7.3 The Executive Search Process — How a Search Actually Runs
An outside CEO search usually runs through a retained search firm and moves in steps: the brief, a long list, a short list, board interviews, an offer and an announcement. The firm is typically paid one-third of the new hire’s first-year cash pay. The offer often includes a make-whole award, which replaces pay the candidate gives up by leaving the old job. That is why an outsider’s first-year disclosed pay can look inflated.
Why it matters: A big first-year pay number may simply be replacing what the person left behind.
Summary: An external CEO search is usually run by a retained search firm that moves from mandate to long list, short list, board interviews, offer and announcement, and is typically paid one-third of the hire’s first-year cash compensation. The offer often includes a make-whole award that replaces pay the candidate forfeits, which is why an outsider’s first-year disclosed pay looks inflated.
- Search fee example: ($1.4m base + $2.1m target bonus) ÷ 3 = $1.17 million.
- A make-whole replaces forfeited stock and bonus; in the example it adds $7.9 million to $12.0 million of ongoing pay.
- Replace like for like: stock for stock on the same vesting dates, performance shares at expected payout.
- Paying the equity part in cash on day one can cost $5.4 million more if the CEO leaves after a year.
When an external CEO search is warranted, the board typically does not run it directly — it engages a specialist executive search firm (sometimes called a “headhunter” or, at senior levels, a “retained search firm,” since payment is structured as a retainer rather than a contingent fee paid only on success). The process itself moves through a recognizable sequence.
| Stage | What Happens |
|---|---|
| 1. Mandate & Search Committee | The board forms a search committee (often the members of the nomination committee) and agrees on a formal candidate specification with the search firm |
| 2. Long List | The search firm identifies a broad initial pool, drawing on its own network and confidential market mapping — both internal candidates and external ones from competitor and adjacent-industry companies |
| 3. Short List | Rigorous vetting narrows the pool to typically 3–6 candidates, including confidential reference checks conducted discreetly to avoid signaling a candidate’s job search to their current employer |
| 4. Board Interviews | Shortlisted candidates meet the full board, or a delegated subset, often across multiple rounds, sometimes including a presentation on strategic vision |
| 5. Offer & Negotiation | The compensation committee (Section 7.5: Say-on-Pay and Compensation Committees) negotiates final terms, frequently including a “make-whole” payment to compensate an external candidate for unvested equity forfeited at their current employer |
| 6. Announcement & Transition | A carefully sequenced public announcement, often paired with a defined handover period if an internal transition, to manage market and employee reaction |
The “make-whole” payment in Stage 5 is a significant, often underappreciated detail: a strong external CEO candidate at a rival firm may be walking away from several years of unvested stock grants, and boards routinely negotiate substantial one-time payments or grants specifically to offset that forfeited value — which is why a new CEO’s first-year total compensation disclosure often looks unusually large compared to their ongoing annual pay going forward.
A board hires an external CEO at a $1.4 million base salary, a target bonus of 150% of base and annual equity grants of $8.5 million: target pay = 1.4 + 1.5 × 1.4 + 8.5 = $12.0 million a year. The candidate’s current employer’s stock trades at $50.
| Item | Formula | Value |
|---|---|---|
| Search fee (one-third of first-year cash) | (1.4 + 2.1) ÷ 3 | $1.17 million |
| Unvested time-based stock forfeited | 90,000 shares × $50 | $4.5 million |
| Unvested performance shares forfeited | 60,000 × $50 × 80% expected payout | $2.4 million |
| Pro-rata current-year bonus forfeited | agreed estimate | $1.0 million |
| Make-whole total | 4.5 + 2.4 + 1.0 | $7.9 million |
First-year disclosed pay = 12.0 + 7.9 = $19.9 million, or (19.9 ÷ 12.0) − 1 = 66% above the ongoing level; this is why year-one pay for an outsider looks inflated. The performance shares are valued at an expected payout below 100% because they might not have vested. Outsiders also cost more on an ongoing basis: The Conference Board reports that externally hired CEOs are paid 33% more than internal ones.
Replace forfeited value like for like and no more: time-based stock with your time-based stock on the same vesting dates, performance shares with performance shares (or at their expected, not maximum, payout), and cash only for cash the candidate actually loses. If the candidate insists on cash up front, require repayment on departure within the original vesting period. When the forfeited awards are underwater options, their fair value, not their face value, sets the ceiling.
