Medical Device Link.

Originally Published MX January/February 2006

FINANCE

A looming shift in accounting protocols is significantly affecting how medical device companies compensate their executives.

Ted Ginsburg

A recent accounting rule change will dramatically affect executive pay practices at many medical device companies in 2006. In light of the change, which requires employers to record the value of stock options granted to employees as an expense on financial statements, many medical device companies are reevaluating their executive compensation strategies.

This article discusses the nature of the accounting rule change, the impact of the rule change on companies' executive compensation practices, and what medtech executives can expect to see in the future.

Before and After

Most medical device companies use fair-market-value (FMV) stock options as a key part of their executive compensation programs. FMV options give executives the right to purchase shares of their employers' stock at a price equal to the fair market value of the shares on the date that the option is granted. If the share price rises after the options are granted, the executives can make a significant profit.

FMV options have traditionally been used to help align the interests of shareholders and executives: if executives can profit from upward movement in the company's share price, they arguably will act in the best interest of the shareholders, who naturally also want to see the price rise.

In previous years, medical device companies were not required to show the issuance of FMV options as expenses on financial statements. These only showed up as expenses on financial statements when the executives exercised the options. This accounting practice was one of the primary reasons FMV options were so popular among employers. Under it, companies were allowed to give executives something of perceived value with no immediate cash outlay or accounting expense. Critics of this accounting practice, prior to the rule change, argued that there must be a value to the options when they are granted, otherwise executives wouldn't value them.

After 20 years of debate and several postponements, the Financial Accounting Standards Board in December 2004 issued Financial Accounting Standard 123R (FAS 123R), which requires employers to recognize a financial statement expense when FMV options are granted as opposed to when they are exercised.¹ Consequently, starting in 2006, companies must recognize FMV options as financial statement expenses even if the options are never exercised. These options can go unexercised for several reasons, including an executive departure or a drop in stock price.

FAS 123R became effective for most publicly traded companies on the first fiscal year that started after June 15, 2005; privately held companies are required to adopt FAS 123R for the first fiscal quarter that begins after December 15, 2005.

Once it goes into effect, FAS 123R retroactively covers a company's existing FMV options that have not yet vested. It also covers any previously granted vested option that is exercised, as well as new options that are issued, after FAS 123R becomes effective for the employer. Outstanding nonvested options as of the effective date will result in a financial statement expense as they vest, and options issued after the effective date will result in a financial statement expense as they are granted.

Employers are currently evaluating their outstanding FMV options and equity programs to determine FAS 123R's full impact on future financial statements. As a result of these evaluations, the equity piece of executive compensation is undergoing tremendous change. A 2005 survey by Deloitte Consulting (New York City) of 343 companies across a wide range of industries found that 75% of employers were cutting back on the number of options granted. Not only are companies reducing the number of employees eligible to receive options, but those who remain eligible are finding themselves entitled to fewer options.²

Employers are not abandoning equity-compensation programs altogether, but they are changing the methods that are used to deliver these benefits to executives. The Deloitte survey indicates that 52% of publicly traded companies are moving toward time-vested restricted stock or restricted stock units (RSUs), and 40% are moving toward performance-based equity.

The Impact of FAS 123R

The medical device industry mirrors other industries in its use of fair-market-value stock options as the primary vehicle to put equity into executives' hands. The 2005 Medic Executive Compensation Survey, which includes input from 83 medical device companies, found that 63% of respondents offered nonqualified stock options and 51% offered incentive stock options. Some employers offered both. While only 16% of the surveyed companies had already adopted FAS 123R, 23% intended to change the terms or the grant levels of their nonqualified stock option programs in response to FAS 123R, and 15% of the companies offering incentive stock options intended to make changes. Additionally, 44% of respondents to the survey, conducted by Top Five Data Services Inc. (Fremont, CA), indicated that they planned to increase the level of restricted shares given.³

Prior to FAS 123R, many medical device companies maintained simple stock options for their executives. The options typically were priced at the fair market value on the date of the option grant, had a term of 10 years, and typically vested over a three-to- five-year term. Because FMV options were the standard of the industry, it was easy for employers and executives to compare their equity compensation packages with those of their competitors. The accounting, tax, and cash-flow effects of FMV options made them an ideal method of executive compensation for companies at all stages, from start-ups to multinational publicly traded entities. The chief drawback of FMV options was that their liberal use had an adverse effect on shareholder dilution.

The medical device industry is rapidly adapting to FAS 123R by decreasing FMV option usage and replacing that benefit with other equity vehicles that will have a less drastic impact on financial statements. Based on public filings with the Securities and Exchange Commission (SEC; Washington, DC), the following are examples of what medical device companies of varying sizes have done in this area.