The Internal Governance of Firms

We develop a model of internal governance where the self-serving actions of top management are limited by the potential reaction of subordinates. We find that internal governance can mitigate agency problems and ensure firms have substantial value, even without any external governance. Internal governance seems to work best when both top management and subordinates are important to value creation. We then allow for governance provided by external financiers and find situations where external governance, even if crude and uninformed, complements internal governance in improving efficiency. Interestingly, this allows us to develop a theory of dividend policy, where dividends are paid by self-interested CEOs to maintain a balance between internal and external control. Finally, we explore how the internal organization of firms may be structured to enhance the role of internal governance. Our paper could explain why young firms with limited external oversight, and firms in countries with poor external governance, can have substantial value, and why improving external governance may not be a panacea for all governance problems