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.
Dan you say that only a portion of the shares are sold at IPO. Does this portion include all the shares that have been awarded to all the employees? Or just the top management group?
Posted by: Jacque Vilet | 10/08/2014 at 10:35 AM
Jacque,
Great question. The shares sold at the time of the IPO are usually reserved to those held by outside investors, founders and a portion of what is held by executives (most of their shares are required to be held after the IPO). Sometimes former employees who hold actual shares will be allowed to participate.
Shares must be registered with the SEC (or eligible for an exemption to registration) in order to be sold after the IPO. Most of the shares offered are registered using a S-1 filing. Shares from employee plans are registered using a S-8 filing (a bit less onerous). Shares may also be subject to rules like 144 (defines post purchase holding periods) or 701 (an exemption from registration for certain pre-IPO shares associated with employee stock plans) that cover the issuance of shares that are issued prior to the SEC filings (pre-IPO shares).
The shares that are awarded to employees through approved employee stock plans are filed using an S-8. (https://www.sec.gov/about/forms/forms-8.pdf) Once properly registered ior exempted they can be traded publicly.
In most cases shares that are not allowed to participate in the actual IPO offering are subject to a 180 day, post-IPO lock up period. This adds additional risk and mystery to the value of employee equity. Will the IPO price be the highest price for years? Will the IPO spark a feeding frenzy that drives the price higher and higher? Allowing the employee to reap greater gains down the road> Will the stock price lep for a few days or a week then drop to a level lower that than IPO price?
Like the end of an old Batman episode, there are as many questions at the time of IPO as there are answers. A smart person once explained it this way. All the work to get to the IPO is like and athlete or student working to be a start in college. Once they are hired or drafted the REAL work begins.
Posted by: Dan Walter | 10/08/2014 at 12:25 PM
Dan: It would probably be useful for our readers to know that the underlying purpose of the IPO is that it is the exit strategy of/for the angels, VCs and mezzanine funders, and that it is also the way to get the company into a (theoretically) more sustainable capital structure.
I think it's also worth pointing out that, ceteris paribus, one will be in the same economic position before and after a forward or reverse split.
Posted by: Tony Bergmann-Porter | 10/08/2014 at 09:01 PM
Great point Tony. Thanks for the addition.
IPOs may not always be the "exit strategy" for many companies, even when they its an aspiration.
I find that even though values remain constant before and after a split people often feel like they have lost or gained something. It can be hard when you work at a company that has given you 10,000 stock option shares at $0.20 per share strike price to find out that, as a result of the IPO, the really have 500 stock options shares at a price of $4.00.
With an IPO price of $20 this would give the employee $8,000 (500 shares, with a gain of $16 per share) in compensation if they did a same day sale.
The participant is likely to have been calculating a potential windfall of $158,000 (10,000 shares with a gain of $15.80 per share).
As always, communication is critical, but first someone must understand this potential.
Posted by: Dan Walter | 10/09/2014 at 03:53 PM