Tying Pre-IPO Compensation to ESG Commitments

If your company is gearing up for an initial public offering (IPO), you’ll need to be preparing now for heightened scrutiny around your environmental, social, and governance (ESG) practices and thinking about company strategy around ESG.

One increasingly hot issue that many public company activists are now focused on is whether executive compensation should be tied to ESG performance. The pandemic and the resulting economic crash magnified preexisting economic and social inequalities, and accelerated conversations about how ESG should impact wages, bonuses, and incentives for executives.

But creating an ESG-focused executive compensation program doesn’t happen overnight, and there is no one-size-fits-all, cookie-cutter approach. While there may be very real and urgent pressure to tie ESG to compensation, it’s important not to jump the gun. Unlike financial performance metrics, ESG metrics can be much more difficult to quantify, measure, and adjust. Successfully marrying executive compensation with ESG can happen only after taking the following two critical steps:

Ensure that the company has a holistic, strategic approach to ESG.

Having an ESG-driven incentive compensation component is just one factor within your wider ESG strategy. Many emerging, pre-IPO companies do not yet have a sophisticated ESG program in place, complete with compliance review, data analysis, and reporting. Since tying ESG commitments to compensation requires having concrete goals—and methods of working toward them and measuring progress—it is often one of the last compensation elements to launch in more mature, robust programs.

Getting a solid ESG program in place pre-IPO is important in three major ways:

• to meet the demands of the public market

• to prepare for heightened regulatory scrutiny

• to prepare for necessary disclosures

As a growing company, attracting talent—especially younger generations who care deeply about their employer’s commitment to addressing environmental and social issues—is also critical to success. Institutional investors are similarly attracted to companies that have thoughtfully considered ESG as a critical component of long-term success.

A starting place for creating an ESG program is evaluating what is truly material to your company and creating a plan to integrate those considerations into the operations and management of the business. This includes developing appropriate initiatives, programs, and policies, and tying ESG to your risk management strategy.

Establish mechanisms that will allow the company to tie compensation to ESG commitments in a measurable way.

Once clear ESG goals and strategies are in place, a company is better prepared to start tying them into executive compensation. Still, taking baby steps is critical, as is ensuring that any metrics are directly linked to your company’s overall ESG strategy. ESG metrics that are folded into executive compensation need to be tailored specifically to the company’s business goals, ESG strategy, and unique circumstances. It is also imperative that any ESG data that is benchmarked against the company’s larger ESG goals are accessible and have been pressure-tested or determined to be legitimate and indisputable so that there are no gray areas.

When metrics are first added into executive compensation plans, consideration will need to be given to how they fit into the overall compensation program and align with strategic priorities.

To take small steps toward adding ESG-focused metrics into pay plans, consider the following:

• Including ESG-related goals in executives’ performance reviews or work plans. While this doesn’t specifically tie ESG metrics to compensation, it still makes it clear that management is committed to achieving these goals at the highest levels.

• Using ESG as a modifier that increases or decreases performance-based payouts depending on the achievements of ESG-related objectives.

• How your company is going to message the importance of ESG to the entire organization, including executives, particularly if ESG is a new consideration.

• Whether it makes more sense to tie metrics to a small portion of an executive’s annual bonus, or to a longer-term incentive plan aimed at creating measurable change over time.

• Introducing metrics initially as a “carrot” rather than a “stick,” meaning that there are additional benefits for reaching goals rather than a reduction in compensation for not meeting those goals.

• Making your metrics appropriate for your company’s usual goal setting and evaluation practices.

The main message: don’t move too fast or follow the herd. Executive incentives work best when they are clear and consistent, and truly align with the overall goals of your company. Dive into what matters for your company and your industry, and then use executive compensation as a tool to make your ESG aspirations a reality.

Jean McLoughlin is partner and cochair of the executive compensation group at Paul, Weiss, Rifkind, Wharton & Garrison.

Dave Curran is co-chair of the sustainability and environmental, social, and governance (ESG) advisory practice and executive director of the ESG and law institute at Paul Weiss.