New challenges for succession planning

On June 11, when Lululemon CEO Christine Day announced she was leaving on the heels of a very public flap over the firm’s see-through yoga pants, the stock of this Vancouver-based company tumbled 13 percent. For boards everywhere, the message wasn’t so much about a wardrobe malfunction as it was a wake-up call that succession planning must be handled exactly right.

Lululemon is not the only firm that has found itself in the uncomfortable position of having to find a new chief executive at an inopportune moment. Around 10 years ago McDonald’s appointed three separate CEOs in two years after two of its CEOs died within nine months of each other. Fortunately, this type of epic misfortune is rare but, for boards, even the grimmest and most unlikely eventualities bear consideration.

‘The most important job of the board – hiring the CEO – is not being done adequately at many places,’ contends Richard Leblanc, associate professor at York University in Toronto. He cites 2010 research by Stanford University and Heidrick & Struggles that finds the average board spends a mere two hours a year on succession planning – and that 39 percent of all boards haven’t selected an immediate successor to the CEO.

On the other hand, the savviest boards are viewing CEO succession as a risk issue and are taking more active roles than ever before. ‘The old-school way of doing this is for the board to hire and fire the chief executive, and then for him or her to do everything else. That’s changing,’ says Leblanc.

Donald Keller, a partner in PwC’s Center for Board Governance, says directors themselves recognize that succession planning deserves greater attention. In his firm’s 2012 Annual Corporate Directors Survey, 68 percent of the 860 participating directors expressed a desire to devote more energy to succession planning at their company in the coming year.

One reason for the sudden awareness of CEO succession planning is the media, which has begun to relentlessly scrutinize companies that appear adrift when a CEO dies or suddenly departs. Another reason is shareholder proposals demanding that public companies disclose their succession plans, a request the SEC is now allowing to appear on proxies. 

Clarke Murphy, CEO at New York-based Russell Reynolds Associates, also attributes the heightened attention to changing economic conditions. ‘Many boards have realized that managers being groomed as CEOs in a growth economy weren’t necessarily the right managers to lead in a volatile economy,’ he says. Over the past five years, Russell Reynolds has seen executive succession planning grow from 10 percent of the firm’s overall business to 40 percent.

Deciding when to get serious

Boards don’t bungle succession planning because they lack the expertise to do a good job of this critical board function; instead, they falter for a raft of other reasons – some practical, some psychological. Too often, succession planning is placed on a back burner because of a lack of time. When a firm is facing more pressing issues, the hypothetical need for a new CEO can seem less urgent. Emotion plays a role, too. ‘Directors have historically been hesitant to discuss succession as it calls into question their own mortality,’ suggests Murphy.

Chris McGoldrick, a senior analyst at Equilar, agrees that this is a touchy subject for directors and executives alike. He points out that a sitting chief executive is not the only person requiring delicate handling; companies are reluctant to give any successor ‘too much power before the current CEO is actually on his or her way out the door. You have to be pretty nuanced about how you’re cultivating the power from within.’

That said, there is mounting evidence that boards fare best when they have conversations about CEO succession earlier rather than later, especially given the fact that CEO tenure is on the decline. According to the Conference Board, the average tenure of a departing CEO went from roughly 10 years in 2000 to 8.1 years in 2012.

Jack O’Kelley, managing partner for Heidrick & Struggles’ leadership consulting practice for the Americas, argues that chief executives feel far less threatened if a conversation about succession planning happens almost immediately. ‘If you’re a CEO for four, five, or six years, and then the subject of succession planning comes up, it can be very awkward,’ he says. ‘You may start inferring it’s about your performance when the board is truly just trying to mitigate risk.’

Leblanc offers a slightly different take: ‘If a board is aggressive right out of the starting gate and says, We’d like to see mentoring and developmental plans for the direct reports and the high potential talent, that can be resisted by the incumbent CEO as a sign of a lack of confidence in him/her. No one wants to plan for his or her own succession. Most companies want to give the incumbent CEO enough runway time without clamping down in terms of having a succession plan.’

Disclosure can be tricky

Increasingly, companies are being asked to disclose more about their executive succession planning process to stakeholders. The Conference Board finds that nearly half (48.4 percent) of companies with revenues exceeding $20 billion are including information about succession planning in their annual reports. And the Canadian Coalition for Good Governance (CCGG) recommends strong succession planning disclosure in proxy circulars, singling out Royal Bank of Canada’s 2012 proxy circular for praise.

Companies that get it right, notes Tony D’Onofrio, CCGG’s director of board engagement and head of research, ‘are saying enough to investors [to allow them to] conclude that the board is on top of these kinds of things, but they’re not saying, Here are the three candidates we see as the next CEO.’

To identify the right successors, a company must clarify its own strategy – another reason why boards enjoy the perfect vantage point for overseeing this critical responsibility. Murphy notes that ‘many chief executives are tempted to select a successor in their own image.’ But the firm’s long-term strategy and the realities of a given industry are always changing so what’s needed in a chief executive might be changing, too.

A sound succession process usually strives to identify two kinds of successor: ‘an emergency successor and a successor in due course,’ says O’Kelley. ‘Every executive should be held accountable for identifying both.’

