May 26, 2022

TPL Insights: Building Peak-Performance Cultures #120 The High Cost of Poor Succession Planning – Part 2

By Rob Andrews

With paraphrased content from Claudio Fernandez-Araoz, Gregory Nagel, and Carrie Green from HBR Magazine May – June 2021

Last week we left off our discussion of the high cost of poor succession planning with how to purposefully identify and develop rising stars. Click here to read part one.

Appoint the Most Promising Executives to the Board—or Give them Access

In the United States, in part because of regulatory mandates following executive malfeasance at Enron, Tyco, and other companies, most large companies’ boards have become fully independent, with the CEO as the only employee director. Faleye found that the proportion of U.S. boards set up this way exploded from about a third in 1998 to more than two-thirds in 2011. That the percentage of fully independent boards has continued to increase, rising to 76% by 2018.

While there are clear benefits to getting oversight and advice from outside experts, the authors believe independent boards are less equipped to manage CEO succession. With so little exposure to internal up-and-comers but extensive knowledge of potential external hires from their own organizations and other board experiences, directors are understandably more likely to favor outside CEO candidates or be unduly influenced by individual opinions. As one veteran director recently told us, “It’s scary to see how little insight boards about top internal executives have these days; a lot of the views are painted, either too positively or too negatively, by the sitting CEO.”

We believe that boards should make room for one to three executives who are potential successors to the CEO. Not only does that allow directors to see likely candidates in action, but it better prepares those individuals to take on the top job. When Faleye compared the performance of internally promoted CEOs who had prior director experience against that of insiders who lacked it, he saw that during their first two years the CEOs with board experience had an average return on assets that was 12.5 percentage points higher. Interestingly, this massive difference disappeared during year three, suggesting that while both types of executives had similar levels of competence and potential, the exposure to strategic board-level discussions as well as the relationships established with directors drastically flattened learning curves.

Indra Nooyi, for example, joined PepsiCo’s board when she was the company’s CFO—five years before becoming its CEO. Watching her firsthand, the board became confident in her competence and potential and, after her appointment as CEO, was more open to her plans to radically transform the company by expanding its portfolio beyond sugary drinks and steering it toward greater social responsibility. During Nooyi’s tenure as CEO, PepsiCo’s net profit increased 122%.

Make Room for One to Three Executives on the Board

Boards should make room for one to three executives who are potential successors to the current CEO. Board experience goes a long way to prepare those individuals to take on the top job. If you have too many directors already or too many promising potential CEO successors in your ranks, an alternative (though suboptimal) approach is to ask your rising stars to frequently attend and present at board meetings. This will improve their exposure, contributions, and development. Before the pandemic, good boards ran dedicated off-sites or group trips where directors and top executives, and even their spouses, could connect professionally and personally. As boards get back into their rhythms post-Covid, we hope that such in-person social interaction will resume. For further development, you might also encourage some of your most likely successors to selectively join other companies’ boards.

Carefully Examine Internal and External Candidates

The best practice is to carefully outline your ideal CEO profile and then look both inside and outside for the person who best matches that description. While the authors believe that every company should first master the art of spotting internal talent and create succession plans based on its current roster, they also see value in external searches for benchmarking and comprehensiveness. (And so do companies like Mastercard, PepsiCo, P&G, and American Express.) Research from the Center for Creative Leadership has consistently shown that when companies consider wide pools of insiders and outsiders, executive appointments are more successful. Whether you’re shopping for a house or for your next top executive, comparative evaluations produce better decisions.

Make sure to conduct thorough assessments of all candidates, even the insiders who are well known to the board. Consider not who has performed the best until now but who is ready to meet the future challenges of the CEO role and has the potential to continue adapting in a volatile, uncertain, chaotic, and ambiguous world. Judge everyone against your job specs, grill candidates in well-structured interviews, and conduct in-depth reference checks. This is the only way to avoid appointing the wrong people to the job.

Executive search firms can usually add great value to succession efforts. Consultants with the right training and experience can identify the competencies that each senior position requires, get more out of interviews and reference checks, and distinguish potentially great performers from the rest. Such consultants also tend to have trusting relationships with candidates, sources, and references.

However, the search profession still probably hurts as much as it helps, owing to two blatantly perverse incentives: the contingency arrangement and the percentage fee. Most search consultants are compensated when they produce a hire, regardless of that person’s fitness for the job or origin. They make no money on inside hires, who don’t need to be found and brought in. Traditionally, search consultants are paid a third of the new executive’s annual cash compensation (salary plus bonus). As a result, whether consciously or unconsciously, some oversell high-priced outsiders and shoot down internal alternatives. The solution is to swap the percentage fee with a prearranged fixed fee that’s based on the importance of the position and the complexity of the search and to replace the contingency fee with a retainer so that the consultant is paid the same no matter who is appointed. If you’re working with a true consultant who’s been there and done that, the retainer fees you pay will be well worth the investment.

You should use search consultants in special situations—for example, if your internal candidates are unsuitable, you can’t identify or access appropriate external candidates on your own, or your company is entering a new business, region, or period of strategic change. Then approach the selection of your consultant as you would any other people decision: Determine what kind of relationship you seek, Ask for recommendations, consider multiple firms, and check references. Once you’ve developed a short list, meet the recruiters in person to get a read on their relevant experience, as well as their level of professionalism, candor, and concern. Place more value on the consultant’s broad experience, processes, and judgment than specific industry experience.

Companies and institutions must do a better job of getting CEO succession right—their organizations, their industries, and their market returns depend on it. We hope this article helps senior executives, directors, and investors recognize the magnitude of the problem and act accordingly. Microsoft shouldn’t have required a long and public search to conclude that Nadella was the right leader to get the company back on track after Ballmer’s years of struggle. It should have already had him—and even other potential successors—waiting in the wings. How many rising stars like Nadella do you have at your company—and what can you do tomorrow to put them on a path to becoming your next (and ideally best) CEO?

Our work at Allen Austin is all about building cultures of peak performance. Claudio Fernandez-Araoz, Gregory Nagel, and Carrie Green’s experience mirrors much of ours. The advice the authors give in this piece apply to every middle and senior level position in your firm. Let’s have a conversation around your company’s succession planning. We’d love to be your thought partner.

Warmest Regards,

Rob Andrews
Allen Austin
Consultants in Retained Search & Leadership Advisory