PRIVILEGED & CONFIDENTIAL — ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT
MEMORANDUM
Date: August 10, 2022
From: Sandra Okafor, Counsel, Corporate/M&A, Calderwood & Harkness LLP Devon Archer, Associate, Labor & Employment, Calderwood & Harkness LLP
To: Bernard Crawford, Partner, Labor & Employment, Calderwood & Harkness LLP Aaron Whitfield, General Counsel, Arbor Health Technologies Inc.
Re: Equity Award Structuring for Dr. Marcus J. Elliston Under AHT 2020 Equity Incentive Plan (as Amended May 2021)
Matter No.: 1010-00004
Client No.: 81-30294
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I. Executive Summary and Purpose
This memorandum analyzes whether the AHT 2020 Equity Incentive Plan (as amended May 2021) (the "Plan") has sufficient capacity to accommodate the proposed equity grants to Dr. Marcus J. Elliston in connection with his prospective engagement as Chief Operating Officer of Arbor Health Technologies Inc. ("AHT" or the "Company"). This memorandum further addresses the terms under which such awards should be structured for compliance with the Plan, applicable tax requirements, and the contractual obligations of AHT and its stockholders.
The proposed grants to Dr. Elliston consist of two components: (i) stock options representing 1.25% of the fully diluted equity of AHT, and (ii) restricted stock units ("RSUs") representing 0.50% of the fully diluted equity of AHT, for an aggregate equity allocation of 1.75% of the fully diluted capitalization. These grants are intended to serve as a material component of the total compensation package being assembled to recruit Dr. Elliston from his current position, and are informed by market benchmarking data provided by AHT's compensation consultant.
In addition to Plan capacity and award structuring, this memorandum addresses the required consents and approvals from Ridgeline Capital Partners, LP ("Ridgeline"), which serves as the majority private equity sponsor of AHT and holds approximately 68% of the Company's equity, and Helix Ventures Fund III, LP ("Helix Ventures"), a minority investor holding approximately 14% of AHT's equity. These consent requirements arise under the Ridgeline Capital Partners Stockholders' Agreement dated December 20, 2019 (as amended, the "Stockholders' Agreement"), which governs the rights and obligations of the Company's principal equity holders.
Background. AHT is a Delaware corporation headquartered at 400 Brattle Commerce Park, Suite 1200, Cambridge, MA 02138, Employer Identification Number 84-3297461. The Company operates as a healthcare services and software-as-a-service ("SaaS") business, providing a cloud-based clinical workflow and revenue cycle management platform to hospitals, health systems, and physician practice groups across the United States. AHT currently employs approximately 620 individuals across its Cambridge headquarters, regional offices, and remote workforce. For the fiscal year ended December 31, 2021, the Company reported annual revenue of approximately $127.4 million, representing year-over-year growth of approximately 22% from fiscal year 2020.
AHT was acquired by Ridgeline Capital Partners Fund IV, LP ("Fund IV"), a $2.8 billion private equity fund managed by Ridgeline Capital Partners, LP, in a take-private transaction that closed on December 20, 2019 at an enterprise value of approximately $340 million. Since the acquisition, AHT has operated as a privately held Delaware corporation, with Fund IV and its affiliated co-investment vehicles holding the majority of the Company's equity and Helix Ventures and members of AHT management holding the balance.
Documents Reviewed. In preparing this memorandum, we have reviewed the following documents and materials:
• AHT 2020 Equity Incentive Plan, as originally adopted (February 14, 2020), and the First Amendment thereto (adopted May 18, 2021) (collectively, the "Plan");
• AHT Amended and Restated Certificate of Incorporation, filed with the Delaware Secretary of State on December 20, 2019;
• AHT Amended and Restated Bylaws, adopted December 20, 2019;
• Ridgeline Capital Partners Stockholders' Agreement, dated December 20, 2019, by and among AHT, Ridgeline Capital Partners Fund IV, LP, Helix Ventures Fund III, LP, and the other stockholders party thereto (the "Stockholders' Agreement");
• Employment Agreement between AHT and Priya Chandrasekaran (Chief Executive Officer), dated January 15, 2020 (the "CEO Employment Agreement");
• Employment Agreement between AHT and Derek Solano (Chief Financial Officer), dated March 1, 2020 (the "CFO Employment Agreement");
• Internal equity grant term sheet for Dr. Marcus J. Elliston, circulated by Aaron Whitfield on July 18, 2022 (the "Internal Term Sheet");
• Broadleaf Compensation Advisors LLC Peer Benchmarking Report, dated June 2022 (the "Broadleaf Report") — this report was referenced by AHT management in developing the Internal Term Sheet but was not produced by Calderwood & Harkness LLP; and
• Miscellaneous Board and Compensation Committee minutes related to prior equity grants under the Plan.
