CEO Change-in-Control Package: 280G, 409A, and Gross-Up Design
Cedar Peak Software, a private company, is negotiating a change-in-control package for CEO Priya Raman. Her base salary is $650,000, her annual bonus target is 80%, and she holds unvested options with an intrinsic value of $1.8 million. The proposed agreement provides severance of 2.5× base plus 2× target bonus, immediate vesting of all equity, and a $300,000 gross-up for excise taxes. Cedar Peak is being acquired by a public company for $180 million. Priya owns 12% of Cedar Peak. The company also maintains a 409A nonqualified deferred compensation plan; Priya has deferred $400,000. The plan permits distribution upon a change in control only if the transaction is a 409A change in control. The deal is structured as an asset sale of substantially all assets. The compensation committee asks whether the gross-up is necessary and whether the deferred compensation can be paid at closing. Assume Priya's five-year average annual compensation is $1.1 million.
1. Calculate the approximate parachute payment and determine whether the proposed package exceeds the 280G safe harbor. What planning steps would you recommend?
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The 280G base amount is the average annual compensation over the five years ending before the change in control, given as $1.1 million. The safe harbor is three times the base amount, or $3.3 million. Parachute payments include the severance and bonus: 2.5 × $650,000 = $1,625,000; 2 × 80% × $650,000 = $1,040,000; plus immediate vesting of options with $1.8 million intrinsic value. That totals $4,465,000 before any gross-up. The excess parachute payment is approximately $4,465,000 − $3,300,000 = $1,165,000. The executive would owe a 20% excise tax of about $233,000, and the company would lose the deduction for the excess. The $300,000 gross-up is therefore not necessary if the agreement is cut back; it is being used to solve a problem created by the package. I would recommend either a "best net" cutback to $3.3 million or a private-company shareholder approval under §280G(b)(5). Because Cedar Peak is private and Priya owns 12%, the disinterested shareholder vote must be structured carefully before closing.
2. Can the $400,000 deferred compensation be paid at closing? Analyze under 409A.
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Section 409A permits payment on a change in control only if the plan defines the event in a manner that satisfies the 409A change-in-control rules: a change in ownership of the corporation, a change in effective control, or a change in ownership of substantial assets. An asset sale can qualify under the substantial-assets prong if the gross fair market value of the assets transferred is at least 40% of the total gross fair market value of the corporation's assets immediately before the transaction. A sale of substantially all assets for $180 million likely exceeds that 40% threshold, but the plan must expressly provide for payment on that event. Here the plan says payment is permitted only if the transaction is a 409A change in control, so the first step is to confirm the asset sale meets the 40% test and that the plan's definition is compliant. If it does, payment at closing may be permitted if the plan's timing rules allow it. If it does not, paying at closing would trigger immediate inclusion, a 20% additional tax, and interest. I would not rely on the closing date alone; obtain 409A counsel's certification and amend only prospectively if needed.
3. Recommend changes to the CEO's change-in-control agreement to manage cost and tax risk.
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The agreement should be redesigned around three choices: trigger, amount, and tax protection. Use a double trigger - severance and vesting only on a qualifying termination within a defined period after the change in control - rather than immediate vesting at closing. That reduces the parachute payment and keeps the CEO focused through integration. Replace the gross-up with a cutback to the 280G safe harbor or a "best net" analysis that pays the higher after-tax amount. If the company wants to preserve the full package, seek the private-company shareholder approval exemption before closing, with adequate disclosure and a disinterested vote. For the deferred compensation, conform the plan's change-in-control definition to 409A and specify a permissible payment date, such as closing or a fixed date thereafter. Finally, coordinate the equity vesting with the 280G calculation so the compensation committee sees the total cost before signing.