Nelson Mullins Riley & Scarborough LLP
2020 was a year of “not normal.” Not only on the health and human interaction front, but also in the world of corporate mergers and acquisitions. An alternative method of “going public,” utilizing a SPAC, has had a resurgence and accounts for more than 50% of initial public offerings (IPOs) in the past year. The change in ownership involved when a private company undergoes the de-SPAC process can have a direct effect on executive compensation, including outstanding stock options. The following highlights some change in control considerations in such situations.
Let’s start with the basics:
SPACs are special purpose acquisition companies (shells) which are formed to raise capital through an IPO with the purpose of acquiring an existing private operating company. Once the capital is raised, an operating company merges with, or is acquired by, the publicly traded SPAC to become a listed company.
For our purposes, an “Equity Incentive Compensation Plan” governs grants of stock options, restricted stock, stock appreciation rights, restricted stock units or other stock-based compensation to employees, consultants and non-employee directors of a company.
Now let’s set the scene:
A SPAC is formed by an experienced business management team of “founders” and then “goes public” by offering 80% of the ownership of the SPAC to public investors through an IPO. The funds raised are held in trust. The SPAC then identifies a target company (Company A) and completes an acquisition by acquiring a portion of the stock of Company A (the “De-SPAC” transaction). Before the De-SPAC, Company A has an Equity Incentive Compensation Plan under which 1,000 non-qualified stock options have been granted to each of five key employees. At the time that the SPAC and Company A are combined into a publicly traded operating company, 50% of the outstanding stock options are unvested. In our example, let’s say that the SPAC funds are used to purchase 40% of the equity of Company A, with 60% ownership remaining in the hands of the pre-acquisition Company A owners.
And now let’s review key equity compensation issues:
NOTE: If, at the time of grant, 1) the options were all issued at an exercise price of not less than the fair market value of the stock as of the grant date; 2) the options are to purchase common stock of the company; and 3) the company is the “employer” or the parent company of the employer and generally owns more than 50% of the employing company, then the stock options are exempt from being considered nonqualified deferred compensation for purposes of the Internal Revenue Code (the “Code”) Section 409A.
Under Code Section 280G—known as the “golden parachute” rules—a “change in control” comes in three flavors and may or may not match the definition used under the Equity Incentive Plan or grant agreements for purposes of vesting acceleration. Under 280G, a “change in control” can occur upon a:
In our De-SPAC transaction, a stock purchase, we need to focus on the acquired percentage of ownership or effective control of Company A. In our example, the SPAC is acquiring 40% of Company A’s stock, so we don’t have a “change in ownership” or a “change in ownership of a substantial portion of a corporation’s assets.” However, we may have a “change in effective control.”
If there is a “change in effective control,” then a 280G analysis must be run. An analysis would be performed to determine whether the key executives are “disqualified individuals” and whether the value of the acceleration of the vesting of the options, along with any other contingent payments, equals or exceeds three times each disqualified individual’s “base amount” (generally, the average W-2 compensation over the 5-year period prior to the year in which the transaction occurs). If the “3x rule” is triggered, then the value of the aggregate continent payments in excess of one times the base amount is subjected to a 20% excise tax and loss of deduction.
The good news here is that, while an acquisition of 20% or more of the target company’s total voting power is presumed to result in a “change in effective control,” it is a “rebuttable presumption.” In several private letter rulings, the IRS has described the types of evidence which can be used to rebut the presumption that an effective change in control has occurred. Such evidence will be case-specific, but the following queries serve as a gauge:
Don’t let executive compensation issues get lost in the hurried shuffle of a corporate SPAC transaction. Proactively engage with your executive compensation legal counsel to examine the issues and address applicable considerations early in the process.
Sue Stoffer is a partner at Nelson Mullins Riley & Scarborough LLP, practicing in executive compensation and employee benefits law. Sue has spent more than 30 years, including many with a large international law firm based in New York, counseling clients on equity and non-equity incentive plans and complex retirement plan and health and welfare plan compliance issues.
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