28 August 2020
One of the most important issues that arises in any M&A transaction from a compensation perspective is the treatment of stock options, restricted stock, restricted stock units (RSUs) or other compensatory equity awards, whether vested or unvested, held by executives and other employees in the transaction. Below is a high-level summary of key issues to consider in managing equity awards in the transaction.1
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Scope of Outstanding Equity Awards. The first step to determining the treatment of equity awards of the target company in a transaction is to understand the type and number of outstanding equity awards and their terms, including the groups of holders and key employees, whether vesting is time-based and/or performance-based, whether any vesting will be triggered by the transaction and the anticipated value of the awards, both vested and unvested, based on the estimated transaction price. This analysis will help frame the potential treatment of the awards in the transaction.
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Alternatives for Treatment of Equity Awards. A variety of factors may impact how the parties intend to treat the target company’s equity awards, such as the extent of cash available that may be used, potential dilution of the acquirer’s equity holders, employee retention, whether any awards are out-of-the-money, legal compliance, corporate, tax and securities law issues and administrative issues. Importantly, the terms of the target company’s equity plan will need to be reviewed to determine whether the proposed treatment of the awards is permitted by the plan – if not, consent from the affected participants may be required. Common alternatives for treating equity awards in a transaction include the following:
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Cash Out of Awards at Closing. Awards may be cancelled in exchange for a cash payment at closing based on the per share transaction price (or, in the case of a stock option, the excess of the per share transaction price over per share exercise price). In a private company sale transaction, post-closing payments, such as escrow or earnout payments, are typically made to selling shareholders and consideration should be given as to whether award holders will participate in those payments. The tax consequences of a cash-out should also be considered. In the US, cash-outs of awards are common, but in certain jurisdictions outside of the US, it may be more tax-efficient to require that awards be exercised or settled in shares with those shares being cashed out rather than cashing out the awards themselves. Also, post-closing payments made to award holders may need to be structured to avoid adverse tax consequences. For example, in the US, the deferred compensation rules of Internal Revenue Code Section 409A (Section 409A) include provisions governing post-closing payments that may apply.
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Conversion of Awards Into Cash Payable Over the Original Vesting Schedule. Awards may be cancelled in exchange for a cash payment based on the transaction price payable over the original vesting schedule of the award. In this arrangement, holders of vested awards would generally receive payment at closing, while holders of unvested awards would receive payment only to the extent that they become vested under the original vesting schedule of the award, which is typically tied to continued employment with the acquirer post-closing. In the case of stock options held by US taxpayers, this design raises potential Section 409A issues that should be discussed with counsel. In certain non-US jurisdictions such as Canada, this design may also raise tax issues that should be discussed with counsel.
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Assumption of Awards by Acquirer. An acquirer may assume outstanding awards under the target company’s equity plan, and the plan itself, so that the vesting and other terms and conditions of the award will generally continue in effect after closing, except that shares of acquirer stock willbe issued under the award in lieu of target company stock. The number of shares subject to the award and, if applicable, the exercise price per share, will need to be adjusted to reflect the transaction. Tax issues relating to an assumption of awards should also be considered. For example, under US tax law, an adjustment for stock options must preserve the aggregate spread value in order to comply with Section 409A and stock options that are designated as “incentive stock options” cannot be modified in a manner that would result in a loss of their tax-qualified status. Similar requirements for preserving the intrinsic value of the awards may apply in other countries to avoid negative tax treatment upon the assumption.
If the target company’s equity plan is assumed, any shares that remain available for issuance under that plan may be used for future grants by the acquirer and should not count against the share reserve of the acquirer’s equity plan. The acquirer will need to comply with applicable securities law with respect to the assumed awards which, for US publicly held companies, may require registration on Form S-8 for shares underlying the assumed awards.
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Substitution of Awards by Acquirer. An acquirer may substitute awards by cancelling the target company’s awards and issuing new awards under the acquirer’s equity plan. Shares of acquirer stock that are issued under the acquirer’s equity plan may count against that plan’s share reserve depending on the terms of the plan. Like an assumption of awards, the number of shares subject to the new award and, if applicable, the exercise price per share, will need to be adjusted to reflect the transaction and similar tax issues should be considered, such as preserving the aggregate spread value for stock options and avoiding modifications to incentive stock options that may jeopardize their tax-qualified status.
The same form of equity award is typically issued in substitution of an award (i.e. substituting acquirer RSUs for target company RSUs). If the parties desire to substitute a different form of equity award, then the substitution will need to be reviewed for legal compliance, tax and securities law issues in the relevant jurisdiction. For example, under US tax law, target company stock options are generally substituted with acquirer stock options to avoid the risk of running afoul of Section 409A.
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Mandatory Exercise of Awards. A target company may provide that holders of equity awards, to the extent exercisable (i.e. vested stock options), will have a specified period of time (i.e. 15 days prior to a change in control transaction) to exercise their awards and, if the awards are not exercised prior to closing, then they will be cancelled for no consideration at closing. In this case, shares acquired upon exercise of the award should be treated in the same manner as shares of the same type held by other stockholders in the transaction. The exercise of the award will typically be contingent upon the closing of the transaction so that if closing does not occur for any reason the exercise will be disregarded. In some jurisdictions this structure may be more favorable to participants from a tax perspective than providing for an automatic cash out of awards at closing.
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Cancellation of Awards for No Consideration. An acquirer may desire to cancel out-of-the-money awards (i.e. underwater stock options for which the transaction price per share is less than the exercise price per share) for no consideration. The terms of the underlying equity plan documents will need to be reviewed to determine whether this cancellation is permitted – if not, then consent of the affected award holders would be needed. It would be unusual for in-the-money awards to be cancelled for no consideration, except in the case of performance-vesting awards for which the applicable performance metrics are not achieved.
