Stock options in a merger

The treatment of options stock options and other equity compensation awards is often a key element of a sale transaction. Last week, in Fox v. CDX HoldingsInc. As further discussed below, the decision serves as a cautionary reminder that the rights of optionholders are contractual and, unlike the rights of shareholders, are not governed by statute or fiduciary principles in a sale. Cashing Out or Rolling Over Outstanding Merger Options.

While the balancing of the considerations in answering that question will vary from deal to deal depending on type of deal public or privatetype of purchaser strategic or financialvalue of options in-the-money or underwater and other facts and circumstances, many of the considerations are common across deals. In a typical sale of a privately-held company for cash, vested options must be exercised merger closing or else they will terminate or are cashed out.

In a cashout, the holders generally receive the excess of the per share sale price over the exercise options in exchange for cancellation of the options. Vesting of unvested options may be accelerated, in whole or part, in connection with the sale. If any options are out-of-the-money or underwater, the parties generally desire to cancel the underwater options for no consideration. Receipt of a portion of the option proceeds like stock proceeds may be subject to indemnification holdbacks or escrows.

Option Plans May Not Permit the Intended Treatment. If the option plan and award agreements do not contemplate these actions e. Stock action may pose a stock of legal claims for breach of contract or otherwise.

For instance, in Lillis v. The merger agreement provided for a proportionate holdback from the stock and option proceeds — a commonly-included deal term in a private deal. However, under the terms of the stock option plan, each holder was entitled to receive for each share covered by an option the difference between the fair market value of the share and the stock price of the option.

The court held that the stock plan, and not the merger agreement, governed the relationship between the optionholders and the company and concluded that because the merger could have provided, but merger not provide for such a holdback, it was not permitted.

Does Your Plan Permit the Intended Treatment? The starting point for the Lillis and CDX rulings is the fundamental principle that the rights and obligations of the company and optionholders are governed by the terms of their contract — the equity plan and award agreements. As recited in CDX: Rather, the terms of the plan and award agreements must authorize and permit the intended treatment — in these cases, the cancellation of options or an escrow holdback.

A company generally cannot change the plan terms at the time of the sale without the consent of the optionholders if the proposed treatment would adversely affect stock rights. Amending an equity plan in a manner that adversely affects optionholders may also require optionholder consent and, if the company is stock public company, may require stockholder approval.

Options companies are required under exchange act listing requirements to obtain stockholder approval of equity compensation plans and any material amendments. Because obtaining the consent of optionholders or obtaining stockholder approval at the time of the transaction can raise unwanted complications and may not be feasible given the timing of the transaction or number of optionholdersit is important for the company and the purchaser to be aware of the terms of the option plan and award agreement well before negotiating the terms of the sale.

Accordingly, purchasers should also review transaction documentation from previous acquisitions and communications to employees that may bear on the rights of the optionholders. If there is any uncertainty which plan terms govern or whether the intended treatment is permitted, the parties will have to determine whether to obtain consent from the optionholders and weigh any timing or other potential factors related to obtaining consent against the risk of possible claims by optionholders if consent is not obtained.

Give Plan Administrators Flexibility When Devising Option Plan. For example, a plan could provide that holders of stock options cancelled in connection with a merger would receive the same consideration on the same terms as the holders of common stock in the deal, less the exercise price. Note that under this formulation, underwater options would likely receive no consideration. Companies should also have the flexibility to treat options in a sale transaction in a manner agreed to by the administrator of the plan as set forth in the merger agreement which would allow among other things the assumption or substitution of options by the purchaser and the acceleration of vesting of options held by key employees.

It should also permit the administrator to take different actions with respect to different options or holders. For example, in some sale transactions, the parties may want to apply the escrow holdback to the founders or senior options team but not to other merger or may want to treat current employees differently than former employees. The plan should also permit the administrator to take different actions with respect to the vested and unvested options, and to accelerate vesting, in whole or in part.

In some cases, stock employees or other optionholders may have negotiated for special rights stock connection with a sale or other change-of-control such as automatic vesting or acceleration rights.

It is important to review all relevant plans, awards and employment agreements for these change-of-control provisions in connection with a sale transaction and to consider their effect on the pricing and other terms of the deal.

Understand stock Requirements of the Plan and Abide by Them. In CDXthe court found that the Board was required to determine the fair market value of each share covered by the option options to adjust the options to account for the spin-off options of the transaction, but failed to do so in good faith. Instead, the court merger that the controlling stockholder and the CFO who was not on the Board made the determinations without sufficient involvement or formal action by the full Board, contrary to the merger of the plan.

The court found that only one director besides the controlling stockholder had any involvement at all in the value determination in limited emails with the CFOand that one director did not even know the plan existed. The court noted that the CDX Board could have delegated the fair market value and adjustment determinations to a committee of the Board consisting of one director the controlling stockholderbut in failing to do so, the full Board was required to make the determinations by formal action.

In affirming the judgment, the Delaware Supreme Merger noted that it was not enough for the Board to fulfill its contractual obligations under the plan solely by noting in its Board resolutions that such obligations existed. This aspect of the opinion is a recurring theme in recent Delaware decisions underscoring that judges will disfavor results-oriented valuations and may second-guess a fair market value determination in litigation that diverges from prior valuations made in connection with stock plan issuances or otherwise in the ordinary course of business.

Of course, there can be legitimate reasons why a deal price may differ from fair market value determinations made in other contexts. However, boards should be prepared to reconcile the discrepancies in litigation and would be well served to create a good record of their reasoning, deliberations and conclusions.

By using the blog, you agree that the information on this blog does not constitute legal or other professional advice. The blog is not a substitute for obtaining legal advice from a options attorney licensed in your state. The information on the blog may be changed without notice and is options guaranteed to be complete, stock or up-to-date, and may not reflect the most current legal developments.

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