Stock Options for New Biotech Firms: Dealing with Early Hires and Buyout Scenarios

Mitigating Price Volatility

A number of issues around employee equity can be especially difficult to handle for first-time founders and their Boards. These are problems we’ve seen wrestled with in hundreds of pre-commercial biotech Board meetings every year, as newly formed Compensation Committees encounter a familiar set of challenges around attracting and retaining top talent. The first of those challenges— and typically the most immediate—is the volatility of share prices as new biotech firms grow.

That volatility creates a set of interlinked difficulties. Stock options, whether ISOs or NSOs, come with an exercise or strike price that is most often determined at time of issue. Two employees might be hired just a few days apart and granted the same number of shares, and still end up with equity that differs in value by 10% or more. The result is a lack of grant consistency between employees, a lack of grant consistency over time, and an inability to implement a fair, well-documented plan for both short- and long-term employee compensation.

Because equity is typically a primary element of offers made by newer, relatively cash-poor startups, failing to deal with the problems quickly can result in significant lost opportunities and reduced competitiveness during a critical growth stage. We have seen three solutions work well.

First, you can grant equity partly in the form of restricted stock or Restricted Stock Units (RSUs). RSUs are less tax- efficient than stock options, and do not offer the same leverage, but they also give the new employee outright ownership of a given number of full-value shares—there’s no exercise price, and so no disparity between grants issued to different employees. This approach is the simplest, and by far the most common.

Second, companies can spread grants over multiple dates, mitigating volatility by effect- ively averaging unit value across multiple exercise prices. While you do need to be careful of introducing added adminis- trative complexity with this approach, and should certainly consult your accounting team to avoid punitive accounting or tax implications, it can be a simple means of ensuring that no employee is overly disadvantaged.

Third, and perhaps most usefully, you can set excise price using an averaging period rather than a single date. This is a more complex and powerful alternative to the multiple-dates solution, but it can also make the company subject to heavy penalties under IRC Section 409a. To avoid those penalties, you’ll need to ensure three conditions are met:

1. The decision to measure the option exercise price must be made at the beginning of the period, and is irrevocable
2. The individual recipients and their award sizes must be identified at the beginning of the averaging period
3. The averaging period cannot be more than 30 days before or 30 days after the grant date

To select the option that’s best for you, we recommend having your accounting team model the outcomes for direct comparison. If you have enough employees, model retrospectively, comparing what your outcomes would have been had you adopted each approach. If you’re still operating with a small team, make some reasonable projections for growth and model those.

Protecting Employee Equity in M&A Scenarios

The end goal for most smaller biotechs is acquisition by a major player in pharma, services, or med-tech. When that happens, the employees responsible for your success can have the value of their equity dramatically reduced if appropriate safeguards are not put in place, resulting in damaged morale, lost loyalty, and reduced performance. While M&A deals are too complicated to allow for any generalized solutions, there are a few considerations that should be top-of-mind as you prepare equity packages.

• Vesting schedules should be generous enough to ensure that at least some shares have vested by the time a merger takes place. Unvested shares are at much higher risk of losing value, especially if they are underwater (i.e., if their current market value is lower than their exercise price). Failing this, negotiations and pre-merger funding should prioritize accelerating existing vesting schedules wherever possible.
• Offer multiple forms of equity in every compensation package. Options should certainly be balanced with RSUs, and it can be worth it to include Stock Appreciation Rights, “phantom” equity, and other grants.
• Offer lengthy post-termination exercise windows. This increases employees’ flexibility and freedom as they make decisions about their own futures once notified of the M&A, reducing the likelihood of finding themselves trapped in “golden handcuffs.”
• Communicate proactively about the merger or acquisition, and offer guidance on equity outcomes as soon as possible.
• Finally—and this really goes without saying—where possible, ensure that the acquiring company will assume, substitute, or cash out existing equity.