Who should appropriate profits?

Praveen S
Sunday, September 5, 2021

Spicebar is a new agri-startup focusing on organic spices. They have access to unique spices that they are able to source from certain agro-cooperatives at a reasonable price. They also know a scientist who helped them in making a vital processing technology customized for the particular spice. They have registered the company, and the shareholding structures are in place. The four partners who have divided the shares among them are passionate and enthusiastic about the company. All of them have worked for 15-20 years and now used a part of their savings to invest in the company. They do not know when they will be profitable. However, they are hopeful of making some money shortly. It is well reasoned that they invested a lot of their personal resources and hence should appropriate the profits based on their investments. But what about the other stakeholders such as agro-cooperative and the scientist?

Most firms utilize different resources that go into value creation. Financial resources invested by the shareholders are one of them. There are other stakeholders who invest their resources with the firm, for example, suppliers, customers, employees, government, etc. Many of these investments in resources are integrated towards the final creation of value.

Not all types of resources generate economic profits. An economic profit is equal to the difference between the firm’s revenues and total opportunity cost of the resources that are used to generate those revenues. Opportunity costs mean the value of the best alternative foregone by using these resources in the firm’s revenue generation. Only a few of the resources are critical in that they help generate economic profits by providing a competitive advantage. Some of the resources provide competitive parity; that is, such resources are available to all the competitors alike. For example, access to a database of different tourist destinations in the locality is needed for all firms working in the tourism sector. Without such a database, none of the firms will be able to operate and generate economic profits. However, since all competitors will have access, it is no more a source of competitive advantage and cannot provide above normal economic profits.

Only resources that are valuable, rare, non-imitable, and non-substitutable are critical and contribute to economic profits. Certainly, the financial resources do not belong to such a category in efficient markets. The financial resources that the entrepreneur inputs, therefore, do not contribute to the economic profits; they only provide the competitive parity.

For most entrepreneurs, their valuable resources come from other stakeholders. It can be in the form of the patent that they are allowed to use, an experienced employee possessing valuable technical know-how, a friend who is willing to share a unique location, a regulator who agrees to share information ahead of competitors, suppliers who invest in the production process, or logistics partners who ensure quicker delivery. Such resources contribute to economic profits when your competitors face difficulty or substantial costs above you in acquiring access to such resources.

When designing the structure of how the economic profits are appropriated, entrepreneurs usually make the mistake of considering only the financial resources. Often equity and ways of appropriating the economic profits are divided based on the financial resources that go in as investments. Research has proven that it is impossible to sustain valuable, rare, inimitable, non-substitutable resources when they are not given residual rights to profits; that is, those who provide such critical resources should be able to derive their part of the profits. Therefore, in the case we started, about the entrepreneurial firm, Spicebar would need to think about sufficient mechanisms that allow the agro-cooperative and scientist to appropriate fair value, depending on the critical nature of the resources they input.