Introduction
The decisions of the Chief Executive Officer are extremely important as their decisions affect the entire future of their company. Having the right person in the CEO role can result in great success, while the wrong person can lead a company to disaster. Mistakes at this level of an organization can be catastrophic whereas good decisions can lead to rapid growth and higher profitability. This article will analyze the choice between the internal promotion of an existing employee to the role of CEO versus an external recruitment to fill a vacant CEO position.
We then recommend some optimal hiring practices for CEO replacement. We will suggest that wherever possible an internal candidate should be chosen to be the next CEO. However, some companies are either not mature enough to engage in this practice or find themselves in too deep a crisis to exercise this rule of thumb. Therefore we will also look at some circumstances where external candidates might be chosen instead.
The success of a company is the result of several variables, but having the right person at the top of an organization is one of the most crucial. The CEO is usually the most important employee in determining the success of a company and as such, businesses invest much time, effort and expense into making sure that they find the right person to fill this role. In addition to making strategic decisions for a company, there are other important ways that a CEO contributes to the business including setting the vision, strategy, and corporate culture.
The CEO is the leader of the company and as such, the better the CEO leads, the more successful the company. However, finding the right CEO is just as challenging as it is important. Not many people possess the skills and experience necessary to be an effective CEO. In order to be successful in finding the best fit for the role, companies need to identify and prioritize the characteristics that are important to them while being honest and realistic about any company deficiencies that may exist. This is why succession planning is so essential. To identify the
ideal candidate, organizations must not only have sound talent management practices, but also be cognizant of the benefits and limitations that warrant the selection of an internal or external applicant.
Internal Promotion
Many leading business commentators have championed the practice of internal promotion into the CEO position as a way to build and guide exceptional organizations. In light of these views, there are scenarios where the practice of an internal CEO selection can be more beneficial to a large organization than other options.
By and large, the practice of internal CEO selection has been an effective strategy in mature business environments with historically stable results and less industry volatility. Collins and Porras assert that organizations that are guided by a long-standing core purpose and vision are ideal settings for the selection of an internal candidate (1994, para. 5).
From Collins and Porras’ perspective “the key is to develop and promote insiders who are highly capable of stimulating healthy change and progress, while preserving the enduring core ideology of the institution” (1994, para. 12). By perpetuating the selection of organizational leaders that possess exceptional skill and are intimately knowledgeable about the organization’s core ideology, the organization retains its identity while adeptly pivoting with the strategic business direction charted by the newly selected CEO.
Business commentators often laude the management capability of General Electric’s Jack Welch, however, based on a Return on Equity Basis, Welch’s exceptional performance was consistent with his predecessors (Collins and Porras, 1994, para. 9). These results suggest that despite Welch’s immense talent, it is GE’s commitment to internal hiring and a long-standing core ideology that enables it to consistently produce exceptional CEOs. These sentiments are consistent with additional academic research that suggests that an individual’s performance is strongly associated with the firm’s resources, networks and colleagues (Groysberg, 2010, p.163).
Ultimately, when an organization can operate with stability, it has the capacity to design processes to build and identify top talent that can lead the organization into the future. Building on the idea of generating organizational stability, internal hiring is also an effective strategy in a competitive labor market environment to retain existing talent. Internally selecting a CEO sends a strong signal to the employees of an organization that their organization has the capacity and foresight to develop and reward outstanding performance. According to Wharton Professor Wayne Guay, internal hiring ‘creates an incentive for executives to do a good job’ (2013, para. 4).
The internal hiring argument can be bolstered due to the fact that the internal selection of the CEO also sends a strong signal to new or prospective employees that ‘advancement is a possibility within the organization, making entry-level jobs more attractive’ (Roach and Dixon, p. 139). Additionally, a succession planned internal selection reinforces the organization’s confidence and stability in its future. From the standpoint of retention, internal CEO hiring allows the organization to tacitly or directly acknowledge the cultural attributes and engagement required for career success to its employees.
