WEBVTT

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Prof: Think back
to--this is meeting six.

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It's about the rise of the
joint stock corporation.

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The joint stock corporation is,
without doubt,

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the most important institution
in the world economy today.

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Its only rival might be states
or governments,

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but it is just a massively
important thing.

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The question of how it got here
and why it takes the form it

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does is our topic today.

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Let's begin with Adam Smith.

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Would somebody--would one of
you guys go up there and get

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that on slide one slideshow and
I'll rejoin it when we get

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there?

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Adam Smith, in talking about
the invisible hand,

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is also at length to say that
the productive use of the

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division of labor kicks in only
when you get big markets,

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only where market scale
justifies an elaborate division

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of labor and a large investment
of capital,

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do you get the benefits of
capitalism, really.

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In tiny markets where you're
making,

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for example,
clothing for others in a

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village of a thousand,
the possibility of a

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sophisticated manufacturing
scheme which--

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>

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--somebody who knows this stuff
please do this.

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Navigator.

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Get it into navigator and then
onto slide one and play

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slideshow and we're set.

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So Smith talks about scale of
markets,

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and the great limitation on
scale of markets until the early

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1800s was the poor quality of
land transportation.

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Ocean transportation had by
that time gotten pretty good.

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Sailing ships had gotten better
and better in the three or four

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hundred years before 1800,
and steamships had improved

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that.

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But--I'm going to skip some
slides--

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but the great interior of all
the continents still relied on

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transportation systems,
none of which were superior to

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a horse.

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The cheapest form of
transportation was canal

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shipping where the motor power
was essentially a horse on a

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draw path next to the canal.

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Then beginning in the 1820s and
accelerating decade after decade

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into the 1860s,
the railroad took over.

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For the first time ever one
could move freight vastly faster

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than a horse,
and vastly cheaper than any

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previous means of
transportation.

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The cities grew up initially at
the intersection of ocean

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shipping, coastwise shipping,
and canals.

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They grew up because there was
always an economic advantage to

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being at the junction point
between the main systems of

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transportation.

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Rail took this and raised it by
many powers.

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The American Rail Network,
this is a simplified map Rand

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McNally from 1944,
and it's about passenger rail.

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The real density of the U.S.

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rail network is about five
times what this suggests.

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That density created exactly
what Adam Smith contemplated:

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a gigantic market where the
division of labor could be

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refined to a much higher level
than ever before.

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One result of that--this is a
contemporary map of greater New

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York, and the coloring is
dollars of earned income per

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square mile.

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The densest places,
right around in here,

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reach past ten billion such
dollars per square mile.

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The great cities of the world
are invariably ones today which

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enjoy powerful rail
transportation,

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generally supplemented by water
transportation.

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But rail, and New York's
extraordinary advantage as a

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gateway to the interior of the
United States,

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by water first up through the
Hudson and then across the Erie

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Canal to the Great Lakes,
and then beginning with the

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1840s, a fabulous deepwater
harbor for shipments to the rest

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of the world connected by rail
to the entire continent.

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The double challenge faced by
railroads,

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two things, one they were very
expensive to build,

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so finance capital,
raising large amounts of money

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in order to construct railways,
was one challenge.

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In some senses,
an even greater challenge was

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actually running a railroad.

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It turns out that railroads get
inordinately complicated after

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they get big.

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When they are one section of
about forty or fifty miles,

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railroads are actually not very
complicated things to run.

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But when they get to be
hundreds or even thousands of

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miles, the logistics of
management get extremely

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challenging.

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So you have two challenges;
one is finance,

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the other is operations.

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Let's start with operations.

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In the nineteenth century train
collisions occurred at rates

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varying from about 400 to 1,000
a year in the U.S.,

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and they were often ugly,
and they reflected the

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challenge of management.

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This is a simple one section
rail that operated in the 1840s

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and 1850s between Boston and
Worcester, Massachusetts.

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Almost all the railroads built
just one track.

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The question was:
How do you run trains back and

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forth between these two cities
without collisions?

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The solution,
it's in Chandler,

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that these people had was to
instruct the engineers of the

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trains beginning at the two end
cities to proceed to Framingham,

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and one turns--and each take a
right turn so to speak--

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and sit there until the other
train is in view.

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After the other train is in
view and stopped,

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proceed to the end of your
journey.

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Pretty simple management.

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And that railroad had only
about fifty employees.

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It was four trips a day,
and a very simple thing.

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Characteristic of capitalism is
that people are not content with

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small success.

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Therefore, they try to string
together many short railroads on

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the theory that average cost
will decline as scale of

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operation increases.

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The New York Central System,
which was the glitziest of all

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the railways at its peak,
it's peak coming roughly from

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the period of World War I to the
end of World War II,

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this railroad was created by
splicing together dozens of

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little railroads.

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The Mohawk and Hudson ran
between Schenectady and Albany,

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and it was the kernel from
which this was formed.

