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...use unobservable characteristics are likely to affect each company’s market value, I estimate both ordinary least squares (OLS) regressions and fixed-effects models. The OLS model includes two-digit SIC dummy variables that allow a different intercept for firms in each industry, while the fixed-effects estimator assigns a unique intercept to each company. Hausman and Taylor (1981) state that the fixed-effects framework represents a common, unbiased method of controlling for omitted variables in a panel data set. Table 2 presents coefficient estimates for the OLS and fixed-effects models, with White (1980) robust standard errors accompanying the OLS estimates. The regression estimates for both models show an inverse and significant association between firm value and board size. This downward slope is consistent with an interpretation that coordination, communication, and decisionmaking problems increasingly hinder board performance when the number of directors increases. Further, the convex relation implied by the log form of the board-size variable suggests that costs accumulate at a decreasing rate as board size grows. A convex relation also emerges from estimates of different functional form...

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... for other variables that I expect either to affect Tobin’s Q directly or to affect each board’s incentives and ability to monitor managers. A company’s profitability has a significant impact upon its market value, so I include return on assets (ROA) in the regression model as an explanatory variable. I calculate ROA as operating income divided by total assets (measured at the start of each year) and compound the ratio continuously. The regression model includes ROA for the most recent year and two years of lagged values. In addition to current and past profitability, many theorists including Myers (1977) and Smith and Watts (1992) argue that firm value depends on future investment opportunities. Like others, I use the ratio of capital expenditures over sales as a proxy for investment opportunities. Below, I consider whether other possible measures of investment opportunities lead to differences in the model’s estimates. During the 1984-91 period of this study, diversified firms were valued less highly in the capital markets than stand-alone businesses, as shown by Lang and ZThe lone difference between my methodology and the q pw estimator of Perfect and Wiles (1994) is that my estimate of the...

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... boardrooms are dysfunctional’, because directors rarely criticize the policies of top managers or hold candid discussions about corporate performance. Believing that these problems increase with the number of directors, Lipton and Lorsch recommend limiting the membership of boards to ten people, with a preferred size of eight or nine. The proposal amounts to a conjecture that even if boards’ capacities for monitoring increase with board size, the benefits are outweighed by such costs as slower decision-making, less-candid discussions of managerial performance, and biases against risk-taking. Jensen (1993) takes up this theme, pointing out the ‘great emphasis on politeness and courtesy at the expense of truth and frankness in boardrooms’ and stating that ‘when boards get beyond seven or eight people they are less likely to function effectively and are easier for the CEO to control’. Some evidence shows that reducing board size has become a priority for institutional investors, dissident directors, and corporate raiders seeking to improve troubled companies. Kini et al. (1995) present evidence that board size shrinks after successful tender offers for under-performing firms. At American Express,...

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...of the subsequent fiscal year. The main explanatory variable is the firm’s cumulative abnormal stock return for the current year and two prior years. The abnormal stock return is defined as the raw stock return minus the return predicted by the CAPM. The sample consists of 3,438 annual observations for 452 firms between 1984 and 1991. Companies are included in the sample if they are ranked by Forbes magazine as one of the 500 largest U.S. public corporations at least four times during the eight-year sample period. Utility and financial companies are excluded. Coefficient estimates appear with White (1982) robust standard errors. Missing values occur for companies that do not have a three-year history of common stock returns. To illustrate how CEO incentives from the threat of dismissal are affected by different characteristics of boards of directors, the second column presents estimates for a model that includes an interaction term between the abnormal stock return and the log of board size. Both models also include variables for the fraction of common stock owned by the CEO, CEO age, dummy variables for CEO ages 64, 65, and 66, and dummies for one-digit SIC industries. Dependent variable: CEO...

