Internal candidates offer continuity and familiarity, but external candidates bring fresh perspectives and openness to transformation.

There is no more important decision for a board than selecting a future CEO. Whether it be for a Fortune 500 company, a health system or a generational family business, this decision can put the organization on a prosperous path with the right successor or can wipe out value and cripple a business with the wrong one. This decision becomes even more complicated and polarizing when the board must consider whether an outside candidate offers a better chance for success given the intersection of future business needs with the market, social and political dynamics of our time.

Internal candidates offer institutional knowledge and continuity and are well-known by the board. External candidates bring new perspectives and are unencumbered by sociopolitical baggage that can prevent the much-needed transformation or, in some cases, future survival. This decision is about the leadership change needed to compete while managing the risk of an external candidate experiencing “tissue rejection” by the organizational culture. While the risk of an internal candidate being rejected by the culture is less, the question remains: Will they bring sufficient disruption to help the business transform and find the next growth curve?

Four primary factors drive CEO succession events: the CEO retires (or leaves the company), resigns due to pressure from either the board or shareholders, the company changes control or health reasons require the individual to vacate the role. These factors largely drive the question of whether to seek out an internal or external succession candidate. The choice is primarily due to the time horizons these events pose to boards when looking for a replacement. For obvious reasons, when a CEO’s health falters or a scandal breaks, there’s little time to scan the market for viable external candidates. Often, board members or individuals from the management team must step into the role on an interim basis. The key for boards is to determine whether an external candidate brings greater potential for future growth and whether the inherent risks of an “outsider” to the dynamics of the executive team and culture can be managed.

Because of the inherent risks of external CEO candidates, the trend has increasingly leaned toward internal promotions. In 2023, for example, internal candidates made up 68% of new CEOs in the S&P 1500, which is a sample size that represents around 90% of U.S. market capitalization. Further, large public company boards seemingly prefer internal candidates because they offer the least disruptive path forward, with the largest companies being even more biased toward internal promotions. Naturally, these companies, through the benefit of having divisional structures or business units built around market or segment P&Ls, tend to produce internal candidates more readily — 74% of new S&P 500 CEOs came from inside in 2023. Like previous research, recent data point to more outside candidates coming into CEO roles during periods of significant market disruption or poorer performance than in previous periods. In other words, in times of distress, companies look for an external solution to their problems. As noted in a recent report by the search firm Spencer Stuart, private investors choose external leaders 75% or more of the time, likely driven by shorter investment horizons and expectations for maximizing returns by quickly steering the company in a new direction.

What’s most important to take away from these trends are the four key decision factors that emerge. These factors, which can unfold in a predictable sequence of influencing events, determine whether internal or external candidates are sought. The opportunity, however, for boards is for optimal decision-making when succession events are out of their control through effective succession planning.

 

Factor 1: Shareholder or market expectations for improved results. If the market and, in some cases, activist shareholders or influential stakeholders demand change because of a failing strategy, poor performance, gross mismanagement or improprieties, directors can be forced to break planned internal succession slates. The assumption is that an internal successor brings more of the same strategy, behaviors and results, and that change is needed now. According to FactSet data, during the 2023 proxy season, 30 activist campaigns removed officers and achieved a nearly 25% success rate. In many of these cases, the activists were demanding the ouster of the CEO to install a different strategic agenda. Hopefully, this situation will never present itself to the board as options become limited, but it’s good to have a contingency plan if it does.

 

Factor 2: Disruption and the level of transformation needed to compete. A sector that is going through or anticipates significant disruption often needs a new playbook and a bold leader willing to sacrifice the sacred cows, tear down the old and bring ideas that transform the business. Can this be done by an existing CEO or internal successor groomed in their shadow? Yes, but it takes a unique leader who is low on ego, bold, willing to disrupt the status quo and capable of thriving in ambiguity through incredible intellectual agility. Tim Cook, the CEO of Apple, is one of those rare leaders who, in the shadow of Steve Jobs, was willing to make important but unpopular changes to secure future results beyond the blockbuster iPhone product. These leaders are rare. Most challenging can be the relationship and cultural ties that form while rising through the ranks. It is difficult to break away from the tribe when a business needs to pivot to stay competitive. Sometimes, the external CEO is exactly what’s needed to find a new growth trajectory. Still, it is not without risk and requires a very high-functioning management team and engaged board that understands these risks and is closely monitoring for tissue rejection.

 

Factor 3: Viability of internal candidates. Assuming you don’t have activists breathing down your neck and the business is performing well, most boards naturally look to internal candidates. This presents the least risky, most pragmatic and often most prudent path forward, especially if the candidate has a skills profile that aligns with the needs of the business. The background of the CEO signals to the market and internal stakeholders what “kind of company” it is or wants to become. Promoting a CFO into the CEO role for a technology business, for example, sends a strong signal of what matters and will influence the narrative for better or worse. Often, internal candidates are COOs and divisional heads, especially in larger enterprises where these roles are proving grounds for CEO candidates. There are, however, two potential stumbling blocks in this lower-risk approach. Many boards neglect to consider how the business must evolve to compete as market forces and customer needs change and whether a candidate curated and groomed by the current CEO can execute transformative change.

