How M&A Affects Your Equity
M&A can be difficult to explain because they’re ultimately a contract…and no one contract is the same. To simplify, one could just look at the possible outcomes for your equity. Your equity is either: continued, cashed out, or canceled. Using this simple framework, you’ll be ready to finally understand M&As.
Company just mentioned a M&A…Where do I start?
The best place to start is by pulling up your equity agreements—these are the documents you received when you were first granted equity. There are two specific documents you’ll want to look for—The company’s overarching equity incentive plan (also referred to as the “the plan”) and the grant notice specific to your individual grant. Within those documents, you’ll specifically want to look for a section titled Change in Control or something similar to that. This will help you understand the few guarantees you can hold onto, as your company cannot unilaterally void or cancel the contract. These two documents serve as the constraints upon which the board of directors makes decisions about the deal. Outside of that, it’s a free-for-all for the board and the purchasing company to figure out—as long as they stay within the realms of regulatory accounting, financial, and tax laws. This is why M&A can be difficult to generalize because, ultimately, it’s a contract and no one contract is the same. These kinds of transactions vary wildly from deal to deal.
Factors that affect your equity in an M&A:
Your current equity plan
The actual deal’s contract
Tax consequences from a company and individual standpoint
Transaction’s financial accounting
The willingness of the buyer to preserve the equity
The difference in the stock’s value between the buyer and seller
The trick here is discovering what you can and can’t control so you know what’s in the realm of possibilities. The board of the company that’s being purchased (“the target company”) and the acquiring company will be meeting to decide the terms of the deal. By definition, you probably didn’t have any say in this process and as a result, you have no control. The trick here is discovering what you can and can’t control so you know what’s in the realm of possibilities. The truth is, even if you’re a c-suite executive, you don’t have much control over the decision. So it’s important to focus on what you can control.
What is a Merger and Acquisition (M&A)?
There are typically two companies involved here, the acquiring company and the Target company—No not that target company. The Target Company is another way of saying the company that’s being purchased. Let’s quickly define the types of M&A before addressing the outcomes:
Mergers: This is a form of acquisition that combines the two companies as one legal entity. This is most common for larger or public companies. This is mostly being done for tax considerations.
Acquisition: Where part or all of the company is being purchased (could be stock or assets)
Divestiture: Is a transaction affecting only a portion of the company
Spinoff: This is a type of divestiture where the portion of the company becomes its own stand alone company (i.e. IPO), instead of being sold to a 3rd party.
So that’s what’s happening from a high level, but what about the outcomes?
How does an M&A affect my equity?
Here are 3 possible outcomes for your equity:
Continued: Shares / options are continued through being assumed, converted, rolled over, substituted, or Swapped.
Canceled: Mostly reserved for unvested shares
Cashed out: Acquiring company may payout the whole stock options pool (both vested and unvested) in cash.
Choice between Cash-out or continue. The company may even give you a choice or require you to do some combination. Put differently, you’re either walking away with buyer stock or options, cash, nothing, or some combination of cash and options/stock. Let’s walk through each one.
1. CONTINUE SHARES
If the purchasing company exchanges the options, then oftentimes vesting will continue without modification, unless there’s accelerated vesting. If the purchaser doesn’t exchange or accelerate the shares then they can be lost. The good news is that if you’re still employed at the new employer, then oftentimes, you’ll receive a completely new grant—with no relation to your previous equity (in size or vesting period). These new grants would reflect the acquirers option strategy. It would be as if you were a new hire with a completely new vesting schedule.
When it comes to conversions, it’s pretty straightforward. Vested options get exchanged for vested options at the new company and unvested options are exchanged for unvested shares at the new company. These options are converted according to the negotiated value of the share prices. If the stock options are underwater, then they’ll most likely be canceled and issued new shares with a lower strike price as a way to incentivize employees or executives to stay.
What about the taxation here? Well when it comes to swapping shares or options, often these are considered tax-free exchanges, just like you’d have in a 1031 exchange for rental properties for example. But the IRS is weary of you getting more value in the exchange without it getting taxed. So if there is a possibility of getting better terms or switching the types of options (i.e. ISO for NSO), then you’ll likely trigger taxes, or lose the qualifying tax benefit of ISO. There may need to be an adjustment of strike price here to prove to the irs, that one isn’t getting a larger spread on the exchange.
But how is this all taxed? While there are definitely some nuances, for the most part, the taxation of stock options doesn’t change. Ordinary income, capital gains, and AMT are still applicable depending on the type of equity—ISOs, NSO, ESPP, or restricted stock. It can definitely get more complex with exchanged, so you need work with a professional.
2. CASHED OUT
Being cashed out can be an exciting proposition, but can also bring its own challenges.
Private Companies
If it’s a private company, then valuing the shares can be difficult in comparison to a public company where the shares value is easily determined. The value is more subjective and is open to interpretation from bankers and other valuation experts. Typically, they’ll consider things like future revenue or past quarters performance or various mathematical models to determine the value of the options being cashed out. A common model for valuing stock options is Black Scholes which takes into account multiple factors including, strike price, valuations, and how much time a stock option has until expiration. If you think about it, the actual value of an option isn’t as simple as the price FMV. For example, what stock option would you rather have: a stock option with 10 days before expiration or a stock option with 10 years until expiration.
