WASHINGTON -- Long accustomed to singing the blues aboutunpredictable science, regulatory oversight and a capitalcrunch, biotechnology executives added mournful dirges in1993 about politicians who seem dead-set on reviewing drugprices. To that grim litany, add accountants.
The Financial Accounting Standards Board (FASB), the rule-making body of the accounting industry, this week resumedpublic hearings on its proposal to change stock optionreporting. The new rules would require companies to calculatethe value of stock options and charge that amount againstearnings (or, in the case of the biotechnology industry, add it tolosses).
Despite testimony from executives representing just aboutevery industry in the country and companies both large andsmall, it appears that FASB is moving steadily toward adoptingthe rules later this year. If passed, they would take effect in1997.
Biotechnology executives feel that the FASB rules willinadvertently hit the wrong target -- not unlike the price-control mechanisms in health care plans, which they feel areprimarily aimed at large pharmaceutical companies.Proponents of the new rules cite as examples of excess MichaelEisner, chairman of Walt Disney Co., who made more than $50million last year by selling off stock options that did not appearas a charge against his company's earnings.
"FASB and Congress want to stop abuses by the big guys, but indoing so they are hurting the little guys," said Kenneth Lee,national director of accounting firm Ernst & Young's LifeScience Industry Services.
Lee argued that biotechnology companies grant stock options toa greater percentage of employees than is the norm in almostany other industry and would therefore sufferdisproportionately from the rule. He said granting options is acrucial tool used to lure top scientists and management intoparticipation in a risky, volatile industry.
Under the new rules, companies would have to place a value onthe options they hand out and then add them as non-cashcharges to the bottom line (net income). For example, take thecase of one anonymous biotechnology company that hasalready calculated the potential effects of the rule on its profitand loss statements (P&L). The company has roughly 200employees, stock options that vest over a five-year period andan annual burn rate of $20 million.
In the first year the rule takes effect, the company estimated itwould take a non-cash hit to earnings (losses) of between $1.5million and $2 million. By the fifth year, when the chargereaches a "steady state" after rising progressively for theprevious four years, the company expected the figure to rise tobetween $3 million and $6 million. If the burn rate remainedconstant (an unlikely scenario), the charge would routinely addbetween 15 and 30 percent to the total.
Such a charge could delay the time point at which a companyreached profitability, according to executives and accountants.In addition, they fear that the higher burn rate might look badto stock analysts and investment bankers, who want to seecosts controlled. "The expense won't necessarily show up on aseparate line on the P&L statement," said Lee. "It might beburied in footnotes so that analysts can't easily subtract thenew hike in the burn rate from the regular spending rate."
Denise Gilbert, a former stock analyst who is now chieffinancial officer at Affymax Research Institute of Palo Alto,Calif., agreed. She also argued that the accepted mathematicalmodel for valuing stock options, the Black-Scholes model, isflawed. "Black-Scholes tends to overestimate the upside versusthe downside for volatile stocks," said Gilbert.
It's clear that in an industry as volatile as biotechnology, stockoptions that could be worth untold millions if the stock pricerises can just as easily sink deep "under water" into a darkdomain where the exercise or strike price of the option ishigher than the market price of the stock. But while Black-Scholes attempts to account for such volatility, Gilbert believesit does not do so adequately. "Stock options clearly have value,but how to value them to some future point in time is veryproblematic," she said.
If last year's proxy statements are any indication, companiesrarely used the Black-Scholes model to disclose the value ofoptions they granted to top executives. Rather, they used asimpler formula, approved by the Securities and ExchangeCommission, which assumes that the stock price on the date ofthe option grant appreciates at either 5 or 10 percent,compounded annually, for the entire term of the option.
According to Lee, aversion to use of the Black-Scholes model inproxy disclosure may stem from the fact that the model makesstock options in a volatile industry look more valuable than theSEC's 5 or 10 percent calculation. In a BioWorld review of theproxy statements of 69 biotechnology companies that handedout options as part of executive pay, the average potentialvalue of the options, using a 10 percent appreciation, was $1.8million -- not a paltry sum for executives who earned anaverage of $271,000 in cash compensation (see "BioWorld's1993 Annual Report on Biotechnology" for details.)
However, Larry Smith, managing director of Life SciencesResearch at Hambrecht & Quist in New York, said he doesn'tunderstand what all the fuss is about. "Most analysts I knoware capable of reading footnotes," he said. "I see nothing wrongwith the new rules." He quoted former Supreme Court JusticeLouis Brandeis, who once said, "Sunshine is the bestdisinfectant."
Smith said full disclosure and accounting of stock options willallow investment bankers and investors to take a good look atwhether companies are making intelligent decisions abouthanding out incentive stock options or are indiscriminatelydiluting shareholder value. "If I'm going to be a partner in yourbusiness, I want to know everything," he said. He added thatsome companies may be afraid of the new rules because thenumber of stock options granted is "embarrassingly high."
Smith said that analysts should focus on cash flow, not netincome, when analyzing burn rates. "Net income is a figment ofan accountant's imagination," he said. And for executives whoworry that stock analysts will be unable to discern true burnrates through the haze of non-cash charges to account for stockoptions, he said, "Tell them not to worry. The analyticcommunity will figure it out."
-- Lisa Piercey Washington Editor
(c) 1997 American Health Consultants. All rights reserved.