By James Bristol

For companies that are acquired in an all-cash merger, it is not unusual to “cash out” some or all employee stock options. This works well when options are all “in the money.” The option holders receive the intrinsic value of the options, which is the spread between the exercise price and the merger value for the company’s stock. The situation is more difficult when options are underwater or “out-of-the-money,” i.e., the exercise price is greater than the merger value. Some have argued that underwater options are worth $0, since they have no intrinsic value. Therefore, the argument goes, an acquirer should be able to cancel underwater options with or without the consent of the holder.

Most stock option plans make provisions for change in control transactions. It is common for options to become fully vested. Many plans provide for assumption of options and stock incentives by the surviving entity. Some plans specify that the compensation committee can adjust or cancel options in connection with change in control transactions.

In Lillis v. AT&T, the Delaware Chancery Court ruled unilateral cancellation of underwater options violated the rights of the option holders. The language of the option plan stated that in the event of a merger, options “shall be appropriately adjusted . . . provided that each Participant’s economic position with respect to the Award shall not, as result of such adjustment, be worse than it had been immediately prior to such event.” Even though the options were underwater and had $0 intrinsic value, they are deemed to have “fair value” that can be measured under Black-Scholes or some other method. This value is calculated and reported on a company’s financial statement in accordance with FAS 123R.
The court awarded the option holders the Black-Scholes value immediately prior to the merger. The language in the option plan was not unique. Chances are, similar fact patterns will emerge in a lot of cash mergers where there are under-water options. The lesson is that unilateral cancellation of options for no consideration can be costly.

Careful plan drafting can help, but it is difficult to anticipate every possible outcome in advance. It seems that in the Lillis case the plan language could have been interpreted to permit cancellation of underwater options. If possible, it is always best to try to get agreement from option holders as to how they will be treated in the merger. Some holders may be asked to rollover some or all of their options into the new company. Another approach is to offer option holders cash for all options, both in the money and underwater, equal to the intrinsic value of the in the money options. For those who have only underwater options, some form of consideration may be needed to support cancellation.