Understanding Golden Parachute payments in M&A

Introduction

  1. Mergers and Acquisitions always causes an internal disruption within the target organization that is going to be acquired. Acquisitions generally would involve a restructuring cost within the organizations and this will create an anxiety in the target employees.Most of the target employees would be concerned about their future in the organization post acquisition.
  2. This anxiety is not limited to only rank and file employees and mid level employees.This anxiety is also extended to senior level employees to C Level executives.

What is a Golden Parachute?

  1. Golden parachute is a protection given to the senior level employees by their organization by compensating them monetarily in the case of their termination on an event of change of control in the organization.
  2. This is primarily observed in M&A transactions which actually triggers a change of control in ownership of the target company.
  3. Golden parachute generally protects the highly senior talented employees with a soft landing ground as a parachute helps a passenger smooth fall.The payments done includes Severance payments, Cash bonuses and Stock options.In most of the cases, the employees are not granted perks and rewards post their termination along with any retirement benefits that they shall accrue.The payments are credited generally within 3 months of the date of the termination.
  4. These payments generally come with an undertaking from the terminated employees that they shall not initiate any legal proceedings against the employer.In the case of any legal proceedings initiated by the employee, the employee may stand to forfeit the pending payments.

Rationale behind having Golden Parachute payments

  1. Companies use Golden parachute clause as a tool to hire and retain talented employees.In addition, these payments can be used as a deterrent against any hostile acquisition. The hostile acquirer while looking to acquire the target needs to be cognizant of the fact that it needs to compensate the select target employees post acquisition as employee can trigger Golden parachute provisions.
  2. In order for a Golden Payment provision to be triggered, the employee need not be terminated by the acquirer.The employee can trigger the clause when they decide their role and responsibilities have considerably reduced and changed post acquisition.
  3. Golden parachute payments are not provided when employees are terminated due to their incompetence on failing to discharge their responsibilities and when they are caught in an illegal activity like fraud.In reality, companies do compensate the key employees on the outstanding payments even when the officers are found to be incompetent and failed to discharge their responsibilities.
  4. Golden parachute payments also encourage the CEO of the target company to be supportive of any acquisition that has a significant opportunity to increase the shareholder value.This is due to the Golden parachute provisions vested to them.If these provisions are not there, then the target leadership would not be supportive of the acquisition as the acquisition can impact their earning future.A classic instance of Golden parachute payments was the case of Marissa Mayer, CEO of Yahoo when she received ~$44M payments after Verizon acquired Yahoo.
  5. Such hefty payments granted to the outgoing CEOs post acquisition has attracted severe criticism from the employees and shareholders. The average employee only receives a severance payout which is again subjected to his tenure in the organization. The costs associated with Golden parachute payments for the acquirer will be minuscule compared to the overall transaction cost, hence this might not be deterrent for them to close the transaction. The acquirer on the other end would try to manage the costs from Golden parachute payments by down sizing more employees at the mid and low level.This will further affect the position and future of the average employee. The shareholders also are opposed to the huge payouts granted to the senior executives as these payments are going from the shareholder pockets.
  6. There is also a belief that Golden parachute payments might not motivate the senior leadership to discharge their duties and exceed expectations as they would be receiving hefty payments per Golden parachute provision, even when they don’t perform per expectations.

Section 280G of IRC on Golden Parachute payments

  1. Due to the heavy criticism for the Golden parachute provisions, high taxes are levied when the employees receive excess payments.
  2. When an employee receives a payments that is more than 3x the average annual compensation over the last 5 years preceding the change of control, then it is deemed as excess Golden parachute payment and would invoke Section 280G. As per the section, the employees have to pay 20% excise tax in addition to the income tax that they need to pay.
  3. Golden parachute provisions are only applicable for Public and private companies.Other companies structures like S Corp and Partnerships do not have these provisions and hence section 280G cannot be invoked for them.
  4. Section 280G is also not applicable when more than 75% of stockholders approve of these payments to the employee.This is generally prevalent in private companies and startups where their equities are not traded in public.Here a group of individuals own majority control of the company.The board needs to be disclosed the complete details of the payments to the employees along with terms and conditions.
  5. Section 280G is not applicable to sale of subsidiary by the parent company as there will be no change of control in the parent entity post acquisition.

Conclusion

  1. With record level of M&A activity currently happening, Golden parachute payments form a significant factor for when conducting target doing due diligence.
  2. The acquirer needs to look at the costs to be incurred on the trigger of Golden parachute provisions by the target employees before/after acquisition. Basis that, the acquirer needs to do tax planning and diligence after Section 280G is invoked.
  3. With M&A activity more regular in technology and retail, most of the companies operating in these sectors have Golden parachute payments clauses as part of their employment agreements for senior level executives.


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