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Preparing for an IPO – Compensating Your New Directors

June 16, 2014

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One of the many challenges facing technology companies as they prepare for an initial public offering involves the composition of their Board of Directors. As an initial matter, companies need to ensure that they have a majority of independent directors to serve on the Board and staff the key Board committees. At the same time, it is not uncommon for the representatives of the company’s initial investors to rotate off the Board to focus their attention on other portfolio companies. As a result, it is often necessary to recruit one or more new directors. Typically, venture-backed companies pay no compensation to Board members who are representatives of the company’s investors while in the early stage of their development. It is the norm, however, to provide a small equity stake – usually in the form of a stock option – to any “outside” or independent director who joins the Board during the company's early to mid-stages. As these companies seek to add new independent directors in the run-up to an IPO, they often use “transition” equity awards and a modicum of cash compensation – usually in the form of an annual retainer – as a way to recruit experienced individuals to serve on the Board.

In our experience, the decision of how much equity to award new directors is largely dependent on the anticipated value of the company upon the IPO and the timing of when the individual joins the Board. With these considerations in mind, we reviewed approximately 100 technology company IPOs during the 2011–2013 period to identify equity award trends for new directors.

This Thoughtful Pay Alert summarizes the results of our examination of these trends.

Competitive Equity Positions for Pre-IPO Companies

The size of the equity award (measured as a percentage of a company’s fully-diluted shares outstanding) tends to decrease as the company moves closer to its IPO. In practical terms, this isn’t surprising, as the number of shares needed to deliver a meaningful award should go down as the value of the company’s equity securities increase and its risk profile changes.

Data from pre-IPO technology companies at various stages of maturity show director ownership levels ranging between 0.21% to 0.69% of fully-diluted shares outstanding for early-stage companies down to 0.19% to 0.31% of fully-diluted shares outstanding for late-stage companies, with, in the case of the latter, a median director ownership level of 0.24%.

Board Members Total Equity Holding

Equity Awards Immediately Preceding IPO

Among recent technology company IPOs, the trends are more revealing. For the period from 2011 through 2013, we evaluated the director compensation decisions of 106 technology companies that went public during that period. Of this group:

  • 72 companies (68%) granted equity awards to new directors who joined the Board during the 12-month period immediately preceding the IPO.
  • Of the 34 companies that did not make any awards:
    – 19 companies (18%) either did not add any new directors during this period or did not make any equity awards to their newly-recruited directors, and
    – 15 companies (14%) postponed compensating their new directors (as well as existing directors) until the adoption of a formal director compensation program either in connection with or following their IPO.

For comparative purposes, it is customary to evaluate these awards in terms of their dilutive effect (rather than their value) since the “percentage of the company” metric is most familiar to investors, and most pre-IPO equity award values are highly speculative. On this basis, of the companies that made an equity award to one or more new directors who joined the Board during the 12-month period preceding their IPO, these awards (measured as a percentage of the shares outstanding) ranged from 0.002% to 0.44% of the shares outstanding, with a median award of 0.13%. Specific percentiles were as shown in the chart below.

Director Equity Grants Immediately Before IPO (% of Co)

Characteristics of Most-Recent (2013) Pre-IPO Equity Awards

In determining the desired equity position for new directors, it’s useful to understand what technology companies have done most recently in terms of pre-IPO awards. Overall, our research shows that, in the case of the 35 technology companies that went public during 2013, 28 companies (80%) made an equity award to one or more new directors who joined the Board during the 12-month period preceding the IPO. These awards (once again measured as a percentage of the shares outstanding) ranged from 0.02% to 0.44% of the shares outstanding, with a median award of 0.17%. Specific percentiles were as shown on the chart below.

Director Equity Grants Immediately Before IPO – 2013 IPOs (% of Co)

Form of Award

In addition, we note that 90% of the companies granting pre-IPO equity awards in 2013 to their new directors made the awards in the form of a stock option to purchase shares of the company’s common stock, with the remaining awards made either as a restricted stock unit award (two companies) or a fully-vested stock award (one company). The high prevalence of stock options is attributable to both tradition and the favorable tax treatment available to the director-recipients.

Need Assistance?

Compensia has extensive experience in helping technology and life sciences companies prepare for their initial public offering of equity securities and transition their executive compensation program to that of a publicly-traded company. If you have any questions on the subjects addressed in this Thoughtful Pay Alert or would like assistance, please contact us.

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