Undervaluation of directors in the board hierarchy: Impact on turnover of directors (and CEOs) in newly public firms

• DOI: http://doi.org/10.1002/smj.2716
• Author: Sam Garg,Qiang (John) Li,Jason D. Shaw
• Published date: 01 February 2018
• Date: 01 February 2018

RESEARCH ARTICLE

Undervaluation of directors in the board hierarchy:

Impact on turnover of directors (and CEOs) in

newly public firms

Sam Garg

1

| Qiang (John) Li

1

| Jason D. Shaw

2

1

Department of Management, School of Business

and Management, Hong Kong University of

Science & Technology, Kowloon, Hong

Kong SAR

2

Department of Management and Marketing, The

Hong Kong Polytechnic University, Kowloon,

Hong Kong SAR

Correspondence

Sam Garg, Department of Management, School of

Business and Management, Hong Kong

University of Science & Technology, Clear Water

Bay, Kowloon, Hong Kong SAR.

Email: samgarg@ust.hk

Research summary:We examine the consequences of

the formalization of the board leadership structure at IPO

for board-level turnover. We introduce the concept of

director undervaluation. It indicates the degree to which

a director’s qualifications based on normatively accepted

criteria for board leadership are not duly reflected in

his/her appointments to the board chair and committee

chair positions. We find that the higher the average

undervaluation of directors on the board (“board under-

valuation”), the greater the turnover levels of undervalued

directors. This effect is stronger when board interaction

frequency is higher. We contribute to the behavioral per-

spective on corporate governance by introducing justice-

based legitimacy as a key normative institution, and by

providing a novel predictor of aggregate turnover of

directors (as well as the firm’s CEO).

Managerial summary:Why do outside directors exit the

board? We offer a novel answer to this question in the con-

text of newly public firms. We suggest that when directors

are passed over for the board chair and committee chair

positions despite having higher qualifications than their

peers, they have been “undervalued,”and a negative board

climate is likely to develop. We find that the higher the

average undervaluation of directors on the board, the

higher the turnover levels of these undervalued directors.

More frequent board meetings exacerbate these turnover

levels. Further, these turnover effects are not restricted to

undervalued directors—even the CEO is more likely to

We are grateful for the excellent guidance of our Editor Jim Westphal and the helpful reviews from our anonymous reviewers.

We also thank Phanish Puranam, Kathy Eisenhardt, JT Li, Jinyu He, Wei Shen, Tim Pollock, Steve Boivie, Pavel Zhelyazkov,

and Yonghoon Lee for many helpful suggestions on earlier versions of this article. Finally, we acknowledge the helpful com-

ments we received at the Asia Management Research Consortium, Academy of Management Annual Conference, West Coast

Research Symposium, and from the seminar participants at HKUST and ESSEC.

Received: 4 April 2016 Revised: 17 July 2017 Accepted: 20 July 2017 Published on: 12 January 2018

DOI: 10.1002/smj.2716

Strat Mgmt J. 2018;39:429–457. wileyonlinelibrary.com/journal/smj Copyright © 2017 John Wiley & Sons, Ltd. 429

exit. This study demonstrates the critical importance of

developing a legitimate and fair board leadership structure.

KEYWORDS

board leadership structure, board of directors, hierarchy,

justice, turnover

1|INTRODUCTION

When privately owned entrepreneurial firms transition to public-listed companies, formal corporate

governance issues come to the fore. A key change during the initial public offering (IPO) process is

the formalization of the board leadership structure. By board leadership structure, we mean the chair

of the entire board as well as the chairs of the three major committees—that is, audit, compensation,

and nomination and governance. Prior to IPO, privately owned entrepreneurial firms usually have

informal boards with very limited or even no leadership structures (Garg, 2014; Shen, 2003; Wasser-

man, 2009). In contrast, public firms are typically required by regulating authorities to have an

explicit board structure, including a board chair and specific board committees that are chaired by

particular outside directors (Hochberg, 2012). At IPO, then, newly public firms formally identify

their board members, including both inside and outside directors and both longstanding board mem-

bers and those recently recruited for the IPO event (Certo, 2003; Chen, Hambrick, & Pollock, 2008;

Pollock, Chen, Jackson, & Hambrick, 2010). Similarly, they also create the board leadership struc-

ture (i.e., formal hierarchy on the board): some outside directors are appointed to the board leader-

ship structure and so assume chair positions, while others remain as ordinary directors.

1

Prior literature recognizes that formal hierarchical structures such as board leadership structures

are consequences of—and are consequential for—social systems (Fiske, 2010; Magee & Galinsky,

2008). Yet, it is also clear that not all leaders in a formal hierarchical structure are appointed to their

positions based on normatively accepted criteria. History is replete with examples of formal hierar-

chies in corporations, governments, and society more broadly that are based on favoritism, nepo-

tism, politicking, friendship, or simply error. But the governance literature, in general, tends to

ignore this legitimacy issue for the board leadership structure. As a result, this literature implicitly

assumes that the assignment of chair positions is either normatively appropriate or inconsequential

for effective board functioning and board-level outcomes. We question this assumption here.

In this study, we consider the board-level consequences of a newly established board leadership

structure that cannot be explained by normatively accepted factors for chair assignment. Thus, we

focus on the formalization of the board leadership structure (i.e., the appointment of specific direc-

tors to the four chair positions) during the crucial transition from private to public firm that occurs

during an IPO. When a director’s experience, qualifications, and overall fitness according to norma-

tively accepted criteria are high vis-à-vis fellow directors on the board but not recognized by

appointments to the newly public firm’s board leadership structure, the director is undervalued. By

extension, board undervaluation refers to the average director undervaluation on the board, and it

represents the extent to which the overall board leadership structure cannot be explained by norma-

tively accepted criteria. Because this study considers board-level consequences, we focus on board

undervaluation, the board-level aggregation of individual directors’undervaluation.

1

Only outside directors (“directors”henceforth) are eligible for committee positions and are the focus of this study.

430 GARG ET AL.