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...re likely to behave in shareholders’ interest. See, for example, Weisbach (1988) (CEO turnover), Byrd and Hickman (1992) (tender offer bids), and Brickley, Coles, and Terry (1994) (poison pill adoptions and control auctions). Rosenstein and Wyatt (1990) find positive investor reactions to appointments of outside directors. With respect to board stock ownership, Merck, Shleifer, and Vishny (1988) find significant, though nonmonotonic, associations between different levels of director stock ownership and Tobin’s Q, suggesting that some levels of board stock ownership have systematic advantages. McConnell and Servaes (1990) and Hermalin and Weisbach (1991) report similar results, while Bagnani, Milonas, Saunders, and Travlos (1994) find that bondholder returns also exhibit a nonmonotonic association with board stock ownership. Lipton and Lorsch (1992), Jensen (1993), and other advocates of small boards contend that board size affects corporate governance independent of other board attributes. As noted above, their arguments focus on the productivity losses that arise when work groups grow large, an insight borrowed from organizational behavior research such as Steiner (1972) and Hackman (1990). According to Jens...

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...1984 and 1991. Companies are included in the sample if they are ranked by Forbes magazine as one of the 500 largest U.S. public corporations at least four times during the eight-year sample period. Utility and financial companies are excluded. Data for board size is gathered from proxy statements filed by companies near the start of each fiscal year. Tobin’s Q is estimated at the end of each fiscal year as Market value oj assets/Replacement cost of assets. The estimation of Q follows the ypw specification of Perfect and Wiles (1994), which is described more fully in the text. Stulz (1994) and Berger and Ofek (1995). Moreover, diversified companies are likely to have larger boards, because many boards grow in size when companies make acquisitions and because boards of conglomerates may seek outside expertise for a greater number of industries. To control for diversification, I include a variable that counts the number of business segments for which firms report audited financial statement data in each fiscal year’s annual report. As discussed in Section 2, many investigators have suggested that boards with high stock ownership and a majority of outside directors monitor managers more effectively. I inclu...

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...sible explanations in Section 3.3, after presenting my main finding of a negative relation between firm value and board size. 3. Board size and firm value The main hypothesis of this paper is that firm value depends on the quality of monitoring and decision-making by the board of directors, and that the board’s size represents an important determinant of its performance. Below I estimate a straightforward model of the relation between firm value and board size. I follow the methods of several recent related studies, such as Merck, Shleifer, and Vishny (1988), Hermalin and Weisbach (1991), and Lang and Stulz (1994) by regressing a set of explanatory variables against an estimate of Tobin’s Q, which measures the ratio of a firm’s market value divided by the replacement cost of its assets. I include controls for such variables as firm size, industry membership, board composition, and past company performance. After presenting the main result, I illustrate its robustness to a variety of alternative specifications and evaluate whether alternative theories can account for the observed inverse relation between board size and firm value. 3.1. Data description My analysis uses a panel of firms drawn from the an...

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...but these studies have largely overlooked board size. Instead, investigators have most frequently examined the importance of outside directors and directors’ equity ownership. Studying board composition, Hermalin and Weisbach (1991) find no relation between firm performance and the fraction of outside directors. However, this conclusion is not supported by Baysinger and Butler (1985), who find some evidence that companies perform better if boards include more outsiders. Other studies find that boards dominated by outsiders are more likely to behave in shareholders’ interest. See, for example, Weisbach (1988) (CEO turnover), Byrd and Hickman (1992) (tender offer bids), and Brickley, Coles, and Terry (1994) (poison pill adoptions and control auctions). Rosenstein and Wyatt (1990) find positive investor reactions to appointments of outside directors. With respect to board stock ownership, Merck, Shleifer, and Vishny (1988) find significant, though nonmonotonic, associations between different levels of director stock ownership and Tobin’s Q, suggesting that some levels of board stock ownership have systematic advantages. McConnell and Servaes (1990) and Hermalin and Weisbach (1991) report similar res...

