Virtual reality arcades. Space travel. A home-shopping network for millennials. Ideas for startups abound and rarely lack for ambition.
But how do you develop the market strategy, executive talent and grasp of equity and tax law to turn your new company into a “unicorn”—a startup with a billion dollar valuation, poised to make the leap from private to public, and a successful public company at that?
Here, we share insights from industry experts on the unicorn’s six essential qualities—plus some key considerations to make sure your company’s success survives beyond its IPO.
To market, to market
1. Your startup needs a well-defined and practical go-to-market strategy, says Lane Bess, founder of Bess Ventures & Advisory LLC, who has co-led several unicorns in the securities industry. “Most of the unicorn founders,” says Bess, have “identified a true disruption that they can bring to a substantial marketplace.”
2. Be sure the potential market is substantial enough, Bess adds. “Some founders,” he notes, “mistake a product or a feature for being a company.”
3. Consider expanding your product or service lines to achieve disruption. But, beware, this approach can be tricky, says David Faugno, CFO of Qualtrics, a customer experience management company.
You can create a serious dilemma for your company, Faugno says: “How to be good at multiple things? And how do you maintain the right balance, giving each product area everything it needs to be successful—versus managing the portfolio?”
One solution for this dilemma may be partnerships. “Channel partners that will speak for your product, distribute your product, are very key,” Bess says. “There are other relationships, but leverage is really the word there. Alone, a startup will struggle to utilize the cash and grow to unicorn status.”
4. Create the right culture to attract the right people. Perception of your company—from the way it operates to your CEO’s conduct—can help draw or drive away good candidates, who are essential to your success.
5. Show them the equity. Increasingly, the startup community sees the presence of a CFO as a must, where a junior accounting team might have once sufficed. And potential board members often find they can be more effective serving on one board than governing multiple companies.
As a result, competition has intensified among startups to fill these CFO and board-member roles—and equity offerings are often the deciding factor in candidates’ decisions.
“Many companies are chasing a high-demand group. Directors can pick and choose the companies that they want to get involved in,” says Mark Borges, a principal at Compensia, which advises compensation committees and senior management teams. “It's not easy to fill out the board, particularly with independent individuals, which is what you're going to need as a public company.”
6. Retain that talent. You need to keep essential employees and keep them happy through an initial public offering.
On average, stock options make up 78% of all IPO-year equity awards. But full-value awards are still in the mix for some companies such as those in the healthcare, industrials and consumer sectors.1 “As people approach an IPO, some of the other senior executives are suddenly diluted, because other investors are brought in,” says Robert Barbetti, head of Corporate Executive Advisory, at J.P. Morgan Private Bank. “How do you true them up—or do you true them up at all?”
Adds Borges: “You tend to want to true up people who maybe have earned the majority or all of their executive or equity comp and give them a new carrot that presumably is priced pre-IPO.”
Strive to establish your equity plan well ahead of the IPO date, as changes do not require a shareholder vote prior to going public. Moreover, before you consider the level of dilution, you should identify the objectives of your long-term incentive (LTI) plan.
“Are the grants for all employees, a select group or only the C-suite? What’s the purpose of the grants: retention and/or performance?” Barbetti asks. “Asking questions like these is key.”
Ready, set—unicorn goes IPO?
Once you’ve reached unicorn status, your likely next step is to issue an IPO. Before you do, make sure to look at such major considerations as:
- Rewarding top management. In the year of the IPO, typically there are a number of equity awards granted to the management team or named executive officers (NEOs). Barbetti says NEOs receive a median of 31% of the IPO-year awards with the CEO receiving approximately 9% of the aggregate awards. That said, only 2% of the IPOs disclose granting equity awards to nearly all employees.2
- Offering stock options. Stock options remain the preferred long-term incentive award granted in the year of IPO. In a recent survey, they comprised 78% of all IPO-year equity awards (73% when calculated based on grant-date fair value of IPO-year awards).3
- Assessing QSBS status. Gains from the sale of shares in certain small businesses can be realized tax-free. Depending on when the shares were acquired, the gains may be eligible for up to a 100% exclusion from capital gains tax for as much as 10 times the basis in the shares or $10 million, whichever is greater.4 Furthermore:
Anyone who is gifted or inherits QSBS qualifies for the same tax treatment as the transferor and tacks the transferor’s holding period.
An important QSBS consideration when drafting an irrevocable trust: The grantor could make gifts to separate non-grantor trusts for the benefit of different children or family members for example, instead of making a gift to a single pot trust, in order to maximize the number of separate taxpayers able to claim the $10 million gain exclusion.
If the QSBS has been held for more than six months, another significant advantage exists: The investor may sell QSBS and invest the proceeds in another QSBS issuer (within 60 days) without recognizing gain.
Sounds good, right?
As tempting as the prospect of an IPO may be, don’t rush into it.
“Many investors like to see their companies get [the unicorn] label, because it carries a bit of a cachet and creates a little bit of excitement and reputation build behind it,” Bess says.
But, if you are that company’s CEO or executive, beware. “You really want to have your ducks in a line,” says Bess. Have the operational infrastructure in place. Understand your productivity. Know your go-to-market.
“Because once you get that unicorn status,” says Bess, “you don't want to have to turn back.”
To learn more about investing in early-stage companies and how it might align with your planning strategy, we invite you to contact your J.P. Morgan advisor.
1Towers Watson Compensation Bulletin.
4This may include exclusion from the alternative minimum tax and the 3.8% Medicare surtax. If an employee made an Internal Revenue Code Section 83(b) election with respect to unvested restricted shares, the employee should be treated as having received the shares as of the IRC Sec. 83(b) election date for purposes of the “qualified small business” test (for the company) and the five-year holding period (for the employee).