Selecting a CEO – Looking at the Principal Agent

Econ 101 story… When hiring a CEO, shareholders should worry about competence, but also about the Principal-Agent problem. The CEO has one set of motivations as CEO (e.g., increase pay, live extravagantly on the company dime, and accumulate adulation) while shareholders have another, namely to increase the value of the company.

Now, for most people, that is a good argument for having a CEO that comes from a family that owns the biggest block of shares in the company. Who else, these people ask, could possibly be as motivated to see the company succeed as the biggest shareholder? Who could be more motivated?

My response – just about any randomly selected corporate Vice President in that same company. Consider such a person. He (and this person is still probably a he) has worked for the company for 20 years, rising from a lowly entry level position. This not only means he knows the company inside and out, but it also that a major part of his wealth is tied to the company – mostly in stock options, but the pension and other benefits and perks also contribute substantially to his net worth. Even his experience – his human capital itself, after 20 years, is heavily tied to the company.

Compare that to a member of the largest shareholding family. Odds are, this is only part of the family empire, each element of which demands some attention. If the company fails, that person will still very wealthy, and may find him or herself with the time and resources to start just the sort of enterprise he or she finds most interesting, as opposed to running some big stodgy un-sexy company that’s been around for decades.

Thus, the largest shareholder probably has less incentive, not more, to ensure the success of the firm than the random corporate Vice President. He probably also pays less attention, and has less knowledge of the industry. Additionally, the amount of compensation necessary to motivate the random corporate Vice President is probably a lot less than the amount of compensation needed to motivate someone significantly wealthier.

All things considered, it seems to me that Fortune 500 companies not only often select candidates that are far from the best possible choice, they also have a selection process that ensures that none of the best candidates are even considered. Back in the 14th century, the selection process for lord of the manor was much the same.