Marissa Holob is chair of the firm’s Executive Compensation and Employee Benefits practice. She advises clients on a wide range of executive compensation and employee benefits issues, including those that arise in the context of mergers and acquisitions, restructurings, and similar transactions.

Q: How should buyers approach their due diligence, and what key factors should they look for when reviewing the compensation arrangements of a target company?

A: The diligence process is always an important first step in any transaction. On the compensation side, it not only helps identify potential issues and liabilities but also gives insight into the culture of the target company and the types (and amount) of compensation that executives and employees have historically received.

Diligence review of compensation arrangements will typically focus on individual employment agreements, severance plans, equity ownership by management, and other short- and long-term incentive arrangements. It is especially important to determine whether the proposed transaction will trigger any payments or springing rights under any compensation arrangements and the potential costs involved, as well as to identify any compliance issues. For example, a potential buyer will need to confirm that all compensation arrangements comply with, or are exempt from, some of the more difficult rules governing nonqualified deferred compensation arrangements (Sections 409A and 457A of the Internal Revenue Code), in order to avoid any surprise taxes for employees or surprise liabilities for the acquiror. In addition, a buyer will want to make sure that the management team continues to be aligned with the ongoing company post-transaction. This is one reason it is very common for management employees of portfolio companies of private equity funds to be required to either roll over a portion of their equity or invest post-close.

Q: Is there any potential tax rule in particular that can be triggered by a merger or acquisition?

A: While there are many areas of compensation arrangements that need to be addressed, Sections 280G and 4999 of the Internal Revenue Code, often referred to as the golden parachute rules, should always be considered in a transaction context. By way of background, Section 4999 imposes a 20 percent excise tax on excess parachute payments, and Section 280G denies a tax deduction for excess parachute payments. The golden parachute penalties apply if a “disqualified individual” receives payments in connection with a change in control that are equal to or exceed three times the individual’s base amount (five-year average annual compensation). If the aggregate present value of such payments equals or exceeds three times the individual’s base amount, then the individual is subject to a 20 percent excise tax on all parachute payments in excess of one times the individual’s base amount and the company is denied a deduction for those amounts.

The 280G rules apply to “corporations.” This means that they generally do not apply to payments made by a partnership or limited liability company (that has not elected to be taxed as a corporation), even if those payments are contingent upon a change in control. However, it is important to consider whether all the entities under common ownership are partnerships (or LLCs) or whether some of those entities are corporations. If the group of entities under common ownership is comprised of both partnerships and corporations, further analysis is needed to determine whether these rules are implicated. Factors to be considered are the entity employing the disqualified individuals, the entities that the individuals perform services for and the entity that is the payor of the change in control payments.

In addition, for non-public companies, an exemption from the parachute rules exists if the shareholder approval requirements are met. Not only must the company receive the necessary percentage of shareholders to approve the payments to meet the shareholder approval exception, there are several other requirements to satisfy, including the fact that the vote must be determinative of the individual’s right to receive or retain the payments, and adequate disclosure of all material facts regarding the potential parachute payments must be provided to shareholders. This requires careful planning to make sure that everything is completed prior to the change in control.

Q: Is compensation part of deal planning as well? How should a buyer approach the structure of future compensation and incentives in order to maximize their effectiveness and cost efficiency?

A: Typically, in the private equity context, as I mentioned before, buyers will both have key management employees roll over equity and enter into new incentive arrangements with those individuals. This allows the executive team to be personally invested in the company and be aligned with the equity owners. It also allows for forward planning with the incentive structures.

There are several driving forces behind compensation decisions: tax implications, securities laws, retention of key executives, competitive compensation package and exit strategies/performance. In addition, a purchaser will want to be aware of the market for the targeted industry in order to be competitive in terms of total target compensation. Compensation arrangements, especially for key individuals, should also address what occurs when those individuals leave under different circumstances.

For example, typically, senior level executives have protection in the event of a termination of employment without cause or a resignation for good reason, which can include severance benefits and/or certain accelerated vesting of equity awards. Conversely, the purchaser will want to make sure it has appropriate protections in place, such as certain restrictive covenant agreements, which may include non-competes, non-solicits and confidentiality provisions.

I do not believe in a one-size-fits-all approach to compensation arrangements. Best practice is to structure executive compensation arrangements to properly align and incentivize employees with the goals of the company and its shareholders (while being tax-efficient).

Q: Are there any trends in the types of compensation arrangements at private equity portfolio companies?

A: While upside-only awards, such as stock options and profits interests, continue to be popular incentive vehicles at private equity-backed portfolio companies and sponsors continue to require a large portion, if not all, of any equity or equity-based grant to be subject to performance-based vesting triggers (such as achievement of return goals, often measured by IRR or MOIC or both), compensation arrangements at these entities is an area where we see significant innovation and are able to help design creative compensation programs that meet the specific goals of the company and its sponsors.