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June 9‚ 2011
The Treatment of Stock Options in the Context of a
Merger or Acquisition Transaction
By Pamela B. Greene
and Ann Margaret Eames
A principal issue in merger and acquisition transactions is
whether, and to what extent, outstanding options will survive the
completion of the transaction and whether and when the vesting of options
will be accelerated. It is critical for a properly drafted equity incentive
plan to include clear, unambiguous provisions for the treatment of
outstanding awards in connection with these types of transactions, which
include a company’s consolidation with or acquisition by another entity in
a merger or consolidation, or a sale of all or substantially all of a
company’s assets (hereinafter referred to as a “Corporate Transaction”).
Whether a change of control of a company should provide for
accelerated vesting is a business decision and a separate and distinct
issue from the impact the Corporate Transaction will have on the
outstanding options. Equity incentives have significant implications in the
negotiation of a Corporate Transaction, as their treatment can affect the
value of the Corporate Transaction and the consideration to be received by
stockholders.
Corporate Transactions
To avoid unintended consequences and unwelcome constraints in
the negotiation of a Corporate Transaction, equity incentive plans should
provide the maximum flexibility for a company to equitably adjust awards
under its plan and should permit a company’s board of directors in its
discretion to determine at the time of the Corporate Transaction whether
outstanding options should be (1) assumed or substituted by the acquirer,
(2) cancelled at the time of the acquisition if not previously exercised,
or (3) cashed out in exchange for a cash payment equal to the difference
between the exercise price of the option and the price per share of the
underlying stock to be received in the Corporate Transaction. In a well
drafted plan, options do not need to be treated uniformly. For example, in
a cash transaction it would be most desirable to cancel “out of the money”
options for no consideration and provide for a cash payment for “in the
money” options.
Assumption vs. Substitution
An acquirer may want to assume the target company’s options
instead of substituting them to avoid depleting the acquirer’s existing
equity incentive plan pool and to avoid inadvertent modifications to the
awards that would convert an option intended to qualify as an incentive
stock option into a nonqualified stock option or cause application of
Section 409A of the Internal Revenue Code of 1986 (the “Internal Revenue
Code”). In addition, if the acquirer is a public company, subject to
certain limits and rules, the stock exchanges permit the issuance of shares
remaining under the target company’s assumed plan pool without additional
shareholder approval.
In contrast, an acquirer may decide to substitute instead of
assume the target company’s options because the acquirer wants all of its
options to have uniform terms and conditions, assuming this can be done
without the optionee’s consent and under applicable provisions of the
Internal Revenue Code. In addition, if the acquirer is a public company,
the acquirer will not have to register the shares underlying the
substituted options under the securities laws because a registration
statement would already be in effect, which is not the case with respect to
assumed options.
Cancellation
An acquirer may not want to assume the options because their
terms or the depth to which the company grants options within its workforce
may be inconsistent with its compensation culture. If the acquirer is not
paying cash for the underlying stock in the Corporate Transaction, it may
be unwilling to cash out the stock options. Therefore, the plan must
provide the flexibility to terminate options in order for the target company
to satisfy the acquirer’s position as how to best compensate the target
company’s employees going forward, which may or may not include the use of
options. In a cancellation, the optionees are provided the opportunity to
exercise their vested options up until the time of the Corporate
Transaction. In addition, in recent years as underwater stock options have
become more prevalent, the ability to cancel underwater options
unilaterally—and avoid post-closing dilution and compensation income
expense to the acquirer—has allowed the target company to reallocate, among
its stockholders and employees, the “cost” of these options in a Corporate
Transaction in a more productive manner.
Cash Out
Cashing out options provides similar benefits to an acquirer
as terminating options does, including no post-closing administration,
compensation expense, or increased potential dilution. It provides a simple
way for employees to receive cash for their equity without having to first
go out-of-pocket to fund the exercise price. It simplifies the
administrative and tax reporting process of the option exercise, as the
optionee will receive a cash payment and the company does not have to go
through the stock issuance procedure. Private company option holders favor
cashing out because it finally provides optionees with liquidity without
having to make an investment.
