July 25, 2021
By Bertha Masuda
For a company preparing for an initial public offering (IPO) of its stock, it is important to understand the new norms of public company compensation and process of making pay decisions. Compensation expectations shift as the investor base broadens and proxy advisory firms’ recommendations and regulatory requirements become more important. Below, Compensation Advisory Partners (CAP) addresses common issues that arise when a company prepares for an IPO.
Specific pay areas to address ahead of an IPO
Determine Pay Philosophy and Peer Group: One of the first items is for the compensation committee, working with management, to define the pay philosophy, including the peer group of comparable companies used for pay benchmarking. As a newly public company, the peer group should reflect other public companies with similar characteristics (industry, size, geography) to the company going public. Pay positioning against this peer group will be established; the company will need to decide whether a change in pay mix between salary and incentives is appropriate now that the newly public company has the benefit of marketable and liquid stock.
Design IPO Equity Incentive Plan and Employee Stock Purchase Plan (ESPP): Prior to the public offering, the committee will determine the equity incentive plan for the newly public company, which usually includes requesting additional shares for the plan in conjunction with the IPO, and, increasingly, an annual “evergreen” replenishment to the share reserve. An IPO is also the appropriate time for companies to consider implementing an Employee Stock Purchase Plan. ESPPs, often designed as tax-qualified plans under Section 423 of the Internal Revenue Code, are an attractive benefit to employees, as such plans allow them to purchase company stock — often at a discount — through payroll deductions.
Evaluate internal equity amounts and retention risks: While a public offering is an exciting event, it is important to continue to motivate and retain key executives and employees in the period following this milestone. As a result, the compensation committee and management team need to review the equity amounts held by executives and employees and identify any retention risks. For instance, key positions may need “topping off” of grants to ensure adequate retention, recognize outstanding performance, or address any internal relative inequalities among individuals. In addition, equity awards may be broadly granted to employees in recognition of the significant milestone of becoming a publicly traded company.
Review Executive Incentive Plan Practices: Executives at public companies have a significant “at-risk” portion of their compensation tied to company performance. As a result, the compensation committee should review the incentive opportunities and structure of executive annual and long-term incentives to ensure that they align with the company’s business strategy and typical public company incentive pay practices. Generally speaking, annual incentive plans become more structured and use less discretion, with bonus opportunities tied to achieving specific company performance targets. With respect to long-term incentives, equity grants (e.g., stock options, restricted stock, performance shares) are usually made before or in conjunction with the IPO. In the year following an IPO, the norm is for companies to grant awards that have performance requirements, and for executives to meet stock ownership guidelines within a specified time period (commonly five years). Annual risk assessment of the incentive programs is also conducted as part of the compensation committee’s agenda.
Review Current Employment Contracts and Practices: The company should review and audit current executive and employee agreements, pay practices, change in control, and severance policies to ensure that there are no “poor” or egregious pay practices, such as executive loans, tax-gross-ups, single trigger change of control severance, excessive perks, etc. Any issues found can be corrected and conform to best practices ahead of the IPO.
Determine Board of Director Pay Practices: Serving on a public company board involves more risk than private company board service. Given the increase in risk, the amount of director compensation increases, and the pay mix changes to be more heavily weighted to equity instead of cash. The structure of the pay package is designed to achieve alignment with shareholder objectives, and typically involves stock ownership guidelines similar to those established for executives
Prepare Required Disclosures: Required disclosures of a newly public company are substantial and vary depending on the company’s filer status (e.g., emerging growth company or regular issuer). With respect to compensation, the company will work with its legal counsel to determine the appropriate disclosure of the company’s compensation philosophy and programs in its SEC and stock exchange registration filings.
As discussed above, compensation planning in preparation for an IPO entails thinking through the appropriate pay levels and practices for the board, executives, and employees. A structured process and checklist of items to discuss will enable compensation committees and management teams to design the pay philosophy and programs that will not only support their companies in achieving their strategic and financial objectives post-IPO, but also align with market expectations of publicly traded companies.
Bertha Masuda is a Partner in the Los Angeles office of Compensation Advisory Partners.