memo.”  The memo sets forth a variety of factors that federal prosecutors must consider when determining whether to indict business entities, including the willingness of such entities to waive attorney-client privileges and whether the entities pay the legal bills of employees who are accused of misdeeds.   Prosecutors evaluate an entity’s cooperation based on its compliance with these factors.  In KPMG’s cases, it was able to avoid criminal prosecution in part because of its continued cooperation with the government.  And hence KPMG’s refusal to pay legal fees.  Prosecutors insisted that they applied no pressure on KPMG, but Judge Kaplan characterized their actions as holding the “proverbial gun” to the head of the company.

The decision may have a significant impact on the criminal prosecutions of corporate officials.   Post-Enron prosecutors apparently have utilized aggressively the tactics outlined in the Thompson memo, and those tactics seemed to have paid off because they essentially allow prosecutors to rely on the corporation to help build cases against various officers and directors within a corporation.  This appears to have resulted not only in the high profile guilty verdicts we have seen, but also in a host of guilty pleas from corporate actors.  Certainly cutting off legal fees to employees is just one of the techniques available to prosecutors outlined in the Thompson memo, but the tone of Judge Kaplan’s decision appears to raise concerns about government overreaching more generally—thereby casting a disapproving net over the entire Thompson memo.

It is not clear what kind of impact the decision will have on businesses and their employees embroiled in these suits.  Indeed, Judge Kaplan did not dismiss the suit against the KPMG employees.  Instead, the judge encouraged employees to file a lawsuit against KPMG for their legal fees.  As other commentators have noted, the decision appears to bind entities to pay the legal fees of its employees, even when there is no written agreement to that effect.  (KPMG apparently had an unwritten policy of paying such fees).  But this seems contrary to governing law, which of course does not require that corporations indemnify their employees.  At the very least the decision may encourage corporations and other entities to more affirmatively exclude particular employees from indemnification.  The decision also may make it more difficult for businesses to appear cooperative, forcing prosecutors to make good on their threat that such entities will be criminally indicted and suffer the fate of Arthur Andersen.  Given the Supreme Court’s ultimate resolution of the Arthur Andersen case, the realistic impact of that threat is not entirely clear.

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         The Washington Post reports that about 47,000 employees have accepted buyout packages from General Motors and its supplier Delphi Corp, which makes it the largest of such buyout in corporate history.  This kind of buyout is apparently on the rise.  Ford has instituted a buyout program in which it expects 11,000 workers to participate.  Even the federal government has gotten into the act.  The GAO reports that since 2002 when Congress authorized such buyouts, the number of federal agencies offering buyouts to their employees has nearly doubled.

           On the surface employee buyout programs seem like a win-win situation.  Employees get to control their own fate, while the corporation gets to restructure and cut costs in a manner that appears—as some have argued—“compassionate” and “humane.” 

           But then I am reminded of something Judge Easterbrook said of another GM program in McNab v. General Motors, 162 F.3d 959, 960 (7th Cir. 1998): "Like many other firms, General Motors Corporation uses early-retirement programs to reduce its workforce without resorting to involuntary separation. One problem with early-retirement systems, however, is that the best employees may leap at the opportunity, knowing that they can add income from other jobs to their retirement packages; the firm wants to keep these superior employees while shedding those who are not up to snuff, but the sub-par workers are less willing to go, because they may value sinecures and do not expect to find comparable employment elsewhere. If the firm augments the early-retirement incentive to make it attractive to employees who lack prospects of finding other jobs, then the best employees have even more reason to take the offer. To overcome this problem of adverse selection, firms may limit early-retirement programs to employees chosen by management. Managers offer the package to the weakest members of the staff, simultaneously cutting their unit's budget and improving the average quality of its workers. But good workers may take exclusion poorly; why, they may ask, should rewards vary inversely with quality? Resentment may lead to litigation."

       So the win-win idea may be taking it a bit too far.  As Easterbrook suggests, these programs appear to target older workers who lose benefits they may not be able to recover in the market.  Yet it seems like a better alternative than lay-offs.  Thus, it still feels like a net positive for both groups.

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As more and more old-line companies--Generous Motors, Ford, Delta--struggle to retool around their legacy costs, the Kaiser Family Foundation has recently released a survey report detailing some of the costs of this retooling.  The report describes the effect of two major steel company bankruptcies--LTV and Bethlehem Steel—on health coverage for retirees and their dependents.  The two bankruptcies left approximately 200,000 retirees and dependents without health coverage between 2002 and 2003. While most respondents (about 74%) were able to find health coverage after the loss of their retiree benefits, the loss of benefits caused significant disruption to their lives and retirement plans. For example, about one-half of pre-65 retiree respondents reported that they or a spouse returned to work or delayed retirement as a result. Twenty-five percent of pre-65 respondents reported that they cashed in “a lot” of their savings or assets to cover health care or insurance premium costs. Also 49% of pre-65 respondents reported postponing or going without needed physician care, and 29% reported postponing or going without need hospital care, because of cost concerns.

