The initial public offering (IPO) market has exhibited a dramatic resurgence in the past year, and the momentum continues unabated. IPO Monitor reports a parade of over 120 companies going public during 2010, up almost 300% from 2009, with the average company raising $100MM in equity per transaction.
Recently, I attended a board meeting for a company that had just completed an IPO where a number of compensation questions could be gleaned from the directors’ comments. Although this organization had addressed many compensation matters with an eye towards the new governance standards and disclosure requirements for a public company, they had not addressed the strategic compensation challenges that are inherent in the evolution to public-company status.
As part of this transition and growth process, it is important for companies to resolve the following three critical tension points:
1. Pressure to bring cash compensation closer to market
Going public eliminates the uncertainty regarding the company’s valuation of its stock incentives. At the same time, being public makes employees more visible from a recruitment standpoint, and may reduce the effective retention value of stock incentives, given the more liquid market for cashing out, along with the perceived moderation in stock price growth.
To retain both proven employees, and attract experienced employees to fill talent gaps, companies typically must increase cash compensation to more competitive market levels. Additionally, discrepancies may exist internally depending on when employees were hired. Often, the pre-IPO compensation structure has been designed to attract and retain a small group of core employees and does not address internal pay inconsistencies. As such, many companies find that a general market adjustment to cash pay levels (salary plus any bonus opportunity) must be made to the overall pay structure. As a result, in the post-IPO phase, establishing internal equity in the pay structure is more critical to future success than the pay chaos that occurs when the focus is solely on getting new candidates in the door as quickly as possible.
2. Pressure to tone down equity incentive grant levels
Up until the IPO, many pre-IPO companies typically rely on the upside promise of equity incentives, while making grants throughout the organization to all employees. Having completed the IPO, equity may offer a less compelling recruitment tool on an ongoing basis, as the “pop” associated with the going public has already occurred.
Options granted post-IPO, especially if there has been a run up in the market price, may have less wealth accumulation potential than the pre-IPO stock. Additionally, a post-IPO company cannot continue to grant options at the pre-IPO rate or it will have serious burn-rate issues. As a result, boards must begin to migrate to a more balanced total rewards package.
3. Pressure to differentiate more critically based on employees’ performance
Along with a change in the ownership of the company come changes in the leadership structure and responsibilities for many employees. Additionally, whereas all employees may have been considered top performers prior to the IPO, the substantial growth of the organization requires more accountability and employee feedback processes to ensure that the organization is spending scarce resources wisely on its employees. Equity incentives may now be granted more selectively based on an assessment of both performance and potential. More importantly, post-IPO companies need to structure employee feedback processes that hone staff development, and ensure that critical talent requirements not go unfulfilled.
What actions should be taken next?
To resolve these dilemmas, each company should revisit and if necessary revise its overarching compensation philosophy on a go-forward basis, given the changes inherent in becoming publicly-owned. The compensation philosophy sets the framework for the compensation program and articulates the linkage to business strategy.
A compensation philosophy should address the following areas:
- Competitive peer group(s) for talent: Note that some companies may have different talent set for different strategic populations. What is the appropriate peer group for benchmarking pay given the broader talent pool that may now be required to achieve ambitious growth objectives?
- Role and mix of each pay component: Salary typically becomes more important for a post-IPO company to attract and retain talent. Additionally, a formal cash bonus plan is typically established to more directly communicate expectations and accountability for executing the business model. Equity remains important, but typically evolves into ongoing management and administration, rather than one-time grants associated with a new hire or promotion during the pre-IPO stage.
- Performance measures that encourage accountability: What is the proper balance between short-term and long-term metrics and results? How should performance targets be set?
- Equity plans: Do existing plans offer sufficient share availability going forward? Given their post-IPO wealth, how will management be retained and incented to realize the growth expectations implied in the share price? What equity programs best balance retention and pay-for-performance going forward?
Likewise, by articulating the necessary framework for the company’s compensation philosophy, a company can lay the foundation for effective ongoing governance. An important part of that ongoing governance will involve defining a process for how decisions get made by establishing an effective dialog between management, the board, and external stakeholders, thereby ensuring a seamless transition to public ownership.
Ronald R. Bottano is a vice president at Farient Advisors, LLC, an independent executive compensation and performance advisory firm. He is responsible for advising the firm’s clients on performance measurement and compensation strategy, with the ultimate goal of aligning reward programs with the creation of shareholder value. He also oversees the firm’s leading edge research into proprietary analytical methodologies that ensure client’s executive pay decisions are defensible, timely, and transparent to all stakeholders.