04 Dec Compensation Strategies for Moving from Private to IPO Public Company
By Tom Wilson
As a company moves from private to public through an IPO (Initial Public Offering), there are many tasks needed to prepare the company. Among them is a review and recalibration of the total compensation programs of the firm. Below, I outline the 12 steps needed to prepare the compensation programs of the company for this important transition.
First please note that this work should not be completed alone. The firm should obtain the advice and counsel of an investment banker, attorney and compensation consultant. I’m simply providing an overview of the tasks ahead to help you understand the scope and degree of changes needed. This is an important time for the company; one of meaningful change. The following are the primary areas where analysis, discussion and change should be focused.
- Establish the Board’s Compensation Committee to manage the executive compensation
First, the corporation needs to elect a compensation committee that is comprised exclusively of outside directors. This group has the authority to seek external counsel and advice, and will be responsible for managing the total compensation programs of the Named Executive Officers (customarily the Top 5 paid executives). Second, under Section 162(m) of the IRS Code and Section 16 of the Exchange Act, the Compensation Committee has the responsibility to design and administer the total compensation plans, and the performance based plans in particular. This means approving performance goals at the beginning of the year as recommended by the CEO, and assessing performance and determining if and how much will be paid to the executives for their achievements. Third, the programs need to be well documented and strongly performance based. The plans will need a formal plan document and policies by which they are administered. The determination of pay will need to be based on clear performance criteria, a formula and well defined process. This program and decision process will need to be described in the firm’s Compensation Discussion and Analysis (CD&A) of the Proxy. Finally, the Committee will need to consider the assessment of investor advisory groups (Institutional Shareholder Services (ISS) and Glass Lewis) to assure the firm receives the desired support of these groups.
There are certain features these advisory groups want in compensation plans:
- Unless there is a well defined and defensible strategy, compensation levels should be targeted to achieve the 50th percentile of the market.
- There should be provisions for claw-backs of all payments if the payouts were based on faulty or misleading information.
- Do not provide for gross-up payments for excise taxes incurred if compensation exceeds the limits defined in Section 480G of the IRS Code during a Change-in-Control.
- Restricted stock (and all equity based plans) should be based on performance, as customarily reflected in total shareholder return over 3 to 5 years.
- Time or service based vesting should be held to a minimum.
- Certain excessive executive benefits are discouraged.
2. Conduct a competitive compensation plan audit and establish a total compensation philosophy
The first step in the preparation for an IPO is the assessment of the competitiveness of executive compensation. This competitive analysis should be based on a well defined list of peer companies and established compensation surveys that reflect the firm’s market, sources for executive talent, and strategy. Once the company is public, this list of companies will need to be included in the Compensation Discussion and Analysis section of the public filing document (14A – Proxy). The peer group should be comprised of between 10 and 15 (or up to 20) companies, and should have revenues that are approximately 50% to 200% of the company’s revenues. These firms should be in the same or closely related industries. The analysis should examine all key elements of compensation including base salaries, bonus target and payouts, total cash compensation, the value of annual equity awards, and other compensation (i.e., benefits paid by the company, perquisites, etc.). The total of these dollars is the Total Direct Compensation. Finally, any special arrangement, contractual agreements or other compensation provisions should be identified and documented.
Once this competitive assessment has been completed, the executives and Board should establish the firm’s total compensation philosophy. This philosophy statement should include a set of critical principles that define how plans should be structured and how competitive the plans should be. This philosophy statement should be specific enough to provide guidelines for making decisions about executive and total employee compensation. As a strategy based document, it should provide clarity as well as flexibility in determining how the company should allocate its salaries, bonuses, equity awards, benefits and special provisions for the executive leadership team.
3. Establish total compensation levels for executives based on the philosophy
It is customary that cash compensation levels for executives of companies undergoing an IPO will increase. The total compensation arrangement is “rebalanced” to account for less reliance on equity as the basis for compensation, and more emphasis on salary and performance based bonus compensation plans. Furthermore, there is a significant increase in the responsibilities of key executives once the company becomes a public entity. There are major increases in responsibilities for communicating with shareholders, following all regulatory requirements, and higher levels of risks that are associated with a public company. The CEO and CFO have to now certify that all financial statements are true and accurate under Sarbanes-Oxley. It is not uncommon for salaries or total cash compensation to increase from 12% to 20% depending on the compensation arrangement prior to the IPO. Further, bonus targets are usually increased to be more consistent with market practices. Finally the value of equity awards decreases to limit dilution and is more often contingent on formal performance requirements after the IPO.
4. Establish formal, clear performance based cash compensation plans
The SEC rules require the disclosure of corporate and individual performance factors used to determine bonuses, equity awards or other special performance based compensation arrangements. This includes the target bonuses, measures, weighting of the measures, and results on which the bonus payouts or equity awards were based. The most frequent measures for bonus plans include revenues, net profits, EBITDA, earnings per share, return on investments, equity or capital, and defined personal objectives. Target payout levels should be competitive with the external market.
