As if implications of the Enron Corp. situation hadn't already messed things up enough for biotechnology (and just about every other sector that uses balance sheets and ledgers), another spawn of the scandal has reared its head for industry leaders to fear and loathe.
Several spawns, actually. They come in the form of legislation in the House and in the Senate, and moves by the Internal Revenue Service and Financial Accounting Standards Board to change the guidelines for reporting employee stock options (ESOs) specifically, to require that the options appear on profit-and-loss balance sheets.
The issue has come up before. In 1994, the FASB mulled a provision that would require ESOs show up in stark black and white as part of expenses (rather than elsewhere, as they do already, in disclosures required by the Securities and Exchange Commission), but the board ultimately backed off, asking only for disclosure.
"Silicon Valley managed to beat it back the first time, but it's a different environment now," said Joseph Dougherty, analyst with Lehman Brothers.
After Enron, not only is the FASB back in the game, but bills have appeared (and been referred to committees) in the House and Senate, too, that would amend the Internal Revenue Code of 1986 so that "corporate tax benefits from stock option compensation expenses are allowed only to the extent such expenses are included in a corporation's financial statements."
What's wrong with that? Stock options surely represent a "cost." As such, they ought to be accounted for, so that investors can peruse a company's books and have some idea what kind of potential dilution they're dealing with, right?
Opponents in biotechnology say it's not quite so simple. To attach a value or cost to a stock option is an altogether hypothetical affair, and coming up with a formula on which everyone agrees could be almost impossible.
What's more, they argue, biotechnology executives faced with such complications might just throw up their arms and quit offering them, especially to lower-level employees (the better of whom might be recruited through such a lure) thus blunting the firm's competitive edge so severely that its chances of success are sadly reduced.
Steve Lawton, vice president for regulatory affairs and general counsel of the Biotechnology Industry Organization, insisted "it's not about [companies keeping or losing] profitability" as a result of adding ESOs to their balance sheets.
"This hurts the blue-collar guy," he told BioWorld Financial Watch, since reporting of ESOs the way reformers want would mean exposing them to IRS levies that are more painful for "blue-collar guys" that is, medical doctors and Ph.D.-level researchers.
"The CEOs can pay the tax," Lawton said.
IRS officials have clamored separately for a change in the rules, so there are two efforts afoot: one in Congress, and one by tax collectors.
"They have nothing to do with each other," Lawton said. The former is a proposed change in reporting methods, and the latter is "an event by the IRS to get more revenue."
An April 8 letter from trade associations including BIO to House Speaker Dennis Hastert (R.-Ill.) says the House bill, H.R. 4075, would "discourage broad-based, rank-and-file access to stock options; lead to investor confusion and less accurate financial statements; and raise taxes on companies issuing employee stock options."
The letter goes on to say boosters of the bill "erroneously claim Enron's accounting for its employee stock options significantly contributed to its collapse, [whereas in fact] stock options granted to Enron's employees were fully and clearly disclosed in its financial statements and had little if anything to do with its downfall."
Carl Feldbaum, president of BIO, said his organization is "unalterably opposed" to the legislation.
He's hardly alone although a sponsor of the identical bill in the other branch of Congress, Sen. Carl Levin (D-Mich.), has argued that the denial of any Enron connection is just plain wrong. The existing situation, Levin said, is what let Enron take $600 million in deductions without reporting them as expenses.
BIO also is asking the IRS to rescind Notice 2001-14, which will require employers to withhold FICA taxes on the exercise of incentive stock options and on purchases under employee stock purchase plans.
"As you know, Revenue Ruling 71-52 held that income recognized by employees and former employees from a disqualifying disposition of stock acquired under a qualified stock option is not 'wages,' and therefore the employer is not required to withhold FICA taxes on the income," BIO argues in the letter.
Enron or not, skeptics of the current guidelines (adopted several decades ago) abound in the accounting world. Under those rules, compensation expense need not be shown as an accrual if the exercise price is near the market price on the initial date the share numbers and the exercise price are made known.
ESOs are of particular interest in biotechnology. More employees there than in other tech sectors tend to get them, and they tend to get bigger ones usually a grant when hired that vests over three to five years, priced at the market rate when granted (or at the last valuation, for privately held firms), Dougherty said.
"Typical option grants at employment may be in the range of hundreds of options for junior employees, 5,000 to 15,000 for new Ph.D. scientists, tens of thousands for senior scientists and directors, and hundreds of thousands or more for senior management," Dougherty wrote in a research note. "Further option grants may follow during the course of employment, most significantly for senior management."
BioWorld's 2002 report on CEO compensation in the biotechnology industry found that the average potential future value of stock option grants awarded to the 244 full-year CEOs surveyed was $2.2 million, with a median of $553,000, with 171 CEOs (70 percent) receiving options. Eighty-eight CEOs (36 percent) exercised stock options and realized value in the 2000 fiscal year and, while the average long-term compensation for all CEOs was $1.9 million, those 88 realized average gains of $5.1 million and median gains of $799,000.
ESOs are also important further down the staff ladder, not only bringing the workers' interests closer to parallel with shareholders, but adding to the comfort level of new hires at start-up firms. Exercising an option, an employee buys shares from the company at the grant price and often sells them right away to cover the exercise price and along with any tax liabilities so the "value" of what's given the employee fails to appear as plainly as critics would like on profit-and-loss statements, hence the move in Congress to change the rules.
As Lawton pointed out, "In most of the companies, everybody has stock options. There are legal secretaries at Amgen [Inc.] who are millionaires."
Since 1995, companies have been providing rough estimates of ESO expenses in SEC reports, using what's called the Black-Scholes option pricing algorithm which is hardly precise, Dougherty notes. ESOs are difficult to transfer and have no value unless vested, for example, so accounting for them only when they are issued means nothing.
If "costs" appear in profit-and-loss statements (as Dougherty believes they will, maybe as early as 2003), will the Black-Scholes algorithm be used?
Dougherty finds it "no more offensive than any other likely candidate," he wrote. "Other, more complex option valuation methodologies may have more theoretical respectability but would also be comparatively opaque to investors."
He told BioWorld Financial Watch some firms already are issuing fewer options.
"It has the result of a pay cut for biotech employees," he said. "Many of them have been getting higher net compensation than they would in large pharma or academic settings."
Which firms will be hit the hardest?
"Most of the companies that are marginally profitable would feel this the most, but it's significant for some of the large-cap companies, too," Dougherty said, with a nod to Amgen and to Genentech Inc. The latter's stock-option expenses are greater than its net income, he said.
"The little companies just starting to offer them aren't profitable, so it's not such an obvious hit for them," Dougherty said, but those companies that have just attained profitability status could be in trouble.
"That's where people will find it most disconcerting," he said. "It's a real effect, too, because you lose some buyers for the stock." Inside the firms, although the "blue-collar" people will suffer, senior management is the more serious target.
"Those folks are highly motivated by this kind of mechanism," Dougherty said. Many scientists, on the other hand, "didn't choose that career for the compensation. They're still attracted [more by the] opportunity to do stimulating, rewarding work."
Lehman Brothers has issued a report titled, "If Another Accounting Shoe Drops, Biotech Toes May Be Hit." Dougherty said he's "not the only one who feels like this is going to happen." A number of chief financial officers have told him the same.
"My motive in putting out the report was not to rain on any parades, but let people know far enough in advance that this is coming, and [investors] can decide what they think of it," he said.