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Monday, December 9, 2019

CEO Insider

Executive Compensation in a Pre-IPO Company

The startup you work for is gaining acceptance in the market and with remarkable growth, you are now eyeing the prospects of an IPO.  The fruits of your team’s labor are at hand. But do you know how your executive compensation package will change as a result of becoming an employee of a public company? What rewards should you expect at the IPO stage?

Alternatively, your business unit may be divested from its parent company in the form of an IPO. How would your executive employment terms and compensation change?

Public company equity compensation

Executive compensation in public companies is subject to the scrutiny of the SEC and public shareholders. Specifically, the Compensation Discussion & Analysis (CD & A) section of the public company’s proxy statement will disclose how executives at the highest level are compensated. In addition, shareholders also have an advisory vote on executive pay matters, known as ‘Say on Pay’ vote. As a result, the design and structure of top-level executive compensation in public companies also need to meet the expectations of the public.

Executive compensation packages typically contain both cash and equity compensation. For public companies, equity is readily available and its value is determined by the market.  Because the shares are publicly traded, post-IPO shares offer the executive liquidity, and are subject to black out period and SEC rules, for example those against short swing profits and insider trading.

Often equity will be the largest component of C-level and senior executive compensation packages.  Executives are typically compensated based on performance, measured by multi-year financial/market-based company objectives.

Private company equity compensation

For private companies, equity compensation is often in the form of time-vested restricted stock and stock options, as well as performance-vested stock options.  Private companies in the pre-IPO stage often pay lower cash compensation because they are less well funded than the post-IPO company.  The gap is often made up in equity.

Executive equity compensation in a private company has the disadvantage of being illiquid. Yet, it can also hold important advantages that make joining a pre-IPO private company attractive.

One advantage of equity in a private pre-IPO company is valuation.  Because the stock is not traded and its value not yet set by the public market, the Board has some flexibility in valuation.  Typically, executives receiving common stock will receive a significant discount in valuation from the preferred shares issued to investors.  This discount would be confirmed in the IRC section 409A valuation.

The other advantage of equity in a private company is the chance for a large tax-favored gain. Often, the IPO will see a large increase in stock price.  Then, depending on equity structuring, equity issued by private companies offer greater potential for favorable capital gains tax treatment. This is especially so with restricted stock.

Transitioning to a public company 

In preparation for IPO, a private company will design a new executive pay program to meet government requirements and investors’ expectations. This is typically done by benchmarking with a peer group of public companies. During this transition, the private pre-IPO company, which often use restricted stock and stock options in executive pay, will gradually transition to paying executives performance-vested equity. As it is difficult to set multi-year performance goals for the newly-formed public company, the actual transition may take a few years after the IPO.

If significant equity had not been granted in the years prior to the IPO, or if most of the outstanding awards will be fully vested at the time of IPO, a special equity award or ‘founders grant’ is often given to executives at or near IPO. This boosts the equity holdings of senior executives to levels typical of a public company, and provides an incentive for executives to stay during the critical IPO period.

Key employees, employees who are asked to perform additional duties for a period of time related to the IPO, and employees of particular retention risk are likely to receive special targeted retention incentives or transaction incentives as well.  Once again, to achieve maximum tax favored benefit, restricted stock, often called founders shares, is desirable.

Negotiating your executive compensation in the pre-IPO company  

So, if your company is planning an IPO, what should you do to protect your interests?  Clearly as said above, you should seek a retention agreement with tax-favored equity to the extent possible.

How much should you be paid? You need to be aware of the executive compensation in peer companies.  But if this is not possible, then seeking a package not out of line with the company’s structure but at the same time commensurate with your value to the company and success of the IPO is a reasonable goal.  If you are instrumental to the success of the IPO or at least an important player in the company’s success and the team presented to investors, this should provide necessary leverage to achieve these needed terms.

How do you structure your equity compensation as the value of the stock increases? Earlier articles of mine discuss the structure of your equity as restricted stock or RSUs to allow the executive to realize the big run up in stock price associated with an IPO as a capital gain event rather than ordinary income.

Bonuses can also be a key part of executive compensation in public companies, and the private company pre-IPO may update your bonus structure. My earlier article on structuring executive bonuses may also be of benefit to you.

What other equity-related terms to seek before the IPO? Beware of clawback clauses in your executive employment agreement, but also seek pro-executive clawback clauses and acceleration terms on your C-level or senior executive equity package.  Because as said above, the benefits of the IPO can be so considerable, you want provisions that deliver you that benefit if you remain through to the IPO and also if you are terminated before but still did much to contribute to the company’s success.

Additional employment terms to consider post-IPO  

After an IPO, if your executive team is successful in creating shareholder value, your company may become an acquisitions target. Your executive employment agreement should have terms that protect your interest in this kind of change-of-control situation as well.  If your company is “in play” at some point after the IPO, you might wish to review my earlier articles on change of control agreements and retention agreements.

Structuring and negotiating executive compensation are complex matters and should be handled with care. It is wise to seek the advice of an experienced executive compensation attorney.


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Robert A. Adelson, Esq
Robert A. Adelson, Esq. is a corporate and tax attorney and partner at Engel & Schultz LLP, Boston, Massachusetts. He represents C-Level executives and key employees in negotiations over employment terms, equity, compensation, relocation, retention and separation agreements, severance packages, and where necessary suits over wrongful termination. Robert A. Adelson, Esq is an opinion columnist for the CEOWORLD magazine.
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