I once read the idea that companies (firms, corporations, etc…) can be thought of as a fictional story that is made up by society and, in essence, are a set of beliefs shared by all the members. Those beliefs are codified as contracts between various entities — employees, owners, suppliers, customers, regulators, etc. And in essence, there are a rather limited number of combinations of those contracts in use today.
And I am thinking — why does it have to be a limited number? Permutations of how people could contract with each other could be endless. And certainly more than just LLC and partnership and business corporation. I want to explore possibilities around that idea in this article.
All the members of society have agreed that something imaginary like a company exists and it is a thing, and it follows some rules and is allowed to do this or that as if it were a human being. Many smart people have thought about this idea over the centuries, and no wonder that there is even a term for it — “legal fiction.”
It is easy to imagine the history of this legal fiction. At first, there were partnerships between people, where several entrepreneurs teamed up, pooled resources, and then shared the spoils of some venture. Contracts between partners evolved in complexity and length and became more permanent. Later, various regulations were imposed from the top by various governments on what activities can be done and how.
Various levies, fees, and taxes were raised already on a shared entity, not on each separate person. And this, in turn, required the government to recognize the company as a separate legal entity.
A major step in the evolution of companies was the invention of limited liability firms, where owners and investors were not risking all of their assets. Instead, their liability was limited by whatever capital they had officially invested in the company. This led to an explosion of entrepreneurial activity as companies could now take risks without a chance of complete financial ruin for owners and their families.
After a while, more types of firms evolved, and each took a separate niche in how risks and rewards are handled. (Names of the types vary greatly across the world as well as exact definitions)
- Sole entrepreneurs. Governments needed some way to allow a single person or household to do simple variations of business activity without too much oversight and bureaucracy, but still with the possibility of doing proper accounting and taxing.
- Full partnerships. In some cases going all in and having each founder of the company fully liable with all their assets was still the best choice of how a company could exist and grow.
- Limited Liability Corporations. As defined above, each owner risks only with the assets that are added as a part of the capital when founding the company. Possibility to do risky projects with high possible rewards. The most common type of company in the world.
- Publicly-traded corporations. For the larger public to participate in the limited liability corporation’s risk and reward formula, ownership needed to be spread wider. This brings even more possible rewards, as more capital allows to build bigger companies. But it also brings extra risks of potential small shareholders being defrauded by the original owners or managers. To offset this risk, companies of this type are more regulated by the government.
If we look at most of those types of corporate setups, then they all differ mostly on two dimensions— on the amount of liability that owners have and the level of regulation that this requires.
On the liability dimension, much of the differences were visible in the list above. However, there can be even more aspects to it. In some countries, investors are required to provide collateral to create a limited liability corporation. In some cases, the amount of liability can depend on the industry that the firm is operating in. There is also liability insurance that might be required to do any business in some areas.
On the regulatory dimension, there is also much more regulation possible than described before, especially in the case you want to open a very risky or very impactful business. Like a bank. Or a weapons factory. Or distillery. Licenses you will need to get, reports you will need to provide, and audits you will need to endure will approach the infinity in some of those businesses.
However, on the other dimensions, they are all very similar. They need to employ people in much the same way, they need to distribute profits in the same way, they need to deal with competitors predictably, and they need to contract suppliers similarly.
And as those extra dimensions become more regulated, there is a natural tendency for startup founders to try and disrupt the status quo by using technological inventions to do something differently. And this is where we see that current legal fiction is breaking down and is struggling to support the innovations.
A typical case is Uber. Changing the dimension of employment. Instead of heavily regulated employer-employee one-to-many relationship or company-supplier one-to-few relationship, they choose the one-to-many company-gig-worker approach. That approach gave enormous benefits to the company as they could avoid a large amount of regulation and liabilities brought in by the classical employee relationships. At the same time, the company’s relationship with the newly minted “gig supplier” was dominant in a way that they would never get if they would deal with other classical companies, not gig workers, as their suppliers.
Of course, they would argue that innovation lay in the ease of getting a gig-work for people, thus improving their chances of earning a living, as well as automatically balancing supply and demand in the ride-hailing market, thus improving the deal for millions of consumers.
