The Insiders or the Outsiders?

"Insiders" who went on to lead large companies include Mary Barra, Tim Cook and Satya Nadella. Some “outsiders” include Marissa Mayer, Alan Mulally and Lou Gerstner Jr.

After a search that stirred anxiety among other boards of directors that it would poach an outsider as its new leader, Microsoft Corp. instead appointed a 22-year insider as its new chief executive.

Satya Nadella, who had served as executive vice president of Microsoft’s Cloud and Enterprise group, succeeded Steve Ballmer as the world’s largest software-maker struggles with disappointing sales of Windows 8 and to expand beyond software.

Microsoft’s announcement on Feb. 4 of its leadership transition comes after a number of other prominent companies have chosen longtime company insiders for their top jobs. At General Motors Co., a 33-year veteran of the automaker took its helm in January. At Wal-Mart Stores Inc., a 23-year company veteran became CEO on Feb. 1. And at defense contractor The Raytheon Co., a 10-year insider is slated to take charge on March 31.

By the end of 2013, more than 1,245 organizations had changed CEOs, according to Chicago-based outplacement firm Challenger, Gray & Christmas. That’s the highest rate of CEO turnover since 2008, just after the dawn of the Great Recession.

At the same time, CEOs appear to be serving shorter terms. The average CEO tenure was 8.1 years in 2012, according to The Conference Board, a business research and consulting group, compared with a decade high of 11.3 years in 2002.

The pace of change and the number of prominent transitions has corporate America again debating where to look for the next generation of leaders. The answer? A company’s decision whether to select an internal or external candidate should hinge on the skills and competencies needed to achieve the strategy of the future — and on the bench strength, experts say.

“Internal is better in every case unless you have a really deficient internal candidate,” said John Thompson, vice chairman of the global CEO and board practice, at executive-search firm Heidrick & Struggles, whose clients have included Amazon.com Inc., Microsoft and The Walt Disney Co. “External candidates should really be head and shoulders above internal candidates to be chosen.”

Indeed, companies with insider CEOs delivered better shareholder returns during their tenures, according to research from management consulting firm Booz & Co. From 2009 to 2011, insiders outperformed their regional stock market index by a median 4.4 percent, while outsider CEOs delivered 0.5 percent shareholder return.

From Within

Most companies appear to be developing their future leaders from within. Booz found that public companies selected insiders as CEOs 71 percent of the time in 2012, the most recent year from which data were available. A quarter had worked at the company their entire careers.

Boards of directors have become more involved in succession planning since the Sarbanes-Oxley Act of 2002. The reduced average CEO tenure reflects their increased oversight, Thompson said. Board members face scrutiny by investment advisers such as Institutional Shareholder Services Inc. and Glass Lewis & Co., which will recommend that shareholders withhold votes during elections if the firms believe that board members haven’t been good stewards. Activist investors also will pressure the board to act if they feel a company’s performance has lagged, he added.

Even organizations enjoying success shouldn’t reflexively seek a clone of the outgoing chief executive, said Steve Krupp, CEO of the Conshohocken, Pennsylvania-based leadership-development consultancy Decision Strategies International. They need to identify the leadership skills and attributes needed to achieve the future business strategy.

“There has to be time spent developing what the criteria are: What is the profile of the CEO of the future?” Krupp said. “That is the conversation that happens first.”

Working with the chief human resources officer, boards then can use the criteria to identify potential candidates internally and compare them with executives externally, said Jane Stevenson, who leads the global CEO succession practice at Korn Ferry International.

Some companies hire search firms to identify outsiders who match the future CEO profile, and look at their experience but never meet with them. Other boards get to know external executives.

‘Internal is better in every case unless you have a really deficient internal candidate.’

—John Thompson, vice chairman, Heidrick & Struggles

“It helps boards to hold leadership to a different standard because they start to see where the leadership stacks up and to have a firsthand perspective,” Stevenson said.

Comparing internal to external candidates also gives the board something to trumpet, said Charley Polachi, managing partner at Boston-based Polachi Access Executive Search.

“When that happens,” Polachi said, “the board can say to the press and the industry analysts, ‘We did a thorough and exhaustive search. We looked at a dozen candidates, and at the end of the day the best person to do this job is right here. And is that a testament to how good we are at developing talent?’ ”

Many companies identify an “heir apparent,” said Jim Westphal, a professor of strategy at the University of Michigan. This approach lets the current CEO mentor and train the next one.

Some of the biggest transitions in recent years followed this model.

Apple Inc. co-founder Steve Jobs promoted Tim Cook several times after he joined Apple in 1998. Jobs named Cook acting CEO during the co-founder’s three medical leaves before the terminally ill Jobs resigned in August 2011. Chip-maker Qualcomm Inc. recently promoted Steve Mollenkopf, who had been second-in-command, after news broke that Microsoft’s board was eyeing him. And before Ford Motor Co. CEO Alan Mulally took himself out of the running for the Microsoft job, Wall Street interest intensified in Ford Chief Operating Officer Mark Fields, who is widely considered Mulally’s heir apparent.