The old-line corporate social contract is probably no longer sustainable except in a handful of less-than-competitive industries, and companies seem to be transitioning to more defined-contribution type arrangements.  Some folks are getting caught in the transition.

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From its inception, the (non) application of SOX to foreign issuers has been controversial.  Now the whistleblower protections of SOX have come into focus as another avenue for crossborder tensions.  The ABA Journal has a nice summary of current issues.  Europe, it turns out, is much less enamored of whistleblowers than we are in the States.  While "Americans like to elevate whistle-blowers to near folk-here status, from Daniel Ellsberg . . . to Sherron Watkins," in Europe, whistleblowers are often thought of as informants, as rats.  in Germany, "the term  term most likely conjures up memories of the Gestapo . . . .  In France, the term evokes images of the Vichy regime’s collaboration with the Nazis and of neighbors ratting out one another." 

No wonder that the EU has had some trouble coming to terms with the application of the new Sox whistleblower provisions to its issuers crosslisted in the US--especially the requirement that issuers establish procedures to allow employees to file internal whistleblowing complaints anonymously.  Europeans are apparently more concerned about the privacy and reputation of the accused.  "[W]hile the Americans are most concerned with protecting whistle-blowers to ensure market integrity, Europeans place a higher premium on guarding personal reputations of targets of complaints, which sometimes arise out of spite, revenge or other suspect motives."

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But, I probably wouldn't have been invited.  The WSJ reports today that four Morgan Stanley has fired four employees for taking clients to an "adult entertainment" venue during a business trip.  Although in years past this may have been business as usual, after MS had to pony up big bucks in 2004 in a sex discrimination case brought by a female trader (which Scott Moss, who worked on the case, can tell you about personally at any time!), MS now has rules forbidding such exclusionary outings on business trips. 

When I started practicing law in 1993 in the South, stories of these types of jaunts among attorneys and attorneys/clients were widespread.  (If you've ever driven on the Loop in Houston and looked at the billboards, you know how widespread this type of activity is!)  But surely we've come a long way since then.  Notably, the MS guys were at the Arizona Biltmore.  If you can't think of anything else to do at one of the most beautiful places in the world than go to a sleazy strip club, there's something wrong with you.

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The W$J editorial page excoriates GM for its "job bank":

[The] "jobs bank" ... is the company's euphemism for a post-employment limbo in which GM pays laid off members of the United Auto Workers not to work. If you want to know why GM's costs are too high for the number of cars it sells, here's one explanation.

GM doesn't like to talk about the "jobs bank," to the point that it won't disclose how many idled workers are in the bank or even how much it costs the company. However, the Detroit Free Press has dug around and reported that the "bank" holds some 5,000-6,000 employees, at an annual cost of as much as $800 million a year. And that's just the beginning of the damage it does.

The jobs bank was created in 1984 at a time when it became fashionable to worry that automation would cause robots to replace workers on factory floors. So in exchange for the right to introduce productivity improvements in factories, GM, Ford and Chrysler all consented to jobs banks. The idea was that in exchange for educating themselves, doing community service or in some cases just sitting around a factory, workers would continue to collect pay and benefits until the automaker could find another job for them.

This is one of those stories that I read and think, there must be more to this. Or maybe not. The W$J tells the story of a worker who is scheduled to retire in about four years, having spent 10 of his 30 years at GM "in the bank." As I have said here repeatedly, GM's CEO Rick Wagoner took over a company with some serious structural obstacles to reform, and this looks like one of those. The job bank is part of the UAW agreement, which will not expire until 2007.

And you thought academic tenure was cushy!

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There's a very interesting article in the New York Times about a drive by the Service Employees International Union to organize janitorial employees at five big Houston companies.  The article reports that the union is claiming victory in their drive to organize over 5,000 employees.  In many ways, the union is using a familiar tactic: organizing all the employers in a particular community and/or industry, thus ensuring that cheaper competitors won't undercut the unionized firms.  SEIU has used this strategy in its "Justice for Janitors" campaign in other cities.  As a chart at this SEIU website makes clear, janitors in New York, Los Angeles, and Chicago are represented by SEIU and make considerably more than their Houston counterparts.