 

Factor 4: Scenarios and CEO-readiness time horizons. It’s important for boards to reevaluate various succession scenarios and associated time horizons constantly. This will help to determine when “ready now” internal candidates present viable options and whether exploring external candidates is a necessity. In situations where no members of the management team could move into the CEO role in the next few years, a plan that includes an interim placement, perhaps by a board member, and a well-defined process to select external candidates is necessary. In these situations, bringing in talent from the outside onto the management team can be a prudent step to shorten readiness horizons while acculturating and grooming for the CEO role. Given the pace of change and industry disruption, succession planning frames for the CEO beyond five years have limited utility. Boards need to be thinking about immediate successor options and considering succession horizons for the next 18 months, three years and five years ahead. This is not to discourage talent management processes that identify future “potential” of mid-level managers five years out, but simply to recognize that businesses change so much faster than leaders do, and visibility to what’s needed in five years is rarely clear.

 

Do External CEOs Perform Better?

Researchers have long been exploring the relationship between business performance and CEO succession events. What’s clear is that the relationship between succession and business performance is complicated and murky. Still, there are some apparent signals as to when an external candidate is brought in. Specifically, research clearly points to struggling companies being more likely to hire an external CEO. Also, companies are more likely to hire an external successor in times of uncertainty. According to Kathleen A. Farrell and David A. Whitbee in the Journal of Accounting and Economics, “Boards are willing to accept the uncertainty associated with an outside replacement CEO when their firm’s long-term prospects are both poor and uncertain.” While the market typically reacts positively to the announcement of an external successor, evidence for meaningful gains in performance over a substantive period is inconclusive. Mark Huson, Paul Malatesta and Robert Parrino, offering one of the more robust studies of the relative performance of internal and external CEOs in the Journal of Financial Economics, found significant decreases in operating performance (ROA) in the year prior to succession, but only modest evidence that ROA improves when an outside CEO is appointed.

These patterns are explored in Figures 1, 2 and 3 using more recent data provided by the Corporate Governance Research Initiative at Stanford Graduate School of Business that were generously shared. Three-year total return to shareholders (three-year T

RS) surrounding 1,220 CEO departure events from the Russell 3000 from November 1, 2016, to June 2, 2021, were examined to understand the performance of the business in the three years leading up to the succession event and the three years following the event. After matching three-year TRS data from S&P Capital IQ with the Stanford succession events data and excluding extreme outliers, the analysis sample includes 839 companies, where 621 events were internal and 218 were external. These results offer similar findings, where companies that went external for a CEO candidate had relatively lower three-year TRS than compared with companies that went internal. Additionally, the three-year TRS after the event improved marginally compared to the previous three years before the event for externally promoted CEOs, which complements previous research. However, internal CEO candidates, overall, performed much better in generating shareholder returns than external candidates but trended lower in the three years after the succession event. All these differences were statistically significant.

 

The signal becomes clearer when looking at TRS differences across the sectors (Figures 4 and 5). Specifically, internal candidates in the communications, energy, real estate and utilities sectors have performed much worse. These are sectors going through intense disruption due to technological advances, innovation, regulation and changing consumer preferences. For example, companies such as AT&T, CBS Corporation and SiriusXM, included in the communications-internal category, have been experiencing massive disruptions from cord-cutting, streaming and on-demand media. Looking at these results, the question is whether these businesses could have benefited from an outsider who brought different ideas and a new playbook to transform these businesses.

 

The Advantages and Drawbacks of Internal and External Promotions

Internal candidates. Internal candidates clearly offer continuity and stability and are a prudent choice for CEO succession of a high-performing business. They also fare better in highly complex businesses with highly technical products and complicated supply chains or service models. Internal CEO succession also sends a cultural signal that great talent can rise to the top and be the catalyst for a human capital strategy supporting the upward movement of talent into the C-suite. Many companies tout their high internal placement rate as a success and point to internal leadership development and upward mobility as a key competitive advantage. The main drawback associated with internal succession relates to the level of change businesses in many sectors are experiencing and whether an internal CEO placement has the capacity to seek new pathways to growth and dismantle what has been built to redeploy capital to new areas. (See the previous examples from the communications sector.) These changes can be incredibly difficult for internal candidates to execute because of the tendency to admire and protect one’s accomplishments. Boards need to consider whether these leaders can truly make sacrifices to unlock the next growth trajectory. Boards should explore how internal candidates have approached strategic challenges in the past — by confronting, avoiding or flanking. And whether their skills, mindsets and tendencies will enable sufficient flexibility to transform the organization by creating new capabilities.

