CEOs generally know that those in their field are rarely fired. Why is that? Wharton School finance professor Luke Taylor heard that boards of directors won’t fire underperforming CEOs. Some 2% of Fortune 500 CEOs are fired on average each year but Taylor said there was no data to suggest if that number is on target.
So he produced a model on firing a CEO. Published in the December 2010 issue of The Journal of Finance, Taylor presented two costs when firing a CEO. Some were direct costs, such as severance. Some were “entrenchment” costs, “intangible costs that board members feel but shareholders do not” such as a “personal relationship between board members and the CEO.”
Taylor found entrenchment cost for firing was, on average, $1 billion — far more than the $300 million in direct costs. If entrenchment costs went to zero — the annual rate of CEO firings for the S&P 500 would go from 2% to 13%, he said.
“When a CEO is fired, research shows there is a huge impact on that person’s career,” Taylor said. CEOs fired from one job, go to a smaller company, that company is 90% smaller and the CEO is paid significantly less.
In addition, if boards push CEOs out quickly, new CEOs may be less inclined to take risks, according to Taylor.
Interestingly, profitability is not a good predictor of whether a CEO will get fired. A board of directors looks at a number of factors when it evaluates a CEO, he said.
These other factors may include: how the CEO is spending his/her time; changes in market share; or new projects that are not yet contributing to earnings.
In addition, searching for a replacement CEO is costly.
Taylor says that a board does not directly observe CEO ability, but learns about it over time. To compound the problem of CEO replacement, a new CEO has an uncertain ability.
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