A numbers game

Professor Paul Kerin considers the issue of board size and whether less is more when it comes to boardroom governance. 

For several decades, influential thinkers have argued that smaller boards are better. In the early 1990s, when the typical board size of US listed companies was 10 –12 people, two eminent Harvard professors argued for much smaller boards. American economist, Michael Jensen, claimed that the optimum board size was no more than seven to eight members, while organisational theorist, Jay Lorsch, claimed it was no more than eight to nine and should be limited to a maximum of 10 members.

While those claims were based on qualitative judgements, subsequent economic research has largely supported them.

What is optimum size?
How can a board think about optimum board size? We need to start with the board’s overall objective and key roles (monitoring and advising/decision-making) and consider how board size affects its ability to perform those roles and thereby achieve that objective. Whether it’s a business seeking to best serve shareholder interests or a not-for-profit seeking to best serve a social interest, determining optimum board size involves the same trade-off.

That trade-off is between the benefits and costs of increasing board size. The optimum board size is the one that maximises the net benefits.

The possible benefits include more expertise, knowledge and diversity. The costs may be many and varied. Apart from extra director fees, there are many “soft” costs that are impossible to quantify but may be substantial. Co-ordination and communication problems increase with group size. Given meeting time constraints, directors have less opportunity to present views and influence outcomes, raising incentives to free-ride (apply less effort). The bigger a group, the harder it is to achieve consensus and make timely decisions.

Many economic studies confirm that the relationship between board size and organisation performance is hill-shaped. Adding a director to an undersized board helps climb the hill, but an oversized board is over the hill.

A recent UK study found that a board size of five to six maximised return on assets (ROA). Adding a seventh director to a six-person board was found to reduce earnings before tax and interest (EBIT) by AUD 3.7 million for the average listed company. As that’s much more than one director’s compensation, it reinforces that the “soft” costs can be substantial.

Furthermore, studies show that investors place less trust in larger boards to get key decisions right.

Influential factors

So far, we’ve talked in absolute terms. But shouldn’t board size depend on an organisation’s characteristics? Studies show that actual board size is higher for more complex organisations (such as larger, more diversified firms with high debt). However, they also show that organisation-specific factors generally have relatively small impacts on optimal board size, typically raising/lowering optimum board size by one or two at most.

Companies also tend to exhibit strong mean reversion towards a common board size range. A recent study of US listed companies found that small boards (less than eight directors) tended to grow, while large boards (more than 11 directors) tended to shrink. This suggests that the target (and possibly optimum) board size for most US companies is in the eight to 11 range.

One Australian study found that the optimal board size of Australian listed firms was eight to 10. The average board size of Australia’s top 10 companies (9.8) has hardly changed over the past decade, despite those companies experiencing substantial growth in business size and complexity. This is consistent with research findings that organisation-specific factors have relatively little impact on optimum board size. Boards should think carefully about whether to expand membership or fill a vacancy. We often underestimate the “soft” costs and we can sometimes get the advice we need in other ways (e.g. external advisers) and avoid the downsides of a permanently bigger board.

Optimum board size also depends on other factors under the board’s control. Adding an independent director may be less worthwhile if the board is dominated by non-independents. Optimum board size also depends on getting the board mix right to ensure an appropriate balance of skills, experience, independence and knowledge.