Saturday, December 02, 2006

Why Yahoo!'s and other Outside Directors Should Have Skin In the Game

In 1999, I got to work with Don Hambrick at Columbia on a major research study funded by McKinsey and Korn/Ferry. Academics from across the country were chosen to study particular domains of management and how they impacted corporate performance over the long-term. For example, one academic studied executive compensation, another studied organizational structure, etc.

Don was asked to study corporate governance and my job, as his research assistant, was to sift through hundreds of corporate proxies in the library (and the SEC’s office at the tip of Manhattan), coding all the possible corporate governance characteristics that might impact an increase in total shareholder returns over time.

This project, called “Project Evergreen,” studied about 200 companies from 50 industries over a 10-year time period, roughly from the mid-80s to mid-90s. For each industry, we looked at 4 companies: 1 “Star” (which outperformed the industry benchmarks over the 10 years), 1 “Found It” (which underperformed but later outperformed the industry benchmarks), 1 “Lost It” (you get the picture), and 1 “Never Had It.”

We coded every corporate governance variable you can imagine that might have had an impact on a company’s stock price: director age, board size, director background, how many committees or other boards they served on, whether the CEO and Chair role was split, how much stock they owned, etc. Of all these various characteristics (and we looked at well over 50), only one predicted an increase in company performance over time (controlling for company age, size, and its previous success): whether the company had a majority of outside directors who had purchased sizable equity stakes in the company (as opposed to being given stock or options).

The complete article was published in California Management Review and is located here. It’s worth a read, if only because it’s remarkable how few companies today (even in our post-Enron world) can claim they have outside directors that do this.

Most companies still dole out big options or grants to their directors, which, according to our research, had zero impact on later company stock performance. Very few require directors to dig into their own pockets. The claim I have often heard made by companies in response to our research finding is that “If I did that, I couldn’t get anyone good to serve on my board.” Our reaction: “If that’s the case, what does that say about your company and what are you doing to fix it?”

Let’s take Yahoo! as an example. They claim 8 out of their 10 directors are “outsiders” or “independent” (although 2 of the 8 have been on the board over a decade making it arguable how much of an outsider’s eye they can really bring to board discussions). The stock has certainly been depressed in the last 2 years (down from $40 to under $26.50 yesterday), while their chief competitor’s stock has vaulted ahead. Their policy is that outside directors should try to hold 12,000 units of stock (or $320,000 at recent prices). However, this stock can be held in the form of grants or options. Yahoo! pays its directors in stock for serving on its board, not cash (each director received 50,000 options in 2005, except 1 who received 100,000). Almost all the outside directors have total options today between 300,000 – 750,000 with strike prices well below the currently depressed level. These options should make them feel like ‘owners.’ Yet, where has been the board vigilance in the past two years? Where has been the ‘tough questions’? Just giving out lots of options has not led to increased performance. Yahoo! has no requirement for directors to buy stock. They should.

In the previously mentioned 2000 CMR article referred to above, we quoted a recently retired CEO about how putting ‘skin in the game’ and buying stock affected his behavior as a director:

I’m convinced that having a significant financial stake in the company affects the alertness and behavior of directors. I’ve seen it in others, and I’ve seen it in myself. You seek more information, you spend more time with the information, you ask more questions, you probe much more. And, best of all, the CEO knows you’re super-interested, and so he does a better job too.

I’ve been on several boards. I’ve always held small, token amounts. But now I’m on a board where the CEO encouraged us to buy and hold significant shares. I’m in for about a half a million dollars, and I can tell you I’m a heck of a lot more attentive to this company than I have been to the others. If this company faces a challenge, I lose sleep at night – which is what you want from your directors.

All outside directors should be investors in the companies they are involved in. If they aren’t willing to drop a quarter or half million of their own money to be involved, should the company’s investors really want them to have a say at board meetings? The evidence overwhelmingly says no.

A couple of closing caveats. We recognize in the paper that some directors can’t easily invest this kind of money due to their jobs, yet they make fabulous directors. You can’t simply set a financial number as a threshold and limit these people from the pool of possible directors. We offer some suggestions for how to handle this tricky issue in the paper.

Finally, when I slogged through the proxies (with the help of several Columbia College students) coding governance characteristics, we necessarily had to look at “governance structure” variables not “process” variables as predictors. After all, we weren’t in the room to observe how these directors asked questions and conducted meetings. How a board operates is even more important that who sits on a board and how much stock they own. We’ve just completed some new research with over 150 organizations that bears this out. More on this in a future posting, but for now, check out more details on our Breakout Performance Index tool and some information on our recent study here.

All directors should have ‘skin in the game’ – this makes them, according to our research, not passive observers, but active and more effective fiduciaries.

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Hans said...

Yahoo has missed the boat a long time ago.