Board structure and composition
Catherine M. Daily and Dan R. Dalton
There is a rich tradition in corporate governance studies of examining the structure and composition of boards of directors. This is true whether the organizations of interest are entrepreneurial or otherwise. Importantly, the defining characteristics of board structure and composition are invariant across firm types, but their relation ships with firm processes and outcomes are sometimes dependent on firm context (Dalton et al., 1998). These differences are salient to entrepreneurial firms, as adherence to board structure and composition configurations pre scribed for traditional large corporations may yield different outcomes for entrepreneurial firms.
In brief, board structure refers to whether the chief executive officer (CEO) concurrently serves as chairperson of the board of directors. Board composition refers to the relative proportions of inside (management) and outside directors. While these two board configurations are most salient in the corporate context (i.e., firms whose stock is publicly traded), private firms, too, rely on boards of directors to enhance firm effectiveness.
Board Structure
Whether the CEO serves simultaneously as board chairperson (a condition commonly referred to as CEO duality when these positions are combined) is often regarded as an indicator of the potential for management to dominate the board of directors. This structure is most at issue for public firms where there is a separation between management and control. Under such conditions, management can become en trenched, thereby reducing the ability of the board of directors to effectively oversee firm management (Finkelstein and D’Aveni, 1994). This view is consistent with agency theory principles, which suggest that the board of directors is a necessary element in the system of checks and balances that ensure managers’ interests are effectively aligned with those of shareholders (Jensen and Meckling, 1976). Formal separation between management and the board enables the board to better hold management accountable for firm processes, and this should result in higher levels of firm performance (Shleifer and Vishny, 1997).
An alternative view is groundedinste wardship theory (e.g., Davis, Schoorman, and Donaldson, 1997). This perspective suggests that CEO duality provides for unified vision and leadership within the firm. Importantly, this unification has benefits both internally with organizational employees and externally with firms’ stakeholders (e.g., customers, investors, suppliers). Absent ambiguity regarding who is responsible for marshaling the firms’ resources, firms should achieve superior firm performance.
Interestingly, a meta analysis of the relation ship between board structure and firm performance indicates no significant relationship between these variables. This is true when the size of the firm (i.e., entrepreneurial/small firms vs. large firms) is considered, as well as when accounting versus market based firm performance measures are considered (see Daily et al., 2002, for an overview specific to the entrepreneurial context). Reliance on CEO duality or the separate board leadership structure, then, appears to be a choice between the benefits to be gained as a function of unequivocal leadership as compared to separate (i.e., independent) board leadership.
Board Composition
While the classification of directors as insiders or outsiders may seem rather straightforward, there are a number of subtleties that under lie board composition. A common element of any board composition classification, however, is the level of independence afforded by the various categories of directors (Daily, Johnson, and Dalton, 1999).
A dominant theme in the configuration of any board of directors is how to comprise the board for effective oversight of firm management. This focus on independence through board composition has been a consistent theme for shareholder activists and the focus of recent legislation (i.e., Sarbanes Oxley Act of 2002) and stock exchange guideline revisions (e.g., New York Stock Exchange and Nasdaq) in the United States. Greater board effectiveness board structure and composition 13 through independence is also consistent with agency theory. Agency theory is premised on the view that managers may, given the oppor tunity, seek to satisfy their own interests at the expense of shareholders (Jensen and Meckling 1976). As a result, an appropriately comprised board of directors protects shareholders from managerial self interest through effective moni toring.
Not all types of directors are believed to be equally suited for the oversight function. There is, however, little consistency in the classifica tion of directors (Daily et al., 1999). Inside dir ectors are typically operationalized as directors concurrently serving as firm officers. As noted by Daily et al. (1999), however, some researchers have expanded this definition to include former officers and relatives of management. Many ob servers would argue that inside directors are ill suited for directors’ oversight role. With regard to CEOs, they are, in effect, asked to monitor themselves. With regard to other inside dir ectors, they are asked to monitor themselves, but more importantly the person to whom they report, the CEO (Fama and Jensen, 1983; Zahra and Pearce, 1989). There is, however, an alternative lens through which to consider inside directors. Some observers believe that inside directors have incentives to expose a poorly per forming CEO and that they provide valuable firm specific information to board deliberations (e.g., Baysinger and Hoskisson, 1990). For example, insiders often possess superior firm specific information that can be valuable in stra tegic decision making processes. Outsiders are generally not privy to the operational function ing of the firms they serve and, as a result, are less able to contribute to strategic deliberations at the same level as insiders.
Outside director classification is substantially more complex than that for insiders. Outside directors have been segmented into independ ent, affiliated, and interdependent categories, each with differing degrees of independence from management. Here, too, however, there is little consistency in measurement within each of these categories (see Daily et al., 1999, for an overview). Independent outside directors in clude those directors who maintain no personal or professional relationship with the firm or firm management. As a result, these directors are believed best capable of fulfilling the monitoring function.
Affiliated (also referred to as grey or SEC6[b]) directors include outside directors with some form of personal or professional relationship with the firm or firm management (Daily and Dalton, 1994; Johnson, Hoskisson, and Hitt, 1993). Examples of affiliated relationships in clude outside board members who directly pro vide or whose employer provides legal counsel, investment banking services, or consulting ser vices. Also included are board members repre senting major customers or suppliers, as well as board members with familial relationships with firm management. In agency theory terms, the issue is that these directors may not effectively monitor firm management and risk their board positions.
While affiliated directors are not generally believed to be effective monitors, they are per haps effectively positioned to fulfill an alterna tive board role – that of resource acquisition (e.g., Pfeffer and Salancik, 1978). Affiliated dir ectors who maintain professional relationships with the firm or firm management are positioned to assist in the acquisition of critical resources and provide valuable expertise as a function of their external contacts and professional expertise.
A third category of outside directors is that of interdependent directors. The distinction here is based on the timing of directors’ appointments to the board. Interdependent directors are ap pointed during the tenure of the standing CEO (Wade, O’Reilly, and Chandratat, 1990). Here the issue is the extent to which interdependent directors maintain a sense of obligation to the CEO (the individual who almost certainly extended the invitation to join the board), which mitigates their propensity to effectively monitor firm management.
Incorporating the multiple means by which board composition has been measured, Dalton et al. (1998) conducted a meta analysis of the relationship between board composition and firm performance. Their findings did not sup port the view that greater board independence will result in superior firm performance. This conclusion is true regardless of the measurement of board composition (i.e., inside, outside, etc.), and regardless of the type of performance 14 board structure and composition indicator (i.e., accounting, market). Importantly, this relationship does not differ for entrepre neurial/small versus large firms. While boards might be constructed to fulfill a variety of needs, the level of independence is apparently not the path to better performance (see Daily et al., 2002, for an overview of studies supporting a relationship between various aspects of boards of directors and firm performance in entrepre neurial contexts).
Board structure and composition can be espe cially critical issues for entrepreneurial firms. It is in this organizational context that boards of directors are uniquely positioned to facilitate organizational processes and outcomes. Strategic leaders often have a greater influence in entre preneurial firms, as they are less constrained by more complex or established systems and struc tures typically found in larger, more traditional corporations (see Daily et al., 2002, for an over view) (see boards of directors in new ventures).
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