Compensation matters, including retention packages, equity treatment and related disclosure, are always key negotiating points in M&A transactions. In a challenging M&A market that is stifled by overall volatility and uncertainty, high interest rates, and reduced valuations, issues related to compensation may become more fraught as parties navigate alternative transaction structures and forms of noncash deal consideration. In this post, we discuss compensation challenges in M&A deals in a depressed market and how dealmakers can address these issues.
Challenge #1: Managing equity incentive plan share reserves
When a buyer uses shares in lieu cash on hand or financing as consideration in a transaction, it often puts pressure on the buyer’s share reserves to the extent shares are needed to assume target awards or incentivize acquired employees with new equity. Companies listed on Nasdaq or the New York Stock Exchange generally are required to seek stockholder approval of equity compensation plans, adding another layer of complexity for a buyer looking to use shares as consideration and go-forward retention. Typically, M&A transactions involve converting target equity awards into buyer equity awards and granting new hire and retention awards to incoming employees. These transaction-related equity grants may prematurely deplete the buyer’s equity plan share reserve. It is important to consider the best treatment of existing and future awards, as we’ve outlined below.
Option 1: Substitute awards
One option is to convert target equity awards into acquirer equity awards.
Advantages of this option:
- Stockholder approval is not required to convert, replace or adjust outstanding target equity awards to reflect the transaction.
- This exemption covers both assumptions and substitutions of target equity awards.
- Equity plans commonly address substitute awards and may explicitly provide that substitute awards do not count against the share reserve. (The buyer’s equity plan should be reviewed to confirm permissible treatment.)
Challenges of this option:
- The target equity plan should be reviewed to confirm that assumption and/or substitution are permitted actions.
- The buyer’s plan may provide that substitute awards count against the share reserve.
- While substituted or assumed awards may be excluded from the burn rate analysis used by proxy advisory firms, such awards will be considered as part of the overhang analysis in determining whether to support a subsequent equity plan proposal.
Option 2: Assume unused share reserve
Another option is to assume the unused share reserve under the preexisting target equity plan, which can be used for post-closing grants by the acquirer, subject to certain limitations. This option can be used in combination with Option 1.
Advantages of this option:
- Shares available under equity plans acquired in an M&A transaction may be used for certain post-transaction grants without further stockholder approval.
- Shares may be used for post-transaction grants under the preexisting plan or another plan.
Challenges of this option:
- It’s only available in situations where the target company has shares available for grant under preexisting plans that meet requirements of Nasdaq Rule 5635(c) and IM-5635-1 or NYSE Listed Company Manual Rule 303A.08.
- The time during which relevant shares are available for grants is not extended beyond the period when they would have been available under the preexisting plan, absent the transaction.
- The awards may not be granted to individuals who were employed by the buyer at the time of the transaction so this option may not be as useful if buyer is not retaining the target employees or hiring new employees.
Option 3: Inducement grants
A third option involves making grants to new employees under a nonstockholder-approved equity award plan.
Advantage of this option:
- There’s a stockholder approval exception for issuances to a person not previously an employee or director of the company (including following a bona fide period of non-employment) as an inducement material to the individual’s entering into employment with the company.
Challenges of this option:
- It must be approved by either the company’s independent compensation committee or a majority of the company’s independent directors.
- Promptly following the inducement grant, a company must disclose in a press release the material terms of the grant, including the recipients of the grant and the number of shares – and filing a Form 8-K may be required for awards to executive officers.
- Shares issued under nonstockholder-approved equity plans will still count in the burn rate and overhang analysis used by proxy advisory firms in determining whether to support a subsequent equity plan proposal.
Option 4: New equity plan
A fourth option involves the adoption of a new or amended equity plan with a fresh share reserve.
Advantages of this option:
- In certain cases, adopting a brand new equity plan, subject to stockholder approval, may be the preferred approach.
- Putting up a new equity plan for stockholder approval may be a good opportunity to include certain company-friendly/stockholder disfavored provisions (such as making the plan evergreen and including the ability to reprice options without stockholder approval).
Challenges of this option:
- The hiring plan, compensation benchmarking and go-forward grant practices must be considered to help determine the adequacy of the share reserve.
