Firm Complexity and Board of Director Composition

• Published date: 01 November 2007
• Author: Antonio Parbonetti,Garen Markarian
• Date: 01 November 2007
• DOI: http://doi.org/10.1111/j.1467-8683.2007.00643.x

Firm Complexity and Board of

Director Composition

Garen Markarian and Antonio Parbonetti*

This paper examines the relationship between f‌irm complexity and board of director compo-

sition. Utilising the board typology of Baysinger and Zardkoohi (1986), we classify board

members either as insiders, business experts, support specialists, or community inf‌luentials,

and examine board composition in relation to f‌irm internal and external complexity. Internal

complexity refers to the sophistication of internal work processes (proxied by f‌irm R&D

expenditures, and the amount of invested capital), while external complexity relates to the

external competitive structure (proxied by the number of business and geographic segments,

and industrial leadership). Utilising a random sample of 150 f‌irms drawn from six industries

over the 2003–2005 time period, and after classifying 4,408 directors to one of our board

categories, multivariate results conf‌irm conjectures that complexity is related to the specif‌ic

capabilities that each board member brings to the f‌irm. We f‌ind that externally complex f‌irms

substitute community inf‌luentials for insiders. Additionally, internally complex f‌irms have

lower levels of community inf‌luentials, which are substituted by insiders and support spe-

cialists. This study adds to a small but growing literature that examines the economic deter-

minants of board structure (Boone et al., 2007; Coles et al., 2005; Gillan et al., 2003; Linck et al.,

2005), by providing a unique lens in examining board characteristics that goes beyond the

traditional insider/independent classif‌ication.

Keywords: Firm complexity, board composition, corporate governance, determinants of

boards, strategic governance

1. Introduction

Despite the large body of research, the

notion of an “optimal board structure” is

still far from being clear (for a recent study, see

Boone et al., 2007). Because of the mixed and

sometimes contradictory f‌indings in empirical

research, there is a need to better understand

the factors that affect board composition, and

its relationship to f‌irm internal and external

characteristics.

According to agency scholars (Jensen and

Meckling, 1976; Fama and Jensen, 1983) the

board of directors performs two critical func-

tions: monitoring top executives, and reward-

ing them. On the other hand, stewardship

theory (Davis et al., 1997; Muth and Donaldson,

1998) emphasises the strategic function of

boards; while resource dependence theory

(Pfeffer, 1972; Pfeffer and Salancik, 1978)

views boards as boundary spanners. However,

none of the above-analysed theoretical per-

spectives has received def‌initive empirical

support. The relationship between board

characteristics and f‌irm performance remains

a moot point in capital markets, regulatory

circles, and academia: studies have found

weak, none, or contradictory relationships

between board composition and f‌irm perfor-

mance (Baysingerand Butler, 1985; Bhagat and

Black, 2002; Chaganti et al., 1985; Daily and

Dalton, 1992, 1993, 1994; Dalton et al., 1998;

Ezzamel and Watson, 1993; Kesner et al.,

1986; Pearce and Zahra, 1992; Peng, 2004;

Rosenstein and Wyatt, 1990; Schellenger et al.,

1989). As a consequence, in the academic lit-

erature, the superiority of a specif‌ic board

composition is unclear (Raheja, 2004; Boone et

al., 2007; Linck et al., 2005). Despite the impor-

tance of corporate governance in the f‌inancial

*Address for correspondence:

Dipartimento di Scienze Eco-

nomiche, via Del Santo 33,

35121 Padova, Italia. Tel: +39

049 8274261; Fax: +39 049

8274211; E-mail: antonio.

parbonetti@unipd.it

1224 CORPORATE GOVERNANCE

Volume 15 Number 6 November 2007

© 2007 TheAuthors

Journal compilation © 2007 BlackwellPublishing Ltd, 9600 Garsington Road,

Oxford, OX4 2DQ, UK and 350 Main St,Malden, MA, 02148, USA

markets, academics have not yet reached def‌i-

nite conclusions regarding the factors deter-

mining board size and composition (Boone et

al., 2007).

