March 29, 2023

Deal Professor: When Picking a C.E.O. Is More Random Than Wise

Deal ProfessorHarry Campbell

What makes the perfect chief executive? If the way corporate boards at Yahoo and Duke Energy picked chief executives is any indication, it may be up to chance in large part.

Take Marissa Mayer, the newly appointed chief of Yahoo. She is a Stanford graduate, age 37, and Google’s 20th employee. Until her new gig, Ms. Mayer was one of Google’s stars and helped develop Gmail. She was a well-known face for Google, serving on the board of Wal-Mart Stores, attending White House state dinners and appearing as a regular member of Fortune’s 40 under 40 of the hottest young business executives. In the ultimate sign of tech prominence, she has almost 200,000 Twitter followers.

Why her? According to the tech blog All Things D, she was thought to be a decisive and “disruptive agent of change” pushed by Daniel S. Loeb, the manager of the hedge fund Third Point, which owns about 6 percent of Yahoo. (Third Point disclosed in a regulatory filing on Tuesday that it had purchased an additional 2.5 million Yahoo shares.) Ms. Mayer is also from Google’s technology and product side, an area that Yahoo wants to focus on as it struggles to define itself either as an Internet company like Google or a media company, its main source of revenue.

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Ms. Mayer is now the youngest chieftain of a Fortune 500 company. She has no experience running a public company or reorganizing one, something that Yahoo desperately needs. And in her previous job, she had an almost embarrassment of riches in terms of money and people, something that Yahoo lacks, at least on Google’s scale.

The Yahoo board decided to go with youth and decisiveness over experience. In doing so, the company has agreed to pay a package that could exceed more than $100 million over five years if Ms. Mayer works out.

Marissa Mayer, the new chief of Yahoo.Evan Agostini/AGOEV, via Associated PressMarissa Mayer, the new chief of Yahoo.James E. Rogers, her counterpart at Duke Energy.Scott Eells/Bloomberg NewsJames E. Rogers, her counterpart at Duke Energy.

Is she the right choice? It is hard to know.

There is little solid analysis on what makes an effective chief executive. Most of it is in the form of quasi self-help books like “The 7 Habits of Highly Effective People” and “Good to Great: Why Some Companies Make the Leap … and Others Don’t.” Even these are remarkably vague, often citing factors like being “proactive.” Academic research is also not particularly helpful either, and often looks at youth versus maturity and experience. (Maturity typically wins.)

The consequence of this uncertainty is reflected in the high failure rate of chief executives. According to the Harvard Business Review, two out of five chief executives fail in their first 18 months on the job.

This all makes the choice of a chief executive a product of the board’s vision and personalities rather than one of studied research on what characteristics the person needs.

This creates its own problems, as the drama unfolding in the merger of Duke Energy and Progress Energy illustrates. Directors took only hours after the merger to replace William D. Johnson, the Progress chief who was to run the combined company, with James E. Rogers of Duke.

The reason given in testimony by Ann Gray, the lead director of the combined company, is that Mr. Johnson withheld information about repairs at the company’s nuclear plan in Crystal River, Fla. More tellingly, Ms. Gray testified that the directors thought Mr. Johnson was imperious and that he had described himself to the board as “a person who likes to learn but not be taught,” leading the Duke directors to conclude that their input was not sought.

Both Mr. Johnson and Mr. Rogers are former lawyers who worked in private practice and appeared to graduate at the top of their class. Both also rode successive mergers to be leaders at their companies. They have remarkably similar backgrounds. This dispute can be chalked up to different personalities and cultures rather than finding the best person for the job.

All this suggests that boards picking chief executives are essentially acting on their hunches and reflecting their own biases in their decision-making.

Culture and personality appeared to play a part in Ms. Mayer’s selection as her search was reportedly heavily influenced by Mr. Loeb’s presence. He’s a brash, outgoing hedge fund activist who has made one of the biggest bets in his career with Yahoo. Picking someone like Ms. Mayer, who is known for her decisiveness, will play well with the Silicon Valley crowd, mitigating her negatives of inexperience and perhaps youth. After all, 37 is practically ancient in the hedge fund universe, as it is in Silicon Valley.

Compare this with how the search is likely to have unfolded if Yahoo’s board had viewed itself as a media company. In that industry, top executives come up through the ranks. Leslie Moonves, the chief of CBS, is typical. He’s 62 and has been in the industry almost his entire life. Robert A. Iger of the Walt Disney Company is 61 and is also deeply experienced of the industry. Ms. Mayer would never have come close to being picked.

This all means that the selection of a chief seems more about group decision-making than anything else. And group decision-making can be quite random.

I’m reminded of an exercise I once did at an old law firm retreat run by a group of consultants. We were divided into five groups of 10 people each. Each group was given the same 10 résumés and told to pick the best candidate for an executive position and rank the rest. Not surprisingly, group dynamics took hold and each group selected a different rank and almost all selected a different top pick.

This result is in accord with research on small-group dynamics and decision-making. The selection of executives is influenced by directors’ own biases and backgrounds. Media boards tend to be directors who pick media people of a certain type; similarly with technology boards. This is influenced by a group negotiation process that depends on the people and personalities involved. In the end, these boards tend to pick people who reflect themselves and the world they already know — something that psychologists call the confirmation bias.

