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The Secret Life of Equity Compensation at IPO

The IPO market has remained strong for a while now. Equity compensation is a huge part of compensation at IPO. Yet, for all the publicity stock-based compensation receives, it is still mostly a mystery to those involved. Most of us know that an Initial Public Offering is a way to get your company's stock into the hands of outside investors. But, how does this process impact equity compensation?

This is a bit simplistic, but for many it will be eye opening.

Many people don't realize that a company sells only a portion of its outstanding stock into the public market. Sometimes this portion isn’t even a majority of all of the stock held. Founders and early investors will include some or all of their shares in the offering. Much of the stock held by founders and insiders prior to the IPO will remain in their possession for months, years or longer.

The shares that are offered for sale must be priced with two considerations. First, the bankers and company must determine the total value of the company and the value of the shares that will be sold in the IPO. This is the expected value of the IPO to the company and its investors (and bankers). Second, the price per share is then determined by dividing the expected value by a reasonable IPO offering price. For most companies (not the outliers like Facebook), the IPO price will be between $12 and $15 per share.

All of that seems obvious to those who watch the IPO markets. So, how does this impact stock options, restricted stock units, employee stock purchase plans and other equity compensation?

It is important to note that most companies perform some sort of reverse stock split just prior to their IPO. This means the number of shares outstanding will go down. In some cases, privately-held companies may have billions of shares outstanding prior to their IPO and will need to do a reverse split of 1:10 or far more to get the number of shares to a level where the per share value equals the IPO price.  When the number of shares goes down, the relative exercise price goes up.

Those stock options with an exercise price of a penny or two may end up having a strike price of several dollars. RSU awards with hundreds of thousands of units may end up being just a few thousand. This can surprise participants who are doing back of the envelope calculations and planning on retiring to their new yacht when the final value of their grants may only be enough for a down payment on a mid-priced car.

In addition to the reverse split and IPO pricing adjustments, many companies have preferred stock that converts to common at unusual ratios. All of this can make it nearly impossible for an employee (or compensation professional) to accurately predict the potential value of equity compensation. Add this confusion the simple fact that these calculations will be different for nearly every company.

As the IPO market continues to power forward, you need to start planning at least 12 months ahead of your hopeful IPO date. For some companies, this means dialing back equity usage and preparing for the inevitability of newly minted millionaires leaving the company. For other companies, it means adjusting compensation philosophy to prepare for a talent battle of post-IPO proportions. It may also mean communicating that “thousandaire” is still a pretty good goal.

While an IPO is a great thing for most companies that achieve it, it may not always mean something spectacular for employees. It is important to fully understand your company’s capitalization table, and potential IPO value and the impact it will have on grant sizes and values.

With a goal of keeping this to a reasonable length for the Compensation Café, I will wrap it up for now. Please feel free to join in the discussion in the comments and I will expand and provide details where it makes sense. I can always make this a multi-part series if the interest warrants it.

Dan Walter is the President and CEO of Performensation a firm committed to aligning pay with corporate strategy and culture. If you appreciate Dan’s thoughts on compensation you might want to get a copy of the new book from 3/8ths of the Compensation Cafe: “Everything You Do in COMPENSATION IS COMMUNICATION.”Written by Ann Bares, Margaret O’Hanlon and Dan Walter. Dan has also co-authored of several other books including “The Decision Makers Guide to Equity Compensation”“If I’d Only Known That”“GEOnomics 2011”and “Equity Alternatives.” Connect with him on LinkedIn or follow him on Twitter at @Performensation and @SayOnPay.

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