Paying the equity part of a make-whole in cash on day one. In the example, the forfeited stock is worth 4.5 + 2.4 = $6.9 million. Paid in cash, all of it is gone if the CEO leaves after twelve months. Replaced with stock vesting one-third a year (and the performance shares on their original three-year cliff), only 4.5 ÷ 3 = $1.5 million would have vested, so the cash route costs 6.9 − 1.5 = $5.4 million more in that outcome.
How much do executive search firms charge?
A retained search typically costs one-third of the hire’s first-year cash compensation, billed in installments during the search, often with a minimum fee. For a CEO with $3.5 million of first-year salary and target bonus, that is about $1.17 million. Some firms quote flat fees instead.
What is a make-whole payment?
A make-whole award compensates an executive for pay forfeited by leaving the old employer, usually unvested stock and a pro-rata bonus. It is a one-time item, so it inflates first-year disclosed pay: $7.9 million on top of $12.0 million of ongoing pay in the worked example.
Why do boards use search firms even when an insider is likely to win?
To test the insider against the market. A search firm’s long list shows whether the internal candidate is the best available or only the most familiar, and the comparison protects the board if the choice is later questioned.
A retained search firm runs the external search, typically for one-third of first-year cash pay, from mandate through short list, interviews and offer. Make-whole awards replace pay the candidate forfeits and inflate first-year disclosed pay; they should mirror the forfeited awards’ form and vesting rather than be paid in cash up front.
Six questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. A retained search firm bills one-third of first-year cash compensation. The new CEO’s base salary is $1.2 million and the target bonus is 125% of base. What is the fee?
- $1.5 million
- $0.9 million
- $0.4 million
- $2.7 million
Reveal Answer
Answer: B. First-year cash = 1.2 + 1.25 × 1.2 = $2.7 million, and 2.7 ÷ 3 = $0.9 million. $2.7 million is the cash pay itself.
2. A candidate forfeits 50,000 unvested restricted shares and 40,000 performance shares (expected payout 75%) at $40, plus a $0.5 million pro-rata bonus. What make-whole matches the forfeited value?
- $2.5 million
- $4.1 million
- $3.7 million
- $3.2 million
Reveal Answer
Answer: C. 50,000 × $40 = $2.0m; 40,000 × $40 × 75% = $1.2m; plus $0.5m bonus = $3.7m. $4.1m values the performance shares at 100%.
3. Why does an external CEO’s first-year disclosed pay often look much larger than later years?
- It includes a one-time make-whole award
- It adds salary paid by both employers
- It counts the CEO’s sign-on options twice
- It includes the search firm’s fee as pay
Reveal Answer
Answer: A. The make-whole replaces pay forfeited at the old employer and is reported once, in the first year.
4. What is the best way to replace a candidate’s forfeited time-based stock?
- Cash paid in full on the first day of employment
- Stock options vesting immediately at grant
- Performance shares valued at maximum payout
- Company stock vesting on the forfeited awards’ dates
Reveal Answer
Answer: D. Like-for-like replacement keeps the retention effect; cash up front is lost if the executive leaves early.
5. Worked problem: A retained search firm charges one-third of first-year cash pay. The hire gets a $900,000 base and a $1.2m target bonus. What is the fee?
Reveal Answer
Answer: Fee = ($900,000 + $1,200,000) ÷ 3 = $700,000.
6. Worked problem: The new CEO forfeits $4.2m of stock and bonus and a make-whole replaces it, on top of $5.5m of ongoing pay. What is the first-year total?
Reveal Answer
Answer: First-year total = $4.2m + $5.5m = $9.7 million.
7.4 Executive Compensation Design — Base, Bonus, and Equity
Executive pay has three parts: a base salary, an annual bonus and long-term equity. The long-term part decides whether pay really follows performance. Performance share units that vest on relative total shareholder return pay little when the company lags its peers in a rising market, while time-vested stock pays anyway. Since 2023, US-listed companies must also claw back incentive pay that restated results show was not earned.
Why it matters: How equity is structured decides whether pay rewards results or only time served.
Summary: Executive pay combines base salary, an annual bonus and long-term equity, and the long-term part decides whether pay tracks performance. Performance share units that vest on relative TSR pay little when a company lags its peers in a rising market, while time-vested stock pays anyway; since 2023, US-listed companies must also claw back incentive pay that restated results would not have earned.
- Value at vesting = units × payout × price; payout scales from 0% below the 25th percentile to 200% at the 75th.
- In the worked example, a laggard in a rising market receives $6.72 million under a 60/40 PSU/RSU mix against $16.80 million under all-RSU.
- SEC Rule 10D-1 and exchange rules (effective October 2, 2023) require no-fault recovery over three completed fiscal years.
