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.
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.
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.
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.
Under a single trigger provision, the vesting of options is accelerated and awards become exercisable immediately prior to a change of control.
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.
Steps to Consider
In preparation for the negotiation of a Corporate Transaction, companies should consider taking the following steps:
Pamela Greene, Member, PBGreene@mintz.com
Pamela Greene is a Member in Mintz Levin's Corporate & Securities Section. She concentrates on counseling the firm's public company clients with respect to executive compensation-related issues; securities compliance under both the Securities Act of 1933 and the Securities Exchange Act of 1934; and corporate governance matters, including compliance with the Sarbanes-Oxley Act of 2002. Pam works with public and private company management teams, boards, and compensation committees to develop and design appropriate executive compensation programs, and to resolve legal issues confronting employers when implementing and revising such programs. Pam also handles corporate and securities law matters for a range of businesses, including emerging companies and private equity investors. She represented both corporations and investors in private placements, public offerings, mergers and acquisitions, and general corporate law matters. Pam is admitted to practice in Massachusetts and is a member of the National Association of Stock Plan Professionals and received her J.D., cum laude, from Boston University School of Law.
Ann Margaret Eames, Associate, AMEames@mintz.com
Ann Margaret Eames is an Associate in Mintz Levin's Corporate & Securities Section. Her practice is focused on securities, venture capital and general corporate law. Ann Margaret advises public companies in connection with public offerings, SEC reporting compliance, listing requirements and general corporate governance matters. In addition, she represents both public and private companies and investors in a range of corporate transactions, including mergers and acquisitions, stock and asset purchases, and other finance transactions. Ann Margaret is admitted to practice in Massachusetts and received her J.D., summa cum laude, from Suffolk University Law School.
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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Mintz Levin. This work reflects the law at the time of writing June, 2011.