The foregoing documents were provided to us by AHT's regular outside corporate counsel, Wentworth & Gage LLP (Richard D. Gage, Partner, 125 High Street, Suite 2800, Boston, MA 02110), with the exception of the Internal Term Sheet, which was provided directly by Aaron Whitfield, and the Broadleaf Report, which we have not reviewed in full but which has been described to us by AHT management.
This memorandum does not address the terms of Dr. Elliston's Employment Agreement, which is the subject of a separate memorandum prepared by Devon Archer and Bernard Crawford, nor does it provide a comprehensive Section 409A analysis, which is being prepared by Gregory Tan, Partner, Tax Group, Calderwood & Harkness LLP, and is expected to be delivered on or about August 22, 2022. Devon Archer's change in control analysis memorandum, dated July 28, 2022, is cross-referenced herein where relevant.
II. Overview of the AHT 2020 Equity Incentive Plan (as Amended May 2021)
A. Plan Adoption and Amendment History
The Plan was originally adopted by the AHT Board of Directors (the "Board") on February 14, 2020 and approved by the Company's stockholders by written consent on the same date, effective as of the closing of the Ridgeline take-private transaction. The Plan was designed to provide equity-based compensation to officers, employees, directors, and consultants of the Company and its subsidiaries in order to attract, retain, and incentivize key personnel in connection with the Company's operations as a privately held portfolio company of Ridgeline Capital Partners.
On May 18, 2021, the Board adopted, and the stockholders approved by written consent, the First Amendment to the Plan (the "May 2021 Amendment"). The May 2021 Amendment made several material modifications to the Plan, including:
• An increase in the aggregate share reserve from the original level of 3,000,000 shares to 4,200,000 shares of AHT common stock, par value $0.001 per share, authorized for issuance under the Plan;
• The addition of RSUs as an expressly authorized award type under the Plan (the original Plan authorized incentive stock options, nonqualified stock options, restricted stock, stock appreciation rights, and other stock-based awards, but did not specifically enumerate RSUs as a distinct award category);
• Modifications to the share counting mechanics to clarify the treatment of shares withheld for tax withholding purposes; and
• Technical amendments to conform certain Plan provisions to updated guidance under Section 409A of the Internal Revenue Code of 1986, as amended (the "Code").
The Plan is administered by the Compensation Committee of the Board (the "Compensation Committee"). As currently constituted, the Compensation Committee comprises three members: Thomas R. Glenwood, who also serves as Board Chair and is a Managing Partner of Ridgeline Capital Partners, LP; Jennifer M. Torres, a Ridgeline Capital Partners Vice President who serves as a Ridgeline Board designee; and Dr. Anand Krishnamurthy, an independent director appointed to the Board in connection with the Company's healthcare regulatory compliance needs. Given that two of the three Compensation Committee members are Ridgeline designees, any action by the Compensation Committee effectively requires the concurrence of Ridgeline's representatives, a point that is relevant to the consent analysis set forth in Section V below.
B. Authorized Share Reserve
The Plan, as modified by the May 2021 Amendment, authorizes the issuance of up to 4,200,000 shares of AHT common stock in connection with equity awards granted under the Plan. This share reserve represents the maximum aggregate number of shares that may be issued or delivered pursuant to all awards granted under the Plan, subject to adjustment for certain corporate events as described below.
