Do Boards Affect Firm Performance?
Why do boards exist? Agency theory posits that since the shareholders of public companies are too numerous and far removed to govern the enterprise, they appoint a board to act as their agent. As agents, the board’s key responsibilities include assessing the CEO’s performance, influencing strategic decisions, monitoring risk, approving the use of corporate resources, protecting the company’s reputation, and managing CEO succession. To do this, the board establishes committees for oversight, works with external auditors, requires regular reporting, establishes short and long-term rewards and incentives that are aligned with the mission, ensures the board’s independence and assesses the board’s own performance in meeting its responsibilities.
Although it is implied, the board is not formally charged with responsibility for the firm’s performance. That responsibility is vested in the CEO. The board’s influence on performance is therefore indirect, and in the end, comes down to the board’s ability to replace the CEO if performance doesn’t meet shareholder expectations. Boards are supposed to minimize agency costs, which is the price the organization pays for the board to carry out its work. Agency costs include the board’s direct compensation, the costs associated with internal and external monitoring, the cost of board meetings and shareholder meetings, and burden the board imposes on the CEO and others to prepare materials for board meetings, respond to inquiries, and engage in work for the board between board meetings.
Given the importance of the board’s role and the effort and costs associated with the board’s work, it makes sense to ask whether boards make a difference over time in the performance of the organizations they oversee. The answer, based on a multitude of studies across thousands of organizations, is an unequivocal “sometimes”. At the extreme, when CEOs are underperforming or misbehaving, the replacement of the CEO by the board can make the difference between organizational survival and dissolution. Under normal circumstances however, the value added by the board isn’t as clear.
The reason for this surprising finding, according to Finkelstein, Hambrick and Cannella in their book Strategic Leadership, is that there are too many factors that mediate the board’s influence on performance to draw a straightforward conclusion. Starting with historical and evolving market forces, firms face wildly different challenges. Some companies are up against a wall while others enjoy clear sailing. The board’s potential influence on performance is limited by their range of motion. Then there are factors that surround the board’s composition that make it a more or less effective body in light of performance challenges. Large boards have difficulty reaching consensus while small boards may endorse actions that are too risky. Boards may or may not possess the knowledge and experience to address key challenges, or the board may not have sufficient independence to act apart from management even when some members see problems clearly. Boards vary in their involvement in setting strategy, a major determinant of performance. They also vary in their willingness to use their power to discipline management or demand change. Some boards are better at designing incentive systems for executives that are aligned with the organization’s mission, while others may be more or less prepared to fend off takeover attempts. Some boards demand detailed information from executives on performance-related issues while others settle for high-level dashboards. Because organizational circumstances vary and boards approach their work in such different ways, the link between boards and performance remains elusive. While it’s clear enough that a one-size board doesn’t fit all situations, we aren’t advanced enough in the science of matching board design and board processes to situational requirements to ensure that the time, effort and cost of board work contribute to an organization’s bottom line. Like a municipality that maintains a fully staffed and operational police department to respond to serious crimes that may never occur, companies must abide by the requirement to have a board to deal with situations that have not and may never manifest.
Does that mean that all the effort put into CEO-board collaboration and the board’s role in monitoring are a waste of time? Not at all. It’s impossible for scientists to measure the impact of actions that would not have been taken without the board’s existence. Because of the vicissitudes of the market, we can’t say for certain that public companies with boards are better off than private companies that operate without board oversight. However, there are at least as many CEOs who praise the contributions of their boards as there are those who complain about board interference.
Agency theory dictates that boards exist to represent the interests of shareholders, not executives. But there is another model for governance that has become increasingly popular, namely stewardship. In the stewardship model, the board and CEO are viewed not as adversaries, but rather as sharing responsibility for the organization’s success. Rather than being skeptical and demanding detailed reporting, stewardship boards are trusting, engage in open dialogue and shared learning, and view the CEO as motivated by success rather than just money. Stewardship boards are more likely to take a longer-term perspective rather than holding the CEO accountable for quarterly results. Stewardship boards focus on building adaptive capacity for the future, not on maximizing short-term profits through relentless cost cutting. Stewardship boards focus on purpose, investments and innovation rather than dividend payments and extraction.
Most boards are a mix of agent and stewardship models. While that probably makes sense, it can be confusing for shareholders, CEOs and even the board itself. Unless the parameters are clear for moving from one stance to the other, it can feel like the board is a driver is throwing a car from forward into reverse in a random fashion.
I hope this exploration of the question of whether boards influence performance raises questions for boards that are worth further exploration. For example, as a board, what is our basic stance: agency or stewardship? Regardless of which role the board sees as primary, how does it make room for the other when required without causing confusion? In addition, the board should discuss what it does that might contribute to improving performance and assess how effectively it is engaging in those activities. It would be for the best if members of the board agreed among themselves that these activities should be prioritized and even better if the CEO concurred. The board might also review how much time, energy and cost is associated with non-performance-improving monitoring and investigate ways to mitigate such activities.
The CEO is ultimately responsible for performance, but the CEO can’t dictate how the board should operate. If the board wants to increase its value added, it has to figure out how to do that itself.