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It's one aggregation after
another,

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and the construction of that
marvelous terminal in midtown

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Manhattan which we're all
familiar with,

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and ultimately,
after the thing reaches the end

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of its competitive lifecycle,
and the New York Central

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Railroad was essentially at the
end of its competitive lifecycle

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by the 1950s.

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It was there because?

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What was hard on railroads?

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What was hard on passenger
railroads?

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Long haul passenger railroads?

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This is a soft pitch, guys.

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Yes.

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Student:  Introduced the
highway system.

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Prof: Highway system.

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And on freight,
what was the big competitor

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over land?

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Student:  Interstate
highway.

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Prof: Okay,
so the interstate highway

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system with trucking and
ultimately de-regulated trucking

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which was much more efficient,
the competitive position of

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railroads seemed to be terminal.

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And the Pennsylvania Railroad
and the New York Central were

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combined in a bankruptcy
proceeding in 1968 to form The

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Penn-Central System,
which soon went bankrupt,

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and it went bankrupt because
the two managements hated each

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other,
and each did as little as

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possible to help the other
succeed.

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The--this idea of a mortal
lifecycle of the corporation is

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one which comes up again and
again.

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A week from today we'll do the
Polaroid Corporation which

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begins as a brilliant innovative
firm and ends up playing defense

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against other more brilliant,
more innovative firms,

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only a generation and a half
after it began.

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What really happens with
railroads if you don't know how

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to run them,
and the early railroads nobody

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knew how to run,
was that as the railroad scope

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or scale got larger,
average costs actually went up.

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The reason they went up was
that you had to build a mammoth

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bureaucracy to run the thing.

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The Pennsylvania Railroad got
to 50,000 employees fast.

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The challenge of how to
organize that large workforce

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became severe.

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The first cut was spatial,
without the kind of

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surveillance and information
technology we have today,

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they had the telegraph fairly
early on and that's all they

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had.

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The control over a massive
network--

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this is The New York Central
System--

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meant that they cut the system
into sections and created a set

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of authorities within each such
section.

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The ones I've drawn here in red
are merely illustrative.

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Then there was a division of
function.

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There were people who worried
about railroad cars.

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There were people who worried
about track.

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There were people who dealt
with passengers,

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others with freight,
finance, cost accounting,

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human resources,
and so on.

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So you have all these
functional stripes--

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all this is Chandler,
and I'm just simplifying what

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he says--
these functional stripes,

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and then you've got the
geographic sections,

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and the question becomes,
what do you with the

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intersections?

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The fundamental administrative
question was,

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do you let the functional
groups boss the geographic

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groups around,
or do you let the geographic

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groups boss the functional
groups around?

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What ended up happening was
this pattern,

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which ultimately gives priority
to the geographic groups.

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It creates enormous power at
the top in general management.

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And the top people in American
railroad, who were very well

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compensated, often took on
ownership stakes,

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and were true big shots.

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The functional people operated
as staff to them;

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the people who did accounting,
the people who did finance,

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the people who did
construction,

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maintenance,
and rolling stock and so on.

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Then there were several tiers
of specific managers,

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superintendents with
responsibility for geographic

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areas,
and they too had functionally

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divided staff--
people to worry about the

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rolling stock,
the track, the construction,

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etc.--and the pivotal decision
makers were always the people

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with a geographic focus.

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They were the ones who had to
take all the factors,

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all the functions together,
and make the thing work.

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They became the first general
managers of the modern

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description that MBAs are
training for.

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It's essentially the origin of
the managerially operated joint

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stock corporation.

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The Europeans used a different
pattern, which gave priority to

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the functions,
and by and large,

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the American system worked
better.

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Now why are European trains so
much better than American trains

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today?

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Anybody know?

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Let's hear.

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Student:  Socialism.

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Prof: Socialism!

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Okay, yeah socialism is part of
it.

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Please elaborate;
let's get from one word to ten.

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We got a mic?

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Student:  People seem to
be more comfortable in states in

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the Eurozone with diverting
taxpayer money to public

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project,
such as infrastructure.

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Prof: Okay,
this is particularly true of

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continental Europe I think.

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Where the trains have become,
in many, not quite all cases,

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publicly operated systems.

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There's another reason,
there's a historical reason.

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Student:  The price of
gasoline.

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Prof: Price of gasoline,
that's another point.

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I hadn't actually connected the
dots.

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Gasoline there is roughly two
or three times what it is here,

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so passenger train for short
and middle sized runs makes a

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lot of sense.

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Big historical event, yes?

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Student:  They didn't
really have--the interstate

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highway kind of bloomed.

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Prof: Say again?

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Student:  Like they
didn't have like a highway

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system or
>

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Prof: Okay,
I think--well some of them did.

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I mean the German Autobahn was
pretty impressive,

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even if the Nazis built it,
it was pretty good highway.

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What I'm fishing for here is
World War II.