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... expect either to affect Tobin’s Q directly or to affect each board’s incentives and ability to monitor managers. A company’s profitability has a significant impact upon its market value, so I include return on assets (ROA) in the regression model as an explanatory variable. I calculate ROA as operating income divided by total assets (measured at the start of each year) and compound the ratio continuously. The regression model includes ROA for the most recent year and two years of lagged values. In addition to current and past profitability, many theorists including Myers (1977) and Smith and Watts (1992) argue that firm value depends on future investment opportunities. Like others, I use the ratio of capital expenditures over sales as a proxy for investment opportunities. Below, I consider whether other possible measures of investment opportunities lead to differences in the model’s estimates. During the 1984-91 period of this study, diversified firms were valued less highly in the capital markets than stand-alone businesses, as shown by Lang and ZThe lone difference between my methodology and the q pw estimator of Perfect and Wiles (1994) is that my estimate of the replacement cost of proper...

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... systematic advantages. McConnell and Servaes (1990) and Hermalin and Weisbach (1991) report similar results, while Bagnani, Milonas, Saunders, and Travlos (1994) find that bondholder returns also exhibit a nonmonotonic association with board stock ownership. Lipton and Lorsch (1992), Jensen (1993), and other advocates of small boards contend that board size affects corporate governance independent of other board attributes. As noted above, their arguments focus on the productivity losses that arise when work groups grow large, an insight borrowed from organizational behavior research such as Steiner (1972) and Hackman (1990). According to Jensen (1993), ‘. . as groups increase in size they become less effective because the coordination and process problems overwhelm the advantages from having more people to draw on’. Empirical research on the importance of board size is thin. Holthausen and Larcker (1993a, b) consider board size among a range of variables that might influence executive compensation and company performance. Holthausen and Larcker (1993a) present results indicating a positive association between board size and the value of CEO compensation. Holthausen and Larcker (1993b) fail to ...

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...ement data used in regressions from Compustat, except for a handful of observations for which data were handcollected. Data for board size, board composition, and inside stock ownership were obtained from annual meeting proxy statements. Because unobservable characteristics are likely to affect each company’s market value, I estimate both ordinary least squares (OLS) regressions and fixed-effects models. The OLS model includes two-digit SIC dummy variables that allow a different intercept for firms in each industry, while the fixed-effects estimator assigns a unique intercept to each company. Hausman and Taylor (1981) state that the fixed-effects framework represents a common, unbiased method of controlling for omitted variables in a panel data set. Table 2 presents coefficient estimates for the OLS and fixed-effects models, with White (1980) robust standard errors accompanying the OLS estimates. The regression estimates for both models show an inverse and significant association between firm value and board size. This downward slope is consistent with an interpretation that coordination, communication, and decisionmaking problems increasingly hinder board performance when the number of directors increases...

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...nce and current board size The analysis above shows that companies with small boards of directors attain higher values in the capital markets than do their counterparts with large boards. However, we might interpret these findings in two ways: Small boards could contribute to better performance, or companies might adjust board sizein response to past performance. If companies expand their boards in the aftermath of poor performance, the causation of the board size-firm value relation may run in the opposite direction from the Lipton-Lorsch (1992) and Jensen (1993) hypotheses. Prior studies by Hermalin and Weisbach (1988) and Gilson (1990) examine the interplay between company performance and changesinboards of directors. Hermalin and Weisbach (1988) find that poor performaglce lead&to both more departures of board members and more appointments to the board. While Hermalin and Weisbach are silent on the net ieffect.’ of these two forces, they estimate similar magnitudes for each, suggesting&at director turnover increases after poor performance, but board size does not. Gilson (MO), in a study limited to financially distressed companies, also finds that boarukrtatuwiwer increases after poor performance; moreove...

