Jan 2 2006

Two Last Things On Assumption of Stock Options

In our previous post – which started to get long and unwieldy (ah – the need for an editor – where are those guys when you need them) – we didn’t cover two critical issues: (1) What happens if the acquisition is in cash vs. public stock vs. private stock, and (2) Who pays for the “basis” of the stock options?

The form of consideration of the acquisition can be a many spendored thing. We’re going to ignore tax considerations for this post (although you shouldn’t – we just don’t want this to be 12 pages long.) If I’m an employee of a seller, I’m going to value cash differently than public stock (restricted or unrestricted?) differently than public stock options differently than private stock (or options). If the buyer is public or is paying cash, the calculation is pretty straightforward and can be easily explained to the employee. If the buyer is private, this becomes much more challenging and is something that management and the representatives of the seller who are structuring the transaction should think through carefully.

The “basis” of the stock options (also known as the “strike price” or “barter element”) reduces the value of the stock option. Specifically, if the value of a share of stock in a transaction is $1 and the basis of the stock option is $0.40, the actual value of the stock option at the time of the transaction is $0.60. For some bizarre reason, many sellers forget to try to recapture the value of the barter element in the purchase price and allow the total purchase price to be the gross value of the stock options (vested and unvested) rather than getting incremental credit on the purchase price for the barter element.

Yeah – a little confusing, but lets assume you’ve got a $100 million cash transaction with $10m going to option holders, 50% of which are vested and 50% are unvested. Assume – for simplicity – that the buyer is assuming unvested options but including them in the total purchase price (the $100m) and that the total barter element of the vested stock is $1m and the barter element of the unvested stock is $3m. The vested stock has a value of $4m ($5m value – $1m barter element) and the unvested stock has a value of $2m ($5m value – $3m barter element). So – the option holders are only going to net $6m total. Often the seller will catch the vested stock amount (e.g. vested options will account for $4m of the $100m) but the full $5m will be allocated to the unvested options (instead of the actual value / cost to the buyer of $2m). This is a material difference (e.g. the difference between $91m going to the non-option holders versus $94m).

Of course, all of this assumes that the stock options are in the money. If the purchase price of the transaction puts the options out of the money (e.g. the purchase price is below the liquidation preference) all of this is irrelevant since the options are worthless.