Trends in Public CEO Compensation

Stock options are out, performance shares and restricted stock are in, equity may constitute 50% to 70% of the compensation of a public company CEO, and the ISS is on the move. Trends in CEO compensation for the coming year were examined at the November 11th Breakfast meeting in Boston of the New England Chapter of the National Association of Corporate Directors.

Stock options used to be the standard equity play for CEOs. For companies undertaking substantial growth, they still can constitute a serviceable compensation tool for the equity side of the equation. However, performance shares and restricted stock seem to have taken over as the equity mechanisms of choice in most instances.

Other trends include establishing ownership guidelines for a CEO, and what is likely to come next is a mandatory holding period during which the CEO must retain shares after they have vested.

Golden parachutes are shrinking in importance, the multiple of annual salaries paid to CEOs in the event they are fired after a change of control is shrinking. Nobody is any longer granting a tax gross up to these CEOs to cover the taxes in the event they receive a parachute payment.

There was speculation that activist shareholders might be holding down run-away CEO pay, and there was debate over the efficacy or non-efficacy of the proposed SEC disclosure rule which will require information about the “all in” compensation of CEOs expressed as a multiple of the median employee salary. This metric, long overdue, creates problems for companies with international operations, where compensation of a US CEO will be perhaps thousands of times higher than median pay if most employees are located in places like India or China. It was suggested that alternate metrics could be provided, in addition to the required disclosure, perhaps also expressing CEO compensation as a multiple of median United States-only employees.

The influential Institutional Shareholder Services, which advises investors as to whether boards should be supported, is introducing a variety of changes to its outlook on CEO compensation for the 2015 proxy season. In terms of disclosure, credit will be given to companies for positive forward-looking compensation disclosures (historically disclosures have been more backward looking), and in evaluating plans for equity compensation the ISS will be more holistic, considering such matters as planned cost to shareholders (SVT or “shareholder value transfer”), grant practices (including historical plan grant burn-rate), and plan features (minimum vesting periods, minimum holding periods and clawbacks).

The ISS is also considering gender diversity, indicating that boards without women pose a higher government risk to investors based upon academic studies, and is also considering the number of financial experts on an audit committee (implying that having more than one such expert may result in less governance risk).

Getting Reimbursement Codes for Med Devices

Over the last few years, medical device companies have learned that in order to get financing at any level it is not only necessary to establish efficacy and potential economic benefits, but also necessary to understand a strategy for obtaining reimbursement for these benefits. A medical device company, to obtain financing, must show value to the party making the payment, not to another party in the use of the technology.

At MassMEDIC’s November 7th conference discussing markets for medical devices, it was suggested that one way to prove efficacy might be to target a smaller cohort notwithstanding the fact that one’s device might have general applicability. Proof of efficacy in the smaller cohort, and obtaining a reimbursement code, may be easier if focus is narrowed.

Noting that the United States is an outlier in the world’s healthcare universe, spending a disproportionate amount per person on healthcare, it was also noted that the value of a medical device in the United States market is higher by definition. Spending one day in a Unites States hospital is three or four times more expensive than one day in a European hospital. The United States also has an unusual model in that doctors are paid separately, which increases the likelihood that individual doctors will support new devices.

Some key take-aways with respect to the reimbursement system in the United States:

Reimbursement depends upon the setting, with different codes and different rates for the same procedure dependent upon whether that procedure is performed in a doctor’s office, a hospital ambulatory setting, or a hospital inpatient setting.

In the coming year, new ICD-10 codes, with far greater granularity, will be introduced in the United States, with mandatory usage beginning October 1, 2015. This will have huge impact on hospitals. (Coding for doctor offices and for outpatient treatment will continue to be under the CPT system.)

For a variety of reasons, many medical devices these days are first introduced in Europe, in the UK or Germany or Nordic countries. Most of Europe is on a single payer system. We thus have an anomaly: the value of medical devices is highest in the United States but the preferred path of introduction nonetheless is moving toward Europe in any event, by reason of ease of regulatory clearance and obtaining payment.

Why cannot a Med Device be more like a Molecule?

At the November 7th MassMEDIC Boston conference on medical devices, a panel suggested that the medical device industry could learn a lot about how to finance early stage development by looking at the bio pharma model. It was posited that the bio tech model was better, in every year studied, in raising Series A funding and in reaching the IPO market. Why?

