Dear CEO: Congratulations on signing the letter of intent to sell your company (a corporation or an entity treated as a corporation for tax purposes)! You've agreed on terms for your go-forward employment with the buyer, your board of directors has agreed to accelerate the vesting of your stock options, and you've been promised a retention bonus. It's all smooth sailing from here ... except there's a relatively obscure section of the U.S. tax code—Section 280G, adopted during the "Barbarians at the Gate" takeover era in the 1980s—that could put a significant portion of any compensatory payments you are receiving in the deal at risk of a large excise tax and prohibit the buyer from taking a tax deduction for that portion of the compensation they are paying you.

The good news is that there is a workaround that privately held companies can use to avoid that tax. By obtaining a "cleansing" vote from more than 75 percent of your stockholders (those who are eligible to vote on the matter— more on that later), you can avoid the excise tax and the buyer can take the tax deduction for your compensation. However, there is a catch (and here's the part you are going to really hate): to take advantage of this cleansing vote, you are going to have to put that portion of your compensatory payments at risk of complete forfeiture, and every single one of your stockholders (yes, even the former employee who exercised options and left on bad terms and is now working for a direct competitor) will know exactly what kinds of compensatory payments you are getting in the deal.

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Mergers and acquisitions can be a lucrative and exciting way to achieve liquidity for the founders, investors, and management of a tech startup. However, behind the scenes, there are myriad laws, regulations, and tax issues that can be challenging— and even demoralizing —for seller management teams to handle. One of these challenges, and one to which management most often fails to pay attention until late in the deal process, is the application of Section 280G of the U.S. Internal Revenue Code (the Code), commonly referred to as the "golden parachute" rule.

Section 280G was introduced in the 1980s as a way to curb perceived abuses and limit excessive executive compensation at the expense of shareholders during public company takeovers. Not surprisingly, Section 280G is a complex web of substantive and disclosure rules that seller management teams find daunting. Care must be taken to follow all the specific nuances of Section 280G.

Summary: Section 280G and a related section of the Code impose 20 percent excise taxes on "excess parachute payments" made to "disqualified individuals" (generally officers, 1 percent of the most highly compensated service providers, and 1 percent of stockholders, including vested options) and provides for a loss of tax deduction for "excess" compensatory payments made in connection with a change-of-control transaction. These excess payments do not typically include payment for stock owned by the disqualified individuals or vested options granted more than one year before the change of control, but they do pick up payments contingent on the change of control as well as any new or increase in compensation entered into in connection with the transaction, such as a new employment package and any new or increase in compensation provided to the disqualified individual within the 12 months prior to the change of control.

How does Section 280G work?1

Section 280G disallows a tax deduction by the payer for any excess parachute payment made in connection with a change of control of a corporation (or an entity treated as a corporation for tax purposes). A related provision, Section 4999 of the Code, subjects a person who receives an excess parachute payment to a 20 percent excise tax (in addition to other taxes) on that amount. Sections 280G and 4999 do not apply to all persons receiving payments in connection with a change of control and only require analyzing payments made to certain disqualified individuals.

(For the purposes of this article, we are going to use "change of control" to mean the sale of the corporation through a merger or stock sale, though the phrase can cover more ground as a technical matter under the Code, and these provisions can be triggered by certain changes of effective control or asset sales.)

An excess parachute payment is the amount by which any parachute payment made to an individual exceeds the applicable "base amount" allocated to that individual.

This set of rules applies to excess parachute payments made to disqualified individuals, a highly technical analysis that includes examining employees or consultants who, at some point during the 12-month period prior to and ending on the closing date of the transaction, have been officers (either by title or by having the authority of an officer) or directors (in some cases) of the corporation; own 1 percent or more of the corporation's stock (including vested options) based on fair market value; or were in the 1 percent of the mostly highly compensated individuals of the corporation. This may implicate former service providers. There are other nuances to these categories in order to determine who is considered a disqualified individual, but you get the idea.

