CEOs, in particular founder-CEOs, are often visionaries with strong beliefs about the right strategic direction for their firms. For example, Apple CEO and founder Steve Jobs was known to be obsessed with product quality and design. The strategy to produce the highest quality products was deeply ingrained in the company and part of Jobs’ vision. Apple’s board of directors was likely less obsessed or convinced than Jobs and hence more willing to revise the organization’s strategy in response to new information. How should a board of directors that does not necessarily share the visionary CEO’s strong convictions advise and monitor the CEO?
In a recent paper, we study this question, using an analytical model. In our model, there are two mutually exclusive firm strategies (e.g., producing more electric vehicles or more gas-guzzling SUVs), and the “correct” strategy depends on the state of the world. Visionary CEOs are modeled as having a strong prior belief about the world’s true state and hence the correct strategy. The board performs several tasks. First, it can spend resources to acquire information about that state and is more likely to obtain an informative signal if it spends more resources. The signal either confirms the CEO’s vision or indicates that switching to an alternative strategy is optimal. While the signal is sufficiently precise to influence the board’s opinion about the optimal strategy, it does not necessarily change the visionary CEO’s opinion since he has a stronger belief that his vision is right. Second, the board has the final authority over the direction of the firm and either approves or rejects the manager’s proposed strategy. Third, the board provides the CEO with an incentive contract that induces effort to implement the chosen strategy. The manager’s effort is more productive when the firm’s strategy is better adapted to the environment, that is, implementation effort and the quality of the strategy are complements.
We show that the role of the board depends on how strongly the manager believes that his vision is right for the firm. Suppose the manager’s belief bias is relatively small, that is, he is only mildly confident that his vision matches the state of the world. In this case, the board plays an advisory role: It acquires information to advise the manager, and the manager listens to the advice and changes his opinion if new information indicates that his vision is no longer right.
When the manager’s belief bias is above a certain threshold, the board can still acquire information to advise the manager, but the manager will probably not listen to the advice. Specifically, when the board discovers a signal that indicates the manager’s vision is flawed, the signal will weaken the CEO’s confidence but not enough to change his opinion. To ensure a change in direction, the board has to use its authority and enforce a change. The question is whether it is optimal for the board to do so. We show that the board will overrule the manager and block his vision if the manager’s belief bias is intermediate, but not when it is high. For intermediately biased managers, the board therefore plays a monitoring role: It acquires information about the optimal firm strategy and intervenes and forces a change in strategy if the obtained information does not support the manager’s vision.
When the manager’s belief bias is high, the board will concede to the manager and approve his vision even when information arises that indicates that a change in strategy is optimal. The reason is that a manager who strongly believes in his vision will continue to have strong beliefs that he is right despite evidence suggesting otherwise. A visionary CEO is then highly motivated to execute his vision but would be much less motivated if the board dictated a change in the strategic direction. For example, if the manager strongly believes in the future of electric cars, he would be quite pessimistic about the chances of success if the firm concentrates on gas-powered cars. Low implementation effort would render the manager’s belief that the alternative strategy is unlikely to succeed self-fulfilling. The board could counter by offering the manager a higher incentive payment for success, but incentive pay is not very effective when the manager does not believe in the firm’s strategic direction. The board’s best response is then to approve the manager’s vision, that is, the board plays a rubber-stamping role. Although the information obtained by the board does not change firm strategy, it still has value because it guides the degree of the manager’s effort. Specifically, a signal that confirms the manager’s vision will further boost his effort, whereas a signal that undermines it will reduce his effort. The signal therefore leads to a reallocation of managerial effort to those situations where effort has a greater impact on firm performance and hence increases shareholder value.
Our results suggest that boards gather less information in firms in which CEOs are more confident in their judgment. When the board plays an advisory role (i.e., the CEO’s belief bias is small), the board’s incentive to obtain information is the strongest. This is intuitive because the board’s information acquisition not only leads to a firm strategy that is better adapted to the environment, but the manager is also motivated to work hard on the strategy because he agrees with it. The board’s incentive to invest in information acquisition is weaker when it plays a monitoring role (i.e., the CEO’s bias is intermediate). This result follows because, if the board discovers information that calls for a change in strategy, it has to overrule the manager. The manager then believes the firm is betting on the wrong strategy and is less motivated to execute it. The board’s incentive for information acquisition is weakest when it plays a rubber-stamping role (i.e., the CEO’s bias is strong). This is again intuitive because the obtained information then plays a role only in the degree of the CEO’s effort, but not in the choice of strategy.
Assuming that founder-CEOs believe strongly in their perspectives, the model predicts that boards will be relatively passive (e.g., meet infrequently, acquire little information, and rubber stamp proposals). The passivity is not a sign of poor corporate governance but is the best response to the visionary CEO’s strong beliefs. While the visionary CEO’s confidence is likely an asset when the firm is in its start-up phase, it can become a liability once the firm is more established. This raises the question of whether shareholders are better off if the board replaces the visionary with an unbiased CEO, who is more receptive to new information. We show that the board will optimally retain the visionary CEO when gathering accurate information about the true state of the world, and hence the firm’s optimal strategic direction is difficult and costly. This result follows because the strong motivation of the visionary CEO then outweighs the disadvantage of not being responsive to board advice. The model therefore predicts that corporate boards are more likely to retain founder-CEOs in environments in which learning about the right course of action is difficult, such as in highly uncertain and innovative industries.
Our results suggest that the role of corporate boards in advising and monitoring executives depends critically on whether the CEO is a visionary with strong beliefs about the right strategic direction for the firm.
This post comes to us from professors Xu Jiang at Duke University’s Fuqua School of Business and Volker Laux at the University of Texas at Austin’s McCombs School of Business. It is based on their recent article, “Corporate Boards, Visionary Managers, and Heterogeneous Beliefs,” available here.