Utilising the theoretical approach of Zahra

and Pearce (1989) that identif‌ies the three key

roles of the board as oversight, strategy, and

service, this study argues that depending

on the complexity of the f‌irm’s internal and

external environments, the composition of the

board of directors differs. Internal complexity

refers to the sophistication of internal work

processes (proxied by R&D expenditures, and

the amount of invested capital), while external

complexity relates to the external competi-

tive structure (proxied by the number of busi-

ness and geographic segments, and industrial

leadership).

Using the board of director typology

advanced by Baysinger and Zardkoohi (1986),

it is argued that in f‌irms characterised by

complex internal environments, there is a

larger proportion of insiders on the board, due

to information asymmetries and diff‌iculties in

transferring f‌irm-specif‌ic information to out-

siders. It is also hypothesised that in such

f‌irms there is a larger proportion of support

specialists enhancing f‌irms’ capability build-

ing functions. In contrast, it is hypothesised

that in f‌irms characterised by a complex exter-

nal environment, there is a larger proportion

of board members who are business experts,

facilitating the f‌irm’s resource picking func-

tion. Additionally, in such f‌irms it is hypoth-

esised that there is a larger proportion of

community inf‌luentials, aiding the f‌irm navi-

gate an uncertain political environment.

This study utilises a random sample of 150

f‌irms from 3 hi-tech and 3 non hi-tech indus-

tries, for the years 2003–2005, in examining the

above mentioned relationships. After classify-

ing 4,480 directors according to their charac-

teristics, multivariate tests provide support for

our hypotheses: both internal and external

complexities are related to board composition.

Findings indicate that externally complex

f‌irms substitute community inf‌luentials for

insiders. Additionally,internally complex f‌irms

have lower levels of community inf‌luentials,

which are substituted by insiders and support

specialists. On the other hand, the complexity

measures do not explain the presence of busi-

ness experts on the board. These results are

robust to the inclusion of industry and year

controls, and are in addition to a large number

of covariates that are related to the f‌irm’s eco-

nomic characteristics and elements of its gov-

ernance environment.

Whereas other studies have examined varia-

tions in governance structure using traditional

empirical proxies of governance, such as the

separation of the CEO/chairmanship posi-

tions, board independence, presence of com-

mittees, or board charters and poison pills; this

study uses a relatively novel board typology

based on identifying board member’s unique

capabilities, where board structure is exam-

ined as a function of f‌irm complexity. This

study adds to a small but growing literature

that examines the economic determinants of

board structure (Boone et al., 2007; Coles et al.,

2005; Gillan et al., 2003; Hermalin and Weis-

bach, 2003; Linck et al, 2005). This paper is

organised as follows: the next section brief‌ly

discusses the literature and presents the

hypotheses. Section 3 presents the research

methods, while section 4 presents the results.

Finally, section 5 concludes.

2. Complexity and the board of

directors: roles and composition

2.1. Board of director roles and

composition

In examining board of director composition,

three pivotal ideas are assumed as a starting

point: f‌irst, corporate boards perform different

tasks at the same time; second, each director

plays a role within the board by providing

skills, knowledge, and ties to the environment;

and third, corporate boards perform their tasks

according to the characteristics of the compa-

nies and of their environment (Rindova, 1999).

As a result of their professional experiences,

problem solving skills and business exposures,

there is large variability to the capabilities

that each board member brings to the f‌irm

(Sullivan,1990). Consequently, boardmembers

bring great variety to a f‌irm in terms of choice

in strategic decision making. This diversity,

combined with the expertise and experiences

of the f‌irm’s managers, produces a mosaic of

decision making structures and subsequent

f‌irm behaviour.

A broader understanding of board struc-

ture and function, and how it relates to pro-

tecting shareholder interests, necessitates

re-examining the underlying assumptions for

board effectiveness. Regulators and practitio-

ners alike predominantly regard boards as a

binary function of either being independent or

controlled by managers, and academic studies

mentioned previously have mainly examined

board structure in terms of independence,

size, and power structure. This distinction

between insiders and independent directors is

important to analyse the oversight function of

the board; but since the board simultaneously

performs control, service and strategic func-

tions (Zahra and Pearce, 1989), a thorough

FIRM COMPLEXITY AND BOARD OF DIRECTOR COMPOSITION 1225

Volume 15 Number 6 November 2007© 2007 TheAuthors

Journal compilation © BlackwellPublishing Ltd. 2007