Law & Governance

Law & Governance 9(6) July 2004 : 0-0

10 Questions Every Director Should Ask

Ram Charan

Abstract

A best-selling management guru offers a checklist that board members can use to keep their company focused on the real drivers of wealth.

As boards take charge of how they work, they must also take charge of what they work on. One way to ensure that a board is talking about the things that really matter is to consider the 10 questions every director should ask. The purpose of the questions-to which directors should, but often don't, know the answers-is to help them discover for themselves the areas on which the board might wish to spend more time. Each of the questions here opens the door to a set of follow-ups that determine the extent of the individual's knowledge-and that of the board-on particular issues.

Do you have the right CEO?

The single most important thing you can do as a director is be at peace with yourself on this question. Further, if you are comfortable that this is the right CEO, how are you going to help this valuable officer get better? If you are not comfortable with the CEO, what are the board's plans to do something about it?

Beyond the current CEO, a director must also be comfortable with the succession process. Does the board own it? How disciplined is it, in the case of either an emergency or a planned retirement? How well do you know internal candidates? If you're not satisfied with the internal candidates, what is your plan to recruit from the outside? How rigorous is your selection process? These are the questions that should keep directors up at night.

How well is the CEO's compensation linked to actual performance?

The CEO's compensation is a critical link between the board's philosophy for the company and the actions the CEO will take. Because the CEO's job is so multifaceted, the board can't sit back and simply say,

"We pay the CEO to boost the stock price." Directors must be clear on how compensation reflects both the board's goals and the company's actual performance. Are the performance measurements clear? Will the compensation plan encourage the right behavior?

Of course, the final compensation number is the one that will ultimately appear in the headlines. With that in mind, have you done the math to see how much all the components of compensation could add up to? If the CEO retires early, what's the total value? With regard to equity compensation, have you considered scenarios of sharp market movements? The compensation plan must remain fundamentally relevant under these circumstances. If the stock price rises dramatically, for instance, how much does the CEO stand to make? What if it falls?

Do you have a precise understanding of the moneymaking recipe in the chosen strategy?

No two companies have exactly the same recipe for making money, not even competitors in the same segments. Some may appear to be similar, but in fact every business, whether a corner grocer or a Fortune 500 company, has a unique approach. Directors have to understand a company's strategy and how it translates into a moneymaking recipe. Understanding how a company, a division, or a major product category makes money is crucial. What makes it distinct from competitors, and how long will the competitive advantage last? Will investors appreciate the strategy?

Do fellow directors have the same understanding of the strategy, the plan to make money? As the answers to these questions emerge, they will reveal the key assumptions on which the moneymaking strategy hinges-garnering more shelf space at Wal-Mart, for example, or improving the returns on R&D investments. Relevant activities can then be incorporated into CEO evaluation, compensation, and performance monitoring.

Is the management team looking at external trends and diagnosing the opportunities and threats presented?

The prosperity and survival of the corporation is dependent on adjusting to changes in the external environment. These changes come from a variety of sources: competition within the industry, new entrants, technology changes, new distribution channels, regulation and legislation, activists, global economic trends, and so on. A company's strategy makes sense only within this current and future context. So a board must be satisfied that management has properly assessed external trends, has a plan to address both emerging opportunities and looming threats, and continues to be exceptionally alert to changes. Are rival firms getting in or out of one of your key businesses? Is the competitive dynamic within the industry changing? Are there drivers of change in market segmentation? How well are you, as a director, contributing to the detection of these patterns?

What are the sources of organic growth?

All public companies have to grow. Though acquisitions play a role, companies with longevity have always used organic growth to create long-term shareholder value. Is the CEO's growth plan grounded in reality, or wishful thinking? Has management gone over the plan with the board and kept the board up-to-date on progress? Is organic growth factored into the compensation package of the CEO and other leaders? Is it good growth-that is, growth that is sustainable, profitable, and capital-ef- ficient?

In some businesses and industries, growth emerges from extensive investment in long-term capital projects. Think pharmaceuticals or semiconductors. Are you periodically informed as to how those projects are progressing, which ones still show promise, which ones are fizzling out, and how much capital is being invested in the projects? In other businesses and industries, growth might depend on the latest wave of product introductions or on geographic expansion. Are you monitoring the markets on which the company's growth is predicated?

