Modern Business Capital
What has been said on the use of loan credit has anticipated much of what is peculiar in modern business capital. Such is necessarily the case, since it is in the extensive use of credit that the later phases of the management of capital contrast most strikingly with the corresponding features of earlier business traffic. To follow the terminological precedents set by German writers, the late−modern scheme of economic life is a "credit economy," as contrasted with the "money economy" that characterizes early−modern times. The nature of business capital and its relations to the industrial process under the later, more fully developed, credit economy is in some degree different from what it was before the full and free use of credit came to occupy its present central position in business traffic; and more particularly is it at variance with the theoretical expositions of the economists of the past generation.
It has been the habit of economists and others to speak of "capital" as a stock of the material means by which industry is carried on, − industrial equipment, raw materials, and means of subsistence. This view is carried over from the situation in which business and industry stood at the time of Adam Smith and of the generation before Adam Smith, from whose scheme of life and of thought he drew the commonplace materials and conceptions with which his speculations were occupied. It further carries over the point of view occupied by Adam Smith and the generation to whom he addressed his speculations. That is to Say, the received theoretical formulations regarding business capital and its relations to industry proceed on the circumstances that prevailed in the days of the "money economy," before credit and the modern corporation methods became of first−class consequence in economic affairs. They canvass these matters from the point of view of the material welfare of the community at large, as seen from the standpoint of the utilitarian philosophy. In this system of social philosophy the welfare of the community at large is accepted as the central and tone−giving interest, about which a comprehensive, harmonious order of nature circles and gravitates. These early speculations on business traffic turn about the bearing of this traffic upon the wealth of nations, particularly as the wealth of nations would stand in a "natural" scheme of things, in which all things should work together for the welfare of mankind.
The theory, or what there is in the way of a theory, of business capital in the received body of doctrines is worked out from the point of view and for the theoretical purposes of the eighteenth century scheme of natural liberty, natural rights, and natural law; and the received theorems concerning the part played by capital and by the capitalist are substantially of the character of laws of nature, as that term was understood during the period to which these theorems owe their genesis. What these received theorems declare concerning the nature and normal function of capital and of the capitalist need not be recited here; their content is familiar enough to all readers, lay and learned. Also the merits of such a point of view for purposes of economic theory, and the adequacy of the received concept of capital for the purposes to which it was originally applied, need not detain the inquiry. Modern business management does not take that point of view, nor does "capital" carry such a meaning to the modern business man; because the guiding circumstances under which modern business is carried on are not those supposed to be given by a beneficent order of nature, nor do the controlling purposes of business traffic include that general well−being which constituted the final term of Adam Smith's social philosophy.
As a business proposition, "capital" means a fund of money values; and since the credit economy and corporation finance have come to be the ruling factors in industrial business, this fund of money values (taken as an aggregate) bears but a remote and fluctuating relation to the industrial equipment and the other items which may (perhaps properly) be included under the old−fashioned concept of industrial capital.(1*) Capital has been spoken of as the capitalized (aggregated) cost of industrial equipment, etc.,(2*) a view which had its significance for economic theory a hundred years ago; but since corporation finance has come to pervade the management of business this view is no longer of particular use for a theoretical handling of the facts. To avoid the tedium of argument it may be conceded that under the old dispensation, of partnerships and individual management in business, the basis of capitalization was the cost of the material equipment owned by any given concern; and so far as the methods of partnership and private firms still prevails such may still be the current method of capitalization, especially de jure. But in so far as business procedure and business conceptions have been shaped in the image of the modem corporation (or limited liability company), the basis of capitalization has gradually shifted, until the basis is now no longer given by the cost of material equipment owned, but by the earning−capacity of the corporation as a going concern.(3*) A given corporation's capital is, of course, de jure a magnitude fixed in the past by an act of legislature chartering the company, or by an issuance of stock by the company under the terms of its charter or of the acts which enable it. But this de jure capitalization is nominal only, and there are few, if any, cases in which the effective capital of a company coincides with its de jure capital. Such could be the case only so long as all the securities which go to make up the company's capital were quoted at par on the market. The effective capitalization of any modern company, that is to say, the capitalization which is effective for current business purposes as distinct from the formal requirements of the charter, is given by the quotations of the company's securities, or by some similar but less overt market valuation in case the company's capital is not quotable on the market. The effective (business) capitalization, as distinct from the de jure capitalization, is not fixed permanently and inflexibly by a past act of incorporation or stock issue. It is fixed for the time being only, by an ever recurring valuation of the company's properties, tangible and intangible, on the basis of their earning−capacity. (4*)
