Consultants on Consulting - The CEO Redux
11/09/2006
Obviously, this decision was a hard one for me to make. Why talk about this today? It gives us the time to make a strong transition." It was with these words that Bill Gates, arguably the most influential technology company CEO of his generation, announced his departure from a day-to-day role at Microsoft Corp., the company he co-founded over 30 years ago.

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By Elise Walton Published on 08/1/2006

Mercer Delta partner Elise Walton explains how CEO succession is more than just smooth exits —it's all about building the next generation of CEOs.

The Leadership Redux

However, Gates’s departure — or rather, Microsoft’s leadership succession plan — had begun years earlier in discussions with the board, and has a two-year transition plan looking forward. It has the hallmarks of a good succession process — board involvement, strong talent and succession processes focused broadly on the executive talent base, and an orderly, staged process for the transfer of power. The results: no drama, no stock gyrations, no downgrades related to lack of confidence. Of course, interested press, public, and investors will follow the story, but this well-run succession process minimizes risk and cost to the business, employees, customers, and investors alike.

Consider the recent sudden death of Frank Lanza, CEO of L-3, whose passing left the company without a successor. The company lost 10 percent of its market value in the month after Lanza announced that he had had surgery for cancer. Upon his death, the Wall Street Journal announced, "At L-3, Founder’s Death Sets Off Speculation on a Sale." Unhappy shareholders complained about his lack of succession planning. A director stepped in as a nonexecutive chairman, and the CFO became interim CEO while a search committee seeks a new CEO — most likely from the outside. Contrast this with the well-covered McDonald’s CEO story: Despite unexpectedly losing two CEOs in one year, bench strength and strong succession planning allowed this board to handle the challenges gracefully and expeditiously.

How an organization approaches the transfer of power speaks volumes about that organization. Leadership succession has been one of the most popular, and unavoidable, topics since the inception of organizations. Top leadership changes receive particular attention. They signal actions in the future. They create hope or doubt. And the time of transition — before, at, and after — is a time when organizations may be most unstable and vulnerable to external and internal threats alike.

As with all leadership transitions, CEO succession gets a lot of attention. The attention to the CEO succession process has increased, and the process itself has undergone substantial changes. Across top public companies, there is wide variation in practice — from the aging patriarch who refuses to discuss succession, to the New Age career CEO who sets a short-term contract while planning his next CEO role, to directors who demand succession discussions the moment a new CEO steps into his role.

CEOs and boards are working out new approaches by building on established practice but adding more. Across the variety of experience and practice, data suggest that there are some right answers and better practices affecting companies’ organizational continuity and robustness, talent retention, customer retention, and, over the long term, shareholder return. And, across all models, two trends are changing the CEO succession process permanently and affecting how HR approaches succession and talent development.

First, after a long tradition of letting the incumbent CEO guide the process of finding his replacement, directors are taking significant and active interest in the succession process and the decision. According to a recent study jointly conducted by Mercer Delta Consulting and the National Association of Corporate Directors (NACD), most directors indicated that they are taking overall responsibility for planning and decision-making, reflecting an evolving shift away from a CEO-led board concurrence process and toward a board-run CEO-input process. Of the directors surveyed, 39 percent of all boards collaborate on the process with the CEO; some 28 percent have primary responsibility for the process; and 50 percent acknowledged that boards should take the lead in succession planning. Most expect this trend to spread and consolidate.

The change is part of an overall trend toward greater board engagement. Increased scrutiny, regulation, and accountability — including personal costs to directors of firms gone wrong, such as MCI WorldCom — have led directors to become more engaged in all aspects of governance. Directors understand that selecting a CEO is potentially the most important and influential activity the board undertakes. It is the one decision that is clearly the board’s to make, and poor decisions are costly and hard to reverse. Good decisions not only offer financial and organizational benefit, but also affect the very work of the board itself. Because they have to live with their choice, directors have an incentive to find a CEO they’ll want to work with.