Although selecting the CEO’s successor gets the lion’s share of attention, a well-crafted succession plan should delve far deeper. Leblanc points out that the board should also ensure potential successors have been identified for the top management positions, such as chief financial officer, chief technology officer, general counsel and heads of the major business units. Beyond knowing that a plan exists, the board should make sure the options are suitable. ‘You might be looking at 20-30 positions,’ says Leblanc. ‘And you see red flags when someone doesn’t have the experience to succeed his or her direct superior.’

D’Onofrio points out that even though shareholders and the media frequently fault directors for a breakdown in succession planning when a CEO departs, outsiders don’t always know what’s actually going on in the boardroom. Referring to the drop in lululemon’s stock price, he says: ‘To the extent the news came out of the blue, there was a market reaction. But I wouldn’t read into that market reaction that the board wasn’t on top of succession planning. It may indicate that the company just hasn’t communicated [about succession planning] in an effective way.’

Leblanc agrees: ‘Boards may not disclose everything publicly, but most directors know who’s strong and who’s weak. And many boards can rank members of the C-suite as potential successors. So when people say it’s not adequately done, it’s a really broad generalization.’

Overseeing the process

Although the full board is ultimately responsible for executive succession, many boards designate a particular committee to oversee the task. Most often, says O’Kelley, the nominating and governance committee takes the lead, although the compensation committee is another logical choice. In some instances, boards appoint a special talent committee to step in.

Regardless of how the responsibility is parceled out, the entire board should play a role in vetting key personnel. Proactive boards are beginning to meet possible internal successors well before a vacancy opens up.

‘Some boards are starting to invite next-level management down to some board meetings, either to present what’s happening in their area or to board lunches or dinners,’ says Brian Breheny, a partner at Skadden Arps Slate Meagher & Flom. He applauds boards for carving out informal opportunities ‘to start meeting internal candidates’ who might someday fill the firm’s top slots.

Boards that nurture key internal talent are helping their companies immeasurably. ‘Often, people promoted from within succeed better and are compensated significantly less than an outside hire,’ says Regina Olshan, partner and global head of the executive compensation and benefits group at Skadden Arps.

A 2013 Equilar study shows that the premium paid to externally hired CEOs is hefty: external hires at mid-cap companies in the S&P 1500 received total compensation packages worth 38.2 percent more than internal hires, while external hires at large and small-cap firms were paid premiums of 33.2 percent and 36.5 percent, respectively. ‘Superstar CEOs are often a big draw, but may not always be the right fit,’ Olshan continues. ‘Experience and academic studies show high-profile hires are not always the path to success. For many firms, a surer path to success is to promote from within.’

Nurturing internal successors takes time – yet another reason why executive succession planning should be high on the board’s agenda. O’Kelley says a company cultivating a prospective CEO successor from the outside should begin three years before the newcomer would take the helm. In that time, a company might need to shift personnel and carve out new roles for various employees before giving the candidate a solid 18-24 months to achieve results.

‘It’s a chess game,’ says O’Kelley. ‘You have to look at your strategy and the competitive environment, and figure out which pieces to move where – and when.’

Internal vs external replacements

It goes without saying that the person selected to replace the departing CEO plays a major role in the success or failure of the leadership transition. A key consideration is whether the replacement comes from inside or outside the company, and each approach has its pros and cons.

• An inside candidate offers the benefit of institutional knowledge and an understanding of the company’s culture. But many internally promoted CEOs can carry over negative habits or outdated thinking from a predecessor. Additionally, if there is more than one qualified internal candidate, the selection process can cause those top executives passed over for the CEO position to leave the company for other opportunities.
• External candidates, on the other hand, can bring new ideas and varied experiences to the company. They may also have the ability to make sweeping changes, unfettered by a company’s traditions or existing processes. On the downside, externally promoted candidates can have a hard time assimilating into the culture of the organization and gaining the trust and support of the existing management team.

Equilar’s study of CEO turnover shows that for internal promotions, the median one-year total shareholder return (TSR) for the previous fiscal year was 6.22 percent. For external hires, the median TSR was –10.1 percent. The study also finds that more than two thirds (67.8 percent) of the incoming CEOs were internal hires, so they worked for the company immediately prior to being appointed CEO. Less than a third (28.5 percent) of the incoming CEOs were hired from outside the company. At the remaining 3.7 percent of firms, a former chief executive returned to retake the reins.

Total compensation for new CEOs

In the 2013 Equilar report, ‘Paying the new boss: compensation analysis for newly hired CEOs’, total compensation is calculated as the sum of base salary, discretionary bonuses, the target value of short-term cash bonuses, restricted stock awards, stock option awards, the target value of long-term cash and equity incentives, and all other compensation. All elements of compensation including salary, bonuses and equity awards are measured on an as-reported basis. Values for all equity awards represent the grant-date value of new awards, as noted by the company in the grants of plan-based awards table in the report.

S&P 500 chief executives hired externally received median compensation of approximately $9.5 million in 2013. Internally promoted CEOs lagged behind, receiving median total compensation of approximately $7.1 million. A similar pattern held true at mid-cap and small-cap firms.