Better to Mix than to Match: Board Compositionand Firm Size

Boards of directors serve several functions, chief among them the monitoring of the firm and management. We model the monitoring activities of directors, who themselves face a moral hazard problem and need incentives to avoid shirking. The firm simultaneously sets wage incentives for all employees (directors and workers), and also chooses the size of the firm. Larger firms are more productive, but costlier to monitor. Our main result shows that directors that are more dissimilar to each other will allow firm profits to rise and the firm size to grow. Similar directors have redundant signals on firm performance and are therefore worse monitors than dissimilar directors. This creates a causal relationship between board composition and firm size, which can be tested with data. We’d like to thank Rohan Williamson, Lee Pinkowitz, Prem Jain for helpful conversations. The Capital Markets Research Center at Georgetown University provided financial support.