August 13, 2002 | The media and institutional shareholders have been jumping on the "excessive executive compensation and stock options usage" bandwagon as of late. Legitimate stories of excessive executive compensation in the face of abysmal performance certainly exist, as do many technology firms that used stock options like a drug and are now paying the consequences. But does the life science industry fall into the same category as the once high-flying Internet firms? Results of the recently published Clark/Bardes study on executive compensation in the life science industry suggest not.
First, compensation must be put into the proper perspectives. Strategically, life science firms, particularly biotechnology and pharmaceutical companies, have a much longer time to market than most other industries. It is therefore critical to link executives and employees to the long-run success of the organization, primarily through stock options. Equally important is to offer competitive cash compensation, because the time frame to potential upside on the stock is lengthy, making it difficult to engage in cash-for-equity tradeoffs like those used in the technology sector.
|Cracking the Compensation Code: Executive Compensation and Stock Option Usage in the Life Sciences Industry — A 2002 Review of 109 Biotechnology, Medical Instruments and Drug/Pharmaceutical Firms. (Clark/Bardes Consulting)
Second, the financial dynamics of the industry are conducive to strong executive compensation packages. It takes tremendous capital to start these companies, given the lengthy, costly nature of research and clinical testing. Much of this investment is in human capital and compensation. Given the long development windows, most firms also go public with little or no revenue generation (in contrast with other industries). This provides liquidity to pay key talent competitive wages. The returns for successful firms in the life sciences have been substantial, further enabling highly competitive executive pay opportunities.
Finally, from a human capital perspective, success in the biotechnology and pharmaceutical industry is all about hiring and retaining top talent. The industry's rapid growth has put a premium on executive talent, albeit not quite on the scale of the dot-com boom. One reason for the relatively modest salary and stock escalation is that many new entrants hail from academia.
Source: Clark/Bardes Consulting
Let's examine an overview of executive compensation trends in the life science industry in comparison to other sectors, focusing on the CEO, chief financial officer (CFO), and chief legal officer (CLO). Two primary factors influence executive compensation: the firm's revenue and the industry sub-sector. Pay differs in biotechnology, medical instruments, and pharmaceutical companies, because the structural characteristics of the industries differ.
For example, there is a $400,000 average base salary for CEOs in biotechnology firms, compared with $381,000 for pharmaceutical companies and $300,000 in medical instrumentation. By comparison, CEO salaries in the technology industry survey averaged $515,000 for 2001. This gap will likely narrow as the industry matures. Pay also increases with revenue: CEOs at firms with revenues under $50 million receive an average of $300,000, but an average of $932,000 at firms with over $1 billion in revenue.
CEO bonuses also differ significantly by both firm size and sub-industry category. They average about 55 percent of base salary in firms under $250 million, but more than 100 percent in firms over $250 million in revenue. Drug firms pay the highest bonuses (66 percent), followed by biotechnology (43 percent). Most technology firms pay token or no bonus awards when revenues are below $50 million. This difference is probably related to the lengthy product development life cycles in life sciences, and the use of bonuses and incentives to keep executives and employees on track to meet major milestones in the development process.
Stock options remain by far the most significant component of executive pay. The median face value of CEO annual option grants for the life science industry was $2.3 million. Although certainly eye-catching, they fall significantly below those in high technology, where the 2001 median annual grant value was $10.4 million. However, CEO grants as a percentage of the total shares outstanding of the companies were almost identical (around 0.25 percent).
Overall, company-wide stock option grants have averaged 3.3 percent per year over the last three years. The high technology "burn rates" over the same period was in the 5.5 percent to 6.5 percent range. Three primary factors account for the difference: smaller headcounts for smaller firms mean less hiring and reduced demand for stock options; talent coming from academia and the big pharmaceutical companies do not expect options; and the life science industry has a strong desire not to repeat the "mistakes" that their technology company peers made relative to "overusing" equity.
An interesting trend is the relationship between CFO and CLO pay. Unlike virtually every other industry, in the life sciences the pay of the top legal executive is higher than that of the CFO — $250,000 versus $230,000, respectively, for base salaries, $330,000 versus $300,000 for total cash compensation. By contrast, CFOs in high technology receive $280,000 base salary and $403,000 total cash compensation, whereas CLOs earn an average of $266,000 with $363,000 total cash compensation. Why is legal more highly valued than finance in life science companies? Two factors: the necessity to protect intellectual property, and the equally important aspect of managing regulatory and testing processes.
Is pay relatively high in the life science industry? Yes. Should it be? Yes. Given its strong human capital focus, tight supply of highly qualified labor, and the increasing demand for talent, the trends we see in the life science industry are both understandable and justifiable.
Is executive pay in the life sciences out of control or too high? Hardly. Although it may appear high at the low revenue range of companies, the underlying foundation of this industry calls for a different level and structure of compensation than that found in other industries.
Jack Dolmat-Connell is a principal at Clark/Bardes Consulting. He can be reached at email@example.com. The full report is available in the "White Papers" section at www.bio-itworld.com.