In this capitalization of earning−capacity the nucleus of the capitalization is. not the cost of the plant, but the concern's good−will, so called, as has appeared in the last preceding chapter.(5*) "Good−will" is a somewhat extensible term, and latterly it has a more comprehensive meaning than it once had. Its meaning has, in fact, been gradually extended to meet the requirements of modern business methods. Various items, of very diverse character, are to be included under the head of "good−will"; but the items included have this much in common that they are "immaterial wealth," "intangible assets"; which, it may parenthetically be remarked, signifies among other things that these assets are not serviceable to the community, but only to their owners. Good−will taken in its wider meaning comprises such things as established customary business relations, reputation for upright dealing, franchises and privileges, trade−marks, brands, patent rights, copyrights, exclusive use of special processes guarded by law or by secrecy, exclusive control of particular sources of materials. All these items give a differential advantage to their owners, but they are of no aggregate advantage to the community.(6*) They are wealth to the individuals concerned differential wealth; but they make no part of the wealth of nations.(7*) It is in the industrial corporations that this capitalization of good−will is seen to the best advantage − including, under the term "industrial corporations," railway companies, iron and steel concerns, mines, etc., as well as what are known in the stock market specifically as "industrials." The corporation is, of course, not the only form of business concern in the industrial field, but it is the typical, characteristic form of business organization for the management of industry in modem times, and the peculiarities of modem capital are therefore best seen in these modern corporations. Many of these corporations have grown out of partnerships and firms previously existing, and such is still the genesis of many of the corporations that come forward from time to time. In such a case of conversion from partnership or firm to corporation the rule is that the new corporation takes over a body of good−will, under one form and name or another, previously pertaining to the partnership which it displaces. Conversely, when a flourishing partnership or similar private firm has gained an assured footing of good−will, in the way of any or all of the items enumerated under that term above, its lot, as prescribed by modern business exigencies, is to go up into a corporation, either by simple conversion into the corporate form or through coalition with other firms into a larger corporate whole. There is in this matter no hard and fast rule, of course. On the one hand, the approved methods of corporation finance may in some measure be resorted to by a private firm, Without formal conversion of the concern into the corporate form; and on the other hand, an incorporated company may continue to carry on its business after the manner usual with privately owned concerns. But taken by and large, it will be found that with the assumption of the corporate form is associated a more modern method of capitalization and a freer use of credit. The advantages which the corporate form offers in these respects are commonly not neglected. The more archaic forms of organization and business management, in which recourse is commonly not had to the characteristic methods of corporation finance, prevail chiefly in those "backward" lines of industry in which monopoly or other differential advantages of an intangible nature are not readily attainable; such, e.g., as farming, fishing, local merchandising, and the minor mechanical trades and occupations. In this range of industries large (corporate) organization has hitherto been virtually impracticable, and here at the same time differential advantages, of the nature of good−will (as indicated above), are relatively scant and precarious. Where extensive differential advantages of this kind come in, the corporate form of organization is also likely to come in.
The cases are also frequent where a corporation starts out full−fledged from the beginning, without derivation from a previously existing private firm. Where this happens, the start is commonly made with some substantial body of immaterial goods on which to build up the capitalization; it may be a franchise, as in the case of a railway, telegraph, telephone, street−car, gas, or water company; or it may be the control of peculiar sources of material, as in the case of an oil or natural gas company, or a salt, coal, iron, or lumber company; or it may be a special industrial process, patented or secret; or it may be several of these. When a corporation begins its life history without such a body of immaterial differential advantages, the endeavors of its management are early directed to working up a basis of good−will in the way of trade−marks, clientele, and trade connections which will place it in something of a monopoly position, locally or generally (8*) Should the management not succeed in these endeavors to gain an assured footing on some such "immaterial" ground, its chances of success among rival corporations are precarious, its standing is insecure, and its managers have not accomplished what is looked for at their hands. The substantial foundation of the industrial corporation is its immaterial assets.
