Too many investments in life science companies are made without the appropriate human capital due diligence which can lead to problems post-deal in areas like poor talent retention and excessive salary costs. Aon’s Keaton Hoffman – Partner, Executive Compensation, Talent Solutions and Matthew Robinson – Life Science Industry Leader, explore why getting the human capital due diligence right is vital and where venture capital firms and the wider private equity market should be focusing.
The life sciences industry is primed for investment. Figures from EY reveal total M&A investment of US$191 billion in global life sciences for 2023, up from US$142 billion in 2022. And while equities still look cheap compared to historical norms, with many big pharma companies sitting on significant cash piles and looking for growth, the life sciences sector is set to see an increase in deal activity and total M&A investment through 2024 and into 2025; a prediction already being played out given the raising of US$6.8 billion in venture capital funding for biotechs for the first quarter of 2024 – an almost US$1 billion increase over the busiest quarter of 2023.
Critical to the success of that investment, however, is the growing role and importance of human capital due diligence. For small venture capital firms (VCs) particularly, due diligence in the life sciences sector in the UK and Europe has been focused on legal, financial and scientific areas, but often lacks attention relating to an organisation’s human capital.
Consequently, it’s vital for VCs but also the wider private equity (PE) market to carry out appropriate human capital diligence before providing capital to spinouts or early phase biotech, medical tech or pharma companies. It’s a process that involves identifying key talent and retention risks as soon as possible, ensuring there is the right talent on board, not only at C-suite level but also throughout the organisation, and that the appropriate steps are taken in areas like compensation and benefits, organisation design, job architecture, job levels and workforce planning.
Pay Problems
It’s often the case that VCs in the UK and Europe complete their due diligence in the people and the team from their target, but do less investigation as to how they are compensated. Activity is mostly focused on the top management layer but not the full organisational structure which inevitably means problems arising post-deal in areas like salary levels, or whether there is a gender pay gap issue. Amongst some US life sciences investors, however, and even some European investors particularly in the tech space, there are often talent operations roles at VCs enabling them to take a more proactive role in executive recruitment and management of ongoing compensation systems, as opposed to merely occupying board seats on renumeration committees and steering and/or reacting to company proposals.
Hanging on to the Talent
Incentivisation plans offered to employees of small innovative biotechs when a VC comes should be another area of focus and need to be extensive because of the ongoing challenge around talent retention and recruitment. Having a structured incentivisation approach to new hires and the option of refresh grants for both founders and non-founders to drive towards some exit event is vital. How much compensation should be triggered at that value crystallisation event versus several years after? Are investors just trying to drive to the sale or the IPO, or are they looking to continue as a minority investor? If that’s the case, it is important to make sure existing talent continues to have “skin in the game” which will necessitate a different compensation structure that is phased for a period of time after the event.
A common question is around the size of the equity pool a VC needs to allow for when considering how much ownership it is prepared to give to employees through equity incentive plans. Rather than simply relying on a “rule-of-thumb” equity pool benchmark of, say, 10-15 percent of the fully-diluted share capital and working on a top-down approach, Aon encourage clients to take a bottom-up approach based on the specific hiring needs and rewards philosophy at the organisation. It’s important to understand which roles are being hired and where. In addition, the requisite pool size should vary based on the type of equity plan companies are offering, whether such plans are tax-qualified, and what exercise price is being used for option awards or growth share plans. Companies are organised differently with different equity needs, so the structure of that equity pool should be tailored rather than based on an overly simplistic headline percentage measurement.
Better Compensation Communication
There is also not enough investment in educating employees about what equity compensation means with a disconnect between equity value from an accounting perspective that an investor might be thinking is being delivered to employees, and actual compensation with a real return on investment.
There needs to be a shift away from talking about compensation in percentage terms to focus on actual value. Investors give away all this equity value, but employees often feel that what they got at the end of the day was less than was promised. It comes down to having a well thought out communications strategy and providing clear materials for employees to understand their future equity value. In addition, it is important to highlight the tax advantages that company incentive schemes offer, for example, and move the thinking to ‘net compensation’ – a benefit from the company structure underplayed in the communications.
Organisation Design, Job Evaluation and Workforce Planning
Another area often overlooked is in organisation design and job evaluation. Companies can frequently pay chief level salaries and compensation packages to people who aren’t really chiefs, which means they are overpaying in areas where they are not getting the job profiles and job levels right. Job evaluation tools, for example, can offer more structure around how companies should approach whether they have the right people in the right roles, which should also trigger a discussion about future workforce planning.
Many of these early-stage life sciences companies are looking for VC investment to build out new functions, moving into clinic, and setting up and preparing for later stage regulatory filings. The cost of building out those functions in the UK or Europe, for example, versus the US could look very different, so a critical question is where a company chooses to grow and what is the cost of talent and the impact on cash flow as a result of that decision? In some instances, access to the right talent is very location reliant and there will be some roles which have to be in the same geography where the organisation is trying to sell its products. Similarly, for other roles and how a company chooses to grow its business functions and set up additional research hubs, the issue of location might be less important.
Critically though, it’s not just about understanding what the company’s growth plans are as an investor, but pressure testing the cost of those growth plans in areas like workforce planning and evaluating whether they are optimised. If investors are expected to authorise a further increase down the road, this should be built into and understood at the point of the investment decision.
More Focus Needed on Human Capital
In the life sciences sector in the UK and in Europe, there are fewer talent operations specialists within the portfolio arm of the VC or investor that are specifically focused on talent and people topics. Attention is overly focused at executive level and pays less attention to wider staff population, potentially resulting in misaligned employee retention strategies and eroding workforce resilience. If broader human capital due diligence is undertaken pre-emptively, however, organisations can protect investments around their people risk, enabling better financial forecasting, and more certainty for investors which is particularly relevant around later stage or growth stage firms, when a product is close to commercialisation.
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