Determinants of Board Size and Composition: A Theory of Corporate Boards

Abstract

This paper models the interaction of firm insiders and outsiders on a corporate board and addresses the question of the ideal size and composition the board board. In the model, the board is responsible for monitoring projects and making CEO succession decisions. Inside directors are better informed regarding the quality of firm investment projects, but outsiders can use CEO succession to motivate insiders to reveal their superior information and help the board in implementing higher value projects. The optimal board structure is determined by the tradeoff between maximizing the incentive for insiders to reveal their private information, minimizing the cost to outsiders to verify projects, and maximizing outsiders' ability to reject inferior projects. I show that optimal board size and composition are a function of the directors' and firm's characteristics. I also develop testable implications for the cross-sectional variations in the optimal board structure across firms.

Keywords: Boards, insiders, outsiders, governance, monitoring

JEL Classification: G30, G34, G38