Setting up Startup Compensation

Planning Startup Compensation

by David Johnson
of Ernst & Young

As venture-backed and other private companies rapidly evolve through
the development lifecycle, they face unique challenges and
opportunities in their compensation design. And while some are looking
to an initial public offering as part of their strategy, they must also
think about the other potential pathways and the various compensation
strategies, which may be more flexible.

Additionally, boards of directors are becoming more focused on
developing compensation strategies with accounting and tax efficiency
in mind, as well as more fundamental objectives such as paying for
performance, retention of key talent and the like.

Design for longer horizon

While companies should be proactive and thinking about their
compensation programs throughout the entire lifecycle, the two years
leading up to going public, the “Red Zone,” mandates even closer
scrutiny of these programs. The convergence of FAS 123R, SEC disclosure
rules as well as special tax issues such as Internal Revenue Code
Sections 409A, 162m and 280G have resulted in compensation programs
requiring special attention in anticipation of an IPO.

We are in an era of increasing pressure on transparency to have
refined and well-articulated compensation strategies and philosophies.
Companies preparing to go public, or even those thinking about it as
part of their exit strategy, need to articulate their overall
compensation strategies. This should include the rationale for the pay
mix between short- and long-term incentives, the rationale for the mix
between cash and stock-based compensation, and the rationale for how
competitive pay is determined.

Cash vs. equity

Each year, Ernst & Young LLP—in conjunction with J. Robert Scott
Executive Search and WilmerHale—studies trends in executive
compensation in the IT and life sciences industries. The study shows
the strong correlation between executive compensation and a number of
variables, including financing stage, company size in terms of revenue
and head count, founder/non-founder status, product stage and geography.

Studies of startups in IT and life sciences have shown continued and
significant use of stock options with some use of restricted and common
stock grants.

The split between base salary and bonus and the role of equity-based
compensation takes on a more formal process as the company matures. As
the strategic and financial goals become clearer, there is more
discipline in the business plan, budgeting and thus the incentive bonus
process. Incentives then increasingly become based on objective,
pre-established performance goals.

Equity holdings for the founding CEO, president/COO often drop after
the first round of financing. With each successive round of financing,
their equity stake becomes more diluted, yet they are willing to accept
this dilution in hope of greater upside potential when the company does
its IPO or accomplishes whatever other exit strategy it has planned.
Additionally, the founding executives are often more willing to step
aside and allow experienced executives to take the company to the next
level in hopes that this will in turn lead to more value in their
equity stakes.

The use of equity-based compensation as a strategic component of the
overall pay mix generally includes an assessment of market competitive
practice from a qualitative and quantitative perspective position. In
other words, how much value should be transferred for a particular
executive or management position in the form of equity-based
compensation and what types of awards should be used (e.g., stock
options, restricted stock, stock appreciation rights) and what other
features or conditions should be built into the awards (e.g. vesting
conditions, liquidity provisions, valuation methodology)?

Equity-based programs should be designed with the flexibility that
will enable companies to use different types of awards, features and
conditions from year to year, as well as the ability to address special
issues. Companies should also forecast how many shares they will need
to issue down the road, including shares needed for compensation
programs in the first year or two after the IPO. To forecast, employers
have to estimate the run rate or burn rate and the life of the pool.

Before share usage can be estimated for future years, the
compensation strategy must be clear with regard to the following key
issues (among others):

  • How will the company determine competitive pay? Against which peer companies or other benchmarks?
  • What is the intended mix of pay between cash and equity, short-term vs. long-term incentives, fixed pay vs. variable pay?
  • How deep in the organization does the company wish to use equity as
    part of a recurring pay package and which employees might be eligible
    for one-time grants?
  • Will full value awards such as restricted stock be used or will appreciation rights or options be used?
  • What will the employee headcount look like and how much equity will
    be needed to allow awards for new hires and/or for sign-on grants for
    future executives?

Once award types are selected, vesting structures and other features
must be considered. Some shareholders/investors mandate performance
vesting or time vesting with a performance acceleration. Setting
meaningful targets can be difficult for early stage companies, but it
typically becomes easier as a company matures and performance can be
predicted more accurately.

Equity-based compensation can be a powerful component of a company’s
compensation strategy, but planning for such programs requires careful
consideration of current and future considerations.

Tax and accounting considerations

Now that FAS 123R, the revised standard for accounting for
share-based payments, has been implemented broadly, discussion is
ongoing as to the true cost and effectiveness of share-based
compensation, including alternative features and conditions to drive
financial efficiency and to bring better balance to all stakeholders.
Shareholders continue to seek a strong linkage between share-based
compensation programs and performance as well as controls against
excessive dilution.

From a governance perspective, the risks directly or indirectly
associated with share-based payments and FAS 123R can relate to such
processes as value and report share-based payments and ensuring
reasonable levels of dilution associated with share-based payments, as
well as risks associated with design features of programs that may be
in conflict with shareholder interests. Moreover, there may be
additional risk associated with proper tax accounting treatments as a
result of the wide array of complex tax rules affecting share-based
compensation.

The new rules have been a catalyst to a much broader strategic and
tactical review of share-based compensation as well as an increased
focus on technical compliance. While many companies have focused
heavily on general compensation program design and strategy, ongoing or
more intense review of accounting considerations and tax compliance and
efficiency should be strongly considered or revisited going forward.

From a tax perspective, emerging companies possibly planning an IPO
have other issues that are important to consider in terms of
compensation program planning. These include the $1 million
compensation deduction limitation under IRC Section 162(m) for top
officers of publicly traded companies, the potential application of
excise taxes and lost deductions for excess “Golden Parachute” payments
in a change of control under Section 280G of the Internal Revenue Code
or the possible adverse tax ramifications of violation of the new IRC
Section 409A rules affecting deferred compensation.

Deferred compensation programs in the U.S. take many forms,
including voluntary and involuntary deferral programs, share-based
compensation with deferral features (such as restricted stock units)
and supplemental retirement plans. IRC 409A also applies to stock
options that are determined to be issued at a discount, i.e. when the
strike price or exercise price is less than the fair market value of
the stock on the date of grant. In a private company situation, 409A
adds a new dimension of risk if an issuer of stock options can’t
establish that the options were issued at fair market value.

The tax and accounting considerations associated with compensation
program design are sometimes not carefully planned for. In light of the
growing focus on financial efficiency for compensation programs and the
ever-changing technical rules, compensation strategy development and
design should include careful consideration of the tax and financial
implications.
–By David Johnson, Ernst & Young

*******

David G. Johnson is a Principal in Ernst & Young’s Tax
Advisory/Performance & Reward practice in Cleveland, and is the
National Practice Leader in Compensation Strategy & Design.

This article provides general information, and each company’s
management should consult with their financial and tax advisors to
receive advice they can rely upon in moving forward with a plan
tailored to their company’s needs. The views expressed herein are those
of the author and do not necessarily reflect the views of Ernst &
Young.

 

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