Preparing for an initial public offering (IPO) involves many facets of an organization’s business including legal, regulatory, financial and operational considerations. Public companies face additional regulations and greater disclosure requirements than private companies, particularly regarding the transparency of a company’s executive compensation program. Because of the additional requirements, executive compensation has become a relatively complex aspect of preparing for an IPO.

By forming an IPO compensation roadmap, however, a company can ensure that its executive compensation program and policies are:

• Competitive with the market;
• Within industry norms;
• Compliant with various governance requirements; and
• Aligned with executive and shareholder interests.

This edition of Tax Advisor Weekly provides a five-step process to develop an effective executive compensation IPO strategy that will ensure a pre-IPO company’s executive pay programs don’t get lost or stranded along the path to becoming public.

Step One: Beginning with the End in Mind

The first step in our process is to develop a set of guiding design principles and a compensation philosophy for the IPO roadmap. The guiding principles should be referenced throughout the roadmap to ensure all compensation decisions are in harmony with the direction of the company.

The compensation philosophy is developed out of the guiding principles and further details the company’s views on the key principles that define how various compensation constructs should be used by the organization to better recruit, motivate and retain the executive talent. The philosophy should also be developed with the strategic intent to provide clarity as well as flexibility in determining how the company should use fixed and variable elements of compensation to create a competitive advantage in the marketplace.

A major component of the compensation philosophy is formalizing the company stance on how it positions itself relative to the market, and if the company is trying to develop a strong pay-for-performance culture that heavily emphasizes variable “at-risk” compensation. The process depicted above should facilitate a company in affirming its approach to executive pay, and ensure the company is considering the return on its financial investment in the company’s executive team.

Step Two: Identifying Competitive Compensation Arrangements

A pre-IPO company should determine an appropriate comparator peer group for the purposes of benchmarking competitive levels of executive pay. A thorough peer group development process will encompass more than just standard revenue and market capitalization ranges, typically employed by shareholder advisory services. A more robust evaluation would include companies that are similar in respect to their organizational structure and business model (i.e., the source of a company’s revenue), as well as those companies where talent is lost or recruited.

Assessment of an organization’s approach to executive pay should be based on the compensation benchmarking analyses that consider compensation levels, mix, and annual and long-term incentive design features. The resulting compensation insights will be used to establish the total compensation levels for a company’s executive team both leading up to and following an IPO.

First, a pre-IPO company should evaluate each executive’s equity position to arrive at the appropriate mix of the compensation elements (i.e., cash vs. equity) leading up to and following the IPO.

Second, a pre-IPO company should complete a competitive analysis of key terms for employment agreements, severance and change in control agreements, and set the terms going forward based on the market. Depending on how these agreements are drafted, it is possible that severance payments or vesting of equity may be triggered by the IPO itself or upon a qualifying termination or resignation in the period leading up to, or following, the IPO. It is also important to note that compensation payable upon termination must be disclosed in the company’s proxy in the future.

Finally, companies should pay attention to how the compensation programs will operate post-IPO. After the excitement of the IPO begins to fade and the company begins to operate in the new public environment, executive retention and continued financial success/shareholder value creation will become imperative. In preparation for the post-IPO environment, a company should evaluate when a more mature executive compensation program should be structured and when following the IPO (i.e., annual equity awards for executives) that program should be implemented.

Step Three: Designing a Long-Term Incentive Pay (LTIP) Program  

Once a company has defined its compensation philosophy and competitive pay strategy, the human resource team should collaborate with stakeholders to develop the pre-IPO and potentially portions of the post-IPO LTIP plan(s). This would include determining who will be eligible for pre- and/or post-IPO equity awards, the post-IPO equity award approval process, how much equity will be rewarded to the executive team, and what types of equity instruments will be used. By using an effective mix of LTIP vehicles, a newly formed public company can balance current and future stock price appreciation as well as company valuation growth with executive retention/ownership.

Pre-IPO companies need to consider the dilutive effect of using equity awards to reward executives. There are multiple ways to measure the costs to the shareholders in a way that should help a company evaluate and mitigate dilution. One of the most commonly used methods to measure the explicit cost to shareholders is by calculating the LTIP program’s annual burn or run rate. The burn rate is calculated by dividing the total shares granted in any given year by the total common shares outstanding in the year the award was granted. It generally reflects how quickly an organization is using its available equity.

Therefore, a company should set an equity utilization (burn rate) budget as well as acceptable levels of dilutions in the year that the organization plans to go public. Monitoring the company’s burn rate is a good governance practice, and Institutional Shareholder Services (ISS) publishes “allowable cap” benchmarks based on the organization’s listed status on the Russell 3000 Index and industry.

