“Boards were behaving as if firing the CEO costs the company about $1.3 billion,” Taylor says. But his work showed that the hard costs to the company were just $300 million. That includes not only the severance and headhunter costs, but the impact on the firm’s bottom line from all the upheaval. For example, much of the upper level management team may also be replaced when a new CEO comes in. And it may take time for that new team to build relationships inside and outside the company, and set a new strategy.
Still, that leaves a whopping $1 billion in costs that are unaccounted for. According to Taylor, this remaining $1 billion probably stems from two factors. First, there is a personal cost to board members who terminate the company leader – in the form of the time and stress of making a management change – as well as the loss that directors face in the departure of a business ally or golfing friend.
Another contributor may be the fact that the board simply does not care all that much about maximising shareholder value – at least not as much as keeping a CEO with whom they feel comfortable. Taylor notes that while his model did not attempt to further analyse those two factors to see which was the dominant force, both can contribute to reluctance to remove an underperforming CEO. In any case, evidence from his model is clear, he says: “CEO entrenchment is real and it’s big.”
The story varies a bit when studying different timeframes or company sizes. When Taylor looked at the larger half of the S&P 500, he found the entrenchment cost was close to zero – in fact, it was slightly negative. Why the difference between small and large firms? One possibility, Taylor says, is that directors in larger firms have a higher public profile and care more about their public reputations. That may make them more inclined to fire a CEO when times are tough.
Taylor’s work also found there was less entrenchment in the 1990 to 2006 timeframe than in the earlier period studied. He says that this is not surprising, in part because of growing shareholder activism over the past two decades. Regardless, Taylor says it is clear that “entrenchment has gone down, and that is good news”.
One seemingly counterintuitive finding in Taylor’s work is that a company’s profitability is not a good predictor of whether a CEO gets fired or not. Taylor says that this is often a point of outrage in the popular press where the question is asked: “How can a CEO of a money-losing company keep his job?”
According to Taylor, the reason profits are not a good predictor of CEO firings is that the board of directors looks at a number of other factors when it evaluates a CEO, a circumstance he collectively calls the “additional signal”. This includes everything from how the CEO is spending his or her time, to changes in market share for the company, to new projects in the works that may not yet be contributing to earnings. Paying more attention to these factors makes complete sense, he adds, because “there is a lot of noise in profit [numbers]”, including accounting charges and other forces outside the CEO’s control.
In fact, eliminating the $1 billion entrenchment cost does little to move the needle on the profitability of the S&P 500 companies, according to Taylor. His model shows that eliminating this cost altogether results in an increase in profitability across the S&P 500 of only 0.5% – for two reasons.
First, even with more aggressive boards, bad CEOs can still do some damage before they are fired. Second, if boards force out CEOs more frequently, the direct costs associated with changing leaders – severance and the like – will have to be absorbed more often. Taylor notes there would also be a likely diminishing return at work since the truly terrible leaders are already being fired. In this more activist era, the additional firings would come from “bad but not horrible CEOs”. This means that the bump upward to company performance from the change would likely be a bit muted.
“If CEO turnover entails a real cost for shareholders – for instance, because searching for a replacement is costly – then firing an unskilled CEO is not always in shareholders’ interests,” Taylor writes in his paper. “Complicating matters, the board cannot directly observe CEO ability, but instead learns about it over time … At each point in time, the board … assesses the CEO’s ability, and then decides optimally whether to replace him or her with a new CEO of uncertain ability.”
Taylor says the results of his model should provide ammunition for some boards that are under pressure from irate shareholders and from populist anger over CEO pay. In particular, boards of larger firms – where the entrenchment cost has been shown to be close to zero – can argue they have been more aggressive than many others in dumping underperforming leaders.
Members of such boards “could defend [themselves] against this rage by saying: ‘Here’s a paper that shows that our CEO firing rate is optimal for shareholders,’” says Taylor. “They could argue that the reason they don’t fire CEOs more often is that it takes time to learn about a CEO’s ability, and there are real costs to shareholders from the firing.”
