The costs of CEO failure: getting it wrong costs the economy as much as $13.8 billion.

Author:Stoddard, Nat
Position:MANAGEMENT
 
FREE EXCERPT

During the last half of the 1990s, turnover rates of CKQs of major North American corporations were consistently in the 10 percent to 11 percent range or lower. In the first seven years of this millennium, however, average turnover jumped to 14 percent--an increase of nearly 50 percent.

[ILLUSTRATION OMITTED]

According to Challenger, Gray & Christmas, the number of CEO departures in the U.S. between 2005 and 2007 averaged almost twice that of the preceding three years. By mid-year 2008, this rate was again on the increase. And among global companies, CEO departures escalated a whopping 41 percent in the first three quarters of 2007 over the same period of 2006.

This trend poses a serious challenge to U.S. businesses and nonprofits for several reasons, not the least of which is what it's costing them. The impact of any change in leadership on both the company and the individual are huge We are all aware of the exceptional severance packages provided to some notable CEOs like Bob Nardelli from Home Depot ($210 million), Hank MeKinnell from PSz-| er ($123 million), Gary Forsec from Sprint ($40 million), Carly Fiorina from Hewlett-Packard (a mere $23 million) and Richard Grasso from the New York Stock Exchange ($188 million). (1)

Our experience with hundreds of senior-level executives' severance provisions is less sensational than the extremes mentioned above and more reflective of norms that fail to make the headlines. (2) In 2007 our compensation experts informed us that the average total cash compensation (including bonuses) for large-cap company CEOs (revenues greater than $4.5 billion) was $1,650,000.

Paul Hodgson, senior research associate at The Corporate Library, puts the customary severance that most companies pay a departing CEO equal to approximately three years' total compensation. Using that multiplier, their severance would be around $5 million. (3) (This being the case, however, Martin Sullivan's current $ 11 million compensation would still convert to a severance of at least $33 million and John Thain's $16 million would translate into a minimum of $48 million.)

It has also been our experience that most CEOs of mid-cap or smal1er corporations receive lesser severance packages--two years is more common at the mid-size companies and one seems to be the rule at smaller firms. Using average total compensation figures for these groups, the average severance payments would be closer to $1.7 million and $650,000 respectively.

Some Hidden Costs

While not as impressive as the headline "funny money" payments to a handful of executives, severance costs are not the only direct, cash costs incurred when CEO failure occurs. Other costs may include a retained search to find a replacement or to "benchmark" an internal candidate at 27 percent to 33 percent of total annual first-year compensation, plus the travel costs to and from interviews for all concerned.

Add to that the possibility of buying out the bonuses, options and other incentives the new hire would be leaving on the table at his or her current position. As noted above, severance guarantees made by the candidate's company for purposes of retention must be addressed. Continue by factoring in a six-digit sign-on bonus to help with incidental, up-front expenses, and then add in the cost of both parties' advisory support teams, including contract lawyers, compensation and tax specialists, an assessment team, and possibly an on-boarding advisor. Since it usually takes a newly hired or promoted executive six months to reach breakeven--the point at which new leaders have contributed as much value to their new company as they have taken from it--that initial "sunk cost" needs to be factored in, too. (4)

Now throw in all the "exceptional items" for both the departing CEO and the new replacement: the buy-back of the house, outplacement services, partial or full-year bonuses (often paid to the outgoing executive and guaranteed to the incoming one), Special Executive Retirement Plan (SERF) costs, relocation expenses (including gross-ups for tax purposes), special medical and life insurance premiums, reimbursement of club memberships, the loss on the sale of the company car, and on, and on, and on. Having tallied up all these direct costs, which are out of pocket and affect the bottom line, take 50 percent, and multiply that amount times three. You'll have the approximate cost of replacing each of the three executives who will comprise "involuntary departures--or the 25 percent of executives who will, on average, leave the company after a new CEO is brought in from the outside. (5)

But hold on. We're not through vet. There are other, non-cash costs that occur when the CEO fails to deliver the expected results. For public companies, one extremely important indirect, but very real cost comes from the stock market's reaction to the change. Researchers at Booz Allen Hamilton recently found...

To continue reading

FREE SIGN UP