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World War II destroyed the
European rail system,

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and because it was destroyed,
and because of the U.S.

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Marshal Fund,
which paid for an awful lot of

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reconstruction,
they started more or less from

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scratch and made the thing work.

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We had this higgledy-piggledy
remnant of a previous period,

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and never really made the
investment by socialism or

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capitalism.

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The challenge of finance was
equally important,

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perhaps more important.

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Historically,
projects that involved high

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capital investment were funded
locally.

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People made investments within
small circles,

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within one city,
within the people who lived

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next--
the zone where people living

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next to a canal or a segment of
a canal would,

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in effect, buy bonds and
finance the thing.

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Railroads were catastrophically
expensive, they sucked up vast

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amounts of capital,
and so a device as in this

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bridge, the Eads Bridge in St.

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Louis over the Mississippi,
there were hundreds,

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even thousands of terrifically
expensive construction projects

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to be financed.

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The mechanism chosen was the
joint stock corporation.

18:36.980 --> 18:43.330
The forms of funding were of
two main kinds,

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I'm going to get to some detail
in a minute.

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One were railroad bonds where
people in effect loaned money to

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the railroads and achieved a
predictable income,

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relatively predictable income,
from that investment in debt.

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The other was the joint stock,
where you bought into the

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equity of the company and became
a partial owner.

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This is a world railroad grid,
and I'd like you to just in

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passing notice the very uneven
density of it,

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and the fairly strong
correlation between the density

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of the railroad grid and the
wealth of the place.

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The railroads were both cause
and effect of capitalist

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development.

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Where there were railroads,
there was capitalist

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development, where capitalist
development, railroads.

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And colonialism had odd effects.

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Africa's railway system got
developed not so much to create

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internal markets as to get goods
quickly and efficiently out for

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shipment to the metropolitan
power,

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which controlled the
colonization.

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Now a chart, the dreaded chart.

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And here we have on the
vertical dimension three major

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forms of ownership.

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Indeed, these are the three
most important forms of

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ownership.

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Proprietorship means outright
ownership.

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You just own it, end of story.

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Partnership means what it says,
and interestingly,

20:44.118 --> 20:46.788
and for reasons you'll probably
figure out by the end of the

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hour if you don't know it
already,

20:48.470 --> 20:53.470
partnerships tend to be used in
a certain kind of company.

20:53.470 --> 20:59.090
It's a company where the value
of the firm consists largely in

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the talent of its employees so
that the big consulting firms,

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the big investment banks,
the big law firms,

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all take the form of
partnerships and they are--

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and that actually changes and
one of the HBS cases you're

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getting is the one where Goldman
Sachs ceases to be a partnership

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and becomes a company.

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And of course third,
the joint stock corporation.

21:28.740 --> 21:34.950
Then we look at each of these
with the five considerations

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across the top in mind.

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One is, what's the
accountability chain here?

21:40.380 --> 21:42.060
How do we keep people doing
their job?

21:42.058 --> 21:45.438
How do we see the difference
between a job well done and a

21:45.442 --> 21:46.512
job poorly done?

21:46.509 --> 21:53.159
The second is the role of
ownership and the third is

21:53.163 --> 21:54.733
liability.

21:54.730 --> 21:57.870
Every one of these is a huge
factor in understanding this.

21:57.869 --> 22:00.969
The fourth is liquidity.

22:00.970 --> 22:05.660
If I own something or a part of
something, how easy is it for me

22:05.657 --> 22:06.697
to sell out?

22:06.700 --> 22:12.140
Finally scalability;
to what extent can we start

22:12.140 --> 22:16.030
with something small and grow
something enormous?

22:16.028 --> 22:19.868
The three forms vary
importantly in each of these

22:19.865 --> 22:23.295
five dimensions,
and I'm afraid I'm going to

22:23.301 --> 22:25.381
walk you through them.

22:25.380 --> 22:29.830
The chain of accountability in
a proprietorship is pretty

22:29.834 --> 22:30.554
simple.

22:30.548 --> 22:33.638
I own it, I run it,
I'm the boss.

22:33.640 --> 22:38.130
I hire and fire the employees,
I make the business decisions,

22:38.134 --> 22:42.034
I don't submit plans to anyone
else, I just do it.

22:42.029 --> 22:47.239
In a very small enterprise,
that has its advantages.

22:47.240 --> 22:53.240
In a partnership things are
more complicated.

22:53.240 --> 22:57.770
The trouble with a partnership
is this: Every partner has a

22:57.765 --> 23:00.725
right to participate in
management,

23:00.730 --> 23:06.670
and I can't admit a new partner
without the consent of the other

23:06.672 --> 23:07.712
partners.

23:07.710 --> 23:14.300
Now the work around for this is
the hybrid form,

23:14.298 --> 23:16.738
which creates a general partner
who runs it,

23:16.740 --> 23:19.660
and then a bunch of limited
investment partners who

23:19.660 --> 23:23.680
participate passively,
and lots and lots of things

23:23.679 --> 23:25.859
take that hybrid form.

