Diminishing returns: employee stock options in an acquisition

Mergers and acquisitions create and destroy massive amounts of money, and are hugely important to the financial world. Associate Professor of Finance Ilona Babenko’s recent research supplies a missing piece of the complex merger jigsaw puzzle.

What happens to employees’ stock options when their company is acquired by another firm? That question from a doctoral student inspired Associate Professor of Finance Ilona Babenko to investigate. Working with colleagues PhD student Fangfang Du and Associate Professor of Finance Yuri Tserlukevich, she studied 1,277 merger-and-acquisition (M&A) deals and found that 80 percent of the time, the acquiring company canceled at least some employee stock options. The average M&A deal reduced the value of stock options to employees by more than 48 percent.

That’s bound to be disappointing news for many workers. The use of employee stock options has increased more than ninefold over the past 30 years, and they were the most prominent form of individual equity compensation in 2014. They’re especially prevalent in the tech industry. Stock options often serve as a carrot for startups to attract talent, since they can’t pay wages high enough to compete with larger companies. Successful startups and small businesses are also frequent acquisition targets. Babenko found that the most common tactic for the acquiring company is to cancel all out-of-the-money employee stock options held by the business they are buying (the target company) and to cash out those that are in-the-money. But some acquirers also cancel in-the-money options, providing no payment to employees, sometimes even if those options are vested. That happened, for example, to workers at Skype when Microsoft bought the company in 2011.

Limited value for options

Usually, employees who are forced to cash out their options because of the merger don’t receive the full financial benefit from them. They do get the “intrinsic value,” which is the difference between the strike price and the current market price. For example, an option with a strike price of $100 and a market stock price of $101 has an intrinsic value of $1.

"However," Babenko explains, “If employees can hold onto their options until maturity and exercise them later, they will typically obtain more money. Since there is a possibility that a stock’s price will rise over the period an option can be held, an option contract that lasts for five to 10 years is valued higher than the one that must be exercised within a shorter timeframe.""

Imagine, for example, that it is equally likely that the stock price drops or increases by 50 percent over the next five years. If the stock price increases to $151.5, employees will obtain $51.5 by exercising their options. If the stock price drops to $50.5, employees will not use their options and get a value of zero. Still, a lottery with an equal chance of getting $51.5 or $0 could be preferred by many employees over $1 offered through a merger cash-out. In the rare cases where the acquiring company does preserve the target company’s employee stock options, their value usually drops after the acquisition. Larger companies are less volatile than smaller businesses. With options, higher volatility means more possibilities for growth — and higher premiums.

Why do they cancel options?

Acquiring companies are concerned about containing costs when they buy a new business. If employee stock options were left unchanged, their value would balloon after a merger because the acquirer is paying a premium to purchase the target company’s stock. On average, the offer price for a company is 41 percent higher than its market value. The higher stock price would push employee options deeper into the money, and because options are leveraged, their value would increase exponentially. If not modified or canceled, they could quickly become a huge financial burden to the acquiring company.

It’s about shareholder value

Ultimately, acquiring companies cancel employee stock options to create more value for shareholders of the new firm. Though target firm employers are not eager to throw employees’ stock options under the bus, they also have a duty to their shareholders. Nevertheless, employees can make trouble by lobbying to oppose the merger. Perhaps for that reason, acquirers pay a 4.6 percent higher premium for a firm when some options are canceled than when some are preserved. Babenko also found that takeover premiums are larger when the target firm has many employee stock options, especially if they are out-of-the-money and unvested.

This suggests that “squeaky wheel” employees at the target company may influence managers to demand a higher premium. Babenko’s research raises an interesting question: If target company executives know they will get a higher price for their business if it has lots of stock options, might that influence them to issue more options to employees to increase their bargaining power? “We can’t answer the question explicitly, but it appears that they may be doing that,” Babenko says. Another possibility is that companies may increase the number of employee options to serve as a “poison pill” to prevent a takeover. Again, there’s no evidence, but it’s an intriguing possibility. There’s no denying that the stock market favors deals where employee stock options are canceled. But for employees, all is not lost. Many also own stock in the company, often obtained at a discount. The premium paid by the acquirer will benefit them as shareholders in the new business.

The role of employee stock options

Mergers and acquisitions create and destroy massive amounts of money, and are hugely important to the financial world. Babenko’s research supplies a missing piece of the complex merger jigsaw puzzle, revealing how executives, shareholders, employees, and the market view the value of employee stock options. Anyone involved in a merger should pay close attention.

Other research coming out of the W. P. Carey School of Business at Arizona State University includes online shopping during off-hours and mapping brain signatures. Read the spring 2017 W. P. Carey magazine to find out how retailers can learn from early birds and night owls about the art of online shopping. Also, meet the management expert that maps brain signatures of "bad" bosses.