This article is written by Nishish Mishra Rajnish, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
Table of Contents
Introduction
Employee stock options are essentially a method of retaining or attracting employees having specific skills in a particular company. As a part of his compensation, the employee can buy a certain number of shares/stocks in the company at a fixed price and within a certain time period. Most employee stock option schemes provide for a waiting period before these can be exercised since the core idea is to reward an employee for staying with the company. Since the management of an investee/target company changes hands after an M&A transaction, the employees, together with their options are likely to be affected.
How are the employee stock options impacted in the event of an acquisition?
If the target company has in place an employee stock option scheme, how the stock options are impacted will depend upon the stage at which the option is, how the acquirer is looking to deal with the options, and the offer price.
Pool stock
ESOPS in Pool means those options which can be granted as a part of the scheme. A listed company usually blocks lists of the options since it is an administrative inconvenience to apply for listing every time the options are exercised. If the listed company is taken private, it will be delisted and therefore, the block listed options would cease to exist.
Granted options
Granted options are the options from the total pool which have been allocated to the employees on the basis of their performance. The granted options will be dealt with depending upon whether these are vested or unvested.
Vested options
Vested options are those which entitle an employee to exercise them and acquire shares in the company. Since this right is already available to the employee once an option is vested, the acquiring company would have to make some kind of payment for the employees to forego this right. For instance, the options could be cashed out in which case the amount will be paid depending upon the price offered to the shareholders as an exit opportunity. Alternatively, the options could be substituted with the stock of the acquiring company, just as the shares. It is also possible for the employees to exercise their shares and then surrender the shares to the acquiring company, but if the same price is being offered for the options as for the shares, the latter would be preferred since it takes less time.
Unvested options
That part of the granted options which have not vested is unvested stock options. These options are usually canceled, but in a less likely scenario, the acquiring company may accelerate the vesting of the unvested options to allow an exit option to the employees. This depends on whether there is a provision in the scheme providing for acceleration on the happening of a particular event such as a change in control (single trigger acceleration). There may also be a double trigger acceleration clause, for instance providing for the acceleration only that both the events happen, for example, change in control as well as the termination of the employment within a specific period. However, this would be a financial drain on the acquirer and might or might not go down well with the acquirer’s own employees.
Exercised options
If the options are already exercised, then they cease to be options. It simply means that the employee holds shares in the company. They will be offered an opportunity to exit like any other shareholders of the company and if there is a share-for-share swap, they will be offered the shares of the acquirer company. How options are dealt with can also depend upon what has been agreed upon between the two entities in the event of a recommended takeover.
In cash deal cases, the vested options are cashed out while the unvested options get converted into stock options of the acquiring company. The vesting schedules may remain the same for these unvested options. In stock deal cases, the acquiring company pays in stock for the target company, so all the vested and unvested options of the target company get converted into options of the acquiring company, and the same portion remains vested or unvested, as it were. In case the deal was a combination of stocks and cash, the employee may receive a portion of his option in cash while the remaining portion might be converted to the acquiring company’s stock.
What happens to in-the-money (ITM) or out-of-the-money (OTM) stock options?
An out-of-the-money (OTM) stock option is when the offer price is lower than the strike price, while an in-the-money (ITM) stock option is when the offer price is higher than the strike price. Employees of the acquired company are sometimes forced to accept the lower Intrinsic value of the stock options even in the case of ITM stock options instead of the application of the ‘Black & Scholes Model‘ which is the commonly used method for valuing the options. The out-of-the-money (OTM) stock options of the company being acquired are generally canceled.
There can be several outcomes when acquiring companies deal with the ESOPs of the target companies. For instance, when Microsoft bought Skype in 2011, the employees were unable to hold on to the vested part of their stock options. However, there are also instances of the employees being hugely benefited from ESOPS, for instance, the Walmart-Flipkart (2018), more than 2000 employees are eagerly waiting for the buyback of 100% of their vested options. Additionally, there are instances where the top-executives are heavily compensated by their vested and unvested options, for instance, RedBus – Ibibo (2013), It is to be noted that in some cases, the acquiring company might give additional stock options to the newly acquired key employees as a part of the retention bonus.
What should the acquiring company take care of in relation to the employee stock options?
Due diligence
- The provisions of the employee stock option scheme would be checked at the time of due diligence so that the acquirer company can know what the obligations are under the scheme. The treatment of the stock options and different awards and the issues likely to arise after the transaction should clearly be highlighted by the lawyer or other consultant/employee performing the due diligence.
- It might be noted that the stock options are linked to employment. The provisions of the employment agreements of the relevant employees will also be checked to know the exact outcome for the stock options. If as a consequence of the M&A transaction and depending upon the agreement of the company with the employee, the employment is terminated, in the absence of a clause relating to acceleration the unvested stock options will lapse. Not only this, if there is a specific clawback provision in the employment agreement even the vested option can be taken back.
Valuation
a. There are certain standard valuation models that allow the acquiring company to successfully value the employee stock options. They are;
(1) The Black & Scholes Model, 1973 (B-S Model),
(2) the binomial model of Cox, Ross, and Rubinstein (1979), and
The B-S Model is the most commonly used formula.
b. Valuation of the target company includes the valuation of its ESOPs and this is done just after the preliminary discussions of acquisition planning, and right before the negotiation, where the offer value by the acquiring company will be negotiated upon. The valuation is to be done by a certified valuer, i.e., a Chartered Accountant who gives a valuation certificate (if done by a Merchant Banker, he will obtain a Valuation Certificate from an Independent Chartered Accountant) that mentions the valuation method, the value on the date of valuation, and the information available for such valuation.
c. The use of the valuation models also depends upon the provisions of the scheme and sometimes, the provisions of the scheme make the use of certain valuation models not feasible.
What should the target company take care of in relation to the employee stock options?
A target company has to take care of its employees and ensure that the acquirer offers proper terms to them. Irrespective of whether or not there is an M&A transaction, it is vital that the employee stock option plan is properly drafted, and the following is kept in mind.
- Cash-out of options with payments equivalent to the distinction between the exercise of the option and the cost per share of the underlying stock. This benefits the acquirer as well as the employees.
- The cancellation of underwater options without consideration. Underwater stock options are those where the exercise price is greater than the market price of the underlying stock.
- Intermittently keep reviewing the stock option plans and types of understanding in light of proceeding with changes in the law (for instance, the Companies (Share Capital and Debenture) Rules, 2014, in India) and market practices In compensation arrangements and corporate transactions.
Can employees complain anywhere if they face unfavorable terms on account of the m&a transaction?
Employee stock options are provided as a part of the employment agreement and are usually in accordance with the prevailing stock option scheme. Therefore, any dealing with the stock options which is not in accordance with the employment agreement can be treated as a breach of contract. The employees can also oppose the scheme of arrangement before the NCLAT since the scheme of arrangements in India needs to be court-approved, and the NCLT should be approving the scheme of arrangements in the public interest and also because, in absence of an objection, the Courts should not reassess the scheme of arrangement even if it does not benefit employee option holders, particularly when it holds majority assent by the shareholders.
Conclusion
We understood that the Employee Stock Options (ESOP) are a great method to retain the best employees having expertise, skills, and talents in the company. We also studied that if the target company has in place an employee stock option scheme, then the stock options impacted will depend on various factors. In the end, we also discussed that an employee can complain if they face unfavorable terms on account of the M&A transaction as such a term will be treated as a breach of contract.
References
- https://economictimes.indiatimes.com/definition/Esop
- https://visionpointcapital.com/2020/07/esops-in-mergers-and-acquisitions/
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