1. Key Issues for the Acquiring Company Compensation Committee

On either side of a merger or acquisition, the compensation committee will typically face challenging issues. At the acquiring company, decisions will have to be made about how to treat ongoing compensation programs (e.g., short-term incentive plans, long-term incentive plans) to incorporate the impact of the newly acquired business. The committee will likely also need to rethink aspects of the pay program prospectively to reflect the newly transformed company (e.g., peer group, performance measures, etc.). The compensation committee of the acquired company has challenges of its own. They need to ensure that interim compensation arrangements are effective at motivating and retaining employees through the close of the acquisition, recognizing that many employees may not be needed by the acquiring company following the transaction.

Key Issues for the Acquiring Company Compensation Committee

a. Due Diligence

Understanding the target company’s compensation programs begins with the due diligence process, which is typically led by management. The compensation committee should expect that the management team will develop a clear understanding of the compensation processes at the target company, with a particular focus on what the transaction will mean for employees of the target company. Key questions to be addressed include:

• What is the value of outstanding equity held by executives/employees of the target company?
• How much of this value is unvested?
• Will the vesting accelerate upon the close of the transaction or only upon a termination of employment following the close?
• Are they eligible for severance if terminated following the transaction?
• Will the severance trigger any IRC 280G excise taxes and associated loss of deductibility?

If a key rationale for the acquisition is to acquire the talent of the target company, then the HR team of the acquirer will want to develop a clear understanding of the compensation and benefits programs at the target company and how they compare to the acquirer’s programs. The acquiring company should understand how favorably target company employees will view the transition onto the acquiring company’s programs.

b. New Organization Structure

The impact of the newly acquired business on the acquiring company’s organization is an important question to answer early in the process. The fundamental issue is whether the acquired products and services will be merged into existing business units or managed as a separate, stand-alone business unit. Under the first approach, headcount reductions are likely to be extensive.

If the new business is managed separately, it will be critical to retain key employees with customer relationships, product knowledge and a grasp of business fundamentals. Preparing a new organization chart is an important first step. Identifying potential replacements for critical roles is also very important if retention efforts are unsuccessful, particularly if change-in-control benefits are extensive.

c. Retention Incentives

Many organizations reserve a pool to fund retention incentives after the transaction closes. Considerable sums are allocated to retaining employees in large transactions. While there is considerable variation in approach, depending on the specific circumstances of each situation, the approaches to retention incentives that we see most frequently are summarized below:

Participation:	Selective; offered to key employees
Size of Award:	50% to 100% of regular performance–based annual incentive
Payout Schedule:	1 installment for retention periods of 1 year or less; 2 installments for retentions periods of 12-–24 months
Form of Payment:	Cash; stock is used infrequently
Vesting:	Payment is made if acquiring company initiates early termination; payment is forfeited if employee resigns voluntarily

Treatment of Outstanding Incentive Plans

It is common for an acquisition to have significant impact on the performance determination for the annual incentive plan and for long-term performance plans. Annual incentive plans are typically assessed based on financial performance measures (e.g., revenue, EPS, cash flow, etc.). While mergers or acquisitions will generally be accretive to revenue, they may have an adverse impact on short-term financial performance. There are typically direct costs associated with the merger (e.g., professional fees, severance) that are recognized in the year of the acquisition. In our experience, companies commonly exclude these costs from the determination of financial performance for annual incentive plan purposes. It may also make sense to exclude any benefits to revenue growth from the merger, unless acquisitions were included as part of the underlying growth assumptions in the business plan.

For performance share plans, it may be more complicated to isolate merger impacts from the determination of performance. The equity plan documents or award agreements will typically provide the compensation committee with the authority to modify performance to account for the impact of an acquisition or merger on outstanding performance awards. Since these performance plans typically span multiple years, it is challenging to simply exclude the impact of the acquired company on the financial performance. A more common approach is to potentially exclude the impact of the acquisition on the determination of performance for the year of the merger close and then adjust the goals for any future years to reflect the combined company. Generally, these modifications are not simple to make and can have accounting implications. We recommend that the compensation committee request that management begin to address these issues early in the merger process so that the committee can discuss the appropriate approach over multiple meetings.

d. Post-Merger Integration Incentives

Some companies also introduce special incentive plans tied to the capture of synergies post-merger. Post-merger performance can be measured in different ways. After large acquisitions, teams representing all major functions — marketing, sales, supply chain, R&D, HR, etc. are created. Team members are tasked with achieving integration goals in a timely manner, often requiring significant investments of management time and effort. Additional bonuses, either discretionary or performance-based, are frequently provided.

