Equity-based compensation — Northern California’s universal answer to engendering loyalty in employees — is a useful tool but a complicated one. This was one of several hard truths heard by attendees during BayBio’s recent Lunch & Learn event by RoseRyan. Accompanied by compensation consultancy Radford, RoseRyan hosted this packed event on February 26 at BayBio’s headquarters in San Francisco.

To retain top talent these days, companies have a variety of stock-based methods, which are accompanied by their share of accounting, tax, and legal issues. What strategy a company picks today for rewarding employees could affect how smoothly it can transition to another version of itself later on, either as a public entity or as an acquisition target.

During their comprehensive overview of what private companies need to realize as they structure and maintain their comp plans, Kelley Wall, a director at RoseRyan who leads the firm’s Technical Accounting Group, and Kyle Holm, an associate partner at Radford, hit upon the following hard truths.

1. Your company will have to up the ante as it matures.
Startups tend to begin with just stock options and then work their way up to restricted stock or restricted stock units and eventually performance-based awards. Each compensation type comes with its own set of pros and cons. For example, stock options do not lead to immediate dilution whereas restricted stock does. Employees may favor restricted stock for the fact it will give them ownership right away, but tax consequences upon vesting can be troublesome.

And while performance awards encourage goal-based behavior, they are not without their challenges. With these type of awards, companies have to regularly determine the probability of employees meeting their performance targets and adjust their stock-compensation expense accordingly, which can create some volatility in earnings. And it may be difficult for early-stage companies to adequately assess performance targets — any modifications of those targets down the road will result in modification accounting and likely additional compensation expense.

2. Modifications can be messy.
Modifications will happen. The roles of employees change, employees come and go, and employees’ individual targets for reaping the benefits of a pay plan will evolve. And so will the way the company accounts for compensation. Situations where accounting changes come into play include: giving a terminated employee an extended period to exercise their options beyond what was initially agreed upon; changing performance-based metrics; and hiring consultants and allowing them to continue to hold the stock options they were granted as consultants. In general, any change to an award or an award holder’s status should trigger a review of accounting modifications.

3. Your payment systems are only as accurate as the data you’ve put into them.
Wall acknowledged this truth seems fairly obvious but cautioned that lack of data integrity continues to trip up companies. Too often companies lean too heavily on outside lawyers and accountants without realizing those service providers can’t keep up with changes within a business if they don’t know about them.

The fact is the majority of stock-based compensation data has some underlying issues. For instance, RoseRyan has seen a company with vesting stock options for employees who left five years ago — which led to an overstatement when the information was uncovered. To make sure the data surrounding their equity plans are clean, companies need a system of checks and balances — such as reconciling awards granted with board minutes at least once a quarter and having a process to tie employee terminations to the equity records.

4. You have a lot to consider about your equity plans if an IPO is in your future.
One of the hardest truths hits in the time leading up to a public offering. This is when tough questions arise over all the decisions that have been made beforehand, Holm warned, and even more difficult choices will need to be made. Those who have a stake in the company will shift their focus from their percentage of ownership to the actual value of their shares. Companies going through the transition will need to determine whether they should consider amending their stock plans. They’ll also need to define their post-IPO equity pool size. And they’ll need to take a look at how they communicate beyond one-on-one pay agreements. It’s also a good time to consider what information will be publicly disclosed in your registration statement. For one, details about pay plans for the most highly paid senior leaders will be publicized, not only to investors and securities regulators but employees as well. There’s also a lot of information regarding the plans and award details included in SEC filings, and newly-public companies are burdened with additional disclosures around stock valuation.

While equity-based compensation comes with issues, Wall noted, managers can provide robust pay plans that do what they’re supposed to — retain top talent — as long as they operate with their eyes wide open with an awareness of how changes and new decisions will have consequences.

This post originally appeared here, on BayBio’s website.

Keep your employees motivated with stock-based compensation, the thinking goes, and you will be rewarded with high productivity and gains in your company’s growth track. What managers often fail to consider is that if they make mistakes along the way—and we’ve seen many when it comes to equity-based compensation plans—they could actually end up with low employee morale, putting a crimp in the pace of the performance-aligned goals they have set up.

Whenever a company has to amend awards previously made or restate their financial statements because of adjustments in equity-based comp, employees will naturally have concerns—even when the change has little, if any, financial impact on them.

The risk of dents in morale is just one of many consequences RoseRyan has observed while helping clients with issues in their equity-based pay strategies. You’d be amazed at the range of problems we have seen—many of them due to honest mistakes. In our experience, 9 out of 10 companies have had some issue with their underlying stock data that affects their stock-based compensation expense.