Acceleration of Vesting upon a Change of Control
A separate issue that must be assessed, at either the time of
the option grant or at the time of the Corporate Transaction, is whether
the vesting of any options should be accelerated if the Corporate
Transaction also constitutes or results in a change of control of the
company. Acceleration provisions may be set forth in the equity incentive
plan or other agreements outside of the plan, such as the agreement
evidencing the award, employment agreements, or severance and retention
agreements. Generally, change of control acceleration is in the form of
either a “single trigger” or a “double trigger.” Some plans and
arrangements contain a hybrid of the single and double trigger approach,
such as providing for the partial vesting of awards upon a change of control
event, with additional vesting if a second triggering event occurs; or
vesting that depends upon the treatment of the options in the Corporate
Transaction, such as providing for accelerated vesting only in the event
that awards are not assumed by the acquirer, since the optionee will no
longer have the opportunity post-transaction to continue to earn the option
through vesting, even if he or she remains employed.
Single Trigger
Under a single trigger provision, the vesting of options is
accelerated and awards become exercisable immediately prior to a change of
control.
Advantages
·
Aligns the interests of option holders and stockholders by
allowing the option holders to share in the value they have created
·
Provides for equitable treatment of all employees, regardless
of their length of employment (assuming all options are fully accelerated)
·
Provides for a built-in retention award, allowing the target
company to deliver an intact management team to the acquirer, which can
eliminate the need for a cash retention arrangement through the date of a
Corporate Transaction
·
No affect on earnings as vested equity awards are treated as
an expense of the target company
·
Beneficial when acquirer is going to terminate the existing
equity plan or will not be assuming or substituting the unvested options
Disadvantages
·
Can be viewed as a windfall for option holders who will be
terminated by the acquirer or who were recently employed by the target
company
·
No retention or motivational value after the change of
control
·
Will require the acquirer to issue its own equity
post-transaction to newly incentivize employees of the target company
·
The payment in respect of the acceleration will be taken from
the consideration that would otherwise go to the stockholders of the target
company
·
The acquirer must deal with the fact that its acquired
workforce has fully vested equity awards, while its pre-existing employees
do not, which may present integration issues
·
Viewed negatively by stockholders and investors, and
specifically by governance groups, as a problematic pay practice
Double Trigger
Under a double trigger provision, the vesting of awards
accelerates only if two events occur. First, a change of control must
occur. Second, the option holder’s employment must be terminated by the
acquirer without “cause” or the optionee leaves the acquirer for “good
reason” within a specified period of time following the change of control.
Advantages
·
Aligns option holder and stockholder interests more fully
·
Provides a key retention tool for senior executives who are
instrumental to the integration process
·
Alleviates the need for additional retention incentives by
the acquirer in the form of cash or additional equity
·
Provides protection for the option holder in the event of
termination of employment due to a change of control
·
Viewed by corporate governance and stockholder advisory
groups as the preferred approach to acceleration of vesting
Disadvantages
·
Option holders, unlike stockholders, may not immediately
share in any tangible increase in value of the company’s stock (or the
acquirer’s stock)
·
Loss of value if the unvested options are not assumed or
substituted by the acquirer, since a double trigger is useless if awards
are terminated at closing
·
If the acceleration provides a substantial payment, it provides
a disincentive for employees to be retained by the acquirer and a
motivation for those who continue to be employed to be asked to leave the
acquirer
Steps to Consider
In preparation for the negotiation of a Corporate
Transaction, companies should consider taking the following steps:
1. Review
the company’s existing equity incentive plans to determine and understand
what ability (or lack of ability) the company has to determine the
treatment of its stock options and other awards in connection with a Corporate
Transaction, and consider whether the plan or agreement can be amended to
fix problem grants.
2. Confirm
that the company’s existing equity incentive plans expressly and
unambiguously permit without the optionee’s consent the assumption,
termination, and cash out of options, including the cancellation of
underwater options without consideration.
3. Review
any and all agreements containing change of control provisions to ensure
that the provision governing the treatment of the award in a Corporate
Transaction and change of control protection (if any) are consistent.
4. Periodically
review the equity incentive plans and forms of agreement in light of
continuing changes in the law and market practices in compensation
arrangements and corporate transactions.
If you have any questions about this alert, please contact
the authors or your Mintz Levin attorney.
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