23:25.858 --> 23:28.778
The pure partnership is very
awkward.

23:28.778 --> 23:31.718
You've got to talk to everybody
all the time;

23:31.720 --> 23:35.070
it's like being married to a
room full of people at once.

23:35.069 --> 23:37.149
What a nightmare!

23:37.150 --> 23:43.370
The corporation,
the chain of accountability is

23:43.366 --> 23:48.906
very different,
and it looks like this.

23:48.910 --> 23:55.140
You've got investors over here;
you've got capital markets with

23:55.143 --> 23:59.083
brokerages, stock exchanges,
and such like;

23:59.078 --> 24:03.458
then you've got a board of
directors, then top management,

24:03.462 --> 24:07.382
then layers of other
management, and then layer upon

24:07.384 --> 24:09.774
layer of regular employees.

24:09.769 --> 24:15.279
And the chain of accountability
is the white line.

24:15.278 --> 24:20.298
I've made this one a little
crooked because it is a little

24:20.298 --> 24:21.178
crooked.

24:21.180 --> 24:26.770
How many of you own a stock in
a specific company?

24:26.769 --> 24:34.659
Not--can we get a mic down to
this gentleman here with the

24:34.663 --> 24:38.683
olive colored shirt please?

24:38.680 --> 24:41.420
Is it a publicly traded company?

24:41.420 --> 24:41.690
Student:  Yes.

24:41.690 --> 24:44.170
Prof: Name it please.

24:44.170 --> 24:45.300
Student:  Sasol.

24:45.299 --> 24:46.399
Prof: Pardon.

24:46.400 --> 24:47.370
Student:  It's called
Sasol;

24:47.368 --> 24:48.788
it's a South African oil
company.

24:48.788 --> 24:51.658
Prof: Okay,
and you take an active role in

24:51.663 --> 24:52.983
running the company?

24:52.980 --> 24:53.960
Student:  No.

24:53.960 --> 24:58.440
Prof: Do you like
everything the management does?

24:58.440 --> 25:00.080
Student:  No.

25:00.078 --> 25:02.928
Prof: Why don't you fix
it then?

25:02.930 --> 25:05.040
Student:  Because I
don't own enough shares to make

25:05.035 --> 25:05.585
a difference.

25:05.588 --> 25:09.248
Prof: Okay,
and if you called up the CEO

25:09.246 --> 25:11.796
and said,
"I don't like what you're

25:11.803 --> 25:14.803
doing," how would you
imagine the conversation would

25:14.795 --> 25:15.165
run?

25:15.170 --> 25:16.430
Student:  Very short.

25:16.430 --> 25:18.960
Prof: It would be short
and what would his

25:18.963 --> 25:21.343
suggestion--his not indecent
suggestion be?

25:21.339 --> 25:24.649
Student:  Pound sand.

25:24.650 --> 25:28.020
Prof: Pardon.

25:28.019 --> 25:28.799
Student:  Pound sand.

25:28.798 --> 25:31.488
Prof: Okay,
pound sand or sell the damn

25:31.490 --> 25:31.970
stock.

25:31.970 --> 25:34.470
You don't like it, get out.

25:34.470 --> 25:41.890
The characteristically weak
control that investors have here

25:41.892 --> 25:47.682
puts enormous importance on the
exit option.

25:47.680 --> 25:52.280
Indeed, the exit option becomes
dominant.

25:52.279 --> 25:54.549
And in day trading,
for example,

25:54.547 --> 25:58.567
what people are doing is owning
companies for very short

25:58.568 --> 26:01.928
periods,
owning tiny slices of companies

26:01.928 --> 26:07.458
for very short periods,
and exercising no influence or

26:07.463 --> 26:11.983
accountability but just,
"I don't like it,

26:11.980 --> 26:13.320
I'm gone,"
or,

26:13.318 --> 26:16.668
"I believe the price is
going to fall,

26:16.670 --> 26:18.470
I'll short the stock and get
out."

26:18.470 --> 26:23.950
What you've created here is a
brilliant device for scooping up

26:23.950 --> 26:29.430
small amounts of investment from
a large amount of people,

26:29.430 --> 26:32.410
a large number of people,
so that with a joint stock

26:32.414 --> 26:34.644
corporation you can have
thousands,

26:34.640 --> 26:36.520
tens of thousands,
hundreds of thousands of

26:36.521 --> 26:37.061
investors.

26:37.058 --> 26:40.898
They don't know each other,
they don't talk to each other

26:40.902 --> 26:44.212
by and large,
only the large institutional

26:44.205 --> 26:48.535
investors track the company's
behavior with any care,

26:48.538 --> 26:51.998
the specific fundamentals of
the company,

26:52.000 --> 26:58.990
and the distancing--think about
proprietorship,

26:58.990 --> 27:02.220
where the boss is in the shop;
and partnership,

27:02.220 --> 27:05.630
where the owners are the
partners who actually do it.

