Mergers and acquisitions (M&A) are complex transactions where numerous financial and structural elements influence the valuation and final deal structure. One often overlooked but crucial factor is the treatment of employee option pools. In particular, option pools can significantly impact valuation, especially in hybrid transactions where sellers are not fully exiting but engaging in a secondary sale.
This article explores the role of employee option pools in M&A transactions, their impact on valuation metrics, and the key negotiation considerations for both buyers and sellers.
Pre-Money vs. Post-Money Valuation
One of the primary ways option pools affect valuation is in how they are accounted for in pre-money and post-money valuations.
Key Considerations:
- If a company is being valued on a fully diluted basis, the unallocated option pool is generally included in the equity value. This is because unallocated options represent potential future dilution, which impacts ownership structure.
- In venture capital (VC) deals, investors typically prefer to include the unallocated option pool in the pre-money valuation rather than the post-money valuation. This effectively lowers the founders’ ownership percentage, ensuring that future employee stock issuances do not dilute the investor's stake.
- In M&A transactions, the treatment of option pools varies depending on how the buyer values the pool and whether they intend to retain it for future incentives.
Impact on Enterprise Value (EV)
Enterprise value (EV) is one of the most fundamental valuation metrics in M&A. It reflects the total value of the company,including its debt and excluding excess cash. However, the treatment of optionpools in the context of EV requires careful analysis.
How Option Pools Affect EV:
- EV is independent of the option pool since EV represents the entire firm’s value before considering its ownership structure.
- Unlike equity value, which accounts for stock dilution, EV does not typically include the option pool separately.
- However, when transitioning from EV to equity value, any outstanding options—both allocated and unallocated—affect the fully diluted share count. This, in turn, influences the final per-share purchase price, making it a critical aspect of deal negotiations.
Negotiation Considerations and Treatment in M&A Transactions
The treatment of employee option pools in an M&A deal can be a significant factor in determining the final purchase price and equity allocation. Different buyers have different approaches to handling unallocated option pools, and sellers need to be aware of the implications.
Key Negotiation Factors:
- Retention of Option Pools Post-Transaction
- If the buyer plans to retain the existing unallocated option pool for future employee incentives, they will likely include it in the fully diluted equity calculation.
- This approach ensures that the acquirer does not need to create a new option pool post-transaction, which could otherwise lead to unexpected dilution.
- Exclusion of Unnecessary Option Pools
- If the option pool is deemed unnecessary after the transaction (e.g., if key employees are leaving or the company’s hiring strategy is changing), the seller may negotiate to have the unallocated portion excluded from the valuation.
- This adjustment can benefit sellers by increasing the equity value and per-share purchase price.
- Adjustments to the Purchase Price
- In some transactions, unallocated options are treated as potential liabilities rather than assets, leading to a reduction in the purchase price.
- Buyers may seek to adjust the valuation downward to account for the cost of future option grants if the pool is expected to be replenished post-closing.
Final Thoughts: Structuring a Favorable Deal
The treatment of employee option pools in M&A transactions is a nuanced issue that requires careful negotiation. Whether you are a founder, investor, or employee, understanding how these pools affect valuation can help you structure a more favorable deal.
Key takeaways:
- In VC deals, unallocated option pools are typically included in pre-money valuation, reducing founder equity.
- In M&A, option pool treatment varies based on buyer strategy—whether they plan to retain, exclude, or adjust the valuation based on unallocated options.
- The transition from EV to equity value means that any outstanding options, allocated or unallocated, will impact the final per-share price.
- Careful negotiation around option pool treatment can significantly influence both the total transaction value and individual ownership outcomes.
If you’re considering an M&A transaction, it’s crucial to work with financial and legal advisors to ensure that the treatment of your employee option pool aligns with your overall deal objectives.
