Most parties today agree that outsiders should hold the balance of power on a board. Perhaps so, but there is also a third way, write these authors, who suggest that insiders and outsiders should have equal power.
The issue of who should have more power on boards – inside or outside directors – is a major one for public firms today. (Insiders are senior managers who also sit on their firms’ boards, while outsiders have no other affiliation with the firm). Both the media and academics strongly recommend that there should be more outsiders than insiders, since outsiders’ objectivity must prevail over the self-interest that can conflict insiders.
On the other hand, if outsiders hold the balance of power, the board may lack sufficient firm-specific knowledge. Consequently, the board may rely on financial controls alone, rather than on a combination of financial and strategic controls, which generally enhances firm performance.
In this article, we discuss this issue in one of the more important contexts for any board’s deliberations, business diversification.
Types and levels of diversification
As Table 1 illustrates, we define five categories of businesses according to their levels of diversification. These range from the low levels characteristic of single and dominant businesses to the high levels in firms with either related or unrelated businesses. Companies with related businesses have links that enable them to share resources and activities such as distribution channels, technologies, services and products, although diversification becomes more constrained as the number of links increases. Companies that have unrelated businesses can still be highly diversified.
A company’s level of diversification is an important consideration for both its shareholders and its senior managers. Shareholders can lessen their risk by building their own diversified investment portfolios. However, there is a ceiling on the level of diversification they prefer. They want each firm in their portfolio to be focused on its products, and to diversify only into related areas, since there is greater potential for economies of scope. Unfortunately, this type of firm is a riskier place for managers, as they are more likely to lose their jobs. What’s more, because diversified firms with related businesses are less complex and smaller than diversified firms with unrelated businesses, managers are generally compensated less than they would be in more complex highly diversified firms. Consequently, there is a real incentive for managers to diversify more than is beneficial for shareholders – managers want to decrease their employment risk and increase their compensation. This is why boards can find it difficult to align the goals of senior managers with those of shareholders.
Internal controls for implementing diversification strategies
The type of internal controls that a company uses to support its diversification strategies is also important. Generally, two types of control systems are employed – – strategic and financial. Designed appropriately, these controls provide employees and managers with a system that can improve a firm’s performance.
Businesses that employ strategic controls evaluate themselves by using subjective criteria and judgments that focus on the operational aspects of the strategies. This means that boards must fully understand an organization’s operations and markets if they choose to use strategic controls. By the same token, strategic controls require an exchange of strategic information between outside directors and inside directors, that is, senior managers.
On the other hand, firms that use financial controls rely on objective criteria, such as return on investment, for evaluating their performance. For this approach to work, the firm’s business units must enjoy a high degree of independence. Therefore, if an organization is pursuing a diversification strategy based on interdependence — such as “related constrained” — the effectiveness of financial controls in implementing strategy will be limited. This means that the use of financial controls alone is suitable for diversified firms with unrelated businesses, while a combination of strategic and financial controls is preferable for diversified firms with related businesses.
If an organization moves beyond an appropriate level of diversification, the effective use of strategic control is lost, at which point only financial controls are used (see Figure 1). Financial controls alone may diminish creativity and innovativeness in the organization, which are necessary to generate above-average returns in the long-term. Therefore, board members need to ensure that strategic controls are used in combination with financial controls, a practice that generally enhances firm performance.
The paradox of the inside director
Senior managers generally have the discretion to lead their organizations from limited to related diversification and subsequently to unrelated diversification. The move from limited to related diversification is in the best interests of shareholders. On the other hand, the move from related to unrelated diversification represents a potential loss for shareholders in two ways. First, from a performance standpoint, unrelated diversification offers no potential for economies of scope, which in turn limits the firm’s potential to achieve above-average performance. In addition, the cost to shareholders of unrelated diversification is over and above the cost of diversifying their portfolio. Consequently, outside directors are needed on the board to ensure that managers do not over diversify to reduce their employment risk and increase their compensation, and that the firm’s diversification is consistent with shareholders’ interests. Based on this argument, outsiders should have more power than insiders.
Yet, if insiders are prone to over diversification, why have them on the board at all? The reason pertains to the potential loss of strategic control: If outsiders have more power, they may prefer to rely only on financial controls, instead of including strategic controls. Most directors work hard to fulfill their fiduciary responsibility. However, the tendency of outside directors to emphasize financial controls is understandable given their time constraints and limited firm-specific knowledge. An unintended consequence of a situation where outsiders are more powerful than insiders may be not only an emphasis on financial control, but also a loss of strategic control, as firms come to operate as if they were unrelatedly diversified, regardless of their actual situation.
By providing firm-specific knowledge and strategic focus, insiders will ensure that outsiders emphasize strategic issues as well as financial ones. This reasoning suggests that insiders should have more power than outsiders.
A balance of power for outside and inside directors
We would like to offer a third alternative, namely that insiders and outsiders should have equal power because both groups help to preserve strategic control. Outsiders need sufficient power to keep insiders from engaging in inappropriate diversification; insiders need sufficient power to ensure that the board has the necessary amount of sensitive, firm-specific information.
Is equal power on a board achieved by having an equal number of outsiders and insiders? Some research suggests no. Ada Demb and F. Friedrich Neubauer, in their book, The Corporate Board: Confronting the Paradoxes, (Oxford University Press, New York, 1992), argue that insiders and outsiders do need equal power, but that the way in which this is achieved will be different for each board. They suggest that the proportion of insiders to outsiders should reflect the personalities and expertise of the board members. For one board, five capable outsiders may balance seven insiders; for another, equal power may mean having more outsiders than insiders on the board.
The goal of any board should be to maintain an appropriate level of diversification and to utilize both strategic and financial controls. To achieve this goal, each board should determine its appropriate composition through open, intense and on-going discussion. In our view, the relative number of insiders and outsiders on the board is less relevant than the method by which these groups achieve a balance of power.