Research

Employee stock options suffer in most merger deals

When a company succeeds to the point that other firms come calling with merger or acquisition offers, the thinking goes, those stock options will turn into big payoffs for the employees. However, new research shows it generally doesn’t work out that way.

By Jane Larson

2021-07-28

Especially for workers who join promising startup companies, stock options make up an attractive part of their compensation packages. When the company succeeds to the point that other firms come calling with merger or acquisition offers, the thinking goes, those stock options will turn into big payoffs for the employees.

But, new research shows it generally doesn’t work out that way.

Ilona Babenka and Yuri Tserlukevich, both associate professors of finance, along with a colleague from California State University, Fullerton, found that in about 80% of deals, at least some of the employee stock options are modified or canceled to cut company costs, and company shareholders are the ones to benefit from the higher stock prices that result.

Previous research on the topic had looked at executives’ compensation and found that top managers fare very well in mergers and acquisitions, Babenka says. But it when it came to employees’ stock options, Tserlukevich added, most research had focused on the cost of their plans and how effective they were in motivating employees to work harder.

The team wondered about what happened to employee compensation and company valuations when M&As result in at least some of the employee stock options being canceled.

“The question becomes this: If a new company comes in and the new owners decide to cut compensation, sometimes down to zero, does the cut in compensation show the company becomes less efficient and employees become less incentivized, or is it OK to redo compensation without affecting employees?” Tserlukevich explains.

To answer their questions, the team assembled data on 1,277 deals announced between 2006 and 2014 in which the companies targeted in the deals were publicly traded companies. They then searched U.S. Securities and Exchange Commission filings for details of how the companies’ employee stock options were to be treated in the event of a merger or acquisition. They also analyzed the stock prices of the target companies and the acquiring companies for four weeks before and four weeks after the deals were announced.

They focused on two numbers: how much money employees lost when their stock options were canceled, and how much value companies added by canceling the options.

Most deals cancel at least some options

They found that in 80% of M&A deals, the merger agreements enabled the acquiring companies to cancel at least some employee stock options and not replace them with new, equity-based grants. Cancelations or contract modifications reduced the value of the target companies’ employee stock option plans by an average of 38.4%, or $15.3 million, which equaled 3.1% of the target firms’ market capitalization before the mergers, the researchers found.

Whether options were cashed out, assumed, or canceled varied with the type of option. For example, 76.4% of vested “in-the-money” stock options — those in which the target firm’s market price was higher than the price for which employees could acquire their stock — were cashed out at current prices, giving employees the current value of the stock but costing them any expected future gains. In 17.9% of cases, the acquiring companies assumed or converted the target companies’ options to ones for the acquirers’ often less-volatile stock. Unvested “in-the-money” options were treated similarly, with acquiring companies cashing out them out in 70.2% of cases and assuming them in 22.1% of cases.

For vested “out-of-the-money” stock options — those in which the target firm’s market price was lower than the price for which employees could acquire their stock — 79% were canceled outright, costing employees the possibility that their firms’ stock would be worth more in the future, and 18.3% of such options were assumed. Unvested “out-of-the-money” options were canceled in 76% of cases and assumed in 21.4% of cases.

On the shareholder side, agreements to cancel or modify employee stock options reduced the target companies’ costs, which made those firms more attractive and brought them higher premiums on their stock prices. The takeover gains for target companies in deals with stock-option cancelations were 3.6 to 4.4% higher than the gains in deals without such cancelations. Shareholders of acquiring firms also benefited from the cost-cutting, but the price of their shares changed to a lesser extent.

In other words, if indeed some company is able to cancel 38% of the employee stock option compensation, then the market value should immediately go up by 3 or 4%

– Yuri Tserlukevich, associate professor of finance

The researchers also found that the combined returns from mergers were larger when the employees’ losses were larger. Deals with the largest employee losses generated average combined returns of 8.7% to shareholders, while those with the smallest employee losses generated average combined returns of 3.3% to shareholders.

“Basically, cost cutting translates into higher value for shareholders of the merged entity, and there is not much negative effect,” Babenka says. “So it seems the managers are doing a good job for the shareholders, at least, if not so much for employees.”

Merger deals tend to include canceling or modifying employee stock options because such actions allow companies to control labor costs and adjust compensation for employees who may be entrenched or overpaid at the target firms, the researchers explain. But Babenka doubts companies could modify employee stock option plans if a merger wasn’t in the works.

Employees under pressure in mergers

“Employees are very worried about keeping their jobs,” Babenka says of merger situations. “A lot is at stake, and they are afraid they will be redundant. So it’s kind of easy for the acquiring agency to say, ‘Look, the old deal is off, you want to keep your jobs, we’re going to do something different, sorry, your options have to go … Employees are more willing to probably agree to such treatment because they are under stress.”

Unfortunately for employees in some mergers, the acquiring company is more interested in acquiring technology or intellectual property and less interested in retaining the bulk of the target company’s employees. Especially in those cases, the acquiring company expects few negative effects from canceling or modifying employees’ stock option plans, the researchers say.

To see if employees’ attitudes toward potential mergers were related to the type of options they had, the team also examined data from a 2010 survey of employees at four public firms. They found negative attitudes toward a merger were more pronounced in employees who had many unvested or newly granted stock options, while employees who already owned more stock were more likely to vote for a merger.

Going into the research, the team thought they would find that cuts in stock options have long-term effects. Instead, they found that the cost-cutting amounted to a one-time benefit for shareholders. They also realized that as a target company’s stock price rises due to the prospective merger, so does the value of the employees’ options, making cost-cutting even more justifiable.

The research shows that options may have been essential before a merger as a way for companies to encourage innovation and maintain key employees, Babenka and Tserlukevich explain, but that it is possible to cancel options and incur little negative effect when companies undergo changes in their structures.

The findings break new ground, the researchers say, in that they reveal how the incentive portion of employees’ compensation is treated in mergers. The findings also add to the ongoing debate in the compensation field and among institutional investors about whether such options are necessary and what is the right amount of options to grant.

Babenka and Tserlukevich next want to study more mergers and see whether significant cuts to employee compensation might be a sign that acquiring companies did not want to retain the target firms’ employees for their own workforce.

The bottom line

Babenka and Tserlukevich say their findings have these implications for the various stakeholders in mergers and acquisitions:

• Employees of target firms should be aware of the risk that some of their stock options could be taken away in a merger. When joining a firm, workers should weigh whether they would prefer higher wages or are willing to take the risk of the gains or losses that come with options. They should study compensation documents to understand when and how their stock options could be modified or canceled.
• Stockholders can see mergers as good news, because they will benefit from the cost-cutting that results. Shareholders, especially of target firms, can push managers to negotiate harder to cut options so the result is a higher premium on their stock.
• Acquiring companies should realize that failing to negotiate about employee stock options means they likely will pay higher prices for their targets. They should look closely at the target firm’s documents regarding employee stock options in the event of a merger. Stock option plans that don’t allow for modifications or cancelations will be more costly to an acquiring company than plans that do.
• Boards of directors of potential target firms should recognize the cost-cutting and stock-price benefits of having flexible plans and should reserve the right to modify their employee stock option plans. That flexibility gives the board leverage in negotiations and can improve a deal’s outcome.

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