In this issue, answers to:

• What are the executive compensation priorities when preparing for an IPO?
• What are some of the common considerations in developing peer groups for compensation benchmarking?
• What are the key agreements, plans and policies that should be in place?
• How do regulations of public companies affect the oversight of the executive
  compensation programs?

As the stock market indices have recovered, rising from their recession lows, the number of companies completing initial public offerings (IPOs) has also increased. Based on the number of companies that have completed or are planning for an IPO in the coming months, the number of US IPOs may return to pre-recession levels.

In preparing for an IPO, a review and modification of executive compensation programs should be a top agenda item. From both the compensation committee’s and management’s perspectives, it is important to ensure that compensation levels remain competitive in order to retain key staff and that governance and risk management protocols are followed to comply with regulations and avoid controversial practices. This Perspective explores five key areas of focus for organizations that are planning to launch an IPO.

Pay philosophy and levels

Executive compensation program design starts with an executive compensation philosophy. The philosophy sets the guidelines within which the executive compensation programs will be designed and will be disclosed in the IPO registration statement and subsequent annual proxy statements. Management will typically take the lead in developing a draft philosophy statement, which is reviewed, revised and approved by the compensation committee.

A comprehensive philosophy addresses key topics, which are identical to those that may have been considered by the company pre-IPO; however, it is common that the philosophy may not be formalized until the time of the IPO. A philosophy addresses the following areas:

• Attraction and retention
• Definition of the market for benchmarking
• Competitive pay positioning
• Elements of rewards
• Role of compensation elements
• Approach to paying for performance
• Definition of performance
• Mix of fixed versus variable pay
• Mix of short-term versus long-term pay
• Equity ownership levels
• Communication

Once the philosophy is set, a compensation peer group – typically ranging from 10 to 20 publicly traded companies – is selected for the evaluation of pay levels and programs. The two most common criteria used for selecting compensation peers are industry and company size.

Mercer’s typical approach is to target peer companies that are one-half to two times the company’s revenue, with an overall peer group median revenue near that of the company’s revenue. For companies that lack enough similarly sized industry peers, it may be necessary to look beyond the industry and find companies that share other characteristics, such as business model, brand strength and/or operational complexity. In fact, in the context of a potential IPO, it may be more appropriate to identify recent IPOs with similar business characteristics than to focus solely on companies with comparable revenue and a similar industry.

After the peer group has been established, compensation data and practices for both executives and nonemployee directors are gathered from proxies and surveys. Data are captured for the following pay elements:

The company’s current pay levels and types are then compared to the compensation data collected from the peer group and evaluated for market competitiveness. Mercer typically considers pay to be competitive if it is within +/-15% of the market target percentile.

As compared with a private company, there are three positions in a public company that tend to have higher levels of compensation, given the increased reporting and regulatory requirements, public attention, shareholder expectations and communications associated with these roles: the Chief Executive Officer (CEO), the Chief Financial Officer (CFO) and General Counsel. For this reason, at the time of an IPO, the board of directors should also consider whether the individuals filling those roles pre-IPO are appropriate to continue in those roles post-IPO. In determining appropriate pay levels, the compensation committee members should not only consider external competitive data from peer companies but also consider internal factors such as company performance, job structure, executive performance and experience.

Equity compensation

Equity compensation is a particularly important element of compensation in preparing for an IPO. The financial community and other investors look for executives with meaningful equity ownership and view equity compensation as a key way to align an executive’s interests with those of management.

Most companies award equity compensation to executives prior to an IPO. However, the practice varies significantly by industry, the level of pre-IPO equity grants, concerns about valuation of the company pre-IPO and accounting and tax issues regarding “cheap stock.” IPO awards are typically in the form of stock options, although mature companies with lower opportunities for growth and companies with high dividend payout ratios (for example, real estate investment trusts) tend to use restricted stock or performance shares.

Share dilution levels post-IPO from the equity incentive grants vary significantly by industry. Such differences are illustrated through a comparison of equity compensation dilution levels shortly after IPOs of internet-based and manufacturing companies:

Source: Mercer 2010 IPO research

Furthermore, post-IPO, the internet businesses’ CEOs had approximately $8 million worth of equity compensation outstanding, at median. In contrast, the manufacturing firms’ CEOs had approximately $5 million worth of equity outstanding.

For shares owned at the time of the IPO of the company, the underwriters will usually prevent them from being sold for 180 days post-IPO. This period is referred to as a “market standoff” or “lock up” and is used to allow the market enough time to fully absorb the newly issued shares. These lock-up provisions are commonly included in pre-IPO equity grant agreements or shareholder agreements.

Pay and performance

The alignment of pay and performance is a critical agenda item for all companies. The key factors that determine the degree of alignment are pay levels, pay mix, incentive measures and goals, and discretion. Many companies prefer to calibrate plans so that target level payouts are near market median levels and maximum payout levels are near or above the market 75th percentile levels. Nevertheless, the actual pay and performance alignment greatly depends on the performance measures and goals. Organizations should attempt to balance risk and reward and short- and long-term perspectives.

The selection of the right incentive plan performance measures is critical. Quarterly earnings per share will receive a lot of attention after the IPO; however, rewarding only for earnings without considering growth, margins and returns may not lead to sustainable value creation.