That is true enough. But employment contract dimension was disrupted. And around the same time, the same disruption was performed by many other companies in the “gig economy,” applying the same principle to different industries and areas of life.
I don’t want to discuss the pros and cons of this particular disruption. Instead, I want to look into possibilities of even more radical disruptions and with less clearly visible winners and losers. Less collateral damage to society, more win-win to all participants.
To begin this thought experiment, we should imagine a company that is sitting in the middle of the complex web of contracts that it has with different entities. Those contracts (contracts in the widest possible sense of the word) can be categorized into the following types:
- Regulatory contracts with the government. With the tax agency, regulatory body, lawmakers, municipal authorities, courts, police, etc. With some of those entities contract is explicit —for example, when creating a company, both sides put a signature on a piece of paper. With some, it is implicit — laws are expected to be followed regardless of what the company thinks about that. And with some, it is tangential — police don’t get involved in the normal daily operations of your company unless something unexpected happens.
- Supplier contracts with other companies. For the company to create value, it requires other companies to provide resources, land, and technologies. Or, to put it simply — goods and services.
- Employee contracts with people working for the company. Those types of contracts are related to the supplier contracts but are regulated very differently and have different moral aspects as well.
- Non-government regulatory contracts. A typical example is a Labor Union, which provides collective bargaining power for employees. But there are also others — standards bodies, trade organizations, industry lobby groups, and similar.
- Customer contracts with other companies or directly with consumers. Either explicitly signed contracts or implicit obligation that the goods or services provided by the company are of good enough quality and are performing as advertised.
- Investor contracts with the owners of the company and other, bigger and smaller investors who have provided initial capital or another type of launch boost for the company and are expecting different kinds of returns.
The company sits in the middle of those contracts and builds a nest of value. Value depends on the strength of many of those contracts, and often it is government contracts that are keeping the value intact. The government does that by providing protection for intellectual property. Or protection of property in general. And by providing laws and courts to make all other contracts enforceable and working. Without this, value creation would be much more complicated, if not impossible.
At the same time, as we have discussed before, some subset of this contract type can also be destroyed to create value in some situations. A quite dangerous proposition, if you ask me, but nevertheless part of the equation. And sometimes necessary for the evolution of society.
We have also seen companies try and innovate by combining employee and customer contract categories, but this has mostly ended up with results that are borderline criminal and are generally frowned upon. I am talking about multi-level marketing and various other pyramid-like structures, where employees and customers are one. However, there could probably be other ideas in this space that would end up being less toxic.
So, what could be the new type of legal fiction that could build this nest of value in a different way? I am thinking about combining the investor contract class with the employee and customer contract classes.
The simplest way how to do it would be to create some entity that has a start and an end. Where some set of customers come together, create contract among them, where they invest money, provide some labor, and then share the spoils. This type of setup has been seen with the shared financing of real estate projects or some joint venture firms.
Unfortunately, this setup doesn’t really work for our thought exercise, as there is no new engine of permanent value creation. A new type of company needs to be more permanent. That is how to multiply all the value that various contracts built into newly created wealth, instead of just executing a single venture once and getting the return once.
A better way would be to combine investors and employees. In essence, making employees own the company. This has obvious downsides — if there is extra capital required, then employees are unlikely to be able to provide it. Also, employees tend to quit, and new ones tend to be hired over time. Managing classical equity of company shares for this type of ownership would quickly become a nightmare. Legal nightmare.
Investor plus customer contracts we have also seen being directly disrupted by the crypto ICO craze several years ago. Did not end well.
To truly innovate, we would need to rethink contracts themselves. Let’s take employment contracts first. There are many versions, some more protected (with unions), some less protected, and some with very weak protections (temp workers, terminated contracts, and similar). Yet all of the contracts have a similar core structure — fixed income in exchange for fixed labor, which feeds into the company’s larger value engine.
