Ten Questions Every Board Member Should Ask

And for that matter, every shareholder too. The responses should tell you everything. By Ram Charan and Julie Schlosser, FORTUNE Magazine The best questions are often disarmingly simple. So simple, in fact, that we often forget to–or are embarrassed to–ask them. But when it comes to fulfilling your role as a company director, asking the […]

And for that matter, every shareholder too. The responses should tell you everything.

By Ram Charan and Julie Schlosser, FORTUNE Magazine

The best questions are often disarmingly simple. So simple, in fact, that we often forget to–or are embarrassed to–ask them. But when it comes to fulfilling your role as a company director, asking the right questions is the most essential part of the job. It is at the very heart of corporate governance. Indeed, it is an equally critical task for managers and shareholders of all stripes. (Directors, though, have a better shot of getting the answers!)

The goal is not to demonstrate what you know; it’s to learn what you don’t. You are not querying a company’s CEO and CFO merely to fulfil a fiduciary requirement though, these days, it may feel that way. So, once you’ve posed a question, make sure to get out of the way and listen. That means paying attention to how someone says something as well as to what they’re saying.

The process need not–and should not–feel like an interrogation; the “gotcha” question is as unproductive as the softball. What you want is a conversation–an unscripted exchange conducted in plain English. So set your jargon filter to “on.”

Here are ten simple questions that are always worth posing–even if you feel a bit foolish asking them:

1. How does the company make money?

There is no more central question in business; it applies equally to the corner grocery and to the FORTUNE 500 company. But many of us confuse the issue of “making money” with “posting earnings.” Net income is an accounting figment of sorts–an estimate at best–and one that often sheds little light on where the money is actually being made. Cash, on the other hand, is real. (Just ask any grocer what he’d rather fill his register with.) Cash is the blood flowing through the company, and tracking it shows the anatomy of the business and how the various parts work together.

So, don’t be shy about asking management where the cash is coming from and how it’s disseminated through the company. (This is particularly important if cash flow and earnings are heading in different directions or if profits are rising even as sales are in serious decline.) If the company’s managers don’t answer in terms that you truly understand, something could be wrong. When a FORTUNE reporter posed such elemental questions to Enron executives back in February 2001, they took umbrage. “People who raise questions are people who have not gone through [our business] in detail and who want to throw rocks at us,” CEO Jeff Skilling said at the time. It was not a good sign. While few managers are hiding an Enron-scale deception, the point holds: If management can’t provide a clear answer to the most basic business questions, don’t nod politely and move on. Call in the auditors.

2. Are our customers paying up?

Cash comes from sales. But a sale isn’t cash–not until the customer actually forks it over. Until then, all you’ve got is a fancified IOU known as a receivable. So, ask management to talk candidly about the pace of sales growth in the context of receivables. If the pile of IOUs is growing faster than sales, it means that customers aren’t paying up as quickly as they used to–or, perhaps, they aren’t paying at all. If so, why aren’t they? Maybe the company’s customers are struggling or going bankrupt. If the board members of telecom-equipment makers, circa 2000, had asked company executives whether or not dot-com customers were paying their balances due, maybe the telcos wouldn’t have crashed so hard. Or perhaps management has been extending overly generous payment terms in a desperate attempt to pump up sales (0% financing, anyone?). Whatever the story, if the cash drawer is filling up more slowly than usual, you’d better known sooner rather than later.

3. What could really hurt–or kill–the company in the next few years?

Think of it as The Worst-Case Scenario Survival Handbook for directors–a way of getting people to think through crises before they occur. Part of your job is to do the same–by posing a series of “What ifs?” What if the company loses its biggest customer? What if the FDA rejects your new drug? What if the business loses its precious AAA credit rating?

The exercise has all the fun of estate planning. But unexpected events have a nasty way of triggering other unexpected events, as Pacific Gas and Electric discovered in 2001. Domino No. 1 was California’s electricity crisis. Domino No. 2 was the downgrade of the company’s debt by rating agencies. Domino No. 3 was the utility’s inability to get further financing to purchase power. Click, click, click…right into Chapter 11. What companies in crisis too often lack is a circuit-breaker? A good board of directors will be just that.

4. How are we doing relative to our competitors?

No one wants his company’s costs, sales, or profit margins to be in line with industry averages, of course. We want our costs to be lower, our sales to be brisker, our margins to be fatter. But when there is a big difference (good or bad) between your company’s numbers and those of its peers, it can sometimes signal that something inside is wrong. And sometimes is the operative word. (Quick quiz: Why were WorldCom’s operating expenses so much lower than its competitors? Oh, this one’s too easy.)

When asking this question, however, don’t limit the parameters to the company’s financials. Equally important are issues of strategy. Are rival firms, for instance, getting in or out of one of your key businesses? Is Wal-Mart or Dell or eBay doing what you do faster, better, or cheaper? Managers should at least be able to provide a straightforward analysis of the competition–even if they haven’t quite worked out their defense.

5. If the CEO were hit by a bus tomorrow, who could run this company?

The U.S. Army requires every officer to have multiple subordinates ready to take over his or her job. (In fact, the contingency planning goes even deeper: “When you are given a mission, you need to brief down all the way to the soldier at the lowest level,” says an Army spokesman.) General Electric has an emergency leader-in-waiting should something befall CEO Jeff Immelt. The principle is simple: An organization’s fate is more important than the fate of its current leadership. If the top managers don’t have capable replacements at hand, the organization could be left with a gaping hole.

