Preparing for an IPO requires a company to revisit its equity compensation plan. Whether replacing an existing pre-IPO plan, increasing the available share pool, or designing an equity incentive plan for the first time, the majority of U.S. companies going public approve a plan granting equity compensation to employees and directors prior to the IPO. Many public companies have employed similar processes when designing – or redesigning – their equity plans; but it is vital that pre-IPO companies recognize and take advantage of the unique design opportunity this process affords them.
For example, pre-IPO companies typically engage directly with a small group of investors regarding the equity plan, instead of the more formal process of holding a shareholder vote with uncertain results. Although there is a definite need to offer options and/or shares as part of key employees’ compensation packages, understanding the motivations and concerns of the investors allows for a much better equity compensation plan.
1. Determine the long-term incentive plan (LTI) and grants
Founders and private equity firms have a particular concern with new equity plans since the plans may have an impact on their stake in the company. Therefore, considering the level of dilution and setting the parameters is an important first step.
Before considering the level of dilution, the objectives of the LTI plan must be considered:
- Are the grants for all employees, a select group or only the C-suite?
- What is the purpose of the grants: retention and/or performance?
- And finally, consider the equity plan cost and dilution limits that founders may impose.
Dilution can be limited in a number of ways:
- Limiting the shares that can be held in reserve or granted each year;
- Accounting cost that limits the cost of the plan per year or in the aggregate;
- Percentage of the company’s market capitalization, either per year or in the aggregate; Company’s future value gains earned by the employees under the equity plan.
Pre-IPO companies should be talking to the investors about the cost of the equity plan and not about the number of options or shares until the IPO.
In particular, companies that grant only options post-IPO must consider the percentage of the future gain in the company’s value that will be returned to the employees through stock option grants. Investors and underwriters are typically held to a six-month lock up post-IPO and the locked up shares will be considered in the valuation models.
Stock options still remain the preferred LTI award granted in the year of the IPO. In fact, approximately 75% of all IPO yearly equity awards are stock options with 9-14% in the money at the time of the IPO. But we have seen grants of options to all employees result in underwater options, dilution and an expense when the stock suddenly falls from, for example, a failed Food and Drug Administration report. Lessons learned have resulted in RSU grants, which will at least retain some value to the broader employee base.
2. Establish a share pool pre-IPO
Most of the pre-IPO companies have evergreen provisions that will allow the company to grant equity for a specific number of years without having to ask shareholders for more shares. Most companies refuel their equity plan with new shares at the time of the offering. The total share reserve usually represents 1% to 2% of shares outstanding at the IPO. And more than the majority of IPO plans include a 1% annual evergreen increase. The median overhang at these companies after the new-share reserve additions was 14.6% of common stock outstanding. In comparison, median overhang for Fortune 500 companies is approximately 10%. So when considering an evergreen plan, ask who the investors are when asking for additional shares. Note that to preserve the tax deduction under IRC Sec. 162(m), a shareholder vote is required on plans authorizing equity grants by the first shareholder meeting following the three-year anniversary of the IPO.
3. Review composition of equity grants and individual grants of peer group
At the time of the IPO, review base salary, bonus, equity grants, metrics and benefit plans of the company’s peer group to determine how competitive it is. Remember to keep shares in reserve if hiring employees that are eligible for equity grants.
Choosing the correct peer group in today’s environment may not be as straightforward as in the past. We worked with a company that provides financial services, but the heart of their business model is their technological innovation. As they approached their offering, they chose to compare their performance to peers in the tech space rather than traditional financial services firms. Selecting the right peer group allows executives – and companies – to be benchmarked appropriately.
4. Anticipate dilution from the impact of accelerating grants
Review the individual grant values when considering the grant sizes and the life of the equity pool. Note that outsized option grants or multiyear grants to the C-suite may cause future grants to be less in order to stay within the cost limits.
5. New equity–based incentive plan at IPO
When a new equity plan is adopted that becomes effective upon the IPO, the legal documents filed at that time should be flexible enough to include the equity grants post-IPO. Now with the valuation of the company nearly finalized the plan values need to change to a specific number of shares and/or options and to allow the board to grant all types of equity — performance shares, time-vested RSUs, restricted stock and all combinations. In fact, more than 50% of the recent IPOs made stock grants in the year of the IPO with more than one type of equity — usually time-based.
Successful companies strike a balance between full value awards, such as restricted stock or units, and options that reward appreciation. A sharing economy-focused company that grew tremendously while private, for example, recently began granting share awards as they approached their offering. Pre-IPO level growth is less common when public so executives should enjoy a portion of their compensation as time vesting full value awards.
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The views and opinions expressed herein are the views and opinions of the author at the time of publication and may not be updated. They do not necessarily reflect those of The NASDAQ OMX Group, Inc. The content does not attempt to examine all the facts and circumstances which may be relevant to any particular company, industry or security mentioned herein and nothing contained herein should be construed as legal advice
Opinions expressed in this article are the author's own view. Neither JPMorgan Chase nor its affiliates guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use.
Stats Sourced: Towers Watson 2014 Executive Compensation Bulletin
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
