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THE INS AND OUTS OF “ACCELERATION OUT” CLAUSES IN STOCK
OPTION PLANS: Who should be protected in the event of a sale of the business?
By: Peter H. Ehrenberg1
At least for the time being, as we move into 2001, the bloom on the IPO market
experienced in the late 1990’s and the first quarter of 2000 may have fallen off the rose.
Whether the tightening of the capital markets is a temporary or long term phenomenon
remains to be seen. In any event, during this period, it is not surprising that attention
turns to acquisition strategies. For companies that are “long” on creative concepts but
“short” on capital, a sale of the business may represent the most viable way for
shareholders to attain a liquidity event. For companies that are “long” on capital and for
potential investors, the current economic landscape provides substantial opportunities to
acquire companies at reasonable, if not depressed, prices.
The treatment of stock options in the context of a sale of the business can present
a near Marxian conflict between the interests of labor and the interests of capital. Most
stock options granted to employees contain vesting provisions which require optionees to
remain with the granting company for a period of several years. These vesting provisions
constitute a form of “handcuff” that requires an optionee to think twice before leaving
the granting company for greener pastures elsewhere. Outside of the acquisition context,
stock option vesting provisions are relatively standard and, in effect, become a “fact of
life”. In a stable business environment, optionees typically are able to gain some job
security and, accordingly, recognize that as long as they continue to perform in
accordance with recognized standards, their options will continue to vest.
This sense of security may be jolted in the event that the granting company is
acquired. If the granting company’s stock options are assumed by the acquirer, the
holder of unvested options is likely to feel exposed. In virtually any acquisition, the
optionee must at least wonder whether new management will be comfortable with the
optionee’s performance. This concern is amplified in those transactions in which the
principal justification arises from the synergies developed from the elimination of
duplicative jobs.
The solution for the exposed optionee is quite simple. If his or her stock options
accelerate in the event of a change in control, the optionee at least knows that his or her
options will be fully vested in the event that the acquirer assumes the options and then
determines to terminate the optionee’s employment. Thus, for the optionee, and for an
issuer seeking to implement an optionee-friendly plan, an optimum result likely would be
1
Peter H. Ehrenberg is a member of the Roseland, New Jersey law firm of Lowenstein Sandler PC. Mr. Ehrenberg is the
Chairman of that Firm’s Corporate Department and the M&A and Corporate Finance Practice Group.
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to provide for all assumed stock options to be fully vested upon consummation of a
change in control.2
Acquirers, on the other hand, will not be happy to observe that all unvested
options accelerate upon the consummation of an acquisition. An acquirer will
understand that if all options accelerate, it will be necessary for the acquirer to develop
new “handcuffs” in order to assure that the employees are suitably incentivized. Thus, if
all of the target company’s options accelerate, the acquirer may very well conclude that it
will be necessary to issue new options to valued employees in order to assure their
continuing service to the combined business. Since most companies are acquired not for
their brick and mortar, but rather for the prowess of their employees, the number of
options covered by such supplemental grants could be significant.
The acquirer’s solution to this dilemma is also rather straightforward. The need
to grant supplemental stock options will likely be funded out of the shares and other
consideration that otherwise would have been transferred to the target company’s
shareholders upon consummation of the acquisition. In short, there is a substantial
likelihood that if an acquirer must grant additional stock options to compensate for
accelerated vesting, the additional dilution will be “taken out of the hides” of the
shareholders of the target corporation.
For target shareholders who are also optionees, the result of this process acceleration of options, grant of new options and reduction of consideration to target
shareholders - may not be significant, and, indeed, may prove to be a positive
development. On the other hand, for shareholders of the target who do not participate in
the option plan, the acceleration of stock options upon a change in control is likely to
translate directly into reduced consideration in the merger.
As we have all learned, investors in pre-IPO rounds of financing are sophisticated.
They understand the need for option plans to be optionee-friendly. On the other hand,
they also understand the likely impact on them in the event that employee options
accelerate upon a change in control. Accordingly, issuers can expect sources of capital to
object to stock option plans that contain provisions mandating an acceleration of stock
options upon a change in control.
There are least two potential approaches that may ameliorate the differences
between non-employees and employees with respect to the issue of accelerated vesting.
First, a plan may be drafted with a provision that provides the issuing company with
discretion to accelerate stock options at the time of a change in control. This approach
would allow the target and the acquirer to negotiate with respect to the particular options
to be accelerated. This solution, prevalent in many older plans, contains at least two
drawbacks. First, the voluntary acceleration of stock options will preclude a business
2
It should be noted that such acceleration could, under certain circumstances, lead to adverse tax consequences under
Section 280G of the Internal Revenue Code.
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combination from being accounted for as a pooling of interests. At least until such time
as pooling treatment is eliminated, plan provisions that permit voluntary acceleration will
result in no acceleration if the applicable transaction is to be accounted for as a pooling of
interests. Second, voluntary acceleration will, under the FASB’s FIN 44, result in
variable accounting treatment (i.e., the recognition, for book purposes, of expense in the
amount of the appreciation over the exercise price) for options that are accelerated on a
voluntary basis. Public companies, as well as companies that anticipate the possibility of
an IPO, are likely to be reluctant to subject themselves to variable accounting treatment.
An alternative approach is to provide for post-closing acceleration in the event
that the optionee is terminated without cause within a specified period after the closing.
Such a provision provides the acquirer with a “handcuff,” since an employee will not be
able to take advantage of post-closing acceleration in the event that the employee
voluntarily terminates his or her employment. On the other hand, such a provision also
gives the optionee protection, in the sense that an involuntary termination by the
acquirer will result in acceleration of the optionee’s stock options.
