Wharton finance professor Luke Taylor decided to study why CEOs are rarely fired:
Taylor’s model contained two costs of firing a CEO. Direct costs, such as severance, make up the first component. The second component is what Taylor terms “entrenchment” costs, which are intangible costs that board members feel but shareholders do not — for instance a personal relationship between board members and the CEO. If there are any entrenchment costs, then boards fail to get rid of CEOs whom shareholders would like to see fired — in short, creating an environment where fewer top executives are let go than should be, based on performance.Taylor’s model found that the entrenchment cost per firing was, on average, $1 billion — far more than the $300 million in direct costs.
One area Taylor did not examine is what impact a higher level of CEO turnover would have on the ranks of CEOs. His model does, however, predict that if the entrenchment cost went to zero — meaning that sacking a CEO came with only financial costs and no intangible consequences — the annual rate of CEO firings for the S&P 500 would go from 2% to 13%. That would result in a one-time bump in value for the S&P 500 of 3%. Taylor notes that this higher level of firings could potentially cause talented individuals to choose career paths other than those that might lead to a CEO position.
These findings aren’t universal:
When Taylor looked at the larger half of the S&P 500, he found the entrenchment cost was close to zero — in fact, it was slightly negative. Why the difference between small and large firms? One possibility, Taylor says, is that directors in larger firms have a higher public profile and care more about their public reputations. That may make them more inclined to fire a CEO when times are tough.
Taylor’s work also found there was less entrenchment in the 1990 to 2006 timeframe than in the earlier period studied. He says that this is not surprising, in part because of growing shareholder activism over the last two decades. Regardless, Taylor says it is clear that “entrenchment has gone down, and that is good news.”