Planning Startup Compensation


David Johnson of Ernst & Young wrote this piece for the Venture Capital Journal this fall. He examines compensation strategies for VC-backed companies–something to be ever-mindful of. –Alex

Planning Startup Compensation

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

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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.