Radford Perspectives

Private Company Compensation

Discover the biggest compensation trends, issues and challenges facing in technology and life sciences private companies today.

 

Private companies in high-growth mode must juggle incentivizing employees and operating with greater oversight from investors.

The IPO market rebounded in 2017 and continues to perform well in 2018, however many companies are still taking their time to go public. We expect this trend to continue. Venture capitalists are hungry for good investments and private equity firms are also showing a thirst for growth investing. Last year, we saw many well-known and highly-valued private companies sit on the sidelines and delay life as a public company. The stock market has a decent appetite for newly public companies, but it also has strong requirements. Pre-IPO businesses want to make sure they have a strong growth trajectory before they expose themselves to the scrutiny of the public market.

Here we highlight some of the biggest HR and compensation trends we’re witnessing in the pre-IPO market. Some of these issues are a continuation of multi-year trends that private companies can’t ignore— such as a migration to value-based equity vehicles, while other issues are really emerging for the first time— such as the impact of the new United States tax bill.

Rethinking Rewards to Provide Immediate Value

Late-stage private companies are acting more and more like public companies in how they pay, but they still face a major obstacle: providing liquidity for employees. In response, many pre-IPO companies are investing in other rewards to offset this drawback, including an annual cash program, switching to a value-based approach to equity program design and investing more heavily in perquisites and their corporate culture.

While it can be challenging for private companies to rely too heavily on cash for their employee rewards, a majority of technology and life sciences companies in the Radford US Pre-IPO/Venture-Backed Survey say they have a formal bonus plan as shown in Figure A.

Figure A
Prevalence of Bonus Plans and Payouts at Pre-IPO Companies
 

  •   Technology
  •   Life Sciences
  Fomal bonus plan Percent of non-sales employees who typically receive a bonus
 

Source: Radford US Pre-IPO/Venture-Backed Survey Practices Report, November 2017

 

While it can be challenging for private companies to rely too heavily on cash for their employee rewards, a majority of technology and life sciences companies in the Radford US Pre-IPO/Venture-Backed Survey say they have a formal bonus plan.

For more information about when pre-IPO companies typically adopt a bonus plan in their lifecycle, read our article Tech Startups Embrace Bonus Plans but Design Features Change with Revenue Growth.

 

 

On the equity side of rewards, there's been an evolution in program design among private companies over the past three to five years. While stock options are still the equity vehicle of choice, restricted stock units (RSUs) are becoming a more viable alternative for companies and employees that may be worried about the inherent risk involved in stock options that only have value if the price goes up. This risk can be worrisome when the stock market is volatile and the current high expectations investors are placing on IPOs, particularly for unicorn companies. While certain vesting conditions need to be met before an employee can swap RSUs for stock or cash, they don’t have a strike price like options, which means RSUs will have some value regardless of price performance from date of grant.

Companies typically have to make cash or stock payments to employees as the RSUs vest and employees may incur a tax liability as a result, so we recommend companies design an RSU program with a time-based vesting schedule, but also include a liquidity requirement such as an IPO. For tax purposes, this is called "constructive receipt" upon a liquidity event, and allows the employee’s tax liability to be deferred until the stock is liquid.

Figure B shows the evolution of common equity vehicles through the different stages of companies. RSUs are an emerging equity practice among startups but are still typically combined with stock options.

Figure B
Equity Vehicle Choice is Heavily Influenced by Company Size

  Start-up Mid-cap/ Growth Market Mid-cap/ Mature Market Large-cap/ Mature Market  
Stock options only         Focuses on absolute stock price growth and future upside potential
Restricted stock or RSUs only         De-emphasizes stock price growth; supports employee retention and ownership, especially at slower growth companies
Option-restricted stock mix or RSUs         Combines stock price growth incentives with greater emphasis on employee retention and ownership
Performance shares         Allows companies to introduce specific performance-based contingencies into equity awards
Long-term cash         Requires maturity and cash reserves, and often the ability to select metrics/set goals over time
Relative TSR         Reflects institutional investor perspective (portfolio performance); maturity of market required for reliable comparator group/index

 

  •   Most common practice
  •   Emerging practice
  •   Least common practice

The US tax bill that was passed at the end of 2017 adds another wrinkle to companies’ equity programs. The legislation allows employees at private companies who receive stock options and stock-settled RSUs to defer recognition of taxable income for up to five years when they exercise those options or receive a stock settlement for RSUs. Previously, gains from exercised stock options and shares received upon settlement of RSUs were taxed as wages. This was a burden for employees because the shares aren’t typically liquid until the company is publicly traded. With companies taking longer to go public these days, this new tax provision can be seen as a big benefit for employees. It could also reduce the need for employees to sell their illiquid stock into a secondary market or grapple with expiring stock options if their employer has been private for a long time.

We should note there are certain requirements and stipulations with the provision. It only applies to companies that give equity to at least 80% of their workforce (which is common among technology and life sciences companies). Certain conditions under this new provision, such as the company going public, can trigger earlier taxation, and executives and certain high-earners are exempt from the tax benefit.