Generally, a parachute payment is a payment or benefit payable to a disqualified individual that (i) is in the "nature of compensation," (ii) is contingent on a change of control, and (iii) together with other payments ascribed to the same individual has an aggregate present value of at least three times the disqualified individual's base amount (the parachute threshold). If the value of the parachute payments is below the parachute threshold, there is no Section 280G issue. If the value of the parachute payments exceeds the parachute threshold, Section 280G is triggered and all parachute payments over the base amount are considered excess parachute payments.

Remember that three and five: the calculation is three times the base amount, and the base amount is the average of the prior five taxable years' compensation.

Calculating the base amount can be a bit complicated, but basically, the base amount is the person's average annual compensation for services performed for the corporation with respect to which the change of control occurs that was includible in the individual's gross income for the most recent five taxable years (or a shorter period of service with the corporation) ending before the date of the change in control.

The parachute payments are a combination of payments or benefits payable made (i) that are considered contingent on a change of control (such as a sale bonus or new compensation from a buyer) and generally measured at full present value and (ii) that become vested as a result of a change in control (for example, accelerated vesting of a stock option), though it is possible to include only the value of the payment that is contingent on the change of control. There are all kinds of payments that could potentially fall into this category: retention bonus, carve-out plan payments, stay bonus, severance payments (even if not triggered), increases in go-forward compensation or new compensation payable by the buyer, acceleration of option vesting, etc. Further, compensation granted within the year prior to the change of control counts too— such as option grants made during that period, or potentially any new or increase in compensation, even if in the normal course of business.

The fix: A 75 percent cleansing vote of shareholders

For a private, venture-backed company, the most common approach to dealing with Section 280G and avoiding the excise tax and loss of tax deduction for excess parachute payments is to obtain significant shareholder approval for the payments themselves. Since the whole point of Section 280G was to align the interests of management and shareholders, it makes sense that supermajority shareholder approval should serve as a safety valve for the severe penalties under Section 280G.

So, what does it take to cleanse the excess parachute payments by shareholder approval?

  • The voting threshold is at least 75 percent of shareholders eligible to vote immediately prior to the change in control (or earlier if a different record date is selected under the Section 280G requirements), excluding those shareholders with excess parachute payments.
  • In order to take advantage of the cleansing vote process, the disqualified individuals need to irrevocably waive their rights to the excess parachute payments prior to seeking shareholder approval. Members of management find the dreaded waiver to be absolutely frightening. If the vote fails, they don't receive any payments that exceed the parachute threshold, period.
  • The vote is to approve the payments themselves. The vote cannot be coerced by combining it with the vote on the change of control of the company. In other words, a shareholder can vote to approve a merger and vote no on the excess parachute payments.
  • The vote cannot be coerced through a drag-along or locked in through a voting agreement.
  • The vote is sought through a detailed, written information statement that must be provided to all shareholders. The information statement provides, in uncomfortable detail, the payments being made to the disqualified individuals and other information about the transaction.

To add even more complexity to the voting process, some "entity shareholders" on the cap table would need to obtain the vote of more than 75 percent of the voting power of the entity shareholder's owners— if the value of the shares of the company being sold equals or exceeds one-third of the total gross fair market value of all the assets of the entity shareholder without regard to any liabilities associated with such assets and the entity shareholder owns more than 1 percent of the total value of the corporation undergoing the change of control.

Seeking and obtaining the cleansing vote can add time, complexity, and uncertainty to the transaction. It may impact some but not all entities in a corporate structure, so it requires analyzing the entire corporate structure. Coordinating with many stockholders and dealing with look-through votes can add delays to an already complex M&A process. Getting the attention of a disparate group of stockholders and convincing them to vote in favor of compensation packages when it is often against their personal interests to do so can be quite a challenge. Buyers may get nervous about the uncertainty introduced by the vote as well. However, buyers often will require a seller to seek a shareholder cleansing vote as part of the transaction documents.

Other mitigation strategies include limiting parachute payments to avoid exceeding the three-times base amount or parachute threshold, treating certain payments as consideration of a noncompete (and obtaining a noncompete valuation), treating certain payments as "reasonable compensation" under the Section 280G rules, or, in an extremely rare case, paying the excise tax and losing the deduction.

