Pre/Post IPO Compensation Issues
Companies fall into one of three major ownership categories: privately-owned, publicly-traded, and not-for-profit. Each of these categories carries with it specific tax, regulatory, and ownership restrictions that impact how they are operated, managed, and staffed. For a variety of reasons, most of which include access to a larger market and much greater financial resources, many companies aspire to become public, and as such, venture into the world of the Initial Public Offering (IPO).
The majority of our clients are privately-owned and closely operated companies; therefore, Compensation Resources (CRI) has had the opportunity to work with a significant number of them to make the successful transition from being a private, entrepreneurial organization to becoming a public company. The conversion to a public company, with all of its regulations and scrutiny, has inherent responsibilities associated with the requirement for arms-length determination of compensation for senior level executives and Board members. Because of the need for transparency and the intention of acting in a more “business-like” manner, many of the same issues occur when a privately-owned company is considering its acquisition or merger with another organization.
IPO Compensation Issues
At the time a company is preparing for an Initial Public Offering (IPO), sale or merger, experience has shown that the greatest emphasis is typically on the financial and legal aspects of the transaction, while the people side of the equation is often ignored, or at best, given a secondary consideration. And yet, the original reasons behind the IPO or sale often involve the owner’s personal issues such as their desire for an exit strategy and liquidity, as well as related human resource issues such as wealth sharing and the retention of key employees. The purpose of this white paper is, therefore, to provide an overview of the issues and considerations, plus the compensation components that should be examined in preparing for an IPO.
Some companies proceeded with their IPOs without sufficient preparation for the compensation and people matters. These companies were forced, after the fact, to correct and put in place appropriate executive compensation arrangements, often at considerable cost and anxiety. It is much easier and more effective to develop and install such pay arrangements beforehand, rather than later. To facilitate this process, we have grouped the necessary activities into three (3) major time periods: Pre-Transaction, During the Transaction, and Post-Transaction.
The most important pre-transaction issue is to determine what the goals of the overall executive compensation program will be, and set about to develop a strategy that identifies how to achieve those goals. It is important to add two (2) major caveats here: the first is to establish a longer-term executive compensation strategy that looks at least 3 to 5 years into the future, not merely the immediacy needed to prepare for the IPO.
The second caveat is the need to clarify the desired Compensation Philosophy, which provides the documentation of such concepts as the specific labor market with whom the company will attempt to compete; at what level they will compete (above, middle of the pack, below); to what extent the company will embrace the concept of “pay-for-performance” and the use of variable pay programs; how widely equity and stock based programs will be used, as well as the degree to which various long-term programs will be utilized in the organization; who will receive employment agreements; and a host of similar issues. It is critical that each of these issues with respect to the Compensation Philosophy is considered and discussed, since they will serve as the baseline for establishing all specific compensation programs and related documentation. Therefore, the Philosophy should:
- Clarify the company’s intended pay position vis-à-vis its marketplace (everyone wants to be “competitive”; but, what does that mean?).
- Determine which companies will be selected as peers for comparison purposes, and why. They should be as similar as possible, including industrial classification, key financial measures such as revenue, assets, profitability, sustained growth, etc. Geographical considerations are not as significant as they were historically, but may be considered if appropriate.
- Be consistent with the company’s overall business strategy, marketing plan, economic reality, and corporate culture. This is best illustrated by establishing performance measurements and awards that are aligned with the strategy and business plan, and which will effectively drive the desired results and move the company forward. Clearly, they should not reward mediocrity or unrelated performance.
- Establish the components of the Total Rewards Package (TRP). Whereas privately-owned companies are typically reluctant to share actual ownership even with their key players, it is widely recognized that some form of long-term incentives are a major element of the TRP for key management. These plans serve four (4) main purposes: (1) allow the executives to share in the wealth associated with continued growth; (2) provide a balance in short-term and longer-term goal setting; (3) act as a significant retention devise; and (4) offer a commonality of purpose with the shareholders.
- Provide sufficient flexible to meet the company’s current needs, as well as to handle future issues and changes in the company’s business direction, external competitive pressures, and ever changing government regulations. Strategic plans clarify a company’s direction and establish the method used to achieve its longer-term goals, but must allow for course adjustments to respond to changes affecting the business. Similarly, the compensation program must be flexible enough to continue to provide the motivation and retention necessary to achieve the company’s business and strategic goals, as they are modified.