“Ford has taken grooming the next generation of leadership very seriously,” said Washington and Lee University Professor Michael Smitka, who specializes in the economics of the auto industry.

Succession planning should extend beyond one potential CEO turnover, says Korn Ferry’s Stevenson. Companies should be identifying and preparing three generations of leaders.

The first-generation leader is for the role tomorrow if the current chief executive is hit by the proverbial truck, Stevenson said, while the third generation includes candidates for a decade from now.

“What you’re looking for in the third-generation leader is probably not what you want in the first-generation leader,” Stevenson said. “Why? You would hope that the business strategy is going to change and develop over time.”

The board and CEO should be looking at strategic priorities today and down the road and linking them with the evaluation of the organization’s leadership bench strength, she said. It serves two purposes: understanding today’s talent and helping to prepare tomorrow’s leadership.

To be set on a path to the corner office, high-potential talent needs to be given rotational assignments, to evolve from functional experts to business leaders and to direct businesses within the company, said Tracy Benson, founder and CEO of the business consultancy On The Same Page, whose clients include Merck & Co., PepsiCo Inc. and Travelocity.

“They’ve got to give them a hot-seat opportunity to perform,” Benson said.

The Outsiders

Sometimes the profile of the next CEO calls for an outsider. Think Mulally, who helped turn around Ford, or Marissa Mayer who now heads Yahoo Inc. after a successful stint at Google Inc. There’s also Lou Gerstner Jr., who came to IBM Corp. in 1993 from RJR Nabisco Inc. and guided the company from the verge of bankruptcy to one of the turnaround stories of the decade.

Chief executives plucked from outside the company are more willing to make big changes, Westphal said. When a company needs dramatic change in strategy, it should at least consider outsiders.

Car rental company Dollar Thrifty Automotive Group changed chief executives twice during Maryann Keller’s 12 years on its board.

The first time, the board tapped an insider.

The second time, the board chose someone who was essentially an outsider. Scott Thompson, hired as chief financial officer in May 2008, was elevated to CEO that July. A key criterion: someone who could help the company, which Keller described as in “a desperate financial situation,” talk to banks.

“We found the right person who had that skill set, and he was able to effect change,” said Keller, who once served as head of Priceline.com’s automotive unit.

The stock rose to $87.50 a share, the price paid by Hertz Global Holdings Inc. when it acquired Dollar Thrifty in 2012, from a low in March 2009 of 62 cents a share.

Outsiders come at a price. Compensation-research firm Equilar found that — based on data from CEOs hired between January 2010 and April 2013 — externally recruited CEOs cost more. Chief executives externally hired into companies in the Standard & Poor’s 500 index received median compensation of $9.5 million, according to Equilar, compared with $7.5 million for those internally promoted.

The difference holds true across company size. Smaller companies paid external candidates an average of $2.6 million compared with $1.9 million for internal ones.

External CEOs cost more because they’re walking away from long-term incentives, said Tony Preston, chief customer strategy officer at SilkRoad, a cloud-based HR software provider. Boards also pay more for what they “perceive the value of someone is,” he said.

Preston cautions that turnover tends to be higher when an outsider takes the reins. Those executives often fill the C-suite with their own people, Preston said, and assume that “they need to fix things that are broken.”

But turnover is a risk for companies that promote from within, too. Employers risk losing runners-up, especially when the selection devolves into a “public horse race” between two or three candidates.

Executive compensation consultancy Pearl Meyer & Partners surveyed 153 Fortune100 companies and nonprofits in 2011. Of those that had changed CEOs within five years, 32 percent said key internal candidates left the firm to work for another organization or retired after being passed over. Another 31 percent said they adjusted the pay or position of those internal candidates so they would stay.

At General Motors, the board changed the automaker’s leadership structure after Dan Akerson stepped down as chairman and CEO, giving top spots to two leading internal candidates. Mary Barra, who had been the global product development chief, became CEO. Daniel Ammann, who had served as GM’s CFO and was widely considered a candidate for CEO, became president. In addition, Theodore Solso, a former CEO of engine-maker Cummins Inc., became the nonexecutive board chairman.

“While Mary Barra got the title CEO, she did not get what I would consider the kind of totality of control that her predecessor had,” said Keller, an auto industry consultant.

Boards can reduce the chances of losing runners-up by avoiding a public competition, experts say.

“When you have a visible horse race, the stakes get higher and egos get bruised,” said Krupp, who has worked with Deutsche Bank, Johnson & Johnson and United Airlines Inc.

Emphasizing leadership development helps make succession planning “invisible,” said Korn Ferry’s Stevenson.

“The more the company focuses on leadership development as a course of business all day, every day, all year, every year, the less it created a horse race,” Stevenson said. “Where it becomes problematic is when a process is started around a transition.”

If executives know they were runners-up, board members should tell them that they’re valued and point out what they could gain by working with the new CEO, said Heidrick & Struggles’ Thompson.

“If you go outside, how do you keep internal people from bolting?” Thompson says. “Sometimes, you can’t.”