Second, the staffing preferences and processes for the CEO role are changing, and there are increasing votes for inside talent. The CEO role is changing for many of the same reasons boards have changed — increased scrutiny, regulatory requirements, and accountability. CEO turnover in the world’s 2,500 largest companies was 15.3 percent last year — 70 percent higher than 10 years ago. Approximately one-third of that turnover was performance-related. Associated with increased turnover has been increased compensation. Both buyers and defenders of talent, who have to offer competitive pay to retain top talent, feel the pressure of increased CEO churn. This compensation, however, is not viewed favorably by investors, regulators, or watchdog groups, and can cause significant embarrassment to directors who approve the packages. In one recent case, a board decided not to proceed with an external offer because the cost of the recruit was deemed excessive. The current CEO stayed on while accelerating development of successors.

Aside from compensation cost, the risks posed by an outsider are also evident. A recent study by Booz Allen ("The Crest of the Wave," Strategy & Business, May 2006) showed that returns for companies who hired outside CEOs were lower than for those who promoted CEOs internally. Further, outsider CEOs, who produce better than average returns for investors in their first two years, don’t do as well over the long haul. As tenure grows, insider CEOs do better for the shareholders. Even CEOs who are brought into troubled companies can backfire — they don’t always make the turnaround work. Or, the outsiders fix a cost problem only to be stuck unable to generate growth.The Leadership Redux

Directors are getting the point. Under increased pressure to justify total pay and control manageable risks, directors are expecting to see more internal supply of candidates. Pressures to build internal candidates will continue, good models for building candidates abound, and directors’ expectations of being informed and active in CEO succession will continue to increase. Directors and CEOs alike are looking to build the best, most effective CEO succession process for their company — and they are looking to be sure that they will have ample talent to choose from, both for the CEO and the senior team.

The good news is that there are plenty of good models on how to manage CEO succession and associated talent development well. The General Electric transition from Jack Welch to Jeffrey Immelt may well have been the most written-about succession in the history of U.S. business. GE’s robust talent development practices have been reported, benchmarked, and ported to other companies by talent hired away from GE. GE is only one of numerous companies — Bank of America, Johnson & Johnson, McDonald’s — that have invested heavily in talent development and succession planning. In enterprises that include two or more distinct businesses, the leadership formula becomes part of the glue and value that keeps the parts together.

What boards are focusing on is building a process that creates visibility, accountability, and greater control and alignment for all involved. There’s a clear focus on valid and effective processes, which create a net increase of the influence all parties have in the process. Candidates feel better about good processes, directors feel better, CEOs feel better, and the process has a higher probability of leading to a good outcome. The recent Mercer Delta–NACD study identified 10 best practices for board involvement in CEO succession (summarized on the next page). In our work with corporate boards, we see several of these becoming standard processes. Specifically, it is increasingly common that we see CEOs and their boards doing the following six things — they start early, they know what they need, they build talent architecture, they create the right experience, they stay connected, and they use the CEO succession process to build influence and capability. Let’s take a look at these factors in more detail.

Start early.

On average, the directors we spoke to advocated starting preparation three to five years prior to the expected CEO transition date. Several directors advocated starting as soon as the new CEO takes charge. Most of the directors interviewed described this advance timing as a "best practice," yet when directors were surveyed on this issue, there was a wide discrepancy between the desired lead time and the amount of time boards typically take. While more than half the directors said that they prefer having three to five years to complete the process, less than a quarter said that this was typical. In fact, more than half said that boards get involved less than two years before a transition date.

The companies that are getting it right realize that CEO succession becomes a topic on Day One. Said one director: "Then it’s less personal. It’s not like, ‘Why are you raising this now?’" Another director felt that having the conversation regularly kept directors focused on developing talent within the company, which is important for ensuring that the talent supply will be there when needed.

