Equity Compensation During Merger or Acquisition

Casey Fenton

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September 2, 2023

Mergers and acquisitions (M&A) are common in the business world. It’s a way for private companies to grow and expand their operations, acquire new technologies, enter new markets, and increase shareholder value. However, M&A can also be a time of uncertainty and anxiety for employees of both the acquiring company and the acquired company, especially when it comes to equity compensation.

Equity compensation refers to various types of incentives and benefits that companies offer their employees in the form of stock-based options, restricted stock units (RSUs), stock appreciation rights (SARs), and other equity awards. Equity-based compensation is a powerful tool for attracting and retaining top talent, aligning employee interests with those of the shareholders, and motivating employees to work towards the company’s long-term goals.

However, when a company is involved in an M&A, the value of its equity awards and the fate of its equity position may be uncertain. In this article, we’ll explore what happens to stock based compensation during mergers and acquisitions, and what employees can do to protect their interests.

What Happens to Equity Compensation During Merger or Acquisition?

In an M&A, the acquiring company buys the acquired company, and as a result, the equity awards of employees of the acquired company may be affected. Here are some possible scenarios that employees of the target company may face:

Vested Stock Options

If an employee has vested stock options in the target company, they may have the option to exercise their options before the deal closes. This means they can purchase the company’s stock at the strike price and potentially sell it at the current market value after the deal closes. However, it’s important to consider the tax consequences of exercising stock-based options and consult with a financial advisor or tax professional.

Restricted Stock Units

If an employee has unvested RSUs in the target company, they may receive cash or stock from the acquiring company for the value of their unvested shares, based on the terms of the deal. Alternatively, the acquiring company may assume the unvested RSUs and continue the vesting schedule according to the original vesting schedule or accelerated vesting provisions.

Stock Appreciation Rights

If an employee has Stock Appreciation Rights (SARs) in the target company, they may receive cash or stock from the acquiring company for the value of their vested SARs, based on the terms of the deal.

Equity Awards of Key Employees

The acquiring company may offer equity awards to key employees of the target company to incentivize them to stay with the new company after the deal closes. This is often done to ensure talent retention and to align employee interests with those of the shareholders.

What About Legal Compliance for Acquiring Company?

It’s important to note that equity-based compensation during mergers and acquisitions must comply with legal regulations such as the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws are designed to protect investors from fraud and unfair practices, and they require public and private companies to disclose information about the securities they offer to their employees.

Furthermore, the acquiring company must ensure that equity compensation offered to employees of the target company is aligned with the acquiring company’s equity plans and vesting schedules. This ensures that employees of the target company are treated fairly and that their equity position is not negatively impacted by the deal.

Tax Implications of Equity Compensation During M&A

Another important consideration when it comes to equity-based compensation during M&A is the tax liability for employees. Here are some possible scenarios:

1. Out of the Money (OTM)

If an employee has unvested options that are OTM (i.e., the current market value of the company’s stock is lower than the exercise price of the options), the acquiring company may also need to consider how the equity-based compensation of the target company aligns with its own stock compensation philosophy. In some cases, the acquiring company may choose to cancel these options, leaving the employee with no equity compensation. Alternatively, the acquiring company may offer a cash payout to the employee instead of equity, which can be subject to payroll tax.

2. Disqualifying Disposition

If an employee decides to sell their stock immediately after exercising their options, this is known as a disqualifying disposition. In this case, the employee will be subject to taxes on the difference between the exercise price and the current market value of the stock. This difference is treated as ordinary income and is subject to payroll taxes, as well as federal and state income taxes.

3. Cancel Underwater Vested Grants

If the acquiring company decides to cancel underwater vested grants, employees will be left with no equity. However, in some cases, the acquiring company may choose to offer alternative stock-based compensation such as restricted stock awards or stock appreciation rights.

4. Double Trigger

Double trigger refers to a provision in equity plans that requires two events to occur before equity-based compensation can be triggered. For example, an employee may need to be terminated without cause and the company may need to be acquired for equity package to vest. This provision can help with talent retention during corporate transactions.

5. Single Trigger

Single trigger refers to a provision in equity plans that only requires one event to occur before equity-based compensation can be triggered. For example, equity may vest immediately upon the acquisition of the company. This provision can make it easier for employees to receive equity, but may not be as effective in retaining key employees.

Employee Retention and Continued Employment for the Acquired Company

Equity based compensation can also play a role in talent retention during and after a merger or acquisition. Key employees may have been granted equity awards, such as restricted stock units or incentive stock options, as part of their compensation packages. These employees may be hesitant to continue their employment with the new private company if the equity based compensation they were promised is no longer available.

To mitigate this risk, the acquiring company may need to provide incentives or guarantees to retain key employees. One option could be to accelerate the vesting of the equity awards of these employees, allowing them to receive the full value of their awards in the event of a change of control. This can help incentivize key employees to remain with the company and work towards the success of the new organization.

Tax Implications

Equity based compensation can also have significant tax obligations for both the target company and its employees. For example, employees who hold vested stock options or restricted stock units may be subject to the alternative minimum tax (AMT) and pay taxes when they exercise their options or receive their shares. Additionally, employees who receive equity-based compensation may be subject to payroll tax, which can impact their take-home pay.

Furthermore, if the acquiring company buys the target company's stock at a premium, employees of the target company who hold employee stock options or shares that are OTM may face a large tax bill if they exercise their options or sell their shares. This can create financial stress for employees and potentially lead to high turnover rates.

Complying With Regulatory Laws

Equity-based compensation plans must also comply with various legal requirements, including those related to securities laws and tax laws. The acquiring company will need to ensure that the equity compensation plans of the target company are in compliance with these regulations. Failure to comply with these laws can result in legal liabilities and financial penalties.

M&A Doesn’t Have to Look Bad for the Employees

Equity-based compensation field is a complex area that requires careful consideration during a merger or acquisition. The value of equity awards, vesting schedules, and exercise prices are all main factors that need to be carefully evaluated. Additionally, the acquiring company needs to consider how the equity plan of the target company aligns with its own compensation philosophy and ensure that the plans are legally compliant.

Furthermore, an equity plan can play a critical role in retaining key employees and incentivizing them to remain with the new private company. Accelerated vesting of equity awards can be an effective way to incentivize employees to remain with the company and work towards the success of the new organization.

Finally, the tax implications of employee stock-based compensation must be carefully evaluated to minimize the financial impact on both the employees and the company. By taking these main factors into consideration, the acquiring company can ensure that the equity-based compensation plans of the combined company are aligned with its goals and objectives and that they provide the necessary incentives for employees to remain with the company and drive its success.

We at Upstock believe that employees are as indispensable as the founders that built the company. That’s why we advocate for equity compensation plans that are designed to build a community of shared interests and goals. If you want to know how Upstock makes equity accessible to employees, drop us a message here and a representative will get back to you!

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ABOUT THE AUTHOR

Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

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