What Happens to Stock Options When a Private Company Is Acquired?

When a private company is acquired, the future of employee stock options becomes a significant concern. Stock options are a form of equity compensation, granting employees the right to purchase a specific number of company shares at a predetermined price, known as the exercise or strike price. This compensation mechanism aims to align employee interests with company success, as the value of these options can increase if the company’s valuation grows. Understanding how these options are treated during an acquisition is essential for employees to navigate potential financial outcomes.

Understanding Your Stock Options and the Acquisition Terms

The treatment of stock options during an acquisition largely depends on the type of options granted and the specific terms outlined in various agreements. Two primary types of stock options are relevant for private companies: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). While ISOs are exclusively available to employees and may offer certain tax advantages, NSOs can be granted to a broader group, including employees, contractors, and advisors.

The specific outcome for your stock options is primarily governed by two documents: your individual stock option agreement and the acquisition agreement between the acquiring and target companies. These agreements outline the terms of your grant, including the number of shares, the exercise price, and the vesting schedule. They also contain clauses that dictate how options are handled in corporate events.

A “Change of Control” provision is a common clause found in stock option plans and acquisition agreements. This provision specifies the actions to be taken regarding stock options when the company undergoes a significant ownership change, such as a merger or acquisition. These clauses often include accelerated vesting terms, which can significantly impact an employee’s equity.

Two common types of vesting acceleration are “Single Trigger” and “Double Trigger” provisions. Single-trigger acceleration means that unvested stock options immediately vest, either partially or fully, upon the occurrence of a single event, typically the acquisition itself. In contrast, double-trigger acceleration requires two distinct events for vesting to accelerate. The first trigger is usually a change of control, such as an acquisition, while the second trigger is commonly the employee’s termination without cause within a specified period following the acquisition. Double-trigger provisions are often used as they incentivize key employees to remain with the company through the transition period after an acquisition.

Treatment of Vested Stock Options in an Acquisition

When a private company is acquired, the fate of your vested stock options can unfold in several ways. One common scenario involves a “cash-out” of these options. In this instance, the acquiring company pays you the difference between the acquisition price per share and your original exercise price for each vested option. For example, if the acquisition price is $100 per share and your exercise price is $50, you would receive $50 per share in cash for your vested options. This will have tax implications.

Another possible outcome is that you may be required or given the option to exercise your vested options immediately before or during the acquisition. If you choose to exercise, you would pay the strike price to purchase the shares, and then these shares would be sold as part of the overall transaction. However, in private companies, exercising options requires an out-of-pocket payment.

A third common scenario involves the conversion of your vested options into equity of the acquiring company. In a stock-for-stock acquisition, your vested options in the target company might be exchanged for equivalent options or Restricted Stock Units (RSUs) in the acquiring entity. This conversion occurs at a predetermined ratio, based on the relative valuations of both companies.

Treatment of Unvested Stock Options in an Acquisition

Unvested stock options face distinct possibilities during an acquisition. In some cases, if no specific provisions are outlined in the stock option agreement or the acquisition terms, unvested options may simply be forfeited. This means they are canceled without any payout or conversion, especially if the options are “underwater” (meaning the exercise price is higher than the acquisition price).

However, many acquisition agreements include provisions for accelerating the vesting of unvested options. A “Single Trigger” clause, as discussed earlier, would cause some or all unvested options to vest immediately upon the acquisition’s close. “Double Trigger” acceleration applies, where unvested options vest only if the acquisition occurs and the employee’s employment is terminated without cause within a specified period post-acquisition. This structure aims to balance employee protection with the acquirer’s desire to retain talent.

Another common outcome for unvested options is their assumption and rollover by the acquiring company. In this scenario, your unvested options in the acquired company are converted into new options or Restricted Stock Units (RSUs) in the acquiring entity. These new equity awards maintain a similar economic value and continue with the original vesting schedule, or a revised one. Continued employment with the acquiring company is a prerequisite for this continued vesting.

Tax Consequences of Stock Option Events in an Acquisition

The tax implications of stock option events during an acquisition are complex and vary significantly depending on the type of option and the nature of the transaction. For Non-Qualified Stock Options (NSOs), the difference between the stock’s fair market value and your exercise price at the time of exercise is taxed as ordinary income. This income is subject to federal income tax, at rates ranging from 10% to 37%, and payroll taxes, including Social Security and Medicare. Any subsequent gain or loss when you sell the shares is then treated as a capital gain or loss, depending on your holding period for the shares.

In contrast, Incentive Stock Options (ISOs) offer potentially more favorable tax treatment, but with stricter rules. When you exercise ISOs, there is no regular federal income tax due at that time. However, the “bargain element,” which is the difference between the fair market value of the stock and your exercise price, is considered an adjustment for Alternative Minimum Tax (AMT) purposes. This can result in an AMT liability in the year of exercise, even if you don’t sell the shares immediately.

To qualify for long-term capital gains tax rates on the entire gain from ISOs, you must meet specific holding period requirements: you need to hold the shares for at least two years from the option grant date and one year from the exercise date. If these holding periods are not met, a “disqualifying disposition” occurs, and a portion of your gain will be taxed as ordinary income, while any additional appreciation may be taxed as short-term capital gains. An acquisition can complicate meeting these holding periods, as the sale of the company might trigger an early disposition of your shares.

When stock options are “cashed out” in an acquisition, the proceeds are taxed as ordinary income for NSOs. This means the difference between the cash received per share and your exercise price is fully taxable at your ordinary income tax rate. For ISOs that are cashed out without being exercised, the transaction is treated similarly to an NSO exercise, with the gain taxed as ordinary income.

If unvested stock options are rolled over or converted into equity of the acquiring company, this event is not a taxable one at the time of conversion. Taxation is deferred until you exercise the new options or sell the new shares received from the acquiring company. However, if the rollover involves a taxable exchange, such as exchanging vested stock for nonvested equity in the acquirer, it could trigger immediate capital gains recognition.

Tax situations are highly individualized, and the specific details of your option agreements and the acquisition deal can significantly alter these outcomes. Therefore, it is always advisable to consult with a qualified tax advisor for guidance tailored to your personal financial situation.