One reason: the potential rewards are higher. A single successful drug can sell billions of dollars per year. Further, some bio tech inventions create a platform which may provide the basis for a variety of drugs, or the application of the technology to a variety of diseases, thereby providing the potential of greater ultimate return. Another argument, somewhat circular, is that bio deals can exit at an earlier stage, so the investment is de-risked.

The panel then took a swipe at engineers who design medical devices. Engineers always seek perfection. In bio, once you have a molecule that is done, it is ready for the clinic and then to go to market. Engineers are always tinkering with machines. And, you also have to build machines, which is more complex then replicating a successfully designed molecule. (Whether these arguments are accurate or not I cannot say, but they were advanced by the panel.)

Another major problem is that you cannot easily do clinical trials in the United States on medical devices, which creates a problem for investors.

Then there is the issue of being able to scale in order to earn money. There is high capital expenditure, in order to reach scale and lower the cost of goods, when you are building a machine. This is not true, it was contended, with respect to chemicals.

Finally, it was speculated that the robust level of communication between investment bankers and the bio tech community is not echoed in the medical device field. Medical device companies, it was alleged, don’t really reach out to the investment bankers and tell their story.

Trends in Med Device M&A, IPOs

At the MassMEDIC conference in Boston last Friday, Neil Oboroi of BOA/Merrill Lynch, an investment banker based in New York, discussed the M&A market for healthcare in general and medical devices in particular. As befits an investment banker, he was enthused with the increasing volume of healthcare M&A, and furthermore had statistics to demonstrate a positive link between M&A activity and stock price.

His belief is that stocks of companies effecting acquisitions in the life sciences out-perform their peer group (companies not undertaking M&A transactions) by 8% based upon share value. He predicts that consolidations in life science will continue, with acquirors seeking return on investment capital as opposed to looking only at earnings per share impact.

Many of the larger deals in the life sciences involved devices and diagnostics. Valuations, which peaked at about five times forward revenues in 2007 and fell to about three times in the ensuing years, are now up ticking again, in part because of the prevalence of cross-border transactions.

He also noted that larger publicly traded medical device companies were now trading at a little bit over twenty-three times forward earnings, down from approximately thirty-two times forward earnings a decade ago; so market multiples are falling. He also noted that many of the larger companies that had undertaken M&A were now choosing to report based on earnings per share, in addition to using a GAAP standard; earnings per share reporting allows easier comparison of companies, particularly as they are emerging.

Oboroi also touched upon inversion transactions, noting that earnings always were taxed where earned. The real play, made harder by recent tax changes, is the ability to utilize offshore cash domestically; the only way today to effect an inversion is through an M&A transaction.

There was also a discussion of the life science new issuance market, which is extremely robust and on a pace to equal or surpass the previous heights of the 2007 IPO market. The criteria for going public with a device company today: hard revenues, with a $25,000,000 to $50,000,000 minimum run rate, a growth curve, and a robust management team. The IPO market was viewed as synergistic with and consistent with the strong med tech M&A market.

New Seed Life Science Funding Source

The Massachusetts Life Science Center announced at the MassMEDIC conference in Boston last Friday that it had established a new competitive grant program designed to provide seed funding for emerging life science companies in order to de-risk subsequent angel and VC financing.

A life science company within broad categories of eligibility, having previously raised at least $50,000 but not more than $1,000,000, can apply for a grant of between $50,000 and $200,000 in order to reach specifically stated milestones identified in the application. The milestone goal might be development of a product, or reaching a certain stage of clinical trials, or obtaining a strategic positioning, or the grant of a patent or the filing of a patent, by way of example.

The application period begins December 8th and ends at noon on February 2nd; informational programs will be held in late November and early December in Boston, Beverly and Cambridge.

The program, called MAP, can be reviewed in detail at the following website: map@masslifesciences.com.

VCs, FDA, Corporate investment in med-tech: Dr. Fogarty speaks

The idea that venture capital has returned to the marketplace in order to finance life science companies, and particularly device companies, is simply not true, says Dr. Tom Fogarty, world renowned inventor and entrepreneur and most recently founder of the Fogarty Institute for Innovation, where he develops life science companies, in Mountainview, California.

