Board structure sits at the heart of corporate governance, but its optimal form remains a subject of debate. A longstanding view – championed by Jensen (1993) and Yermack (1996) – advocates for smaller boards, arguing they are more efficient and less susceptible to CEO influence. However, an opposing view is that complex firms benefit from larger boards, which can fill their need for specialized advice (Coles, Daniel, and Naveen, 2008).
Prior empirical work has relied on crude proxies for complexity – such as firm size or the number of business segments – that risk conflating complexity with other firm characteristics. These metrics also fail to capture the multifaceted and evolving nature of real-world corporate operations.
In a new study, we revisit the link between board size and firm complexity and use a novel and more precise approach: textual analysis of firms’ own language in their annual reports (Form 10-Ks). We analyze over 75,000 firm-year observations from 1995 to 2022, employing a curated lexicon of 53 “complexity words” developed in Loughran and McDonald (2024). These include terms such as lawsuit, derivatives, segments, and securitized. A firm’s complexity is measured by the proportion of these words appearing in its annual report.
Importantly, we go beyond a single complexity score. We arrange the lexicon into six categories that capture different types of complexity faced by management: Finance (e.g., securitized, collateral), Legal (e.g., lawsuit, litigation), Accounting (e.g., carry forward, intangibles), Hedging (e.g., derivatives, swaps), International (e.g., global, worldwide), and Organizational Form (e.g., restructure, segments). This approach enables us to examine whether different types of complexity call for different board sizes – particularly in balancing advisory needs (associated with larger, more diverse boards) and monitoring needs (better served by smaller, more focused boards).
Our findings reveal a robust and economically meaningful link between firm complexity and board size. Firms with more complexity words in their 10-Ks tend to have larger boards, even after controlling for standard governance and firm-level variables such as size, leverage, and age. Importantly, the increase in board size is driven by a rise in the number of outside directors, consistent with the idea that complex firms seek a broader range of expertise and perspectives through board expansion.
However, a more nuanced picture emerges when we examine the categories of complexity individually. Firms with high Finance or Legal complexity tend to have smaller boards. These areas often involve specialized, confidential matters – such as financial instruments or litigation – where streamlined decision-making and tighter oversight may be more effective. In contrast, firms facing Accounting, Hedging, International, or Organizational Form complexity tend to have larger boards. These areas typically require diverse knowledge, external advice, and broader deliberation, making a larger board more suitable. This categorization adds depth to the conventional understanding of complexity. It highlights that the impact of complexity on governance is not one-dimensional, and that effective board design depends not only on how complex a firm is, but on the type of complexity it faces.
We also assess how these relationships translate into firm value. Consistent with prior studies, we find that larger boards are, on average, associated with lower Tobin’s Q – a proxy for firm valuation – likely due to coordination inefficiencies and free-riding. However, this pattern changes in complex firms. When board size interacts with advisory-related complexity (e.g., Accounting, Hedging, or Organizational Form), we find a positive and statistically significant effect on Tobin’s Q. In other words, larger boards enhance firm value in settings where broader advice and expertise are essential. Conversely, when firms with high Finance complexity have large boards, Tobin’s Q declines, reinforcing the argument that focused monitoring – not expanded advising – is what these firms require.
Our study shows that language in public filings is a powerful tool for understanding a firm’s governance needs. By capturing the complexity conveyed directly by management, we offer a sharper perspective on the design of effective boards. The findings also caution against one-size-fits-all governance norms. Our textual approach offers a more detailed and practical framework for linking board size to firm complexity. For directors, regulators, scholars, and institutional investors, our research suggests that effective governance must align not just with firm size or industry, but also with the specific nature of the complexity that firms themselves acknowledge in their disclosures.
This post comes to us from professors Tim Loughran, Bill McDonald, and Jun Yang at the University of Notre Dame. It is based on their recent paper, “Board Size and Firm Complexity,” available here.