To prevent such problems at your company, consider these three tips the next time you evaluate your stock-based compensation strategy (we’ll get into more detail about this topic at our February 26 luncheon called Compensation for Private Companies: The Ins and Outs of Equity, which will be held at BayBio with Kyle Holm, associate partner at compensation consulting firm Radford).

Be obsessive about looking for modifications: Some modifications are obvious (say, repricing a stock option); some modifications are less so (say, allowing a consultant to keep options after you hire that person as an employee). Keep an eye out not only for board decisions but also for management decisions, material transactions, and liquidity events. The rule is, any change to the award or the award holder’s status should trigger consideration of accounting modifications.

Identifying that you have a modification is just the first challenge; the accounting can be tricky as well. How you account for the modification will depend on the type of modification. Variations include measuring the incremental value only, accelerating the expense, or valuing the new award and reversing the value associated with the original award. You also need to be sure you’re entering the modification in your equity system in a way that captures the appropriate modification accounting.

Make sure performance-based awards are on everyone’s radar: Performance-based awards are great tools for both retaining employees and motivating goal-driven behavior. But there is accounting risk here as well. With performance-based awards, companies must assess the probability of achieving the metrics at each reporting date and adjust the expense accordingly. This step often doesn’t happen. Maybe the board minutes lay out the performance goals associated with an award, but the stock administrator gets only a spreadsheet of grants to administer, with no indication that vesting is contingent. Or maybe the stock administrator is aware of the performance targets but doesn’t flag performance-based grants in the equity system, so the accounting team doesn’t know they exist. Such miscommunication can lead to overstated stock-based compensation expense.

Tie your 409A valuations to major grant dates: For private companies, the rule of thumb is to obtain a 409A valuation of your stock at least once a year, and in conjunction with major events such as financings, significant transactions, or material changes to the business. Some companies instead tend to do their 409A at the end of the year, just because they’re doing other valuations and financial decompressions at the same time. But think about this example, from one of our clients that approved a major grant to executives and employees in June 2011, six months after valuing its common stock at $1.25 per share for its annual 409A. By that point, the value of the stock had increased significantly—to $3—based on several design wins and other economic factors. While that’s a nice problem to have, they suddenly faced additional stock-based compensation expense and time-consuming updates to their equity system, among other issues.

It’s easy to think your equity-based compensation is under control; however, we have found time and again that it’s an ever-evolving tool that needs tending to, as your headcount grows, the complexity of your company expands, and situations evolve.

Get in the mode of reevaluating your pay strategy during the RoseRyan February 26 Lunch & Learn seminar about equity in South San Francisco. It will be geared toward private companies. Click here to register. And for more details about these best practices as well as some others to consider, also check out the RoseRyan intelligence report I wrote called Stock options: do you have a problem?.

Kelley Wall leads RoseRyan’s Technical Accounting Group, which provides technical accounting and SEC expertise to public and private companies on complex accounting matters and implementation of new accounting pronouncements. 

I was fortunate to attend “Winning Strategies in Life Sciences: Pursuing Success in Today’s Changing Environment,” an all-day conference held October 5 at the University of California, San Francisco’s beautiful new Mission Bay campus. It was sponsored by Foley & Lardner LLP, Silicon Valley Bank, BayBio, QB3 and RoseRyan. The focus areas covered maximizing growth potential, designing models for the wireless health care industry, ensuring global intellectual property and big-pharma mergers and acquisitions. Part of my quest was to answer a burning question: why isn’t biotech doing better, since the baby boomers’ demographic trends indicate that people are living longer, with a higher quality of life?

The sessions were a little more upbeat than the biotech news has been over the past two years—the industry has taken a beating as venture capitalists have focused on hot new social media and technology start-ups at the expense of the sometimes-capital-intensive biotech industry. One area of intense pride is the new QB3 incubator on UCSF’s Mission Bay campus. It is now full of start-ups (more than 40) that are given access to tools, money and networking opportunities, and find it easier to get from start-up mode to their first and second round of funding. Housed on the Mission Bay campus with other aspiring entrepreneurs, they can share ideas and contacts that can help accelerate their progress. Also, the QB3 center provides a concentrated area of experts that venture capitalists and other companies find attractive. QB3 has partnerships with outside venture partners (as well as service providers) that have poured more than $10M into the start-ups and is in the middle of raising an additional $10M to put into new companies. This is a little known success story outside of the biotech industry!

