Engaging and retaining key employees is a central concern for emerging companies in the biotechnology and life sciences field. However, lack of available cash often serves as a barrier to hiring the right people to take the company to the next level. This client alert summarizes considerations and strategies that may help emerging companies hire and retain key employees in light of these financial limitations.

Considerations

Before settling on the right compensation strategy, companies should consider a variety of factors that may affect the feasibility and success of a compensation scheme. Remember that any strategy should be not only realistic for the current growth stage of the company but also documented and thoroughly communicated to employees, as employees may not place value on a program they do not understand.

• Cash vs. Other Benefits. Cash flow is a central concern for most emerging companies, and working capital can always be utilized for growth and development rather than for compensating employees. Companies should consider how much of their compensation program can realistically be provided via cash and how much will need to be provided in the form of noncash incentives and other benefits.

• Cash vs. Equity. While equity compensation is the driver of many start-up compensation programs, how much equity is delivered, as well as the form of that delivery, varies. Companies that implement equity compensation programs may find years down the road that too much of the company has been “given away” or, alternatively, that the level of equity was insufficient to attract and retain talent. As noted below, a variety of equity compensation vehicles are available, and the challenge is determining which is right for the company after considering its incentive objectives, as well as the tax and accounting implications. Remember, once an equity program is put in place, amending, modifying, or terminating the program can be difficult. Thus, careful consideration should be given to any equity compensation arrangement before adopting it.

• Tax, Accounting, and Securities Laws Implications. As they say, death and taxes are the two certainties in life. But in fact, taxes can be fairly uncertain in the start-up compensation world, and the tax implications of compensation arrangements can vary significantly depending on whether the company is taxed as a corporation or a partnership. Often, companies implement a compensation scheme without fully considering the tax implications for the company or the employees. Additionally, each compensation element has an accounting impact, which varies based on the program. It is critical to understand and model the effect of any program on the company’s books before implementation, especially if the company is expecting to raise additional capital or sell itself down the road. Finally, to the extent equity compensation is being delivered, the company must ensure it is exempt from, or complies with, applicable federal and state securities laws.

• Competitors. When recruiting key employees, companies are faced with the challenge of structuring a compensation program that will attract and motivate talent, but not overpay for that talent. Thus, it is important for a company to understand who it is competing with for talent and the compensation structure at those other firms — generally making sure it has a sense of what is “market” for a particular job function, which will vary by geography and industry. Formal compensation studies, as well as information or anecdotal data, may be useful tools.

• Employee Population. An often overlooked feature in implementing a compensation program is the demographics of a company’s employees. For example, while younger employees without dependents may be more likely to accept noncash compensation with a promising upside, other employees may prefer more cash in hand. Understanding the makeup of its employee base will help a company structure a compensation program that is attractive and effectively motivating.

• Broad-Based vs. Individual Arrangements. For some companies, a broad-based program that applies to all (or all key) employees may be appropriate and feasible to attract talent. But for other companies (especially early-stage companies), individualized compensation packages may be more appropriate. However, while individual arrangements provide a company with more flexibility to negotiate with employees, they are also often more burdensome to administer and maintain as compared to a broad-based plan.

Incentive Arrangements

In addition to wages and other employee benefits, a typical compensation structure often includes one or more incentive arrangements designed to encourage retention and/or motivate achievement of specific individual or company objectives. Most incentive arrangements will require the employee to remain in good standing with the company for a specified amount of time before the award is earned or “vested.”

• Cash Incentives. The most common incentive used by companies is a cash bonus arrangement. Bonus plans are often implemented on an annual basis, although quarterly or more-frequent structures may also be adopted. A bonus plan can also be adopted with specific goals in mind (e.g., cash bonuses upon project completion or finalization of a funding round) or on a broader scale (e.g., annual bonuses equal to 5% of compensation for all employees). More often, bonuses at early-stage companies are tied to annual companywide goals. But awarding bonuses for individual achievement is also a strategy. The obvious potential downside is that cash bonus arrangements require current cash (unless a deferred bonus plan is implemented), which will have an effect on the company’s cash burn rate.

• Equity Incentives. Equity incentives provide employees with an ownership stake in the company. One primary advantage of granting equity is that it aligns the employee’s interests with those of the company and its owners. Equity can be a tremendous motivating factor for employees, especially if they view the company as having significant upside potential. Equity compensation also does not require a current cash outlay. The main disadvantage of equity arrangements is that founders will have to part with an ownership stake, often knowing that subsequent investors will also expect a share in the ownership in the company. Still, for many founders, the decision is not whether to grant equity to employees but how much, and in what form.

Equity compensation vehicles are generally classified as either (i) “full-value” awards, which give the employee the full value of the equity once it is earned, or (ii) “appreciation” awards, which provide the employee with only the difference in value from the date the award is granted to the date it is earned or exercised. Because appreciation awards are not worth anything to an employee unless the value of the company increases, employers may find them preferable to full-value awards, particularly for key employees who are in a position to increase the value of the company. Conversely, an employee who has little or no “line of sight” into how his or her efforts can impact the equity value of the company may not be sufficiently motivated by an appreciation award. Common equity vehicles include:

• • Restricted Stock. A full-value award representing an ownership interest in the company that is subject to transfer and other restrictions. Prior to vesting, the employee is often given the rights of a member/shareholder, including dividend rights and voting rights (although these rights may be limited pursuant to the award agreement or underlying plan document). Once the award is vested, it is also common for private companies to put restrictions on the subsequent transfer of the equity to prevent nonemployees from becoming equity owners.

  • Restricted Stock Units (or RSUs). A full-value award representing a contractual right to receive an ownership interest in the future. This type of award is similar to restricted stock, except that the rights of ownership are delayed until the award is vested and the equity is issued to the employee.

  • Stock Options. An appreciation award representing a contractual right to purchase equity in the company at a predetermined price that is set on the date that the option is granted. In order to avoid potentially negative tax and accounting consequences, the company must grant the option at fair market value (FMV). This means that the company must obtain an independent valuation from an outside source or must have some other way to determine FMV (e.g., recent arms-length investment).

  • Stock Appreciation Rights (or SARs). An appreciation award representing a right to receive an amount equal to the difference, or spread, between the FMV of the equity on the date the SAR is granted and the FMV of the equity on the date it is exercised. SARs are similar to stock options, with the same tax implications related to establishing FMV, except that the holder of the award does not have to pay the actual exercise price in order to receive the award, and payout of the award may be made in cash or equity.

• Phantom (Synthetic) Equity. Phantom, or synthetic, awards are not actual equity awards and do not represent an ownership interest in the company. Instead, such awards are intended to mirror the economic benefits of equity ownership. Typical awards may be based on a number of units or shares or a percentage of the company (e.g., the right to receive the cash equivalent of five shares or the right to receive the cash equivalent of 5% of the company). The vesting of phantom awards is often tied to a liquidity event in order to incentivize employees to work toward a sale of the company. Phantom awards are very flexible and may be structured in a variety of ways depending on the needs of the company and the particular behavior that the company is seeking to incentivize.

The foregoing is intended to be only an overview of the considerations and types of incentive awards available. Further, although many of the equity vehicles described above can be adapted to fit a particular company’s organizational structure, designing equity incentive programs for entities taxed as partnerships involve additional complexities beyond the scope of this article. Before implementing any incentive compensation program, a company should consult with legal and tax advisors to thoroughly evaluate the implications of the program.