The treatment of outstanding stock options and other equity compensation awards is often a key element of a sale transaction. Because stock options can represent considerable value, how they are treated can have a significant impact on the company’s management team and employees. For the parties negotiating the transaction, it can also impact the purchase price paid at closing and the allocation of sale proceeds among the equity owners of the acquired company. The rights and obligations of the company with respect to options and awards are generally governed by a stock option plan and award agreement that is approved by the board early in a company’s life cycle. In a merger, the treatment of the company’s options will be governed by the plan and therefore particular attention should be paid to the plan when determining how they will be treated in a sale.

Last week, in Fox v. CDX Holdings, Inc. (Del. June 6, 2016), the Delaware Supreme Court affirmed a ruling awarding over $16 million in damages to optionholders of Caris Life Sciences, Inc., a privately-held Delaware corporation, for breaches by the company of a stock option plan in connection with a spin-off and merger transaction involving the company’s three business units. The Court upheld the trial court’s ruling that (1) the fair market value of the options was improperly determined by the Board, and (2) the portion of the optionholders’ merger consideration that was held back as part of the indemnification escrow in the merger was withheld in violation of the plain language of the plan. As further discussed below, the decision serves as a cautionary reminder that the rights of optionholders are contractual and, unlike the rights of shareholders, are not governed by statute or fiduciary principles in a sale. Therefore, stock option plans should be carefully drafted to give companies sufficient flexibility with regard to the options in a potential M&A event. The CDX case also highlights the need for the parties to consider early on in the M&A process whether consents will be needed and the required treatment of outstanding options under the plan and equity awards as part of their ongoing due diligence to manage litigation and deal risk.

Cashing Out or Rolling Over Outstanding Stock Options. Broadly speaking, the basic question for deal parties is whether the management teams’ and employees’ outstanding stock options will terminate at Closing (including a cash out/cancellation), or will continue to survive (e.g., an assumption, substitution or a “rollover” to acquire the purchaser’s stock). While the balancing of the considerations in answering that question will vary from deal to deal depending on type of deal (public or private), type of purchaser (strategic or financial), value of options (in-the-money or underwater) and other facts and circumstances, many of the considerations are common across deals. For example, “cashing out” the options will clean up the existing equity but may be perceived by the acquiror as resulting in a windfall, or excessive payout, to the target’s management or employees, and therefore adversely affect retention and performance. On the other hand, a “rollover” of options may be perceived as too dilutive or as untenable given the equity structure of the companies, but may serve as an important retention feature.

In a typical sale of a privately-held company for cash, vested options must be exercised at closing (or else they will terminate) or are cashed out. In a cashout, the holders generally receive the excess of the per share sale price over the exercise price in exchange for cancellation of the options. Vesting of unvested options may be accelerated, in whole or part, in connection with the sale. If any options are out-of-the-money or underwater, the parties generally desire to cancel the underwater options for no consideration. Receipt of a portion of the option proceeds (like stock proceeds) may be subject to indemnification holdbacks or escrows.

Option Plans May Not Permit the Intended Treatment. If the option plan and award agreements do not contemplate these actions (e.g, cashout/cancellation or termination), or at least provide the target’s board with broad discretion to handle options in connection with the sale transaction, the parties may need to obtain the consent of the optionholders for any action taken. Unilateral action may pose a risk of legal claims for breach of contract or otherwise.

For instance, in Lillis v. AT&T Corp (2007), a case arising out of the acquisition of AT&T Wireless by Cingular Wireless, the Delaware Court of Chancery found that the option plan did not permit AT&T to cancel in-the-money options for only their intrinsic value (or spread value), or to cancel underwater options for no consideration. The plan in question included a provision that required AT&T to adjust the options in connection with a sale transaction in a manner that each option holder’s economic position would not be worse than it had been immediately prior to the adjustment. The Court of Chancery ruled that cashing out the options at their “spread value” (e.g., the delta between the option’s strike price and the stock’s fair market value) made the optionholders’ economic position worse because the spread value of their options was less than their so-called “Black-Scholes” value (which also includes the value attributable to the chance that the underlying shares will appreciate before the stock option expires).

In CDX Holdings (2015; aff’d 2016), the Delaware Court of Chancery found that the plan in question did not permit the parties to hold back a portion of the optionholders’ merger consideration in a post-closing indemnification escrow. The merger agreement provided for a proportionate holdback from the stock and option proceeds – a commonly-included deal term in a private deal. However, under the terms of the stock option plan, each holder was entitled to receive for each share covered by an option the difference between the fair market value of the share and the exercise price of the option. The court held that the stock plan, and not the merger agreement, governed the relationship between the optionholders and the company and concluded that because the plan could have provided, but did not provide for such a holdback, it was not permitted.

