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Stakeholders

Guide to Understanding Stakeholders in Corporate Finance

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Stakeholders

Types of Stakeholders: Definition in Corporate Finance

Under the context of corporate finance, the term “stakeholder” is defined as an individual, group or institution with a vested interest in a corporation.

The long-term sustainability of a corporation to continue to generate profits and achieve operational success is tied to its ability to manage its relationships with its stakeholders.

Thus, the business decisions made by the management team running a company should consider the impact on its stakeholders (and their reaction).

In particular, a corporation’s key stakeholders consist of its employees, suppliers, lenders, and shareholders, among others.

Each stakeholder type possesses a different role and unique contribution to the underlying company, but the groups combined play a critical role in determining the success (or failure) of the corporation.

The long-term success of a corporation is therefore a byproduct of management’s ability to work alongside all stakeholder groups to strategize around future value creation.

Certain stakeholders such as shareholders can vote on crucial issues at meetings and offer practical insights to support the company, whereas banks and institutions can contribute debt capital to finance the company’s existing and future projects.

Internal Stakeholders vs. External Stakeholders

Generally speaking, stakeholders can be categorized as either “internal” or “external”:

  1. Internal Stakeholders → The parties with an interest in the corporation characterized by a direct relationship, e.g. employees, owners, and capital providers such as investors.
  2. External Stakeholders → The parties that lack direct interest in the corporation, but are nonetheless still affected by its actions and outcomes, e.g. suppliers, vendors, community and the government.

In the case of internal stakeholders, the parties mentioned are those directly involved in the day-to-day operations of the business, or that have provided the necessary funding that financed the company’s near-term working capital needs and capital expenditures.

Over the long run, practically all companies must raise either debt or equity capital to continue growing and reach a certain scale.

Growth comes at a price and rarely can re-investing cash flows perpetually support all of a company’s spending, e.g. working capital spend, routine maintenance, or growth-oriented expenditures. Thereby, mature companies at the back end of their life cycle tend to have more complicated organizational structures.

Given the role of internal stakeholders in a company’s day-to-day operations, the ability to coordinate cohesively and work in conjunction toward achieving the company’s goals is crucial.

On the other hand, external stakeholders are less integrated into the company itself, yet are still impacted by its decisions to a significant extent. The most frequently cited examples of external stakeholders are suppliers, vendors, society and the government.

External stakeholders might not have the same amount of involvement as internal stakeholders, but neglecting these groups would quickly become a costly mistake. For instance, the U.S. government and regulatory bodies are not directly engaged in the operations of a company, but their regulatory policies can change the trajectory of a company entirely.

Internal Stakeholders External Stakeholders
  • Employees
  • Suppliers and Vendors
  • Management Team
  • Creditors (i.e. Debt Financing)
  • Board of Directors
  • Customers, Society and Local Community
  • Government and Regulatory Bodies

Stakeholder Theory — Dr. Ed Freeman (UVA)

The origin of the stakeholder theory is credited to Dr. F. Edward Freeman, a professor at the University of Virginia (UVA). In Strategic Management: A Stakeholder Approach, Freeman makes the convincing case that the decision-making of corporations should be done with all stakeholders in mind, instead of solely shareholders.

On the contrary, the premise of the shareholder theory states that a corporation’s fiduciary duty is to benefit its shareholders, wherein the core objective is to ultimately increase its share price in the public markets. But Freeman stressed the importance of corporations making decisions based on the guidance and interests of all stakeholders in mind.

The recommendation is for management to consider all stakeholder groups, as opposed to a single-minded focus on shareholders (and the market share price).

Over time, these types of views have gradually become increasingly accepted as demonstrated by companies nowadays becoming more socially informed and following trends such as environmental, social, and corporate governance (ESG).

In short, a rising share price by itself is NOT indicative of a strong business model nor a solid foundation for long-term success. Corporations should thus strive to optimize their relationships with all stakeholder groups — not just its equity shareholders — and build their trust to improve their operating efficiency and value-creation.

Stakeholder Theory -- Ed Freeman (UVA)

About Section (Source: Stakeholder Theory)

Importance of Stakeholder Management (and Engagement)

Constant engagement with stakeholders is a necessity in business to ensure relationships are managed effectively and maintained over the long term. However, merely listening to them is not sufficient in most cases, as the management team must actually implement their feedback into their decisions to prove their opinions are indeed valued.

Of course, not all stakeholders are entitled to the same level of influence over the corporation’s decisions, which is the reason that companies must prioritize their stakeholder groups (i.e. “mapping”) rather than attempt to fulfill their demands all at once.

The ability to weave through contrasting opinions stems from understanding each stakeholder’s specific desires and communicating their reasoning to ensure it is not perceived as preferential treatment.

In fact, trying to cater to all stakeholders without striking the right balance would be counterproductive, i.e. “A person who chases two rabbits catches neither.”

Since each group will have different priorities based on their own self-interests, each decision by the corporation must balance the trade-offs appropriately to achieve the desired outcome, which requires sound judgment following an objective analysis of the situation on-hand with thoughtful communication by management.

Simply put, an attempt to appease every stakeholder is ineffective and any rational stakeholder must understand that there is a hierarchy in terms of the weight of their opinion (versus those of others).

At the end of the day, the corporation’s financial results and having strategic communication to justify each decision is the determinant of whether differences in opinions become problematic.

Generally, managing relationships with external stakeholders tends to be relatively easier than with internal stakeholders, but conflict can cause substantial operational disruption to a company’s operations such as its supply chain. For instance, imagine the monetary losses and inefficiencies incurred by a company if a key supplier abruptly decided to no longer offer its services to the company.

Stakeholder vs. Shareholder: What is the Difference?

One common misconception is that the terms “stakeholders” and “shareholders” are interchangeable. However, the statement is misguided because shareholders are only one among numerous other stakeholder groups in a corporate setting.

Shareholders own an equity interest in the company, i.e. a partial ownership stake, but equity is NOT required to possess an interest in a corporation and be affected by its operational decisions.

For instance, the local community where a corporation is located is impacted by its decisions, irrespective of the fact that there is typically no equity interest. Suppose the corporation was engaged in behavior with negative effects on the community’s environment and safety, such as air pollution. The members of the community could gather and protest the company’s practices and pressure the company to alter its actions.

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