What happens to Employee Share Options in an exit event?
In our previous articles, we have discussed the basic regulatory framework, EPF and tax implications of ESOS. In this article, we aim to explore the less encountered effect of ESOS issued by private unlisted companies during an “exit event”.
What is an exit event?
An exit event, also known as “liquidity event”, generally includes the company going through a listing on a stock exchange (IPO), an asset sale, or a share sale to a third party.
What could happen to vested options in an exit event?
The participating employees can benefit from an “exit event” taking the form of a third-party acquisition by selling their vested options (but not yet exercised) for cash or substituting them with new options, potentially getting them cash and/or new options in their pockets.
This positive outcome will only occur if the options are “in the money” i.e., when the value of the underlying share exceeds the exercise price of the vested option.
However, this largely hinges on how the deal terms are negotiated and structured with the buyer, as well as the terms of the current ESOS by-laws. There are also other potentially complicated factors like deal structuring, valuation of the options, distribution of sales proceeds and tax considerations to navigate carefully, depending on whether the exit event is a share sale or asset sale.
What could happen to unvested options in an exit event?
Typically, the Shareholders and Board of Directors of the company will have the broad discretion to decide what happens to any unvested options in such events, unless the by-laws already provide otherwise. Broadly speaking, this may include any of the 3 actions, explained as follows:
- Cancellation
The unvested options could potentially be cancelled in an exit event without compensation. This is because the unvested options are not yet earned. Cancellation outright may be perceived by the participant employees as an unfriendly move and it may risk complicating the relationship of the acquirer and the employees or precipitate a flight of talent after the exit event is done.
- Migration
It is also possible for an acquirer to cancel the existing ESOS and migrate/replace the company’s vested and unvested options to acquirer’s own ESOS plan, assuming it has one. This may be especially beneficial for the employee if the acquirer is a listed company, as they can trade and sell their shares in the market easily once the options vest in accordance with the vesting schedule. For the employer, although a migration or replacement may secure the ongoing of target company’s talent, it may dilute the acquirer’s existing equity.
- Acceleration
Some by-laws may provide for the acceleration of unvested options in an exit event. The idea being that an underlying acceleration is an additional reward for the ESOS participants upon reaching the significant milestone of an exit, even though the original vesting conditions (typically time-based) are not yet fully played out.
In practice, an acquirer would first review the target company’s ESOS by-laws as part of its due diligence before purchasing the company and the presence of acceleration rights could be a factor for a re-negotiation or adjustment of the purchase price. Such acceleration rights come in two main forms: single-trigger or a double trigger acceleration.
Single Trigger
A single trigger acceleration simply means all unvested options automatically vest on an exit event.
Employees are immediately rewarded with full vesting for their contribution towards the company irrespective of the vesting schedule remaining. This could mean that even a new joiner with unvested options could enjoy the full vesting of its freshly granted options.
Whilst single trigger acceleration may be favourable for and popular with the employees, it might not be so welcomed by the existing investors of the company or the potential acquirer, as acceleration of the options results in immediate additional dilution or a higher cost of acquisition respectively
Double Trigger
Conversely, a double trigger acceleration typically needs 2 events to happen for the employee to enjoy full acceleration. Firstly, the occurrence of an exit event must happen. Secondly, the company must terminate the employee without cause or if the employee resigns with “good reason” (e.g., caused by the company’s action of cutting pay, mandated relocation or significant downgrade of duties rather than due to the employee’s fault) within a specified time period after the exit event has occurred.
Most start-ups prefer this as it is a multi-dimensional approach that aims to strike a delicate balancing the interests among the employees, current shareholders and potential acquirer.
For existing investors and potential acquirers, a double trigger may sit better as it prevents the company from committing to large cash pay-outs just because of an exit event happening (which is a clear drawback of single trigger acceleration) and yet preserving the ongoing workforce needed for the business. In other words, the acquirer or the company is able to keep its cash to pay any retention bonuses or provide attractive incentives to employees who stay on after the acquisition.
On the other hand, a double trigger acceleration protects the interests of participating employees, since they will be assured of acceleration if, post-acquisition, they are unfairly terminated or treated by the acquirer. The ‘second trigger’ then essentially acts as a deterrent to the acquirer from taking such actions on the option holders, especially if the value of the unvested options is greater than the cost of hiring a new employee.
Conclusion
It is possible for start-ups to adopt a mixture of any of the above approaches surrounding the exit event. It must be noted that, there is no one-size-fits-all solution and companies should seek professional advice and customise their ESOS by-laws to suit the company’s needs and goals, especially when an exit event is in the horizon.
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This article was written by Shawn Ho (Partner) & Sylvia Lock (Associate) with assistance from Low Rui Thong (Intern). Shawn leads the corporate practice group of Donovan & Ho, and has been recognised as a Notable Practitioner, whilst the firm has been recognised as a Notable Firm for Corporate and M&A by Asialaw Profiles 2020 and 2021. We are also ranked as a Recommended Firm by IFLR1000 2020 and 2021. Our corporate practice group advises on corporate acquisitions, restructuring exercises, joint venture arrangements, shareholder agreements, employee share options and franchise businesses, Malaysia start-up founders and can assist with venture capital funds in Seed, Series A & B funding rounds. Feel free to contact us if you have any queries.
