Robert M. Fields
EXECUTIVE COMPENSATION AND EMPLOYEE BENEFITS ISSUES IN M&A SITUATIONS
I. Executive Compensation.
One item often overlooked in negotiations between the buyer and seller of a company is how the target company’s management is to be compensated and otherwise treated pre- and post-transaction. Yet, it is often the case that if the management group of the business being sold isn’t happy, the seller very well may not be able to obtain the best possible deal (or, in some cases, any deal at all).
Unfortunately, in many M&A transactions, executives of the companies being sold are unhappy simply because their interests and concerns are not adequately addressed. The failure to provide adequate representation for these executives often gives rise to uncertainty or discontent within the management group. All too often, members of the management team will engage attorneys who are unschooled in the nuances of executive compensation. Together, these factors can cause significant delays in the closings, unnecessary headaches for sellers and purchasers and the inability of the seller to obtain the most favorable terms that otherwise would be available.
Sellers often provide incentive packages to certain executives in order to (i) entice them to stay with the company through the consummation of the transaction and for a certain period beyond (if desired by the buyer), and (ii) maximize shareholder value in the transaction. To obtain these objectives, the following tools are often used:
Completion Bonus -- The completion bonus is a bonus payment that is paid by the seller at closing to key managers that have continued their employment with the company until the closing date of a sale transaction. Given the uncertainty that a sale process creates regarding future employment, sellers often find that completion bonuses are a reasonable and effective means of ensuring that key employees remain with the company throughout the sale process. Also, completion bonuses compensate key management for their work in the sale process, which can often represent a considerable workload in addition to their normal responsibilities.
In order to provide the desired incentive, the existence and value of the completion bonus must be communicated to the relevant employees at the beginning of the sale process. Completion bonuses vary in amount based on the perceived importance of the employee to the sale process as well as the risk that a sale represents to a particular employee. Completion bonuses typically represent a fixed percentage of annual salary and annual bonus (usually anywhere from 50% to 100% of compensation). They are contingent on the closing of a transaction, but their value is not dependent on the results achieved in the sale process.
Success Bonus -- The objective of aligning management’s interest with the shareholders and maximizing shareholder value is often addressed with a success bonus. A success bonus is a payment by the seller to key management that is directly linked to the value obtained in the sales process. Success bonuses are most frequently utilized in situations where management does not have a significant equity interest in the business, or where management’s options are under water.
Sellers often find the success bonus to be an effective tool for aligning management’s interests with those of the shareholders in situations where management may have a preference for a particular buyer. In the absence of a success bonus, management may be tempted to present the company in a more favorable light to its preferred buyer or in a less favorable light to others. Also, management could provide sensitive process information to its preferred buyer, which could result in a lower purchase price or less favorable terms for the seller.
Similar to the completion bonus, the existence and value of the success bonus must be communicated to employees at the beginning of the process in order for it to create the desired incentives. The value is typically defined as a cash payment that increases as certain pre-defined value thresholds are exceeded. For example, a seller may establish an incentive plan providing for a cash payment of between 50% and 200% of annual compensation based on the degree certain predetermined revenue, net profit, ROI, etc. targets are met. Often, more than one of these goals and targets are utilized and are given different weightings respect to each other (e.g., the revenue target will be given a weighting of 20%, net profit, 60%, ROI, 20%, etc.).
Another approach is to grant employees carried interest or phantom equity interests in the company. The value of the carried interest or phantom equity increases with purchase price, providing perfect alignment between shareholders and phantom equity holders. Often, sellers obligate themselves to paying to selected executives a bonus equal to a percentage of the net sales price over a floor amount, with the percentage amount increasing as the sales price increases, until a ceiling percentage amount is reached. For example, a seller may establish a plan providing certain executives with an aggregate bonus equal to 5% of the net sales price over $100,000,000, with the percentage amount increasing by 0.25% for each $5,000,000 increase in the net sales price, until a ceiling percentage of 8% is reached.
