Will I Get Paid? Employee Stock Options and Mergers and Acquisitions

Employee stock options (ESOs) represent an integral component of modern employee compensation packages, particularly for highly innovative firms and those that operate in the high-tech industry (see e.g., Core and Guay (2001), Ittner et al. (2003), and Chang et al. (2015)). However, these types of firms also make attractive acquisition targets, and the natural question arises as to what happens to ESOs held by rank-and-file employees once their firms get acquired.

Using data from merger agreements on 1,178 deals announced during 2006-2014, we find that ESOs compensation is modified by acquirers in a way that does not benefit employees. In more than 80% of all completed M&A deals, some of the target’s outstanding employee stock options are simply terminated by the acquirer. While the most common scenario is cancelling all out-of-the-money stock options of the target firm, even in-the-money stock options can sometimes be terminated without any compensating payment to employees, and vested and unvested stock options can all be fair game. For example, when Microsoft was buying Skype in 2011, employees were not even able to keep the vested portion of their stock options.

Further, employees are often forced to accept the lower intrinsic value of their vested in-the-money stock options instead of the Black-Scholes value (77% of all deals). Finally, even in cases when acquirers do assume the target option plans, their value is typically reduced because converted options are written on the acquirer’s stock which is typically less volatile than the target’s stock. Overall, we estimate that the average M&A deal reduces the value of stock options to employees by approximately 49% and there is no evidence that these options are replaced with the new grants after the acquisition. Of course, the compensation of top executives is typically treated differently in acquisitions. For example, Hartzell, Ofek, and Yermack (2004) and Fich, Cai, and Tran (2011) document that executives of target firms often negotiate large personal benefits in M&A deals.

Do ESOs and their treatment by the acquirer affect the merger terms and outcomes? On one hand, one might expect that given the prospect of having their stock options taken away, employees may actively participate in merger negotiations and oppose the merger. This would reduce the attractiveness of a firm to the prospective acquirer and imply a lower offer premium. On the other hand, by reducing the value of outstanding stock options the acquirer can potentially transfer some of these gains to shareholders, which would affect the premium positively.

We find that the takeover premium is approximately 3.7% higher for deals in which the acquirer cancels some employee stock options. Interestingly, in these deals the acquirers earn on average a statistically positive announcement return of 0.78%, whereas it is negative -1.74% in deals in which the acquirers have to assume compensation obligations of the target. These results are consistent with the view that cancelling stock options allows the bidder to reduce compensation liability and realize gains at the expense of employees.

The full paper is available for download here.