ESOP Academy 10: Treatment of Equity Awards in M&A Transactions

Written By:
Amit Majumder, CFA
February 27, 2022

What happens with your ESOPs when your company gets acquired?

When you receive news about your company getting acquired, it may come as a surprise. The announcement often results in excitement, as M&A transactions bring a lot of opportunities for the business and you as an employee, but naturally raises some questions you may not have immediate answers to. One of the common question marks for employees will be in relation to their equity stake in the company and how the ESOPs will be treated.

If your company is the acquirer, the transaction will likely have little impact on the treatment of your exiting ESOPs. Their lifecycle will carry on in line with the existing vesting schedule and plan conditions. If you are on the other side of the transaction, things are not as straightforward.

The consideration the target company receives as a result of an acquisition can come in a form of:

  • Cash – each shareholder receives a certain amount for each share held;
  • Scrip (securities) – each shareholder exchanges existing shares for shares in the acquiring company; or
  • Hybrid – consideration is a mix of cash and shares.

But as we discovered earlier, ESOP holders are not necessarily shareholders in their company. So, what happens with the equity awards that may utilise various underlying instruments?

What are the common treatments of ESOPs in M&A?

  • Cash payment

This may appear as the most straightforward approach. The easiest way to think of this method is that it follows a similar logic of the treatment of ordinary shareholders.

Effectively, in this scenario, you will ‘lose’ your ESOPs, and in return will receive a cash payment for their value (which often is significantly higher at the time of transaction when compared to the value just before the announcement of the deal).

The mechanism of the cash payments may vary. Your ESOPs may be automatically converted into shares, and you get paid out as a shareholder, or your ESOPs may be cash settled. What’s the difference? In most cases, from your perspective it leads to the same outcome. However, in some jurisdictions the tax treatment may differ. Your employer and the acquiring company will take that into account and come up with the best way to manage the transaction.

  • Deferred cash payment

In the first scenario, the payment to you is often transmitted when the deal closes. However, your cash payout may be delayed until a later point on time (partially or in full).

In terms of the mechanics, your equity awards are cancelled, and you receive a sum calculated based on the transaction price that is payable over the course of your existing vesting schedule.

In such scenario, the payout may not only follow original vesting schedule of your ESOPs, and even be subject to some of the existing terms and conditions (e.g., forfeiture risk). If that’s the case, you may need to honour the original vesting schedule and the relevant service conditions to receive the full payment. If you already held vested awards, you would generally receive payment of those upfront for those.

  • Replacement awards

Instead of receiving a cash payment, you may instead receive equity in the company that acquired yours. This is often referred to as replacement awards. And this process works exactly as the name suggests – your existing ESOPs in your current company are cancelled and get replaced with an award in your new company.

This swap may not be a straightforward one-to-one transaction, as your employer may need to make various adjustments, including for tax and accounting purposes. Similarly, the terms and conditions of the new awards are unlikely to be identical to rules of your existing equity scheme. In all events, the details of the replacement awards will be communicated to you at the time of the transaction, and generally companies attempt to ensure that you are no worse off with the new grant than you were prior to the transaction. If you held $1,000 worth of ESOPs in your current company, you would most likely end up with similar value of equity awards in your replacement grant.

  • Plan continuation

The acquiring company may also decide to take over the existing plan, so that the existing terms and conditions remain practically the same. As such, they will track your existing awards, but at the time of vesting and/or exercise, you will be able to receive the shares of the new company instead.

Effectively, to you that may appear as a similar approach as replacement awards, but in practice there are administrative differences in the way the ESOPs will be managed. Regardless of the approach, be sure to review all the correspondence you will receive in relation to the transaction.

What are you required to do?

Do you get to decide how your ESOPs will be treated? Generally, no, but in some circumstances, you may have a decision to make. Your choice may be around converting or selling your shares prior to the transaction or signing a legal document (a deed) to enable your employer to apply the prescribed treatment for your ESOPs during the transaction. Any action required and next steps will be communicated to you. The communication will often be accompanied by detailed explanatory notes, tax summaries and guides.

As always, it’s in your best interest to read all plan and transaction related documents thoroughly to ensure you are aware of what's going to happen with your ESOPs.

As you can appreciate, M&A deals are extremely complex in nature, and that’s why lawyers get involved to help companies work through various equity awards issues at hand. Rest assured, companies tend to come up with the best possible approach for equity treatment for the employees after thoroughly evaluating tax, legal and practical considerations.

What other factors come into play?

Every transaction is unique, so there is not one checklist that you will be able to follow to prepare yourself. You can refer to the following list of items you should be mindful of and explore how each may impact what will happen with your ESOPs during M&A.

  • Terms and conditions of existing plan

Treatment of your ESOPs in an event of M&A activity will be dictated, and even prescribed in the plan rules. For instance, your plan may have accelerated vesting provisions that may result in your unvested awards vesting early at the time of transaction. Change of control clauses can also highlight the required treatment. Sounding repetitive here, but always read the plan rules to understand your ESOPs.

  • Vesting schedule

Review and understand your vesting schedule. Are there performance conditions attached? Do you hold both vested and unvested awards? The treatment at the time of transaction may vary for depending on these factors.

When there is a performance condition, the performance outcome may be measured at the time of the transaction as opposed to the original vesting (measurement) date. This may also result in the quantity vested to be pro-rated to reflect the shortened period.

  • Various equity instruments and plan types

Do you already hold shares? They will likely be treated similarly to ordinary shares of regular investors. Hold options or RSUs? Treatment will depend on a range of factors. Do you hold SARs or phantom units? Safe to say that those to be settled in cash rather than securities.

But what if you hold options that are out-of-money where transaction price is (potentially a lot) lower than the exercise price? In some cases, these options may even be cancelled for no consideration.

Do you participate in multiple plans at the same time? Company don’t have to (and sometimes cannot) apply the same treatment for all plans. So, you may end up getting cash consideration for some awards, and replacement awards for those.

  • Tax, legal and administrative considerations

Both the acquirer and target company will have a lot of things to work out when it comes to ESOP treatment. Tax withholding, triggering taxing points for employees, tax implications for the companies, disclosures and reporting obligations across multiple jurisdictions – things can get very complex.

At times, companies may choose or even be forced to treat a subset of their employees differently to others. In some cases, it may not be practical to offer replacement awards to you based on the rules of your country, and you will only get cash, or vice versa. Don’t take it personally if you received a different treatment for your ESOPs than your colleagues in another part of the world. In most cases, this is a result of complex review undertaken to achieve the best possible outcome for both the company and the employees.

  • Timing of the transaction and additional awards

If you company offers regular (e.g., annual) equity awards, the timing of the M&A transaction can have an impact on your next grant. The conditions of the M&A transaction can dictate the ability of your current employer to grant additional awards to you. And should those awards be issued, their terms and conditions may be affected (e.g., no provision for accelerated vesting). Should the awards be delayed and made after the transaction has been finalised, you may instead receive awards as part of the ESOP of your new company, and they will form of your new total compensation.

Amit Majumder, CFA

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