Actually, Dr. Fogarty’s description of the non-presence of venture capital in the marketplace was a bit more descriptive, but I am not quite sure what the standards are for making reference to bovine excrement.  He delivered his remarks at today’s Medtech Showcase conducted in Boston by MassMEDIC.

Other gems:

            The problem with FDA clearance procedures is that the examiners belong to a union and do what they want to do.

            Corporate investment in life science is impeded in that large corporate investors give new technology to their own in-house people to evaluate; new technology that is better than in-house technology will not get funded on that model.

            Academics are no good at commercializing their technology, particularly in medicine.

Next week I will post a series of blogs on other take-aways from the MassMEDIC Showcase, covering a variety of subjects (new funding available through Massachusetts Life Science Center; the state of medical device M&A; the state of medical device IPOs; relative strategies for med device reimbursement in the United States as compared to Europe; a fascinating panel on why medical devices cannot seem to attract investment capital as easily as biotech).

American Law Uber Alles?

How far can American hegemony extend when it comes to laying down the law of international transactions?

Buried in Section B of yesterday’s Wall Street Journal are two articles which suggest that the United States, the world’s most robust economy, is attempting to not only establish a capitalist world, but also to bring along American legal structures that will regulate it.

A Federal Court of Appeals is now determining whether Motorola can bring a treble damages anti-trust case for price fixing against a group of Asian companies which fixed the price on liquid crystal display panels. Motorola purchased about $5,000,000,000 worth of LCD panels for its Razr phones and other uses, but purchased them (fully manufactured) through foreign based affiliates, without United States contact, in 99% of the cases. Do our anti-trust laws reach sales by foreign companies, to foreign purchasers which may be owned ultimately by United States companies, and which occur offshore?

The SEC and the DOJ long have been vigorous in enforcing the United States’ Foreign Corrupt Practices Act, which prohibits bribery of government agencies and government owned companies around the world. The WSJ reports a reduced fine to Avon, an American company, for bribes paid through subsidiaries in Africa and Australia, and the SEC suggests that the fines were greatly reduced by Avon self-reporting its violations to the SEC. DOJ Criminal Fraud Section noted that voluntary disclosure is “a huge factor” in fixing sanctions. The article contrasts Avon ($5,000,000 fine) to Marubeni, a Japanese trading company which did not report and this year agreed to pay $88,000,000 in fines. A commentator, cited in this article, noted that foreign companies are particularly insensitive to the subtle DOJ message that self-reporting is the path to a better economic result.

The international nature of all business raises the need for an international matrix of appropriate, non-obtrusive regulation. Will the relatively strict American legal system end up as the international standard?

And, if you want to truly understand the international nature of things, note that Motorola, claiming anti-trust violations by its Asian vendors, recently was purchased by China’s Lenovo. We have a Chinese parent claiming violation of United States anti-trust laws by Asian vendors supplying LCD screens to non-US subsidiaries outside the United States.

Trends in board’s role in strategy

 The just-released Blue Ribbon Report of the National Association of Corporate Directors on the board’s role in corporate strategy identifies the growing complexity of the marketplace, and the accelerating pace of change, requiring a “new level of board engagement.” Since directors long have considered strategic development as their core obligation, what more is being suggested?

Although the Report is full of specifics and flow charts which are useful, the bottom-line distillate is to move strategic discussion from an annual or quarterly basis to a continual process, identifying strategy as a year round central focus. This new focus is driven by marketplace realities, not by any change in the underlying law.

Not to be critical of the specific recommendations of the Report, which are both informative and cautionary, but one can read the report as primarily suggesting “do more of the same but do it better.” There are no startling “how to do it” revelations, which when you think about it is not surprising.

One interesting suggested innovation did catch my attention: executive sessions at the start and finish of every board meeting to permit independent directors to discuss strategy. The trend towards greater use of executive sessions, rubbing up against the practicalities of timing for board meetings, continues onward.