27:05.630 --> 27:09.300
We've come a long way from that
with the joint stock

27:09.300 --> 27:13.190
corporation, and it's an
extremely efficient device for

27:13.190 --> 27:15.350
raising money in that way.

27:15.348 --> 27:19.458
The internal operation,
on the other hand,

27:19.464 --> 27:20.774
is complex.

27:20.769 --> 27:26.209
You've got market mechanisms of
exchange outside the firm,

27:26.210 --> 27:30.510
but inside the firm you've got
to manage people,

27:30.509 --> 27:35.269
you've got to incent them,
motivate them to do what needs

27:35.266 --> 27:37.046
doing for the firm.

27:37.048 --> 27:42.708
The board of directors plays a
symbolically central role in all

27:42.713 --> 27:46.463
this because they pick top
management,

27:46.460 --> 27:50.110
and top management is
accountable to them,

27:50.109 --> 27:52.269
at least in theory.

27:52.269 --> 27:56.549
If you think about the recent
crisis in American capitalism,

27:56.548 --> 28:01.788
a lot of it has to do with the
fact that boards have failed,

28:01.788 --> 28:07.018
sometimes catastrophically,
to exercise any real

28:07.022 --> 28:10.922
accountability on top
management.

28:10.920 --> 28:15.260
The characteristic problem,
which I've mentioned to you a

28:15.255 --> 28:18.575
couple of times,
about the firm is so-called

28:18.584 --> 28:22.904
principal agency;
I hire you to do something,

28:22.895 --> 28:26.175
and you go off and do it or
not.

28:26.180 --> 28:30.110
For example,
let's suppose I run something

28:30.112 --> 28:35.292
as simple as a bar and I hire
you--I'm not there in the

28:35.290 --> 28:39.320
evening and I hire you to run
the bar.

28:39.318 --> 28:44.328
I give you an hourly wage,
and I let you keep your tips,

28:44.325 --> 28:49.595
what might occur to you as a
way to maximize your income at

28:49.604 --> 28:50.974
my expense?

28:50.970 --> 28:55.190
Student:  Free drinks.

28:55.190 --> 28:56.540
Prof: Free-who said it?

28:56.538 --> 28:58.908
Free drinks or the very deep
pour;

28:58.910 --> 29:04.180
you order a scotch,
I pour you a double.

29:04.180 --> 29:08.210
You save the $5 and give me $2
of it.

29:08.210 --> 29:12.520
The characteristic of this
situation is that you

29:12.520 --> 29:18.210
have--what's your advantage over
me in scamming me this way?

29:18.210 --> 29:20.440
Student:  I keep the
tips.

29:20.440 --> 29:21.830
Prof: You keep the tips.

29:21.828 --> 29:23.588
But how do you manage to get
away with it?

29:23.588 --> 29:26.558
If you called me up and said
I'm going to do this,

29:26.564 --> 29:27.964
I'd say you're fired.

29:27.960 --> 29:31.160
But you get away with it.

29:31.160 --> 29:31.920
Why?

29:31.920 --> 29:33.270
Student:  You're not
there.

29:33.269 --> 29:34.459
Prof: I'm not there.

29:34.460 --> 29:37.790
You have the eyes and ears on
the scene, and I don't.

29:37.789 --> 29:39.069
You're the agent.

29:39.068 --> 29:41.898
You have so-called information
asymmetry,

29:41.900 --> 29:45.080
you know a lot more than I do
about what you're doing,

29:45.078 --> 29:50.098
and so the characteristic
problem for people trying to

29:50.101 --> 29:54.241
manage inside the box,
inside the firm,

29:54.240 --> 29:59.110
is to keep others for whom--
for whose achievements or

29:59.105 --> 30:01.355
malfeasance they're
accountable--

30:01.358 --> 30:03.608
to keep them motivated and
honest.

30:03.609 --> 30:10.179
The role of ownership;
the sole proprietor runs the

30:10.180 --> 30:11.290
thing, simple as that.

30:11.288 --> 30:14.158
Partnership,
they are all there except if

30:14.155 --> 30:17.685
you have the general partner,
but in general,

30:17.685 --> 30:21.145
say in a law firm they are all
involved,

30:21.150 --> 30:25.360
they will typically create an
executive committee and maybe a

30:25.356 --> 30:28.486
managing partner,
but pushed to shove in a

30:28.488 --> 30:32.868
disagreement about the firm,
they are all part of management.

30:32.868 --> 30:38.058
You make them that because they
are your assets.

30:38.058 --> 30:41.428
In a good law firm the real
assets are the lawyers.

30:41.430 --> 30:45.660
In the corporation the
ownership role is,

30:45.657 --> 30:51.047
as we saw a few minutes ago,
strongly attenuated.

