Originally Published MX May/June 2006
BUSINESS PLANNING & TECHNOLOGY DEVELOPMENT
Acquiring Executive TalentExecutives on both sides of a medtech acquisition stand to prosper, but significant attention must be given to the fine print.
Ted Ginsburg and Aubrey Bout
The pace of corporate transactions in the medical device space, including mergers, acquisitions, spin-offs, and asset sales, continues to accelerate. During the first three quarters of 2005, completed merger and acquisition transactions in the medtech industry increased by almost 13% over the same period in 2004.1
There are many reasons these types of corporate activities occur. Potential acquirers are often looking to fill their pipelines or increase their product offerings. Meanwhile, selling companies may want to focus their energies on fewer lines of business. In addition, corporate transactions are often driven by investors who want to recoup their investment or invest in a business with perceived potential.
The impact of such transactions on the corporate executives involved is substantial. Following a merger, executives at acquiring companies often take on additional responsibilities, as well as duties related to the integration of the companies—including developing a strategy for retaining key executives of the acquisition target. Executives at acquired companies or those that are spinning off a line of business may face the elimination of their positions.
This article discusses the executive-compensation component of changes of control for medtech executives on both sides of such transactions. A cursory glance at the business pages of a newspaper may give the impression that a change of control is the key to untold wealth for executives. But the programs underlying the payments received by company executives are not created on a whim and are often the subject of intense negotiation between the buyer and seller.
Executive Protections for Sales Targets
Although many executives believe that the acquisition of their company will immediately bring them great personal wealth, this is often not the case. The economic benefits of many such transactions are often based on contingencies; the deals are structured with small initial payments followed by larger payments based on the achievement of milestones.
In addition, many acquisitions do not take place at tremendous premiums compared with market price. Therefore, executives who have recently been granted stock options—which generate the majority of the transaction wealth for executives at companies that are acquired—may not enjoy a windfall quite as large as they imagined. Distressed companies may sell at a discount, in which case executives would not receive any gains from options.
Going forward, stock options at medtech companies will be granted in fewer numbers as a result of a change in accounting treatment. According to the 2005 Medic Executive Compensation Survey conducted by Top Five Data Services Inc. (Fremont, CA), 22% of surveyed medical device companies that maintained nonqualified stock-option plans intended to decrease the use of this compensation method in 2005 and 2006.2
The most important protection an executive can have in the event of an acquisition is an employer with change-of-control policies or an employment contract with provisions that cover the executive. However, many companies do not have such agreements in place for their executives. A recent study found that only 43% of chief executive officers at more than 1000 companies of varying size had employment agreements.3
Many financial advisers recommend having change-of-control agreements in place. Although the programs can vary widely in their terms, there are several basic issues that need to be addressed (see sidebar). The most critical issues are as follows.
The financial terms defined in change-of-control arrangements are typically paid by the acquiring company at some point after the close of the transaction and the satisfaction of its conditions. In certain transactions, executives entitled to payment have had to wait a significant amount of time to receive their payments, with some of these disputes entering litigation.
If a hostile takeover attempt is anticipated, some employers have taken the step of funding the change-of-control payments in advance. Although this can take different forms, a popular method is for the employer to create an irrevocable trust. These trusts are funded by the employer, prior to the takeover occurring, with amounts sufficient to make the change-of-control and severance payments upon satisfaction of the conditions. In that manner, the executives will not need to depend on the acquiring company for payment of change-of-control benefits, and can then focus on completing or defeating the transaction.
Another area of concern for executives of target corporations is the impact of an acquisition on their stock-option plans. Many change-of-control plans contain detailed rules about the impact of an acquisition on outstanding options; however, there are those that still don't address this crucial topic. Issues that should be addressed by plans are whether the vesting period of the option accelerates as a result of the change of control, whether the issuer (the acquired company) makes the payment, and when the payment is due. In certain transactions, particularly where the acquirer's stock is exchanged for the target's stock, options in the target's stock may be traded for options in the acquirer's stock. In these cases, there is no immediate benefit to the target's option holder, and problems can result if the vesting period continues as before and the option holder loses his or her position with the new company. The replacement of the target's options with the acquirer's options is a negotiated issue.
Finally, executives should review the terms of any nonqualified deferred compensation programs in which they participate to gauge the impact of an acquisition on their benefits. Issues of concern to the executive include the following.
It is not unusual for an employer to make revisions to its executive compensation programs prior to a change of control (see sidebar).
Acquiring Executive Security
The issue surrounding corporate changes in control that grabs the most headlines is the cost of severance, or 'golden parachute,' packages for departing executives. Many times acquirers are surprised, at least during the negotiation process, at the size of these payments. A prospective acquirer needs to examine employment agreements and severance policies as it performs its due diligence on the target company. While doing so, executives should pay particular attention to the following areas.
