What Happens to Stock Options When a Company Is Acquired?

Stock options are a form of equity compensation that companies offer to employees, granting them the right to purchase company shares at a predetermined price. When a company undergoes an acquisition, the fate of these stock options becomes a concern for employees. This article explains how stock options are treated in an acquisition scenario.

Key Characteristics of Stock Options

Stock options provide the holder with the ability to buy a specific number of company shares at a set price, known as the grant price, exercise price, or strike price. This price is established on the date the options are granted. The option’s value becomes apparent if the market price of the shares rises above this exercise price.

A vesting schedule dictates when an employee gains the right to exercise their options. Options are unvested until they meet specified time or performance conditions. Once these conditions are met, the options become vested. Options also have an expiration date, after which they can no longer be exercised, regardless of their vesting status.

There are two primary types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). ISOs offer potential tax advantages if certain holding period requirements are met. NSOs are more flexible and can be granted to a broader range of individuals, including consultants and advisors. These differences mean their treatment can vary during a company acquisition.

Common Treatments of Stock Options in Acquisitions

When a company is acquired, stock options held by employees undergo one of several common treatments. The specific outcome depends on the terms negotiated in the acquisition agreement.

One common treatment is a cash-out, where vested options are cancelled for a cash payment. This payment is calculated as the difference between the acquisition price per share and the option’s exercise price. For instance, if the acquisition price is $50 and the exercise price is $10, the holder receives $40 per vested option share. This provides immediate liquidity to the option holder.

Option conversion or exchange is another outcome, particularly in stock-for-stock acquisitions. Existing options in the target company are exchanged for new options or shares in the acquiring company. The number of shares and the exercise price are adjusted using a conversion ratio based on the relative stock prices of both companies. This allows the option holder to maintain an equity stake in the combined entity.

Option assumption occurs when the acquiring company takes over the existing stock option plan and the options retain their original terms. The vesting schedule, exercise price, and expiration date remain unchanged. Assumption is common when the acquiring company intends to integrate the target company while maintaining its existing equity compensation structure.

Accelerated vesting is a treatment where unvested options become immediately exercisable due to the acquisition. This allows employees to exercise options earlier than their original vesting schedule would permit. Acceleration can happen with other treatments, such as a cash-out of all options, including those that just accelerated. This makes more options available for immediate realization.

Factors Influencing Option Treatment

The specific treatment of stock options during an acquisition is shaped by several influencing factors. These determinants are outlined in legal and compensation documents and are subject to negotiations between the involved parties.

The overall acquisition deal structure determines how options are handled. Whether the deal is structured as an all-cash purchase, an all-stock exchange, or a combination directly impacts the available options for equity holders. For example, a cash deal leads to cash-outs, while a stock deal might favor conversions or assumptions.

The terms of the original stock option plan and the company’s equity plan documents are important. These documents contain “change of control” clauses that specify what happens to options upon an acquisition. These clauses can dictate whether options accelerate, are assumed, or are cashed out, providing a pre-defined framework.

Negotiations between the acquiring and target companies are central to the final treatment of options. The acquiring company’s strategy for employee retention and the target company’s desire to provide value to its employees influence these discussions. The treatment of stock options is a point of negotiation, impacting the overall value proposition for employees.

The vesting status of an option, whether vested or unvested, affects its treatment. Vested options have a clearer path to liquidity or conversion. Unvested options may be subject to different rules, such as accelerated vesting or cancellation, depending on the deal terms.

The relationship between the fair market value (FMV) of the shares at acquisition and the option’s exercise price also matters. Options are “in-the-money” if the FMV is higher than the exercise price, meaning they hold intrinsic value. Conversely, “out-of-the-money” options have an exercise price higher than the FMV, rendering them worthless if exercised. This status directly impacts their value and the likelihood of a cash-out or conversion.

Tax Implications of Option Treatment

The tax consequences of stock option treatment during an acquisition vary depending on the option type and specific outcome. Tax rules differentiate between Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).

When options are cashed out, the payment received is taxed as ordinary income for Non-Qualified Stock Options (NSOs). The difference between the acquisition price and the exercise price is treated as taxable wages, subject to federal, state, and payroll taxes. For ISOs, if cashed out without being exercised and held for the required period, the gain may also be taxed as ordinary income and subject to employment taxes.

Option conversion or exchange, where options in the target company are swapped for options or shares in the acquiring company, does not trigger an immediate taxable event. Taxation occurs later, either when the new options are exercised or when the acquired company’s shares are sold. This deferral of taxation can allow for potential long-term capital gains treatment if holding periods are met.

When stock options are assumed by the acquiring company, there is no immediate tax implication. The tax event is deferred until the assumed options are exercised and the shares are subsequently sold. At that point, taxation follows the standard rules for ISOs or NSOs, including potential alternative minimum tax (AMT) for ISO exercises if certain conditions are not met.

Accelerated vesting itself does not trigger a taxable event. However, exercising options that have accelerated vesting has tax consequences. For NSOs, the difference between the fair market value of the shares and the exercise price at exercise is taxed as ordinary income. For ISOs, while there is no regular income tax upon exercise, the spread between the exercise price and the fair market value at exercise can trigger the Alternative Minimum Tax (AMT). It is always advisable to consult with a tax professional to navigate the specific tax implications of any stock option transaction.