After a recent slower period of activity in the initial public offering (IPO) markets, there has been speculation in accounting and finance markets that there might be an increase in activity over the course of the 2025 calendar year. Private companies considering a near- or mid-term IPO need to take a number of steps in their preparation for that undertaking, including review and development of an executive compensation program, which will help ensure that their IPO is successful and that their management team remains engaged prior to, in connection with, and after an IPO.
CONSIDERATIONS BEFORE AN IPO
During the period prior to an IPO, private companies often seek to incentivize employees through the grant of stock and stock-based equity awards. While this practice is frequently a successful means of incentivizing key employees and service providers, without sufficient preparation and consideration, the practice can raise the issue of whether pre-IPO awards represent “cheap stock.”
The granting of cheap stock awards can trigger a myriad of accounting, tax, and disclosure issues and tends to raise concerns with, and increased scrutiny from, the US Securities Exchange Commission (SEC) during the registration process. With equity being a popular form of compensation for many pre-IPO companies, the following are key considerations companies should take prior to the IPO:
- Work with outside advisors well in advance of the IPO process (especially in the 12-month period prior to the IPO) to understand the potential accounting, tax, and disclosure implications of cheap stock grants.
- Obtain frequent independent valuations with respect to the value of shares underlying all equity awards made during the pre-IPO period (with the valuations made contemporaneous to, or close in time to, the grant date of the equity awards).
- Ensure that there is a good corporate record of all grants of equity awards, including formal approvals by the company’s board and its consideration of outside independent valuation.
CONSIDERATIONS FOR THE IMPACT OF AN IPO
In the lead-up to an IPO, a company should consider the impacts that the IPO will have on existing executive arrangements generally and equity compensation considerations specifically. For example, it is common for an IPO not to be treated as a “change in control,” “change of control,” or “liquidity event” under its equity plan and the individual award agreements that govern private company equity awards. Many companies do not have other bonuses or arrangements with key executives that will become automatically payable in connection with an IPO.
It is advisable to review all outstanding equity awards and other executive compensation arrangements to ensure that executives have sufficient incentives to get to the IPO. If no arrangements will be automatically triggered, consider structuring bonuses or other arrangements to reward the executive team for getting the company through a successful IPO. It is not uncommon for members of the executive team to retain their own legal advisors to negotiate these arrangements and advise on market practices from the executives’ perspective. This review tends to be coupled with the proposals and considerations below to ensure that key employees and service providers will be incentivized for post-IPO success.
CONSIDERATIONS FOR MAINTAINING SUCCESS AFTER AN IPO
It is common for companies engaged in an IPO process to implement changes to enhance its executive compensation program. Four common actions taken include (1) adopting a new public company-style omnibus equity compensation plan (a PubCo Equity Plan); (2) granting equity awards upon the effective date of the IPO; (3) implementing new public company-style employment agreements that are consistent with prevailing market practice; and (4) considering the adoption of an Employee Stock Purchase Plan (ESPP).
- In our experience, nearly all companies adopt a new PubCo Equity Plan in connection with an IPO, and the adoption is nearly always in advance of an IPO to take advantage of private company approval before public stockholder approval is required post-IPO. A PubCo Equity Plan will have certain guardrails that are required for public company executive compensation equity grants and authorize a share pool for the PubCo Equity Plan to maintain grants for several years following the IPO. A PubCo Equity Plan may also include company-favorable provisions that are common for a company in the middle of an IPO, but are often viewed negatively by shareholder advisors for a more mature public company, including an evergreen provision (which automatically authorizes a certain number of shares be added to the PubCo Equity Plan annually); and a liberal share recycling provision (which adds back to the PubCo Equity Plan share pool shares of awards that are forfeited or used to satisfy exercise price payment or withholding tax obligations).
- It is also very common to set aside a portion of the initial PubCo Equity Plan share reserve to be used as grants for key executives effective on, or shortly following, the IPO to incentivize and retain these individuals. Companies going public often start with granting time-based awards, and later incorporate performance-based awards into their grant practices; however, size and type of awards used to make IPO grants can vary significantly. Companies should work with outside compensation consultants to tailor their awards to align with the needs and goals of the company and properly incentivize their C-suite team.
- Companies almost always enter into new employment agreements with certain employees and executive officers tailored to each individual’s position and/or responsibilities at the company. It is common practice for companies to formalize executive arrangements just before an IPO goes into effect. This helps ensure that the company’s intended IPO terms are implemented properly on the effective date and makes executives fully aware of their responsibilities post-IPO.
- Companies also consider adopting an ESPP, which allows eligible employees to purchase shares of the company’s common stock at periodic rates through after-tax payroll deductions accumulated under the ESPP. An ESPP is generally offered to a broader set of employees than a PubCo Equity Plan, and so many companies consider adoption of an ESPP concurrent with, but prior to, an IPO to ensure that all employees are incentivized for success.
If the market rebounds in 2025 as reporters and accountants predict, companies should keep in mind executive compensation in their IPO preparations.
If you have any questions about the information addressed in this post, or any other questions relating to the executive compensation considerations in connection with an IPO, please contact the authors or your usual Morgan Lewis contacts.