- The pay-versus-performance table shows five years of compensation actually paid beside TSR and net income.
- Stress-test every grant across bear, base, bull and rising-market-laggard scenarios.
Modern executive pay is deliberately structured across three components, each serving a distinct governance purpose: aligning the executive’s personal financial interest with shareholders’ interests over different time horizons.
| Component | Time Horizon | Purpose |
|---|---|---|
| Base Salary | Immediate, fixed | Provides stable income independent of performance, typically the smallest component of total pay at senior levels |
| Annual Bonus (STI — Short-Term Incentive) | 1 year | Rewards achievement against annual financial and strategic targets set by the compensation committee |
| Long-Term Incentive (LTI) — Equity Grants | 3–5 years, often with vesting conditions | Ties a large share of total pay to the company’s stock price and long-run performance metrics over multiple years, discouraging short-term decision-making |
LTI grants themselves usually split further between time-vested restricted stock (vesting simply by staying employed for a set period) and performance-vested equity (vesting only if specific metrics — total shareholder return relative to a peer index, or cumulative earnings targets — are actually achieved). Governance-conscious compensation committees increasingly weight LTI heavily toward the performance-vested category specifically to blunt criticism that equity pay simply rewards a rising market rather than genuine management performance.
A CEO receives a $12.0 million long-term grant at a $100 share price: 60% as performance share units (PSUs, 72,000 units at target) and 40% as time-vested restricted stock units (RSUs, 48,000 units). PSUs vest after three years on relative TSR, the company’s total shareholder return (price change plus dividends) ranked against a peer group: below the 25th percentile pays 0%, the 25th pays 50%, the 50th pays 100%, the 75th or above pays 200%, with straight lines in between. Value at vesting = units × payout × price.
| Scenario (3 years) | Price | Peer rank | PSU payout | PSU value | RSU value | Total vs $12.0m grant | All-RSU design |
|---|---|---|---|---|---|---|---|
| Bear | $70 | 30th | 60% | $3.02m | $3.36m | $6.38m (−47%) | $8.40m |
| Base | $120 | 55th | 120% | $10.37m | $5.76m | $16.13m (+34%) | $14.40m |
| Bull | $160 | 80th | 200% | $23.04m | $7.68m | $30.72m (+156%) | $19.20m |
| Rising market, laggard | $140 | 20th | 0% | $0.00m | $6.72m | $6.72m (−44%) | $16.80m |
Check the Base row: payout = 100% + (55 − 50) ÷ 25 × 100% = 120%; PSU value = 72,000 × 1.20 × $120 = $10.37 million; RSU value = 48,000 × $120 = $5.76 million. Realized pay runs from 0.53× to 2.56× the grant. In the last row the stock rose 40% with the market but trailed 80% of its peers, so the mixed design pays $6.72 million while 120,000 RSUs would pay $16.80 million.
Two US rules now test the design after the fact. The SEC’s pay versus performance table (Regulation S-K Item 402(v), adopted August 25, 2022) shows five years of compensation actually paid, which marks equity to market, beside TSR, peer TSR and net income. And every NYSE and Nasdaq company must have a compensation clawback policy: under SEC Rule 10D-1 (adopted October 26, 2022) and exchange rules effective October 2, 2023 (policies due by December 1, 2023), after a restatement to correct a material error (large or small) the company recovers incentive pay received in the three completed fiscal years before the restatement that exceeds what the restated numbers would have paid, on a no-fault basis, computed before tax, with no indemnification. Example: a bonus pays 50% of target at $400 million EBITDA, 100% at $460 million and 200% at $520 million, on a $3.0 million target. Reported EBITDA of $500 million paid 100% + (40 ÷ 60) × 100% = 166.7%, or $5.0 million; restated EBITDA of $440 million pays 50% + (40 ÷ 60) × 50% = 83.3%, or $2.5 million. The company must recover $2.5 million.
| Situation | What changes | Why |
|---|---|---|
| Negative TSR, above-median rank | Consider capping PSU payout at 100% | Paying 150% while holders lost money fails the alignment test |
| Grant made after a price crash | Cut the units or price the grant on a longer average | A fixed dollar grant at a low price buys extra units and a windfall on recovery |
| Restatement with no misconduct | Rule 10D-1 recovery still applies | The rule is no-fault: it recovers pay the true numbers never earned |
| Award based on stock price or TSR | Recovery uses a documented reasonable estimate | The formula cannot be rerun mechanically on a price |
| Peer group changed mid-cycle | Rank can move with no change in performance | Dropping strong peers raises the rank |
| External hire’s first year | Make-whole awards sit outside the normal mix | They replace forfeited pay (Section 7.3: The Executive Search Process — How a Search Actually Runs) |
Put at least half of the long-term grant into performance-vested awards, measure part of it relative to peers so a rising market alone cannot pay out, and pay 0% below the 25th percentile. Before approving, run the grant through at least the four scenarios in the table: if the laggard case pays more than the grant value, the design rewards the market, not management. Where no credible peer group exists, use multi-year financial targets instead.
