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The Real Cost of Firing a CEO

Showing top execs the door can be an expensive proposition-and not just because of hefty severance packages.

When G. Richard Thoman resigned from Xerox Corp. after only 13 months as CEO in May 2000, the struggling photocopier company reached deep into its pockets to see him off.

Thoman had left under pressure from dissatisfied board members of the Stamford, Conn.-based company, which was reeling from a stock price nose-dive, a botched sales-force reorganization and back-office consolidation that left the company in chaos. A $13 million deferred compensation plan payment was only one feature of his severance package. Then 55, Thoman also received a bonus of $375,000, a $200,000 payment in place-of-life insurance, office assistance for two years and an $800,000 annual payment for life, according to SEC filings.

Thoman’s multi-million-dollar send-off-and he had supporters for his decisions during his tenure-was hardly unique. Ample packages for departing CEOs are so common that they barely merit headlines anymore. But huge as they can be, such payments are often the most obvious costs that corporations incur when an out-of-favor chief leaves. In no way are they the only costs. A company pays dearly when it loses prized talent and when worthy projects are left on drawing boards.

To be sure, boards of directors rarely consider dismissing a CEO without good reason, and nine times out of 10 they act wisely, says Charles M. Elson, director of the Center for Corporate Governance at the University of Delaware at Newark. Still, he warns, “a termination is never without costs,” and sometimes, he says, the expense can be substantial.

That observation rings with particular resonance today as CEO firings have become almost humdrum. Jacques Nasser, former CEO of Ford Motor, and Linda Wachner of Warnaco, an apparel company, are among the latest members of a swiftly growing club. In the early 1970s, about 10 percent of CEOs left large, publicly traded companies under pressure, according to a recently published study in The Journal of Finance. By the early 1990s, that figure had jumped to 23 percent, says Mark R. Huson, a University of Alberta at Edmonton finance professor who is one of the study’s authors.

Some of the costs of firing a CEO are easy to measure. “Golden parachute” severance guarantees, for example, are now standard in CEO employment contracts. Unless the chief has been convicted of a felony or engaged in other beyond-the-pale behavior, the company usually has to pay up, says Edward C. Archer, managing director at Pearl Meyer & Partners, a New York-based executive compensation consulting company.

A typical severance package starts by giving the departing boss twice his or her annual salary and bonus, but some agreements provide for much more. After Jill Barad resigned at the board’s urging from toy maker Mattel in February 2000, she received five times her annual salary; forgiveness of a company loan to buy a home; a $3.3 million payment to offset certain taxes; and an assortment of other features, including temporary security services.

After paying the departing CEO, companies must cough up to find a replacement. Gerard R. Roche, senior chairman of the executive search firm Heidrick & Struggles, declines to say how much he charges clients, but confirms that the industry average is about one third of the incoming CEO’s first-year total compensation which could include salary, bonus and stock options.

How much can that come to? One of Roche’s own headline-grabbing projects in 2000-matching the former top General Electric executive Bob Nardelli with The Home Depot-is likely to have cost more than $1 million. An employment agreement contained in a quarterly filing with the Securities and Exchange Commission spells out that Nardelli is entitled to an annual base salary of at least $1.5 million and a bonus of at least $3 million.

Other measurable costs stem from the effect of the CEO’s departure on interests outside the company. Suppose, for example, the executive had pushed for a merger or acquisition that faltered after he or she left. Sometimes, the company left at the altar is entitled to compensation for the unconsummated union, notes Dan Ciampa, co-author of Right from the Start: Taking Charge in a New Leadership Role.

A stable stock price can be another casualty. In a recent study looking at CEO turnover at large public companies from 1979 to 1995, three researchers found that stock price volatility was up to 25 percent higher at companies where the chief’s exit was forced than at companies where the CEO left voluntarily. Further, this higher level of volatility persisted on average for two years after the departure. Wide stock-price fluctuations, in turn, can adversely affect all kinds of corporate matters, says Jay Hartzell, co-author of the study and assistant professor at the University of Texas’ McCombs School of Business in Austin. A potential merger partner, for example, might insist on payment in cash rather than stock because of the uncertainty of the stock price.

