After M&A – 4 considerations for your team’s equity

Going through a merger or acquisition can have a major impact on a company’s employee equity compensation strategy and individual plans. Businesses need to ensure that by day one post-event they are ready to adapt to these changed circumstances.

With the recent uptick seen in global mergers and acquisitions (M&A) expected to intensify in the year ahead, increasing numbers of companies may find themselves entering into processes that will eventually lead to massive change, whether that involves joining with or being taken over by another entity, with even greater upheaval in prospect if any such deal involves taking a previously private company public or vice versa.

While the M&A process can impact upon just about every aspect of a company’s operations, one area almost certain to see significant change is that of employee equity compensation. The precise nature of that change will depend upon the specific equity awards regime operated by individual companies, but it is highly unlikely that any set of equity-based incentives would emerge from an M&A process without at least some alterations, whether that be the modification or ending of existing plans and/or beginning the process of introducing new stock awards.

Here, we look to highlight some of the main considerations, but it is important to note that we cannot look to deal with every point that may arise within the confines of a single blog-style article.

What happens to stock options after M&A?

Taking stock options as an example of a common type of equity used in employee compensation, what might happen to such plans by the time a merger or acquisition has played out? The answer to that question will most likely depend upon whether those options are vested or unvested.

With vested options, one of the following may occur:

• Cash out: All shares might be converted into cash. This could happen in the event of a takeover where the new owners do not offer equity compensation to employees and would therefore not want individuals in the company being absorbed to retain an equity interest.
• Assuming the options: In this scenario, the post-M&A company would allow the existing awards situation to continue. That means employees would be free to continue to hold their options or look to exercise them.
• Substitution: A third possibility is that the existing options plan would be cancelled, but replaced with new awards for affected employees in line with the terms already being offered to its people by the acquiring company.

When dealing with unvested, all of the above are possible courses of action, but an acquiring company might also choose to:

• Cancel the options: A new owner will not be obliged to honor unvested options and can therefore simply choose to cancel them. This would be the worst possible outcome for employees. However, in practice, new owners, assuming they want to cultivate a positive atmosphere at the outset, will tend to shy away from such a course of action.

Another possible scenario is:

• Accelerated vesting: Depending upon the terms of the stock options agreement, a merger or acquisition may trigger an accelerated vesting clause, wherever some or all outstanding options automatically vest. This may not be the preferred outcome for a purchasing company, but is favorable for employees.

New stock plans post-M&A

While being part of a merger or subject to an acquisition can be an exciting time at company level, it is also true that it can breed a certain level of anxiety among employees. This is not unusual, given that people tend to feel uneasy about major change and upheaval, with this possibly raising feelings of uncertainty around the future, whether justified or not. Offering new equity incentives and broadening the eligibility base can help to flip this and instead boost morale and generate enthusiasm around the company’s future.

What plan or plans you decide to introduce will depend upon the circumstances of the business, your employee profile, and what you want to achieve from expanding equity compensation opportunities post-merger or acquisition.

Among the possibilities are:

Employee stock purchase plans (ESPPs): ESPPs can be a popular choice when looking to broaden eligibility to most or all employees. Under this type of plan, companies typically make shares available at a discount (5% to 15%), with the price based on fair market value (FMV) on the first or last day of a defined offering period, usually using whichever price is lower as the reference point. This is commonly referred to as a ‘lookback’ feature.

There are two types of ESPP – qualified and non-qualified. Qualified ESPPs receive more favorable tax treatment, whereas there is more flexibility in how non-qualified ESPPs can be designed.

Stock options: Already referred to above, with stock options, a company grants employees the right to purchase a specified number of shares at a set price, with such awards commonly linked to a vesting schedule determined by performance and/or time.

There are two distinct types: incentive stock options (ISOs) and non-qualified options (NSOs). ISOs are granted under a formal stock plan and adhere to rules that make them eligible for favorable tax treatment. When options don’t abide by those rules, they are deemed to be NSOs and receive less favorable tax treatment.

Restricted stock: With restricted stock, employees are awarded company shares, but the vesting terms dictate when they receive those shares.

Shares can be granted for free, at a discount, or based on FMV.

Depending upon how they settle their tax liability, employees may receive favorable treatment. If they opt for a Section 83(b) election, participants pay their tax bill at the outset, with the reasoning being that they will benefit if the FMV increases over time. This can play out well, but there is also risk attached. For example, in the event of shares being forfeited during the vesting period, participants can lose out, as any Section 83(b)-related tax payment will be non-refundable.

The importance of effective employee communications around M&A

The period leading up to and following a merger or acquisition can be a bit of a whirlwind, with so much going on that it can be difficult for employees to keep up with the information relevant to them. That is why effective internal communications are so important during this time.

As it relates to equity compensation, there may be a number of points that need to be made clear:

• Are any pre-M&A equity plans being wound down?
• What do employees need to do around their awards?
• Are new awards being introduced?
• Who do employees need to reach out to?
• Are there specific internal information resources that can be accessed?

The above questions and many more may be relevant for employees, depending upon how the M&A process plays out and what the new combined company’s intentions may be. However, as with so many other situations, sometimes people can only know the right questions to ask if they have already been provided with key relevant information. In other words, if you haven’t been told about the things you need to know, then you won’t be in a position to ask the right questions about those things. To borrow a line, there are known unknowns and unknown unknowns. An effective communications strategy should give all affected employees the opportunity to turn the unknowns into knowns and leave them equipped to address all relevant issues and required courses of action as the business navigates its changed circumstances after M&A.

The specific features of any effective communications campaign will depend upon the make-up of the target audience, i.e., what that looks like may differ depending upon whether the bulk of employees are office-based or work on a factory floor etc. However, commonly seen elements include:

• A dedicated section on the company intranet
• An email campaign
• In-person or online town hall-style meetings and Q&As
• Posters in common areas to raise awareness around key issues and how more information can be accessed

Stock plan administration and M&A

The M&A period is a logical time to also review your stock plan administration practices.

How have you administered your employee equity plans pre-merger or acquisition? If you relied on spreadsheets to keep track of all information, this might be the time to consider alternatives. After M&A, the admin burden around equity comp might ramp up significantly, meaning that any manual approach will become even more vulnerable to human error, i.e. accuracy cannot be guaranteed.

_{At J.P. Morgan Workplace Solutions we provide businesses of all sizes with an all-in-one equity compensation management solution. We handle all the equity award administration so you’ve got more time to focus on your company’s journey. Get in touch today to find out how we could assist with equity design and management at this crucial time.}

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