Typically, there are target, threshold and maximum incentive performance goals. Compensation committees should be confident that the performance goals warrant the corresponding payout levels and should understand the range of potential payouts and the incremental performance required to earn the payouts.

Agreements, plans and policies

Compensation agreements, plans and policies set the boundaries within which compensation programs operate; they are disclosed to investors and must comply with regulations covering publicly traded companies. Common documents include:

• Annual incentive plan – Some companies will want to have their annual incentive plans deemed “performance based” so that payouts do not count against the company’s annual compensation tax deduction limit of $1 million for the CEO and the three other highest-paid officers (other than the CFO). Although there are a number of requirements for a plan to qualify as performance-based, companies that disclose the material terms of their plans in their IPO registration statements will have temporary relief from the requirements until the earlier of the first regularly scheduled shareholder meeting that occurs more than three years after the IPO or the date on which the plan expires or is materially modified.

• Equity compensation plan – The plan under which equity compensation awards will be granted as a public company needs to comply with securities and tax laws and is often designed to be supported by proxy voting advisory firms. Although the number of shares reserved under equity plans varies, a typical reserve of available equity share awards would be within the range of 8% to 10% of shares outstanding. Stock ownership guidelines – Guidelines for executives and nonemployee directors are standard and often require them to retain all or a portion of their equity compensation and restrain from selling their shares until they reach certain levels of ownership.

• Employment, severance and change-in-control agreements – Companies continue to use these agreements to attract and retain executives. The key terms to consider when structuring severance protection are triggering events, amount of severance, treatment of equity awards and post-employment restrictions. Some recent changes a few companies have made include the removal of automatic renewals, a reduction of severance multiples and the removal of change-in-control tax gross-ups, as well as a general movement away from severance-protection contracts altogether.

• Insider trading and anti-hedging policies – The compensation committee should take an active role in the prevention of insider trading violations by company officers, directors, employees and other individuals by adopting an insider trading policy. Such policies prohibit transactions in company securities while an individual is in possession of material nonpublic information, and they also typically establish trading windows outside of which those who are covered are prohibited from certain transactions. Disclosures about a company’s hedging policies are a pending requirement under the Dodd-Frank Act.

• Clawback policy – CEOs and CFOs of public companies have been required to reimburse the company for bonuses and other incentive-based compensation paid and any profits on stock sales realized if the company is required to restate its financials due to material misconduct. Furthermore, the SEC will soon prohibit stock exchanges from listing any company that does not have a policy to recoup compensation from all executive officers after an accounting restatement caused by material noncompliance with any financial reporting requirement.

Regulatory compliance and governance

Numerous regulations cover executive compensation at public companies. Compensation committee members should understand the regulations, as part of the oversight of the executive compensation programs, through an initial and continuing education process.

One of the more significant regulatory requirements is compliance with the SEC’s executive compensation disclosure rules. The Compensation, Discussion and Analysis section discusses the compensation of the named executive officers, who generally include the CEO, the CFO and the three most highly paid executive officers. The requirements include a discussion of the compensation objectives, what programs are designed to reward, elements of compensation, why the elements are used, how the amount for each element is determined and how each element fits into the overall compensation objectives and affects decisions regarding other elements.

Several new requirements under the Dodd-Frank Act include:

• Say on pay – At least once every three years, companies must hold a shareholder vote on their executive compensation programs.

• Independence of compensation committee members – Exchanges will be prohibited from listing companies whose compensation committees do not consist entirely of independent directors.

• Independence of compensation committee advisers – Exchanges will require companies to consider “competitively neutral” factors when selecting advisers.

• Compensation consultant disclosures – Companies must disclose, in their proxy statements, whether the compensation committee hired a consultant and any conflicts of interest that may have posed.

• Additional disclosures – Companies will be required to disclose pay for performance, internal equity (this part of the act may be repealed), hedging and leadership structures.

• Other rules – Incentive pay at financial institutions is restricted, and shareholders will have great access to submit proposals for director nomination.

In addition, proper governance processes and procedures reduce the risks associated with executive compensation programs. A few of the typical governance items to have in place include:

• Compensation committee charter – This details the purpose, the organization and the responsibilities of the compensation committee. The charter should comply with any exchange-listing standards and be approved by the committee and the board of directors.

• Shareholder advisory services – Institutional investors use a proxy advisory firm to guide them on how to vote. If the executive compensation program doesn’t meet certain standards, the advisory firm may recommend against the say-on-pay vote or may recommend voting against the election of compensation committee members or even the full board.

• Compensation committee calendar – A calendar should be established covering all the responsibilities described in the committee charter.

• Nonemployee director compensation – Prior to the IPO, some companies may not have a formal director compensation program. As companies recruit new, nonemployee directors, having a formal program will be important.

• Risk assessment – Companies must annually identify any risks arising from compensation programs, policies and practices that are reasonably likely to have a materially adverse effect on the company.

Final thoughts

The IPO process is complex. The topic of executive compensation is personal to management and should be a matter of particular priority on an IPO checklist. Never before has there been more attention paid by investors, employees and regulators to executive compensation. It is important for compensation committees to have advisers who can provide the right data, knowledge and expertise. Such advice enables compensation committees and management to make informed decisions that minimize risk and drive results.