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The boards of public companies have made substantial progress over the past decade in many aspects of corporate governance. By all indications, they are more independent, with stronger lead director and nonexecutive chair roles, meaningful independent director meetings, and increasingly rigorous risk management, audit, compensation, and governance practices. While boards have clearly raised their game, the task of evaluating and rewarding CEO performance remains a critical challenge. Addressing this challenge requires a board to put in place a rigorous, performance-enhancing evaluation process. Based on our work with CEOs and boards, we have established a six-step blueprint for a better CEO evaluation process.
1. Create joint accountability. Successful boards collaborate with their CEOs on every aspect of the evaluation process, from defining performance measures to deciding what information to collect and determining how results will affect compensation decisions. To make the process work, both parties must establish a meaningful partnership characterized by good faith, mutual respect, and genuine appreciation for the value each brings.
2. Set balanced performance goals. Boards face a difficult dilemma. On the one hand, shareholder demands and proxy firms have increased the pressure on boards to focus on clearly identifiable financial outcomes. On the other, boards know that creating the conditions for high performance and sustainable shareholder value requires CEOs to attend to a host of operational and leadership challenges beyond quantitative financial metrics. In this context, some leading boards have incorporated “balanced scorecards” and 360-degree survey methods into their formal CEO evaluation process.
Balanced scorecards measure the CEO’s performance against goals defined at the beginning of each fiscal year. Aligned with a company’s strategy, scorecards include not only standard financial measures, such as revenue, profit, and share price, but also operational, customer, and human capital metrics. Additionally, balanced scorecards look forward as well as backward, using indicators of both future success and past performance.
While scorecards measure performance outcomes, 360-degree surveys evaluate how CEOs achieve their results. Outcomes matter, but so do the leadership behaviors required to deliver sustainable performance. Progressive boards understand this, recognizing that a CEO’s development does not end when that person moves into the corner office. What leadership capabilities are required for success now and in the future? Are some qualities, such as integrity and respect for others, non-negotiable? With the use of 360-degree surveys, a board can evaluate the CEO’s leadership strengths and development needs in the context of an ever-changing strategic environment.
3. Clarify stakeholder roles. Another key element of an effective evaluation is having clearly defined roles and responsibilities. Yet surprisingly, this is an area that remains ambiguous among some boards. Who will lead the evaluation process? What role should independent directors play? Who will deliver the year-end performance review? Although every situation is unique, stakeholders must understand their responsibilities at each stage of the process.
4. Get the “appraisal” part right. Many boards underestimate the importance—and difficulty—of appraising CEO performance. The appraisal process includes how performance criteria are measured, how data are collected, how results will be analyzed and reported, and ultimately, how performance feedback will be delivered. Given the complex and sensitive nature of this work, the challenge is to inject appropriate rigor and objectivity into the appraisal process. Some boards have looked to other companies for guidance, adopting best practices to avoid common pitfalls. Other boards partner with trusted external advisors for help while retaining full ownership of the evaluation process.
5. Ensure a constructive performance review. The annual performance review is a critical link in the evaluation chain—if it fails, little else matters. At the same time, it is not an isolated event but part of an ongoing exchange between the board and the CEO. Combining regular informal feedback with the year-end review provides the CEO with constructive feedback on everything from his or her leadership style and behaviors to critical strategic and operational issues.
CEOs must enter the performance review with an open mind, ready to listen to constructive feedback. Their challenge is to take the feedback to heart and apply insights from the discussion. The board’s responsibility is to deliver a fair and balanced performance appraisal. The appraisal must meet the test of clarity, fairness, and objectivity. But delivering a fair evaluation is not enough; the results must be vetted and endorsed by the independent directors as a whole. CEOs need to know that their evaluation reflects the considered judgment of the entire board, not just that of an inner circle or subset of the board.
Finally, the director responsible for delivering the feedback must engage the CEO in a meaningful discussion of the results. That director must truly listen to, and want to understand, the CEO’s point of view and concerns, in a manner illustrated nicely by one non-executive chair we interviewed: “I deliberately cultivate a two-way dialogue with the CEO to create an opportunity for him to express his hopes and concerns. I try being open and to avoid being defensive. …This, in turn, leads the CEO to be more open and less reactive. The CEO now regularly turns to me for support and help and to express his concerns.”
6. Align pay to value-building metrics. Given the shareholder pressure to align pay to financial performance, boards must avoid the trap of creating too close a connection between short-term financial results and compensation. One director we interviewed explained: “CEO performance and compensation should be correlated but not on a one-to-one basis. Creating some separation between the functions makes it easier to focus on the CEO’s development and future growth while still providing a strong incentive for her or his current performance.”
As noted earlier, the objective is to move beyond reliance on financial metrics to include a broader set of operational, human capital, and customer measures, so that boards can reward CEOs for actions that ensure the long- and short-term performance of the enterprise.
Raising the Bar on CEO Evaluation. While many boards view CEO evaluation as a required annual exercise, a growing number see it as an iterative process in which the board and the CEO engage on critical issues affecting the health and performance of the enterprise. Approached as both a meaningful dialogue and a mandated annual review, the evaluation process creates a powerful ripple effect, unlocking opportunities and delivering extraordinary value. Working together, boards and CEOs can achieve this result by adopting this six-step blueprint designed to markedly improve evaluation outcomes, as it calls for joint board/CEO accountability, balanced metrics, clearly defined roles, rigorous appraisal methods, constructive iterative feedback, and pay tied to leadership actions that create sustainable shareholder value.