Contests to Become CEO: Incentives, Selection and Handicaps

Abstract

Should a firm favor insiders (handicap outsiders) when selecting a CEO? One reason to do so is to take advantage of the contest to become CEO as a device for providing current incentives to employees. An important reason not to do so is that this can reduce the ability of future CEOs and, hence, future profits. The trade-off between providing current incentives and selecting the most able individual to become CEO is the focus of this paper. If insiders are good enough (better or nearly as good as outsiders), incentive provision to insiders typically dominates and it is optimal to handicap outsiders, sometimes so severely that they have no chance to win the contest. However, if outsiders are sufficiently better than insiders, selection dominates and it is the insiders who are severely handicapped. This finding is in sharp contrast to the existing literature which has so far ignored this trade-off. In all, our model provides useful insight into contests to become CEO and rationalizes empirical regularities in the source of CEOs chosen by firms. In particular, our analysis helps to explain the lower tendency of firms in more heterogeneous industries and firms with a product or line of business organizational structure to select an outsider as CEO.

Keywords: Contests, CEO contracts, moral hazard

JEL Classification: D21, D82, L20