Overlooking Executive Comp Packages Puts M&A Deals at Risk

Understanding a target’s compensation programs and philosophies and analyzing how to motivate senior leaders are key components of any successful merger or acquisition.

Compensation often directly affects a target’s key decision-makers—individuals who may have power to decide whether to move forward. Executive compensation can be one of the more expensive line items in a deal when factoring in costs of incentive equity, base salary, bonus opportunities, severance entitlements, and health and welfare programs.

Add a multitude of tax, securities, corporate, and employment-related rules and regulations for executive compensation, and you’re left with a mission-critical area of law.

Transaction Structures

Depending on the nature of a transaction, you may be thinking through different executive compensation-related items. If the target is a private company, there will be very few disclosure concerns. But if the target is public, there will be significant disclosure obligations—for senior executive officers, at the very least.

Some M&A transactions are true acquisitions where one entity is purchasing the other, and other transactions are mergers of equals. In the latter case, it will be critical to understand who will make compensation-related decisions in the combined company going forward.

For carve-outs, we need to consider whether the executives are technically incurring a termination of employment and subsequent re-hiring by the acquiror. If they are, new offer letters should be drafted with applicable compensatory terms and provisions.

It’s important to consider which party will bear the cost of any severance obligation triggered by the transaction, regardless if the executive accepts the new offer of employment.

The transaction’s form of consideration is another imperative question when dealing with incentive equity awards—we look to whether employees will receive liquidity, if they’ll have any type of windfall, and/or whether they will have sufficient cash to cover any tax obligations that arise in connection with the vesting and/or settlement of outstanding equity awards.

Severance and Bonuses

Employees may feel nervous during deals because of concerns over being deemed redundant and potentially laid off. One way to aid employee performance is through severance protections in the case of an involuntary termination—which typically follows a termination without cause or resignation for good reason.

Severance can vary in duration and dollar value depending on seniority, job level, and other relevant factors. Other tools to be used to motivate, retain, and incentivize employees could be through transaction and/or retention bonuses. Transaction bonuses aim to motivate employees to get the target to the finish line.

Often, the bonuses are a set percentage of the purchase price paid in the transaction, and other times, they’re based on a fixed dollar amount. With retention bonuses, employers are attempting to keep key employees in their seats through certain dates and milestones.

We often see retention bonuses split into two or three tranches, requiring continued employment through the applicable vesting dates as a condition to receiving payments.

Covenants

Another key area of focus for the buyer is setting forth certain restrictions around what the target can do during the period between a transaction’s signing and closing. Standard covenants include restrictions on: amending, modifying, or terminating an existing benefit plan; increasing compensation, benefits, or severance; hiring or terminating employees; and granting, vesting, or settling incentive equity awards.

On the target side, companies often want to ask for certain post-closing employment-related covenants in the transaction agreements. Primarily, targets may want protections for compensation and benefits post-closing. These covenants frequently guarantee compensation and benefit levels for a period—often 12 months—and occasionally includes continued rights to participate in severance programs.

Sections 280G and 4999

A major workstream in most transactions revolves around the golden parachute rules: specifically Sections 280G and 4999 of the Internal Revenue Code. If golden parachutes are triggered due to certain compensatory payments being funded, vested, and/or settled in connection with a change in control, a 20% excise tax could be levied on certain service providers of the target, and a loss of compensatory tax deduction may be in play for the target.

If the target is a private company, a shareholder cleansing vote may be available, resulting in no excise tax or loss of compensatory tax deduction if successfully obtained. If the target is public, such cleansing vote is not available.

In this case, the target would need to try to mitigate the potential problem by performing reasonable compensation analyses, valuing non-competition agreements, and trying to shift compensation from a future tax year into the current tax year—potentially increasing the service provider’s base amount and safe harbor thresholds.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Ian Sherwin is partner at Reed Smith with focus on executive compensation and employee benefits in M&A and other transactions.

Write for Us: Author Guidelines