Designing effective compensation programs is never easy. Supporting shareholder value creation, motivating employees, determining realistic performance goals, complying with government regulations and addressing investor expectations are complex and often competing objectives.
The biotechnology industry faces these difficulties, and more. Companies in this industrymust attract employees with cutting-edge knowledge and skills, manage five- to ten-year product development cycles and obtain government approval as a make-or-break point in the business all the while conserving capital and riding the volatility of the market for biotechnology shares.
Stock-based programs are often the solution. Yet linking employee interests to those of shareholders while rewarding employees for results they can influence may be the biggest challenge of all in the temperamental biotech equity market.
The Issues
While often lumped into the broad category of technology companies, significant differences from software and networking companies render their equity compensation strategies moot for biotech firms.
The technology industry's focus on stock options works well when a series of new product introductions can somewhat predictably produce the economic performance to support a continually rising share price. This, in turn, creates a great opportunity for the innovative use of stock-based compensation.
The biotech industry's great variation in company size and strategy complicates the discussion of biotech compensation. Many companies in this industry are private, hoping for the right combination of market success and stock market timing to allow a public offering perhaps long before any prospect of profitability. Others enter joint ventures with major companies, providing a more stable situation. Still others have become established and grown to mature companies faced with patent expiration and threats of new developments by competitors.
While there is great commonality among compensation structures in other industries, a single model does not apply to this industry.
Potential Solutions
Despite the continuing focus on regulatory issues, many constraints limiting compensationdesign -- accounting charges, tax regulations and investor expectations -- have little impact on some biotech companies. These firms can take a fresh view of many available compensation tools.
Stock Options. Biotech companies with no foreseeable prospects of profitability may choose to use Incentive Stock Options (ISOs), enabling employees to defer taxation at the time of exercise and receive capital gains treatment on the entire gain when the stock is sold. The company tax deduction that would be realized with a Nonqualified Stock Option (NSO) maybe of no concern for these firms.
Discounted stock options can combine insulation from short-term stock price volatility with adeferred compensation opportunity. A source of institutional investor criticism, earnings charges and lost deductibility for grants to top executives, discounted options may meet the needs of an emerging biotech company with affiliated investors, a focus on revenue overshort-term profit and no taxable income.
Stock Grants. Restricted stock or outright stock grants with no restrictions can be an effective approach to replacing cash with equity while eliminating some of the risk of options. Like discounted options, stock grants present the issues of earnings charges, investor objection and lost deductions for senior executives but when designed and explained well, they may be an effective solution.
Simulated Equity. Many situations, such as close ownership of equity by founders or joint ventures, may preclude the use of actual equity in compensation plans. In these instances, simulated equity programs, such as phantom stock, may provide equivalent benefits and beacceptable to all parties. These programs can be structured to later convert into actual equity programs with no negative accounting or tax effects.
Performance Measures
The compensation strategy that worked at the time of the start-up or the public offering maybe less effective as the company matures. While stock price is an effective measure of overall success for smaller enterprises, as companies grow and diversify their product offerings they must tailor rewards to subsegments of the organization. Potential approaches include:
Product Milestones. The long development cycle and market volatility in the industry may require delivery of rewards, particularly to key technical staff, before realizing financial outcomes. Granting and/or vesting stock awards at completion of key product development events can bridge the gap between internal efforts and market results.
Financial Milestones. Early investors may resist rewarding employees before they see their investments bear fruit. Certain financial milestones venture capital, private placement or initial public offering may represent key performance accomplishments by executivesinvolved in the transaction as well as the technical staff's accomplishments that create value for investors.
Shareholder Return. Of course, the enterprise's ultimate performance measure is return to shareholders, and investors may want the employees equity-based compensation value to parallel investor returns. Creative approaches to vesting and restrictions on sale, combined with a reasonable and progressive liquidity plan, can allow employees to reap incremental rewards while reassuring investors that all parties are locked in until expected returns materialize.
Reaching the Right Solution
An industry full of opportunities for creating economic value while solving worldwide health issues also has unique opportunities for rewarding employee achievements. Ultimately, companies in the biotech industry must consider equity as a solution to employee compensation challenges. But emulating the technology sector's use of ordinary stock options with standard terms and provisions may not work. Meeting compensation objectives through stock-based programs requires thinking through the purpose of the equity.
Any stock-based approach must be analyzed thoroughly to ensure strategic, financial and behavioral considerations are balanced and support the needs of the business.
Fred Whittlesey is a founding principal of Compensation and Performance Management, Inc.(CPM), a management consulting firm based in Newport Beach, Calif. CPM works with clients to improve organization performance through evaluation, design and implementation of employee compensation programs and performance management processes. The firm specializes in working with entrepreneurial growth companies.