Pressure Testing Annual Incentive Programs for Emerging Growth Life Science Companies

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.

We're going to start with life sciences. Over three episodes, we'll discuss the key differentiators that make this industry and resulting compensation program design and decisions unique. 

To kick things off, Mark and Aalap are joined by Terry Newth, a partner in our Boston office and the founder of Pearl Meyer's Life Sciences practice. Terry is a frequent author and speaker on executive compensation related topics, and he's here to talk about creating a balanced annual incentive program and process. Let's listen.

Mark: Welcome to the pod, Terry!

Terry: Thanks for having me, guys. I finally got the invite, excited!

Mark: So, Terry, what are the two or three most important aspects to consider when an emerging life science company is designing its incentive plan for the next year?

Terry: Yeah, great question. And an important one as well. This is one of the key things that the compensation committee does each year. And I think it has a real impact and importance in the overall business and also how pay is aligned with performance. And it's different in life sciences than you would see in a traditional commercial company.

So, in a traditional commercial company, you've got financial measures that are typically the cornerstone of a short-term incentive plan, think revenue, or earnings, or return on capital. Strategic goals may play a small role in that overall bonus. And then juxtapose that against emerging growth life science companies, it’s the opposite. The strategic goals are the cornerstone, and these play the most important role in the bonus plan. And financial goals, if at all, would play a secondary role.

So, with that backdrop, there are few key points as it relates to setting the plan at the beginning of the year. The first would be around how you think about the goals themselves. Should they be execution-related goals or outcome-related goals? And this is a debate that many compensation committees have with management teams. An execution-related goal would be an activity or set of activities that are more internally driven. And, more so in the control of management. Think about enrolling a study, submitting an IND application, as examples.

Whereas outcome-related goals would be the results of those activities and they have more external factors involved. Maybe it's a positive data readout or raising capital, something like that. That's the first one. It's do you set up the plan to have execution-related goals, outcome-related goals, or some mix of both?

And then second is around the leverage of the plan and how you get to certain payout levels. This same thread occurs here between execution and outcome-related goals. I don't think the board would want a plan that pays out at 150% when all of the goals are more or less activities with no real value creating outcomes. And I don't think management would be very happy if the plan did not pay out, even though they executed really well against the plan and unfortunately the results were not great.

Aalap: So, Terry, how do you combine the execution and outcome-based goals with the pay outcome?

Terry: I often think about it in terms of a nine box, and this could be a good overlay to the goals once you set them—and a good way to pressure test the goals. If you think about one axis being execution related goals and one axis being outcome related goals, and then within that you might have poor, mixed, or superior results. So, you end up with a nine box there, and you can plot different payout ranges within each one of those nine boxes.

And it's really a good way to check and balance. The top right would be superior execution and superior results. And maybe there the payouts 120–150% of target. And then on the bottom left, conversely, you'd have poor execution, poor results, is going to be something close to 0% payout.

Aalap: Yeah, I think the nine box concept is a really good frame here. I haven't thought about it before. I think it could resonate with management teams. They've probably been subject to a nine box before you can kind of supersede, you know, two nine boxes. One on the nine box on the individual and then sort of the nine box on the company to determine what impact individual performance could have. So, I think that's a really innovative and, you know, good frame you know for companies to potentially use.

Mark: At the risk of being too complicated.

Aalap: I agree. I mean it could be complicated, but I think nine box has been around and used in multiple forms. But a question that often comes up is, when you go from pre-commercial to commercial, do you just flip the switch in terms of your cash incentive design. Is it really that simple? How should companies think about it?

Terry: No, it's really more of an evolution. It's not like you would flip to being predominantly a financially oriented company from an incentive design standpoint. My experience and what I think is best practice is you would incorporate financial goals into that balanced scorecard that you have and then over time evolve the weighting as the financial results become more important.

In the year of a commercial launch, it's going to be very hard to predict exactly what revenues are going to be. And so, it'll be on the balance scorecard in terms of a measure, but you might have a lower weighting on it at least in year one until you get a sense of how to budget and how to forecast.

Aalap: Terry, you laid out a good process in establishing goals, how to think about them. But what if there's a pivot in business priorities during the year? How should a company think about the existing incentive plan? Do we just throw it out, or what do we do?

Terry: I think this gets into philosophy, it also gets into governance, and you know, certainly alignment with business strategy. Most plans are anchored around an annual goal-setting process, and that aligns with corporate planning and budgeting, certainly. But if you're an emerging high-growth company, you may need to make a decision during the year that impacts the relevance of certain goals. If that were the case, it's really just how adjustments should be made.

Mark: Terry, you may have a situation where some of your studies are not going the way that they need to, and you are having to do a big pivot. Because you can know that in the first half of the year. On strategic metrics, there are changes that are not known at the beginning of the year. 

Terry: Yeah, I think it comes down to three factors. One would be, are the goals no longer relevant? And in this case, they would be, Mark. Right? The second would be, should management be held accountable for that outcome? That's obviously an important factor to the extent it's uncontrollable external factors that drove it. There's probably a little bit more flexibility that you can have. 

