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Protect Yourself With Change-of-Control Agreements

With M&A activity being what it is today, executives are using change-of-control agreements to protect themselves against unwanted surprises. By Carolyn Tang | INSIGHT Archives

Contract

Like those nested “if-then” statements in a complicated spreadsheet, change-of-control provisions have become a key negotiating factor in executive management contracts. By defining compensation packages for various merger and acquisition scenarios, these provisions enable executives to set aside personal financial objectives and focus on maximizing a company’s shareholder value.

Why put it in writing?
“The usual reason change-of-control provisions are done by boards of directors is to avoid distracting the executive from the concerns of worrying about if the company gets taken over, and to keep him or her objective and neutral,” explains Michael Sirkin, head of Proskauer Rose LLP’s executive compensation practice.

However, reasons for using change-of-control provisions differ from organization to organization. They are sometimes used to lure turnaround talent to smaller, troubled companies. However in today’s active M&A environment, larger companies realize that the stability they were once able to offer is perhaps not as solid as they would like. Which is why they need to make provisions for management should a change of control occur.

“Most organizations realize that it could happen to them. For example, Compaq and HP, Exxon-Mobile, AOL-Time Warner. The executives insist on the clauses and the corporations acquiesce. Both sides see the logic,” says J. Larry Tyler, president of Tyler & Company, an Atlanta-based executive search firm.

Who needs them?
While change-of-control provisions are more likely to be found in upper-management contracts, such arrangements do appear at the middle-management level. Some companies, for instance, extend retention bonuses to lower executive tiers to prevent a “mass exodus” should there be a change of ownership.

Regardless of the size of an organization, when a company is merged or acquired, executives could fall victim to duplication of responsibilities and relocation or demotion—outcomes that are entirely unfavorable. “However, with a change-of-control provision, the executive might be more amenable to other solutions to the problem than just continuing on to run the firm into the ground,” Tyler suggests.

What’s negotiated?
Several factors are negotiated in a change-of-control provision, the most common being salary, bonus and stock options. Other points of contention may be medical benefits and executive perks. However, even before these terms are discussed, the types of “triggers” that would activate use of such a provision need to be agreed upon.

According to Sirkin, there are three common types of triggers: A “single trigger” provides for an executive who steps down at the time of transition. A “double trigger” kicks in if an executive is terminated during a predetermined period of time after the change of control has come into effect. This, says Sirkin, is the most popular trend today. Finally, a “trigger and a half” kicks in if an executive quits after a predetermined period of time.

Once the triggers are negotiated, salary, bonus and stock options are generally the next topics to enter the limelight. According to Tyler, the general rule of thumb is to provide three times the executive’s annual salary plus annual bonus. In terms of stock option treatment, both parties must take into account vesting and valuation. A good portion of executive contracts award stock options that vest over time. Lacey Gourley, a labor and employment partner with Austin-based law firm Bracewell and Patterson, urges executives to “negotiate when they vest, at what rate they vest, and what happens if you lose your position or get demoted. Will the company buy back those options, and if so, at what price?”

It’s not only a matter of how much the executive will be compensated, but also how that compensation will be paid out. Decisions made will have a significant impact on future tax issues. According to IRC Section 280G, for example, target corporations cannot deduct change-of-control payments from taxable income when three requirements are met: First, when there is a change of control or ownership; second, if payment is made to a “disqualified individual,” which, as defined by the IRS, is any employee or independent contractor who owns stock with a fair market value that exceeds 1 percent of the fair market value of the corporation’s outstanding stock. Third, the entire change-of-control compensation package must equal or exceed the disqualified individual’s base salary by a factor of three. If these three conditions are met, then executives are subject to a 20-percent excise tax on all payments above their base salaries. (More details on this provision can be found at www.irs.gov.)

To compensate for this excise tax, it is common for companies to gross-up the executive’s change-of-control compensation. However, this can be very expensive. “At lower levels, it may be grossed up, it may be cut back, or maybe nothing happens,” Sirkin explains. “I think people are looking closer at change-of-control provisions in light of the recent corporate governance divisions. They’re looking at the economic impact of change-of-control provisions and what is going into them.”

Other compensation elements that should be considered during negotiations are soft benefits such as medical and retirement. Although, “If an employee has been terminated, a company can’t continue to carry them on any sort of medical benefit or retirement plan,” explains Gourley, there are some worthwhile discussion points. “For example, even if the company can’t continue to carry you on its medical and health insurance as an employee, you do have a right to COBRA and the company can pay costs associated with that.”

All in the timing
According to William Kanzer, founder of Chicago-based executive search consultant firm Kanzer Associates, executives should negotiate change-of-control provisions early on, preferably at the time an offer is extended. “If a person is already employed and does not have something in their offer letter about a change-of-control provision, then it’s unlikely that the company will guarantee the employee anything on a going-forward basis,” Kanzer explains. “Obviously, the more senior the executive, the more likely changes can occur with rewritten definite agreements.”

In order to have the upper hand in change-of-control negotiations today, says Gourley, “You better be hot stuff!”