Private companies are from Mars and public companies are from Venus.
Okay, we’ve exaggerated, but there’s no doubt that privately held and publicly listed companies run many aspects of their business differently, including how each handles executive equity compensation plans.
Our IPO executive compensation checklist lays out 9 things for you to consider when transitioning your plan from pre-IPO. But, before going through our checklist, we first need to know why this matters.
Why does Executive Compensation Matter When Prepping for an IPO?
For practical terms, IPO-related securities filings require companies to make extensive disclosures about their compensation programs for executives and directors. There’s also scrutiny of executive compensation by investors, regulators, and the public. So, companies should be mindful when planning for it.
If you already have an executive compensation plan in place, it doesn’t mean you can skip the process since executive compensation plans for private companies won’t necessarily work well for public companies.
So it’s important to carefully review and plan your executive compensation program early in the IPO process.
The SEC requires extensive disclosures that are intended to ensure that investors and other parties receive clear, comprehensive and transparent disclosures regarding executive and director compensation and related matters.
IPO Executive Compensation Checklist
1. Set up Compensation Committee
Any company in the pre-IPO period should have a Compensation Committee in place, whose responsibility it is to consider how best to modify all relevant executive compensation plans and practices. This process should begin as early as is feasible, but it usually doesn’t happen quickly and it’s normal for this to continue into the post-IPO period.
The Committee effectively draws up a pre-IPO checklist, with the purpose of this being to create a roadmap that will enable a company to transition its executive compensation plans over time.
2. Identify Peer Group for Benchmarking
Selecting a public company peer group will allow the Compensation Committee to effectively benchmark your own executive compensation approach as a publicly listed business.
Companies in such a group should be of similar size, and this can be done by reference to key indicators such as business models, revenues, assets, market cap, and industrial classification.
These peers should fall into an appropriate range in terms of size, typically 0.5 to 2 times the size of the company, to be a suitable comparator. Generally, the group consists of 12 – 20 companies. Some even have 20 – 25 companies.
Don’t underestimate the time and effort involved in peer-group construction. Poorly constructed peer groups have been linked with compensation levels that are either too small or too generous.
Typical areas of SEC comment:
Identification of other companies used for benchmarking purposes
3. Build Compensation Philosophy (or Framework)
A compensation philosophy is a well-documented report that formally outlines a framework for employee compensation with the rationale. It needs to be established early on, as it will serve as the foundation for most if not all compensation-related decision-making.
Among the points that need to be addressed in forming this philosophy are:
- Compensation plan objectives including a set of guiding principles reflecting company values and actions.
- Pay mix (base salary, annual incentives, long-term incentives, and additional benefits – with the blend highlighting short-term vs. long-term and also performance vs. retention and/or attraction)
- Where the company wants to position itself relative to its peer group
- The type and amount of equity to be used
- The approach to benefits and prerequisites (what perks are on offer and what boxes must be ticked to become eligible to receive them)
Aside from the fact that it’s good practice to establish a compensation philosophy, it’s necessary for practical terms. Companies are obliged to disclose their approach to executive compensation practices^, which is one of the registration statement requirements.
^Most pre-IPO companies avail themselves of the Emerging Growth Company (EGC) designation which provides an easier on-ramp for newly public companies by requiring less robust compensation disclosures for five years after the IPO.
4. Revisit Executive Pay Levels
A public company executive compensation plan is usually thought to be attractive to retain executives and attract top talent.
Based on a 2019 study, there is a huge gap in total value of executive pay between a private and public sector. To dig deeper, we can see the driving factor is long term incentive treatment from the following graphic.
The study shows that base salaries and target bonuses for executives at private companies are similar to those at public companies. But, their long term incentive plan (LTIP) practices differ most noticeably. Private companies are significantly less likely to provide a regular LTIP (38% of private company CEOs vs 97% of public company CEOs). Of those that do provide LTIPs, their plan is quite different from a public company’s:
- 80% of LTIPs are performance cash plans
- Less likely to use real stock or options
- less likely to use value-based performance measures
This being the case, executive pay arrangements need to be reviewed in the pre-IPO period. Consider your compensation philosophy and think about if they reflect your go-forward philosophy?
