KEY CONCEPT
Formal succession plans ensure more careful and efficient CEO turnover decisions, and reduce the economic and organizational disruptions that can undermine a company in the wake of a CEO’s departure.
IDEA SUMMARY
The departure of a CEO inevitably leads to disruption and uncertainty — from a nervous workforce unsure of what the future will look like to the markets monitoring carefully the performance of a new leader in a new situation. Often, other top managers may decide that a leadership change is a good time to leave the company.
A new study based on 17 years of CEO turnover data reveals the extent to which having a rigorous, formal succession plan in place can reduce these and other negative effects — including making an inefficient decision to terminate a CEO in the first place.
Specifically, the data showed that a formal succession plan:
- Enhances leadership continuity. To begin with, companies with succession plans have less forced turnovers than those without succession planning. In addition, firms with succession plans are more likely to pick a successor from inside the company — and to pick a permanent replacement rather than an interim CEO. Another advantage is that these firms also are able to keep the departing CEO involved in the transition to a successor. Finally, firms with succession plans are less likely to avoid the brain drain that can occur in other companies as key managers just below the CEO follow their boss out the door.
- Mitigates the economic uncertainty of a CEO turnover. The announcement of a CEO’s departure can hurt shareholder value as markets react to the uncertainty. However, the data shows that in the immediate period after the announcement and during the first year of a new CEO’s tenure, firms with succession plans experienced less stock return volatility around a CEO turnover event than firms without succession plans. One particularly telling result for these companies is the rapid drop in stock return volatility after the turnover, which indicates that the markets learn about a new CEO’s capability much more quickly; the additional disclosure of information during the succession planning process probably plays a role.
- Improves the efficiency of executive transitions. Companies with succession will link management turnover decisions to performance more effectively. Specifically, succession plans increase turnover-performance sensitivity — in other words, the link between CEO performance and termination decisions. For example, companies with formal succession plans are more likely to fire a CEO following poor performance (the authors of the study examined pre-turnover ROA, EBITDA and Q ratios to reach this conclusion). Intuitively, this makes sense as a company that has laid the groundwork for a smooth transition to a new CEO will be less hesitant about letting a poor performer go. At the same time, however, succession planning also prevents firms for firing CEOs for reasons that are outside the CEO's control — for instance, in response to industry-wide (or even economy-wide) downturns beyond the CEO’s influence.
- Reduces post-turnover costs and aligns the CEO’s interests with shareholders. Succession planning also helps companies make decisions related to the newly hired CEOs that are better aligned with shareholder interests. For example, the data shows that these companies are less likely to overpay new CEOs, and are more successful in linking the performance of newly hired CEOs to results.
BUSINESS APPLICATION
Succession planning is much more than just creating a strong leadership pipeline for your company. As this in-depth study of more than 3300 public companies experiencing CEO turnovers between 1993 and 2010 reveals, succession planning can ensure that management turnover decisions are appropriate and timely, that any negative impact from turnovers are short-lived, and that new CEOs are welcomed with a compensation structure that links their interests to shareholder interests.
The results of this study are unequivocal: the return on time and investment in succession planning is invaluable in terms of the nature and efficiency of turnover decisions — and in terms of the company’s prospects after the new CEO is in place.
REFERENCES
Changing of the Guards: Does Succession Planning Matter? Dragana Cvijanovic, Nickolay Gantchev, Sunwoo Hwang. SSRN (November 1, 2016).
