- In this paper, Hillman and Dalziel show that to understand the link between firm performance and board of directors, two dominant theories in the literature have been utilized – agency theory, and resource dependence theory. Both perspectives are useful. However, there is need of an integrated theory, to show a richer picture. This piece is my personal reflection of the paper.
- In firms, directors are hired to monitor. It is their responsibility to protect the interests of the owners (shareholders). This seems to be a necessary consequence of separation of ownership and control. There has been considerable work claiming that the monitoring by the board would reduce the agency costs which arise by letting loose the self-interested manager. The board is not only hired to monitor the agent. Apart from that it is there to monitor the implementation of strategy, planning for CEO succession and also appraising the firm’s CEO and other top managers.
- But why would the director monitor? To answer this question, agency theory would say that the director chooses to monitor because of board incentives. On this multiple works have been done. Eugene Fama (1980), as also Jensen & Meckling (1976) proposed that if the the board’s incentives are aligned with that of shareholders, monitoring will be more effective. By implication, agency costs for the firm would go down.
- But then, what incentives do we pick for the board of directors so that their interests are aligned with the shareholders? There are two proxies for it. Board dependence, measured as the proportion of dependent directors to independent directors. The prevailing argument here is that dependent directors have a disincentive to monitor management effectively. Multiple studies using this as a proxy has supported this idea. On the contrary, there is a meta-analysis that found no statistical support using 54 studies (Dalton et al, 1998). Another proxy is equity compensation. There are conflicting results in this case.
Reducing Agency Costs: Agency Theory, or Resource Dependence Theory?
- If we go by agency theory first, we can begin my asking if the board of directors, who have been hired to monitor the agent, could also do better at monitoring if they are given incentives to monitor. Unfortunately, there is work that shows that there is no statistical support between board incentives and firm performance.
- Taking the other path, if we go by resource dependence theory, we can try to visualize directors as resource bundles. They bring experience, expertise, and reputation as human capital and their network of ties to other firms or entities as relational capital. This is how directors provide resources. There is a good amount of evidence that there is a positive link between the board’s resource provision and firm performance. And there is good rationale for it, that resource dependence theory provides: reduction in firm’s dependence on external resources, lowering of transaction costs, and even firm survival.
- But why do the authors say that there is an incompleteness in both the theories in themselves as lenses? In agency theory, there is much focus on incentives and blindness to ability (board capital). On the other hand, resource dependence theory ignores the role of incentives. Directors are doing a mix of activities, and both of these theories individually overlook that mix.
The Integrated Model
- In the integrated model, board capital becomes an antecedent to both monitoring and resource provision, and not just resource provision, as was suggested by resource dependence theory. The argument here is that the ability of the board directly enhances its ability to model. Considerable evidence has been generated on this front. They offer two propositions in this regard: 1a) Board capital is positively associated with the provision of resources, and 1b) Board capital is positively associated with monitoring.
- In the integrated model, board incentive becomes a moderator. The argument? Independently incentive does not determine performance; they only influence the strength of relationship between board capital and board’s actions. They use expectancy theory to understand motivation better. According to expectancy theory, performance is function of both ability and motivation. Since incentives are seen as motivations too, perhaps they can be seen as moderators in the integrated model? Using this they develop further propositions: 2a) Board incentives will moderate the relationship between board capital and monitoring, and 2b) Board incentives will moderate the relationship between board capital and the provision of resources.
- But there are proxies for board incentives – equity compensation and board dependence. Would the use of each moderate the relationship differently? We need more propositions for this: 3) Equity positively moderates the capital-monitoring link, and 3b) equity positively moderates the capital-resource provision link. The other proxy – board dependence – would as a conflicting moderator, and so the propositions developed are: 4a) Dependence negatively moderates the capital-monitoring link and 4b) dependence positively moderates the capital-resource provision link.
Critique
- Oversimplification of core constructs – board capital and board incentives. These two types of capital are not the same. They have different, or maybe, conflicting effects. One could ask: Do human and relational capital have differential effects on the board’s ability to monitor versus provide resources? Through this we are essentially trying to see through board capital, which has been treated as a black box in the paper. For incentives by way of measuring it through dependence, board dependence becomes a uniform variable. But board dependence can also have its nature – managerial, familial, commercial. Could these differentially moderate the relationship between board capital and board functions?
- There is a lack in the model for contextual and environmental factors. Environment is a function of required monitoring vs resources. It may be that the firm’s life cycle determines the degree of relative importance it puts on either. It may also be that the industry of the firm determines the relative importance of monitoring vs resource. For instance, by interacting the two – life cycle of the firm, and industry – one could think of a start-up which is in a volatile tech industry desperately seeking resource-provision (VC Connections, Strategic advice), and a mature firm in a relatively stable environment preferring monitoring to prevent managerial complacency.
- What about feedback loops? The model is static and linear. Governance has a dynamic nature. If we factor in reverse causality, we may want to ask if firm performance could recursively influence board capital and the nature of board incentives over time.