What Happens to Call Options When a Company Is Acquired

Key Takeaways

• In a buyout, call options can be adjusted, converted, exercised early, or rendered worthless depending on the offer type and strike price.
• The value of call options is largely determined by how the buyout price compares to the strike price.
• Cash buyouts often result in options being cashed out for intrinsic value, while stock-for-stock deals may involve adjustments to the number of shares and strike prices.
• Vesting schedules, acceleration clauses, and termination provisions significantly affect unexercised options during acquisitions.
• It's crucial to consider tax implications and potential liquidity changes resulting from acquisitions.
• Call options may be assumed, canceled, or replaced by the acquiring company depending on the terms negotiated.

About Options in a Buyout

A situation that results in a buyout includes a merger, which involves at least two companies. This could result in one company being dissolved and a new business being formed. Before a merger can commence, the board of directors for all companies involved must approve the merger transaction.

Some states may require the approval of the shareholders before a merger can take place. During a merger, the stockholders may receive cash, stock, or both cash and stock.

The announcement of a buyout by another company is often deemed beneficial for shareholders of the company being purchased. This is because the offer is generally at a premium price compared to the market value in place prior to the announcement.

Key Considerations for Option Holders in a Buyout

When assessing what happens to call options when a company is acquired, it’s important to understand that not all options are treated equally. Several factors influence how options are handled, including:

• The structure of the acquisition: Cash vs. stock deal outcomes differ.
• Whether the options are vested or unvested: Unvested options often face cancellation unless accelerated.
• Type of equity plan in place: Some plans have provisions that automatically terminate or convert options.
• Terms negotiated during acquisition: Companies may choose to assume, convert, or cash out options depending on employee retention goals and legal obligations.

Buyouts may include acceleration clauses that allow options to vest immediately upon a change in control. Conversely, some deals cancel unvested options outright unless renegotiated.

Call Options and Buyouts

There is the situation where call option holders may or may not be in a favorable position. This depends on the strike price (set price) assigned to the options they hold and the price being paid in the buyout.

• Call options give the person holding the option the right to purchase at a set price any time before the options expire. This is assuming these are American options.
• In effect, a call option would not be exercised to purchase shares at the set price if the set price had a higher price than that of the current market price.
• When a buyout offer is made where a set amount for each share is offered, it limits how high the shares can go. This is assuming no other offers will be made, and the initial offer will most likely be accepted.

If the offer price is below the strike price (set price) of the call option, there is a good possibility the option will lose a good portion of its value. On the reverse side, when the strike price is below the offer price, there can be a moderate to significant increase in its value. For example, if a buyout offer is received for $80 per share and the call option is $70, the shareholder will make money. If the call option is $90, the shareholder will lose money.

It is recommended that if the stock price is high enough before the settlement date to cash out. Once the buyout occurs, whatever you have in place is final. Or, the company that initiated the buyout may adjust the stock options as long as it was not a cash buyout.

In general, there are nearly no good reasons for shareholders to retain short-term call options throughout the buyout process. This is due to the net win or loss already being attained prior to the completion of the buyout.

When the buyout occurs, and the options are restructured, the value of the options before the buyout takes place is deducted from the price of the option during adjustment. This means the options will become worthless during the adjustment if you bought out of the money options.

Outcomes for Vested vs. Unvested Options

• Vested Options: These are typically treated based on their intrinsic value. If the option is "in the money" (i.e., the strike price is below the buyout offer), the holder may receive a payout or converted equity. If "out of the money," the options may expire worthless.
• Unvested Options: These may be forfeited, accelerated, or assumed by the acquiring company. The treatment depends on the merger agreement and the underlying stock option plan.

Optionholders should carefully review their grant agreements for any provisions related to change of control events, including single-trigger and double-trigger acceleration clauses.

Types of Buyout Offers

• All-Stock Offer: Companies involved with a stock-for-stock merger have agreed to exchange shares based on a set ratio. The number of shares in a call option is updated, adjusting for the buyout value.
• All-Cash Buyout: This refers to a company bought for a cash price per share. In this case, the options are valued for a cash settlement of the effective date of the buyout.
• Stock Plus Cash Buyout: With this type of buyout, there is a change with the covered stock of the purchased company, the number of shares to be delivered, and a cash amount. For example, the buying company is swapping 1/2 of a share of the company plus $3 for each share of the company being purchased. Based on 100 shares, once the merger is finalized, a call option for the company that was bought would require the buying company to deliver 50 shares (of its shares) plus $300 ($3 x 100 shares) if the call is exercised by the buyer.
• Reverse Merger: This occurs when a public company acquires a private company. The result is the exchange of shares by the shareholders and management for a controlling interest in the company.

How Acquirers Typically Treat Options

Acquirers have several strategies for dealing with existing options:

1. Assumption: The acquiring company may honor existing options but convert them into options of the new company, adjusting strike price and number of shares.
2. Substitution: Similar to assumption, but the new options may be on different terms altogether.
3. Cancellation for Value: Some options are cashed out based on their intrinsic value at the time of acquisition.
4. Termination without Value: If options are far out of the money, they may be canceled with no compensation.

The acquiring company’s decision is typically based on legal requirements, the strategic value of retaining employees, and the financial structure of the deal.

Tax Implications of a Buyout on Options

The acquisition of a company can create several tax consequences for call option holders:

• Early exercise before acquisition may allow holders to benefit from long-term capital gains treatment if holding requirements are met.
• Cash-out scenarios are typically taxed as ordinary income on the gain between the exercise price and acquisition price.
• ISO (Incentive Stock Options) holders risk losing favorable tax treatment if options are not exercised in compliance with IRS guidelines.
• AMT (Alternative Minimum Tax) could apply if ISO holders exercise large quantities pre-acquisition.

It is recommended that holders consult with a tax advisor to navigate the implications based on their personal financial situation.

Liquidity Considerations for Private Company Options

In private company acquisitions, liquidity outcomes for call options can vary widely. If the acquiring company is public, the result may be a welcome liquidity event. However:

• If both companies are private, liquidity could be deferred, or stockholders might receive equity in the acquiring company without an immediate cash-out.
• Equity rollover provisions may apply, allowing optionholders to continue participation under the new entity’s equity compensation plan.
• Change-in-control payments may offer partial liquidity or bridge financing until shares can be sold.

Liquidity is often a key consideration for startup employees holding significant equity through options.

Frequently Asked Questions

1. What happens to call options when a company is acquired?
   If the call options are in the money, they may be cashed out or converted. If out of the money, they might expire worthless. Terms depend on the acquisition structure.
2. Are unvested options automatically forfeited in a buyout?
   Not necessarily. Some agreements include acceleration clauses, but others may result in forfeiture unless otherwise negotiated.
3. Will I be taxed on my options during an acquisition?
   Yes, especially if your options are exercised for cash or stock. The type of option and exercise timing affect whether it’s taxed as ordinary income or capital gains.
4. Can I exercise my options before the acquisition completes?
   Generally, yes, but doing so may impact taxes or your ability to benefit from any merger-specific terms. Consult your plan documents.
5. Do all call options convert to the acquiring company's stock?
   Not always. Some are canceled for value, some are assumed and adjusted, and others may be terminated without compensation, depending on their terms.

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