NCPA - National Center for Policy Analysis

Let Outside Directors Become Owners

January 26, 2001

It is now common practice to align shareholder and manager interests by compensating executives with stock in a company. But many outside directors have only token holdings in a company. Consequently, they do not effectively monitor and discipline managers.

A recent study analyzed 40 business sectors in the United States to determine the link between outside director equity holdings and corporate performance over the decade from 1987 to 1996.

The study separated the companies into two groups -- "stars," those that exceeded the median performance of firms in their business sector by 10 percent and "laggards," companies that underperformed the sector by 10 percent. The study found that:

  • Outside directors of star companies owned a median 1.3 percent of total shares in 1987, while outside directors of laggard companies owned a mere 0.1 percent.
  • The median amount invested by outside directors of stars ($470,000) was 5 times larger than that of laggards ($80,000).
  • 45 percent of star companies had two or more outside directors who held at least $500,000 worth of equity as compared to only 16 percent of laggards.

The pre-1987 performance of the stars and laggards did not differ much; but the differences in director shareholdings preceded the companies' divergent paths of performance. This suggests the larger holdings of the stars' directors contributed to those companies' subsequent stellar performance, rather than being a consequence of it.

The authors recommend that outside directors should own roughly $500,000 of equity, which represents 3 to 5 percent of the average director's personal net worth.

Source: "Make Outside Directors Owners," Economic Intuition, Fall 2000; based on Donald C. Hambrick and Eric M. Jackson, "Outside Directors with a Stake: The Linchpin in Improving Governance," California Management Review, Summer 2000.  

 

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