30:51.048 --> 30:57.128
Now in actual fact there are
cases where stockholders rise up

30:57.128 --> 31:03.408
against management and throw the
board out and with a new board

31:03.411 --> 31:06.351
throw the management out.

31:06.349 --> 31:08.959
It does happen, it's just rare.

31:08.960 --> 31:12.610
And it's rare because the
transaction costs,

31:12.611 --> 31:16.691
just the time and effort
required to organize the

31:16.686 --> 31:19.656
shareholders,
is quite extreme.

31:19.660 --> 31:25.440
Stocks;
this is a 1998 tabulation of

31:25.436 --> 31:28.216
the percentage of U.S.

31:28.220 --> 31:34.090
households by income strata,
higher in yellow and lowest in

31:34.088 --> 31:39.148
green, who directly or
indirectly own companies.

31:39.150 --> 31:47.640
The gist is just what you would
think it would be.

31:47.640 --> 31:50.960
You have a majority of people
with six figure incomes,

31:50.960 --> 31:55.060
and you've got to inflate a
little bit here from 1998 to

31:55.057 --> 31:59.097
now,
people with relatively high

31:59.096 --> 32:05.216
incomes are predominantly owners
of companies.

32:05.220 --> 32:10.110
The rate of ownership scales
down with income,

32:10.112 --> 32:14.352
which makes quite a lot
intuitive sense,

32:14.352 --> 32:20.442
but most of the stock is held
in very small parcels.

32:20.440 --> 32:26.900
And the putting together
of--forget a majority--putting

32:26.903 --> 32:33.493
together enough to be noticed,
which begins at about 5%,

32:33.486 --> 32:35.876
is a major task.

32:35.880 --> 32:42.970
Liability;
with a proprietorship,

32:42.968 --> 32:48.788
if you do a harm to someone
else, a tort ,as lawyers say;

32:48.788 --> 32:55.618
if you sell someone a
contaminated bottle of drinking

32:55.616 --> 33:00.866
water, they can sue you without
limit.

33:00.868 --> 33:05.428
If your proprietorship is worth
$100,000,

33:05.430 --> 33:09.250
and you've also got a home
worth $300,000,

33:09.250 --> 33:14.470
and savings worth another
$100,000 to make $500,000,

33:14.470 --> 33:16.670
they can go after all of that.

33:16.670 --> 33:23.570
There is no protection against
lawsuits in the proprietorship

33:23.565 --> 33:24.365
form.

33:24.368 --> 33:27.948
With partnerships things are as
bad or worse.

33:27.950 --> 33:31.100
Let's suppose Tim here and I
are partners,

33:31.098 --> 33:38.078
and Tim for reasons known only
to himself,

33:38.078 --> 33:42.428
creates a catastrophic train
wreck on the line between New

33:42.433 --> 33:46.713
Haven and New York one day and
does it in the name of our

33:46.711 --> 33:50.441
proprietorship,
maybe we're in the business of

33:50.442 --> 33:52.062
something for trains.

33:52.058 --> 33:56.788
And I'm on vacation in Europe,
and Tim calls me up and says,

33:56.792 --> 34:01.292
"We've killed 110 people,
things are really a little

34:01.286 --> 34:02.566
bleak."

34:02.568 --> 34:05.848
My problem then,
of course I'm sorry for Tim,

34:05.846 --> 34:09.046
I'm sorry that Tim will suffer
from this;

34:09.050 --> 34:14.020
but I'm even sorrier about me
because the principle of joint

34:14.023 --> 34:18.743
and several liability applies to
partnerships so that the

34:18.744 --> 34:23.644
litigant can choose among the
partners and go after all the

34:23.635 --> 34:25.485
deepest pockets.

34:25.489 --> 34:34.029
That is a really major flaw in
the ownership structure design

34:34.032 --> 34:39.162
from the individual point of
view.

34:39.159 --> 34:43.229
The most striking single thing
about the joint stock

34:43.233 --> 34:46.993
corporation is that it has
limited liability.

34:46.989 --> 34:55.029
By limited liability we mean if
you own 100 shares and they have

34:55.029 --> 35:01.009
a value of $7 a piece,
there's $700 worth of capital,

35:01.014 --> 35:06.324
the most you can lose is that
$700 no matter what the firm

35:06.324 --> 35:07.074
does.

35:07.070 --> 35:11.150
The firm could blow up the
Atlantic coast and your

35:11.146 --> 35:15.886
liability would be limited to
the $700 which would be,

35:15.889 --> 35:19.659
in effect, you can lose all of
your investment but you can't do

35:19.663 --> 35:20.153
worse.

35:20.150 --> 35:25.000
Now that's a hell of a deal,
that's an enormously attractive

35:25.001 --> 35:27.141
deal,
and if you think about the

35:27.143 --> 35:30.003
purpose of the joint stock
corporation it's easy to

35:30.000 --> 35:30.800
understand.