Starting early makes many other best practices possible. For instance, one director describes a selection process in which the leading internal candidate was great but lacked experience in merchandising — deemed critical for any CEO of this company. They were able to give the top candidate time in the field, which was essential for his readiness for the top job. In another case, the board gave each of an early list of three candidates expanded responsibilities. Seeing how they handled increased scope offered valuable insight into how each might rise to CEO responsibilities. Starting early provided time to give the candidates the experiences they needed and gave the directors time to gain the confidence they required to make the critical decision.

Although all of the best-practice CEO successions Mercer Delta and the NACD studied were internal promotions, three of the CEOs were executives brought in from the outside several years in advance of the anticipated transition. In each case, outsiders were brought in because directors had a good understanding of what was needed and believed the strategic skills required did not exist within the company. By starting early, these boards were able to watch the progress of the external candidate to ensure the best assimilation and development experiences.

Know what you need.

Both in the areas of CEO succession and in CEO evaluation, directors are becoming more definitive about the qualities they expect in the CEO. These are most often driven by the strategy and the strategic requirements for the company. Directors described a process for articulating the critical strategic requirements for the company, as well as the competencies required for the job. One director articulated a benefit from having formal criteria: "It is essential that the board and the CEO work together to review and discuss the selection criteria. Board members may bring a broader perspective to the process and, in some instances, the CEO may become too heavily focused in selecting a new leader like him-/herself. The board can help to intervene if that’s happening."

The collateral benefit when directors work with management to define strategic requirements is that it tends to cascade a talent focus a few levels below the CEO. In several cases, the CEO took the criteria for his own role and, in conjunction with HR, used it to drive talent development for the top 250.

The Ceo Redux - The Role of the Board in CEO Succession

Create the right experiences.

Those familiar with talent development will know the menu of options, often starting with entry-level hiring. Our study found that firms with a clear talent development strategy had an edge in developing a good pool of candidates. This often meant recruiting college (or graduate school) talent into specific jobs that gave the candidates the broadest views of the company. Interestingly, a few directors noted that this pool provided the next generation of CEOs. The next CEO candidate might be in his 40s, and his successor could be in his early 30s. Although directors didn’t seek much interaction with the second generation of talent, they acknowledged its importance in building CEO candidates, as certain experiences are easier to get early in your career.

More important, directors felt that certain development strategies did a better job of building the credibility and capability of CEO candidates. The most important cited was "giving the candidate company assignments to broaden his/her experience." The majority of interviewees (83 percent) indicated that this was something the company actively did. Several directors talked about specific assignments in important parts of the company, but they also talked about job or role expansion — giving the candidate(s) additional responsibilities to see how they did. When companies wanted to avoid taking a leader out of a key role, they were able to expand scope or assignments to see the versatility of the candidate and pressure-test him for additional responsibility. This is consistent with an increasing approach in talent development to provide real-world, "guts building" experiences to extend strength in a real business context. 360? feedback, mentoring, and executive programs are still well used, but they are far more likely to be custom-designed and delivered for the company.

Build talent architecture.

One thing seems clear: Succession planning, talent assessment, and talent development are making a comeback. "Career self-reliance," a term used to describe the absence of planning, is less in vogue. The demands of the board are creating the need for more explicit, well-managed, talent management processes. HR processes are comparing themselves to the beefed-up financial processes and recognizing the need for improvement and, often, for a global approach. Talent processes increasingly include multigenerational or pipeline thinking, strategic external sourcing, entry-level cohorts, and specific development opportunities for the top executives. The processes blend strategic engagement, education, feedback, and mentoring.

In one company, directors are formally engaged in the senior leadership program to provide perspective and mentoring to the company’s top leaders. Talent architecture considers transitions not as an event, but as a process. The process has steps and methods, but it is also a learning and adjustment process. Succession includes preparation — expanded responsibilities, learning and feedback, building a strong staff and delegating activity to your own successor, and onboarding — the support for the new leader during the critical first 12 months.

