What is an employee retention or M&A carveout plan?

February 21, 2010

I was speaking at an event last month to a group of CEOs and was surprised by the number of CEOs that were worried about the value of their common stock in a M&A transaction.  Due to aggregate liquidation preferences that may exceed the acquisition price in an M&A deal, common stock may be rendered worthless.  For example, if a company has raised $20M in venture financings by issuing non-participating preferred stock, the holders of common stock will not receive any proceeds from an M&A transaction unless the transaction value exceeds $20M.  If you can’t figure this out yourself, you should probably build a liquidation preference spreadsheet to model how liquidation preferences work depending on M&A transaction value.

In response to the problem of worthless common stock, some companies have implemented employee retention plans, which are also referred to as M&A carveout plans. This was particularly common from 2001 to 2003, after the dot-com crash when companies had raised a large amount of venture financing at high valuations.

Below are some common structures for employee retention plans and issues related to each alternative.  I have intentionally not covered all of the corporate law implications of designing and implementing a retention plan or provided a comprehensive analysis of any particular tax or accounting issues, as they are fairly complex and depend on specific facts.  A company’s board of directors will need guidance from counsel on meeting their fiduciary duties when implementing a retention plan.

1. Change of Control Bonus Plans

Under a change of control bonus plan, eligible employees are entitled to certain benefits upon change of control transactions as specifically defined in the plan documents.  This can be simple as an agreement with an individual employee that says “if you are still employed when the company is sold, you will receive $X.” 

More complex plans set aside a pool of money for employees and a mechanism for dividing the pool.  In addition, the plan could pay a fixed amount under the plan to the individuals, regardless of the value of the triggering event.  Alternatively, the plan could pay a percentage of the proceeds from the triggering event (e.g. 10% of the size of the deal). In some cases, the payout may be a sliding scale (e.g. 10% of the first $5M in proceeds, 15% of the next $5M in proceeds, and 20% of the amount over $10M).  In plans where the size of the payout is dependent on the size of the transaction, the definition of the transaction value needs to account for situations such as assumption of debt by the acquiror, earnouts, escrows, and illiquid stock as acquisition consideration, among other things.  In addition, given that the plan is intended to solve for situations where common stock is worthless, they should terminate above certain transaction values, or payouts should take into consideration the value of the common stock.

2. Straight Retention Plans

Under straight retention plans, eligible employees are entitled to certain benefits or payments that are not contingent upon any triggering event, such as a change of control.  These bonus payments may be paid as long as the employee is employed on a certain date (i.e. 50% of base salary if still employed 6 months later).

The following issues relate to both change of control bonus plans and straight retention plans:

• Currency. The company must determine the currency with which to pay the eligible employees. Typically, employees receive stock, cash or a combination thereof.  A retention plan that pays employees in acquiror stock is less common than a cash payment plan as payment in acquiror stock will be ordinary income to the employee, and receiving illiquid acquiror stock in a taxable transaction is not desirable in most situations.

• Participation. The company must determine which employees are eligible to participate in the program. Executive management is typically the key participant, however, participation may be determined by time of service or benefits can be given to all employees.

• Allocation. Once the company has determined who is eligible, they must further determine how to allocate the units or stock to be issued to the employees. Alternatives include position, time of service, current equity holdings or other metrics as determined by the company’s board of directors.  The board can set aside some of the “retention pool” for future issuances. However, it must determine when establishing the plan what will happen to the pool upon certain triggering events.

• Vesting. The company must determine whether the stock or cash distributed will be fully vested at the time of grant or will vest over time. The company must further determine which, if any triggers, will accelerate vesting and to what degree.

• Last Man Standing. Related to vesting issues, the company must also determine whether benefits will be forfeited if employees are terminated within a certain period of time of the change of control and whether the forfeited benefits will be redistributed to remaining employees.  If the employee needs to be employed at the time of the change of control transaction, this may lead to a perverse incentive for company management to terminate employees, especially if the forfeited benefits are redistributed to remaining company management.

3. Junior Preferred Stock

Some companies have implemented junior preferred stock, which often receives a certain percentage liquidation preference on the sale of the company.  The junior preferred can be created as an option plan or sold directly, with or without vesting.  The junior preferred is often junior to existing preferred stock, but senior to common stock, in order to provide liquidation preference for certain classes of employees, senior to common stock.  Participation, allocation and vesting issues are similar to those described above.