Employee options in M&A transactions

24th August 2023

Employee options often play a key role in M&A transactions and need to be considered by all parties. We consider some key issues to be aware of:

  • Which options will be exercised as part of the deal?
  • How will the exercise price be funded?
  • Tax pitfalls and opportunities
Which options will be exercised?

When a company merges with or is acquired by another company, employees with share options usually get to exercise all their options, otherwise known as ‘full vesting’. However, there are some exceptions to this. For example, if employees have not worked for the required time or if certain performance targets have not been met by the time of the deal, they might not be able to exercise their options in full.

Before the deal, it’s essential to review if any unexercised options will become fully vested.  Some options contain ‘accelerated vesting’ clauses, whereby any outstanding performance or time-based vesting targets are automatically waived if an exit occurs.

If the decision to waive these targets depends on the directors’ discretion, care must be taken.  This can have adverse implications for tax-advantaged options, such as Enterprise Management Incentives (EMI) and Company Share Option Plans (CSOP), where applying director discretion to accelerate vesting can cause a loss of tax-advantaged status, resulting in PAYE and National Insurance contribution (NIC) charges.

How will the exercise price be funded?

Where the exercise price represents a material cost to the option holders, thought needs to be given to its funding. If the payment is pure cash, the exercise price, along with any PAYE/NIC, can typically be withheld from sale proceeds.

However, if the payment includes non-cash elements, such as shares, loan notes or earn-out rights, it can become complicated when withholding such amounts from the gross sales proceeds. In some cases, the cash consideration is not sufficient to cover the exercise price and PAYE/NIC liabilities. Therefore, it is often necessary to adjust the split of cash to non-cash consideration, for option holders to receive more cash. Where a deal includes substantial non-cash consideration, an early analysis of the net cash impact on option holders is recommended – especially for those holding unapproved options – to identify those cases where there is a cash ‘gap’.

Tax pitfalls

The immediate tax issue to consider is whether the exercise of an option creates PAYE/NIC charges. Whilst tax-advantaged options, such as EMI and CSOP, can potentially remove these liabilities, they can still be subject to PAYE/NIC in certain scenarios, such as:

  • EMI options granted at undervalue
  • EMI options subject to a disqualifying event (such as for a leaver who retains their options)
  • CSOP options exercised within three years of grant

A penal tax regime applies where PAYE is not correctly accounted for or recovered from the employee within the required time limits.

A review of employee options will typically be the focus of legal and tax due diligence, with appropriate warranties and indemnities then provided by the sellers.

Tax opportunities

Where conditions for Income Tax relief are met, EMI and CSOP options can provide employees with exit proceeds at Capital Gains Tax rates at 20%, or even 10%, in the case of EMI options held for two years or more.

Additionally, the exercise of employee options typically results in a Corporation Tax deduction for the employer company. This deduction is based on the market value of the shares when the options are exercised, less the exercise price paid, and is due even where the employees’ gains are not subject to Income Tax.

Where sizeable Corporation Tax deductions are due, the sellers may seek to negotiate with the buyer so that any resulting tax saving leads to additional sale proceeds being paid to them. In other words, the sellers may seek to benefit from the tax advantages by increasing the amount they receive from the sale. This negotiation would be a way for the sellers to capture some of the financial benefits that arise from the favourable tax treatment of the transaction.

How haysmacintyre can help

Our Share Schemes team has extensive experience advising from a buyer or seller’s perspective and can help with:

  • Sale readiness and vendor due diligence
  • Buyer financial and tax due diligence
  • Financial modelling
  • Tax planning for individual and corporate sellers
  • Post-deal tax compliance for employers and sellers

Get in touch with David Bareham, Share Schemes Director, for further advice.

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