That said, succession planning goes well beyond preparing for emergencies. Your role as board member is as much about finding tomorrow’s company stewards as it is about engaging today’s. And the bigger the bullpen of talented relievers, the better the team’s chances. Agreeing upon a few names is only a start. The board of directors should then make sure the process of grooming takes place. No CEO should be upset at the thought. After all, you’re just making sure his legacy is protected.

6. How are we going to grow?

All public companies have to grow. It’s a pressure so inescapable that it can easily overwhelm the best managers, tempting them to make big promises and cut corners when they can’t meet them. Your job is to make sure that the CEO’s growth plan is grounded in reality, not wishful thinking.

Since there are really only two ways to get growth–making it yourself (“organically”) or buying it through acquisitions–this means you have to ferret out management’s assumptions and apply a common-sense test. If the CEO is promising double-digit organic growth in a mature industry and a flat economy, respond with questions that force specificity: What new products or businesses, for example, are going to deliver that growth? And if the answer begins, “Well, Wall Street expects…,” then look out below.

Alternatively, if management has grand visions of growing the company through strategic acquisitions, ask what may seem like an obvious follow-up: Are there any businesses in the CEO’s M&A cross hairs that are actually affordable now? If so, does he or she intend to pay in cash or stock? If not, what’s the plan? Overpaying, by the way, is not a plan–though several studies suggest that managers routinely do so. Nor is board surrender an appropriate strategy on the growth front. That’s the tack Tyco’s board seems to have taken in 2000, according to recent court testimony, when it granted CEO Dennis Kozlowski authority to do deals of up to $200 million each without its approval. The board wasn’t merely rubber-stamping Deal-a-Day Dennis, it seems; it handed over the rubber stamp.

7. Are we living within our means?

This question flows naturally from No. 6. Boards need to look beyond the here-and-now of quarterly earnings to the company’s long-term obligations. Obtaining a true picture is rarely easy. Most debt does show up in the “liabilities” column of the balance sheet. But stock options typically don’t, even though they too are likely to be a claim on the future wealth of the company. Pension obligations–which get pretty big when you’ve got more retired autoworkers than autoworkers–can be played down using some rosy assumptions in small type. But let your debt, option, or pension burden get too big, and you’ve got a GM-sized problem. These days the automaker has been issuing a lot of debt to help cover its pension payments–the equivalent of using one credit card to pay off another. Better to ask well ahead of time: Are we spending money today that we’ll need for bills that come due tomorrow?

8. How much does the CEO get paid?

The recent disclosure that Dick Grasso, then chairman of the New York Stock Exchange, had been granted $139.5 million in compensation was startling to many. But just as striking was what FORTUNE learned in the wake of Grasso’s downfall: One Exchange director claimed that board members outside the compensation committee had never seen the total pay package broken down before.

The fact is many board members don’t really know how much money the CEO stands to make. That has partly to do with the crazy complexity of CEO contracts, which resemble giant equations in which x is the performance-related bonus, y is the unvested portion of retention grant five, and z is either salary or “other,” whichever is greater. But it’s also the result of a classic boardroom error: No one bothers to do the math. You don’t need calculus to ask the head of human resources (or an outside compensation consultant that reports to the board) some basic “if … then” questions. If the stock price rises to $150, for instance, how much does the CEO stand to make? If the CEO retires early, what’s the total take-home value of cash and prizes? If the chief financial officer were to be fired for looting the company, would we still be bound to give him a $20 million send-off? The final compensation number is the one that will appear in the headlines–and the one you must have in mind when judging whether the CEO is paid fairly or not.

9. How does bad news get to the top?

In most organizations, bad news travels down but not up. That can leave top managers–and thus directors–dangerously unaware of problems brewing deep inside the company. Employee discrimination, improper accounting, low morale: Those are the things management should want to know about. And it’s why they need mechanisms that counteract gravity and pull bad news to the top–whether it’s a simple hotline, an employee survey, or a third-party reporting service that guarantees anonymity and eliminates fear of reprisal. Medical-device maker Medtronic, long considered a model of corporate governance, has a 24-hour privacy-protected 800 number that workers (and anyone else) can call if they wish to report a concern.

Big companies are like big cities. It’s nigh impossible to keep everyone honest. As Wal-Mart CEO Lee Scott said earlier this year, “I can guarantee you that at this very moment somewhere [in the company], somebody is doing something that we all wish they weren’t doing.” The right system, however, can make sure employee misconduct doesn’t turn into a company meltdown.

10. Do I understand the answers to questions 1 through 9?

If not, start again from the top. Good governance is a process, not an exercise you do by rote at board meetings a few times a year, before the chicken Florentine lunch and just after management’s big PowerPoint presentation. So even more critical than asking the questions above is the process of questioning and interacting with the company’s management. If that engagement feels stilted to you, if your questions are dismissed or glossed over with platitudes, or if management responds to your queries with slick charts and graphs that skirt the tough issues, don’t wilt in your chair. Press on until you really understand, in your gut, how the company is performing. Remember, the mere fact that you are raising these questions signals what you, as a member of the board, believe 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.