A company’s CEO typically takes actions that affect the firm’s future performance beyond his own tenure. The CEO leaves behind a legacy. How can a firm incentivize a new CEO who inherits the legacy? How does a legacy affect the firm’s decision to dismiss a poorly performing CEO and to adopt new strategies? And what is the nature of the relationship between a CEO and the strategy he stands for? Even though these questions are at the core of company’s concerns in the face of poor performance, existing theory provides little guidance regarding the economic mechanisms that link CEOs to strategies or that link successive CEOs intertemporally. This paper is aimed at addressing these questions.
The starting point of this paper is the observation that there is an intertemporal link between a new CEO’s incentives and the actions taken by his predecessor. The fact that such a link exists is probably more recognized in the accounting literature than in economics. Pourciau (1993) for example provides evidence that the successor of a CEO who has left the firm for non-routine reasons, tends to depress accounting earnings during their first year in office. Pourciau interprets this as an attempt ‘to take a bath while still being able to blame the predecessor.’ In addition, there is rich anecdotal evidence that illustrates the prevalence of the blame game in which CEO successors often engage, with the corresponding challenge for outsiders to attribute responsibility fairly. For example, when Mike Parton, former CEO of Marconi, was asked “How much blame do you accept for Marconi’s [...] troubles?” he replied that “You can’t be part of management and just wash your hands of it. However, I was not a board member when the key strategic decisions were made, and it’s difficult to say what my view might have been had I been on the board at the time.”
This paper formalizes the intertemporal link between the performance of two generations of CEOs and thereby introduces the notion of a managerial legacy. When a CEO works for a firm he may initiate a long-term strategy that affects the distribution of the firm’s cash flows for several periods into the future. For example, decisions that involve large capital expenditures or that establish a firm’s reputation in a particular market segment typically have long lasting impact. Because of this, such long-term strategic decisions may affect the incumbent CEO’s future incentives to implement a given strategy as well as the incentives of a potential successor who inherits the incumbent CEO’s legacy.
By the same token, if the firm can adopt a new strategy, its success or failure may throw light on the quality of the initial strategic decision made by the CEO. This gives the incumbent CEO a vested interest in seeing his initial strategy succeed that a new manager does not have in the same way. Conversely, an incumbent CEO who has to change strategy may have a vested interest in seeing that new strategy fail so as to vindicate his original choice. As a result contract design, employment decisions and strategy choices are intrinsically linked. The aim of this paper is to explore these dynamic links when managers can create legacies in the firms they manage.
We consider a set-up in which a firm manager can be incentivized both explicitly and implicitly through reputational concerns. The manager needs to take a long-term strategic decision the quality of which depends on his intrinsic and unknown ability. After a strategy has been chosen it needs to be implemented, which requires managerial effort over two periods. Cash flows are also generated over two periods and depend both on the initial choice of strategy and on the implementation effort. The firm can dismiss the incumbent manager after poor performance and hire a new manager to continue the project’s implementation. We assume that a new manager is equally well suited to implement the project.
We first determine the optimal wage contracts and employment policy for shareholders. We show that in the presence of reputational concerns by managers, the threat of firing after bad performance is time inconsistent, i.e., the incumbent manager is entrenched. The reason is that it is cheaper to employ an incumbent manager after he performed badly than to hire a new manager, because the new manager knows that his reputation is less sensitive to performance than that of the incumbent. As a result, higher explicit incentives for the new manager have to replace the implicit incentives of the incumbent, which is costly to the firm. From an ex ante point of view, entrenchment can be costly, though. We characterize under which conditions entrenchment is detrimental to shareholders.
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