Building leadership and employee engagement during an IPO with incentive awards

People and leadership play a critical role in the success of any IPO. Keeping them motivated and committed through IPO-linked compensation is therefore essential. Wael Hafez from Aon outlines the types of incentives companies can use, how they function, and what they mean in practice.

IPO-linked awards are specialized equity incentives designed to align the interests of employees with the company’s goals as it prepares for an Initial Public Offering (IPO). These awards motivate employees to contribute to the company’s success, particularly during the critical period leading up to the IPO.

IPO-linked awards can take various forms, each offering unique benefits and challenges. Common incentive vehicles include stock options, Restricted Stock Units (RSUs), performance shares, phantom stock, and stock appreciation rights (SARs).

Each of these vehicles serves to motivate employees by tying their potential financial rewards to the company’s performance and success in the public market, ultimately ensuring that employees are invested in the overall growth and prosperity of the organization.

Selecting the Right Incentive Vehicle

Selecting the right incentive vehicle for IPO-linked awards is crucial for aligning employee interests with company goals and ensuring effective talent retention. Here’s some considerations on how to choose the appropriate incentive vehicle:

• Alignment with Goals: The chosen vehicle should align with the company’s strategic objectives, particularly the goals related to the IPO, such as driving performance and increasing shareholder value.
• Evaluate Dilution Impact: Assess how each vehicle will impact the overall equity pool and shareholder dilution. Vehicles that require issuing new shares (like stock options) may dilute existing shareholders more than RSUs.
• Time-based vs. performance-based vesting: Decide on vesting schedules that promote long-term retention. Performance-based vesting can tie rewards to the success of the IPO and subsequent company performance.

• Ease of Administration: Consider the administrative burden associated with each vehicle. RSUs are simpler to manage compared to stock options, which require tracking exercise prices and potential admin implications.
• Understand Employee Preferences: Gain insight into what employees value most—cash bonuses, equity ownership, or a mix of both.

Reasons cash-based awards should be avoided

While cash-based awards are still prevalent in the GCC region, their drawbacks can hinder long-term employee motivation and alignment with company success. Shifting towards equity-based compensation may promote more sustainable growth and stronger connections between employee performance and shareholder value.

Here are some reasons why cash-based awards for IPO-linked compensation might be avoided:

Sizing the Equity Pool before the IPO

The equity pool is a reserve of shares allocated to employee incentives. In GCC, companies typically set aside a percentage of total shares outstanding (commonly between 0.5% to 2.5%) for this purpose.

Right sizing the equity pool is crucial as it plays a significant role in compensation strategy. Several macro factors influence this decision, including governance requirements, industry-specific equity practices, and market data from comparable companies undergoing IPOs. Key considerations encompass overhang, dilution, and any provisions for share refreshment.

Overhang refers to the potential dilution for existing shareholders if all outstanding options and awards are exercised. It’s calculated by comparing the total shares reserved for equity compensation to the total shares outstanding. A high overhang can adversely affect a company’s valuation due to investor concerns over future dilution and its impact on earnings per share.

On a micro level, companies must assess their current and projected headcount, IPO economics, historical equity practices, future needs, and their overall compensation philosophy regarding equity usage.

Additionally, companies should plan for future grants through evergreen provisions, which allow for refreshing the equity pool annually by a fixed percentage, which is typically for a decade, without requiring shareholder approval. This flexibility helps maintain competitive compensation practices in the market.

Allocation of the Award Pool

The allocation of an award pool typically follows a structured approach to ensure fairness, motivation, and alignment with company goals. The size of the awards should reflect the employee’s role, contribution, and potential impact on the company’s IPO success. Key positions may guarantee larger awards to ensure retention and motivation. Here’s a high-level overview of the approach towards allocation:

• Level of impact on IPO success: Consider the level of employee’s impact on the successful completion of IPO to recognize the significant roles individuals play in this critical process.
• Market Benchmarking: Analyze industry standards and peer company practices to ensure competitive compensation packages that attract and retain talent.
• Employee Role and Contributions: Consider individual contributions and achievements, allowing for differentiation based on performance and impact.
• Length of service with the company: Recognizing length of service in award allocation highlights the value of loyalty and commitment, rewarding employees who have dedicated years to the organization.
• Internal equity considerations: consider internal equity as a criterion for award allocation fosters a sense of fairness and transparency within the organization.
• Flexibility: Be prepared to adjust the allocation strategy based on company performance, market conditions, and employee feedback.

Strategies to mitigate risk of mass departures

To mitigate the risk of mass departures following vesting of IPO-linked awards, companies can implement several strategies, including:

Converting Shares into Tradable Shares

When a company assigns shares to employees as incentive awards contingent upon the successful completion of an IPO, the process of converting those shares into tradable shares involves several key steps. Here’s how this typically works:

Vesting of Awards

• Timing: Upon the successful IPO, the granted shares (or RSUs) typically vest. This means that employees officially gain ownership of the shares according to the terms set forth in the incentive plan.
• Process: For RSUs, once the IPO is completed, the company issues the shares to the employees’ brokerage accounts or directly to them. For stock options, employees may exercise their options to purchase shares at the predetermined strike price, after which they own the shares.

Issuance of Shares

• From Treasury to Outstanding: The shares that were previously held in the company’s treasury or reserved for issuance are reclassified as issued and outstanding shares.
• Transfer of Ownership: Once the shares are vested, they are transferred to the employees, who now own them outright.

Brokerage Accounts

• Custodial Services: Employees typically hold their shares in brokerage accounts. After the IPO, they can easily sell their shares on the open market.
• Liquidity: The IPO provides liquidity, enabling employees to sell shares they own, realizing the value of their equity awards.

Post-IPO Lock-Up Periods

• Restrictions on Selling: After the IPO, there may be a lock-up period (usually 90 to 180 days) during which employees are restricted from selling their shares. This is designed to stabilize the stock price post-IPO.

In summary, employees can receive shares as incentive awards contingent upon the successful completion of an IPO. Upon this event, these shares are converted into tradable shares through a structured process of vesting and issuance. After the IPO, employees can sell their shares in the public market, though they may face initial restrictions during lock-up periods.

Accounting Impact

Managing the accounting for IPO-linked awards requires careful consideration of timing, classification, and disclosure, as these factors can significantly impact a company’s financial statements and investor relations.

Conclusion

IPO-linked employee awards are a strategic tool for companies preparing for an IPO. By aligning employee incentives with the company’s public offering goals, organizations can foster a motivated workforce ready to contribute to the company’s success.

Careful planning, clear communication, and adherence to local regulations will be key to implementing effective equity incentive plans that drive meaningful engagement and retention during this critical transition period.