- It’s also important to consider the influence of proxy advisory firms’ recommendations in light of the stockholder base. The need to obtain favorable recommendations may restrict the company’s flexibility in plan design.
Challenge #2: Aligning interests on return and go-forward deal level issues
Aligning the interests of investors, directors and employees is especially challenging when all parties may not be getting as high of a return as expected. On the one hand, stockholders are looking to maximize their return. On the other hand, retaining management can be key to the go-forward business. In the mix are the directors, who must approve the deal considering the interests of the stockholders. Allocation of the purchase price is particularly sensitive for unvested equity awards and out-of-the-money options. It’s important to consider how all parties may react to allocating purchase price to equity awards – and who pays for employee compensation and incentives.
Another area where this tension often reveals itself is in the interim period between signing and closing – which may be relatively long because of the regulatory environment – so parties should consider how the target’s annual bonuses and raises will be treated, who pays, and what buyer approvals are required.
As discussed below, timing and related disclosures also are major considerations for resolving these issues.
Challenge #3: Disclosure pressure points and 280G
Stockholders may be keener to contest compensation matters in an M&A transaction if they believe they are not receiving a fair return. This dynamic in a distressed environment puts more pressure on the disclosure of compensation information. Public companies must briefly describe any substantial interest, direct or indirect, of each person who has been a director or executive officer of the company at any time since the beginning of the last fiscal year in the proxy statement. Notably, the disclosure is not limited to named executive officers.
In addition, if buyer stockholders are asked to approve a transaction, the company must provide a separate stockholder advisory vote to approve any agreements or understandings between the target or the buyer and each named executive officer related to the transaction. The target stockholders also have a separate stockholder advisory vote. This information is referred to as the “say-on-golden-parachute disclosure.” Aside from the detailed proxy, the deal announcement and related Form 8-Ks often will describe the treatment of the equity awards, go-forward arrangements with named executive officers, and certain actions taken prior to the deal announcement, such as retention and severance arrangements. Parties should understand the likely stockholder sentiment when agreeing to compensation issues and prepare disclosures carefully. Failure rates for say-on-golden-parachute votes ranged from approximately 10% to 16% during period from 2017 to 2022, according to data published by proxy advisory firm Institutional Shareholder Services. And while say-on-golden-parachute vote outcomes do not necessarily align with the outcomes of votes to approve transactions, companies should keep in mind that low support for say-on-golden-parachute votes may also have implications for future say-on-pay voting outcomes.
For private companies, one of the main areas of compensation disclosure in the transaction context is a 280G stockholder vote. Ensuring a successful 280G outcome requires considering the timing of compensation and transaction talks. As a rule, go-forward arrangements with salary increases, bonus increases and/or new equity grants are presumptively included as parachute payments under Section 280G if executed or significantly negotiated prior to closing. In other words, post-closing arrangements may be excluded from 280G analysis, but only if they were not significantly negotiated before closing. Prior to the deal process, and as part of annual compensation planning, sellers should consider the parachute impact of awards, base amounts and any cutback provisions. Once transaction talks have commenced, the company should engage experts to perform a 280G analysis.
Parties may also be able to implement mitigation measures, which have the goal of increasing 280G safe harbor protection and decreasing parachute payments overall. We’ve listed potential mitigation measures below.
- Reduce excess parachute payments by payments that constitute “reasonable compensation,” which must be:
- Established by clear and convincing evidence.
- For personal services rendered before the date of a change in control – for example, a prorated annual bonus and performance-based incentives.
- For personal services to be rendered on or after the date of a change in control – for example, payment for noncompete, consulting agreements and retention bonuses.
- Pull compensation into an earlier tax year in order to increase the base amount (to the extent that the transaction crosses tax years) – for example, accelerating the payment of annual, transaction bonuses and/or vesting or settlement of equity awards to the current year if the closing is expected to take place in the following year.
- Use cutback, modified cutback or “best net after-tax” provisions.
Traversing the volatile waters of the current M&A market and related compensation matters may be rocky, but a little planning and assessing of options can help dealmakers avoid deal-killing icebergs and find smooth waters.