Does Your Plan Permit the Intended Treatment? The starting point for the Lillis and CDX rulings is the fundamental principle that the rights and obligations of the company and optionholders are governed by the terms of their contract – the equity plan and award agreements. As recited in CDX: stock options are not shares; optionholders are not stockholders; and Section 251 (Delaware’s merger statute) does not authorize the conversion of stock options in a merger. Rather, the terms of the plan and award agreements must authorize and permit the intended treatment – in these cases, the cancellation of options or an escrow holdback. A company generally cannot change the plan terms at the time of the sale without the consent of the optionholders if the proposed treatment would adversely affect their rights. Amending an equity plan in a manner that adversely affects optionholders may also require optionholder consent and, if the company is a public company, may require stockholder approval. (Public companies are required under exchange act listing requirements to obtain stockholder approval of equity compensation plans and any material amendments.) Because obtaining the consent of optionholders or obtaining stockholder approval at the time of the transaction can raise unwanted complications and may not be feasible (given the timing of the transaction or number of optionholders), it is important for the company and the purchaser to be aware of the terms of the option plan and award agreement well before negotiating the terms of the sale.

Do Your Diligence. From a purchaser’s standpoint, it needs to diligence the plans and award agreements of the target company to confirm the intended treatment is permitted by their terms. It is possible that target companies could have multiple plans and award forms and/or different groups of employees could have different rights with respect to their options. For example, in the Lillis case, the court ruled that AT&T Wireless had agreed in a previous acquisition that a plan established by the acquired company years earlier would continue to govern the options issued under that plan (rather than AT&T Wireless’s plan) in the event of future corporate transactions. Accordingly, purchasers should also review transaction documentation from previous acquisitions and communications to employees that may bear on the rights of the optionholders. If there is any uncertainty which plan terms govern or whether the intended treatment is permitted, the parties will have to determine whether to obtain consent from the optionholders and weigh any timing or other potential factors related to obtaining consent against the risk of possible claims by optionholders if consent is not obtained.

Give Plan Administrators Flexibility When Devising Option Plan. From a company’s perspective, it needs to keep an eventual sale in mind when it first puts its stock option plan in place and to provide flexibility to the administrator (usually the board) in connection with a future sale transaction. For example, a plan could provide that holders of stock options cancelled in connection with a merger would receive the same consideration (on the same terms) as the holders of common stock in the deal, less the exercise price. Note that under this formulation, underwater options would likely receive no consideration. Companies should also have the flexibility to treat options in a sale transaction in a manner agreed to by the administrator of the plan as set forth in the merger agreement (which would allow among other things the assumption or substitution of options by the purchaser and the acceleration of vesting of options held by key employees). It should also permit the administrator to take different actions with respect to different options or holders. For example, in some sale transactions, the parties may want to apply the escrow holdback to the founders or senior management team but not to other employees or may want to treat current employees differently than former employees. The plan should also permit the administrator to take different actions with respect to the vested and unvested options, and to accelerate vesting, in whole or in part.

In some cases, key employees or other optionholders may have negotiated for special rights in connection with a sale or other change-of-control such as automatic vesting or acceleration rights. It is important to review all relevant plans, awards and employment agreements for these change-of-control provisions in connection with a sale transaction and to consider their effect on the pricing and other terms of the deal.

Understand the Requirements of the Plan and Abide by Them. In addition, the plan administrator should understand the requirements of the plan and, if the plan administrator is the board, act diligently and in an informed manner in accordance with the board’s fiduciary duties generally under state law. In CDX, the court found that the Board was required to determine the fair market value of each share covered by the option and to adjust the options to account for the spin-off aspect of the transaction, but failed to do so in good faith. Instead, the court found that the controlling stockholder and the CFO (who was not on the Board) made the determinations without sufficient involvement or formal action by the full Board, contrary to the terms of the plan. The court found that only one director besides the controlling stockholder had any involvement at all in the value determination (in limited emails with the CFO), and that one director did not even know the plan existed. The court noted that the CDX Board could have delegated the fair market value and adjustment determinations to a committee of the Board consisting of one director (the controlling stockholder), but in failing to do so, the full Board was required to make the determinations by formal action. In affirming the judgment, the Delaware Supreme Court noted that it was not enough for the Board to fulfill its contractual obligations under the plan solely by noting in its Board resolutions that such obligations existed.

Results-Oriented Valuations Disfavored. In addition, the CDX Court noted that the officers who actually performed the valuations did so in a process that was “arbitrary and capricious.” It cited evidence at trial that established that the value of the spun-off company was not reached in good faith but was based solely on a report by the company’s tax advisors to ensure that the spin-off would result in no corporate level tax. The Court noted that the $65 million valuation assigned to the spun-off company varied substantially from prior valuations of the divisions by management, the company’s financial advisor and a different accounting firm, which had previously generated reports for the same businesses.

This aspect of the opinion is a recurring theme in recent Delaware decisions underscoring that judges will disfavor results-oriented valuations and may second-guess a fair market value determination in litigation that diverges from prior valuations made in connection with stock plan issuances or otherwise in the ordinary course of business. Of course, there can be legitimate reasons why a deal price may differ from fair market value determinations made in other contexts. However, boards should be prepared to reconcile the discrepancies in litigation and would be well served to create a good record of their reasoning, deliberations and conclusions.