It’s been a little over a month since Jason and I wrote posts for our Letter of Intent series. We took a time out for our 409A series and for actually selling two companies (Commerce5 to Digital River and another that hasn’t been disclosed yet) rather than writing about selling companies. This is the first time in four years where I personally haven’t been actively trying to close the sale of a company over the holidays, so I thought I’d put some time in and finish up this series. 2005 was an awesome year for M&A and all the pundits think 2006 will be equally good (or better), especially after all the M&A bankers get their year end bonuses in January and receive a new dose of forward motivation.
After considering price and structure, it is time to discuss other major deal points generally found in an LOI. One item to note here: absence of these terms in your particular LOI may not be a good thing, as in our experience detailed term sheets are better than vague ones (although be careful not to overlawyer the detailed term sheet.) Specifically, this is the case because during the LOI discussions, most of the negotiating is between the business principals of the deal, not their lawyers, who will become the main deal drivers post signing of the term sheet. Our experience is that leaving material business points to the lawyers will slow down the process, increase deal costs and cause much unneeded pain and angst. Our suggestion would be to always have most of the key terms clearly spelled out in the LOI and agreed to by the business principals before the lawyers bring out their clubs, quivers and broadswords.
Today we are going to discuss the treatment of the Stock Option Plan. The way stock options are handled (regardless of how you address the 409A issues) can vary greatly in the LOI. The first issue to consider is whether or not the plan is being assumed by the buyer and if so, is the assumption of the option plan being “netted” against the purchase price. In some cases, the buyer will simply assume the option pool in addition to the base consideration being received; however, it’s typically the case that if the buyer agrees to assume the option plan then the aggregate price will be adjusted accordingly as very few things are actually free in this world.
Let’s presume the option pool is not going to be assumed by buyer. The seller now has several things to consider. Some option plans – especially those that are poorly constructed – don’t have any provisions that deal with an M&A context when the plan is not assumed. If the plan is silent, it’s conceivable that when the deal closes and the options are not assumed, they will simply disappear. Obviously – this sucks and is not in the spirit of the original option plan.
Most contemporary option plans have provisions whereby all granted options fully vest immediately prior to a merger should the plan and / or options underneath the plan not be assumed by the buyer. While this clearly benefits the option holders and helps incentivize the employees of the seller who hold options, it does have an impact on the seller and the buyer. In the case of the seller, it will effectively allocate a portion of the purchase price to the option holders. In the case of the buyer, it will create a situation where there is no “forward incentive” for the employees (since their option value is fully vested and paid at the time of the acquisition), resulting in the buyer having to come up with additional incentive packages to retain employees on a going forward basis.
Many lawyers will advise in favor of a fully vesting option plan because it “forces” the buyer to assume the option plan, because if it did not, then the option holders would immediately become shareholders of the combined entities. Under the idea that “less” shareholders are better than “more,” this acceleration provision would motivate buyers to assume option plans. Of course, this theory only holds true if there are a large number of option holders.
In the past few years we’ve seen cases whereby the buyer has used this provision against the seller and its preferred shareholders. In these cases the buyer has explicitly denied assuming the options, wanting the current option holders to become target shareholders immediately prior to the consummation of the merger and thus receive direct consideration in the merger. The result is that merger consideration is shifted away from prior shareholders and allocated to employees whose prior position was that of an unvested option holder. This “transfer of wealth” shifts away from the prior shareholders – generally preferred stockholders, company management and former founders – into the pockets of other employees. The buyer “acquires” a happy employee base upon closing of the merger. Note, that this is only an option for the buyer if the employee base of the target is relatively small. Also note that the buyer can “re-option” the management and employees that it wants to keep going forward, so that in the end the only stakeholders worse off are the preferred holders and former employees / founders of the company.
Bottom line, the assumptions of stock options can be a more complex term than most people give it credit, as evidenced by this post.