Key considerations for boards of pre-IPO companies
May 2016 | SPECIAL REPORT: OPERATING AN EFFECTIVE BOARD
Financier Worldwide Magazine
As anyone who has been part of a successful IPO will attest, preparing to become a public company in the US involves significant business transformation. The discussion below focuses on key considerations at the board level.
How many corporate directors do boards typically contain?
The average size of a US corporate board is slightly more than nine members, according to Corporate Library research. While boards range in size from three to more than two dozen directors, some financial analysts identify the ideal board size as seven directors. The board needs to be large enough to accommodate board independence and committee requirements set by the SEC and listing exchanges.
What are the relevant listing exchange and SEC requirements concerning the composition of the board of directors?
A majority of the board must be composed of independent directors. NYSE and Nasdaq provide highly detailed definitions and guidance on what qualifies a director as ‘independent’. Companies should work closely with their company counsel or external counsel to evaluate whether directors comply with each listing exchange’s independence requirements.
Given these and other requirements, as well as the board’s involvement in the readiness effort, pre-IPO companies should address board composition early in the readiness process. It can take significant time and effort to select and bring aboard qualified directors if it is determined that the previous composition of the board needs to be altered.
What is directors’ and officers’ liability insurance, and are companies required to purchase D&O insurance for their board members?
Directors and officers (D&O) liability insurance is payable to the company, or the D&Os of a company, to cover damages or defence costs in the event they incur such losses as a result of a lawsuit for alleged wrongful acts while acting in their capacity as D&Os for the organisation. There are three basic levels of D&O insurance; they are commonly referred to as Side A, Side B and Side C. Side A coverage protects D&Os against claims for which the company will not or cannot indemnify a director or officer because of legal or financial solvency reasons. Side B coverage reimburses the company for amounts it pays to directors or officers as indemnification and Side C coverage pays losses arising from certain securities claims against the company. Exclusions will apply for actions taken in bad faith. There are also specialised D&O policies that cover D&Os in cases where the company is not permitted to indemnify them; this type of policy usually rides on top of Side A coverage.
While D&O liability insurance is not legally required, it is exceedingly common in the business world, especially for public companies. Liability exposures remain high, and companies find it beneficial to offer some protection to current or potential directors and officers in order to attract and retain top talent.
The presence of D&O insurance coverage should allow D&Os to operate in the best interests of the business, taking calculated risks within the company’s risk appetite without undue concern about potential, and perhaps baseless, litigation. All D&O liability insurance policies will come with significant exclusions, some of which are negotiable, so it is important that the company, and its D&Os, have a thorough understanding of what is covered and what is not. Consulting legal counsel about the limits of any insurance policy is always advised.
What board committees should be created prior to an IPO or public debt offering?
The committee requirements outlined below reflect NYSE, Nasdaq and SEC rules.
Audit committee. Listed companies must have an audit committee composed of at least three directors, each of whom qualifies as an independent director. Further, each member of the audit committee must be financially literate or must become financially literate within a reasonable period after his or her appointment to the audit committee. In addition, at least one member of the audit committee must be identified and designated as a financial expert, defined as one “who has accounting or related financial management expertise” obtained while serving as a principal financial or accounting officer, controller, accountant or auditor, or having other relevant experience, as required by the Sarbanes-Oxley Act.
Compensation committee. NYSE rules require boards to have compensation committees composed exclusively of independent board directors. Nasdaq does not require a listed company to maintain a compensation committee but does require the determination of officer pay be made either by the company’s independent directors or a compensation committee composed of independent directors. As such, Nasdaq companies can have board compensation committees that are composed exclusively of independent directors, or they may also have compensation committees composed of independent and non-independent directors. However, if the latter composition is the case, executive compensation must be recommended to the board by a majority of the independent compensation committee members.
Nominating/governance committee. Required by the NYSE, nominating/governance committees are responsible for recommending and approving directors and committee members. The NYSE requires listed companies to have a nominating/governance committee composed entirely of independent directors, and directs nominating/governance committees to develop and recommend guidance concerning general corporate governance issues.
What is the compensation committee’s responsibility related to the oversight of executive compensation plans?
Over the last decade, both the authority and influence of the board of directors’ compensation committee have increased, particularly in the area of executive compensation, as new regulations have required more, and increasingly thorough, disclosures concerning executive compensation packages.
The compensation committee’s responsibility is to provide oversight. This means reviewing and approving the executive compensation strategy and plans, providing oversight of the company’s benefit plans, reviewing compensation-related risks, monitoring the approved activities of outside compensation consultants, and reviewing and making recommendations to the entire board of directors regarding the board’s compensation. The compensation committee is also responsible for producing an annual report on executive compensation for inclusion in the company’s proxy statement.
What is an audit committee ‘financial expert’?
In accordance with Sarbanes-Oxley Act Section 407, the SEC requires public companies to have at least one member of the board of directors who qualifies as a ‘financial expert’ serve on the audit committee of the board. The SEC defines ‘financial expert’ as a person who, firstly, has filed financial statements as a chief or principal financial officer, principal controller, principal accounting officer, public accountant or auditor, and secondly, possesses the following attributes: (i) an understanding of US GAAP and financial statements; (ii) experience applying US GAAP in connection with the accounting for estimates, accruals and reserves that are generally comparable to the estimates, accruals and reserves, if any, used in the registrant’s financial statements; (iii) experience preparing or auditing financial statements that present accounting issues generally comparable to those raised by the registrant’s financial statements; (iv) experience with internal controls and procedures for financial reporting; and (v) and an understanding of audit committee functions.
Does the board have any responsibilities or duties within the IPO readiness effort?
Yes, although the responsibilities of employee directors and non-employee directors differ. Directors who also serve on the management team typically lead the transaction readiness effort and play important roles throughout the readiness process. Non-employee directors typically do not fulfil as much of a hands-on role as employee directors. However, non-employee directors review and authorise most, if not all, of the key decisions and documentation, including the registration statement, executed during the readiness effort.
Steve Hobbs is the managing director of Public Company Transformation at Protiviti. He can be contacted on +1 (415) 402 6913 or by email: firstname.lastname@example.org.
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