The decision to pick a chief executive is often steered by flocks of high-level recruitment consultants. Recruiters are paid millions to have a stable of candidates that they feed to boards, steering the process in pursuit of the board’s sometimes ill-defined wishes. This inherently limits the pool of candidates and further pushes boards to confirm their own biases in any selection.

Ms. Mayer and Mr. Rogers may do terrific jobs at their companies. But their appointments do not necessarily mean that they are the best candidates. Rather, their selection is a result of random and nonrandom factors, something that is anything but a perfect process.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

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Analysts Wary of LinkedIn’s Stock Surge

In a sizzling debut last week on the New York Stock Exchange, investors sent stock in LinkedIn, the social-networking site for business professionals, soaring 109 percent on its first day of trading. While the enthusiasm subsided a tad the next day, LinkedIn’s shares still closed the week at around $93, more than twice the company’s initial offering price. This put the value of the company, which made $15 million in profit last year, at more than $8 billion.

From Wall Street to Silicon Valley, the debate was whether this stunning performance echoed the late 1990s, when the bubble around dot-com companies began to inflate. On its first day of trading in 1995, Netscape stock doubled in price. Yahoo shares rose 154 percent on its 1996 offering. shot up to $97 from $9 in its first day of trading in 1998, giving it a valuation of about $850 million.

LinkedIn’s first-day trading gain was the fifth highest since 2001, but the top three were Chinese Internet stocks like Baidu, which zoomed 354 percent on its debut in 2005, with Nymex No. 4.

“In both cases, the Internet bubble of the late 1990s and now, investors are assigning some very optimistic valuations,” said Jay Ritter, a professor of finance at the University of Florida.

Still, many people are hesitant to proclaim that the markets are on the cusp of another tech bubble or that the markets are returning to the days when unprofitable new companies could be valued at billions of dollars. In those days, companies without earnings were assessed with measurements like “eyeballs,” the number of people who visited a site; “stickiness,” how long they visited; and even “mindshare,” how aware the public was of the company or category.

“LinkedIn is not a company you have to value on page views. We’re not talking about a start-up here,” said Matt Therian, a research analyst at Renaissance Capital, based in Greenwich, Conn. “This is a company that grew revenues by 110 percent in the first quarter and, on top of that, it’s actually turned a profit.”

By far, the hottest segment of the Internet market is social media companies. The social buying site Groupon, which raised $1 billion from investors in January, is said to be considering an offering that could value the company at $20 billion.

And the barometer for the segment, Facebook, which is widely expected to go public next year, has rocketed higher in the private secondary markets with its shares trading at an implied valuation of as much as $80 billion in recent months.

As the first social media company out of the gates into the public markets, LinkedIn benefited from all of the attention Facebook has ginned up.

“Do you really imagine that LinkedIn could have gotten this valuation if not for the excitement of Facebook?” asked Kevin Landis, the chief investment officer of Firsthand Funds, which rode the tech boom and bust a decade ago. “I don’t know anybody who could make that case.”

LinkedIn’s valuation, many analysts say, is partly a function of investor demand for all things social media but also related to the fact that a limited number of shares — nine million — were issued. Those shares traded 30 million times in the first day.

Initial public offerings remain rare now, and this scarcity can drive up prices. Only 154 companies went public in 2010, and 63 have so far this year, compared with 486 in 1999.

Of course, the big question is whether LinkedIn is destined to become the next Google or Amazon, or whether it is another, which was a penny stock by 2001, when the dot-com bubble burst.

At LinkedIn’s current valuation, investors are clearly betting the company will show phenomenal growth, analysts say. LinkedIn is trading at about 554 times last year’s earnings of $15 million (the company posted losses in 2008 and 2009).

That compares with a price-to-trailing-earnings ratio of 149 when Google made its debut in the markets or, in a more extreme example, the 947.5 ratio eBay received in its first day of trading, according to data from Mr. Ritter.

Price-to-earnings comparisons for other hot Internet companies, like or even Netscape on their opening days, are difficult as they did not have any earnings.

By another closely watched measurement, LinkedIn is trading at around 25 times this year’s expected sales, said Rick Summer, a senior equity analyst at the Chicago research firm Morningstar.

That’s high, and Mr. Summer says LinkedIn could increase its revenue to $1.5 billion in five years, from $243 million last year. That makes LinkedIn worth about $27 a share, by his estimate.

With LinkedIn shares trading at $93, investors are betting the company’s revenue will rise to $4 billion in five years, Mr. Summer said.

Impossible? No. Difficult? Yes, say analysts.

But that valuation makes sense if an investor believes someone would pay even more for the stock. And that’s how bubbles form.

LinkedIn, which has about 100 million members, does have a revenue model. It offers what is called a freemium business model: users can create free profiles or they can pay a subscription fee for a premium account with special features.

LinkedIn also charges businesses and recruiters for hiring. Although the company is still growing quickly, it faces tough competition from other sites, like the job listing services Monster and CareerBuilder.

The company has repeatedly said it plans to invest in its platform, at the expense of short-term profit, a move that is potentially good for the company over the years, but could make it tough for investors to justify current market valuations, analysts warn.

Mr. Summer said, “We think it’s a very good financial model and a good business, but at these valuations, it’s potentially, ‘Watch out below.’ ”

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