Practices will also need to be brought more into line with how public companies tend to operate, but there is also an onus to make sure that what is on offer to new executives in the future will be attractive.
Unreasonable pay will attract unwanted criticism from investors and analysts.
5. Consider Size of Stock Plan Share Reserve
When transitioning to a public company, a pre-IPO equity compensation plan that often contains provisions that apply only to private companies, will be gradually transitioned to provisions allowing for all types of equity grants. They can be stock options, restricted stock, restricted stock units, stock bonuses, stock appreciation rights, performance-based awards etc
Usually, a special equity award (or called founders grant) is given to executives at or near IPO if significant equity has not been granted in the years prior to the IPO. This provides an incentive to reward them to stay during the critical IPO period.
So, a pre-IPO company needs to consider the size of its stock plan share reserve heading into IPO and should get stockholder approval of any increase to the share reserve prior to the IPO. You will find it much easier to obtain the approval prior to the IPO as compared to after the IPO. Many pre-IPO companies implement “evergreen share reserve provisions” that provide for an automatic annual increase in the share reserve.
6. Ensure Competitiveness of Executive Compensation Levels and Mix
Maintaining a competitive compensation and benefits program is critical to attracting and retaining top talent.
Apart from that, you need to be aware that institutional shareholder advisory groups serve as critics in determining whether you have done a good job in setting compensation. They continue to influence executive equity compensation trends by defining “best practices.”
Compensation strategies need to establish a link between effort and reward and, again, private company executive compensation practices will not necessarily translate well into a post-IPO landscape.
Compensation levels should be set for base salary, target bonus, equity or long-term incentive awards and other benefits. It is important for Compensation Committee to compare total compensation when measuring against the peer group and align recommended levels with the company’s compensation philosophy.
Ensures executive compensation programs and policies are market competitive, adequately sized for future needs, compliant with governance requirements and aligned with executive and shareholder interests.
7. Board of Directors Compensation
Although this is a checklist for IPO executive compensation, don’t forget the SEC also requires extensive disclosures about director compensation and related matters. So, it’s worth discussing major differences between a board of directors compensation treatment in public companies and that in private companies.
Usually, total director compensation levels at private companies are significantly lower than at public companies despite the fact that cash-based compensation is similar. It’s because private sector directors don’t generally receive equity and the companies usually don’t make up this value in higher cash pay for them.
While looking at their public sector counterparts, equity makes up a large portion in their total pay.
8. Lock-up Periods
A lock-up agreement prevents insiders of a company from selling their shares for a specified period of time (usually around 80 – 180 days) after going public.
Lock-up agreements are not required by law, but underwriters will often require executives, investors, and other company insiders to sign these agreements. The general idea behind them is to prevent too much selling of stock in the period right after going public and driving the price down.
What do you need to know when it comes to executive compensation? Essentially, that they exist and should be part of your strategy, from how you communicate it to your executives to how they will impact the IPO and share price itself.
9. Be prepared for Increased Shareholder and Media Scrutiny
Shareholders actively monitor pay practices for executives to ensure pay for performance. They also have an advisory vote on executive pay matters, known as ‘Say on Pay’ vote.
As a result, there is more scrutiny of pay practices for executives. A company should be prepared to justify pay strategy and practices.
Overseeing the Transition when Going Public
As private companies move through the pre-IPO process, they should consider an audit of all aspects of their executive pay practices, to identify what needs to change and over what timeframe.
These changes can be implemented over an extended period, even beyond going public, which means that Compensation Committees should have ample time to identify what needs to be done and oversee the transition from private to public company practices.
While the road to going public may be a long and arduous one, with many twists and turns, when it comes to executive compensation it’s vital to follow the steps outlined above – if not, you may find yourself on the surface of Mars wondering why Venus looks so different nowadays.