FASB Interpretation No. 44 (“FIN 44”) governs the accounting treatment of stock options in business combinations, among other transactions involving stock compensation. We focus our discussion here on the application of FIN 44 to business combinations. FIN 44 applies largely to stock deals because in cash deals, options are typically cashed out or canceled.
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In a business combination, vested stock options or awards issued by an acquirer in exchange for outstanding awards held by the target’s employees are considered to be part of the purchase price and accounted for under FAS 141r. Accordingly, the fair value of the new replacement awards are included in the purchase price.
Unvested stock options or awards granted by an acquirer in exchange for stock options or awards held by the target’s employees are considered part of the purchase price, with the fair value of the new replacement awards included in the purchase price. However, to the extent that continued employee service subsequent to the acquisition date is required for the replacement awards to vest, a portion of the intrinsic value (if any) of the unvested replacement awards is allocated to unearned compensation. The amount allocated to unearned compensation is based on the portion of the intrinsic value at the acquisition date related to the future vesting (service) period, and is calculated as follows:
| Unearned compensation |
= | Remaining vesting period | × | Intrinsic value of unvested target options |
| Total vesting period |
Unearned compensation is recorded as an asset on the balance sheet and amortized as compensation expense over the remaining
future vesting (service) period for accounting purposes.
The intrinsic value of a call option is MAX(0, P−X), where X is the strike price and P is the underlying stock’s price. If the unvested options have no intrinsic value (if they are out-of-the-money) on the acquisition date, no compensation charge is recorded going forward.
Acquirers can avoid FIN 44 compensation charges by either vesting all of the unvested options immediately, or by canceling the options and issuing new acquirer options to the target at the current fair market value. Changing the option plan prior to a transaction, however, would not avoid FIN 44.
For tax purposes, FIN 44 compensation charges are deductible to the company if the options are non-qualified options, but are not deductible if the options are incentive stock options.
The entire fair value of the vested options is included in the purchase price to be allocated to the assets acquired. However, the purchase price will include only the portion of the value of the unvested options equal to the fair value of such options less any allocation to unearned compensation.
When stock options include an automatic vesting provision so that the options vest automatically upon a change in control, the acquirer avoids FIN 44’s compensation charges that would otherwise drag down earnings in periods following the transaction. However, automatic vesting upon a change in control can make employee retention more challenging for the acquirer.
Suppose Alpha wants to acquire Tango, whose current stock price is $12.81. Tango has three tranches of unvested options outstanding as show in the spreadsheet below.
(A) What is the annual compensation expense that must be recognized post-acquisition under FIN 44 at hypothetical acquisition prices of $13.00, $14.00, and $15.00 per share?
(B) Now, suppose that Tango also has 476,000 vested options outstanding with a weighted-average strike price and remaining term of $29.49 and 2.7 years, respectively. The volatility of Tango’s stock price is 60%, the dividend yield is 0%, and the risk-free rate is 4%. What are the fair values of Tango’s vested and unvested options?
(C) If Alpha acquires Tango for $14.00 per share, what value should be added to the purchase price to account for Tango’s vested and unvested options? What value should be recorded as unearned compensation on the combined company’s pro forma balance sheet?
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For part (C), $1.3 + $6.6 − $0.4 = $7.6 is included in purchase price. $0.4 is added to the pro forma balance sheet as an unearned compensation asset.