How rigorous is the process for developing the leadership gene pool?

A critical success factor for the long term is the quality of the company's human resources. The success of the company is directly linked to the right leadership and skill mix at all levels of the corporation. With a superior leadership gene pool, a company will survive short-term bumps in the road and come out ahead in the long term. How comfortable are you with the set of filters through which leaders are selected, promoted, and developed? How often does the board review it? Has management identified trends that will affect the company's future needs? How is management refreshing the leadership gene pool against those needs at all levels? Is the desire to maximize short-term financial success suppressing the continuous development of leadership? What major investments or initiatives are being made?

Do you have the right approach to diagnosing financial health?

When the savviest directors (and investors too, for that matter)-people like Warren Buffett-assess a company, they look at cash flow first, not net income or earnings. Tracking cash is the best way to see how the various parts of the business work together. The idea is to use cash flow to quickly reveal which business units are performing and which aren't, and to detect changes in the pattern. Where is cash coming from? Where is cash going? How do the inflows and outflows work together to create value?

Just as important, directors must be comfortable that the company will survive should adverse circumstances arise. Boards need to keep an eye on the company's long-term obligations, including its pension funding and off-balance-sheet financing. Let a debt burden get too big and a major problem looms if business doesn't work out according to plan. High debt reduces management's margin for error; it can hamstring efforts to grow and can magnify risks.

Are you examining measures that capture the root causes of performance?

For most businesses, accounting figures-revenue recognition, costs, inventories, and the like-are a historical aggregation of estimates. They provide little insight into how the business is executing today. Progressive boards identify the physical drivers whose permance measure you see? How do the measures compare with the competition, and how are they affected by macro factors such as changes in the economy?

Do you get bad news from management, in time and unvarnished?

Even the best of companies will stumble on occasion. Whether a key microprocessor is producing a calculation error or a flagship product is tainted in one country, the board needs to hear the bad news-promptly. Is management sharing bad news with the board? If not, why not? If bad news is shared, is management's plan to address it credible? In some cases, board members have provided sage guidance for management-to settle a lawsuit rather than fight it, for example. That can happen only if management shares the bad news.

How productive are executive sessions?

Executive sessions are a critical vehicle for directors to air their feelings, test their hypotheses, and reach a group viewpoint on items that really matter. The board can make a CEO more productive-or it can dilute the power of the CEO. Is the board coming to a consensus viewpoint on the handful of most important issues? How accurate and precise is the feedback given to the CEO? How constructive and useful is the feedback? What has been the CEO's response and follow-through?

In pondering the 10 questions, a director who is not completely comfortable with the answers should bring up anything that troubles him in executive session. The board might want to raise the importance of a given issue on the agenda and increase the depth of dialogue on the topic.

Once these 10 questions have been answered, and the answers have been discussed within the board, they should be directed to management as well. The process of interacting with management over the answers can be illuminating. Discussion on these issues isn't done merely to hear management's answers. Directors should unmask the assumptions behind the answers, and listen to how those answers are delivered. The process need not-and should not-feel like an interrogation; the gotcha approach is unproductive. What is needed is a conversation-an unscripted exchange conducted in plain language.

If that engagement feels stilted, if questions are dismissed or glossed over with platitudes, or if management responds with slick charts and graphs that skirt the tough issues, a director must press on to really understand how the company is performing.

The fact that directors are raising these questions signals to management what the board believes is important. Just asking them is a good way to get the company's top managers focused on the right issues-even if they don't have the right answers just yet.

About the Author

Ram Charan, a former Harvard Business School professor and the author of several popular books on management, is a consultant to companies ranging from GE to DuPont. This article is excerpted with the permission of the publisher, Jossey-Bass, a Wiley company, from Charan's new book, Boards That Deliver: Advocating Corporate Governance From Compliance to Competitive Advantage.
Copyright ©2005 by John Wiley & Sons.

Acknowledgment

Reprinted with permission.

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