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October 18, 2011

Transaction activity appears to be on the rise, particularly initial public offerings (IPOs). Companies considering or preparing for an IPO should ensure they are prepared so they can cross home plate and earn extra runs.

On Deck, Getting Ready to Bat

Before a company begins setting compensation for its key executives and employees, it needs to scope out the competition. First, it should investigate what levels and types of compensation are going to be competitive, so its compensation structure does what it is supposed to do: incentivize and retain key performers while at the same time maximizing shareholder value. Second, it needs to be aware that institutional shareholder advisory groups — such as Institutional Shareholder Services (ISS) and Glass Lewis — serve as the umpires in determining whether a company has committed an error in setting compensation. These groups continue to influence executive compensation trends by annually defining “best practices.” Hot button issues right now involve the use of perquisites and tax gross-ups.

Before taking the plate, companies should:

Develop a peer group of comparable public companies: In benchmarking compensation, a company should generally consider how its peers compensate their executives. How does a company know who its peers are? It compares itself to other similar companies based on industry, market capitalization, revenue, total assets and/or employee head count. It is preferable to include companies that fall within acceptable ranges (generally, no smaller than half or larger than double) using these factors as a guide.

Develop an executive compensation philosophy: Companies should develop a philosophy regarding how they want to compensate their executives relative to market. Many companies may choose to target the 50th percentile, whereas others may target higher levels. Further, how a company wants to deliver its compensation should be determined. Does it want to provide fixed compensation or variable? Cash or equity? For example, for exploration and production (E&P) companies, the average mix for the CEO is 12 percent base salary, 23 percent bonus, 61 percent long-term incentives, 3 percent deferred compensation and 1 percent perquisites and other compensation.

Review competitiveness of and set executive compensation: Competitive levels are typically set by analyzing the compensation information for peer companies, using either proxy or survey data, and aligning recommended levels with the company’s compensation philosophy. Compensation levels should be set for base salary, target bonus, equity or long-term incentive awards, perquisites and other benefits. It is important to compare total compensation when measuring against the peer group.

Analyze application of Code Section 162(m): Generally, no deduction is allowed to any publicly held corporation for compensation in excess of $1 million paid to any covered employee (typically, the principal executive officer and the top three highest-paid executives). However, the following are not subject to the cap:

(i) Certain performance-based compensation;
(ii) Commissions based on income generated directly by the employee;
(iii) Qualified retirement plan contributions (including salary reductions); and
(iv) Non-taxable benefits.

Additionally, the $1 million limit does not apply to certain compensation arrangements that existed while a corporation was not publicly held. This exemption generally applies for the duration of a reliance period, which lasts until the earliest of:

(i) The expiration or material modification of the plan or agreement;
(ii) The issuance of all employer stock or other compensation that has been allocated under the plan; or
(iii) The first meeting of shareholders at which directors are elected that occurs after the close of the third calendar year following the year in which the initial public offering occurs. For companies that become public through an initial public offering, this relief applies only to the extent that the prospectus accompanying the IPO discloses information about the plans or agreements.

Ensure compliance with SOX: To comply with the Sarbanes-Oxley Act of 2002, any outstanding personal loans between executives and the company should be eliminated prior to going public.

Securing a Base Hit to First

Short-term incentives are a critical part of any compensation package. Therefore, companies should develop a formal short-term incentive plan document that sets forth the performance measures that will be used to determine whether an executive’s performance warrants the award of a bonus, as well as to determine the amounts to be paid upon achievement of the set performance targets.

Companies need to select the financial performance measures they will use and individual performance goals each executive must achieve. In the oil and gas industry, for example, the most prevalent performance measures include finding and development costs, earnings before interest, taxes, depreciation, and amortization (EBITDA), production, reserves, stock price performance, net income, and cash flow. However, this is not an exclusive or exhaustive list. Performance criteria can include one or more measures, including individual performance.

The company should also decide whether it wants to make the annual incentive plan comply with Code Section 162(m), so that it can exclude bonus payments from the $1,000,000 limit on deductible compensation.

Stealing Second

The next step is to review and develop a long-term incentive strategy, which includes determining how much and what type of long-term incentives will be used and the appropriate instrument use or mix of alternatives. By way of example, companies in the oil and gas industry tend to use a mix of stock options, stock appreciation rights, restricted stock and restricted stock units. About half use performance-based awards.

Prior to going public, the compensation committee should develop a long-term incentive award matrix with values for all employee levels. It should also set an equity utilization (burn rate) budget for the coming fiscal year. Setting burn rate caps is one of the best practices monitored by ISS. Burn rate is measured as shares granted divided by total common shares outstanding; it generally reflects the dilutive effect of equity grants. ISS sets burn rate caps for public companies generally based on size and industry.

It should also be determined whether any IPO awards will be made (also known as founder’s shares), to whom and in what amounts.

Executive and Board Stock Ownership and Holding Requirements

The pre-IPO company should consider whether to implement stock ownership and holding requirements. Ownership guidelines typically dictate how much stock an executive or board member must acquire within a specified period of time (usually three to five years). These guidelines are typically defined as a multiple of annual base salary or the ownership of a fixed number of shares. Holding requirements require executives to retain a certain percentage of shares they acquire through the exercise or vesting of stock options, restricted stock and other equity awards. These guidelines help align shareholder and executive interests.

Rounding Third

Pre-IPO companies should review existing employment, severance and change in control agreement terms, conditions and potential payout obligations. Depending on how these agreements are drafted, it is possible that payments or vesting of equity may be triggered by the IPO itself or upon a qualifying termination or resignation in the period of time leading up to, or following, the IPO.

The company should also complete a competitive analysis of key terms for employment, severance and change in control agreements and set terms going forward based on the market. The typical severance protection is set at three times either base salary or the sum of base salary and bonus for the CEO and two times for other named executive officers.

It is important to note that compensation payable upon termination must be disclosed in the company’s proxy on a go-forward basis.

Sliding Into Home

In connection with an initial public offering, the company will need to address several governance issues, including the preparation of the compensation discussion and analysis portion of the S-1 and proxy disclosures and the compensation committee charter.

The company should set the equity award approval process, including what authority, if any, will be delegated to management. A policy regarding award grant timing should be formalized, and a compensation calendar should be developed, identifying when the company will grant long-term incentive awards, award and implement salary increases, and award and approve annual incentives, as well as when the compensation committee will meet. Board of directors compensation for the following year should also be reviewed and set.

Alvarez & Marsal Taxand Says:

There are many issues a company should consider when preparing to go public. Boards of directors and compensation committees want to be perceived not as providing excessive compensation packages relative to their peers, but rather as appropriately incentivizing and retaining key executives while at the same time maximizing shareholder value. Preparation is critical if a company wants to hit it out of the park.

Author

Brian Cumberland 
Managing Director, Dallas
214-438-1013
Profile

Kandice Bridges, Senior Director, contributed to this article.

For More Information on This Topic, Contact:

J.D. Ivy 
Managing Director, Dallas
214-438-1028
Profile

Kandice Bridges 
Senior Director, Dallas
214-438-8447

Lindsey Miller Shapiro
Senior Director, New York
212-763-1878

Mark Spittell 
Senior Director, Dallas
214-438-1017

Allison Hearne
Director, Dallas
214-438-1037

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As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

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