Ebook Managerial horizon and the choice for insiders versus outsiders: evidence from compensation structures of CEO successors
This paper investigates whether to address potential distortions in intertemporal decision making, CEOs appointed from outside the firm are provided with different incentives than CEO successors selected from within the firm. It is asserted that outside CEO successors are more short-term oriented compared to inside CEO successors because of two reasons. First, outside CEO successors are reported to have shorter (anticipated) tenure compared to inside CEO successors (e.g. Brady et al., 1982). That is, the more diversified human capital of outside CEO successors enhances outside employment opportunities vis-à-vis inside CEO successors who possess more firm-specific knowledge that is characterized by limited value outside the respective firm (Parent, 1999).
The shorter a CEO expects to stay in position, the smaller the benefits from future cash flows and the greater the incentives to sacrifice long-term benefits for short-term benefits (Narayanan, 1985). So outside CEOs with a shorter employment horizon can be myopic with regard to the long-term effects of their decisions. Second, boards have superior knowledge of the abilities of inside candidates because of the opportunity to update their assessment more accurately over multiple periods relative to outside contestants (Zajac, 1990). Outside CEO successors who just assumed their position have yet to establish a reputation and will be focused on activities that produce quick wins. That is, they will be inclined to emphasize actions that yield short-term profits even at the expense of firms’ long-term interests in an attempt to quickly build a reputation within the firm (Narayanan, 1985).
To examine whether firms account for the alleged short-termism of outside CEO successors through the incentive compensation packages, we distinguish between short-term oriented and long-term oriented incentives. Short-term incentives are incentives tied to short-term backward looking measures such as current earnings that reward short-term oriented effort.
Long-term incentives are tied to long-term backward looking measures such as future earnings or forward looking measures such as stock price that rewards long-term oriented effort (Dikoli, 2001). We argue that firms can use incentive package features to account for potential distortions in intertemporal decision making entailing the type of succession. As outside CEOs are allegedly more short-term oriented than inside CEOs, we expect that outside CEOs are subject to incentives that redirect their attention to decisions with long term impact. Particularly we argue that that de-emphasizing current earnings while emphasizing future earnings and/or stock price in the respective CEO incentive plans lengthens the time orientation of these managers.
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