For performance-based incentives, one approach is to measure the cost-savings realized. The second approach involves assessing the financial performance of the combined company. We believe the second approach is more effective since such a program answers fundamental questions: Did the deal achieve the promised ROI or increase in earnings? Can we call the deal a success for shareholders and other stakeholders?

e. Integrating Compensation Programs

The merger agreement often provides that compensation and benefits will be maintained at existing levels for a defined period, typically one year but sometimes as long as two years. This allows for some time to assess the compensation and benefit programs at the newly acquired business and develop an action plan. In most cases, employees of the acquired company are merged into the programs of the acquiring company. But in some cases, it may be appropriate to merge the programs by selecting the best features of each.

Action steps are situational. The specific facts and circumstances of the combined company will dictate the optimal compensation program design decisions. While each company will come to its own conclusions, here are some suggested areas of focus:

1. Develop Employee/Executive Roster: Assemble a tally of headcounts and compensation levels by business unit, level and geographic location. Understand the population and markets that you are dealing with. Recognize that roadblocks created by different human resource information system (HRIS) platforms may make this process more difficult than expected.
2. Address Titling Conventions: Determine the extent to which job titles are consistent. Assess whether span of responsibilities associated with different titles (i.e., Manager, Director, Senior Director, etc.) are similar. If inequities exist, develop an action plan to achieve uniformity.
3. Develop Integrated Salary Structure(s): Depending on current practices, this may involve traditional salary ranges or salary bands. It can be supported by job matching to survey data, or other job evaluation systems. Multiple structures in different geographies may be required. This is a critical step to achieve internal equity, but it also requires time to analyze and implement, as well as input from the human resource generalists in the business units.
4. Expand Participation in Annual Incentives: The place to start is to make a side-by-side comparison of the annual incentive plans of the acquired and acquiring companies. Several fundamental questions should be addressed:
   • Do both companies use performance against budget as the basis for annual incentives?
   • Are the award opportunities consistent at target? At threshold? At maximum?
   • Should award opportunities of newly acquired participants be adjusted or grandfathered?
   • What are the performance metrics? Are they similar or different? What makes sense going forward?
   • How about the performance scales? Are the performance ranges and payout percentages similar?Well thought-out decisions on each of these points will help create an annual incentive plan that supports business success and creates a bridge between both legacy populations.
5. Expand Participation in Long-Term Incentives and Equity: Including newly acquired personnel in the long-term incentive and equity programs requires a similar decision-making process. Since long-term compensation is a significant component of pay at the Director level and above at most companies, it is important to size long-term pay correctly. Companies should also project the impact of expanded participation on share usage and make sure that the existing plans can fund awards.

Frequently, the acquiring company assumes the equity plan sponsored by the acquired company. The shares in the plan are converted to reflect the equity of the combined company. This provides another source of shares. However, these shares can only be used for employees of the acquired company unless shareholder approval is obtained. Depending on the size of the two plans and share usage, this may be a worthwhile step to take.

Key

 Issues for the Target/Acquired Company

Prior to the signing of the merger agreement, the target company should ensure that there is a clear understanding of the impact of a potential merger/acquisition on its employees. In particular, the compensation committee has an important role in making sure that the executive leadership team and employees remain with the company through the close of the merger. The committee should make sure that prior to the merger agreement being signed, severance or retention agreements are in place for critical executives and staff that may lose their jobs following the close of the transaction. The compensation committee should recognize that not all mergers/acquisitions make it to closing and that the company will be at risk if they lose key employees before the close of the merger, particularly if the deal does not ultimately close.

Many mergers are subject to extensive regulatory and anti-trust review. There are some cases where more than a year can pass between the announcement of the merger and its close, particularly in highly regulated or concentrated industries. It is important for the committee to understand what flexibility it will have to modify compensation arrangements over this period of time. Ideally, the committee should ensure that ordinary course annual incentive and long-term incentive awards can be maintained while the deal is pending. In some cases, merger agreements forbid the granting of additional equity awards without the approval of the acquiring company. This can be a problem if the timeframe from approval to close extends beyond the period when annual equity awards would typically be made.

It should also be noted that the acquired company will have to include a say on golden parachutes proposal in its merger proxy. This allows for shareholders to weigh in on whether or not they approve of the merger-related compensation provided to named executive officers of the acquired company. While the majority of these proposals tend to pass, roughly 10% to 15% of them fail depending on the year. The primary drivers of failure tend to be high severance amounts and problematic practices (e.g., excise tax gross-ups, single trigger acceleration of equity).

Key Questions for Committee Members to Ask:

• How will the merger impact outstanding annual incentives and long-term incentive awards?
• Are there adequate mechanisms in place to ensure that we will retain key talent from the acquired company through the close of the transaction? If there is talent required post-acquisition, do we have “retention hooks” in place?
• How will the compensation program need to change following the acquisition to recognize the new composition of the company? Will we need a new peer group? New performance measures?