A Fond Farewell Is Just the Beginning
Typically two times annual salary plus bonus. Other features have included payment for life insurance, office assistance for up to five years and a $500,000 to $1 million annual payment for life. In addition, many companies contend with negative shareholder reaction and lawsuits related to the payout.
FINDING A REPLACMENTRecruiting firms typically charge 33 percent of an incoming chief executive’s first-year total compensation.
MERGERS AND ACQUISITIONSThose under discussion may be terminated; the spurned company may be entitled to compensation for the unconsummated union.
WALL STREET’S REACTIONStock price volatility is as much as 25 percent higher when a CEO’s exit is forced; volatility persists for up to two years after departure.

Over a two-year period following a CEO departure, turnover of board membership is as high as 41 percent when a CEO is forced out, versus 22 percent when the CEO’s departure is voluntary.

Personnel in peril
Unexpected CEO departures can have subtler, but no less damaging, effects as well. For example, there’s the impact on employee morale, especially among senior managers, who may wonder if theirs will be the next head on the chopping block. A spirit of innovation and willingness to take risks can disappear for a while, too, as employees wait to see what’s expected of them in the new regime. And boards can create a particularly sticky situation when the CEO does not leave altogether, but is diplomatically set aside in another role at the company. Richard Brenner, CEO of The Brenner Group, a company in Cupertino, Calif., that finds executives to fill temporary jobs, recalls placing an interim CEO at a software company whose previous CEO had been given another title. The ex-chief retained the loyalty of the rank-and-file, however, and the result was a successor who would find his own directives being countermanded by his predecessor.

Then there’s the possibility of a brain drain. Richard Hagberg, CEO of Foster City, Calif., Hagberg Consulting Group, which helps companies cultivate leadership and develop beneficial corporate culture, recalls a real-estate company that he advised five years ago. The chairman of the board and his popular-with-the-troops CEO had a personality clash.

Ultimately, the CEO was asked to leave. After he formed his own company, a number of his former employer’s top agents bolted to join him. During the six months it took for the real-estate firm to find a successor, another group of agents lost faith in the management and competitors lured them away. “It was a sign to headhunters to start raiding,” Hagberg says.

Employees are not the only ones who flee. Under certain circumstances, board members do, too. From 1988 to 1992, 456 chief executives left America’s 1,000 largest publicly traded companies, according to researchers investigating CEO turnover and corporate boards in a study published in 1999 in the Journal of Organizational Behavior.

In cases where the CEO left voluntarily, the turnover rate on the board of directors was about 22 percent for the two-year period following the CEO’s departure. If the board had been sloppy in its monitoring of the CEO and then forced out the chief, however, that turnover figure jumped to 41 percent. So many director departures can hurt a company in the same way that employee flight does, argues one of the study’s authors, Andrew Ward, assistant professor of organization and management at Emory University’s Goizueta Business School in Atlanta. “You’ve got a potential lack of stability and strategic continuity,” he says. “You lose some of that human capital you’re using the board for.”

Projects unplugged
Companies can also lose worthy initiatives set in motion by the CEO. That’s what consultant and author Ciampa has seen at some of the companies he has advised. He recalls the case of a high-tech manufacturing company in the Northeast that brought in a new CEO to reinvigorate a firm, and he considered it part of his mandate to emphasize new product development. The CEO soon encountered resistance from board members attached to the old way of doing things and especially attached to the original products. These board members conspired to force the new CEO out of his job. After they did, they brought in a replacement who promptly dismantled his predecessor’s work, including the development of new products, a new distribution system and sales offices overseas. Those cuts resulted in what Ciampa describes as an “enormous” write-off.