However, there is a lot about the Houston campaign that represents a new approach to organizing.  The union and the employers have committed to a card-check neutrality agreement.  Essentially, instead of exercising their rights to tell employees why not to join the union, the employers here have agreed to remain neutral.  And instead of insisting on a secret ballot election, the employers will accept a union victory if a majority of employees sign cards asking for union representation.

Although still uncommon, card check neutrality agreements are becoming a much more crucial tactic in union organizing campaigns.  Such agreements give unions a much better opportunity to make their case and ensure that employees are not coerced by employer threats.  The question with these agreements always is: why would employers agree to these conditions?  The details about this agreement -- or lack thereof -- present an interesting story.

We don't really know why the employers went along with the agreement.  It includes a confidentiality provision, so the parties aren't talking on the record.  According to other union leaders, the Houston employers were pressured by building owners and pension funds into signing the agreement; in addition, sympathy strikes in other cities played a role.  Government officials, such as the mayor and several congressmen, as well as members of the clergy also pressured the companies to remain neutral.  According to the NYT, the Catholic archbishop told janitors at a union rally that "God was unhappy that they earned so little and did not have health coverage."

The Times report may be premature; this Houston Chronicle article reports that there has been no determination that the union has gotten the necessary majority.  But a union victory wouldn't be a surprise.  The Chronicle quotes Bill Bux, head of the labor and employment law section for Locke Liddell & Sapp in Houston, who represents several building owners that hire cleaning companies.  "I thought they'd have the cards signed within 30 to 60 days.  How hard can it be to get people to sign a card with all the cooperation they're getting?"

Is this organizing drive an isolated story?  We don't know exactly how the union persuaded these employers to sign up.  But two factors likely predominated.  First, the agreement encompassed the five big players in the market, thus removing labor costs from competition.  While unions can no longer do this at domestic manufacturing firms, there may be some services that cannot be farmed out to foreign workers.  Janitorial work is one example.  Second, community pressure seems to have played a significant role here.  Unions are likely to get more community support when they represent poorer workers, such as janitors or migrant laborers.  That may mean these tactics are not available for unions looking to represent middle-class employees.

In this article Jim Brudney persuasively argues why card-check neutrality agreements should be the wave of the future.  But I've always wondered why employers would ever agree to them.  Although the parties aren't talking, I hope further details emerge so we can understand exactly what is happening in Houston.

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This was one of the squibs that greeted me on today's W$J:

Sony will cut 10,000 jobs, or more than 6% of its global work force, and reduce costs by $1.8 billion by early 2008, in an effort to bolster its ailing electronics operations.

I get the concept, but does it strike anyone else as incongruous? Cut = Bolster?

In other unemployment news ...

• "Delta plans to slash up to 9,000 jobs and cut employee pay as the airline tries to achieve an additional $3 billion in annual savings under bankruptcy protection."

• "Initial jobless claims rose to the highest level in two years last week, as workers continued to file for unemployment compensation in the wake of Hurricane Katrina."

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Yesterday Steve Barley of Stanford spoke to our group at the Initiative for Studies in Technology Entrepreneurship (INSITE). Steve has just published a book (with Gideon Kunda) entitled Gurus, Hired Guns, and Warm Bodies: Itinerant Experts in a Knowledge Economy. This is an ethnography of highly skilled contract workers in Silicon Valley. The purpose of the book is to provide a rich description of these contingent workers, examining their motivations for leaving the world of permanent employment (they are, after all, almost all contract workers by choice) and the motivations of employers for hiring them (as you might expect, the bottom line is the bottom line: it's all about saving money). The talk offered an enticing glimpse at employment practices in modern corporations, but I was struck by the superficial acknowledgement of law in this account. Of course, many of the employment practices that Steve described are driven at least partly by law -- or perceptions about law on the part of human resource managers. My comments are not intended as criticisms of the work -- the authors are talented and respected in their field -- but rather as observations about the value of interdisciplinary work. Indeed, Steve expressed (without prompting from me) an interest in learning more law, which he said was "underappreciated" in his field. So, if you are a management scholar, take a lesson: find a law professor who seems open to interdisciplinary work and make friends.

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Madison is in the middle of an active debate about the minimum wage. The city council has been debating a proposal to increase the minimum wage in Madison from $5.15 per hour to $7.75 per hour. The local newspapers are involved. See here and here. This Saturday, the Law School leaps into the fray with a program entitled "DO HIGHER WAGES EQUAL UMEMPLOYMENT? The Living Wage Debate: Just a Theory or a Growing Reality."

The positions are familiar: proponents argue that minimum wage employees need to earn a living wage, while opponents contend that employers will reduce hours or fire employees to shave excess labor costs. An additional wrinkle here is that Wisconsin Governor Jim Doyle is advocating a statewide minimum wage (though he has rebuffed the legislature's attempt to constrain municipalities).