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....ooo9) 0.045*** 0.031*** (0.003) (0.002) 3,425 3,425 66.3 44.3 (0.W (0.W 0.1627 0.1148 I estimate a probit model of CEO turnover, similar to the model of Warner, Watts, and Wruck.(l988). The (0, 1) dependent variable equals one if the CEO leaves his position before the end of the current fiscal year or during the first half of the subsequent:‘fiscal year. The main explanatory variable is the firm’s cumulative abnormal stock return over the current fiscal year and two prior years. The use of a relatively long interval for the abnormal stock return is consistent with other studies. For example, Warner et al. (1988) use four years of performance data in their turnover model. I construct the abnormal stock returns described in Section 4. I include controls for CEO age (which should be positively related to turnover) and CEO stock ownership (which should aI%& turnover negatively, if high stock ownership represents a form of CEO entrenchment). I also include dummy variables for industries and CEO ages 44,65, and D. YermacklJournal @Financial Economics 40 (19%) IKS- 21 I 203 Table 5 Probit coefficient estimates: Board size and CEO dismissal incentives Regression coefficient estimates for a binary probit mode...

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...ton and Lorsch (1992) and Jensen (1993) identify board size as a high priority. 188 D. YermacklJoumal of Financial Economics 40 (I 996) 185 21 I Much empirical research has examined whether board structure is related to company performance, but these studies have largely overlooked board size. Instead, investigators have most frequently examined the importance of outside directors and directors’ equity ownership. Studying board composition, Hermalin and Weisbach (1991) find no relation between firm performance and the fraction of outside directors. However, this conclusion is not supported by Baysinger and Butler (1985), who find some evidence that companies perform better if boards include more outsiders. Other studies find that boards dominated by outsiders are more likely to behave in shareholders’ interest. See, for example, Weisbach (1988) (CEO turnover), Byrd and Hickman (1992) (tender offer bids), and Brickley, Coles, and Terry (1994) (poison pill adoptions and control auctions). Rosenstein and Wyatt (1990) find positive investor reactions to appointments of outside directors. With respect to board stock ownership, Merck, Shleifer, and Vishny (1988) find significant, though nonmonotonic, associations ...

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...igorous CEO performance reviews take place regularly. As noted above, limiting board size has begun appearing on some agendas for reform, although only Lipton and Lorsch (1992) and Jensen (1993) identify board size as a high priority. 188 D. YermacklJoumal of Financial Economics 40 (I 996) 185 21 I Much empirical research has examined whether board structure is related to company performance, but these studies have largely overlooked board size. Instead, investigators have most frequently examined the importance of outside directors and directors’ equity ownership. Studying board composition, Hermalin and Weisbach (1991) find no relation between firm performance and the fraction of outside directors. However, this conclusion is not supported by Baysinger and Butler (1985), who find some evidence that companies perform better if boards include more outsiders. Other studies find that boards dominated by outsiders are more likely to behave in shareholders’ interest. See, for example, Weisbach (1988) (CEO turnover), Byrd and Hickman (1992) (tender offer bids), and Brickley, Coles, and Terry (1994) (poison pill adoptions and control auctions). Rosenstein and Wyatt (1990) find positive investor reactions to appoint...

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... McSherry, the staff of the Cole Room at Harvard Business School’s Baker Library, and more than 100 companies that kindly responded to data inquiries. 0304-405X/96/$15.00 0 1996 Elsevier Science S.A. All rights reserved SSDI 0304405X9500844 5 186 D. YermacklJournal qf’Financia1 Economics 40 (19%) 1X5&2/l mechanisms. I contribute to this literature by evaluating a proposal for limiting the size of boards of directors in order to improve their effectiveness. My evidence supports this proposal, as I find an inverse association between firm value and board size in a panel of major U.S. companies. Lipton and Lorsch (1992) state that ‘. . . the norms of behavior in most boardrooms are dysfunctional’, because directors rarely criticize the policies of top managers or hold candid discussions about corporate performance. Believing that these problems increase with the number of directors, Lipton and Lorsch recommend limiting the membership of boards to ten people, with a preferred size of eight or nine. The proposal amounts to a conjecture that even if boards’ capacities for monitoring increase with board size, the benefits are outweighed by such costs as slower decision-making, less-candid discussions of manageri...

