Contests to Become CEO

Abstract

Firms tend to promote insiders to the CEO position rather than to hire outsiders. This paper explains this phenomenon by developing a framework in which firms value the incentive that the contest to become CEO provides to current employees, but also want the most able candidate (insider or outsider) to become CEO. We determine the optimal payment to current employees, the payment to the new CEO if she is promoted from within, the payment to the new CEO if he is hired from outside, and the size of the handicap imposed on outside candidates (i.e., the bias toward insiders). We find that, at the optimum, outsiders must be clearly superior for the firm to facilitate their selection via negative handicapping (i.e., a bias towards outsiders). By contrast, if outsiders are not clearly superior, incentive provision to insiders via handicapping of outsiders or via higher payments to successful insiders is more important than selecting the most able CEO. We also find that the ability (or inability) of a firm to precommit to a large payment to a promoted insider CEO is critical. The ability to precommit reduces the handicap imposed on outsiders, raises the payment to insider CEOs, and lowers the payment to current employees. The outsider handicap, and so the likelihood that an insider will be chosen, depends positively on the number of insiders and the number of outsiders competing to be CEO, provided that the firm cannot precommit. The handicap imposed on outsiders can depend positively on the extent of commonality among insiders, provided that the firm wants to elicit effort from insiders but this effort is relatively small. The handicap depends negatively on the average ability of outsiders, the extent of commonality among insiders (provided that the firm wants to elicit effort from insiders and this effort is relatively large), the similarity of the shocks faced by insiders and outsiders, and financial stress faced by the firm.

Keywords: Contests, CEO contracts, tournaments, moral hazard

JEL Classification: D800, G300