Despite best intentions, the new SEC rules create additional burden and likely confusion on links between executive pay and company performance.
Years in the making, the SEC recently announced additional pay for performance disclosure requirements under the Dodd Frank act. At 234 pages, the final ruling (Final rule: Pay Versus Performance (sec.gov)), is a lot for most management teams and Compensation Committees to digest. Below, we summarize the high points and discuss the implications for companies in the technology and life sciences sectors.
What is it?
New requirements include an additional pay for performance table and narrative to illustrate the link between pay and performance over a five-year period.
Who does this impact?
All reporting companies, except Emerging Growth Companies (EGCs) and foreign private issuers, will need to include this additional information in their executive compensation disclosure. Smaller Reporting Companies (SRCs) have more limited disclosure requirements under the new rules, but following the same timeline.
The new executive compensation disclosure will be effective for fiscal years ending on or after 12/16/22, so for non-EGC calendar year companies, this will hit the upcoming proxy filed in 2023.
What needs to be disclosed?
Companies will need to include a new table with select compensation and performance metrics over the specified timeframe, as outlined below:
Additionally companies must include a ‘clear’ narrative and/or graphical description to go along with the table that describes the relationships between the performance measures and compensation actually paid to executives. Full reporting companies (Accelerated Filers) will also need to describe how their TSR compares to peer TSR and provide an unranked list of 3-7 financial performance measures the company selects as its “most important” measures (including the company selected measure in table above). Non-financial measures can also be included here.
The SEC has provided an illustrative example of the table format:
Alpine’s Takeaways for Life Sciences and Technology industry companies:
Many of our newly public clients can breathe a sigh of relief knowing EGC’s won’t be subject to PvP disclosure in their first year and can benefit from the learnings of those that do.
However, for those companies in the Life Sciences and Technology sectors that are SRC or Full Filers, we expect this addition to require additional time and effort in this first year of implementation. In particular, the introduction of additional Compensation Actually Paid calculations will require substantial effort and/or outside subject matter experts for many management teams. Most small and mid-cap life sciences and tech industry companies rely heavily on equity compensation and are likely to have numerous outstanding equity awards at the end of each fiscal year which will require new fair value calculations to capture the adjustments needed for this metric.
Note: While the spirit of the new rules is admirable, the disclosure requirements leave something to be desired in terms of providing shareholders useful insights to understand the linkage between executive pay and company performance.
At issue is the fact that the Compensation Actually Paid is anchored on a “fair value” (i.e., accounting value) methodology, rather than intrinsic value (i.e., actual realizable value) which is particularly problematic for stock option users – a common equity vehicle used among growth stage companies. Rather than calculate actual gains (i.e., [FMV less strike price] x number of shares vesting), the calculation measures the accounting value change from the point of grant to the point of vest (as well as year-over-year change in value). The result is yet another table in the proxy that will not translate for the tech and life sciences sectors.
Perhaps more concerning for growth stage companies is the likely disconnect between the required reported metrics and those that have been historically used as company established performance goals. Net income, for instance, is not commonly used as a measure to assess performance among pre-commercial life sciences companies focused on drug development or emerging software companies focused on top line growth. Even with the ability to add a company selected metric in the table – this is oriented to financial measures. Many development stage life sciences industry clients are focused primarily on R&D or clinical milestones and business development achievements that are often binary and simply won’t fit in the multi-year view requested by the SEC.
A potential downstream implication of this new disclosure may be that some companies feel pressured by the external optics to migrate their incentive structures to incorporate or emphasize the metrics focused on here, even if those metrics are not logical for the stage/scale of the company.
Lastly, for the disclosure to make sense, it presumes that the Named Executive Officers are stable during the full disclosure period. For earlier stage companies and those in the Life Sciences and Tech sectors, we know there is a fair amount of change that occurs at the executive ranks – both replacing and adding key roles as the company grows. Changing the basis for year-over-year comparison effectively nullifies the validity of those findings. And if there is a CEO change, there are specific calculations that must make their way into the table.
How to prepare?
Get ready early. Nearly all of the necessary disclosure inputs are available to you right now. Determine who “owns” the disclosure, what capabilities exist internally to complete it and work with your outside advisors to lend support (or fully outsource this effort) to give yourself a preview on the outcomes and the potential optics. Given the issues highlighted above for the tech and life sciences industry, the ‘most important’ company performance metric and narrative explanation will play a crucial role in ensuring the company pay and performance linkages are understood – regardless of what the fair value changes may suggest.
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