Is Your Company Addicted to Value Extraction?

Amazon has recently found itself in the spotlight in the United Kingdom. The company has been accused of paying minimal corporate tax in the U.K. — by channeling sales through a Luxembourg subsidiary — as well as of treating workers poorly. In 2013, more than 150,000 people in the U.K. signed a petition asking Amazon to pay its “fair” share of taxes, and in 2014, more than 50,000 signed a petition calling for Amazon to pay its workers more.

One view is that this is normal. Taking some criticism while legally minimizing taxes and satisfying customers cheaply is part of Amazon’s low-cost business model. Another view is that taking advantage of workers and the U.K. business environment without making a corresponding tax contribution shifts costs onto society. Public awareness of this can be damaging to the Amazon brand.

Amazon’s situation is not unique — and it raises a larger question. Should companies exercise their ability to “extract” value from external or internal stakeholders? What is value extraction? Is it in the long-term interest of the shareholders?

We define value extraction as the capturing of value from other stakeholders, either outside or inside the corporation, by manipulating the competitive market process to the company’s advantage. Depending on developments in national regulatory and legal systems, value extraction may be illegal — or perfectly legal. To use a metaphor, if value creation increases the size of the pie and value capture enables companies to get a slice of that pie, value extraction involves obtaining a larger slice by manipulating the process for dividing up the pie.

Should companies exercise their ability to “extract” value from external or internal stakeholders?

Some companies avoid value extraction as a matter of corporate principle, but other companies integrate value extraction into their business model and assess the trade-off between its benefits and risks. However, this latter approach ignores the possibility that value extraction may either represent or conceal a longer-term flaw in the business model.

That’s not just because value extraction exposes a company to reputational or legal risks that are hard to assess in advance and may prove serious. More important, value extraction can undermine corporate values. Value extraction is typically easier money than the hard work of maintaining a competitive advantage through ongoing value creation. As a result, a company can gradually get hooked on value extraction, to the detriment of real value creation.

Take Enron Corp., for example. Enron management gradually found it easier to book profits with mark-to-market accounting than to continue to develop innovative solutions for their customers. In the process, Enron’s business model lost its competitive edge, and its management got sucked into relying on fraud to capture value.

In another example, Swiss banks that relied for years on Swiss banking secrecy regulation to facilitate “tax savings” for international clients became, in effect, hooked on value extraction — at the expense of the countries where the wealth was created. Swiss bank UBS AG, for instance, was involved in this kind of arbitraging, as well as in a scandal involving interest rate manipulation. UBS also agreed to pay an $885 million fine to settle claims that it had misrepresented mortgage-backed securities.

The board and top management of a company can identify its dependency on value extraction by examining, first, whether value is being captured by distorting the market. Such distortions may include:

• Using political influence to restrict competition. This might entail taking advantage of privatizations of state-owned monopolies or using connections and lobbying to shape the legal and regulatory system to get exclusive monopoly or oligopoly positions.
• Using market power to restrict competition. This may involve using market share, collusion or resource concentration to increase bargaining power over pricing or other aspects of transactions with immediate stakeholders such as customers, employees or value chain partners.
• Employing deception to extract more value by exploiting insider information, lack of transparency, hierarchical position or corruption.

Second, is value being captured using already existing market distortions to shift costs onto society? Examples include: relying on government favors, such as subsidies, tax breaks or implicit guarantees; taking advantage of differences between national regulations, like tax regimes or the pricing of pollution; or ignoring negative externalities, such as the costs to others of pollution or poor working conditions.

The sustainability of value extraction as part of a business model varies with the evolution of the legal and regulatory environment, the power of affected stakeholders and the impact of social opinion and media. Even more important, in our view, is the ongoing effect of value extraction on a company’s corporate values and the risk that value extraction will erode the viability of the business model as a whole. Two questions have to be asked to assess the sustainability of value extraction:

• Can the company manage the potential cost of the legal and reputational risks generated by value extraction? Swiss banks, for example, misjudged the speed with which cash-strapped governments would decrease their tolerance of tax evasion. After being accused of abetting tax evasion, UBS had to hand over client names and was fined $780 million, while Credit Suisse Group AG recently pled guilty to helping Americans evade taxes and agreed to pay $2.6 billion in fines.
• Can the business model continue to survive the creeping neglect and erosion of its competitive advantage often caused by value extraction? It takes a significant change in strategy and organizational culture to get off the hook. At UBS, for example, the turnaround required to deal with the fallout from value extraction has resulted in repeated top executive turnover, as well as restructuring and downsizing.

Although value extraction is a widespread corporate practice, the societal backlash may be growing. A technology-driven trend toward more transparency and accountability, amplified by social media and nongovernmental organizations has affected consumers, employees and investors alike. The potential brand damage associated with value extraction is increasing, while the benefits are becoming more short term.

Even more important for longer-term viability, the board and management have to identify and avoid the threat to the competitiveness of the business model caused by the easier money from value extraction. The ultimate question for boards and top management is whether they want to be known for creating value — or merely siphoning it off from others.