Retaining Executives. Many times, the severance agreements provide for payments if the executive leaves within a certain period of time after the change of control. However, most severance agreements also stipulate that the executive is not eligible to receive change-of-control benefits unless the person leaves the company. The change-of-control benefits can be so lucrative—it's not unusual for them to exceed three years of total compensation—that executives often want to leave as soon as possible. The agreements should be reviewed for any retention bonuses under which the executive receives an additional payment if he or she stays through a certain period.
Severance Costs. Payments under these agreements should be estimated in detail under a worst-case scenario in which all amounts that might possibly be paid out are, in fact, paid out. In regard to the second point, the following are among the issues that executives at acquiring companies must consider.
Payout Timing. Executives must know when liability for payouts under the severance arrangements occurs. Some arrangements provide for payments upon the change of control, whether or not employment has terminated. Other programs provide for payments that are effectively at the discretion of the executive. For example, a program might provide for payment when the executive determines that his or her duties have changed.
Other provisions might restrict the acquiring company's ability to consolidate operations. For example, it is common for executive severance arrangements to provide for a termination without good cause that would entitle the executive to receive payment under the arrangement if, after a change in control, the executive has to report to work a certain number of miles away from the prior work site (usually between 20 and 50 miles).
Excise Tax. Executives must know what, if anything, happens if the total payments are subject to the golden parachute excise tax under IRC, Sec. 280G. If the payments received by an executive as a result of a change of control are subject to the excise tax—and not all payments are subject to the tax—the tax would equal 20% of the amount by which the total payments received by an executive exceed the executive's average annual compensation over the five full years occurring before the change of control.
When added to regular income taxation on the payment, the excise tax means that an executive could pay greater than 60% of the value of these severance payments to federal, state, and local taxing authorities. As a result, some agreements provide tax gross-ups, others limit the total change-of-control payment, and others are silent on this issue.
Stock Options. Executives should consider the impact of the transaction on outstanding stock options or restricted stock. Often, a change of control accelerates the vesting of these options and calls for immediate payout in cash. Although the acquired company has to make the payment, this figure is added into the overall purchase price. The value of these transactions can affect the previously mentioned golden parachute calculation.
Financial Statements. Executives should determine the impact of these costs on the acquirer's financial statements. Under Financial Accounting Standard 123R, stock options generate a financial statement compensation expense as they vest, and many option plans fully vest any unvested options upon a change of control.4
Points of Negotiation
Acquiring companies can take several steps in the course of the negotiation to minimize the impact of severance agreements in place at the acquired company. First, severance policies and employment contracts are negotiable; if the cost of severance is significant, changes in the program should be discussed. The result is often an amendment to the program, which typically reduces the benefit level, or a reduction in the purchase price. If the acquirer wants to retain individual executives, it can ask the seller to negotiate new employment contracts with these executives that would contain incentives to stay, such as retention bonuses, or disincentives to leave, such as noncompetition agreements or increased vesting. Those new contracts may come with some cost, but executives at target companies have been known to agree to these changes to keep the transaction moving.
Another retention strategy involves the acquirer entering into its own employment contract with the executive. This type of arrangement often includes some type of substantial bonus payment, which is typically given in exchange for the relinquishment of some or all of the executive's rights under the employment contract or severance policy with the acquired company. The bonus payment can be paid up front—in which case it is accompanied by some type of disincentive for the executive to leave, such as a noncompete clause or agreement to reimburse the company for the payment if the executive leaves—or can be deferred, thereby attaching some retention strings to the payment.
An issue that acquiring companies often face is that of pay equity. It is possible that the total compensation packages of those executives who are retained in the transaction differ from the packages paid to the executives of the acquiring company. It is also typical that the purchaser's executives assume additional responsibilities as a result of the transaction. The acquiring company will have to look closely at its executive pay program as the companies combine operations. Costs that are related to the transaction, however indirectly, do not necessarily end once the transaction is completed.
Conclusion
An acquiring company often has a strong interest in retaining at least some of the target's executive, engineering, or scientific talent. After all, it was that team that developed the target company and its products to the level that generated the acquirer's interest. In the medical device industry in particular, it is frequently in the best interest of the acquirer to retain target executives' valuable expertise, reputations, and creativity. However, the acquirer's task in retaining these top minds is often complicated by lucrative change-of-control packages that encourage executives of acquired companies to resign their posts. Careful negotiation can help ensure that not only are the acquired company's executives being fairly compensated for their past service, but that they also become significant contributors to the acquirer's future.
References
1. C Burkhardt and S Tardio, "Buy High, Sell High," Medical Device & Diagnostic Industry 27, no. 12 (2005): 40–48. Ted Ginsburg and Aubrey Bout are consulting principals with Top Five Data Services Inc. (Fremont, CA).
2. 2005 Medic Executive Compensation Survey (Fremont, CA: Top Five Data Services Inc., 2005).
3. Severance & Separation Benefits: Benchmarks for Evaluating Your Policies (Woodcliff Lake, NJ: Lee Hecht Harrison, 2005).
4. Financial Accounting Standards Board (FASB) of the Financial Accounting Foundation, Statement of Financial Accounting Standards No. 123, Financial Accounting Series no. 263-C (Norwalk, CT: FASB, 2004).
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