Perhaps more important, however, the board scuttled what Ciampa viewed as an appropriate strategy to modernize the company. Today, says Ciampa, the company, which he declines to identify, still exists but as a faded version of its earlier self.

Speculation and sensation
A company can also pay some unexpected costs in how the outside world perceives the CEO’s departure. Mattel took a public battering for Barad’s severance package. The president of the American Federation of State, County and Municipal Employees’ union, whose members’ pensions were partially invested in the company, described it as a “package that bestows great rewards for colossal failure.” Mattel is still wrangling with at least three shareholder lawsuits based, in part, on investors’ consternation at the size of the payments, according to Matthew Houston, a partner in the New York law firm of Wechsler Harwood Halebian & Feffer, which represents one of the plaintiffs.

Mattel declined to comment on the lawsuits, because it does not discuss pending litigation, says spokeswoman Lisa Marie Bongiovanni. As for the uproar over Barad’s severance, Bongiovanni says Mattel’s board honored previous commitments to Barad, recognized her 20-year tenure with the company and “did what was necessary at the time so we could move on.” Barad declined to comment.

The public may also view an unexpected exit as less a reflection on the person than the company. That’s what happened in the immediate aftermath of Rakesh Gangwal’s resignation from the ailing US Airways’ Group on Nov. 27, 2001. Richard Gritta, a business professor at Oregon’s University of Portland and an expert in airlines and investment, said at the time that he was uncertain whether the decision came at the behest of the company’s chairman or at Gangwal’s seeing “the handwriting on the wall” about the company’s future. Gritta adds today that when a company is doing well, Wall Street and the public can shrug off a sudden departure. But “if the company is in serious trouble and a key person leaves, the perception is €˜something bad is going on-and this person is either quitting or was fired.'” As it stands, US Airways’ stock price has fallen 40 percent to $5 per share in mid-February from $8 on the day Gangwal’s departure was announced.

A spokesman for US Airways declined to comment on Gangwal’s departure beyond a statement released to the airline’s employees when it was announced he would leave. The statement says that Gangwal’s departure was based on his decision to work in venture capital, that the company was disappointed by the decision but wished him well and that the company’s focus going forward would be “on operational excellence and creating shareholder value.” Efforts to contact Gangwal were unsuccessful.

Finally, if board members are not careful, the firing can set them up for more grief. Rakesh Khurana, an assistant professor at Harvard Business School and author of a soon-to-be published book called Searching for a Corporate Savior that examines CEO recruiting, says that too often the board that dismisses the CEO also fails to give the proper time and consideration to finding the right successor.

Disgraceful replacement
Khurana believes that many board members have become star-struck, convinced that what ails a company can be cured by putting a big-name executive from outside the organization at the helm. One example, Khurana says, is what he considers to have been the ill-advised decision by Xerox’s board to put Thoman, an IBM alumnus and relative newcomer to Xerox, in the top slot. Xerox, Khurana says, was one of “the supposed built-to-last companies with great cultures,” and an insider would have been better able to navigate the terrain.

A Xerox spokesman, William A. McKee, retorts: “You can look at any hire in hindsight and say, €˜You could have gone in a different way,’ but I don’t think it’s appropriate to speculate.” What’s important, he says, is that Xerox is on a track back to profitability. Indeed, in late January the corporation announced an operating profit in its 2001 fourth quarter, excluding the impact of unhedged currency and restructuring charges. McKee adds that Thoman’s severance was comparable to the “going industry rate.” Thoman declined to comment.

For his part, Khurana, who notes that Xerox ultimately looked no further than its backyard when it plucked a 25-year Xerox veteran, Anne Mulcahy, for CEO, suggests corporations should aim to cultivate an in-house corps of top-flight executives. “Companies shouldn’t be asking, €˜How do we get a Jack Welch?'” Khurana asserts. “They should be asking, €˜How do we develop a Jack Welch?”‘

A CEO, that is, who will not have to be fired.


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