To the extent these NACD recommendations find their way into the directorship community, we might anticipate: it will take more time to be a director; there will be greater pressure in off-loading the other demands of directorship in favor of greater focus on strategy, which may create time tensions relative to committee service; there may be a subtle rethinking of the definition of a “good director” and an attempt to define the specific slot(s) as a “strategic director;” a change, through decided case law, in the standard of diligence required from directors under the so-called Caremark standard of duty to monitor (that whole area already is fuzzy in terms of its actual scope); and, a necessarily closer correlation between strategic consideration and enterprise risk management in a fluid environment.

Finally, it is good for directors to remember the following working definition of strategy: “the means to create economic value by gaining competitive advantage through unique value proposition.”

Director liability in insolvent companies

Much has been written, but few useful cases decided, defining the role of corporate directors of a company which is insolvent or within the “zone of insolvency.” A deep dive into that debate is beyond the scope of this post, but counselors to corporations under financial stress might want to take a look at the October 1st decision in Quadrant Structured Products decided by Delaware Chancery Court.

You don’t have to be a lawyer to understand the broad teaching here: directors do not owe any direct duty at any time to creditors; creditors can only make a claim against directors on a derivative basis which is to say, where they hold the position of the stakeholders in the corporation and the directors have breached their obligation to the corporation.

What is the standard for determining if a director is liable to a creditor for having managed an insolvent company in a manner which ultimately reduces the enterprise value to the creditors?

Directors should be comforted to know that, generally speaking, the “business judgment rule” applies. Even if a company is insolvent, if directors in good faith believe that by taking risk, spending money, etc. they can increase the value of the enterprise as a whole, then they are entitled to try and they are protected from liability if they have taken reasonable (and not self-interested) steps in that effort. (I do not here deal with issues created by director self-dealing, but there is even good news in the decision on that front.)

Globally, there is much discussion as to the duty of directors to creditors, but in the long run seldom resulting in any strategic adjustment. Typically: directors and management at all times want to build value, not waste it; strategic decisions in that context involve risk; many decisions will prove to have negative impact on value; good faith rational judgment by boards, even when a company is underwater, will be protected (at least in Delaware) from derivative claims asserted by creditors who have ended up short. Insolvency “does not mean that the directors cannot choose to continue the firm’s operations in the hope they can expand the inadequate pie such that the firm’s creditors get a greater recovery.”

Anatomy of a Pharma Exit

How does a bio pharma company with no sales, an FDA order to cease trials on its principal drug candidate, and a burn rate that has absorbed nine figures manage to nonetheless exit with a $3.85 billion dollar enterprise value?

The “how to” was explained at the ACG-Boston breakfast meeting, October 23rd, by Ron Renaud, former President and CEO of Idenix Pharmaceutical.

Idenix was doing research in the hot but highly competitive area of infectious diseases, including hepatitis and HIV, relying on small molecule research in an area described by Renaud as “nucleoside chemistry.” Notwithstanding initial backing from MPM Capital, Nomura and corporate partner Novartis (which also purchased 54% of the company in 2003, from then-shareholders, for $255,000,000), and with subsequent raises of an additional $200,000,000, by mid-2013 Idenix nonetheless found itself behind its competition (particularly Gilead, Vertex and Bristol Meyers). The company adopted a strategic plan to build a single pharmaceutical, administered by pill, which would address most forms of type C hepatitis without reliance on Interferon. In late 2013, the company began clinical trials in the face of a patent law suit by Gilead, with first results available about April, 2014.

Suddenly, without final data available but in the light of acquisitions by larger pharmaceutical companies at substantial multiples, in June, 2014 Merck offered a buyout of $24.50 per share in cash, a 239% premium above market; the deal closed on August 6, 2014, with Merck proudly announcing that it had purchased a company which had a portfolio of promising drugs including some major hepatitis C “candidates.”

Certainly timing had a lot to do with the enterprise value received from Merck, coupled with the worldwide incidence of hepatitis C (indicating a significant and continuing global market).

Renaud also particularly credited several specifics for his ability to guide his company to such a robust exit:

Continuous transparent communication with major shareholders, who were thus not spooked by day-to-day developments in the marketplace.

The raising of an additional $100,000,000 in capital from one of its existing major investors at the start of 2014, which allowed the company credibly to state that it intended to develop and market its own pharmaceuticals, and was not available at distress sale prices.

Renaud’s cynical take: nothing drives up the desire to do a deal, or the valuation of that deal, like telling a major pharma company that you are just not for sale.