Best Practices in Change of Control

May 1, 2006

3 Min Read
Best Practices in Change of Control

Originally Published MX May/June 2006


Many financial advisers recommend that companies have change-of-control agreements in place. Although the programs can vary widely in their terms, there are several basic issues that need to be addressed.

Eligibility. Executives who are likely to lose their jobs following a merger and those who are needed to complete a deal should be eligible for a change-of-control program. Companies might also consider employing change-of-control or retention programs for the following employees.

  • Employees who are critical to the continued operation of the business.

  • Employees who a potential purchaser would view as important to future growth.

  • Employees who would be difficult or expensive to replace.

  • Employees whose departure would place a significant strain on remaining employees.

    Definitions. The definition of change of control needs to be clearly articulated in an agreement and should be specific enough to account for various circumstances, such as selling assets or a significant business unit of the company. Companies should be aware that Internal Revenue Code Section 409A, which imposes penalties for deferred compensation agreements that violate its terms, provides its own definition for a change of control. Agreements that don't satisfy its terms could result in additional taxes being imposed on the payment recipients.

    Triggers. Companies often find it best to employ a double-trigger approach in their agreements, meaning a change-of-control agreement only goes into effect if the executive is terminated during or following the change of control. Most acquiring companies do not want executives to be able to pull their own triggers and resign from the company. A single-trigger agreement allows the executive from the acquired company to automatically receive severance after the change of control occurs, making it difficult for the acquiring company to retain the person.

    Length of Executive Protection. It is fairly common for executives to be protected under their change-of-control agreements for a 12- to 24-month period. This protection period ensures that the executives will receive severance if involuntarily terminated after the change of control.

    Appropriate Severance. It often makes best sense to have three or four tiers of severance in change-of-control programs, depending on the company's size and the number of eligible employees. The first and highest tier applies to the CEO, and the severance multiple can range from 2 to 3 times the executive's annual base salary and bonus. The next tier covers the chief financial, operating, scientific, and possibly other executive officers. The tier below that covers senior vice presidents, with the lowest tier applying to a select number of vice presidents. The severance package for this lowest tier is usually 1 to 1.5 times an executive's base salary and bonus. The amount of benefits coverage typically corresponds to the severance period. For example, an executive with a severance multiple of 2 would receive two years of healthcare coverage.

    There is no definitive figure as to what percentage of the total sale price severance should represent. However, a percentage greater than 5% might deter potential buyers.

    Gross-Ups. Excise taxes will be applicable if total severance, including fringe benefits and option acceleration payments, exceeds 3 times the executive's base amount, defined as the average annual taxable compensation paid to the executive over the five years before the change-of-control year. The prevalence of gross-ups, in which the company pays all excise taxes on behalf of the executive, varies among companies. Advantages of gross-ups include motivating the executive to sell the company for the highest price. The disadvantages include the high potential cost and unfavorable scrutiny from both the acquiring company's and seller's shareholders. There are ways to design gross-up programs that can limit executive or company costs.

    Copyright ©2006MX

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