35:30.800 --> 35:35.150
It's easy to understand because
we want people to make

35:35.150 --> 35:40.160
investments over something they
can't control and can't really

35:40.159 --> 35:42.459
see inside very clearly.

35:42.460 --> 35:46.120
Now we will--I'll ask you
before the term is over to have

35:46.117 --> 35:49.897
a look at a quarterly filing by
a company so you get to see

35:49.904 --> 35:52.064
about what investors can see.

35:52.059 --> 35:56.439
If you can't control it and
have no very powerful

35:56.442 --> 36:01.922
surveillance over its behavior
you wouldn't want to invest in

36:01.920 --> 36:06.850
it unless you were granted
relief from liability,

36:06.849 --> 36:09.909
and that's exactly the design.

36:09.909 --> 36:14.969
There was 100 years ago a race
to the bottom among the American

36:14.967 --> 36:19.617
states in how generously they
treat corporations under the

36:19.617 --> 36:20.267
law.

36:20.268 --> 36:25.868
The reigning champion among
American states for corporate

36:25.869 --> 36:27.669
law is Delaware.

36:27.670 --> 36:31.090
Delaware corporations abound
everywhere,

36:31.090 --> 36:34.460
and in particular,
in places that aren't Delaware

36:34.463 --> 36:38.373
or even close,
because these provisions are

36:38.373 --> 36:42.543
tightest from the corporate
point of view.

36:42.539 --> 36:46.659
Liquidity;
proprietorships are hard to

36:46.659 --> 36:47.089
sell.

36:47.090 --> 36:52.280
In fact, often it's impossible
to really get the value out of

36:52.284 --> 36:56.184
them when you sell them outside
the family.

36:56.179 --> 36:59.479
Often, in fact,
with say retailing,

36:59.478 --> 37:04.328
the value of the firm is
substantially the goodwill

37:04.329 --> 37:08.209
toward the owner the customers
have.

37:08.210 --> 37:14.650
When the owner sells it to
somebody else the value may go

37:14.653 --> 37:18.053
to zero,
although I was just--I had a

37:18.048 --> 37:22.388
boat in the marina on Lake
Champlain for a long time and I

37:22.385 --> 37:26.945
got tired and more tired of the
management of the marina;

37:26.949 --> 37:31.409
lazy, grasping,
unreliable, and I was talking

37:31.409 --> 37:36.679
to somebody on the phone
yesterday and they said,

37:36.679 --> 37:39.129
"You know there are new
owners up there,"

37:39.132 --> 37:40.312
and I thought:
Hazzah!

37:40.309 --> 37:41.889
I may take my boat back.

37:41.889 --> 37:47.169
The proprietorship is a very
delicate creature.

37:47.170 --> 37:49.320
The partnership is worse.

37:49.320 --> 37:53.690
Let's suppose that all of us
are the partners of Wiggin &

37:53.688 --> 37:55.798
Dana law firm in New Haven.

37:55.800 --> 37:59.790
We're all partners,
except Morgan here,

37:59.789 --> 38:05.669
and Morgan is a brilliant
student just finishing the Yale

38:05.670 --> 38:09.030
school and I'm his advocate.

38:09.030 --> 38:13.780
I say Morgan I'm going to make
you a partner.

38:13.780 --> 38:17.580
What do I have to do to make
that happen?

38:17.579 --> 38:20.579
In theory, there are ways to
shortcut this,

38:20.583 --> 38:24.593
but in theory I have to get the
consent of all of you.

38:24.590 --> 38:31.940
And then suppose I say,
"I'm tired and old and I

38:31.936 --> 38:33.486
want out.

38:33.489 --> 38:38.339
I'm going to sell Jim Alexander
my partnership,"

38:38.344 --> 38:43.864
and Jim Alexander is generous
enough to offer me a large sum

38:43.855 --> 38:47.025
of money for that partnership.

38:47.030 --> 38:51.950
Can I just send all of you a
memo about Jim now being a

38:51.949 --> 38:52.859
partner?

38:52.860 --> 38:55.230
No, you've all got to approve
it.

38:55.230 --> 39:02.610
The illiquidity of the
partnership as a result is

39:02.614 --> 39:04.464
notorious.

39:04.460 --> 39:07.740
The corporation is designed for
liquidity.

39:07.739 --> 39:13.459
You don't even ever have to see
the physical stock certificates,

39:13.456 --> 39:16.356
they are just electronic bits.

39:16.360 --> 39:24.020
The time it takes to sell
securities is that.

39:24.018 --> 39:30.238
And the transaction costs are
extremely low compared to the

39:30.242 --> 39:31.532
other two.

39:31.530 --> 39:36.290
Now scalability,
can we make this thing big or

39:36.293 --> 39:36.933
not?

39:36.929 --> 39:44.489
The answer here is in data,
these are--can you read this

39:44.489 --> 39:46.689
from the back?

