M&A – What’s the share plan impact when negotiating the deal?
The world of corporate finance has seen a bit more activity this year (2013) and M&A transactions are picking up as businesses look to consolidate and expand their offerings.
At RM2 we not only implement share plans but also administer them and provide advisory services to our clients to help them manage the share plan aspects of various corporate actions. We are very pleased to have assisted a number of our clients achieve a successful exit this year.
In this article we look at the considerations to be addressed when considering a M&A transaction in the context of employee incentives impact and in particular the question of how to best manage unvested Long-Term Incentive Plan (LTIP) options.
A merger transaction typically involves choosing between a good price or good terms; you can have one or other but not both. Frequently buyers and sellers focus on price and overlook the hidden costs that are buried in the deal terms detail.
One term that can have a significant impact on the deal value is the treatment of the target's unvested share options. Vested options (i.e. options held by an employee where the performance conditions have been met but the option has not yet been exercised) can be assumed by the acquirer or, more typically, cashed-out for their in-the-money value. Unvested options can be treated in a number of ways (the target's option plan typically provides the legal framework for the treatment of unvested options in a merger transaction). Some plans provide that any unvested options are cancelled, some plans provide for full acceleration of vesting in connection with the merger and, as is most common, some plans provide that vesting will be fully accelerated if the options are not assumed (i.e. rolled-over) by the acquirer. Each one of these alternatives should be reviewed carefully in terms of the potential impact to the deal and the purchase price.
Cancelling unvested options removes them from the cap table, eliminating their impact on the purchase price. However, option plans that call for cancelling options in a merger can create discord among the target's employees holding unvested options, who may feel that the merger transaction distorted their pre-transaction compensation arrangement. This can have a disruptive effect on the morale of the target's employee base, particularly the target's most recent hires, who tend to have the largest proportion of unvested options. Furthermore, the prospect of cancellation can result in instability among the target's employee base, making it difficult for the target to retain employees during the transaction negotiation period or following an aborted deal. Similarly, a potential acquirer will want to flag this provision in an option plan since it has real repercussions for the acquirer's ability to retain the target's employee base following the merger in the absence of significant post-close retention mechanisms. To the extent that the acquirer grants new options to retain the target's employees, those new options dilute the acquirer's existing shareholding base, thereby effectively increasing the "cost" of the transaction.
The alternative, full acceleration of unvested options, also has real costs for the target and the acquirer. Full acceleration effectively transfers deal consideration from the target's shareholders to employees who arguably haven't "earned it" by satisfying the employment vesting requirements for their option grants. This also has real costs for the acquirer, because as in the situation where the options are cancelled, the acquirer may need to provide significant post-close retention arrangements to the target's employees. This often has additional hidden costs for the acquirer, whose existing employees perceive the target's employees as getting a "golden hello" at their expense.
Unvested options can also be assumed by the acquirer. There are two potential scenarios. The acquirer can assume the unvested options and convert them to unvested options of the acquirer (for example a qualifying roll-over of Enterprise Management Incentive [EMI] options), which would come out of the acquirer's option pool. Sometimes the acquirer will view these options as a post-close retention cost and will assume the unvested options in addition to the negotiated purchase price. Acquirers are wary of treating the unvested options in this manner because in many cases, in anticipation of an acquisition, targets might make option grants that are outside the ordinary award pattern. This is particularly the case in circumstances where the acquirer may have a different view on the appropriate amount of post-closing retention, whether on an aggregate or individual level basis.
More often than not, the acquirer will take the position that assuming or substituting consideration for the unvested options is part of the deal consideration. In this case, the acquirer has effectively shifted a portion of the purchase price to a post-closing retention mechanism, which arguably should be understood between the parties as a separate post-closing cost of the acquirer.
In addition to assuming unvested options, acquirers can regard standard retention mechanisms as deal consideration. These can include retention bonuses, stock grants, above-market salaries and earn-outs. While we fully expect transactions to be structured with significant back-end "goodies" to successfully transition the goodwill of the business to the acquirer, we would suggest that the parties be clear on the real economics. In other words, the parties should be clear on the portion of the purchase price that reflects payment for the existing business (i.e., solely for the benefit of the target's equity holders) and the portion of the purchase price that could be more accurately characterized as post-closing retention cost (some of which may be for the benefit of the target's equity holders, some of which may be for the benefit of the target's continuing employees and some of which may ultimately revert back to the acquirer).
Finally, in many deals, the top-line purchase price, rather than the actual consideration to the target's equity holders, is the number used to calculate other deal terms such as indemnification limits, escrow amounts, management carve-out amounts and potential retention arrangements. Again, the greater the clarity on the real economics, the less likely it is that these economic terms are skewed in favour of the acquirer or the target. For example, if the deal consideration is £100 with £10 of value allocated to unvested options, should a typical 15% escrow be £15 (i.e., 15% * £100) or £13.50 (i.e., 15% * £90)? Usually this will be for the corporate finance team to advise but often their advice will require input in relation to the share scheme mechanics and that is where we can help.
More and more we are being asked if it is possible to build in post-deal lock-ins to the design terms of plans we are implementing. Of course many things are possible but the more you try to anticipate what an acquirer might want the more you narrow your pool of potential acquirers, as most will want to do the deal working from a clean sheet and not feel fettered by pre-existing ties. It is better to take full advantage of our equity modelling service to ensure that the level of awards made are appropriate, i.e. sufficient to act as a good incentive but not so overly generous that a participant cannot then be tempted by a post-deal lock-in offer by the acquirer.
There are many matters to consider as a business approaches a deal and it is essential to take advice on a timely basis. For example, did you know that changes introduced in Finance Act 2013 have also brought a welcome, albeit, narrow, window of opportunity for early Company Share Option Plan (CSOP) exercises to receive more favourable capital gains tax treatment rather than being chargeable to income tax when an exercise takes place within 3 years from grant as was previously the case? The criteria for the new CSOP legislation to apply are limited but if the deal is a cash takeover by way of general offer then the outcome for the option holders is now much better and there is no need to fear an accelerated transaction if those are the terms on the table. Our share plan health check service provide some salient guidance but please do call if you wish to book a consultation to discuss matters further.
For further advice on any of the content covered in this article, please call Liz Hunter on 020 8949 5522.