The typical modern industrial corporation is a concern of sufficient magnitude to be of something more than barely local consequence, and extends its trade relations beyond the range of the personal contact of its directive officials. Its properties and its debts are also commonly owned, in part at least, by persons who stand in no direct personal relation to the board of managers. In an up−to−date corporation of this character the typical make−up of the corporate capital, or capitalization, is somewhat as follows: The common stock approximately covers the immaterial properties of the concern, unless these immaterial properties are disproportionately large and valuable; in case of a relatively small and local corporation the common stock will ordinarily somewhat more than cover the value of the immaterial property and comprise something of the plant; in case of the larger concerns the converse is likely to be true, so that here the immaterial property, intangible assets, is made to serve in some measure as a basis for other securities as well as for the common stock. The common stock, typically, represents intangible assets and is accounted for by valuable trade−marks, patents, processes, franchises, etc. Whatever material properties, tangible assets, are in hand or to be acquired are covered by preferred stock or other debentures. The various forms of debentures account for the material equipment and the working capital (the latter item corresponding roughly to the economists' categories of raw materials, wages fund, and the like). Of these debentures the preferred stock is the most characteristic modern development. It is, de jure, counted as a constituent of the concern's capital and the principal is not repayable; in this (legal) respect it is not an evidence of debt or a credit instrument.(9*) But it has little voice in the direction of the concern's business policy.(10*) In practice the management rests chiefly on the holdings of common stock. This is due in part to the fact that the preferred bears a stated rate of dividends and is therefore taken up by scattered purchasers as an investment security to a greater extent than the common. In this (practical) respect it amounts to a debenture. Its practical character as a debenture is shown by the stated rate of dividends, and where it is "cumulative" that feature adds a further step of assimilation to the ordinary class of debentures. Indeed, in point of practical effect preferred stock is in some respects commonly a more pronounced credit instrument than the ordinary mortgage; it alienates the control of the property which it represents more effectually than the ordinary bond or mortgage loan, in that it may practically be a debt which, by its own terms, cannot be collected, so that by its own terms it may convey a credit extension from the holder to the issuing corporation in perpetuity. Its effect is to convey the discretionary control of the material properties which it is held to represent into the hands of the holders of the common stock of the concern. The discretionary management of the corporate capital is, by this device, quite as effectually as by the use of ordinary credit instruments, vested in the common stock, which is held to represent the corporation's goodwill. The discretionary disposal of the entire capital vests in securities representing the intangible assets. In this sense, then, the nucleus of the modern corporate capitalization is the immaterial goods covered by the common stock.(11*)
This method of capitalization, therefore, effects a somewhat thoroughgoing separation between the management and the ownership of the industrial equipment. Roughly speaking, under corporate organization the owners of the industrial material have no voice in its management, and where preferred stock is a large constituent of the capital this alienation of control on the parts of the owners may be, by so much, irrevocable. Preferred stock is, practically, a device for placing the property it represents in perpetual trust with the holders of the common stock, and, with certain qualifications, these trustees are not answerable for the administration of the property to their trustors. The property relation of the owners to their property is at this point attenuated to an extreme degree. For most business purposes, it should be added, the capital covered by other forms of debentures is in much the same position as that covered by the preferred stock.(12*)
The various descriptions of securities which in this way represent corporate capital are quotable on the market and are subject to market fluctuations; whereby it comes about that the aggregate effective magnitude of the corporate capital varies with the tone of the market, with the manoeuvres of the business men to whom is delegated the management of the companies, and with the accidents of the seasons and the chances of peace and war. Accordingly, the amount of the business capital of a given concern, or of the business community as a whole, varies in magnitude in great measure independently of the mechanical facts of industry, as was noted above in speaking of loan credit.(13*) The market fluctuations in the amount of capital proceed on variations of confidence on the part of the investors, on current belief as to the probable policy or tactics of the business men in control, on forecasts as to the seasons and the tactics of the guild of politicians, and on the indeterminable, largely instinctive, shifting movements of public sentiment and apprehension. So that under modern conditions the magnitude of the business capital and its mutations from day to day are in great measure a question of folk psychology rather than of material fact.
But in this uncertain and shifting relation of the business capital to the material equipment there are one or two points which may be set down as fairly secure. Since the credit instruments involved in modern capitalization may be used as collateral for a further credit extension, as noted in the chapter on loan credit,(14*) the aggregate nominal capital in hand at a given time is, normally, larger by an appreciable amount than the aggregate value of the material properties involved;(15*) and at the same time the current value of these material properties is also greater than it would be in the absence of that credit financiering for which corporate capitalization affords a basis.(16*)
German writers have familiarized economic readers with the terms "credit economy," "money economy" (Geldwirtschaft), and "natural economy" (Naturalwirtschaft), the later−modern scheme of economic life being characterized as a "credit economy." What characterizes the early−modern scheme, the "money economy," and sets it off in contrast with the natural economy (distribution in kind) that went before it in West−European culture, is the ubiquitous resort to the market as a vent for products and a source of supply of goods. The characteristic feature of this money economy is the goods market. About the goods market business and industrial interests turn in early modern times; and to this early−modern system of industrial life the current doctrines of political economy are adapted, as indicated above.
