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Getting Ahead of the Market Compensation Issues for Pre-IPO Companies

July 30, 2009
A semblance of stock market stability and renewed optimism could lead more small private companies to consider going public. But these days they’ll need more than just a good story to tell investors, who remain relatively risk-averse. They’ll need to demonstrate organizational maturity and viability, particularly in retaining and motivating key employees.

When preparing for a public offering, therefore, companies should review their compensation programs to ensure they are consistent with public-company norms and practices. What works in a small, private company with limited staff is not likely to work in a midsize public company with hundreds of employees.

As an example of how pay is changing, a recent study by Presidio Pay Advisors revealed that compensation for founder CEOs in companies that went public in 2008 now more closely matches that of established public companies.

However, their pay mix has shifted. The study found median salaries are up by 24 percent from 2005 levels, while cash bonuses have fallen by 25 percent, leaving total cash compensation basically unchanged. Median founder CEO equity stakes dropped to 3 percent of shares outstanding at IPO, down significantly from more than 10 percent in 2002. Median nonfounder CEO equity stakes stayed consistent at around 1 percent of shares outstanding, according to Presidio Pay’s study.

These changes appear to be a result of a two- to three-year increase in the time between the founding of the business and the filing of an IPO. In addition, revenues, market capitalization and net income for companies going public are at their highest levels in years. Now more than ever when preparing for a public offering, companies need to ensure their compensation programs are consistent with public-company standards. Here are some key compensation issues companies should consider when planning to go public.

Base salary programs
Base salaries are the largest element of compensation for most employees and are a significant fixed expense for companies. Startup and early-stage companies typically have informal compensation practices. Salaries are based on what’s needed to recruit new hires, input from recruiters and personal experiences of managers and human resources staff. Salary increases are often informal as well, based on each manager’s assessment of employee performance with limited cross-company review.

An informal approach can work for small companies where most or all employees and managers know one another. As companies grow, however, more formal tools and processes for managing salaries are helpful and may be looked upon favorably by lenders and investors. Once companies have 100 to 200 employees, it’s usually time to develop and implement more formalized salary management practices. This will help ensure both internal equity and external competitiveness.

There are three basic tools that assist both HR staff and line managers with base salary management: salary structures, job families and salary increase matrices.

Salary structures: A salary structure is a combination of different salary ranges, each with a minimum, midpoint and maximum. A typical salary structure has 10 to 15 grades, with midpoints 10 to 20 percent greater for higher grades. The spread between the minimum and maximum of the salary range is narrower for lower grades (typically 35 to 50 percent) and increases in width for higher grades.

The lower third of a range is for employees new in their positions who are still mastering job skills. Pay in the middle third of the range is for employees fully proficient at their jobs. Pay in the upper third is for highly skilled employees consistently performing above standards for their positions. Salary midpoints are pegged to competitive market pay data gathered from published surveys of comparable positions in other companies.

By targeting salaries around salary-range midpoints for fully qualified employees, companies will deliver competitive pay. Assigning jobs with similar market rates to the same salary grade helps ensure internal equity. Salary ranges help managers set salaries for offers to new hires and minimize potential conflicts between newly hired employees earning significantly more than existing employees doing comparable work. They also help management identify employees who may be in the wrong position or eligible for a promotion.

Job families: These are collections of positions in the same functional area with increasing levels of skills and responsibilities (e.g., associate financial analyst, financial analyst and senior financial analyst). Outlining the career path for a job family helps both companies and employees understand the differences between position levels and the experience required for each level. Job families help improve the accuracy of job matching and assessing competitive pay levels. Job families should map into salary structures so pay opportunities increase as employees are promoted.

Salary increase matrices: A two-dimensional salary increase matrix is composed of performance levels (e.g., meets expectations, exceeds expectations, etc.) on one axis and position in salary range (e.g., lower third, middle third, upper third) on the second axis, with targeted salary increases in the grid. High performers paid low in range should receive the largest salary increases, while lower-level performers already paid at or above midpoint should receive smaller increases or no increases. This helps allocate salary increases to those employees who are most deserving and withhold increases from those already well-paid for their contributions.

Annual incentives
Small private companies often have informal, discretionary bonus plans that lack clear performance criteria, funding mechanisms or targeted levels of awards. As companies grow, more formalized plans can increase the effectiveness of incentive pay. Well-designed annual incentive plans link participants’ pay to the successful achievement of goals important to company success. They also incorporate targeted incentives with base salaries so that pay mix and total cash compensation levels can be assessed.

Effective incentive plans need performance criteria that drive shareholder value and are within the line of sight or control of participants. Common performance measures for plans covering executives and senior managers include earnings per share, earnings per share growth, net income, operating income, return on equity or return on assets. Performance targets need to balance achievability with a fair return to shareholders. Performance thresholds should eliminate incentives for low levels of performance. To reward exceptional performance, plans should provide the opportunity to earn incentives above target levels.

Equity compensation
Employees at early-stage startups and high-growth private companies can benefit by receiving equity compensation at low valuations because companies that successfully go public can expect significant increases in their valuations. Equity compensation allows employees to share in this value creation. Of course, employees must understand that there is risk. Many startup companies do not succeed and even successful companies may be unable to go public when markets go south.

Equity grants help conserve scarce cash and link the interests of investors and employees, which is why potential investors in IPOs want to see that key employees and executives have an ownership stake in the company and have an incentive to increase its value. It’s important, however, for key employees to have some unvested equity stakes so they must stay with the company for at least a year or two after the IPO and cannot just “take the money and run.” This reinforces the idea that an IPO is not about going public; it’s about being public.

A key issue for investors, whether in private or public companies, is the dilution of their ownership stake that results from equity grants. The challenge is to balance shareholder concerns about dilution with the need to motivate and retain key employees. Prior to going public, companies should get authorization for enough shares to cover projected grants for the two or three years that follow the IPO. As a rule of thumb, potential dilution from shares granted, plus those remaining for grant (also called overhang), should be between 10 and 20 percent of outstanding shares. That’s typically viewed as reasonable.

Preparing to go public is a major undertaking, and it may be tempting to view compensation as a low-priority concern. But getting compensation programs right will benefit all parties. There are tools available to help human resources staff (including some free downloads here). Getting started well in advance of an IPO makes the process more manageable and helps companies implement any necessary changes while still private.