Outsider, non-founder CEOs are often overvalued because many corporate boards think the answer to their problems is a superstar CEO with an outsized reputation. This leads them to overpay for people who are good at creating outsized reputations through networking, interviewing, and taking credit for other peoples' achievements--all bad indicators of future success.
Rakesh Khurana has amply shown how this delusion of the charismatic
savior creates a dysfunctional market for CEOs, allowing the small
number of existing public-company CEOs to demand and receive extravagant
compensation. The myth of the generalist CEO is bolstered by the many fawning media portrayals where CEOs say that their key jobs are understanding, hiring, and motivating people--leading board members to believe that you can run a technology company without knowing anything about technology.
WHY FIRST EXECS MAKE BETTER CHIEF EXECS
The list of successful founders-turned-CEOs is daunting. You have Bill Hewlett and David Packard (HP), Robert Noyce and Gordon Moore (Intel), Bill Gates (Microsoft), Larry Ellison (Oracle), Steve Jobs (Apple). You could say I've hand-picked these names from among hundreds of founders who turned out to be lousy chief execs. You might be right. That's why we need data.
And the data shows that the first executives really do make better chief execs. That's because they have:
1) Better long-term focus: Rüdiger Fahlenbrach found that large U.S. firms run by founders had excess stock market annual returns of 8.3 percent (4.4 percent after controlling for a variety of factors). Founder-CEO firms invest more in research and development and have higher capital expenditures--things that you would expect to improve long-term performance rather than short-term earnings.
2) More value: Renée Adams, Heitor Almeida, and Daniel Ferreira found that founder-CEO firms have higher valuations than other firms, even after using instrumental variables to control for the endogenous nature of founder CEO status.**
3) The right incentives: Darius Palia, S. Abraham Ravid, and Chia-Jane Wang also found that founder-led firms were more valuable than other firms. In addition, they found that founders were less sensitive to traditional pay-for-performance incentives, implying that they're not in it just for the money.
This shouldn't be surprising. Founders tend to know their companies better than outsiders. They know their industries better than most outsiders. They are often more motivated than the average hired-gun CEO to improve a company's long-term prospects. They are more likely to be innovators, having taken the step of founding a company. In tech firms, they usually know technology better than a typical outsider CEO, whose specialty skews toward marketing and networking.
But there's one other factor that comes into play. Investors can't count on a founder CEO to do what they want because a founder has her own power base among the company's employees. An outsider CEO, by contrast, comes in as the creature of the board and knows her first job is to keep the board happy. In theory, this should be good because it makes the CEO accountable to the shareholders -- assuming that the board represents the shareholders, which is a big assumption. But in a startup company, the interests of the majority investors and the interests of the company are not always aligned. Most obviously, if the company gets a new round of funding at a low valuation, the current investors can benefit--if they are the ones putting in more money at the low valuation. And so replacing a founder CEO is often simply a question of power.