The credit economy − the scheme of economic life of the immediate past and the present − has made an advance over the money economy in the respect which chiefly distinguishes the latter. The goods market, of course, in absolute terms is still as powerful an economic factor as ever, but it is no longer the dominant factor in business and industrial traffic, as it once was. The capital market has taken the first place in this respect. The capital market is the modern economic feature which makes and identifies the higher "credit economy" as such. In this credit economy resort is habitually had to the market as a vent for accumulated money values and a source of supply of capital.(17*)
Trading under the old regime was a traffic in goods; under the new regime there is added, as the dominant and characteristic trait, trading in capital. Both in the capital and in the goods market there are professional traders, as well as buyers and sellers who resort to the market to dispose of their holdings and to supply their needs of what the market affords. In either class of trading the ends sought by those engaged in the business are generically the same. The endeavors of those who are in the business of trading, who buy in order to sell and sell in order to buy, are directed to the pecuniary gain that is to be got through an advantageous discrepancy between the price paid and the price obtained; but on the part of those who resort to the market to supply their needs the end sought is not the same in the two cases. The last buyer of goods buys for consumption, but the last negotiator of capital buys for the sake of the ulterior profit; in substance he buys in order to sell again at an advance. The advance which he has in view is to come out of the prospective earnings of the capital for which he negotiates. What he has in view as his ulterior end in the transaction is the conversion of the values for which he negotiates into a larger outcome of money values, − whatever process of production and the like may intervene between the inception and the goal of his traffic.(18*) The value of any given block of capital, therefore, turns on its earning−capacity; or, as the mathematical expression has it, the value of capital is a function of its earning−capacity, (19*) not of its prime cost or of its mechanical efficiency. It is only more remotely, and through the mediation of the earning−capacity, that these last−named factors sensibly affect the value of the capital. This earning−capacity of capital depends in its turn, not so much on the mechanical efficiency of the valuable items bought and sold in the capital market, as on the tension of the market for goods. To recur to an expression already employed in a similar connection, the question of earning−capacity of capital relates primarily to its effectiveness for purposes of vendibility, and only at the second remove to its effectiveness in the way of material serviceability. But the earning−capacity which in this way affords ground for the valuation of marketable capital (or for the market capitalization of the securities bought and sold) is not its past or actual earning−capacity, but its presumptive future earning−capacity; so that the fluctuations in the capital market −the varying market capitalization of securities − turn about imagined future events. The forecast in the case may be more or less sagacious, but, however sagacious, it retains the character of a forecast based on other grounds besides the computation of past results.
All capital which is put on the market is in this way subjected to an interminable process of valuation and revaluation − i.e. a capitalization and recapitalization − on the basis of its presumptive earning−capacity, whereby it all assumes more or less of a character of intangibility. But the most elusive and intangible items of this marketable capital are, of course, those items which consist of capitalized good−will, since these are intangible goods from start to finish. It is upon this factor of good−will in capital that a change in presumptive earning−capacity falls most immediately, and this factor shows the widest and freest market fluctuations. The variations in the capitalized value of merchantable good−will are relatively wide and unstable, as is shown by the quotations of common stock.
In the capital market the commodity in which trading is done, then, is the capitalized putative earning−capacity of the property covered by the securities bought and sold. This property is in part tangible, in part intangible, the two categories being seldom clearly distinguishable. The items bought and sold are put into merchantable form by being standardized in terms of money and subdivided into convenient imaginary shares, which greatly facilitates the traffic. The earning−capacity on which the market capitalization runs and about which the traffic in merchantable capital turns is a putative earning−capacity. It follows that this putative earning−capacity of a given block of capital, as it takes shape in the surmises of outside investors, may differ appreciably from the actual earning−capacity of the capital as known to its managers; and it may readily be to the latter's interest that such a discrepancy between actual and imputed earning−capacity should arise.(20*) When, e.g., the putative earning−capacity of the capital covered by a given line of securities, as shown by the market quotations, rises appreciably above what is known to its managers to be its actual earning−capacity, the latter may find their advantage in selling out, or even in selling short; while in the converse case they will be inclined to buy. Moreover, putative earning−capacity is the outcome of many surmises with respect to prospective earnings and the like; and these surmises will vary from one man to the next, since they proceed on an imperfect, largely conjectural, knowledge of present earning−capacity and on the still more imperfectly known future course of the goods market and of corporate policy. Hence sales of securities are frequent, both because outsiders vary in their estimates and forecasts, and because the information of the outsiders does not coincide with that of the insiders. The consequence is that a given block of capital, representing, e.g., a controlling interest in a given industrial enterprise, may, and in practice it commonly will, change owners much more frequently than a given industrial plant was wont to change owners under the old regime, before the fully developed corporation finance came to occupy the field of industrial business.(21*)
It follows, further, that under these circumstances the men who have the management of such an industrial enterprise, capitalized and quotable on the market, will be able to induce a discrepancy between the putative and the actual earning−capacity, by expedients well known and approved for the purpose. Partial information, as well as misinformation, sagaciously given out at a critical juncture, will go far toward producing a favorable temporary discrepancy of this kind, and so enabling the managers to buy or sell the securities of the concern with advantage to themselves. If they are shrewd business men, as they commonly are, they will aim to manage the affairs of the concern with a view to an advantageous purchase and sale of its capital rather than with a view to the future prosperity of the concern, or to the continued advantageous sale of the output of goods or services produced by the industrial use of this capital.