As you might expect, the facts about the effects of a minimum wage hike are less clear than all of the participants in this debate would have us believe. This is not a particular area of expertise for me, so I will tread gently. A recent study of data from Brazil observes wage compression in the wake of a national minimum wage. In addition, the study finds that a minimum wage increase "does not always have a significant effect on employment and it is not always negative." Both the compression effect and the employment effect seem generalizable beyond Brazil. But do they translate to localized minimum wages?

One thing that seems obvious to me -- and is part of the motivation for Governor Doyle's proposal for a statewide minimum wage -- is that Madison will place itself at a competitive disadvantage vis-�-vis surrounding communities if it raises the minimum wage. Several communities, including my home town of Middleton, are well situated to attract businesses that are not captive to Madison, including restaurants. We will welcome them with open arms.

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Rob the BusinessPundit has discovered an eternal truth: "the profits belong to those who take the risk, not those who do the work." He is starting a new company, and he argues that his employees aren't taking a risk: "If we can't make it, they will simply move on to another job. They won't owe a bank huge sums of money, they won't have lost tens of thousands of dollars of their own hard-earned cash. So from this perspective, who should the profits go to if there are any?" Of course, this is overly simplistic in that employees are taking a risk, too, when they join a startup firm. Moreover, what is stopping Rob from simply moving to another firm if this one fails? Nothing, really, but that isn't what concerns him. What concerns him is the burden of ownership. In examining this burden a little closer, we gain more insights about how profits are allocated.

Taking a cue from "Why Not?", let's try flipping this. Instead of asking who is entitled to the profits, let's ask who is most likely to maximize profits? (After all, from a societal standpoint, maximizing the residual claim maximizes value creation, and we generally like value creation.) On the one hand, anyone who has a claim to the profits will want to maximize them. On the other hand, the only person who has a chance of success is the person who controls the firm. Here is a kernel of insight: profits attach to residual control.

So, sign me up for some residual control!

Well, maybe I failed to mention that people can exercise residual control only by "purchasing" the right (not necessarily from another person, but by exposing oneself to substantial personal loss). This is where the notion of risk comes into the picture. If control were cheap, everyone would want it (which, of course, would cause the price rise ... so that was a silly game, wasn't it?). Residual control is expensive relative to other forms of participation in the firm.

Requiring entrepreneurs to take this step of puchasing residual control acts as a defense against adverse selection: people who know that they have limited competence would not be willing to purchase residual control because the costs of failure are too high.

Viewed this way, risk is a natural consequence of the need to link profits to control. It becomes effect rather than cause.

UPDATE: I wrote this last night (early this morning?) and failed to mention that I am not attempting to tell the story from the entrepreneur's point of view. That story would go something like this:

Entrepreneur discovers an opportunity that she wants to exploit and forms a firm to do just that. The firm needs employees, suppliers, investors, etc. As they divvy up the claims against the firm, the entrepreneur sells the fixed claims first. This is partly because the entrepreneur wants to retain the residual claim (because it has the most upside) and partly because the other participants generally do not want the residual claim (can you imagine an employee agreeing to pay the owner first, then taking whatever is left over?). This leaves the entrepreneur in control and holding the residual claim, which is the riskiest claim. Make sense?

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Earlier today I had a long conversation with one of my students, a scientist who had participated in the founding of Madison's most prominent biotechnology company. After working as a bench scientist for many years, she became an entrepreneur in the early 1990s, and now she is studying to become a lawyer. She had some interesting thoughts about employees in a technology startup.

In a word: paranoia. She now works as a consultant for startup companies and claims to see the symptoms in (almost) every firm. When the firm is formed, the founder(s) and the early venture investors claim the largest stakes. They reserve smaller pieces of the pie for future employees. Those employees -- often extremely talented scientists -- are introduced to a world that is foreign to them. Their subsequent interactions with business people, particularly venture capitalists, are confusing and alienating. Despite their efforts, their share of the company recedes with each round of financing. Even he language of their claim against the company -- "common" stock, as contrasted with the "preferred" stock held by venture capitalists -- reinforces their sense of vulnerability.

The most interesting part of the story is that the employees' sense of paranoia manifests itself in myriad ways, sowing contention throughout the firm. While law and finance professors stand aloof, assuming that equity compensation will work its magic, the firm rots from within. (OK, I took a bit of dramatic license on that last part, but you get the idea.)

According to my student, the solution here is honest communication. The problem resides in the distrust that grows from lack of understanding. The scientist-employee needs some training in the ways of finance, law, and business. Interesting thoughts.

A question for my readers: does this resonate?

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