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...ity ownership. Studying board composition, Hermalin and Weisbach (1991) find no relation between firm performance and the fraction of outside directors. However, this conclusion is not supported by Baysinger and Butler (1985), who find some evidence that companies perform better if boards include more outsiders. Other studies find that boards dominated by outsiders are more likely to behave in shareholders’ interest. See, for example, Weisbach (1988) (CEO turnover), Byrd and Hickman (1992) (tender offer bids), and Brickley, Coles, and Terry (1994) (poison pill adoptions and control auctions). Rosenstein and Wyatt (1990) find positive investor reactions to appointments of outside directors. With respect to board stock ownership, Merck, Shleifer, and Vishny (1988) find significant, though nonmonotonic, associations between different levels of director stock ownership and Tobin’s Q, suggesting that some levels of board stock ownership have systematic advantages. McConnell and Servaes (1990) and Hermalin and Weisbach (1991) report similar results, while Bagnani, Milonas, Saunders, and Travlos (1994) find that bondholder returns also exhibit a nonmonotonic association with board stock ownership. Lipton and Lorsch...

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...s the maturity structure of each firm’s debt and takes account of changes in the prevailing yield on Moody’s index of A-rated industrial bonds. I assume other liabilities have market value equal to book value. The replacement costs of inventories and fixed assets are estimated by recursive algorithms that take account of inflation, real depreciation rates, capital expenditures, and the method of inventory valuation used by each company. Other assets are assumed to have market value equal to book value. The recursive methods for valuing debt, inventory, and fixed assets closely follow those of Perfect and Wiles (1994) in their qpw estimator of Tobin’s Q.’ Fig. 1 illustrates mean and median values of Tobin’s Q for companies sorted by board size. The number of directors for each company was obtained from proxy statements for firms’ annual meetings, which usually occur in the fifth or sixth month of each fiscal year. Mean and median Tobin’s Q values decline almost monotonically over the range of board sizes. For companies with between four and eight directors, mean Q values range between 1.5 and 2, while the mean Q value falls to slightly above 1 for companies with 20 or more directors. In addition to board s...

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...verlooked board size. Instead, investigators have most frequently examined the importance of outside directors and directors’ equity ownership. Studying board composition, Hermalin and Weisbach (1991) find no relation between firm performance and the fraction of outside directors. However, this conclusion is not supported by Baysinger and Butler (1985), who find some evidence that companies perform better if boards include more outsiders. Other studies find that boards dominated by outsiders are more likely to behave in shareholders’ interest. See, for example, Weisbach (1988) (CEO turnover), Byrd and Hickman (1992) (tender offer bids), and Brickley, Coles, and Terry (1994) (poison pill adoptions and control auctions). Rosenstein and Wyatt (1990) find positive investor reactions to appointments of outside directors. With respect to board stock ownership, Merck, Shleifer, and Vishny (1988) find significant, though nonmonotonic, associations between different levels of director stock ownership and Tobin’s Q, suggesting that some levels of board stock ownership have systematic advantages. McConnell and Servaes (1990) and Hermalin and Weisbach (1991) report similar results, while Bagnani, Milonas, Saunders, ...

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...alysis above shows that companies with small boards of directors attain higher values in the capital markets than do their counterparts with large boards. However, we might interpret these findings in two ways: Small boards could contribute to better performance, or companies might adjust board sizein response to past performance. If companies expand their boards in the aftermath of poor performance, the causation of the board size-firm value relation may run in the opposite direction from the Lipton-Lorsch (1992) and Jensen (1993) hypotheses. Prior studies by Hermalin and Weisbach (1988) and Gilson (1990) examine the interplay between company performance and changesinboards of directors. Hermalin and Weisbach (1988) find that poor performaglce lead&to both more departures of board members and more appointments to the board. While Hermalin and Weisbach are silent on the net ieffect.’ of these two forces, they estimate similar magnitudes for each, suggesting&at director turnover increases after poor performance, but board size does not. Gilson (MO), in a study limited to financially distressed companies, also finds that boarukrtatuwiwer increases after poor performance; moreover, Gilson finds th...

