This is “CEO Performance Evaluation”, section 8.1 from the book Governing Corporations (v. 1.0).
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Regular, purposeful, CEO performance evaluation by the board is a cornerstone of effective governance. According to Spencer Stuart’s 2007 Board Index, 91% of directors surveyed said their CEO’s performance is evaluated annually; the remaining 9% conduct more frequent evaluations.This section is based on Rivero and Nadler (2003). Respondents also noted differences in implementation: 45% of respondents cited the compensation committee as taking the lead; the entire board oversees the process in 20% of the participating companies; the nominating and governance committee oversees in 16% of the companies, and the lead director in 12%.Spencer Stuart Board Index 2007.
Performance evaluation at the CEO level is difficult. Rivero and Nadler (2003) note that the difference between a good evaluation process in which everyone wants to participate and one that becomes mere window dressing is the CEO’s attitude toward the process and reactions to the feedback. At the same time, an ad hoc process sprung on the CEO can send the wrong signals about the nature of the board and CEO relationship. Both the CEO and the board need to make an investment to ensure that the process is well planned and part of the normal course of business. Minimizing potential problems at the outset, therefore, raises the odds of creating a successful, sustainable process. Common pitfalls to look for include the following:
A well-thought-out process analyzes both past performance and sets goals for the future, and therefore assists the compensation committee of the board in making decisions about the CEO’s future compensation and employment. A good process helps the CEO and the board to establish focus on the company’s future direction by specifying a set of strategic objectives. This goal-setting aspect of the evaluation can also serve as part of the CEO’s ongoing leadership development, with the board providing feedback about areas where the CEO needs to do a better job, learn new skills, or focus additional attention.
An effective CEO evaluation process, therefore, looks backward, focusing on accountability and rewards for past performance, as well as forward, focusing on future objectives and whether the CEO has the vision, strategy, and personal capabilities to achieve those objectives. Although these are distinct objectives, in practice they are often integrated into the same process. Time constraints often force the board to evaluate the CEO’s performance over the previous year while simultaneously making compensation decisions, setting next year’s targets, and discussing specific areas for improvement, often in a single meeting. As Rivero and Nadler observe, this is unfortunate because when the two objectives are not clearly separated, there is a clear danger that neither gets served very well.Rivero and Nadler (2003).
When time is short the developmental part of the evaluation is often skipped altogether, forcing the board to use the compensation review to set the CEO’s future objectives. This approach is likely to emphasize what the CEO is expected to achieve (usually framed in terms of short-term financial targets) over how the CEO is expected to behave (such as giving more attention to developing future leaders). When this happens, the CEO is unlikely to receive candid, detailed feedback about his or her behavior and personal impact.
Defining an effective set of dimensions to be evaluated represents a major challenge. Based on the distinction made above between a CEO’s impact on corporate performance and his or her actions and effectiveness as a leader, Rivero and Nadler identify three generic sets of measurements of CEO performance: bottom-line impact, operational impact, and leadership effectiveness.
The three categories described above are generic. While the specific dimensions and objectives that are used vary for each company, there are some general principles that leading companies follow in selecting CEO performance objectives. First, their evaluations reach beyond bottom-line performance. Financial measures of corporate performance, while critical, capture only one aspect of CEO performance. To compensate for some of the limitations of bottom-line measures, it is important to include objectives that reveal how the CEO behaves as a leader, as well as the CEO’s impact on the effectiveness of the organization. Second, they focus on a manageable number of objectives. One risk in attempting to capture multiple aspects of CEO performance is that the list of performance dimensions may grow too large to be workable. Too few dimensions, on the other hand, cause the process to be dominated by short-term financial objectives. Best practice is to use between 5 and 10 dimensions. Third, they use separate objectives for chairman and CEO performance, even if it involves the same person. In most North American companies, the CEO also serves as chairman of the board. It is important to evaluate performance in both roles. The chairman role can be assessed either as one component of a formal board evaluation process, or the dimensions of chairman effectiveness can be added to the CEO’s evaluation process. Fourth, they define measures for each objective. Creating explicit measures to track performance against the particular objective is relatively simple for all bottom-line and most operational impact objectives. For “softer” dimensions this is more of a challenge but can be achieved. For example, leadership behaviors can be measured through rating methods that ask board members to indicate how often the CEO demonstrates desired behaviors and what impact these have. Finally, they specify performance levels for each rating measure. Explicit measures for each objective assist in setting performance expectations with the CEO. Specificity helps create shared understanding of the performance standards between the CEO and the board.
Best practice also suggests that an effective CEO performance evaluation process is integrated with the company’s calendar of business planning and compensation review: Step 1 is focused on defining the CEO’s objectives. Before the start of the fiscal year, the CEO should work with the compensation committee of the board to establish key business objectives for the coming year. Using the strategic plan as a starting point, this dialogue should produce an initial set of personal performance targets and associated measurements. After reviewing and amending them if needed, the final set should be discussed and approved by the full board. These targets can then be used to create an integrated goal-setting process that aligns the objectives of each leadership level in the company.
Step 2 is a mid-year review. Six months into the year, the compensation committee and the CEO should review the targets and progress against them. Such a mid-year review can provide great value for two reasons. First, it helps the board see how the CEO is meeting or exceeding targets and to identify areas that require closer attention. Second, it provides an opportunity to amend the targets in light of changed circumstances, such as rapidly changing business conditions.
Step 3 is the year-end assessment. At the end of the fiscal year, the CEO’s performance should be measured against the previously established objectives. As part of this step, the CEO should be invited to provide a self-evaluation and be given an opportunity to address areas where targets were not met. The self-assessment is shared with the compensation committee and then the full board for input on the CEO’s performance. Evaluations by all board members go to the compensation committee, which uses the results to determine the portion of the CEO’s pay that is linked to performance. Before providing feedback to the CEO, the evaluation should first be discussed by the board in executive session, that is—without the CEO or other inside directors present.Rivero and Nadler (2003).