2. Understanding and/or Modifying Outstanding Compensation Arrangements
Understanding and/or Modifying Outstanding Compensation Arrangements
As the company approaches the spin-off, a key compensation issue is how to adjust outstanding compensation arrangements to recognize that one company is breaking up into two companies. Decisions need to be made about what will happen to the company’s long-term incentive plans, as well as retirement and deferred compensation plans. For purposes of this discussion, we will focus on long-term incentive plans, as it is an area that is particularly critical for executive compensation.
The treatment of outstanding long-term incentives (particularly equity incentives) can be complex following a spin-off. There are several steps that need to be taken to transition awards, including review of the following:
- What provisions are specified in the equity plan and equity award agreements?
- Should the committee apply discretion to modify the treatment of employees’ awards based on the circumstances of the transaction?
- What is the preferred approach for converting ParentCo equity (i.e., ParentCo post-spin and SpinCo equity)?
- What will be the timing of the conversion of equity?
Existing Equity Plan and Award Agreements
The first step in reviewing outstanding equity is to understand the treatment that the company’s equity plan and the individual award agreements prescribe for outstanding equity awards. A key issue to understand is what will happen to the awards held by employees of SpinCo. In many cases, the spin-off constitutes a termination of employment and, under ParentCo’s plans, unvested awards are forfeited at the spin-off.
It is important to understand the extent to which the prescribed approach impacts the bottom line of both entities. It is also important to work with internal and external counsel to ensure that there is a common understanding of the contractual rights of employees, the equity plan and award agreements
Another key issue is whether the plan provides for the conversion of outstanding awards in a spin-off transaction. The plan document will likely include a section addressing a change in capital structure and transactions like a spin-off. In most cases, the committee is required to convert vested awards to preserve value but is afforded significant latitude in determining the details of the conversion.
Exercise of Compensation Committee Discretion
In our experience, most compensation committees do not want SpinCo employees to forfeit outstanding unvested equity due to a spin-off transaction. Forfeiture of previously awarded equity could have a serious impact on morale. One way to address this is to accelerate vesting in ParentCo equity or to provide for continued vesting post-spin. Alternatively, if the ParentCo’s compensation committee does not take action to keep SpinCo’s employees whole, then SpinCo’s compensation committee may need to take action following the spin-off. It is important to keep in mind that each situation is different. If outstanding awards are underwater, the spin-off may be an opportunity to eliminate overhang on the stock.
Approaches for Conversion of ParentCo Equity
There are several approaches that are used in practice when addressing how to treat outstanding equity upon a spin-off. The following table provides an overview of the alternative approaches:
|
Approach |
Description |
|---|---|
|
Employee |
Employee awards are converted to equity in the company where they are employed. The participants of the equity plan who remain employed by ParentCo retain adjusted ParentCo equity awards. The equity plan participants who are employed by SpinCo receive converted SpinCo equity awards with similar terms and conditions. |
|
Shareholder |
Employees are treated like shareholders. Regardless of where the participant is employed following spin-off, outstanding awards of all equity plan participants are converted into both ParentCo and SpinCo equity at the same conversion ratio as shareholders, with the same terms and conditions as the original awards. |
|
Hybrid |
A combination of the “Employment” and “Shareholder” approaches based on any of the following: (i) when the equity award was granted, (ii) where the equity holder is employed post-spin, (iii) when the equity award will vest, and/or (iv) the type of equity held at spin-off. |
|
Adjustment Only, No Conversion Approach |
All employees retain adjusted ParentCo equity with similar terms and conditions. Continued employment with SpinCo is treated as employment with ParentCo, for purposes of continued award vesting. |
While several approaches to conversion are used in practice, the Employee approach is the most consistent with the goal of aligning the executives of the company with the shareholders of the entity they support following the spin-off. Other approaches (e.g., shareholder) may attempt to recognize the efforts of employees, prior to the spin, given that such efforts contribute to the future business success of both entities, post spin. The hybrid approach is sometimes used in situations where there is a significant difference in the growth prospects of the SpinCo or ParentCo (i.e., ParentCo is expected to have modest price appreciation potential while SpinCo has strong growth prospects). It is sometimes the case that different treatments may apply to employees within one entity. For example, if the ParentCo hires a senior executive for SpinCo from outside the company prior to the spin-off, their awards may convert using the Employee approach if they have minimal service at ParentCo, yet the Shareholder approach may be used for other employees with more veteran status.
For outstanding long-term performance share or unit/cash plans (typically with three-year performance cycles), practice is mixed, and the conversion approach used will depend on the length of time remaining in the outstanding award cycle, the performance measures used, whether a new program is put in place in SpinCo, and the type of SpinCo company structure. In many cases, ParentCo prorates outstanding long-term incentive awards held by employees of SpinCo to reflect their time as employees of ParentCo. The prorated awards held by SpinCo employees are then paid out based on the original performance criteria at the time payments are made to ongoing employees of ParentCo. Once employees have transferred to SpinCo, the remaining stub periods of each outstanding award may be paid out at the target award amount, or, in cases where the committee of SpinCo wants to preserve a performance-based focus, they may establish new performance goals based on operational or stock performance of SpinCo. There are challenges associated with setting goals for these ‘interim’ performance periods, yet many companies will do so.
Retirement Programs
Agreement on the treatment of retirement programs, non-qualified deferred compensation (NQDC) plans and other benefits is a critical administrative decision. If ParentCo has a defined benefit plan, it must determine whether to transfer assets and liabilities of the pension associated with SpinCo employees to SpinCo. A decision on whether any applicable grandfathering of frozen plans/plan benefits will continue is also required. Non-qualified benefit programs are often only partially funded, or unfunded, and the amounts can be significant. Typically, employee accounts in any NQDC plan of ParentCo are transferred to a SpinCo plan for employees of SpinCo. Alternatively, SpinCo could receive a payout of the NQDC applicable balances. Plan provisions will dictate the course of action. Note that distributions in connection with a spin-off are generally not compliant with IRC Section 409A, since a spin-off is not a separation of service for employees under the section.
Health and Welfare Benefits
Generally, SpinCo is responsible for setting up new health and welfare programs, and both ParentCo and SpinCo are responsible for claims incurred against the respective plans post-spin. Certain programs such as retiree medical, however, may require a determination of how to allocate liabilities to SpinCo (e.g., for current terminated employees, or just future retirees). Decisions on allocating liabilities related to LTD payments, accrued vacation, COBRA, workers’ compensation, etc. may also need to be made depending on the programs of the Parent.
Severance and Change-in-Control (CIC) Benefits
A spin-off could trigger a CIC depending on the provisions of ParentCo’s various plans. While many benefits arising from a CIC are only paid after a “double trigger” (i.e., they are only paid or vested if a termination of employment occurs in connection with the CIC), certain benefits may be accelerated or payments may be triggered immediately. As a result, severance payments could become due to employees transferring to SpinCo. The companies need to determine if any severance obligations apply when employees transfer to SpinCo and who bears the responsibility for such obligations. Note however, that in many transactions, outstanding awards are assumed by SpinCo, in which case, payments would not be accelerated, nor would any benefits be distributed.