39:46.690 --> 39:53.320
There are about 18 million
proprietorships in the country;

39:53.320 --> 39:56.060
a million and a third
partnerships,

39:56.059 --> 40:00.649
five million corporations,
and their average gross revenue

40:00.652 --> 40:03.152
per year are these numbers.

40:03.150 --> 40:08.920
The standard story of a
proprietorship is the dry

40:08.918 --> 40:16.008
cleaner on the corner who makes
$1,000 a week and feels good

40:16.007 --> 40:17.567
about it.

40:17.570 --> 40:20.650
These are actually gross
revenues not net.

40:20.650 --> 40:26.300
What that means is that the
actual take home may be pretty

40:26.297 --> 40:27.087
small.

40:27.090 --> 40:32.160
The ratios are suggestive of
scalability.

40:32.159 --> 40:35.409
The joint stock corporation is
made to get big.

40:35.409 --> 40:41.759
There are several subtypes of
corporation,

40:41.760 --> 40:46.680
but probably the most profound
threshold for corporations is

40:46.681 --> 40:50.301
the public offering,
the initial public offering.

40:50.300 --> 40:53.750
When you take a firm from
private to public,

40:53.746 --> 40:56.066
that is when you,
for example,

40:56.072 --> 40:59.602
an S corporation is a very
private kind;

40:59.599 --> 41:02.079
you can only have 75
shareholders,

41:02.081 --> 41:05.761
you get some tax breaks,
but you can't market your

41:05.764 --> 41:07.874
shares to a wide public.

41:07.869 --> 41:12.029
When you go public--Jim you've
been through that,

41:12.030 --> 41:15.930
going public with a company,
is that right?

41:15.929 --> 41:17.019
Jim Alexander:  Yes.

41:17.018 --> 41:19.418
Prof: Is there a mic for
Jim?

41:19.420 --> 41:21.950
What's the process?

41:21.949 --> 41:24.969
This is Spinnaker Exploration.

41:24.969 --> 41:28.319
Jim Alexander:
You have to interest

41:28.315 --> 41:32.135
various investment bankers in
your, quote, story,

41:32.139 --> 41:34.449
unquote, as they call it.

41:34.449 --> 41:38.969
You eventually choose a group
of people that you feel

41:38.967 --> 41:43.657
comfortable with and who feel
comfortable with you,

41:43.659 --> 41:46.899
you convert their analysts to
thinking you have good

41:46.902 --> 41:51.062
prospects,
you draw up a prospectus,

41:51.063 --> 41:55.703
which is both a selling,
and most importantly,

41:55.695 --> 41:59.965
a legal document describing--
ostensibly describing to the

41:59.969 --> 42:05.279
investors the principle risks
and potential returns of the

42:05.284 --> 42:06.594
investment.

42:06.590 --> 42:13.190
You make sure that you have
what's viewed as a good lawyer

42:13.186 --> 42:17.496
helping you with that,
a lawyer with a good

42:17.503 --> 42:21.643
reputation, make sure that you
have audited financials by a

42:21.635 --> 42:25.905
firm of the highest reputation,
and then eventually when the

42:25.914 --> 42:29.614
timing is right you go around
the country for several weeks

42:29.614 --> 42:33.004
talking to prospective
institutional investors because

42:32.996 --> 42:36.886
retail investors at most retail
firms won't buy with the smart

42:36.887 --> 42:39.137
money,
which is deemed to be

42:39.141 --> 42:41.661
institutional,
it's not buying.

42:41.659 --> 42:48.339
Typically you end up with a
group situation where maybe 20%

42:48.338 --> 42:53.518
to 40% of your company is sold
in the IPO,

42:53.518 --> 42:57.318
new money coming in which
typically pay down debt,

42:57.320 --> 43:04.490
and you end up with 200 to 500
shareholders whom you then have

43:04.490 --> 43:08.810
to keep happy,
at least for the first year or

43:08.811 --> 43:11.211
else bad things happen to you.

43:11.210 --> 43:13.640
Prof: Good!

43:13.639 --> 43:16.549
Thanks.

43:16.550 --> 43:22.060
The gigantic corporation is the
most productive,

43:22.056 --> 43:27.446
not the most creative
necessarily, but the most

43:27.445 --> 43:31.775
productive player in the
economy.

43:31.780 --> 43:37.730
As you can see here,
nearly 90% of all the business

43:37.728 --> 43:44.748
done in the American economy is
done by corporations so that

43:44.748 --> 43:47.788
the--
an analysis of American

43:47.786 --> 43:52.906
capitalism or world capitalism
which neglects the joint stock

43:52.914 --> 43:57.194
corporation neglects the most
important player.

43:57.190 --> 44:02.230
We will be focused on those,
ones like the Pennsylvania

44:02.226 --> 44:05.396
Railroad here,
as we go forward.

44:05.400 --> 44:10.000