Additionally, these positive signals perpetuate organizational stability and cost management as higher retention reduces the need for training new employees and the creation of personnel deficiencies within the organization. This type of employment strategy can be evidenced with Proctor and Gamble, as the organization places emphasis on internal promotion, reinforcing the need of managers to “guide their direct reports on how things should be done the ‘P&G way’ (Proctor and Gamble, 2013). Ideally, P&G builds a cascading set of behaviors that emanate from the internal selection of its CEO and flow through the organization to generate a winning culture that rewards success and generates retention.
When searching for a new CEO, organizations are not only tasked with finding the optimal candidate, but also doing so at a fair price. Internal hiring practices into the CEO role offer organizations benefits when it comes to both organizational fit and cost effectiveness. Research from Matthew Bidwell suggests that external hires will initially perform worse than internal applicants, have higher exit rates and be offered more compensation (2011). Bidwell’s assertion is derived due to the fact that hiring committees generally have incomplete information regarding external applicants who often look better on paper than internal applicants where a history of performance has been observed directly (2011).
In light of this circumstance, the hiring committee must rely on external applicants that have stronger ‘observable indicators of ability such as experience and education’ compared to internal candidates to offset the risks associated with hiring outside the organization (Bidwell, 2011, p. 317). This circumstance can predispose those making the hiring decisions to choose the documented traits of the external candidate over those of organizational fit (Bidwell, 2011). From the perspective of the external applicant, they may demand higher pay to offset the risks of entering a new environment where they cannot accurately judge their own fit (Bidwell, 2011).
According to a recent Wall Street Journal Article by Cari Tuna, “in the S&P 500-stock index, median compensation for outside hires totaled $12.1 million, about 75% more than the $6.9 million for internal hires” (Tuna, 2008, para. 4). Given the disparity in compensation, the duration of time needed for external hiring and the potential opportunity costs incurred by existing executives spending time acclimatizing an outsider to a new environment, external hiring should be approached cautiously.
In order to offset the aforementioned fit and cost issues, an organization can leverage internal CEO selection. By choosing an internal applicant, the organization mitigates fit issues, as it has a larger quantity of information regarding not only the tangible results the candidate has generated, but also the subjective attributes that have been displayed over time.
Given the duration of time the organization has to evaluate the internal applicant, there can be significantly greater confidence that the applicant meets all requisite cultural and fit criteria. As an added benefit, it is also likely that a senior candidate will have an intimate knowledge of the organization, thus limiting the transitional burdens associated with a move into the CEO role. Given these criteria, the selection of the eventual CEO can be made with more accuracy and expediency, thus saving the organization additional costs.
External Recruitment
Motivation to recruit an external CEO generally stems from the need for change within a company. In this instance a company will be facing some sort of challenge. This could be due to many reasons such as poor performance or financial woes, company culture related issues, growth related problems, or even some external event such as a strong competitor or product/service entering the marketplace. Those leading the company then feel that an outsider would “enrich the company with what it needs most – new perspectives, fresh ideas, and decisive action” to more successfully to drive change and lead the firm through its challenge (Lauterbauch, Vu, & Weisberg, 1999, p. 1486).
Alternatively, external candidates can be recruited when there is no major challenge or crisis. Here a company may simply be lacking strong internal talent to succeed the outgoing CEO. However, this instance is most likely the result of some greater company issues like a lack of employee development or long-term succession planning.
There are many advantages to hiring an external CEO. “If the new CEO has worked in different industries or markets, [they] can bring in new ideas and new ways of working into the company” (Askari, 2007, para. 6). In addition, an external hire will “not be biased by existing strategies or existing people within the organization” (Askari, 2007, para. 6). This situation may allow for quicker and more disruptive change as decisions can be made without concern for past working relationships or personal investment in the company’s current business strategies and processes.