Stay Bonus / Severance Programs -- In order to encourage employees to remain with the company through the end of the sale process and to stay with the business post-transaction (if so desired by the buyers), sellers and/or buyers often implement stay bonus plans as part of the sale process. The stay bonus is payable to employees who stay with the company post-transaction for a minimum period of time, typically 12-18 months. The amount of the stay payment is typically a function of the employee’s tenure (e.g., 12-18 months of salary and annual bonus, depending upon the length of the stay period) and is not paid until the stay requirement is satisfied.
Similarly, the seller or buyer may establish a severance program, providing certain executives with a lump-sum payment of between 18 to 24 months of salary and annual bonus in the event their employment is terminated by the buyer without “cause,” or if they voluntarily terminate their employment with “good reason,” within 6 months to 1-year post-closing.
A review and update of employment contracts, severance arrangements, stock options and other cash and equity incentives (whether assumed by the buyer or cancelled by the seller with new agreements and programs established by the buyer) for legal and design purposes is very important in the M&A process. In designing new, or transferring current, contracts and incentives, it is very important that various legal requirements be satisfied, including, among others, the following:
1. Internal Revenue Code Section 409A: This Code Section sets forth very complicated rules governing the design and administration of non-qualified deferred compensation arrangements. For purposes of Section 409A, the term “non-qualified deferred compensation” is defined very broadly, and can include certain severance benefits and cash and equity based incentive arrangements (such as stock options, stock appreciation rights, restricted stock units, etc.), as well as the more traditional forms of deferred payments. The failure to comply with the complex rules set forth under Section 409A will result in very serious tax penalties being imposed on the individuals benefiting under the arrangements, including immediate taxation of payments to be made in the future, a 20% penalty tax and interest charges. It is very important that the form and administration of all types of compensation-related contracts, plans and arrangements, as well as the treatment of these arrangements during the M&A process be reviewed during the negotiation of the stock purchase / merger agreement to insure compliance with Section 409A.
2. Internal Revenue Code Section 280G: This deals with the so-called “golden parachute” rules. Generally, certain payments made to specific individuals in a change in control situation will be subject to corporate deduction limitations and tax penalties being imposed on these individuals. Although Section 280G primarily applies to publicly-held companies, it can also apply to closely-held companies unless certain exceptions apply. Accordingly, it is very important that, in a private company sale, care be taken to insure that these exceptions are satisfied (if possible) in order to avoid the significant penalties imposed by Section 280G.
3. Internal Revenue Code Section 422: This Code Section, dealing with Incentive Stock Options, requires that certain rules be followed in substituting new options to purchase stock of the acquirer for old options to purchase stock of the acquired company. If these rules are not satisfied, the options will lose the tax benefits otherwise available under the special ISO rules.
4. Internal Revenue Code Section 162(m): Applicable to publicly-held corporations, Section 162(m) sets forth very specific rules that must be met in order to permit corporate deductions for performance-based compensation paid to certain executives in excess of $1,000,000 per year. Specific transition rules apply to privately-held corporations undergoing an IPO or that are being acquired by a publicly-held company. These transition rules must be carefully reviewed in the IPO/acquisition process to insure deductibility of excess compensation going forward. PLEASE NOTE: The “performance-based compensation” exception to the application of the deduction limitations set forth under Section 162(m) of the Code only applies to contracts and agreements in effect on November 2, 2017.
5. Securities Issues:
A. The exceptions to securities registration under Rule 701 and Regulation D must be scrupulously followed in the case of grants of privately-held stock or derivatives.
B. For publicly-held corporations, compliance with Rule 16b, the proxy disclosure rules of Regulation S-K and all state securities laws, as well as stock exchange listing standards, must be assured.
I can provide plan design and due diligence services regarding all of these programs to assist you and your clients in effectuating a satisfactory conclusion to the M&A process.
II. Employee Benefits.
From an employee benefits standpoint, I provide due diligence services and advice to both buyers and sellers regarding the assumption by buyer and/or disposition of the seller’s qualified and non-qualified retirement and health and benefit plans and the coverage of seller’s employees under the buyer’s plans post-acquisition. This includes an analysis of the “incurred but not reported” claims under the seller’s self-insured health and medical plans and advising as to which party should be responsible for such benefits.