The development of a stock option plan that conforms to the particular needs of
an issuing company requires careful planning and analysis of several design alternatives.
It is a mistake to believe that option plans require no more than the adoption of
“boilerplate” or “cookie cutter” approaches. In the context of a change of control, the
varying interests of optionees and non-employee shareholders demands that alternative
approaches be considered before any design determination is made.3
3
The appendix to this article contains alternative plan provisions reflecting different approaches that may be utilized in
the context of a change in control.
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APPENDIX
Most stock option plans provide the acquirer with two choices at the time of
closing. The acquirer can either assume the existing stock options or refuse to assume
the existing stock options. Ordinarily, if an acquirer refuses to assume the stock options,
the optionees will be given a brief period, prior to closing, in which to exercise all vested
and unvested stock options. Those options which are not vested would terminate upon
consummation of the acquisition. A standard provision reflecting this approach is set
forth below:
“In the event of a merger or consolidation of the Company with or into
another corporation or any other entity or the exchange of substantially all
of the outstanding stock of the Company for shares of another entity or
other property in which, after either transaction, the prior shareholders of
the Company own less than fifty percent (50%) of the voting shares of the
continuing or surviving entity, or in the event of the sale of all or
substantially all of the assets of the Company, (either event, a “Change of
Control”), then each outstanding Option shall be assumed or an
equivalent option or right substituted by the successor corporation or a
Parent or Subsidiary of the successor corporation. In the event that the
Administrator determines that the successor corporation or a Parent or a
Subsidiary of the successor corporation has refused to assume or substitute
an equivalent option or right for each outstanding Option, the Optionees
shall fully vest in and have the right to exercise each outstanding Option,
including Shares which would not otherwise be vested or exercisable. If an
Option becomes fully vested and exercisable in lieu of assumption or
substitution in the event of a Change of Control, the Administrator shall
notify all Optionees that all outstanding Options shall be fully exercisable
for a period of fifteen (15) days from the date of such notice and that any
Options that are not exercised within such period shall terminate upon the
expiration of such period. For the purposes of this paragraph, all
outstanding Options shall be considered assumed if, following the
consummation of the Change of Control, the Option confers the right to
purchase or receive, for each Share subject to the Option immediately
prior to the consummation of the Change of Control, the consideration
(whether stock, cash, or other securities property) received in the Change
of Control by holders of Common Stock for each Share held on the
effective date of the transaction (and if holders were offered a choice of
consideration, the type chosen by the holders of a majority of the
outstanding Shares); provided, however, that if such consideration
received in the Change of Control is not solely common stock of the
successor corporation or its Parent, the Administrator may, with the
consent of the successor corporation, provide for the consideration to be
received upon the exercise of the Option, for each Share of Optioned
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Stock subject to the Option, to be solely common stock of the successor
corporation or its Parent or Subsidiary equal in fair market value to the per
share consideration received by holders of Common Stock in the Change
of Control.”
Alternatively, an option plan could provide that all stock options will
automatically accelerate upon a change of control. To achieve this result, the first
sentence of the provision quoted above would be revised to provide as follows:
“In the event of a merger or consolidation of the Company with or into
another corporation or any other entity or the exchange of substantially all
of the outstanding stock of the Company for shares of another entity or
other property in which, after either transaction, the prior shareholders of
the Company own less than fifty percent (50%) of the voting shares of the
continuing or surviving entity, or in the event of the sale of all or
substantially all of the assets of the Company, (either event, a “Change of
Control”), then each outstanding Option shall (a) be deemed to be fully
vested and exercisable immediately prior to the effective time of the
Change of Control (including Shares which would not otherwise be vested
or exercisable) and (b) be assumed or an equivalent option or right
substituted by the successor corporation or a Parent or Subsidiary of the
successor corporation.”
The balance of the first provision quoted above would continue to be applicable in this
context.
As noted in the text, another approach (which may result in serious adverse
consequences if pooling of interest accounting treatment is sought or if variable
accounting treatment is regarded as objectionable) allows the plan administrator to
determine, on an option by option basis, whether to accelerate options in the event of a
change of control. Plan provisions which generally allow the plan administrator to
accelerate options could be utilized to effect this result.
Finally, as described in the text, certain plans may provide for options to
accelerate in the event that an optionee is terminated without cause within a specified
period of time after the change of control occurs. This result may be effected by adding
the following provisions to the basic provision first quoted in this Appendix:
“Any outstanding option which is assumed or replaced in the Change of
Control and does not otherwise accelerate at that time will automatically
accelerate in the event that the optionee’s service terminates through an
“Involuntary Termination” effected within eighteen (18) months following
the effective date of such Change of Control. Any option so accelerated
will remain exercisable until the earlier of (i) the expiration of the option
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term or (ii) the end of the one-year period measured from the date of the
Involuntary Termination.
An Involuntary Termination will be deemed to occur upon (i) the
optionee’s involuntary dismissal or discharge by the Company or its
successor for reasons other than “cause” or (ii) such individual’s voluntary
resignation following (A) a change in his or her position with the
Company which materially reduces his or her level of responsibility, (B) a
reduction in his or her level of compensation (including base salary, fringe
benefits and any corporate-performance based bonus or incentive
programs) by more than ten percent or (C) a relocation of such
individual’s place of employment by more than fifty (50) miles, provided
and only if such change, reduction or relocation is effected by the
Company or its successor without the optionee’s written consent.”
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