Many of the disadvantages of hiring externally are a result of the new CEO’s lack of experience within the company. In this situation, the “disruptive effect of bolder strategic changes can be further amplified if the firm’s leadership lacks a good understanding of the firm’s strengths and weaknesses, which may lead them to initiate large-scale but inappropriate strategic changes” (Rajagopalan, 2011, para. 2). Here “bolder changes can be detrimental to the firm’s performance because they may deviate from the firm’s core competences” (Rajagopalan, 2011, para. 2).
In addition, hiring a company’s CEO externally does take longer and is generally more costly in terms of both compensation and costs associated with training. Two examples of successful external CEO successions include IBM’s Lou Gerstner and 3M’s James McNerney. Both individuals were brought in to lead their respective companies during periods of poor performance with the hopes that their broad outsider experience would benefit and lead to positive change.
From the 1960s to 1985, IBM was the marketplace leader in the computer sector, with revenues increasing by 14% annually (Network Marketing, 2012). However during the late 80s this industry began to change with newer technologies and innovations leading to stronger competition. In 1993 IBM declared a record loss of $8 billion (Gifford, 2010).
Lou Gerstner, an outsider with experience from McKinsey & Co, American Express, and RJR Nabisco, was brought in to help save the company. “The first order of business was making the company solvent. Under his guidance, IBM cut billions in expenses (partly through massive layoffs) and raised cash by selling assets” (DiCarlo, 2002, para. 9). He also began to change company’s culture with decisions such as tying employee compensation to the overall company’s
performance, implementing rewards for those who were able to get work done fast, and abolishing the company’s strict dress code. “That Gerstner had no emotional attachment to longsuffering products ultimately worked in IBM’s favour” (DiCarlo, 2002, para. 18). Gerstner ultimately brought IBM back to profits and saved a company that was going bankrupt. The example of Gerstner turning around IBM is evidence that external candidates can be stronger than internal ones in the right situations.
IBM needed some major changes and they were most likely not going to be accomplished by an internal employee whom had worked their entire career at IBM. An internal candidate would most likely be too biased by the company’s past history, including its culture and operations, to be able to institute major change. Like Lou Gerstner, James McNerney was also an external CEO brought in to shake things up at 3M. From 1995 – 2000, 3M’s earnings per share were lagging versus its competitors. Shareholder returns were also lagging the Dow and S&P 500 (Useem, 2002). Quarterly results were underwhelming for investors as the company was turning out fewer and fewer commercial hits. At this time, the board of directors felt the company needed a strong outsider to come in and restore discipline and focus (Bloomberg BusinessWeek, 2004).
In late 2000, the company brought in James McNerney to do just that. At this time, 3M was a very large and decentralized company that let each of its businesses operate freely. McNerney, a senior executive from GE, brought more structure to the company as he implemented many of GE’s management tools, including the data driven Six Sigma program, to better pinpoint the company’s inefficiencies. He initiated “rounds of cost-cutting, layoffs, and smart repositioning of the company into morepromising fields such as health care” (Bloomberg Businessweek, 2004, para. 6).
As a result, in 2003 3M posted some of its strongest results, with profits climbing 35%. As seen in this example, an external candidate like McNerney is less likely to have an emotional attachment to the company’s employees and can therefore more easily institute layoffs and other major structural or operational changes to improve efficiencies.
Optimal Practices for CEO Selection
Succession planning for a complex business requires the incoming CEO to be knowledgeable about the company culture. A complex business can be defined as a large conglomerate or multidivisional organization. If a CEO is hired externally, it should be recommended that the organization account for adjustment costs related to the hire. Kor & Lebleblci (2005) define the adjustment cost as: “Time spent to accumulate the firm specific knowledge about a firm’s business practices, values, and relationships with specific clients; and knowledge of the skills and idiosyncratic habits of people so that the existing and new employees can effectively work and function together” (pg 973).