Mary Barra, a more-than-40-year veteran of the business promoted to chairman and CEO of General Motors (GM) in 2014, is a prime example. As one of the world’s largest automobile manufacturers, GM was playing catch-up with Tesla and other electric vehicle (EV) and autonomous technology manufacturers as the industry began its shift to EVs and electric hybrids. Pivoting a more than century-old business built around the combustion engine and inextricably linked to the United Auto Workers Union was and continues to be a herculean feat. Because Barra has held various roles in engineering, product development and human resources, and has a deep understanding of GM’s operations, culture and challenges, she has been effective at leading the company through significant transformations.

 

External candidates. External candidates signal change to the organization, shareholders and key stakeholders. Often, this is exactly what an organization needs to stay competitive as business models and the products and services that are in demand change at such a rapid pace. Their ability to execute change, though, is a double-edged sword. External candidates can bring new perspectives, ideas and a mindset unencumbered by past successes and failures and have more psychological freedom (and less baggage) to deliver real change. They are often sought for specific skills and capabilities to transform organizations and their business models. They are tasked with creating and executing strategies that upend and pivot from business as usual and embrace disruption. With the right skills and personality, external candidates can revitalize an organization and deliver extraordinary turnarounds that help companies find new growth trajectories.

Bill McDermott, the CEO of ServiceNow, is a notable example of a successful external candidate brought into the CEO role. Before joining ServiceNow in 2019, McDermott was the CEO of SAP, where he significantly increased the company’s market value. His leadership at ServiceNow has continued to be marked by strong performance and strategic growth.

 

 

On the flip side, the wrong-fit external candidate can be disastrous for a company. While difficult to prove statistically, when things go badly for external candidates, they seem to be exponentially worse than internal candidates because of the disruption they bring to the management team and changes to strategy. Bob Swan’s leadership of Intel Corporation from 2019 to 2021 provides a good example. Swan joined Intel as CFO in 2016 from General Atlantic after having held senior finance roles at several other companies, including eBay Inc., Electronic Data Systems and General Electric. His tenure as CEO was marked by manufacturing delays and increased competition from rivals. These issues led to a perception among some investors and analysts that Intel was losing its technological leadership in the semiconductor industry. Swan was criticized for being more of a financially oriented leader in a company that traditionally valued engineering expertise. This contrast in leadership style was seen as not fully aligning with Intel’s core cultural and operational needs. So, if you’re going to go external, it is essential to get the right candidate.

 

Scenario-Based Succession Strategies to Mitigate Risk and Optimize Decision-Making

The key for boards is to understand the trade-offs of internal and external candidates and proactively mitigate the risks associated with emergency succession and more planned transitions where bold leadership might be needed for transformation. As is evidenced in Figure 6, robust succession planning that considers scenarios surrounding the four decision factors is paramount.

 

 

When faced with an emergency succession event, for instance, how will the board respond? Given the context of the event, will the incoming CEO need to instill confidence in shareholders and analysts by taking the business in a different direction? Who internally gives the board confidence in their ability to transform the business if that’s what is needed? How ready are they, and how much risk is the board willing to tolerate for a less-than-perfect internal candidate? Given the immediacy of the succession need, how does more knowable risk compare to the risks and potential benefits associated with an external candidate that may or may not have relevant CEO experience. It becomes a complicated, multifactor problem that many boards, unfortunately, get wrong due to pressure from various stakeholder groups and suboptimal board dynamics that short-circuit the planning and decision-making process. While emergency events are usually out of the board’s control, having a current contingency plan that responds to various scenarios is essential. Boards should be planful around scenarios for each of these decision factors, keeping a close pulse on performance and the sentiment of shareholders and key constituents, understanding market forces and strategic options to remain competitive and carefully evaluating whether the internal or external candidates will generate greater long-term returns on behalf of shareholders.

Should a board need to consider an external candidate for an event occurring in an 18-plus-month time horizon, an “insider-outsider” candidate recruited from outside the company and promoted into the CEO role within 18 months can be an attractive option. The insider-outsider option is becoming a more common strategy, as it can mitigate the risks associated with external placements directly to the CEO and serve as a CEO “audition.” Scott Kirby, for example, assumed the CEO role after serving as the company’s president from 2016 to 2020, where he played a significant role in United Airlines’ cultural transformation and strategic growth plan. More recently, in 2024, Michelle Gass became the president and CEO of Levi Strauss & Co. after joining the company in 2023 as its president. Some research points to the poor performance of insider-outsiders, but these studies are challenged by small samples and, in one case, only 10 insider-outsider CEOs.

Every board should aim to be in a position where the business is performing well and the current CEO is taking steps to deepen competitive advantage while grooming future CEOs in the process. There is no better position to be in. Boards must actively work with CEOs, chief human resources officers and the management team to ensure this scenario plays out.

 

By Aaron Sorensen, Ph.D.

Originally published in Directors and Boards, June 21, 2024