There have been many ideas of making the “fixed” portions of that formula more flexible. How to pay bonuses for extra labor, reward better quality, differentiate payment based on contribution in short and in the long term, and so on. All those methods are just an approximation of the true value of an employee’s contribution. And always skewed to favor the company’s side of the deal and, by proxy, the shareholders. This is to be expected, as the main purpose of the classical company is to create a return for investors.
One way to innovate in this dimension of contracts would be to create employment contracts tied to company results. And to avoid short-term thinking and too large long-term liabilities, the connection should be made between current labor and specific period of future returns.
For example, I am working in a company that produces some goods. I sign this neo-labor contract, and at the end of each month, I get a check for, say 3000 dollars, that I bring home. This sum is lower than the average salary for my position. But to compensate for that, I also get a profit share certificate from the company — the percentage of all the profits that the company makes is going to be distributed to me, with the approximation of additional 1000 dollars per month, which brings my salary on par with the industry average. However, this distribution is not going to happen right now, it is going to happen two years from now on the same month. If profits go up, my share will increase as well. And it will happen regardless of whether I am working in the company or have already left.
Basically, each month, in addition to the salary, you would get a certificate of profit share that has a maturity date in the future. And you would get to keep it whatever happens. It could even be inherited by your loved ones, in case you meet the proverbial bus in unpleasant circumstances.
Supplier contracts could be reimagined in a similar fashion. Suppliers are selling their goods and services with a strict profit margin to meet their profitability goals and keep their companies afloat. But what if our innovative company would offer them to provide their services at a cost, or at least with a significant discount, in return for a chance to participate in a profit share?
Doesn’t sound ambitious enough? What about offering expensive management consultancy firms to pay partially from the gains that the company is supposed to get from implementing their suggestions? And make the payment deferred to the future when the profits can be properly calculated.
This type of supplier relationship management would boost efficiency significantly as companies who are great at sales, but whose products and services are mediocre would not be able to compete anymore. The focus would shift from the PowerPoint excellency to delivery and execution.
Customer contracts could get a boost if somehow more trust could be injected into the relationship. For example, if my mobile phone company would sign a contract with me promising that they are going to charge me exactly the costs of goods sold+ fixed margin. And if they will manage to reduce the costs on their side, then the savings will be automatically passed on to me.
Of course, as a consumer, I would be in no position to verify that. And mobile telephony services, as well as many other types of services, have it notoriously difficult to split fixed costs from variable costs to create proper costs of goods sold. They need to keep continuously investing to stay relevant, and they need to maintain dozens of other complex contracts to keep the value creation engine running.
Carving out some specific and automatic customer contracts related to the cost would be quite difficult. But not impossible. Especially if you would create a new company from scratch around the idea.
Benefits to the company, in this case, would be the ability to build much longer customer relationships, bringing down customer acquisition costs, which are very large in any service industry. This, in turn, would lead to lower prices—the virtuous cycle of game theory.
Also, there would probably be various secondary benefits of increased trust between the company and its customers.
So, if you are a startup founder, or you are just thinking about starting a company, I hope that I could give you some new ideas on how to differentiate yourself. You could become the proud owner of the new Uber or AirBnB by innovating on the contract design, not only on the product itself. Good luck!
While you are here, please check out my new book “The Invisible Complexity.” (note that for shipping to Europe, it is better to use the amazon.de site instead. And the same goes for UAE — use amazon.ae site.)
The book is going to dive deep into the questions you have been too afraid to ask in the domain of enterprise IT. Why exactly do those big projects fail? Why do business and IT people keep fighting? Why is it always so depressing to talk about corporate technology?
There is no single answer, but most of the ideas I provide in the book lie in the intersection of human psychology, economics, and technology. the way how goals are set, how people are incentivized, as well as various psychological biases. All that multiplied by various software architecture antipatterns create a ton of material for thought and have resulted in ten chapters of great content.
post scriptum. In 2021 we have seen the rise of DAO — decentralized autonomous organization. The way how blockchain can be used to establish smart contracts between parties in a decentralized manner. This technology could certainly be used to try out some of the ideas mentioned in this article. It is however in no way mandatory. Simple contracts drafted by lawyers would suffice. They can be digitally signed, though.