If internal hiring is to be successful, the board will need to reach consensus on a succession plan as to who the next CEO should be. Open communication between the board and chairman is key in selecting the right candidate. As the board engages with the stakeholders and the selection criteria is clearly discussed and agreed upon, the company vision as well as the BHAG (Big Hairy Audacious Goals) becomes apparent and reinforced. There must be alignment between the board and the stakeholders on who the CEO should be and why. Miles, Steven (2009) describes why the need for a transparent hiring process is paramount when selecting a CEO:
“Instead of the chief executive officer and head of human resources presenting their succession plan to the board once a year, I suggest that the process start by engaging the board in the development of a forward-looking skills-and-experience profile for the CEO.” Another recommended practice for hiring both externally or internally is to emphasize and prioritize the required skill set of the potential CEO. If the internal candidates that a firm possesses do not have the technical expertise for a new line of business/functional area, then this minimum level of required skill can be criteria for hiring externally. Miles, Stephan (2009) suggests hiring externally below the CEO level to make the transition into the CEO level smoother:
“Bringing in a potential new CEO at a lower level allows the board to view him or her at work for a period of time. Should such an individual prove capable as a successor, his or her tenure in the company reduces the riskiness of the transition.” When hiring exclusively from the outside, the CEO should be hired only if he brings the skills/expertise that your firm is lacking. Kanter and Rosabeth (2006) provide an example where the external hire was brought on for the skills the firm lacked: “Facebook founder and CEO Mark Zuckerberg’s decision to add a second-incommand…showed a mature recognition that he couldn’t be alone at the top and needed someone with different skills…[key] to an expanding high-profile company.”
Conclusion
As we have seen there are pros and cons of hiring both internal and external candidates as corporate CEO’s. Our research shows that although circumstance often dictates which route to take, internal promotion is preferable and succession planning should be initiated as early as possible to either groom an internal talent or bring someone in to be groomed before they are promoted to CEO. Those companies who utilize succession planning tactics will be ready for change at the top of their organization, and can move swiftly to promote their internal applicant already is groomed and “waiting in the wings.”
Companies who have consistently hired successful internal CEO’s, such as GE, show their strength by leading their competition in every facet and have no need to look externally for fresh ideas because hey are always breaking new ground on the cutting edge of their industries. On the other hand, companies who find themselves either in financial turmoil, with poor culture, stagnant growth, or poor succession planning are often forced to pursue external applicants in order to “shake things up.” This however, comes at greater cost to the organization in terms of recruitment time, expenses while pursuing applicants, and the learning curve of both the incumbent CEO and organization as a whole as it adapts to a new voice and unfamiliar approach.
These of course are rules of thumb as no rule is generic to all situations. Alignment continues to be the key as companies working together in harmony between their strategy, structure, systems, and skills are all more productive and efficient than each on their own. Lastly, self-awareness is also essential. Companies who know their strengths can leverage them and companies who know their gaps can work to fill them. Self-awareness allows companies to plan for their next CEO as it is never too early to start thinking ahead. If a suitable candidate exists from within, he or she can be groomed, and if not, someone externally can be brought up to speed before his or her time comes to take over.
References
- Askari, F. (2007). CEO succession: why hire an outsider? Express Computer.
- Bidwell, M. (2011). Paying More to Get Less: The Effects of External Hiring versus Internal Mobility. Administrative Science Quarterly, 56 (3) 369-407.
- Bloomberg BusinessWeek. (2004). 3M’s Rising Star. Retrieved April 7, 2013 from http://www.businessweek.com/stories/2004-04-11/3ms-rising-star
- CNN Money. Retrieved April 7, 2013 from http://money.cnn.com/magazines/fortune/fortune_archive/2002/08/12/327038/index.htm
- Collins, J. & Porras, J. (1994). Companies Need Not Hire Outside CEOs to Stimulate Fundamental Change.
- Collins, J. & Porras, J. (1994). Built To Last. New York, NY: Harper Business.
- DiCarlo, L. (2002). How Lou Gerstner Got IBM To Dance. Forbes.