In general, succession and talent should be reviewed by the board at least annually, and several best-practice boards work on talent far more frequently. Talent review extends beyond the CEO. As one director noted, "Succession is more than just the CEO. You’re tracking a lot of executives if you do it right. This helps because if your number two gets hit by a bus, you have a backup for that position."

Part of the talent architecture is engaging independent third parties to help as honest brokers and advisers. Going outside for data and reference points gives boards an impartial viewpoint and additional ideas. And while directors themselves traditionally have a broad range of experience, consultants bring systematic, process-tested experience from a broad base of clients. Third parties can be helpful in making recommendations that might test goodwill or be unpopular among directors and the CEO. Third parties can also help when board members disagree on how they view the candidates by bringing objective data and proven processes. Most frequently, directors are asking for third-party executive assessments to validate bench strength and provide comparisons to specific industry or general executive talent. One board, after losing the designated CEO successor to another firm, did a full talent assessment of its top 500 executives. Having been caught short, the board wanted to be sure that bench strength was sufficient to deliver on the company’s goals and aspirations.

Given the preference for internal candidates, talent architectures are aiming to intentionally overbuild supply. Having more than enough candidates is important — it enables choice, it provides strength when recruiters pull talent out. Internally, one succession decision means another succession choice is required — directors are well aware that pulling an executive into a CEO position means that there’s a need for a successor in the CEO’s former position. Furthermore, having a strong pipeline can protect against the market losses or PR risk some suffer from departures, particularly when one strong CEO leaves — as in the case of NCR or AutoZone.

Stay connected.

Consistent with the overall trend toward greater engagement, directors cited the benefit of getting to know the candidates in a range of settings, and the particular value of informal connection. Most directors acknowledge that their companies have or are building "books" and processes, but spreadsheets and binders don’t give the full picture needed to understand the talent. One director, a former CEO, pointed out, "If there’s a disagreement between the CEO and the directors on the quality of an internal candidate, guess who’s going to win that fight?" Directors need personal understanding of internal candidates to drive discussion of capabilities opposite expected and required strengths. This means building directors’ exposure to candidates.

One director emphasized the importance of multiple venues for connecting with candidates, saying, "When they’re in the boardroom they are pretty well scrubbed. At a site visit, you get to see them with their team, in their home environment, and you get a better sense of who they really are." In fact, several companies include in their governance charter a requirement that directors visit sites and connect with management.

Use the process to build influence and capability.

Staying connected is one way of creating alignment. Engagement and knowledge improve the ability of all parties to contribute and make a difference. Designing the right processes helps the CEO get the most out of his directors — who often mentor and coach successors, particularly in the fragile pre- and post-transition years. A well-designed talent review and CEO succession process can provide architecture for focusing and structuring the activities of the directors, gaining alignment on the strategic needs of the firm.

Directors we surveyed also felt that CEO involvement — input, organization, transparency, opinions, etc. — was important. One director said, "The effectiveness of a CEO succession process depends a lot on what the CEO is or is not doing. The CEO should be a mile and a half ahead in terms of having a process and transparency. If the CEO is not doing this, the board has to ask that it be done." This is a good summation of most directors’ feelings: The CEO must be an active partner. The CEO who does this well will find himself more effective and his board more effective.

Increased engagement should focus on increased effectiveness. Many boards are feeling burdened with checklists and processes designed to meet listing and regulatory requirements but not adding value. A well-designed CEO succession process, with the right information, the right activities, and the right dialogue, increases the effectiveness and impact of both the board and the CEO.

One can only expect that the trends that are driving these new approaches will continue. Directors will want to use effective practices that increase the probability of success. They are likely to recognize the additional tangible benefits from better approaches — more clarity, more engagement, and a stronger company. Quite likely, the well-told story of GE will be joined by other stories of CEO succession that offer learning and insight into how the people responsible for CEO succession do their job best.