And then third would be, were these changes driven by or explicitly endorsed by the board? I think that's an important factor. If it's something that the board is asking management to do, then I think as a result you should be able to consider some changes to the incentive plan. And then the nature of those changes will be dependent on the facts and circumstances of the situation.

Aalap: Now let's assume that you've decided that it's appropriate to make an adjustment. How do you go about doing it? Because I know in other sectors there is a lot of reticence to make an adjustment during the course of the year. And so, in life sciences, what are the rules of the road? What's a good process?

Terry: Yeah so, you know, Mark mentioned wholesale changes to the incentive program. I think in that scenario you've got a different set of facts and I think that requires a different logic here. In my experience, it's oftentimes you've got one or a couple of goals that may no longer be relevant. It's about how do you modify the plan or adjust the plan to reflect the changing nature of one or two goals. Replacing the goal would be the easiest, and simplest, and most direct approach. And that's really when the original goal is no longer relevant, but there's a clear alternative that exists, right? You could swap one goal out for another.

A second way to do it would be you just remove that goal. Again, we're talking about a balanced scorecard here. There are a number of goals on the scorecard. You could remove the goal and then reallocate the weighting across the other measures. Or you could even remove the goal and not reallocate the weighting but just score it on a lower denominator. There's different tactics that you can put in place to do that.

Aalap: Now Terry, putting on the role of a director, if you will. You're on the board, you probably understand the science, but you're not intimately involved in it. How do you ensure that swapping out of a goal or reweighting a goal isn't just an attempt at sandbagging?

Terry: Well, I think the earlier point around making sure that the board was involved in the decision around the shift in priorities or the shift in strategy and its impact upon the goals is an important piece of it—they're brought along the way. And then ensuring that at the end of the year that there's proper pay and performance alignment is also very important. Can you make a change during the year but just make sure that it's noted and everyone is aware of it at year-end when you're making final determinations around bonus plan funding.

Mark: Yeah, so as you're leading up to year-end, what should the process look like for bonus funding discussion and the approvals necessary?

Terry: This one seems like a lot of blocking and tackling, but I do feel that when companies get it wrong it can create real frustration from either party, being the board or the management team. And it's also a super important step in aligning pay and performance, which is a hallmark of a lot of comp programs, and so it's a really important process to make sure you get right.

I think first and foremost is that the process should start early. Management needs to keep the committee apprised of progress around the corporate goals and a range of the funding, generally starting in Q3 through Q4. And then when you get to year-end, management should be developing a proposed score based on this framework and then include all the details that the committee would need to make an effective deliberation.

This may be different than a commercial company where you have more of a formulaic based approach. There needs to be some quantitative and qualitative aspects to the year-end decision-making process. That’s why it lends itself to this approach. The committee reviews that scoring and the rationale, and then they seek clarification where they need. And then the committee in executive session should make the final determination on funding for the bonus plan.

Mark: But surely, they're weighing in on a regular basis in order to agree with the progress. In the third quarter you're going to have to make sure that you're accruing the right amount and you don't want to be surprised either way.

Terry: That's exactly right. That's why you start the process early and allow for dialogue around how you're scoring each one of them. Some of them may not be known at that time, but at least for the ones that are known, or you have some visibility into you can have that dialogue and that debate earlier on, rather than at the last minute.

Mark: And how often do you find that you are projecting one thing, but something else happens? I mean you never want that, but how much visibility do you actually have in the third quarter?

Terry: I would say that you want to first make sure that you're being consistent with how you're presenting to the committee as well as to the board on all these matters. Obviously, the corporate goals are important to both the committee and the board. The committee's going to get into a little bit more detail around how those objectives translate into funding, but certainly the board is going to be keenly interested in progress towards the goal. So, you want to make sure that you're consistent across both the committee and the board in how you're communicating and just being transparent around what you know and what you don't know, so that there are no surprises at the end of the year.

Aalap: Terry, I know some companies tend to provide a laundry list of ‘look at me’ accomplishments during the course of the year. Do you think that's a useful input in the decision-making process on bonus programs?

Terry: I'm not a huge advocate of this at the year-end, listing out other accomplishments that are not part of the annual incentive plan goals. And I say that because it doesn't always come across as balanced. You're just showing the accomplishments, you're not showing some of the things that could have gone wrong throughout the course of the year.

I do think it would be important to continually share with both the committee and the board, here are the other activities that we have going on, here's how they're going. They may not be part of the annual incentive plan goals, but just to get a broader, holistic sense of performance, and that should be balanced. It should be the things that are positive as well as the things that the team may be lagging behind on.

Aalap: Yeah, that's well said. I think as Mark would say, the more transparency the better. And I think that really it’s helpful when you're determining these incentive payouts.

Terry, I mean great comments today. Really appreciate you spending some time with us.

Terry: Yeah, it was great to be able to hang out with you both.

Mark: Yeah, appreciate your time, Terry.

Jake: Our thanks to Terry for a great conversation around creating a balanced annual incentive program and process. 

On our next episode, Matt Molberger will join Mark and Aalap to discuss the key equity strategy levers that life sciences companies can use to manage their share burn rate and preserve equity plan pools.

In the meantime, you can find our Unscripted episodes on Spotify, Apple Podcasts, pearlmeyer.com, or wherever you get your podcasts. We'll meet you back here next week.