Public Companies
If the acquisition is with a public company, the acquisition is straightforward because they’re mostly structured as a stock purchase, not an asset purchase. What this means is, that the purchase price is the share price on the date the deal closes. Depending on recent performance, the sale could even be at a premium to that price. But because the stock market is so volatile, the two parties may create an acceptable price range for the stock (with a ceiling and a floor). And if the shares are trading outside that range upon the date the deal closes, then the deal may be renegotiated, restructured, or completely canceled.
Unvested Shares
Although this isn’t likely, your unvested shares could also be cashed out. This was the case when twitter was purchased back in ‘22. Both the unvested options and RSUs were cashed out. That’s a pretty sweet deal, but do you have to exercise if it’s being cashed out? In an all-cash deal, you’ll likely have to exercise before the sale happens if you want to keep your stock. These shares will then be sold to the buyer as part of the acquisition.
Depending on the structure of the acquisition, you may have to exercise your options before the deal closes. If you were to exercise in this case, you’d be given whatever the other shareholders get—cash, swapped shares, or some combination. If exercising isn’t mandatory, should you exercise? It’s important for employees to realize the risks in an M&A. You can be sure the purchasing firm/ company will be negotiating the lowest price possible—adversely affecting your stock. So the prudent and conservative thing would be to wait it out. Why? Because typically repurchase agreements only buy the stock back at the lower of two prices, the purchase price or the fair market value.
But, you may be thinking to yourself that companies are purchased because the buyer thinks they can flip in a few years for a healthy profit. You may be thinking to yourself that these investors know things that you don’t—which may be true. And therefore, it makes sense to continue to hold onto shares. But you have to remember that your individual risk capacity varies greatly from a company.
There’s one weird tax quirk about ISOs being cashed out. If you’re not required to exercise and you’re just paid cash for shares, then you’ll owe ordinary income on the gain—which makes sense, but here’s where it gets weird. Typically with ISOs, you can avoid FICA tax on the bargain element (whether it’s qualifying or disqualifying disposition), but when you’re paid cash for your ISOs, you’ll have to pay FICA tax. Things can get even messier from a tax perspective if the company is buying your options with stock and cash.
Once cashed out, you’ll then likely need to diversify to offset risk and achieve your goals. If you’d like help diversifying in a tax-efficient manner, let’s work together.
Tax-Efficient Diversification
3. Canceled Options
The ability to cancel options comes down to those two documents that I mentioned at the start: The plan and the grant document. If your options are vested, companies cannot cancel them—unless the plan allows for it. In this situation, your company may end up repurchasing some of the shares. Repurchasing isn’t always a great deal either. Repurchase agreements will usually buy back at the lower of two prices: the FMV or the exercise price. So it could very well be repurchased at a loss, or at best, your exercise price.
While the three C’s (Continued, Cashed out, and Cancelled) are the possible outcomes, technically, there’s a fourth C—Combination. Your company could give you a choice or enforce an option where you receive some combination of options and cash.
Types of Equity (Vested vs Unvested)
Chances are, you probably own, stock, vested and / or unvested options. How are these various forms of equity and options treated in an M&A? When it comes to stock these are typically treated the same as option holders. For example, if option holders were cashed out, then so would actual stock holders.
When looking at your vested options, most of the time they are secure, but you’ll want to double check your equity agreements. Sometimes with asset acquisitions, the buyer is buying the assets, not the stock—meaning, your rights as an option will not transfer. This is most common for pre-IPO and smaller firms.
Unvested
As for unvested shares, it’s common for the equity plan to allow the board of directors (or other designated committee) to determine the outcome of these shares. Usually, the board has a lot of flexibility in that regard if the stock plan document permits. Frequently, companies have an acceleration clause that accelerates all or a portion of your equity. In a recent study done by a consulting firm found that 90% of surveyed companies fully accelerate all unvested time-based equity grants. And if your grant doesn’t have an acceleration clause, then they may expire.
Acceleration
While acceleration can be a pretty sweet deal, there are a few drawbacks to acceleration. If the change in control (CIC) clause requires an acceleration, the purchasing company may view this with the potential that it’ll lose key employees—prohibiting the deal from actually going through.
In addition, the acceleration clause may be hard to trigger as some companies may have multiple triggers. For example, the clause may consist of specific events such as a greater than 50% change in the board seats, or the purchase of at least 40% of the voting stock of the company. The NASPP found in a recent study that 66% of companies have a double trigger acceleration clause if there’s a change in control (CIC).
Here’s a few downsides to Acceleration: There’s this 1-off tax rule that could destroy your taxes if your shares are accelerated. It’s the $100k rule. What it says is that only $100k worth of ISOs can vest each year. Anything vesting above $100k would be treated as NSOs. In the same vein, a graded vesting schedule unintentionally spreads the tax out, while accelerating can concentrate it—pushing you into a higher tax bracket. Lastly, it’s important to note that acceleration can also trigger the “golden parachute” rules for highly compensated executives.
The complexity of Mergers and Acquisitions will undoubtedly continue due to the open-ended nature of contracts. That being said, things can be simplified by looking at the possible outcomes and then changing what you can control. Perhaps most importantly, you’ll want to avoid silly mistakes like making decisions solely based on taxes. Learn more here.