That is to say, the interest of the managers of a modern corporation need not coincide with the permanent interest of the corporation as a going concern; neither does it coincide with the interest which the community at large has in the efficient management of the concern as an industrial enterprise. It is to the interest of the community at large that the enterprise should be so managed as to give the best and largest possible output of goods or services; whereas the interest of the corporation as a going concern is that it be managed with a view to maintaining its efficiency and selling as large an output as may be at the best prices obtainable in the long run; but the interest of the managers, and of the owners for the time being, is to so manage the enterprise as to enable them to buy it up or to sell out as expeditiously and as advantageously as may be. The interest of the community at large demands industrial efficiency and serviceability of the product; while the business interest of the concern as such demands vendibility of the product; and the interest of those men who have the final discretion in the management of these corporate enterprises demands vendibility of the corporate capital. The community's interest demands that there should be a favorable difference between the material cost and the material serviceability of the output; the corporation's interest demands a favorable pecuniary difference between expenses and receipts, cost and sale price of the output; the corporation directorate's interest is that there should be a discrepancy, favorable for purchase or for sale as the case may be, between the actual and the putative earning−capacity of the corporation's capital.
It has been noted in an earlier chapter that there unavoidably results a discrepancy, not uncommonly a divergence, between the industrial needs of the community and the business needs of the corporations. Under the regime of the old−fashioned "money economy," with partnership methods and private ownership of industrial enterprises, the discretionary control of the industrial processes is in the hands of men whose interest in the industry is removed by one degree from the interests of the community at large.
But under the regime of the more adequately developed "credit economy," with vendible corporate capital,(22*) the interest of the men who hold the discretion in industrial affairs is removed by one degree from that of the concerns under their management, and by two degrees from the interests of the community at large.
The business interest of the managers demands, not serviceability of the output, nor even vendibility of the output, but an advantageous discrepancy in the price of the capital which they manage. The ready vendibility of corporate capital has in great measure dissociated the business interest of the directorate from that of the corporation whose affairs they direct and whose business policy they dictate, and has led them to centre their endeavors upon the discrepancy between the actual and the putative earning−capacity rather than upon the permanent efficiency of the concern. Their connection with the concern is essentially transient; it can be terminated speedily and silently whenever their private fortune demands its severance.
Instances are abundant, more particularly in railway management, where this discrepancy between the business interest of the concern and the private business interest of the managers for the time being has led to very picturesque developments, such as could not occur if the interests of the management were bound up with those of the corporation in the manner and degree that once prevailed. The fact is significant that the more frequent and striking instances of such management of corporate affairs for private ends have hitherto occurred in railroading, at the same time that the methods and expedients of modern corporation finance have also first and most widely reached a fair degree of maturity in railroading. It holds out a suggestion as to what may fairly be looked for when corporation finance shall have made itself more thoroughly at home in the "industrials" proper. Indeed, the field of the "industrials" is by no means barren of instances comparable with the maturer and more sagacious railroad financiering.(23*)
The stock market interest of those men who have the management of industrial corporations is a wide and multifarious one. It is not confined to the profitable purchase and sale of properties whose management they may have in hand. They are also interested in making or marring various movements of coalition or reorganization, and to this ulterior end it is incumbent on them to "manipulate" securities with a view to buying and selling in such a manner as to gain control of certain lines of securities.(24*) Hence it is a rule of this class of business traffic to cultivate appearance, − to avoid, or sometimes to court, the appearance of sin. So that under this leadership the course of industrial affairs is, in great measure, if not altogether, guided with a view to a plausible appearance of prosperity or of adversity, as the case may be. Under given circumstances it may as well become the aim of men in control t