5. Develop clear performance based compensation justification for Section 162(m) executives
Section 162(m) of the IRS Code limits the tax deductibility of compensation paid to executives that exceed $1 million in public companies, except when this payment is “qualified performance-based compensation.” To meet the standards of this section, the compensation program needs to meet certain criteria. First, shareholders must approve the material terms of the performance based compensation plans, including a menu of performance measures and the limit on the maximum amount of any payout to an individual for a year (or in the case of equity awards, the maximum number of shares granted to an individual). Second, the compensation should be subject to the achievement of pre-established performance goals set by the Compensation Committee of the Board. Third, the Compensation Committee must certify after the end of the performance period to what extent the goals have been achieved.
In newly public companies, the rules provide for a temporary exception for payments made pursuant to a plan that existed prior to the company going public, but this plan description and justification for the payment need to be fully disclosed in its prospectus. This exemption exists until the plan expires, there is a material modification to the plan, the awards have been made, or the first meeting of the shareholders at which directors are elected. This exemption does apply for stock options, stock appreciation rights or restricted stock (but not restricted stock units or phantom stock awards) where the vesting period occurs after the IPO.
6. Change the equity compensation plans as the company transitions through the IPO
Prior to an IPO, companies frequently assess their distribution of ownership and increase the number of awards to some extent depending on available shares. After an IPO, the use of equity plans start to mirror customary market practices rather than the unique features of the company prior to the IPO. This means that equity is more limited, and provided to those individuals that truly make an impact on the market value of the company. The opportunity for “Evergreen” stock plans diminishes, but the number of shares available for awards needs to be planned and managed carefully. For these executives and senior leaders, stock options tend to continue as the most common equity vehicle for the initial years (2 or 3 years) of being public. Over time, as the business matures and growth is not as significant as in the past, the use of restricted stock becomes more relevant with the concomitant reduction in the number of stock options awarded. For many technology companies, the total overhang (total shares outstanding plus shares available for grants) ranges from 17% to 30% (with a median of 22%) prior to an IPO, and may increase slightly from 18% to 33% (with a median of 23%) after the IPO. Over time, this overhang becomes reduced to range between 10% and 15% as options are replaced with restricted stock and the number of participants decreases. This total overhang is comprised of the number of equity awards outstanding (median of 18% of outstanding shares prior to the IPO and 14% after the IPO) and the shares available for future awards (a median of 2% prior to the IPO and 8% after the IPO).
Further, companies often establish Employee Stock Purchase Plans (ESPP) for the general employees. These programs allow employees to buy company shares on favorable but not discounted terms. The most common practice is to reserve 1% of shares outstanding for the Employee Stock Purchase Plans on an annual basis.
7. Assure all equity grants are made at the fair market value
The SEC is likely to carefully scrutinize any stock option awards made to an executive within 18-months of the IPO. This is to assure the exercise price or value of the grants is based on the full fair market value of the company. Prior to the IPO, under the direction of Section 409A of the IRS Code, the Board must determine the fair market value using a reasonable valuation method that takes into account all available information. Hence, no discounting or arbitrarily setting a low market value is permissible and will likely have serious consequences.
8. Prepare to manage the equity based compensation following the IPO
In many growth oriented companies, equity based compensation is a major element of total compensation, especially for its executives, leaders and key contributors. When private, the most common practice was to grant someone stock options at hire, then “refresh” the grants in 3 – 4 years depending on the vesting schedule of the options. After the firm goes public, the practice of granting equity awards change. Now, the company has a set of guidelines for awarding stock options or restricted stock units (RSU’s) based on the level or tier of the position within the firm. There is a pool available that needs to be refreshed with shareholder approval every 3 to 5 years. The available pool 4% – 8% of shares outstanding. Individuals receive annual grants based on their performance and/or what is needed to remain competitive. This annual award levels (or run rate) are usually between 2% – 5% of outstanding shares, depending on how much is available and the overall philosophy and structure of the plan. While stock options are frequently used in high growth oriented companies, an increasing number of companies are using RSU’s. Because RSU’s are full value shares, the number of equity shares awarded is 1:4 (RSU versus Stock Option). This reflects the difference between the full value of the share and the projected gain in value associated with the stock option (as determined by Black-Scholes or other option pricing models). The objective is to provide the individual with the same value regardless of the vehicle. The primary advantage of the RSU’s then is that they require less share usage or overhang, and they are customarily vested based on performance. The performance measure used by established companies is usually earnings per share or total shareholder return over the term of the vesting period (3 to 5 years). New IPO companies or rapid growth companies have a great deal of difficulty in accurately forecasting and setting goals for performance over multiple years. Consequently, the Board and senior management need to carefully examine the strategy and plans of the company and identify those metrics that best reflect the value and interests of shareholders. They may also use “relative” performance, which compares the company’s performance against a set of defined peer group companies or S&P 500 Index or Russell 2000 Index. The performance is then judged in comparison to this external benchmark to determine the vesting or number of the RSUs or restricted shares granted. This explanation needs to be disclosed in the CD&A of the proxy filing.