For context, the Company's fully diluted capitalization as of the date of this memorandum, based on the Company's capitalization table provided by Wentworth & Gage LLP as of June 30, 2022, is approximately 20,000,000 shares (on a fully diluted basis, inclusive of all outstanding shares of common stock, all shares issuable upon conversion of any preferred stock or convertible instruments, all shares subject to outstanding options and other equity awards, and all shares reserved for future issuance under the Plan). The Plan share reserve of 4,200,000 shares therefore represents approximately 21.0% of the Company's fully diluted capitalization — a level that is consistent with market practice for private equity-backed healthcare and technology companies maintaining broad-based equity incentive programs for management and key employees.
The Plan contains standard share counting mechanics that govern the recycling and return of shares to the available reserve:
1. Expiration, Forfeiture, or Cancellation. Any shares of common stock subject to an award that expires, is forfeited, or is cancelled without the issuance of shares will be returned to and again become available for issuance under the Plan.
2. Cash Settlement. If an award is settled in cash rather than in shares, the shares that were subject to the cash-settled award will not be counted against the share reserve and will remain available for future awards.
3. Tax Withholding and Exercise Price. The May 2021 Amendment clarified the treatment of shares withheld in connection with tax withholding obligations. Under the Plan as amended, shares that are withheld by the Company to satisfy tax withholding obligations arising in connection with the exercise or settlement of an award do not return to the available share reserve. Similarly, shares that are tendered by a participant or withheld by the Company to pay the exercise price of a stock option do not return to the available share reserve. This "fungible share" approach is consistent with the more restrictive share counting methodologies adopted by many private company equity plans, and we note that it has the effect of reducing the effective number of shares available for future grants.
4. Corporate Adjustments. The Plan provides for customary anti-dilution adjustments to the share reserve and outstanding awards in the event of stock splits, stock dividends, reverse stock splits, recapitalizations, reorganizations, mergers, or other changes in the Company's corporate structure.
We note that the Plan does not contain an "evergreen" or automatic annual increase provision. The share reserve is fixed at 4,200,000 shares and may be increased only through a formal amendment to the Plan approved by the Board and the Company's stockholders in accordance with the Plan's amendment provisions and the requirements of the Stockholders' Agreement.
C. Types of Awards Permitted
The Plan authorizes the Compensation Committee to grant the following types of equity-based awards:
• Incentive Stock Options (ISOs): Stock options that are intended to qualify as "incentive stock options" within the meaning of Section 422 of the Code, subject to the statutory requirements and limitations applicable to ISOs, including the $100,000 annual vesting limit, the requirement that the optionee be an employee of the Company or a qualifying subsidiary, and the holding period requirements of Section 422(a)(1).
• Nonqualified Stock Options (NQSOs): Stock options that do not qualify as ISOs. NQSOs may be granted to employees, directors, and consultants and are not subject to the ISO-specific limitations of Section 422.
• Restricted Stock: Shares of common stock that are subject to restrictions on transfer and vesting conditions as determined by the Compensation Committee.
• Restricted Stock Units (RSUs): Contractual rights to receive shares of common stock (or cash, at the Compensation Committee's discretion) upon satisfaction of vesting conditions and other terms specified in the applicable award agreement. As noted above, RSUs were added as an expressly enumerated award type pursuant to the May 2021 Amendment.
• Stock Appreciation Rights (SARs): Rights to receive the appreciation in value of a specified number of shares of common stock over a base price established by the Compensation Committee.
• Other Stock-Based Awards: Any other award that is denominated in, valued by reference to, or otherwise based on shares of common stock, as the Compensation Committee may determine in its discretion.
We confirm that both stock options and RSUs are expressly authorized award types under the Plan, and that the Compensation Committee has the authority to grant both such award types to Dr. Elliston, subject to the capacity, consent, and compliance considerations discussed in this memorandum.
D. Individual Award Limits
The Plan includes certain per-participant limits on equity awards, which serve as a cap on the maximum number of shares that may be granted to any individual participant during a specified period. Section 5(b) of the Plan provides that no participant may be granted awards with respect to more than 800,000 shares of common stock in any single fiscal year of the Company. This limit applies separately to each type of award (i.e., the limit applies on an aggregate basis to all award types granted to a single participant during the relevant fiscal year, not on a per-award-type basis).
