Michael T. Frank

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Converting Stock Awards in a Merger or
Acquisition July 12, 2006

• Michael T. Frank
• DLA Piper Rudnick Gray Cary US LLP
• 2000 University Avenue
• East Palo Alto, CA 94303
• [phone]
• michael.frank_at_dlapiper.com

Ellen N. Sueda Hewlett-Packard Company 3000
Hanover Street, MS 1050 Palo Alto, CA 43304 (650)
857-3984 ellen.sueda_at_hp.com
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What Do the Plans Provide?

• Targets Plan
• Does the Plan permit conversion of awards?
• Does the Plan permit early termination of awards
  that will not be continued?
• Are there notice or consent provisions?
• Buyers Plan
• Does the Plan provide for substitution of awards?

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Should Buyer Convert Awards?

• Determine the retention impact
• Part or full acceleration of vesting upon the
  change may impact retention planning
• Buyer may not want to convert options if there is
  no retention value

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Should Buyer Convert Awards?

• Consider tax impact
• The loss of qualification of ISOs with
  acceleration of options due to the ISO 100K
  limit
• Section 280G non-deductibility of certain
  accelerated awards and compensation
• Consider the number of former employees of Target
  who hold awards
• Securities held by a former employee may require
  additional securities filings

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Should Buyer Convert Awards?

• Non-U.S. jurisdictions
• Determine labor/employment laws, regulatory
  requirements, e.g., governmental filings, and
  foreign exchange requirements
• Determine if awardees subject to immediate
  taxation upon the change of control
• Consider Buyers policies concerning awards in
  various jurisdictions

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Retention

• Buyer may not want to convert awards that have no
  retention value, e.g., awards that have full
  acceleration of vesting upon a change of control
• Do not forget to review individual employment
  agreements or arrangements in addition to the
  plan and individual award agreements
• Consider the following
• Consent from key employees to amend awards to
  remove or modify acceleration of vesting
• If a cash deal, arrange for a holdback of award
  proceeds for key employees (do not forget about
  409A)

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Due Diligence

• A good due diligence list is important. It will
  remind you of the pitfalls and challenges of
  mergers and acquisitions!

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Assume or Substitute?

• Assumption Pros
• Preserves your share reserve
• Can grant assumed reserve shares, but not for
  employees of Buyer

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Assume or Substitute?

• Assumption Cons
• Multiple share buckets in multiple deals
• Awards treated as non-shareholder approved for
  201(d) table in proxy/10-K
• Additional overhang
• Form S-8 filing, including a prospectus
• Administration of another plans terms and
  conditions in addition to already existing plans
• Who will administer the plan and update
  prospectus?
• Different plan terms and conditions complicate
  any future communications
• Reserves and registration need to be tracked
  separately

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Assume or Substitute?

• Substitution Pros
• One share reserve
• May be able to harmonize rules (beware ISO
  modification and 409A)
• Report awards as shareholder approved in the
  proxy
• No separate Form S-8 filing
• No need to administer another plans terms and
  conditions however, if material terms are
  preserved and are different from regular option
  grant terms, then should be described in the
  prospectus and other communications (also, watch
  modification)

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Assume or Substitute?

• Substitution Cons
• Impacts existing share reserve
• Changing terms may require optionee consent and
  cause confusion to optionees

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Conversion Mechanics

• Preserve Aggregate Spread
• Typically, when applying the conversion ratio,
  round price up and round share number down
• Preserve Ratio of Fair market Value to Strike
  Prices
• Example
• Target holds an option to buy 100 shares _at_ 5
  per share. Target shares worth 10 at closing.
  Buyer shares worth 20 at closing. Target option
  becomes buyer option to buy 50 buyer shares _at_10
• Used to retain ISO status and avoid 409A problems

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Restricted Stock Specific Issues

• Does Plan require explicit assumption/assignment
  of forfeiture or repurchase right?
• Cash deal right to get cash?
• Securities law issue of treating shareholders of
  the same class of stock differently

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Employee Stock Purchase Plans

• Generally are terminated upon an acquisition
• Target should expect that its ESPP will be
  terminated and ensure that the plan document
  provides for mid-period termination

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Additional Issues to Consider

• ISO rules
• 409A compliance
• Earn outs
• Cash transactions
• Grant documentation (accounting or 409A issues?)

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ISO Issues

• Is there a 100K limitation issue?
• Will acceleration of options disqualify all or
  part of the option?
• Will there be any modification causing a
  disqualification?
• Conversion mechanics nearest whole cause a
  disqualification? E.g., rounding shares up or
  rounding strike price down
• If substituting, does Buyers plan provide for
  applicable ISO rules?

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Section 409A Issues

• Discounted stock options
• Option pricing history and methodology
• Reasonable valuation or safe harbor for stock
  valuation for private companies
• Modification of plans or stock awards after
  12/31/04
• Extension of exercise period?
• Faulty conversion?
• Repricing?
• RSUs with retirement features and/or deferral of
  equity awards

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Earn Out Issues

• Exchange of share right for earnout right?
• Including earn out right in option

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Negotiation Items

• Have Target revise non-compliant plans and
  arrangements, e.g., reprice or limit exercise on
  discounted options.
• Special Indemnity Escrow?
• Cover future compliance and other HR costs?
• Consider in light of Section 409A and recent
  option backdating issues
• Adjust purchase price by amount necessary to
  gross-up taxes, e.g., 409A or 280G, and cost of
  withholding/reporting, or include adjustments as
  part of the escrow arrangement.

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For Questions Please Contact

• Michael T. Frank
• DLA Piper Rudnick Gray Cary US LLP
• 2000 University Avenue
• East Palo Alto, CA 94303
• [phone]
• michael.frank_at_dlapiper.com