In the long run, this provision could prompt private companies to make more employees eligible for equity awards due to the 80% requirement, particularly organizations outside of the technology and life sciences sectors that may not have as broad of equity eligibility. It could also improve employee engagement as it eliminates certain tax burdens. To maximize this benefit, HR leaders should review their current approach. If the bill is expected to impact the company’s equity program, we recommend proactively communicating this change to all employees as some may not be aware.



Exit strategies

Exit Strategies: Preserving Culture and Getting Your House in Order

Every pre-IPO company thinks about their exit strategy— whether it’s going public and growing market share or being acquired by a larger competitor. High growth can present challenges for startups, and our clients are spending more time laying the groundwork to protect and preserve their unique culture while at the same time planning for their growth strategy.

Employees at pre-IPO companies tend to be attracted to specific aspects of the startup culture, including the time and autonomy to work on creative and innovative projects, fewer layers of bureaucracy to make decisions, less hierarchy in the organization and, thus, more rapid career advancement opportunities. In order to retain employees who enjoy this unique culture, many pre-IPO companies are protecting these features as they grow larger or get acquired. We’re seeing more acquirers allow startups to operate with greater autonomy and maintain certain features of their compensation program, including higher participation and target levels of equity awards.

Meanwhile, private companies that choose to go public (rather than get bought), need to plan early to ensure their compensation and governance structures will meet investors’ and proxy advisory firms’ expectations. Over the past two years, proxy advisors including Institutional Shareholder Services (ISS) are scrutinizing the governance structures at newly public companies and holding them, in many regards, to the same standards as more established public companies.

For example, two years ago ISS began recommending investors vote against directors at a company that went public with bylaws that the firm considers adverse to shareholders’ rights. These include a classified board, supermajority thresholds to amend the charter or bylaws, limitations on shareholders’ right to amend the charter or bylaws and dual-class voting shares.

Newly public companies still enjoy protection under the JOBS Act, but shouldn’t take for granted that once they meet certain thresholds, such as earning $1.07 billion or more in annual revenue, having a public float of $700 million or more or being public for five years, they are no longer under the umbrella of protection. That means they will be subject to certain proxy voting requirements like Say-on-Pay.

Want to dive deeper? Read our related paper
Is Your Company About to Graduate from the JOBS Act? Here’s Your Planning Checklist



Changes among private investors

Changes Among Private Investors

Private investors are paying attention to a growing body of research showing startups that have well-managed human capital perform better than those that lack support. As such, we're working with investor human capital teams at venture capital and private equity firms in support of their portfolio companies.

Each private investing firm is different in how involved they get with their portfolio companies. On one end of the spectrum, we're familiar with VC firms that create pay benchmarks for their companies and provide compensation tools across their portfolio. Other firms give the leadership at their portfolio companies full autonomy over HR decisions but ask frequent questions and provide a certain level of oversight that didn’t exist at such a wide level five years ago.

Private equity firms are getting in on the action too. PE firms are becoming more interested in investing in growth companies, particularly in the technology space. They are eager to learn more about how rewards should be structured competitively at their technology portfolio companies, yet we still see key compensation differences in startups funded by private equity vs. venture capital.

 

Equity Plan Differences at VC-Backed Companies vs. PE-Backed Companies

 

VC-Backed Equity Vehicle PE-Backed
93.7%

Stock options

 76.9%
11.3%

Restricted stock units

 30.8%
2.1%

Stock appreciation rights

 7.7%
1.4%

Long-term cash

 15.4%
85.5%

1 plan: Options only

 53.8%
7.1%

2 plans: Options + RSUs

 23.1%

 

Cash Premium at PE-Backed Companies Over VC-Backed Companies

 

 
  Base
Salary		 Cash
Bonus		 Target Total

CEO

18%

48%

36%

CFO

24%

3%

18%

Development
Engineering Executive

3%

10%

13%
 

Source: Radford US Pre-IPO/Venture-Backed Survey, July 2017

Note: Headcount is similar across all companies, ranging from 253 to 305
 

 

In general, VC-backed companies place a greater emphasis on equity and have higher participation and eligibility rates for long- and short-term incentives and new-hire awards. PE-backed companies emphasize cash bonuses over equity, higher salary ranges and have a greater mix in equity vehicles. Equity vesting schedules also vary, with awards at PE-owned firms generally subject to longer vesting periods.

In some ways, pre-IPO companies managed by VC firms tend to have compensation structures more in line with the broader technology and life sciences markets. However, as we outlined in this section, rewards in the pre-IPO market are evolving rapidly. The one constant that hasn’t changed is the need to create compelling rewards to compete for talent. And in the private market that typically means providing some level of liquidity and, above all, a compelling culture.

 
 

Meet Our Authors

Kelsey Owen
Associate Partner, Global Relationship Manager

Kyle Holm
Partner, Pre-IPO Practice Leader

Zack Rokos
Associate Director, Consulting

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The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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