How to Protect Equity Pre-IPO?

The transition from a private startup to a publicly traded company is a big moment for founders as well as investors. Managing equity is a fundamental area while preparing your company for an IPO.

It involves keeping track of different types of equity issued, handling changes in your team, and making sure you follow all the necessary rules in various regions. Businesses preparing for an IPO should dedicate time and resources to manage compensation issues.

In this article, let’s concentrate on equity-related factors, as this component of the compensation strategy is expected to witness lots of changes during the transition to a public company.

Solutions for Equity Management in Pre-IPO Companies

In the pre-IPO stage, the company remains privately owned by a select group of investors, founders, and employees who hold shares that are not available on public stock exchanges. In preparation for going public, the company undergoes a pre-IPO transformation.

During the pre-IPO phase — startups undergo expansion, build a market presence, scale operations, and secure funding for future growth initiatives. Startups also invest heavily in operations, growth, and R&D.

The company appoints executives with experience in taking companies public to ensure maximum value is generated for shareholders. Founders, employees with vested stock options, and early investors can realize the value of their shares and provide liquidity and opportunities for secondary market sales.

The pre-IPO stage should be planned really well if the company wants to open with a bumper IPO listing. Here are a few things companies must do to protect their equity during this stage:

Protect Equity with a Pre-IPO Trust

The IPO process involves multiple stakeholders and lengthy timelines. For entrepreneurs and company founders, one of the critical concerns during this transition is safeguarding their personal shares. A simple solution is to establish a pre-IPO trust.

This trust holds the founder’s shares and the ESOPs for managing and protecting these assets through the IPO process. Founders can form a discretionary trust or a reserved powers trust.

During an IPO, companies are required to show their shareholder lists in the prospectus. A pre-IPO trust allows the trust to appear as the sole shareholder and helps to maintain the privacy of the actual owners by preventing disclosure of individual holdings.

Valuation Challenges

Pre-IPO companies can face accounting and tax implications if they issue stock options with exercise prices below the “fair market value” on the grant date.

Accounting Implications: When the exercise price of stock options is lower than the FMV at the time of granting, it can result in “cheap stock” accounting adjustments. These adjustments need to be addressed during the IPO process. High “cheap stock” accounting charges can require the company to revise its financial statements.

Tax Implications: Stock options granted with a strike price below the FMV at the grant date are subject to taxes under Section 409a of the IRS. It means the options are taxed when they vest rather than when they are exercised. They are also taxed again at the end of each calendar year until the options are either exercised, expire, or canceled. Employment taxes and a 20% federal tax penalty are applicable on taxable income.

SEC scrutinizes the valuation of a company’s stock related to stock option grants made within the 12 months preceding the IPO so companies must ensure their stock valuations are on point. Pre-IPO companies can hire an independent third-party firm to perform regular valuations of their common stock to protect their equity’s valuation.

Setting Accountability for Equity Compensation

The roles and responsibilities for managing equity compensation in a private company are usually vague. It can lead to bad compensation planning and difficulties with SEC filings which can raise questions on management — becoming a major pain point.

Before the IPO — it is best to set up transparent governance structures just like a public company. Public companies have a dedicated committee for defining the company’s compensation and benefits strategy. This committee proposes long-term incentive plans to the entire board for approval and oversees the compensation discussion and analysis required in annual SEC reports.

It can initially take some time to do this setup but once implemented a structured framework will allow a smooth transition of your compensation programs as you move towards becoming a publicly traded company.

Revamping Compensation Structures

After an IPO, compensation structures for both executives and non-executive employees need adjustments. Startups must evaluate the current equity awards and their effectiveness, eligibility criteria, and overall design. They can start by defining a compensation philosophy that outlines the objectives, pay mix, and competitive positioning.

Startups must also plan for long-term incentive plans and establish clear policies for severance benefits and termination procedures. There is increased public scrutiny of executive pay for public companies so designing compensation packages that avoid negative media attention and align with shareholder expectations is important.

Startups can also introduce an ESPP to allow all employees to buy company stock. ESPP also maximizes participation and engagement from the outset, which is important to maintain a fair price.

Share Reserve

Before going public, companies must increase their share reserve by getting shareholder approval before the IPO. This will also avoid unnecessary dilution and protect founder’s equity.

Pre-IPO companies should make sure that their share reserve can support equity grants for the next two to five years of the IPO. The percentage of reserved shares compared to the company’s fully diluted common stock — ranges from 10–15% for most firms and 15–20% for technology companies.

Pre-IPO companies can also use “evergreen share reserve provisions,” which automatically increase the reserve each year based on a predefined formula. Companies with evergreen provisions are not required to implement the full annual increase; the Board can choose to waive or reduce it each year.

By managing their share reserves companies can ensure they have the resources to support their equity compensation plans as they go public.

Navigate your Pre-IPo stage with Eqvista!

Transitioning from a private to a public company is a significant transformation. To navigate this change smoothly, pre-IPO firms partner with independent third parties to leverage their technology and migrate to better equity compensation plans.

At Eqvista, we provide comprehensive equity management and cap table solutions by a team of experienced equity professionals.

Consult Eqvista’s experts for a precise value! To reach us immediately, click here.