Burn Rate, Dilution, and the Fight for Life Sciences Talent

Jake: In this season of Pearl Meyer Unscripted, we're looking at executive compensation through an industry lens. Our co-hosts, Mark Rosen and Aalap Shah, are joined by several colleagues who specialize in different industries, including technology, healthcare, oil and gas, and more, to examine the aspects of compensation design that are unique to each.

As we continue our discussion about life sciences compensation program design and decisions, Mark and Aalap are joined by Matt Molberger, a managing director in our Boston office. Matt consults primarily to companies in the life sciences and technology industries as an advisor to compensation committees and senior management, and he's here to discuss the nuances of creating a balanced annual incentive program and process. Let's listen in. 

Aalap: Welcome to the pod, Matt.

Matt: Hi Aalap, thanks for having me.

Mark: Hey, good to see you here today.

Matt: Hey Mark.

Mark: Hey, so you know, one of the first things I think we can kick this off with is why is managing the equity plan pool so important in the life sciences space?

Matt: I don't think that this is a today issue. I think this is an all the time issue. Equity is really the critical component of total rewards, certainly in the pre-revenue life sciences space. Protecting the cash runway is really vital for pre-revenue companies. And so, equity ends up being not just the cheaper, but also the more available currency, so to speak. And I think it really does a nice job of tying the upside wealth creation opportunity to the high-risk, high reward profile of the sector.

Aalap: When you think about the importance of equity and that sort of high risk and high reward profile, that's the profile of the sector, and frankly, the profile of the individuals that are attracted to the sector. How should you think about helping individuals manage that risk and overall manage share usage that happens in the organization?

Matt: It's really critical to do it at the company level. And most of the companies in the sector end up being in densely concentrated geographies. And the talent market for many jobs really is finite. And so, this hyper competitive competition for talent is what drives the need to really differentiate compensation packages in the marketplace. And equity ends up being one of the ways in which companies can differentiate themselves. That can be in terms of the size of awards, it can be in terms of the vehicles, it can be in terms of the vesting. And of course, every company has its unique profile and culture.

For companies in this space, managing the pool ultimately becomes critical to the ability to provide competitive total reward packages on an ongoing basis. Some of those levers include: how you size equity awards, the vehicle mix, the vehicle vesting, new hire and promotion award philosophies, the use of inducement awards, just to name a few.

The primary one that we spend a lot of time speaking with our comp committees about is how do you size awards? Do you benchmark and size awards on what I'll call ‘the percent of company approach,’ where each grant is denominated in terms of a number of units divided by the total common shares outstanding, the piece of the pie approach to equity compensation. Or do you benchmark and size awards based on the grant date fair value, where each option grant is valued using its black shoals, and we can benchmark to publicly available market data from a peer group.

The third approach would be to take a blend of the two, or the hybrid approach, where we would size awards based on usually an average of what those two prior methodologies would suggest. And this is the lengthiest conversation I think that we have with our clients every year. 

We think that the answer can be different at different points in the life cycle. Things like company stage and its risk profile, valuation and stock price volatility, overall market volatility need to be considered. And it doesn't have to be a one-time decision that lasts forever. We think it's appropriate to have this conversation with our clients on an ongoing basis and evolve appropriately.

Aalap: So Matt, it sounds like what I'm hearing you say is that flexibility and ability to be nimble are key, in terms of what strategy you would adopt. But sort of zooming out a bit, I often get asked the question, what is most important once you've established that strategy in terms of managing the pool. Is it the gross burn rate that a company has or is it the net burn rate?

Matt: I like to focus on both, Aalap. And the reason is that the gross burn rate is really indicative of your ability to deliver competitive awards at grant. That's going to be important to your employee population to make sure that they feel like they're being adequately compensated and have the right opportunity to participate in upside. It’s going to be important to candidates that you're trying to attract to the organization. They may have competing offers. Sometimes it may require a little bit of extra education to explain why your package is competitive and how you think about equity internally.

But the net burn rate is also important because that is ultimately what guides how much equity we have available for future issuance and when and if we will have to go back to shareholders to ask for new shares. So, it's really important that companies are looking at both and including those as part of these holistic conversations each year about the equity strategy that's going to be best for the year ahead.

Mark: So, as you think about that, what are the consequences of running out of shares? Obviously that's sort of where you're moving towards. What happens?

Matt: For private companies, the challenge is that you need to go back to your investors and put together a compelling rationale as to why you need them to take on the additional dilution of increasing the pool. And in certain instances, those can be easy and even anticipated conversations. In other instances, they can be far more contentious.

For public companies, it requires shareholder approval to expand the pool. So that is going to mean that there's a proxy proposal, that proxy advisory firms are going to have their opportunity to make recommendations on the proxy proposal, and ultimately shareholders have the ability to say yay or nay to the new equity plan or the share pool increase. So many companies in the space have gone public recently enough that they continue to be able to operate from equity plans that have evergreen provisions. This is a provision that provides an automatic increase to the pool each year, typically on January 1st, of either 4% or 5%. There's a belief in the marketplace that public company shareholders do not favor evergreen increases because they guarantee future dilution.

Many companies that are proposing a new plan or an increase in the pool to their public company shareholders will elect to strike evergreen provisions, seeking instead a pool that they expect to last four or three or two years into the future.

Because the evergreen provision is viewed to be like gold, companies will take different measures to be able to maximize the length of these evergreen plans.

Mark: So, what are some of those techniques to extend that evergreen provision and not go back to shareholders? Things like inducement grants?

Matt: Inducement grants are certainly one of the levers. I tend to put that toward the lower end of my list when working with companies on managing their equity pools. For companies that go public with option-only programs, some of the first things to consider are shifting the mix and toggling the weights. So, introducing RSUs is definitely one of the conversations that we have a lot with clients.