Following approval of the Compensation Philosophy by Top Management and/or the Board, the next step is to examine each of the pay components to determine if they are meeting the following considerations:
- Is the Total Reward Package consistent with the Philosophy?
- Are the pay components in line with the competitive marketplace?
- Is the mix of compensation components consistent with peers, and with the company’s stated philosophy?
- Is their sufficient focus on the desired performance results?
- Are the company’s business objectives being accomplished?
- Is the result a financial Win/Win for both executives and the company?
- Does the compensation comply with best industry practices and all applicable federal and state regulations?
As part of the evaluation of the current compensation program, it is important to consider the internal procedures used to conduct the competitive due diligence and pay determination, as well as the level and transparency of the requisite process and documentation. This analysis should also consider the administrative controls, policies, and procedures that support all aspects of the compensation program. The SEC, as well as each securities exchange, sets forth specific rules that must be followed, the newest of which includes the “Say on Pay” vote by shareholders. These are continually being tightened, and must be strictly adhered to.
During the Transaction:
During the actual preparation in anticipation of the IPO or related action, it may be too late to actually change or put in new plans. This is especially true once the S-1 or “Red Herring” is prepared and filed, or after the due diligence process has begun. However, before that happens, it may not be too late to consider certain stock grants, finalizing employment and change of control agreements for key management, and correcting other pay deficiencies. These can be especially important if they will enhance the retention of critical personnel and is tied to acceptance of non-compete type restrictions.
The inclusion of the details of the executive compensation components in the prospectus may enhance the TRP and signal to the potential shareholders that the compensation is intended to be fair, competitive with peers organizations, and tied to the achievement of meaningful performance goals that follow the concept of pay-for-performance that is directly tied to increases in shareholder value.
As a result of the IPO, sale or merger, the compensation decision-making will be moved from the former owner/managers to the new owners, typically consisting of an independent Board of Directors or subcommittee of directors. If the transaction was a merger or acquisition, the decision makers may be the senior management or Board of the new entity, all of whom are less likely to be familiar with the importance or worth of critical personnel.
The second major change that will occur as a result of the transaction, especially if it is an IPO, is the vastly increased visibility, scrutiny, and required transparency to which executive compensation decisions will now be subjected. Some of the on-going executive compensation needs include the following:
- Analysis of competitive trends and market comparisons.
- Benchmarking of the individual components of the executive compensation package, as well as the Total Cash Compensation (TCC), Total Direct Compensation (TDC), and the Total Rewards Package (TRP).
- Identification of appropriate peer organizations for comparison purposes.
- Design and implementation of new or modified components of the executive compensation package:
- Base salary
- Annual incentives
- Long-term incentives and stock-based plans
- Equity and stock ownership issues
- Supplemental benefits and perquisites
- Deferred compensation arrangements
- Employment, change of control and severance agreements.
- Board of Director compensation
- Preparation of the required narrative and factual documents, including the Compensation Decision and Analysis (CD&A) or the equivalent documentation for subordinate divisions of public and foreign-owned companies.
The third post-transaction area requires far more internal examination of competitive market trends and identification of the rationale and justification for all compensation-related actions. This will be required, since all compensation arrangements are now subject to extensive external scrutiny by a variety of sources, including Boards, shareholders, the media, and various government agencies.
As noted, the transition from a privately-owned company to publicly-traded, or merger into another entity, requires a considerable amount of insight and preparation, not the least of which involves a careful review of existing executive compensation programs. The company’s key management and its Board, as well as with its external legal, financial, and accounting advisors, must ensure that all compensation-related matters are properly handled on a timely basis. Similarly, it is critical to monitor and renew existing programs as appropriate, to ensure they continue to serve the company’s needs, and meet the often changing governmental reporting requirements and regulations.
About Compensation Resources, Inc. (CRI): CRI provides compensation and human resource consulting services to mid- and small-cap public companies, private, family-owned, and closely-held firms, as well as not-for-profit organizations. CRI specializes in executive compensation, sales compensation, pay-for-performance and incentive compensation, performance management programs, and expert witness services.