Client Alert

Accelerated Vesting of Employee Stock Options: Principles and Strategies

16 May 1992

When a company adopts a stock option plan, or grants options to executive officers, there are a number of issues that tend to generate the most debate, discussion and negotiation. One of them is whether the exercisability, or vesting schedule, of the options should accelerate upon a change of control -- that is, when the company is acquired, or merged into a larger company. These issues are particularly important for Israeli companies, especially those in the technology sector, where employees at all levels often expect a large portion of their compensation to consist of equity. This article will discuss the issues that arise when provisions of this kind are used, and will describe recent strategies used by acquirors and targets when companies are acquired that have issued these types of options.

Options granted to both senior officers and rank and file employees alike typically have a vesting schedule that is fixed at the time of the grant. For example, 25% of the options may become exercisable upon each of the first, second, third and fourth anniversaries of the grant date. Or, alternatively, 1/48th of those same options could vest each month after the grant date. There are a variety of possibilities, although vesting schedules of three to five years tend to be common in many industries.

What happens if the issuer of the options, whether it is a private or a public company, is the subject of an acquisition transaction? For example, an acquiror makes a tender offer for all of the outstanding shares, or in a negotiated transaction, merges the company into an entity that becomes a wholly-owned subsidiary of the acquiror?

Option plans and option agreements tend to have three types of provisions to handle these situations:

  • Options Expire upon a Change of Control: any options that are unvested, or vested but unexercised, will expire after the change of control. Due to the employee's loss of an important benefit, these provisions are not the most common.
  • Options Accelerate upon a Change of Control: when a change of control occurs, the unvested portion of the options automatically and immediately vests. These provisions enable the optionee to exercise all of the options, and obtain a portion of the merger consideration, whether such consideration consists of cash or stock.
  • Options Accelerate if Not Assumed by Acquiror: if the acquiror does not assume the options on substantially the same terms as they exist prior to the merger, the unexercised portion will automatically accelerate. In one variation of this type of plan, the options will accelerate after the merger if the acquiror terminates the optionee without cause, or reduces his or her position or compensation, during the first six months or the first year after the acquisition.
Employees prefer the second type of option - accelerated vesting. Since, in general, the exercise price of an option is equal to fair market value on the date of grant, and the total value of a company often increases over time, accelerated vesting can be of great value to the employee. If the acquisition consideration is greater than the exercise price, the optionee might just make a killing exercising all of his or her options immediately prior to the merger, and taking his or her full share of the merger consideration on the closing date. If the merger consideration consists of cash, or unrestricted securities, the employee might just be able to leave the merged company on or after the closing date, and take that fantasy retirement in Fiji. Fortunately for many recent acquirors, and unfortunately for many of these employees, the relatively lower premiums paid in recent acquisitions has limited the value of accelerated vesting for many employees -- delaying their early retirement plans. In fact, many recent acquisitions have been completed at per-share prices that were less than the average exercise prices of the targets' outstanding options. Low recent trading prices on Nasdaq and the Tel Aviv Stock Exchange, and the effects of the intifada on Israeli technology companies in particular, may mean that this problem is not over yet.

Accelerated Vesting - Pros and Cons

In adopting an option plan, or granting options, companies consider a variety of issues relating to accelerated vesting. On the one hand, granting options with accelerated vesting can be a valuable inducement when hiring an employee. Theoretically, that feature of an option may be a useful inducement to convince a potential officer or employee to join the company, or to accept a smaller portion of his or her compensation in cash. Accelerated vesting may also be viewed as a reward to employees, in exchange for helping the company reach the stage of development that made the acquiror even consider the company as a candidate for an acquisition in the first place.

But there is a price to be paid for accelerated vesting:

  • officers and employees with accelerated vesting may have little incentive to stay with the combined company after the acquisition;
  • if the acquiror uses cash to complete the transaction, the total cost is likely to be more expensive, since more shares of the target may be outstanding through the exercise of options;
  • if more shares are outstanding at the time of the merger, the portion of the merger consideration that the other shareholders will receive, including any founders, will be smaller;
  • if the merger consideration consists of freely-tradable stock of the acquiror, the market price of that stock might be hurt by widespread sales by employees who had accelerated vesting, and who are now on a flight to Fiji; and
  • accounting charges could result if vesting is accelerated on a discretionary basis.
Some of these costs of vesting can be minimized if acceleration is limited to situations in which the employees are terminated without cause after the merger. This alternative preserves the "handcuff" on key members of management, while providing protection for these individuals against becoming redundant after the deal.

These issues often lead management to avoid creating plans or granting options with accelerated vesting, as they may have the effect of discouraging a would-be acquiror.

Due Diligence

In light of these issues, in practice, an acquiror must engage in a careful due diligence process with respect to the target's stock option plan. It's generally not sufficient to look only at the terms of the target's option plans in order to understand the extent of accelerated vesting: the acquiror should also review the forms of option agreements that are used under the plans (as well as the target's standard form of employment agreements) and any option agreements that deviate from these forms. The process is also not complete without review of the employment contracts with the members of the target's management team, which often contain stock option terms that supplement (or even conflict with!) the terms of the target's option plans.

With respect to accelerated vesting issues, the acquiror should carefully determine the number of options that are subject to accelerated vesting and the identities of the holders of these options. Who are the key officers and employees of the target that the acquiror seeks to retain? What are the terms of their option grants? What is the impact of accelerating options upon the distribution of the merger consideration to the target's securityholders? Naturally, if the exercise prices of these accelerated options are less than the per share price to be paid in the merger, which is not uncommon in many recent transactions, these issues may be less important.

