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3. Developing Future Compensation for SpinCo

Developing a future compensation program for SpinCo is a critical process that often evolves over time. While the default approach is initially to maintain compensation programs like those of the parent company, there may be a compelling case to make fundamental changes to the compensation program in order to address differences between SpinCo and the Parent. However, depending on the timeframe for completion of the spin-off and the corporate governance structure, the timing of any such changes may be delayed.

Corporate governance of a spin-off can vary and we have seen each of the following approaches used:

  • SpinCo Board of Directors is led by Parent company executives through time of spin-off until Parent company no longer has majority stake
  • SpinCo has Independent Board members appointed prior to spin-off; decisions on compensation for SpinCo may be subject to Parent Company compensation committee approval
  • Parent company compensation committee reviews and approves programs for SpinCo

Prior to a planned spin-off there is typically a designated subcommittee of the Parent company board that begins planning and making decisions related to SpinCo’s compensation program. A Lead Director may be appointed to oversee this planning process on behalf of the new board, working with the company’s HR or designated SpinCo CEO. Prior to the spin-off, coordinated efforts to recruit new directors, develop a compensation committee charter and a Board calendar, etc. are required

In a one-stage spin-off, where all shares of SpinCo are distributed to parent company shareholders at the time of the spin-off, the involvement of ParentCo executives and Board members in SpinCo corporate governance will cease at the time of the spin-off. In other cases, where SpinCo is distributed in stages (e.g., partial IPO to public shareholders followed by a completion of the spin-off or incremental sale of shares in SpinCo to the public), the parent company Board or parent company executives may continue to serve as Board members of the SpinCo up until the time that the parent company has fully distributed its interest in SpinCo.

When parent company Board members or executives are involved in the compensation design, they are more likely to fall back on maintaining a compensation approach that is consistent with that of the parent. They may continue to view SpinCo as akin to a subsidiary. In these cases, SpinCo’s compensation program may evolve from the timing of the initial spin-off through the year following the parent company fully divesting its interests in SpinCo.

Pay Philosophy and Target Pay Levels

For SpinCo, there is typically pre-planning around the desired compensation philosophy, including establishing a defined market or peer group for pay and performance benchmarking. This peer group should be size and industry specific, reflective of the operating characteristics of SpinCo and may or may not include similar peers to ParentCo’s peers.

There is often extensive benchmarking conducted before the spin-off to determine competitive pay levels for executive positions at SpinCo, assuming new position roles/responsibilities as part of a standalone entity (vs. part of a business unit, prior to the spin-off). It is often the case that benchmarking for SpinCo as a standalone entity will support an increase in pay for executive positions. For example, the top finance executive of a subsidiary is a very different role than CFO of a stand-alone public company. Some adjustments to base salaries and bonus opportunities may be made prior to and/or near the spin date, but all should be made within the context of an overall compensation framework to the extent possible. The desired pay mix needs to be determined, with the appropriate emphasis on long-term (equity) incentives to ensure equity ownership build up and alignment with shareholders.

Annual Incentive Program

As with any company, the ongoing bonus program is designed so that funding is based on an appropriate mix of corporate, business unit and/or individual performance. The mix depends on the company’s emphasis on line-of-sight unit results or overall corporate team results. Appropriate performance metrics, whether top line, bottom line, or return based, should depend on the company’s strategy. Some investors may initially focus on EBIT/EBITDA or cash flow, but ultimately determine that a balanced mix of metrics is most desirable.

Long-Term Incentive Program

Key objectives of the long-term incentive program for SpinCo are to build executive/ employee stock ownership and to create excitement, engagement and alignment with shareholder value creation.

An important first step is to determine an overall equity pool to reserve for equity grants at SpinCo, i.e., the amount of public stock outstanding that will be shared with employees as part of the compensation program (This amount is generally under 10% of common shares outstanding once the IPO has occurred and/or upon completion of the full spin-off; industry norms should dictate). Similar to initial IPOs, at full spin-off, it is common to grant a front-loaded equity award to ‘jump start’ employee ownership in the new company. Some companies make a broad-based award to employees deeper in the organization, or beyond the executive group. Stock options and restricted stock are used for this type of grant, yet the use of options (vs. full value awards) should be balanced with participation, share usage and cost considerations.

The core long-term incentive framework for SpinCo should be designed to accomplish multiple objectives. Emphasis on equity programs helps to build shareholder alignment. Stock-based performance programs are strongly recommended, and not only reflect prevalent long-term incentive practices, but are viewed favorably by large shareholders. Performance-based equity will also serve as a tool for the new /leadership team to promote a focus on specific longer term performance results.

Like any long-term incentive program, balance is important. While some specific industries may use more restricted stock than others (e.g., energy companies), most restricted stock is granted at lower levels in the organization, or for special retention/recognition grants. As a new entity, any new design presents an opportunity to assess long-term performance goals related to business strategy and those being communicated to the marketplace. Such goals should likely be incorporated into the long-term incentive program.

Vesting, form of payout and termination provisions are also important. The spin-off is an opportunity for the new company to re-evaluate ParentCo practices. For example, SpinCo may choose to implement somewhat more stringent award termination provisions to support longer term employment of employees. To further align with best practices, companies should include CIC provisions that provide for outstanding award vesting only upon both completion of a CIC and termination of employment for good reason (i.e., a “double trigger”).

Severance Provisions

Severance provisions should be established as part of a formal severance (CIC/non-CIC) program or through severance agreements, or less common, as part of an employment agreement. These programs should be implemented after careful consideration of potential costs and benefits to the participant and to the company. Recognize that severance benefits are a sensitive issue for many investors. Tax gross ups for any 280(G) CIC tax liabilities are no longer common and should not be included. Non-compete and non-solicitation provisions should be put in place for the new entity, as standalone policies or as part of long-term incentive award agreements.

Governance Practices

Certain common, good governance practices should be implemented, as they are in the best interests of SpinCo and shareholders and have come to be expected.

  • Stock Ownership Guidelines are now very much mainstream and expected by shareholders. They should apply to the newly formed executive group. In SpinCo, it may take some time to ramp up ownership in SpinCo stock, particularly if outstanding ParentCo equity awards were converted at spin-off using the shareholder approach. Keep in mind there should be a phase-in period before execs are held accountable and a ‘soft’ penalty may make sense to help facilitate ownership, such as a required holding of 50% of net shares (vested or settled), until the guideline is met.
  • A Clawback Policy for any awards that were based on results impacted by an accounting restatement is a matter of good governance. A majority of companies today have one, with the ability for discretionary recoupment in the case of fraud or earnings restatement, and potentially for executive misconduct.
  • An Anti-Hedging Policy should be in place that prohibits executives from entering into any hedging transactions related to the company’s stock or trading any instrument related to the future price of the stock.

When Dodd-Frank rules are finalized, companies may need to modify these provisions to comply with the final rules, but on their own merit, these provisions should be put in place as a baseline.

Director Compensation

The outside directors’ compensation program of SpinCo ultimately needs to reflect appropriate market norms for companies of similar size and industry, in terms of the amount of pay provided, cash/equity mix, and overall structure of board retainers and committee service pay. The design should consider the duties required of directors, as well as the company’s executive compensation philosophy. Initially however, the structure of SpinCo’s program will often resemble ParentCo’s program.

The equity plan, if separate from the executive plan, follows the same rules. ParentCo’s board typically approves SpinCo’s plan prior to the spin-off.

If any directors work on SpinCo activities prior to the spin-off, special equity compensation may be awarded or pro-rated. If board leadership includes a non-executive chair or lead director, compensation will need to reflect the expected role, responsibilities and time commitment expected at that time.

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