RSUs are now common in the space. We saw a real shift in the early COVID, post-COVID days, where competition for talent was rampant and everybody, all of the smaller companies, were competing for talent from big pharma and big biotech, where some candidates hadn't even had experience previously with stock options. And so there was a sense that RSUs were necessary to be able to attract the right talent to organizations.

There was also a rapid increase in valuations across the sector, and companies started to grow reluctant to continuing to grant stock options at what were then all-time high prices. There was a view that it would be appropriate to start to provide some level of downside protection, and RSUs do exactly that. Whether the stock goes up or the stock goes down, as long as the company remains in business, the RSUs are going to provide some level of value.

And then it's a share preservation mechanism. And so, as companies were figuring out ways to make the equity last longer, companies used RSUs as a way to start to limit their burn rate and manage the pool. And that's because companies don't grant one RSU in instead of one stock option. One RSU is inherently more valuable than one stock option. And so, there's usually a trade-off. A company might grant one RSU instead of two options or one RSU instead of one and a half options. And so that's a conversion ratio that we'll work through with clients to figure out the right trade-off of both the potential value of the award as well as a share preservation effect of the mix.

Aalap: So, Matt, are RSUs here to stay?

Matt: RSUs are here to stay, yes, absolutely. The question in my mind isn't whether RSUs should be in the mix, it's when to introduce them into the mix. And we're now seeing companies go out of the gate as public companies with RSUs in the package. They're still not prevalent amongst private companies in the life sciences space, but certainly amongst public companies. Our clients find it difficult to attract the talent that they want without RSUs in the package.

Aalap: How might equity plans and equity award practices evolve over time, given the dynamics in the industry? You mentioned the movement towards RSUs. Are there any other things that the listener should be thinking about?

Matt: One of the other levers is the use of the inducement exemption. The exchanges permit companies to grant equity to external hires from outside of shareholder approved plans pursuant to this inducement exemption. Companies will grant an inducement award to somebody joining from the outside. The spirit of the rule, in my mind, was really to attract executive talent. Those executives typically receive grants that consume big slugs of equity from the pool. And so, the exchanges permit this exemption so that companies don't draw down their pool too quickly to make key external hires.

What we've seen in the marketplace is that companies have taken a more liberal approach to using the inducement exemption. And some companies will go so far as to grant equity using the inducement exemption to all external hires. Companies are able to do this as long as they adhere to a certain select few rules, one of which is that the company has to put out a press release indicating that they have utilized this exemption for certain new hires. If the person is senior enough in the organization, they have to be named and their grant size has to be clearly disclosed. But at lower levels of the organization, companies can roll up participants and awards and disclose them in aggregate.

One of the other changes that we're starting to see or at least hearing being discussed is this idea of using that inducement exemption to provide more of a front-loaded PE style grant. When a company is hiring now, yes, we need to make equity grants to people at hire, but we also have to start to be planful for the shares that they're going to consume as ongoing employees as part of an annual refresh program. If we are concerned about the draw on the pool a year or two years out, does it make sense to provide even larger new hire grants at the time of hire where we can take advantage of this inducement award exemption, such that we are postponing the draw on the pool in the future.

Mark: Are you seeing any pushback on that from investors?

Matt: At the end of the day, an equity grant is potential dilution. And an equity grant is burn rate, whether we're looking at it through the lens of the equity plan or we're looking at it using and including the inducement exemption.

So yes, Mark, this isn't a get out of jail free card. Companies need to be prudently managing their dilution. But as companies are discussing their overall equity strategy and thinking through all of the different levers at their disposal. The inducement award and how you use it is something that is getting more and more attention of late.

I'll share one other thought about how practices may evolve. We talked earlier about evergreen provisions and this idea that companies likely won't be able to get public company shareholders to approve an equity evergreen provision. When a company goes public, the equity provision typically has a 10-year life. There was this prevailing view that if you were going to put an evergreen provision into an equity plan, that the assumption would be it would also have a 10-year life.

One idea that we are starting to talk about with our clients is implementing an evergreen provision that has a very short and finite life, let's say three years. A company may choose between, do we ask for a pool of 12% of common shares outstanding, that would allow us, all else equal, to grant 4%, 4% and 4% over three years. Or what if we had a 4% evergreen provision that had a finite life and there were only three evergreen provisions. The benefit of that, is that the evergreen provision grows with the company's cap table.

In a market where companies are constantly financing and constantly diluting themselves, that 12% pool that we seek today may only ultimately be 9 or 8 or 7% by the time we make all of the grants out of the pool.

If we can get public company shareholders to approve an evergreen provision for three cycles, that evergreen provision is going to increase with the capitalization of the company. And so, it's an anti-dilution measure that we believe some public company shareholders may be more willing to accept in the future.

Aalap: Well Matt, you've given us a lot to think about, the comments on the front-loaded equity grants, as well as, how to design your equity share request in a different way. Thank you for such a great conversation and providing more insight on equity pool management.

Mark: Thanks, Matt. Appreciate it.

Matt: Thank you both for having me today.

Jake: Yes, our thanks to Matt for his thoughtful perspective on equity pool management. On our next episode, we'll close out this industry segment by examining the compensation issues life sciences companies should address when preparing to go public.

After a quiet period for the IPO market, many life sciences companies are again evaluating their public company readiness. Managing Director Rob James will join us to explain how compensation planning is often one of the areas where companies underestimate the lead time, technical judgement, and investor sensitivity involved, particularly around equity usage and dilution. 

Until then, you can find all of our Unscripted episodes on Spotify, Apple Podcasts, pearlmeyer.com, or wherever you get your podcasts. We'll meet you back here next week.