Some insights from the sessions included:

  • The FDA has gotten better with providing clearer direction, but still has a ways to go.
  • Angel investors like health care IT, because there are fewer regulatory hurdles to jump over.
  • The health care IT sector has had rapid growth due to ARRA’s funding for electronic health records, which provides $45,000 for providers who are “meaningful users” of the technology. This is a clear edict that should provide rapid automation (and hoped-for cost savings) over the next five to 10 years.
  • Investors are frightened by the large numbers of patents that are expiring over the next three to five years, because generics radically drive down the cost of pharmaceuticals.
  • Capital efficiency is key for companies that must deal with a difficult regulatory environment.
  • Many companies continue to go outside of the U.S. to accelerate their testing requirements.
  • The JOBS Act will not have a great influence on whether companies file to go public or not.
  • Wireless is a booming area of biotech growth, as companies are rushing to build applications that focus on personalized medicine and the improving relationships between doctors and health care providers. One wireless private network provider has analyzed more than 25,000 applications.
  • Mergers and acquisitions continue to far outweigh IPO exits. It is imperative for companies to plan for potential exits one to two years in advance.
  • More M&A events are focused on changing the landscape of drug/device combinations, building infrastructure in noncore areas and growing holistic end-to-end solutions.

Although the economy is still muddling along, biotech is holding its own in the Bay Area. I didn’t get my answer to why biotech isn’t booming now, but with the baby boomers aging, Obamacare coming and the pace of innovation increasing, the future looks pretty bright.

Last night, as a BayBio partner, I attended the Ninth Annual Entrepreneur & Investor Roundtables event in Palo Alto. This BayBio event gives entrepreneurs in start-up life sciences companies an opportunity to meet and present to investors, both VCs and angel groups. The format is a speed dating arrangement that gives them about eight minutes to pitch.

I’ve attended this event for the last six years, and it’s an interesting reflection of how the industry has changed over time. In the early days, there was more interest in funding and more resources. Now the sources of funding are fewer, the dollars are more scarce—and the bar of approval is higher.

Investors, both VCs and angels, are more specific in their focus and they need to see higher levels of meeting milestones before approving additional or initial funding. There is more emphasis on demonstrating proof of concept before they fund the next level.

Also, the funding requirements to grow these companies are always going to be higher than many of their entrepreneurial counterparts in the tech industry. This is also different from entrepreneurs in the social media or software space, where an investment of $500K can keep you going for more than a year.

Although the funding climate is difficult and takes patience, the passion among entrepreneurs is still strong. Also, I’ve noticed over the last few years that these scientist-entrepreneurs are more business savvy than in the early years, and they have practiced and refined their presentations and their understanding of business forecasting and strategy.

The virtual company approach is almost universal in one form or another, with everything outsourced except for core competencies. Hiring fewer employees but using more consultants and developing collaborations is the norm. And overseas clinical trials are growing more common, in part because of the difficulty and expense of dealing with the FDA.

I have to say that I am always very impressed with the courage, stamina and determination of the entrepreneurs that I have met in life sciences. They are definitely not doing this for the money, but rather they truly believe that their efforts are helping humankind and/or the environment.

The other recurring fact is that I continue to meet people from all over the world at these events, which demonstrates that the Bay Area is still the global magnet for this type of talent and passion.

The life science community has been anxiously waiting for the announcement of the awards for the $1 billion Qualifying Therapeutic Discovery Project program and the results are out!

Many Bay Area companies did quite well, receiving all or part of what they asked for; this was particularly true for smaller companies. Four of the five companies RoseRyan worked with to develop applications received grants ranging from $244,479 to $733,438. (As a finance professional, I have to ask, Why the odd amounts? So far, we haven’t got an answer to that one.)

The program, part of the health care bill, was designed to spur research and development at biotech companies with 250 or fewer employees through awards of tax credits or grants. According to the San Francisco Business Times, the Treasury Department received applications for about 5,600 projects. The Times published a partial list of Bay Area recipients, and you can see the full lists of recipients by state at the IRS website.)

Last June, my colleague Chris Vane and I spoke with about ten companies at a free consultation with BayBio, and did work for five. This involved helping them write or edit the grant and providing strategic advice, leveraging our prior grant submission work with the Department of Energy as part of our cleantech practice. These companies said it was very useful to sit down with us and talk with them about their strategy for writing grants. We played devil’s advocate, asking questions and helping them look at their business plan strategically.

There could be more grant opportunities cropping up in the future, and it never hurts to apply for a grant or other funding, because it presents an opportunity to take a hard look at your business and appraise why the work is important, where you want to take it and how you will get there.