As discussed in Section III.B below, the proposed grants to Dr. Elliston would encompass approximately 250,000 shares subject to stock options (1.25% of fully diluted equity) and approximately 100,000 shares subject to RSUs (0.50% of fully diluted equity), for an aggregate of approximately 350,000 shares. This aggregate falls well within the per-participant annual limit of 800,000 shares and does not raise individual award limit concerns.
We note, however, that if the stock options were to be structured as ISOs rather than NQSOs, the ISO limitations under Section 422 of the Code would impose an additional constraint: specifically, the aggregate fair market value (determined as of the grant date) of shares with respect to which ISOs first become exercisable by any employee in any calendar year may not exceed $100,000 (the "$100,000 ISO Vesting Limit"). Given the anticipated fair market value per share and the size of the proposed option grant, it is virtually certain that the $100,000 ISO Vesting Limit would be exceeded in at least one calendar year during the vesting period. Accordingly, and for the additional reasons discussed in Section IV.A below, we recommend that the stock options be structured as NQSOs rather than ISOs.
E. Exercise Price Requirements
Section 6(a) of the Plan requires that the exercise price per share for any stock option granted under the Plan be set at no less than 100% of the fair market value ("FMV") of a share of AHT common stock as of the date of grant. The Plan defines "fair market value" as the value determined in good faith by the Compensation Committee, taking into account such factors as the Compensation Committee deems appropriate, including, without limitation, independent appraisals and valuations.
For a privately held company such as AHT, the FMV determination is of critical importance not only for Plan compliance purposes but also for compliance with Section 409A of the Code. Under Section 409A and the Treasury Regulations promulgated thereunder, stock options that are granted with an exercise price below FMV may constitute "deferred compensation" subject to the adverse tax consequences of Section 409A, including an additional 20% excise tax on the participant and potential interest penalties. To establish a rebuttable presumption of reasonable FMV, Treasury Regulation Section 1.409A-1(b)(5)(iv)(B) provides that the Company may rely on a valuation performed by a qualified independent appraiser no more than 12 months before the grant date (commonly referred to as a "Section 409A valuation" or a "409A appraisal").
We understand that AHT's most recent Section 409A valuation was performed by Hargrove & Sinclair CPAs as of December 31, 2021, and that an updated valuation will be necessary to support the FMV determination for the Elliston grant date, which is anticipated to occur on or about November 1, 2022. We recommend that AHT commission an updated 409A valuation as of a date proximate to the anticipated grant date, as discussed further in Section VIII.B below. Gregory Tan's forthcoming Section 409A compliance memorandum, expected on or about August 22, 2022, will address the 409A valuation requirements in greater detail.
III. Analysis of Available Share Reserve Capacity
A. Current Outstanding Awards
Based on the Plan administration records provided to us by Wentworth & Gage LLP, the following table summarizes the current status of awards under the Plan as of June 30, 2022:
The 2,140,000 shares subject to outstanding stock options include grants to the following individuals, among others:
• Priya Chandrasekaran, CEO: 650,000 stock options (granted January 15, 2020; 4-year vesting with 25% annual cliff; exercise price of $12.50 per share based on closing 409A valuation);
• Derek Solano, CFO: 425,000 stock options (granted March 1, 2020; 4-year vesting with 25% annual cliff; exercise price of $12.50 per share);
• Other senior management and employees: approximately 1,065,000 stock options (various grant dates, exercise prices, and vesting schedules).
The 485,000 shares subject to outstanding RSUs and restricted stock include grants made following the May 2021 Amendment, primarily to the CEO, CFO, and other members of the senior leadership team.
The 187,000 shares that have been forfeited and returned to the available reserve are attributable to employee departures during 2021 and the first half of 2022, including the departure of the Company's former Senior Vice President of Engineering in April 2022.
As of June 30, 2022, the remaining available share reserve under the Plan stands at 1,450,000 shares.
B. Proposed Elliston Grants — Share Count Calculation
The proposed equity grants to Dr. Elliston are defined as a percentage of the Company's fully diluted equity. For purposes of this analysis, we define "fully diluted equity" to include all of the following:
(i) all outstanding shares of AHT common stock;
(ii) all shares of AHT common stock issuable upon conversion of any outstanding preferred stock, convertible notes, or other convertible instruments;
(iii) all shares of AHT common stock subject to outstanding stock options, RSUs, restricted stock, and other equity awards granted under the Plan or otherwise; and
(iv) all shares of AHT common stock reserved for future issuance under the Plan (i.e., the remaining available share reserve).