Challenges and frustrations for seller management teams

  1. Complex calculations: Determining what constitutes a parachute payment, the value of a parachute payment, and the base amount requires specialized expertise and a substantial amount of data (including W2s for five years for each disqualified individual). Even determining who is and who isn't a disqualified individual is complex. All of these determinations involve professional judgment calls and perhaps negotiation between the buyer's and the seller's experts. Buyers are often extremely conservative in their views on these determinations, since they value the tax deduction. This complexity adds another layer of cost and bureaucracy to the deal-making process.
  2. The waiver is frightening: As noted above, the primary mitigation strategy is to seek supermajority shareholder approval of the payments and waive any excess parachute payments that are not approved. The waiver is a frightening instrument, especially if presented to an executive late in the process and if the executive has not been involved in the negotiation of the transaction. Many a late-night conversation has been had with frightened and angry executives about the waiver.
  3. The waiver is frightening for a good reason— the vote might fail: While rare, it is certainly possible that the cleansing shareholder vote may not be obtainable, particularly if the seller's cap table is heavily weighted toward former members of management, departed founders, unhappy investors, and others who may skeptical of current management receiving compensation other than in respect of their shares. Alternatively, if there is a large shareholder base and many small shareholders are needed to get to the more than 75 percent approval, there are timing considerations for obtaining the vote.
  4. Talent drain: Retaining key executives is crucial for the stability and continuity of the acquired company. Section 280G can disrupt this process, as executives might perceive the excise tax as a penalty for staying on after the transaction. This perception alone can lead to a talent drain, as executives may opt to leave the company rather than put their compensation at risk.
  5. Section 280G hits tech startups particularly hard: Management teams of tech startups often receive cash compensation that is less than what they would get from larger companies, particularly in the early stages of a company's life. Thus, the base amount calculation, which looks at a five-year average of compensation against which to measure the parachute payments, can feel unfair to startup management, especially if they are not receiving large compensatory payments in the deal.
  6. Dealing with Section 280G is expensive and time-consuming: Compliance with Section 280G requires extensive review, analysis, documentation, and reporting. This process distracts members of the management team (particularly finance and human resources) from other transactions and business functions. Section 280G compliance and mitigation can slow down the transaction timeline, particularly in the crucial days before signing the deal, and contribute to the overall frustration felt by seller management teams.

Meeting the challenges

Here are a few ways to address these challenges:

  1. Start early: Include Section 280G compliance in the early stages of the due diligence and negotiation process. Bring on the tax and legal advisors early in the process. Gather the W2 information and other data needed to conduct the complex legal analysis.
  2. Communicate early, clearly, and often: Transparent communication with affected executives about the potential impact of Section 280G is crucial. Explaining the rationale behind the rule and how the company plans to navigate its provisions can help ease concerns and retain key talent. Consider having an orientation session with the disqualified individuals to walk them through the process. Early awareness of the potential implications can provide seller management teams with the necessary time to strategize and negotiate effectively and become more comfortable with the issues and process. We guarantee that leaving these discussions to the last minute will be a recipe for fear, uncertainty, and doubt, resulting in emotional rather than rational reactions.
  3. Have a clear understanding of the cap table: Understand which votes are obtainable, which shareholders may need look-through votes, and who might be problematic for approvals.
  4. Plan the cleansing vote process: Careful planning and clear, convincing messaging are essential to obtaining the cleansing vote. The process should include analyzing which shareholders may need a pass-through vote of their own, and getting to those shareholders early in the process to streamline the vote. Often a chairperson of the board or a lead investor can be helpful in shepherding the vote.

While Section 280G may have been adopted with lofty goals of protecting shareholders against rapacious public company management, its complex provisions often leave tech startup management teams grappling with uncertainties and challenges during the rush of M&A deals. However, with careful planning and early and frequent consultation with legal and tax experts, seller management teams can be prepared and armed with strategies to navigate the complexities of Section 280G and take steps to mitigate the adverse tax consequences.

Footnote

1. As complex as the issues we discuss are, by focusing on changes of control of U.S. corporations (and entities taxed as corporations), we are avoiding describing the additional complexity of analyzing whether changes of control of partnerships, limited partnerships, limited liability companies, or foreign entities require Section 280G analysis. If you need to go down that particular rabbit hole, please give us a call.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.