The Role Equity Plays in a Merger or Acquisition

In mergers and acquisitions (M&A), many components come into play, including tax obligations, valuation methods, quality of earnings, business growth — and, of course, equity. Equity is the backbone of every business, and it can be valued differently based on the equity makeup, the exercise rights of issued shares or the market at the time. Here are some key equity management considerations.

Plan Documents and Employment Agreements

Before entering into a merger or acquisition, sellers need to understand how their equity incentive plan works. When a sale occurs, how will equity owners be compensated? Will a change in ownership trigger an acceleration clause? How restrictive is the plan, and how extensive are the awards and grants?

For answers, business owners must look beyond even the plan documents. Occasionally, employment agreements or even individual grant agreements have special change of control clauses that should be reviewed and understood.

Another consideration is the timing of events. Consider incentive stock option (ISO) grants. ISOs are granted to key employees, often as part of their compensation, allowing them to purchase stock at a certain price. Whether employees exercise these options before the merger or acquisition is finalized will affect the final valuation number, so sellers should understand how these equity compensation grants work.

Buyers have similar considerations. They need to grasp the target’s plan documents and employment agreements before they proceed. When they understand the existing equity makeup, they can decide how they will take over and whether they will cancel the plan, cash it out or fully assume it. Equity dilution and key employee retention will be chief concerns during these negotiations.

Purchase Accounting Considerations

When buyer and seller work toward an agreement, they often use “purchase accounting” to value the business. Under this method, the business’s assets, liabilities and equity are adjusted to their fair values based on the assumption that the buyer follows through with the purchase. Valuing equity can prove to be tricky. Upon acquisition, the buyer may want to replace the equity incentives with newly issued awards, cancel them or cash them out. Each option will require a different valuation.

But not all equity options affect the purchase price. Consider scenarios where key employees can only exercise their stock options six months or a year after a change in ownership. Even though key employees are expected to exercise those options imminently, their values cannot be included in the purchase price; they are post-transaction expenses. Buyers should invest in careful deal structuring. A good deal includes as many existing equity options as possible in the purchase price.

Sellers should also invest in deal planning. Sellers receive the highest valuation when their employees remain employed with the acquiring entity. To help employees view the takeover as positive, sellers can advocate for specific awards on their behalf and carefully review change-of-control provisions. Key employees may advocate for an acceleration clause in their contract so they can cash in and get out post-acquisition. But limiting that acceleration may make sense for them and the seller in the long run.

Employee Education

Sellers must invest in employee education. Do employees understand how their equity awards work? Do they know the guidelines for exercising their options? Do they know the tax consequences of the merger or acquisition? Cash compensation may be king, but employees want to understand the role they and their options play in a merger or acquisition. ISOs, for instance, are tax-advantageous to employees who exercise them pre-acquisition, but less appealing post-acquisition.

Feel Prepared to Handle Equity and Other M&A Matters?

Equity dilution. ISO grants. Purchase accounting. Employee education. Not confident that you have it all in hand? We can help. Find out how our Mergers and Acquisitions Advisory team can cut through complexity, mitigate risks and maximize your value through all phases of your transaction.