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Equity compensation: 4 hard truths you need to know

Equity-based compensation — Northern California’s universal answer to engendering loyalty in employees — is a useful tool but a complicated one. This was one of several hard truths heard by attendees during BayBio’s recent Lunch & Learn event by RoseRyan. Accompanied by compensation consultancy Radford, RoseRyan hosted this packed event on February 26 at BayBio’s headquarters in San Francisco.

To retain top talent these days, companies have a variety of stock-based methods, which are accompanied by their share of accounting, tax, and legal issues. What strategy a company picks today for rewarding employees could affect how smoothly it can transition to another version of itself later on, either as a public entity or as an acquisition target.

During their comprehensive overview of what private companies need to realize as they structure and maintain their comp plans, Kelley Wall, a director at RoseRyan who leads the firm’s Technical Accounting Group, and Kyle Holm, an associate partner at Radford, hit upon the following hard truths.

1. Your company will have to up the ante as it matures.
Startups tend to begin with just stock options and then work their way up to restricted stock or restricted stock units and eventually performance-based awards. Each compensation type comes with its own set of pros and cons. For example, stock options do not lead to immediate dilution whereas restricted stock does. Employees may favor restricted stock for the fact it will give them ownership right away, but tax consequences upon vesting can be troublesome.

And while performance awards encourage goal-based behavior, they are not without their challenges. With these type of awards, companies have to regularly determine the probability of employees meeting their performance targets and adjust their stock-compensation expense accordingly, which can create some volatility in earnings. And it may be difficult for early-stage companies to adequately assess performance targets — any modifications of those targets down the road will result in modification accounting and likely additional compensation expense.

2. Modifications can be messy.
Modifications will happen. The roles of employees change, employees come and go, and employees’ individual targets for reaping the benefits of a pay plan will evolve. And so will the way the company accounts for compensation. Situations where accounting changes come into play include: giving a terminated employee an extended period to exercise their options beyond what was initially agreed upon; changing performance-based metrics; and hiring consultants and allowing them to continue to hold the stock options they were granted as consultants. In general, any change to an award or an award holder’s status should trigger a review of accounting modifications.

3. Your payment systems are only as accurate as the data you’ve put into them.
Wall acknowledged this truth seems fairly obvious but cautioned that lack of data integrity continues to trip up companies. Too often companies lean too heavily on outside lawyers and accountants without realizing those service providers can’t keep up with changes within a business if they don’t know about them.

The fact is the majority of stock-based compensation data has some underlying issues. For instance, RoseRyan has seen a company with vesting stock options for employees who left five years ago — which led to an overstatement when the information was uncovered. To make sure the data surrounding their equity plans are clean, companies need a system of checks and balances — such as reconciling awards granted with board minutes at least once a quarter and having a process to tie employee terminations to the equity records.

4. You have a lot to consider about your equity plans if an IPO is in your future.
One of the hardest truths hits in the time leading up to a public offering. This is when tough questions arise over all the decisions that have been made beforehand, Holm warned, and even more difficult choices will need to be made. Those who have a stake in the company will shift their focus from their percentage of ownership to the actual value of their shares. Companies going through the transition will need to determine whether they should consider amending their stock plans. They’ll also need to define their post-IPO equity pool size. And they’ll need to take a look at how they communicate beyond one-on-one pay agreements. It’s also a good time to consider what information will be publicly disclosed in your registration statement. For one, details about pay plans for the most highly paid senior leaders will be publicized, not only to investors and securities regulators but employees as well. There’s also a lot of information regarding the plans and award details included in SEC filings, and newly-public companies are burdened with additional disclosures around stock valuation.

While equity-based compensation comes with issues, Wall noted, managers can provide robust pay plans that do what they’re supposed to — retain top talent — as long as they operate with their eyes wide open with an awareness of how changes and new decisions will have consequences.

This post originally appeared here, on BayBio’s website.

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