Commentary: Executive compensation and M&A: When you’re the buyer

Rising costs, lower prices and market skepticism have led to a decrease in mergers and acquisitions (M&A) throughout the mining sector, but economic circumstances may force a number of mining companies to sell off their companies and/or assets within the near future. The flip side is that there could be some good opportunities for companies wishing to expand their operations or holdings.

In my earlier articles, “Executive compensation and M&A: Preparing for selloffs” (T.N.M., Aug. 19–25/13) and “Executive compensation and M&A: How not to get burned in a fire sale” (T.N.M., Sept. 2-8/13), I outlined why we might see a rise in M&A activity in the mining sector and how executive compensation should be managed when selling a company. This third and final article will address how you should approach executive compensation when considering a corporate purchase or merger.

Most often M&A activity occurs to increase value in an organization, and executive compensation is rarely a deal-breaker. However, your company could find itself in trouble if it neglects compensation-related issues as part of its due diligence. As corporate governance and executive compensation gain increasing media, government and shareholder attention, your company needs to include these elements in its pre-transaction activities to make sure you avoid any unforeseen or future problems.

If your company is looking to take advantage of potential deals and contemplating a merger or acquisition, there are a number of things that you should be aware of. Executive contracts and compensation plans can be incredibly complex, and when dealing with executive compensation, most often, the devil is truly in the details. Target-company legacy plans or employment contracts should be evaluated for elements that could catch you, the buyer, off guard. Executive change-of-control provisions should be reviewed closely to ensure that your company is comfortable with any pending golden parachutes.

Last year we witnessed a number of executive exits that had hefty associated price tags. When Barrick Gold determined it wanted a new CEO, Aaron Regent received an exit package of approximately US$12 million, and to fill the position, Barrick paid incoming CEO Jamie Sokalsky approximately $11.3 million in his first year.

In addition, outgoing Kinross Gold CEO Tye Burt received more than $16 million in 2012; and this year, Xstrata’s then-CEO Mick Davis was kept on after the Glencore purchase, only to receive a £9.6-million severance after being let go six months after the purchase.

Media, governments and shareholders are closely monitoring such payments. So understanding, preparing for or avoiding large payouts will definitely help your company steer clear of potential public-relations and stakeholder activist nightmares.

Your company should also review the target company’s pension and benefit plans to understand how they may affect the overall value of the purchase. Pensions can be significant liabilities if they haven’t been managed or funded properly. If the target company has defined-benefit plans, make sure they are fully funded; if it has defined-contribution plans, ensure they are transferable; and if group plans are in place (normally in union-affiliated organizations), purchasers should be fully aware of the liabilities associated with terminating or augmenting such plans.

If it is your intention to keep executive talent, it is advised that your company conduct a compensation and pay-for-performance analysis on the executive team. It is important to understand if the operation you are acquiring is a premium or substandard payer relative to the market. As well, you should know if its historical pay practices align to its realized performance levels.

Pre-acquisition, you will not change the pay practices of the target firm, but understanding the pay practices will enable you to prepare for future adjustments as well as understand the corporate culture you are acquiring and how it may or may not blend with your firm. Some companies consider themselves to be highly competitive, high-paying organizations, while others are comfortable being market-level, median-paying organizations. Studying pay practices ahead of time will enable your board to align the pay philosophies and the practices of the two organizations over time. Pay-for-performance analysis will ensure you are getting value for your money and that the team’s historic compensation has been properly aligned with its performance. An added benefit is that such assessments will help identify individual performance problems and/or areas that should be improved. Knowing this ahead of time enables your board to focus on inadequacies and highlight areas for improvement in the post-transaction, performance-management agreements.

If your intention is to retain much of the acquired corporate expertise, you can mitigate the potential flight of key executives by negotiating retention incentive plans up-front. This type of plan would guarantee a payout after the executives remain in their roles for an agreed number of years.

When acquiring or merging with another organization, your board will have to determine how it will harmonize the equity plans that exist in the two organizations, as well as determine how exiting equity holdings should be handled in the acquired organization. If your company wants to keep existing executives and/or directors, future equity payouts and equity conversions should be assessed to determine how the merger or acquisition activity will impact the equity stakes of the target company.

Consider making pre-arrangements to exchange existing executive and outstanding director equity in the old company, on a tax-deferred basis, for rights to acquire shares of the newly merged corporation. If this is a consideration, one aspect of a pre-deal analysis should include confirming that the equity in the company — be it options or shares — can be properly exchanged on a tax-deferred basis. Sudden vesting of past grants and exercising equity can trigger substantial tax hits. Consequently, we advise that you seek expert advice on the tax impacts of the transaction.

As outlined in my previous article, both cash-based compensation plans and share swaps are fairly straightforward and can be easily settled. All cash-based holdings — such as phantom shares, phantom options or units — must be settled in cash and taxed accordingly. Shares can be swapped on the basis of equal value and retained under existing or predetermined vesting periods to defer tax and maintain the vesting schedules of legacy plans. However, if shares are cashed in or purchased, the settled amount will be taxed at marginal tax rates.

Options on the other hand can be problematic if large portions are “underwater.” Canadian law recognizes that there was a time value included in the calculation of the original grant. Due to this issue — as well as constantly changing tax laws — you should seek expert advice to fully understand all of your rights in dealing with outstanding options.

On a more personal note, your organization has invested significant resources in attracting, developing and retaining your senior executive team. If a purchase is approved, the scope of your operation will likely change. Therefore, if warranted, your company should consider establishing new employment contracts and performance agreements. Doing so will signal to your executives that you recognize that their workloads and responsibilities will change, and that you’re committed to ensuring they are competitively compensated for their efforts.

Compensation levels should be market competitive, and, if appropriate, reflect a newly adjusted comparative peer group. Once fair compensation levels are defined, your company should reassess its executive short- and long-term incentive plans to ensure that executive interests are aligne
d with the interests of your shareholders. New metrics and targets may have to be introduced, but it is important that the performance expectations and long-term objectives be (re-)established, made clear to all executives and stakeholders and be seamlessly maintained throughout the expansion.

Shareholders have become increasingly demanding, but compensation governance doesn’t have to be a topic of contention. If you conduct your due diligence up-front, manage executive compensation and avoid pitfalls like those mentioned above, it will undoubtedly enhance the value of your acquisition or merger and lay a solid foundation for a pain-free transaction.

— Bradley Kelly is a Partner at Global Governance Advisors, an independent board advisory firm with offices in Toronto, Calgary, New York and Miami. He specializes in performance goal setting and the strategic review, valuation and innovative design of executive compensation and corporate governance programs. He can be reached at (416) 707-4614, or brad.kelly@ggovernanceadvisors.com. Follow Brad on Twitter @BradKellyGGA. For more information, visit http://ggovernanceadvisors.com.