Effects of an M&A on Stock Options
Purpose of this article is to briefly discuss the concept of M&A and stock options along with the implications of an M&A on stock options.
An M&A, or Merger and Acquisition, is a transaction in which one company acquires another and creates a new consolidated entity. While stock options in privately held companies are a way to incentivize and retain employees by offering a right to buy shares at a certain price after a particular period of time. Now probably you might wonder what is the impact on stock options in M&A? What will happen to stock options in an M&A deal? What is the treatment of stock options in an M&A? Well, the purpose of this article is to briefly discuss the concept of M&A and stock options along with the implications of an M&A on stock options.
M&A and stock options
You might have heard the terms M&A and stock options in the context of the financial sector. M&A is a traditional and conservative way to integrate two corporations, while stock options are a way to attract, incentivize and retain employees. These two concepts are typically different from each other, however, M&A deals often have an impact on stock options in various ways. Merger and Acquisition (M&A) is a common term in the business world. It generally refers to a consolidation between two companies. On the other hand, stock options are a right for employees to buy a certain number of shares at a particular price on or before a specific date, after which the stock option automatically expires.
What is merger and acquisition?
Mergers and Acquisitions, usually referred to as M&As are classic examples of two companies that are combining their assets, liabilities, and other resources to form a new company, thus consolidating all the business activities. It is essentially a financial transaction that aims at purchasing, integrating, merging, or acquiring one company from another. In other words, an M&A is a consolidation of two companies, in which one company (target company) is acquired by another company (acquirer company), which already exists in the market and is actively operating businesses.
Factors that affect stock options in M&A
Now that you have a fair idea about stock options and M&A let us look at the factors that affect stock options in an M&A. The following are some of the most important M&A factors that affect stock options:
- Vested options – Vested options are options that are either exercisable or still under the vesting period. In the case of an M&A deal, usually, the vested options are cashed out close to the strike price. Likewise, when the acquisition price is nearly the same as the exercise price in the grant, the gain may be minimal. In either case, the vested options are effectively converted into a bonus, which may have tax implications.
- Unvested options – Unvested options are those stock options that have not been vested yet. Similar to new-hire option pools, companies generally allocate entire troughs of shares to create new option grants for employees at acquired companies. In the case of unvested options during M&A, the employee may be issued new grants with a new vesting period, the company may convert it into cash, or the options may be canceled.
- Exercised shares – When options are exercised, the shares are transferred to the option holder. During M&A deals, shares that have been exercised are either paid out in cash or converted to common stock of the acquiring business. It is also important to note that the Employees may be able to exercise their stock options during or shortly after the M&A deal closes.
- Vesting – Vesting is the period of time an option holder must remain employed with the company in order to exercise the options. As a result, the acquiring company can retain the existing vesting schedule and the employees can continue to vest in the new company at the same rate as before. However, when the company grants new options, employees most likely receive a new vesting schedule that is similar to the previous grant.
- Holdback – In an M&A situation, the acquirer company may retain the vested stock options of the company being acquired and hold it back before issuing options to employees, though this is usually limited to founders or executives. Holdbacks often include distinct vesting schedules and conditions that encourage the founder to remain with the new business for a set period of time.
- Escrow – Escrow is a period of time after the M&A transaction is closed where a portion of the transaction value of the exercised options is withheld by the acquirer company. It is generally used to pay outstanding issues such as taxes or lawsuits after the deal is closed. It could take months or possibly a year to receive this money back, as the acquirer must withhold the funds until all outstanding claims have been resolved.
- Triggers – In an M&A deal, companies may trigger stock options of senior employees, executives, or founders. In fact, there are two types of triggers, a “single trigger” and a “double trigger”. Under a single trigger, it states that upon a change in control (i.e., acquisition or IPO) at the company, all of the shares vest. While, in a double trigger, the employee must be terminated and all the shares would vest following a change in control.
