What Happens to ESOPs in Mergers and Change of Control Situations?

A stock option or an ESOP is simply just a derivative of the underlying equity share. This raises the implication that any change in the value of the share has a direct impact on the value of the stock option. In scenarios involving any corporate restructuring event, like a merger, acquisition, amalgamation, demerger, etc, the shareholders of the involved company receive compensation through a share swap in a ratio that will equate the pre-event and post-event value for said shareholder. Similarly, there exists a logical and legal requirement to treat ESOP holders in the same manner, in such situations. 

While the share swap ratio is based on the comparative value of shares, the fair and reasonable adjustment for ESOPs, as required by legislation, calls for adjustment in the number and exercise price of ESOPs without extending the vesting period and life of the ESOPs. The underlying principle of equating the pre and post value is the same for ESOPs as it is for shares. 

The central question posed however revolves around how to compute the value that is to be equated. For shares, this process is rather simple. In the case of publicly traded companies, the value is to be determined by the market price at which the shares are bought and sold.  For privately held companies, the value is based on the fair market value of the shares, which is estimated by using valuation methods. Share swaps are executed on the basis of the intrinsic values, and in many companies, especially in India, the same process is used to arrive at the option swap. 

For example, let us assume a Company A merges into a Company B, and that in this instance, the shareholders of Company A get 2 shares of Company B for every share held in Company A. Applying this principle, the ESOP holders of Company A are given the following FAR adjustment, on the basis of the intrinsic value method:*

‍

Another possible process that could be used is the Option Fair value method, through usage of the Black and Scholes model or a similar binomial model. As SEBI remains silent on which method is to be followed for the restoration of valuation of ESOPs, few companies go above and beyond, using both possible processes to cross-check, in the best interest of ESOP holders.

Change-in-control or CIC in a company occurs when more than fifty percent of the controlling interest is being transferred, either directly or indirectly. This often leads in changes made to the Board of Directors, sometimes paired with changes made in the Top Management team. However, it is important to note that in spite of these alterations, the company’s fundamental structure remains unchanged, though the market value might fluctuate due to perception post the CIC. Therefore, no adjustments to the FAR of ESOPs is legally required. On the other hand, the CIC may cause adjustments to accelerated vesting, invocation of Tag-Along or Drag-Along provisions, as outlined in the terms of the ESOPs. In such a case, the employees become shareholders, with similar rights as other shareholders and participate in the transaction triggering the CIC. 

However, in the off chance that the ESOP scheme does not provide for any acceleration or Tag-Along or Drag-Along, the employees continue to hold their ESOPs with the same terms as before, unless an offer is made to partake in the CIC transaction.

To wrap-up, it can be said that the fate of ESOPs in situations involving M&As remains intact, due to the FAR adjustment mandated by the law. Whereas, in the case of CIC, it is variable, depending entirely on the ESOP scheme terms.