Key Considerations for Comp in M&AZoom inDownload PDF
Many companies are again pursuing mergers and acquisitions (M&A) after several years of a relatively quiet market. A key element of making a merger or acquisition work is getting the compensation program right. Pay related to M&A generally has two stages: developing compensation for key employees in both the acquired company and the acquirer leading up to the deal and developing ongoing programs after the deal closes. Below we explore the key considerations for each stage, based on our experience advising companies going through transactions.
Pre-close considerations typically include special retention awards and transition incentives. Retention awards tend to have more time-based vesting and transition incentives tend to have more performance-based elements. Retention awards can be important tools to ensure that key employees stay through the close of the deal or beyond, while transition incentives help incentivize employees to assist in key activities needed to make the deal successful.
In both cases, it is important that the awards are targeted at the right employees. In our experience, retention awards are most necessary for those employees who are likely to be impacted by the acquisition, including those whose job may be eliminated and are critical to the closing or post-close integration.
The key considerations for identifying the employees eligible for retention awards include:
- Criticality of the role. Is the individual:
- Involved in integration-related activities (pre-close and/or post-close)?
- Central to operation of ongoing business?
- Difficulty of replacing the individual
- Are there other candidates able to replace the individual internally or externally?
- Does the individual have unique skills or are there multiple incumbents that can fill in if the individual leaves?
- Does the individual possess critical institutional knowledge?
- Retention risk
- What is the individual’s degree of job uncertainty? Is individual well known in industry?
- Does the individual have “low switching costs” (e.g., short tenure with company)?
- Are individual’s skills in high demand among competitors or other companies outside of industry?
- Is the individual retirement eligible (early or regular)?
- Performance and potential
- Is the individual a top performer or one with high potential?
The awards would be calibrated using a framework that scores employees across each of the four criteria. The amount of the award would vary by tier, with those in a higher tier receiving a bigger award (as illustrated below).
Often the awards are calibrated as a multiple of salary or as multiple of annual or long-term incentive grants, depending on level within the organization. However, the specific design elements of the awards would vary depending on the person’s role in the ongoing company. Those employees that will continue with the company may receive awards that vest in part after close of the deal and can be denominated in a combination of cash and stock. Those employees leaving shortly after the close of the deal will more likely receive all cash paid close to the closing. Finally, those employees who are needed for shorter periods of time (i.e., before closing) would be paid sooner in cash, once their service is no longer needed. Transition incentives, unlike retention awards, typically have performance-based elements related to the accomplishment of key milestones critical to the deal that may extend beyond closing (e.g., initial planning for and then execution of system and process integration).
Transition incentives are often used in conjunction with retention awards because these employees are needed through the transition period, and in many cases beyond.
In our experience, there are two key integration considerations: 1) harmonizing the pay programs of the two entities and 2) staking awards.
Often companies fail to effectively harmonize their programs because they either simply impose legacy programs on the acquired company, or they choose aspects of each company’s programs. In either case, they may not address the very different needs of the individual businesses or the new strategy of the combined business. For example, automatically including all employees in an acquiring company’s incentive program may not be appropriate if the acquired business has lower margins, requires different skills, and/or if there is no competitive need to do so. On the other hand, if the acquired business is more entrepreneurial than the acquirer, it may be appropriate to use incentives more extensively to help maintain its entrepreneurial nature. Of course, the needs of the different businesses need to be weighed against internal equity considerations to ensure the best outcome for the overall combined entity.
In our view, effective harmonization considers the following:
- Review of pay philosophy in light of business strategy: if the acquisition is transformative or represents a significant shift in strategy, an overall review of the company’s pay philosophy and strategy may be required. To the extent the pay philosophy and/or employee profiles change following the acquisition, pay programs may require more re-design (e.g., total replacement or major reweighting of incentives). On the other hand, tuck-in acquisitions often can be integrated into the acquirer’s regular pay programs without significant upheaval to the continuing business.
- Review of competitive market and pay levels: Often a big acquisition can change the competitive landscape for executive pay. It may be appropriate to change the peer group used to benchmark pay to include larger companies or companies in slightly different industries. If a higher paying peer group is appropriate, it is important to carefully consider the pace of pay increases to executives. In our experience, moving to the new market levels over time is a better approach than a wholesale shift in pay levels across the executive team.
- Assessment of the total cost of pay and benefit programs: Understanding the cost to the company and benefit to employees of the two programs is often essential to achieving the goals of the acquisition, especially if cost savings are a major driver. Often a series of trade-offs are required to integrate the programs in a manner that allows for cost savings (or at least cost containment) without too many takeaways for employees of either entity.
Many companies continue legacy programs for the first year following the acquisition because of the time required to properly consider all aspects of harmonization. This also helps to maintain an engaged workforce in the midst of significant uncertainty. The pace of the business integration should be a primary consideration for determining the timing of harmonization.
Staking awards can also be an important element to M&A integration. Providing staking awards to the management of the acquired company can be an effective way to quickly increase their alignment with the new company. However, staking awards are usually appropriate only if the new executives do not roll over significant amounts of unvested equity from the acquired business.
When sizing staking awards it is important to pay particular attention to new hires or recently promoted executives that represent the next generation of leadership because they are likely to have smaller equity stakes. Large one-time grants required to stake individuals who are disclosed in the proxy should be used prudently and carefully explained in disclosure materials to avoid negative perception by shareholders and proxy advisors. Typically, using performance-based vehicles as a significant component is the most appropriate. Often options can have a meaningful role as well because of the alignment with stock price following the acquisition. The size of staking awards typically ranges from an amount equivalent to a regular annual equity award up to three times that amount in extreme cases. The actual size will vary based on level in the organization and the unique circumstances of the different types of employees discussed above.
Compensation in M&A is an essential element to making the transaction successful. A combination of pre-close retention grants/transition incentives and then careful consideration of the post-close integration and ongoing pay program can provide a balanced approach to pay during a potentially tumultuous time.
This article, written by Greg Arnold and Seymour Burchman, originally appeared in NACD Directorship.