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Accelerated Vesting. A critical issue when evaluating the treatment of equity awards in any transaction is whether accelerated vesting of the award is required or permitted, and the conditions to acceleration. Accelerated vesting may occur solely as a result of the transaction (i.e. single trigger) or upon a termination of employment, either in connection with the transaction (i.e. double trigger) or alone without regard to the transaction. Accelerated vesting provisions may be found in the equity plan, award agreements or other contracts with individual employees, such as an employment agreement, offer letter or severance policy.
When accelerated vesting is triggered by a termination of employment, the termination must typically occur either by the Company without “cause” or by the participant for “good reason,” or, in some cases, retirement or a termination for any reason (a “walk-away right”), depending on the terms of the underlying contracts. If an award holder is entitled to accelerated vesting upon a resignation for good reason, the definition of “good reason” under the contract should be carefully reviewed to determine whether the transaction, or actions taken by the acquirer in connection with the transaction (such as a change in title, duties or responsibilities), may give the holder the right to resign and become entitled to accelerated vesting. If so, the acquirer may desire to enter into a waiver agreement whereby the holder may waive such right in exchange for the payment of additional consideration to avoid triggering the accelerated vesting provision.
Acceleration of vesting in the transaction may also have tax consequences. In the US, accelerated vesting generally constitutes a “parachute payment” under the golden parachute provisions of Internal Revenue Code Section 280G, which may result in the imposition of a 20% excise tax on the individual taxpayer, and a loss of tax deduction by the corporation, if there are any “excess parachute payments” (within the meaning of Section 280G) unless an exception is available.
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Performance-Vesting Awards. Performance-vesting awards are subject to vesting based on the achievement of certain performance criteria, such as stock price, total shareholder return, earnings before interest, taxes, depreciation and amortization (EBITDA) or other company operating metrics or, for example, in the case of a private equity portfolio company, multiple of invested capital (MOIC) or internal rate of return (IRR). Award holders generally become vested in their awards to the extent that the applicable performance criteria are satisfied and the holder remains employed through the end of the performance period. Because the value of performance-vesting awards is primarily tied to company performance, awards typically become vested to the extent that the applicable performance criteria are achieved at the time of the transaction with any unvested portion of the award, for which the performance criteria was not achieved, being forfeited for no consideration. While the terms of the underlying plan and award documents will govern, below are a few key issues to consider when reviewing the documents:
When a transaction occurs during a performance period, actual performance is often measured at the time of the transaction, resulting in a shortened performance period, particularly if it is not practicable to track or measure the applicable performance criteria after closing. Alternatively, performance could be deemed achieved at target, maximum or another level of performance. After determining how to measure the level of performance, the next step is to consider whether to provide for full vesting or pro-rated vesting to reflect the portion of the shortened performance period during which the award holder was employed.
Another approach for performance-vesting awards is to measure the level of performance at closing and then convert the portion of the award for which performance is attained into a time-vesting award that vests after closing based on the holder’s continued employment over the remainder of the existing performance period. Award holders would receive credit for the portion of the performance period that has elapsed prior to closing.
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Pre-Closing Equity Award Grants. It is important to determine whether the target company intends to grant equity awards to employees during the period between the signing and closing of the transaction and, if so, the type of awards, the amount and the vesting (including accelerated vesting) and other terms and conditions of the awards. The transaction documents may include limitations on the ability of the target company to grant equity awards after signing without the acquirer’s consent. If the target company has a practice of granting stock options, then consideration should be given to other forms of equity awards, such as RSUs, because the valuation of the company is likely to approach the transaction price as the closing date approaches so that stock options are likely to have limited, if any, spread value given that the exercise price is generally equal to the fair value of the company on the date of grant. In addition, pre-closing equity award grants typically do not provide for any accelerated vesting upon the closing of the transaction if the award will be assumed or substituted.
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Post-Closing Equity Award Grants. Acquirers will often grant equity awards to certain key continuing employees of the target company shortly after the closing of the transaction as part of their new compensation arrangements with the acquirer. The form of equity award, amount of the equity award pool, individual allocations of awards and vesting and other terms and conditions of awards are often determined prior to closing. Certain key members of management may engage their own counsel to negotiate the terms of their compensation packages with the acquirer and its counsel. An acquirer will often have terms in mind based on its existing equity incentive programs from a business perspective while counsel and other advisors provide guidance on legal, tax and accounting issues as well as market practices. In particular, if these key employees are located in jurisdictions where the acquirer has not granted equity awards (or if the number of new employees is significant compared to the number of existing employees the acquirer has in a country), additional due diligence may be required to determine the feasibility of granting such post-closing awards.
Conclusion. Managing the treatment of equity awards in any M&A transaction requires careful analysis and planning as a variety of approaches are available depending on the type of outstanding awards, the intent of the parties from a business perspective and, importantly, the terms of the governing documents. In addition, special consideration should be given to any equity awards that may be granted by the target company between the signing and the closing of the transaction, as well as the terms of any equity incentive program made available to continuing employees by the acquirer post-closing.
Please feel free to reach out to a member of our compensation team for advice on these issues or any others that arise in your cross-border M&A transactions.
For further information, please contact:
Milton W. M. Cheng, Partner, Baker & McKenzie
milton.cheng@bakermckenzie.com
1 This summary is not intended to provide a complete list of the legal issues that may arise in any particular transaction as other corporate, tax and securities law issues may need to be considered.
