We held a breakfast seminar on 5 December 2006 with New Bridge Street Consultants on senior executive and non-executive remuneration in listed biotech companies. Key issues for participants seemed to be ways to deal with dilution limits and rewarding non-executives with shares.
Two particular concerns emerged from our discussion breakfast with New Bridge Street:
Non-executive directors, share schemes and independence
We discussed how non-executive directors are paid in shares, permitted to benefit from option schemes or required to reinvest their fees in shares in the light of the restrictions imposed on the remuneration of non-executives with shares.
Although there are technical difficulties in providing shares to non-executive directors as well as other non-employees as they do not fall within the scope of an "employees’ share scheme", it is usually possible to overcome these in ways which we discussed at the seminar. The real problem lies with corporate governance issues.
A particular concern was how non-executive directors at the smaller start-up company level do want options (and were often awarded to them pre-float to attract them to the company) yet this causes negative responses from investors concerning "independence" which can lead to some institutions and voting agencies proxy against reappointment of directors. No doubt this will continue to be an area where there will be tension and battles of will between investors and companies.
Dilution limits
The ABI guidelines specify that overall dilution under all schemes should not exceed 10% in any 10 year-period.
This limit continues to cause problems for biotech and other start-up companies as it can quickly be used up.
Solutions to this problem discussed were:
"Phantom" arrangements (where a cash amount equal to the gain on a notional share award is paid) are anathema to most biotech companies as they are under great pressure not to reduce their cash pile unnecessarily. At least one participant at our breakfast uses phantom arrangements - but its unusual cash generative circumstances are what explain this. If you do use cash, however, always remember to consider a cap, and that it is not normally possible to transfer the employers’ NIC burden.
ABI limits only apply to newly issued shares. If a trust buys shares on the market and releases them to participants, this will not count towards ABI limits. However, unless there is a requirement for an employee to pay a large exercise price there is a cash cost to this arrangement, which must be funded by the company. There will also be a need for an employee trust. Please note that treasury shares are treated as newly issued shares for ABI limit purposes.
Free share arrangements use fewer shares and this causes less dilution as a participant receives the whole value of a share, not just its rise in value as with option arrangements.
- SARs (or Stock Appreciation Rights)
A number of companies are now giving themselves the flexibility to satisfy options in this way, although few are actually taking the plunge and taking advantage of scheme rules which permit this. For example, say an option was granted over 1,000 shares at an exercise price of £1, and the option is exercised when the share price is £3. Instead of satisfying the option in the normal way, a company could just issue 666 shares for free - thus cutting dilution down by one third, but giving the option holder the same profit. This does not work for Revenue approved options, however, as it would cause tax approval to be lost.
- Increase the scheme limits?
The ABI do not publicly admit that the 10% guideline can be breached, but there are companies who have done this both with and without shareholder approval. This depends on maintaining good shareholder relations and demonstrating business need. A strategy for complying with the guidelines in the future may also be helpful. Pre-float options are excluded from the limit and so a company coming up to float may do well to grant options early.
- Cancel underwater options (repricing)?
As above, this is publicly not condoned but it does occur, sometimes with express shareholder support. Although ABI guidelines say that cancelled options should count towards individual limits, given the flexibility on individual limits nowadays, this may not be a problem.
One question was asked about shareholder sanctions if ABI limits were breached. If a company did introduce a new scheme without shareholder approval (as is possible if there is an AIM listing) then likely formal responses might include voting against a remuneration report or individual members of the remuneration committee (and in particular, the chairman). It is however, very difficult, for any investor to detect actual levels of dilution caused by share schemes - there is no best practice requirement (yet) to show a company’s scoring against the 10% limit.
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