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...d by such costs as slower decision-making, less-candid discussions of managerial performance, and biases against risk-taking. Jensen (1993) takes up this theme, pointing out the ‘great emphasis on politeness and courtesy at the expense of truth and frankness in boardrooms’ and stating that ‘when boards get beyond seven or eight people they are less likely to function effectively and are easier for the CEO to control’. Some evidence shows that reducing board size has become a priority for institutional investors, dissident directors, and corporate raiders seeking to improve troubled companies. Kini et al. (1995) present evidence that board size shrinks after successful tender offers for under-performing firms. At American Express, the outside director who in 1993 organized the removal of the company’s CEO cited the ‘unwieldy’ 19-person board as an obstacle to change, stating that the ‘size of the board does make a difference’, according to Monks and Minow (1995). Smaller boards have emerged recently during overhauls of corporate governance at such prominent companies as General Motors, IBM, Occidental Petroleum, Scott Paper, W.R. Grace, Time Warner, and Westinghouse Electric. Institutional investor p...

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...en (1993), and other advocates of small boards contend that board size affects corporate governance independent of other board attributes. As noted above, their arguments focus on the productivity losses that arise when work groups grow large, an insight borrowed from organizational behavior research such as Steiner (1972) and Hackman (1990). According to Jensen (1993), ‘. . as groups increase in size they become less effective because the coordination and process problems overwhelm the advantages from having more people to draw on’. Empirical research on the importance of board size is thin. Holthausen and Larcker (1993a, b) consider board size among a range of variables that might influence executive compensation and company performance. Holthausen and Larcker (1993a) present results indicating a positive association between board size and the value of CEO compensation. Holthausen and Larcker (1993b) fail to find consistent evidence of an association between board size and company performance. A clear problem in studying board size is that the number of directors might arise endogenously as a function of other variables, such as company size, performance, or the CEO’s preferences. Along these lines, the man...

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...en (1993), and other advocates of small boards contend that board size affects corporate governance independent of other board attributes. As noted above, their arguments focus on the productivity losses that arise when work groups grow large, an insight borrowed from organizational behavior research such as Steiner (1972) and Hackman (1990). According to Jensen (1993), ‘. . as groups increase in size they become less effective because the coordination and process problems overwhelm the advantages from having more people to draw on’. Empirical research on the importance of board size is thin. Holthausen and Larcker (1993a, b) consider board size among a range of variables that might influence executive compensation and company performance. Holthausen and Larcker (1993a) present results indicating a positive association between board size and the value of CEO compensation. Holthausen and Larcker (1993b) fail to find consistent evidence of an association between board size and company performance. A clear problem in studying board size is that the number of directors might arise endogenously as a function of other variables, such as company size, performance, or the CEO’s preferences. Along these lines, the man...

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...kely to function effectively and are easier for the CEO to control’. Some evidence shows that reducing board size has become a priority for institutional investors, dissident directors, and corporate raiders seeking to improve troubled companies. Kini et al. (1995) present evidence that board size shrinks after successful tender offers for under-performing firms. At American Express, the outside director who in 1993 organized the removal of the company’s CEO cited the ‘unwieldy’ 19-person board as an obstacle to change, stating that the ‘size of the board does make a difference’, according to Monks and Minow (1995). Smaller boards have emerged recently during overhauls of corporate governance at such prominent companies as General Motors, IBM, Occidental Petroleum, Scott Paper, W.R. Grace, Time Warner, and Westinghouse Electric. Institutional investor pressure reportedly contributed to many of these changes, such as the 1995 reduction in Grace’s board from 22 directors to 12. In a sample of 452 large U.S. public corporations observed over the period 1984 to 1991, I find an inverse relation between firm market value, as represented by Tobin’s Q, and the size of the board of directors. The association app...