Boards: Does One Size Fit All?

Abstract

This paper re-examines (1) the relation between firm value and board structure and (2) the factors associated with cross-sectional variation in board structure. Conventional wisdom and existing empirical research suggest that firm value decreases as the size of the firm's board increases, and as the fraction of insiders on the board increases. In this paper, we argue that, contrary to conventional wisdom, some firms may benefit from having larger boards and greater fraction of insiders on the board. Outside directors serve both to monitor top management and to advise the CEO on business strategy. The monitoring role of the board has been studied extensively and the general consensus is that smaller boards are more effective at monitoring. The argument is that smaller groups are more cohesive, more productive, and can monitor the firm more effectively whereas large groups are fraught with problems such as social loafing and higher co-ordination costs. The advisory role of the board, however, has received far less attention. Since one function of board members is to provide advice and counsel to the CEO, we hypothesize that firms that require more advice (more complex firms) will need larger boards. In particular, we hypothesize that larger firms, diversified firms, and firms that rely more on debt financing, will derive greater firm value from having larger boards. Similarly, certain kinds of firms might benefit from higher insider representation on the board. Inside directors possess more firm-specific knowledge. Thus we conjecture that firms for which the firm-specific knowledge of insiders is relatively important, such as R&D-intensive firms, may derive greater value from having higher fraction of insiders on the board. Our findings are consistent with our hypotheses. For firms that have greater advising requirements, such as those that are large, diversified across industries, and rely more on debt financing, we find that Tobin's Q increases in board size. Furthermore, in firms for which the firm-specific knowledge of insiders is relatively important, such as R&D-intensive firms, Tobin's Q increases with the fraction of insiders on the board. Firms with high advising requirements have larger boards. Also, firms with high R&D have larger fraction of insiders on the board. These results challenge the notion that exchange listing requirements, mandates from institutional investors, and restrictions in the law, specifically those that limit board size and management representation on the board, necessarily enhance firm value.