Many companies aren't Prepared to replace underperforming CEOs

Succession planning is a taboo subject that tends to be neglected in many companies Image: Shutterstock

Replacing a CEO is one of the most critical decisions a corporate board can make. But a closer look into executive succession planning finds that many publicly traded companies aren’t prepared to make big changes at the top — and end up paying for their lack of planning.

In a recent paper, David Larcker, a professor emeritus of accounting at Stanford Graduate School of Business; Brian Tayan, a researcher at the GSB’s Corporate Governance Research Initiative; and Edward Wattsopen in new window, PhD ’20, of the Yale School of Management, find that many companies are slow to terminate underperforming bosses, get caught flat-footed when a CEO suddenly departs, and often fail to appoint a viable or permanent successor.

Succession planning is a taboo subject that tends to be neglected in many companies, Larcker says. One reason is that directors may feel awkward about broaching the subject with CEOs, as it suggests dissatisfaction with their performance. “It’s like coming home from school with a bad report card and explaining it to your parents,” Larcker says. “It’s not a fun thing to do.” And personal tiesopen in new window can make directors go easier on the CEO.

One of the most striking findings unearthed by the paper was that 4 out of 10 CEOs retain their jobs despite five years of worst-in-class performance based on return on assets.

Larcker puts this down to risk aversion. A CEO search can be time-consuming and expensive, and the stakes are high. One studyopen in new window estimates the cost of appointing the wrong leader at more than $100 billion. Bad picks can cause stock price drops along with stalled momentum, lost customer goodwill, and diminished trust within the organization. “There’s a reluctance to do it,” Larcker says.

Big Shoes to Fill

One indicator of a board’s preparedness for succession is whether it names a permanent or interim boss. A 2010 survey by the Rock Center for Corporate Governance and Heidrick & Struggles, an executive search firm, found that only half of directors felt ready to name a long-term successor if they had to, with 39% admitting they had zero internal candidates. They said it would take them 90 days, on average, to find a permanent replacement.

“To start the search for a replacement once you get rid of a CEO is too late,” Larcker says. “Companies with a really good succession plan should be able to appoint a permanent successor almost immediately.”

The paper shows that interim leaders are negatively associated with firm performance and increase a company’s long-term risk of failure. In addition, the longer it takes to find a permanent successor, the worse the operating results. “If you appoint a caretaker, that is indicative of the fact that you may not have talked about succession planning,” Larcker says.

These findings chime with a recent string of CEO shake-outs. This summer, for example, Gap Inc. fired Sonia Syngalopen in new window after just two and a half years in the job without naming a permanent successor. Her predecessor, Art Peck, had been ousted in 2019; an interim leader replaced him until Syngal’s arrival. The company’s share price has plunged around 45% since Peck’s abrupt exit.

Another important aspect of succession planning is whether the replacement comes from inside or outside the firm. Outside CEOs are a risker bet than internal candidates, Larcker says. Shareholders may see the appointment of an external CEO as evidence of far-reaching strategic, structural, or cultural problems. It also suggests a weak talent development program and a lack of qualified internal candidates. Larcker found that about half of all underperforming CEOs who are forced to resign are replaced by external candidates, suggesting that their companies did not take succession planning as seriously as they could have.

Also read: Preparing the next gen is an important aspect of succession planning: Douglas Shackelford

What “Stepped Down” Really Means

Another central question for shareholders is whether the incumbent CEO was fired. This information is helpful for assessing the quality of board governance. But Larcker and his coauthors found that the ambiguous language used to describe CEO departures makes it difficult to determine the truth. Firms usually say that CEOs have “retired,” “resigned,” or “stepped down” when they have in fact been forced out.

A tool for reading between the lines is the Push-Out Score, developed by financial journalist Daniel Schauber, which examines the circumstances of a CEO’s exit to determine the likelihood that they were pressured to leave. Larcker and his colleagues examined Push-Out Scores from nearly 1,400 turnover events at Russell 3000 companies between 2017 and 2021. They found that 29% earned a high score, suggesting an involuntary departure, while only 23% had a low score indicative of a voluntary exit.

This suggests boards may be more likely than initially thought to hold CEOs to account. But most CEO exits tend to fall in the middle of the spectrum between a termination and a friendly split.

The research also finds a strong correlation between stock price performance and the likelihood a leader was pressured to quit. Former CEOs with low Push-Out Scores delivered shareholder returns of around 8% in the three years leading up to their departure announcements, compared with -42% for those with scores indicating they were fired.

This is because voluntary separations almost always involve the naming of a permanent CEO, while involuntary exits involve a higher number of interim successors, who are associated with worse financial performance. The paper suggests that boards that appoint an interim leader usually do so because they fired the incumbent, not because of an unexpected resignation. Those boards may not have a long-term succession plan even though they instigated the turnover event.

Larcker adds that some top executives may be reluctant to step down because they aren’t prepared for what comes next. “The succession event works a lot better when that person knows what he or she will do with their life going forward.” Bosses who are forced out are more likely to join other ventures as a CEO, executive, investor, consultant, or founder. Those who step down voluntarily are more likely to retire or join the board.

Also read: Family business: Defining lines of responsibility is paramount

What incentives would convince directors to increase their readiness for succession events? Larcker says dissatisfied shareholders can vote against board members when they come up for re-election. Another incentive is the reputational damage associated with a poorly managed succession event. “It’s a lot of work, and it’s embarrassing when it’s discussed in the press,” he says.

Board members can incentivize the CEO to play a more active role in talent development and succession planning by tying these two factors to their bonus packages. “The best companies,” Tayan says, “seem to be those who take talent development and mentoring at the board level seriously and continuously” — long before there’s an empty corner office.

This piece originally appeared in Stanford Business Insights from Stanford Graduate School of Business. To receive business ideas and insights from Stanford GSB click here: (To sign up : https://www.gsb.stanford.edu/insights/about/emails ) ]