The target's option plans and option agreements should be reviewed to determine whether the target has any repurchase rights. That is, are any of the shares purchased upon the exercise of options subject to repurchase by the company if an employee does not remain with the company for a specified period of time after the exercise? How are these provisions affected by a change of control? These provisions may have the effect of discouraging the employee from leaving the company rapidly following his or her option exercise.

Solutions

In recent merger situations, particularly ones in which the acquiror is a publicly traded company, the parties have used a variety of strategies to reduce some of the unwanted effects of accelerated vesting. Some of these strategies can be used whether the target's entire option plan is subject to accelerated vesting, or the issue is confined to a limited number of key employees.

Amending the Option Terms. The parties may agree to make the transaction conditional upon the agreement of the holders of a certain percentage of the outstanding options, or the options held by the employees who are deemed to be most valuable, to continue vesting after the merger, notwithstanding the existing accelerated vesting provisions.

Lock-Up Agreements. As noted earlier, one of an acquiror's major concerns is that accelerated vesting provisions may have the effect of depressing the market for its shares if the target's optionees exercise their options and sell a large portion of the acquisition consideration. As a result, a common feature of many acquisitions is to require a specified portion of the target's optionees to execute lock-up agreements. These agreements provide that, although the optionees may exercise their options, they must hold the purchased shares for a specified period of time before selling them. Alternatively, the optionees may be limited by contract to selling only a specified number of shares each month, quarter or year.

Employment Agreements. In many situations, the acquiror is concerned that key officers or employees with accelerated vesting may depart from the merged company after exercising their options. Accordingly, the execution of new employment agreements with these individuals is often a key part of the merger transaction. A new employment agreement may provide for the assumption of all or a portion of the accelerated options, lock-ups or repurchase rights with respect to any exercised shares, and other types of provisions designed to incentivize these key individuals to remain with the merged company.

Inducements. The target company generally has no ability to require its optionees to amend the terms of an option agreement, or to agree to execute a lock-up agreement in connection with a merger. (And placing pressure upon an employee to do so may render his or her agreement unenforceable if that pressure is deemed to be duress.) As a result, parties to mergers have adopted several types of measures to encourage their optionees to agree to these types of arrangements. In one approach, the acquiror (or the target, immediately prior to the acquisition) may announce plans to issue a new round of options to the target's employees, which have vesting periods that are designed to incentivize employees to remain with the merged companies. Although this approach may help with respect to employee retention issues, it does not prevent employees from exercising their existing options and selling the underlying shares. As a result, in some merger situations, an employee's participation in the new option grant may be made conditional upon his her agreement to revise the accelerated vesting terms of existing options, or to agree to a lock-up provision.

Another possible inducement to help convince an employee to amend his or her option terms is to promise a different, but milder, form of accelerated vesting. In this form of agreement, the option will not vest upon the change of control, and will be assumed by the acquiror. However, the option will immediately vest if the acquiror terminates the optionee's employment without cause or good reason, or reduces the optionee's rank or responsibility within the combined organization. This form of vesting does not satisfy the employee's desire to receive an immediate benefit in connection with the change of control. However, it does help provide some assurance that the optionee will retain some degree of job security following the merger.

Conclusion

On virtually every business day, companies adopt option plans, or negotiate options with their personnel. A company and its employees alike spend substantial amounts of time discussing accelerated vesting upon a change of control. However, in practice, parties to a merger work hard to structure their transactions to reduce the impact of these provisions. And in some cases, where the impact of these provisions can not be mitigated in a way that is satisfactory to the target and/or the acquiror, some potential acquisitions may not occur at all. As a result, while many companies have options that contain change of control features, the effect of these provisions in actual change of control situations tends to be smaller than one might anticipate.

 


Comparing the Option Plans

 

Type of Plan Common Type of Plan? Favorable to Existing Shareholders? Favorable to Target's Employees? Risk of Employee Departure after Acquisition? Will Negotiations be Needed with the Buyer as to the Option Pool?
Options Expire upon a Change of Control No Yes No Depends upon terms and condition of employment after merger. Usually no
Options Accelerate upon a Change of Control Yes No Yes Yes Very often
Options Accelerate if Not Assumed by Acquiror, or if the Optionee is Terminated after the Merger Without Good Cause Yes Usually yes, if options are in fact assumed. If options are assumed, it depends largely upon acquiror's future stock performance. Yes, if options accelerate because they were not assumed. If the options are assumed, depends upon terms and conditions of employment after merger. Usually yes as to the terms of the assumption.

 


Accelerated Vesting Can Dilute an Acquisition

The following simple example shows the possible effect of adopting an option plan that features automatic vesting upon a change of control.

Smith and Jones are the founders of Little Widget, Inc., and split the ownership of the company, 50 shares each. Little Widget has issued options to key employees to purchase a total of 25 shares, but none of these options are presently vested. Big Widget, Inc. proposes to buy Little Widget in a stock-for-stock merger, but refuses to issue more than one million of its shares in the deal. In recent trading days on Nasdaq, Big Widget's shares trade for about $10.00 each. The exercise price of Little Widget's options is $1.00 per share.

Type of Option Plan Number of Big Widget Shares for Smith and Jones Number of Big Widget Shares for Key Employees
Options Terminate upon a Change of Control 500,000 Shares Each (or $5.0 million each) Zero
Options Automatically Vest upon a Change of Control 400,000 Shares Each (or $4.0 million each) 200,000 Shares (worth $2.0 million in the aggregate)

If the acquiror assumes the target's outstanding options, the effect of the dilution won't necessarily be felt at the time of the closing of the merger. Instead, the effect of the dilution will be felt if the acquiror's stock price rises in the future, as the optionees exercise their options.

 


This article has been adapted from an article published in Compensation & Benefits Review, March/April 1992, Sage Publications.

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