Acquisition scenario
Let us now imagine a more realistic situation to understand how stock options are accounted for in an M&A deal. Following is a table that illustrates the stock option treatment in an M&A deal:
Scenario | Meaning | Tax implication |
---|---|---|
At a predetermined ratio, the shares of an acquired company is effectively exchanged for stock in the acquiring company. | Whether the acquiring company is public or private will determine this. Shares that have been exercised and vested are typically paid out. | Taxes in private companies are based on the types of options and shares (ISOs, NSOs, or RSUs). |
An acquiring corporation pays cash for the acquiree and distributes funds to every security holder in accordance with a pre-determined valuation. | Those shares that are still outstanding and options that have vested often provide money. | Probably the tax implication will take place. |
A portion of equity shares are cashed out when purchased for both stock and cash, and the remaining amount is converted to stocks or options. | It's likely that the ratio of shares to cash will be the same for the majority of employees. | Depending on the amount of money and the kind of options that are granted. |
When a corporation is acquired for less than its previous valuation, this may occur when the acquired company has a high level of debt or performs poorly compared to its valuation. | This can result in the stock losing all of its value, depending on the strike price and investor liquidity preferences. | Even if the stock is worthless, the option holder might be able to deduct stock losses from the taxes. |
How does M&A impact stock options?
In a merger or acquisition, stock option holders may experience several changes. Below mentioned are some of the scenarios that could be witnessed in a merger or acquisition process:
- Most deals cancel some options – It has been noticed that most of the M&A deals include a significant number of stock options being canceled. In many cases, the cancellation often affects a majority of the stock options held by employees. However, while companies may cancel options, they generally reissue or grant new options to employees in order to keep the same vesting schedule in effect.
- Employees under pressure – Another common observation among many M&A transactions is that employees are under significant pressure during the merger or acquisition process. Employees under pressure in M&A could be due to their stock options, as employees are placed in a difficult dilemma of having to make a very difficult decision. Further, the decision could be expensive for the employees as they may have to pay high taxes on their options.
General outcomes for different types of equity in M&A
The following table provides some of the general outcomes for different types of equity based on an M&A situation:
Scenario | Exercised share | Unexercised vested Options | Unexercised unvested Options |
---|---|---|---|
Cash out | In most cases, an acquirer buys equity in the acquired company for cash. | The acquirer may pay cash consideration net of the strike price. Holdbacks may be applied to this consideration. | The acquirer may provide cash consideration net of the option's strike price. Restrictions may apply to this consideration. |
Estimations or substitutions | The acquirer may pay equity compensation. | The acquirer may assume or replace the acquirer's stock net of the strike price. While holdbacks may apply to this substitute equity. | Unvested options in the acquisition may be assumed by the acquirer or replaced by the acquirer's stock, net of the strike price. Restrictions might apply to this alternative equity. |
Cancellation | No change. | The acquirer can cancel underwater options. | Acquirer may cancel vested options regardless of whether it is underwater or not. |
Acceleration | Typically no change. | Option exercise may be permitted before, during, or after the M&A deal is complete, depending on the acquirer. | The acquiring party may permit the option exercise before, during, or after the completion of the M&A transaction. |
What to consider when getting issued equity?
In any case of issuing stock options to your employees during M&A, it is important for companies to consider various factors. These include:
- Liquidation preference – Liquidation preferences are often seen in the event of a merger and acquisition. It is important to ask the acquiring company to suggest a definite preference or negotiate a cap on the level of liquidation preference that could be paid upon the M&A deal. As a result, be clear on the number of shares that the acquiring company would prefer to sell during the IPO process.
- Exercise early and taxes – In case of a merger and acquisition, employees often exercise their options early in order to reduce tax liabilities. Depending on the type of stock and the date it was issued, exercising early may qualify for more advantageous tax treatment. Thus, it is important for the company or acquirer to consider this and institute a tax-friendly method for exercising options.
- Public companies – When the acquiring company is a public organization, the rules and regulations differ significantly. In some cases, employees are required to hold their options for a minimum period of time before they can sell their options. In this regard, it is imperative to decide the course of action based on whether the acquiring company is a public or private company.
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