9. Prepare Change-in-Control provisions for key executives
As the company goes public, there is more vulnerability that it will be acquired by another firm. In this case, Change-in-Control (CIC) provisions are necessary to assure executives remain focused on the best interests of the shareholders. The provisions will include a single versus double trigger – payment if the firm is sold/bought by another firm and payment if the executive is terminated as a result of the acquisition. The median practice for the CEO and CFO in new IPO companies is to provide the executive with 1 year total compensation (i.e., salary plus target or actual bonus) when there is a double trigger event; lesser amounts are provided to other key executive officers (e.g., CMO, CTO, etc.). This is lower than the common market practice of established companies. In these companies, when there is a change-in-control and a termination, the practice is for the CEO to receive 2x to 3x total compensation and for those reporting to the CEO to receive 1x to 2x total compensation. It is common that all equity awards become vested when there is a single trigger (a change in control) but no further action is common at this event.
10. Remove or restructure any element of total compensation considered “egregious”
As a private company, some firms have unusual compensation arrangements that were needed to attract or retain a certain individual. As the company becomes a public entity, and therefore under public scrutiny, any special arrangement will need to be identified, addressed, explained or restructured. This is not to indicate that the individual is any less important, but regulators, shareholders and shareholder advisory groups will now have an influence on the existence of these programs. Ideally, they should be addressed prior to filing the S-1 for the IPO.
11. Establish the compensation levels for the Board of Directors
When the company goes public, frequently many of the early investors (and Board members) use this opportunity to divest themselves and move on. This may not happen immediately during an IPO, but it may occur within a short period. The members of the Board changes and new, independent individuals are brought onto the Board. This means that the Compensation Committee has to establish the pay levels for the Board and receive Board approval. The structure and decisions regarding Board compensation include the annual retainer for being a Board member, whether or not there will be meeting fees and how much, and the type, value and number of equity awards for being a Board member. The Committee will also need to determine the pay levels for people who serve on the Board’s committees as well as serve as a chair of a committee. The Committee will also need to determine if other benefits will be available to Board members including the reimbursement of their travel related expenses, the use of company facilities, matching charitable contributions, deferred compensation programs, etc. Finally, depending on the structure of the Board, the Committee will need to determine the compensation for the Chair of the Board if it is not the CEO or the pay for a Lead Director. These compensation arrangements are usually based on the role and scope of responsibilities of the committee heads and Chair or Lead Director. The Compensation Committee has the responsibility for determining whether ownership guidelines are required for Board compensation or executive compensation. The Committee will need to review these annually or periodically to assure the pay levels of the Board are competitive, fair and reflective of the integrity and governance principles under which the Board functions.
12. Continue to monitor and adapt programs to meet internal and external requirements
As stated above, the Compensation Committee will now have the responsibility for the design and management of the executive compensation program for the company. These independent directors will need to review current practices and work with the CEO, CFO, CHRO, and General Counsel to assure the policies, programs and practices are consistent with the company’s philosophy and market practices. This group will need to be prepared for the “Say-on-Pay” vote of the shareholders, and address any concerns expressed by shareholder advisory groups (Institutional Shareholder Services, Glass Lewis, etc.). The Committee will need to prepare the documents under Item 402 (the Compensation Discussion and Analysis) of the proxy, and this should clearly state, in language that is common and well understood, the philosophy, programs and decisions of the Committee regarding executive compensation. The Committee will need to conduct a risk assessment, and determine whether the current compensation plan presents any material risk to the performance of the company; they should state whether there is or is not such risk in the current plans. If so, they need to state what is being done to address this risk. Finally, the Committee will need as stated above to approve the compensation plans for the Named Executive Officers, including the performance goals, compensation plans, bonus payouts and equity awards. Finally, the Compensation Committee may need to be involved in succession or continuity planning for the leadership of the company. It is important to have contingency plans based on the potential loss, departure or transition of executive leadership talent in order to assure the company can continue to serve the interests of all its stakeholders – shareholders, employees, customers, suppliers, etc.
A public company will look and operate differently than a private company, but it need not lose the entrepreneurial or mission-driven spirit of the founders. The compensation plans will need to be more formal and transparent, and there is clearly more accountability for these programs to the shareholders. These actions, however, should serve to strengthen the connection between the individual and the company, and create an environment where the individual is truly valued for the performance and contributions made to the company. In this way, the foundations for growth and performance are in place.