NACD - National Association of Corporate Directors

How Compensation Strategies Can Enhance Succession Planning

by Kelly Malafis and Eric Hosken |

Kelly MalafisSuccession planning for CEOs and other top executives is a key focus for directors. There are significant risks to the company (e.g., employee retention, Eric Hoskencustomer retention, increased risk of acquisition) if the executive leadership transition is not smooth. Today, boards proactively push management to provide them with insight and access to senior management to ensure that they have a strong understanding of the company’s succession plans and potential candidates.

Frequently, the responsibility for succession planning falls under the purview of the compensation committee. This group is generally well suited to direct succession planning efforts, as they often oversee individual performance assessments of the senior management team and the compensation decisions that support the effectiveness of the succession plan. In fact, compensation is a valuable tool to aid employee retention before and after a leadership transition.

When all goes well, the company will be prepared to appoint an internal successor upon the end of the CEO’s tenure. The company knows the likely successor, and the board already understands of the candidate’s strengths and development areas. Even if the incumbent CEO’s departutre comes as a surprise (e.g., due to death or disability), the transition can be smooth if an internal candidate is already being groomed for the role. Once the board identifies who are the best internal candidates, it may be wise to begin to differentiate their compensation and roles and responsibilities relative to other members of management. Doing so signals their value to the organization and helps to ensure that they will be less likely to leave for other opportunities while waiting for the opportunity to be CEO. The board may also want to include succession planning in the incentive goals of the incumbent CEO to reinforce its importance.

A similar approach should be used below the CEO level. Once an employee is identified as a high performer and a succession candidate, the company should take the opportunity to provide higher compensation opportunities with an emphasis on performance-based and long-term incentive compensation. This demonstrates the employee’s value to the company and encourages employee retention due to the multiple-year vesting periods of incentives like performance shares and restricted stock.

A key challenge for the board during the transition period is maintaining management team stability. Retention of the senior executive team is a concern whenever there is a CEO transition, for two key reasons. First, some senior executives (e.g., CFO, major business unit leaders) may feel they were “passed over” for the role. They may believe they were viable CEO candidates, and if they did not get the role now, it would be best to look elsewhere for future career advancement. Second, some members of the executive team may have had strong relationships with the former CEO but weak relationships with the newly promoted CEO. They may fear that the new leader will want his or her “own team” to run the company in the future. It is often the case that the new CEO will want to make changes in the management team within two years of assuming the role.

A number of large companies have put programs in place to help retain top management through the transition period, with prominent examples including Best Buy and Intel. Other companies proactively address retention risk by ensuring that their senior executives have significant unvested equity holdings that will be at risk of forfeiture if they choose to leave.

While sometimes necessary, recruiting a CEO from outside the company is one of the most challenging situations for compensation committees, especially if identifying external candidates was not part of the ongoing succession planning process. The compensation committee in these situations often has very little leverage in negotiating terms, and CEO contracts frequently have undesirable features that can expose the committee to external criticism. In addition, external hires are, by definition, high risk, as the board has limited exposure to them compared to an internal candidate. For these reasons, spending time on effective succession planning and supporting the retention of high performers can be a valuable investment of the compensation committee’s time and effort.