Letting time-vested stock dominate. In the laggard case, an all-RSU grant pays 120,000 × $140 = $16.80 million for bottom-fifth performance; the 60/40 design pays $6.72 million. The difference, 16.80 − 6.72 = $10.08 million for one CEO over one cycle, is pay for the market’s move. ISS ranks five-year CEO pay against five-year TSR within a peer group, so this is also what triggers a negative say-on-pay recommendation (Section 7.5: Say-on-Pay and Compensation Committees).
What is the difference between RSUs and PSUs?
Restricted stock units vest if the executive stays employed, so their value moves only with the share price. Performance share units vest in a number that depends on results, often relative TSR or multi-year earnings, from zero to a cap such as 200% of target.
What is a clawback in executive compensation?
It is the recovery of incentive pay already received. Every NYSE- and Nasdaq-listed company must recover incentive pay received from October 2, 2023, that exceeds what restated financials would have paid, over the three completed fiscal years before the restatement, regardless of fault.
What is “compensation actually paid”?
The SEC’s pay-versus-performance measure, which revalues unvested equity at each year-end instead of at grant. It is closer to realized pay than grant-date values.
Pay combines salary, an annual bonus and long-term equity, and performance share units on relative TSR stop a rising market from paying a laggard: $6.72 million against $16.80 million for an all-RSU grant in the worked example. Since October 2, 2023, US-listed companies must claw back incentive pay that restated results would not have earned, regardless of fault.
Six questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. A CEO holds 50,000 performance share units. Payout is 50% at the 25th percentile of peers and 100% at the 50th, linear between. The company finishes at the 40th percentile with the stock at $90. What vests?
- $4.5 million
- $2.7 million
- $1.8 million
- $3.6 million
Reveal Answer
Answer: D. Payout = 50% + (40 − 25) ÷ 25 × 50% = 80%; value = 50,000 × 0.80 × $90 = $3.6 million. $4.5 million assumes 100% payout.
2. A restatement shows that a CEO’s bonus should have been $1.8 million instead of the $3.0 million paid. No one committed misconduct. Under SEC Rule 10D-1, what must the company do?
- Recover the full $3.0 million bonus paid
- Recover $1.2 million less the CEO’s taxes
- Recover $1.2 million, computed before tax
- Recover nothing, since there was no misconduct
Reveal Answer
Answer: C. Recovery is no-fault and covers the excess over what the restated numbers would have paid, computed before tax.
3. From what date must NYSE- and Nasdaq-listed companies apply their clawback policies to incentive pay received?
- October 2, 2023
- October 26, 2022
- December 1, 2023
- January 21, 2011
Reveal Answer
Answer: A. The exchange rules took effect October 2, 2023; policies were due by December 1, 2023; Rule 10D-1 was adopted October 26, 2022.
4. A stock rises 40% in three years, but the company ranks at the 20th percentile of its peers. Under the chapter’s relative-TSR design (0% below the 25th percentile), what share of target do its PSUs pay?
- 80%
- 0%
- 40%
- 100%
Reveal Answer
Answer: B. Below the 25th percentile the PSUs pay nothing, however much the absolute price rose; only the time-vested RSUs pay.
5. Worked problem: A CEO holds 50,000 performance share units that vest at a 150% payout when the share price is $40. What is their value?
Reveal Answer
Answer: Value = 50,000 × 150% × $40 = $3,000,000.
6. Worked problem: Payout scales linearly from 0% at the 25th percentile of relative TSR to 200% at the 75th. What is the payout at the 40th percentile?
Reveal Answer
Answer: Payout = (40 − 25) ÷ 50 × 200% = 60%.
- SEC Rule 10D-1 (17 CFR 240.10D-1) — Mandatory clawback: three completed fiscal years, pre-tax amount, no indemnification, reasonable estimate for TSR awards (7.4).
- SEC press release 2022-192, clawback rules adopted — Adoption date October 26, 2022, and implementation sequence (7.4).
- SEC press release 2022-149, pay versus performance — Item 402(v) adopted August 25, 2022; five-year table of compensation actually paid, TSR, peer TSR, net income (7.4).