What Happens to Call Options When a Company Is Acquired?

When a company undergoes an acquisition, financial instruments tied to its stock, such as call options, are directly impacted. A call option grants its holder the right, but not the obligation, to purchase a specific number of shares of a company’s stock at a predetermined price, known as the strike price, before a certain expiration date. Corporate acquisitions are common occurrences that significantly alter the landscape for these options. This article clarifies what happens to call options when the underlying company is acquired, detailing the various outcomes and their financial considerations.

Impact of Acquisition Structure

The specific structure of a company acquisition dictates how existing call options are handled. The terms outlined in the merger agreement are paramount, determining how options are treated and the consideration shareholders receive.

In an all-cash acquisition, the acquiring company pays a fixed cash price per share for the target company’s stock. Under these circumstances, call options are settled in cash. This means option holders receive a cash payment based on the option’s intrinsic value, provided it is “in-the-money.”

An all-stock acquisition involves the exchange of shares from the target company for shares of the acquiring company. In such deals, call options are converted into options or shares of the acquiring company. The terms of the original options, such as the number of shares and strike price, are adjusted to reflect the exchange ratio of the acquisition.

A mixed cash and stock acquisition combines both payment methods, offering a blend of cash and shares from the acquiring entity. This hybrid structure can lead to a combination of cash settlement for some portion of the option’s value and conversion into new options or shares for the remainder. The specific allocation depends on the negotiated terms within the acquisition agreement.

Treatment of Call Options

The specific outcomes for call options during an acquisition build upon the type of acquisition structure. These outcomes are governed by the merger agreement and original option terms. The option’s value is influenced by how the acquisition price compares to its strike price.

One common outcome for in-the-money call options is a cash-out. This occurs when the acquisition price per share is higher than the option’s strike price. Option holders receive a cash payment representing the intrinsic value of their options, which is the difference between the acquisition price and the strike price.

Conversion or substitution is another common treatment. In stock-for-stock deals, call options convert into options or shares of the acquiring company. Terms, including strike price and number of shares, are adjusted to maintain the option’s economic value relative to the acquisition terms. This adjustment ensures the option holder’s position is not economically worse than before the acquisition.

Conversely, out-of-the-money call options, where the strike price is higher than the acquisition price, are cancelled without value or simply expire worthless. Since exercising such options would result in a loss, they hold no intrinsic value in the context of the acquisition. Trading in options of the acquired company ceases upon merger completion. Option holders may also have the opportunity to exercise their options prior to the acquisition closing date. This decision depends on the timeline of the deal and the specific terms, as exercising early can sometimes impact the tax treatment or the ability to benefit from merger-specific considerations.

Valuation and Settlement

Understanding how the value of a call option is determined and when settlement occurs is crucial for option holders during an acquisition. Options typically lose their time value upon acquisition, meaning only their intrinsic value, if any, remains or is converted. This process ensures option holders receive their due consideration based on the agreed-upon acquisition terms.

For cashed-out options, the payment is calculated using a straightforward formula: the acquisition price per share minus the option’s strike price per share, multiplied by the number of shares underlying the option. For example, if a company is acquired at $80 per share and an option has a $70 strike price, the holder would receive $10 per share. This calculation directly reflects the intrinsic value of the option at the time of the acquisition.

When options are converted into new options or shares of the acquiring company, the number of new options or shares received is determined by the acquisition’s exchange ratio. This ratio specifies how many shares of the acquiring company’s stock are issued for each share of the target company’s stock. For instance, if the exchange ratio is 0.5, each option on 100 shares of the target company might convert to an option on 50 shares of the acquiring company.

Settlement of cash payments or distribution of new shares/options typically occurs at the close of the acquisition or shortly thereafter. Option holders are usually notified of the process and their options through official communications from the acquiring company or through their brokerage. This communication outlines the precise terms and timeline for receiving their consideration.

Tax Implications

The tax consequences for call option holders in an acquisition vary significantly depending on how the options are treated and individual circumstances. Understanding these implications is important for financial planning. Tax laws are complex, making personalized advice from a tax professional advisable.

When call options are cashed out, the payment received is generally treated as a capital gain or loss. The classification as short-term or long-term capital gain depends on the holding period of the option. If the option was held for one year or less, any gain is considered short-term and is taxed at the individual’s ordinary income tax rate, which can range from 10% to 37% federally. If held for more than one year, the gain is long-term capital gain, subject to lower preferential tax rates, typically ranging from 0% to 20%. The original cost basis of the option, including any premium paid, factors into the calculation of the gain or loss.

For options that are converted or substituted into options or shares of the acquiring company, the tax treatment can differ. This exchange may not be a taxable event at the time of conversion, especially if the acquisition qualifies as a “tax-free reorganization” under Internal Revenue Service (IRS) guidelines. In such cases, the tax liability is generally deferred until the new options are exercised or the new shares are subsequently sold.

However, if the conversion does not meet the criteria for a tax-free reorganization, or if the option type changes (e.g., from an Incentive Stock Option to a Non-Qualified Stock Option), there could be immediate tax implications. The specific rules regarding non-qualified stock options and incentive stock options can lead to different tax treatments, including potential ordinary income recognition upon exercise.