Prior to finalizing the LTIP program, another important factor to take into consideration is establishing how many shares should be available for grant upon IPO and for future issuance under the program post-IPO. It is preferable to obtain approval of additional shares for future grant prior to the IPO, as the shareholder approval process is simpler in the pre-IPO stage and will receive transition relief from the $1-million deduction limitation under IRC Section 162(m) (as discussed below). A&M typically advises clients to benchmark the equity available for issuance, the burn rate and the overhang (i.e., share reserve plus outstanding awards relative to total shares outstanding) relative to recently public companies to ensure that all the aforementioned factors are aligned with market practice and are being considered from an effective governance standpoint.

Upon conclusion of step one through three, a company should have a good understanding of how the executive pay programs will function leading up to and following the company’s IPO. Furthermore, using A&M’s approach will increase the likelihood of retaining key executive talent and of rewarding founders and critical contributors to the organization appropriately in both the pre- and post-IPO environments.

Step Four: Addressing Governance and SEC Filings

In connection with an IPO, there are several governance concerns a company will need to address.

1. First, a pre-IPO company should evaluate the composition of its board of directors to ensure it is primarily composed of independent directors. The stock exchanges require boards to have a majority of independent directors within one year of listing.
2. The compensation committee, which should comprise exclusively two or more outside directors, should be elected. This committee’s primary responsibility is to provide oversight over executive compensation and the benefits plan.
3. During the process of developing an executive compensation strategy, the board and the compensation committee should be aware of the influence of institutional shareholder advisory groups (such as ISS and Glass Lewis). These groups continue to affect executive compensation trends by annually defining “best practices.” Some of the recent hot-button issues these groups have focused on include generous equity vesting, excise tax gross-ups, and pay-for-performance misalignment garnered from a lack of performance-based equity, discretionary awards, inappropriate benchmarking and non-rigorous incentive programs.
4. Securities and Exchange Commission (SEC) filings, such as a Compensation Discussion and Analysis for the initial registration form, S-1 and proxy disclosures, need to be prepared, as necessary. A pre-IPO company also needs to be cognizant of whether it falls under the “emerging growth company” definition, because it will relieve a company from certain compensation-related disclosure requirements under the Securities and Exchange Act and the Dodd-Frank Act. A pre-IPO company should also ensure that it is in compliance with the Sarbanes-Oxley Act of 2002 by eliminating any outstanding personal loans between executives and the company.
5. Lastly, a pre-IPO company should also analyze the application of Internal Revenue Code Section 162(m) to its executive compensation strategy. Generally, under Section 162(m), compensation in excess of $1 million paid to the CEO and the three highest paid officers of a public company is not tax-deductible. The following, however, are not subject to the cap: (i) qualified performance-based compensation, (ii) commission-based compensation, (iii) retirement income from a qualified plan or annuity, and (iv) nontaxable benefits. The most prevalent of the four is the qualified performance-based compensation exception, which requires certain specific conditions be met. Another exception, if certain requirements are satisfied, to the 162(m) cap is compensation agreements that existed while a corporation was not publicly held. This exemption applies to any compensation received or granted pursuant to an agreement made prior to the expiration of the reliance period.

Step Five: Maintaining a Competitive Executive Compensation Program

After developing an effective executive compensation program leading up to the company’s IPO, the company should regularly evaluate and scrutinize its pay programs to ensure external market alignment, internal equity and alignment with shifting strategic objectives. This is generally done by:

• Periodically assessing compensation pay levels and annual and long-term incentive program effectiveness;
• Updating the compensation committee on market changes and trends in executive compensation, best practices and new regulations or legislation to stay competitive and retain employees;
• Updating benchmarks and pay analyses; and
• Preparing for the initial Sarbanes-Oxley review.

Alvarez & Marsal Taxand Says:

The time leading up to an IPO can be exciting and represents an important milestone in a company’s history. However, there are several pitfalls and roadblocks that can present themselves throughout the process. Dynamic business strategies, changing regulations and the need to keep executive teams intact may contribute to companies not realizing their full potential post-IPO. Along the way, boards, and specifically the compensation committee, want to be perceived not as providing excessive compensation packages to executives, but rather as appropriately incentivizing and retaining key executives while at the same time maximizing shareholder value. The Alvarez & Marsal Compensation and Benefits team is here to guide you past the potholes, roadblocks and diversions that will hinder your organization’s IPO governance and pay readiness strategy by ensuring your compensation programs have the premium gas necessary to be firing on all cylinders. 

Disclaimer

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.

About Alvarez & Marsal Taxand

Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisers who are free from audit-based conflicts of interest and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the United States and serves the United Kingdom from its base in London.

Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisers in 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.

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