Based on the Company's capitalization table as of June 30, 2022, the fully diluted share count is approximately 20,000,000 shares. The proposed Elliston grants are calculated as follows:
Accordingly, the proposed grants to Dr. Elliston would require the allocation of a total of 350,000 shares from the Plan share reserve.
C. Capacity Determination
Comparing the 350,000 shares required for the Elliston grants against the remaining available share reserve of 1,450,000 shares, we conclude that the Plan has sufficient capacity to accommodate the proposed grants without amendment. Following the Elliston grants, the remaining available share reserve would be approximately 1,100,000 shares, representing approximately 5.5% of the Company's fully diluted equity. This residual reserve provides the Company with continued flexibility to make equity grants to future hires, existing employees, and directors, although the cushion is not unlimited and should be monitored.
We note, however, that the capacity analysis is somewhat sensitive to the definition of fully diluted equity and the date on which the calculation is performed. If the Company issues additional shares or grants additional awards between the date of this memorandum and the anticipated grant date, the remaining available reserve could be reduced. Conversely, any forfeitures of outstanding awards during the intervening period would return shares to the reserve.
In the event that the Plan did not have sufficient capacity, or if the Company wished to preserve additional headroom in the share reserve for future grants, the following alternatives would be available:
(a) Plan Amendment. The Board could adopt, and the stockholders could approve, an amendment to the Plan to increase the share reserve. Such an amendment would require the approval of both the Board (including the Compensation Committee) and the holders of a majority of the outstanding shares of AHT common stock. Given Ridgeline's approximately 68% equity stake, Ridgeline's written consent would be sufficient to constitute stockholder approval, subject to any additional requirements under the Stockholders' Agreement.
(b) Reduction of Proposed Grant Size. The Company could negotiate a smaller equity package with Dr. Elliston, although doing so could reduce the competitiveness of the offer relative to the Broadleaf benchmarking data.
(c) Combination of Plan Awards and Off-Plan Arrangements. The Company could structure a portion of the equity compensation as off-Plan arrangements, such as phantom equity, profit interests (if the Company were restructured as a limited liability company), or cash-settled awards. However, such arrangements would introduce additional complexity and may raise Section 409A and other tax considerations.
Based on our analysis, we do not believe that a Plan amendment is necessary to accommodate the Elliston grants at this time, and we recommend proceeding under the existing Plan reserve.
D. Dilution Impact Analysis
The issuance of the full Elliston grants (350,000 shares, representing 1.75% of fully diluted equity) would result in a modest dilution of the existing equity holders' percentage ownership. The following table illustrates the pre-grant and post-grant ownership percentages for the Company's principal equity holder groups, assuming that the Elliston grants are made and that no other changes to the capitalization occur:
The dilution to each existing holder group is proportional to the size of the Elliston grants and is consistent with the level of dilution that would be expected for a C-suite executive equity award in a private equity-backed company of AHT's size and stage. We note that this dilution analysis is directly relevant to the consent and anti-dilution provisions discussed in Sections V and VI below.
IV. Proposed Award Terms and Plan Compliance
A. Stock Option Award Terms
The following summarizes the key terms proposed for the stock option grant to Dr. Elliston, as reflected in the Internal Term Sheet and as discussed with Aaron Whitfield, and our assessment of each term's compliance with the Plan:
Grant. Options to purchase 250,000 shares of AHT common stock, representing approximately 1.25% of the Company's fully diluted equity. The grant would be made pursuant to a Stock Option Award Agreement between the Company and Dr. Elliston, to be entered into on the grant date.
Award Type. For the reasons discussed in Section II.D above (specifically, the likely breach of the $100,000 ISO Vesting Limit and the magnitude of the grant), we recommend that the stock options be structured as nonqualified stock options (NQSOs) rather than incentive stock options (ISOs). NQSOs are expressly authorized under Section 6(a) of the Plan and are not subject to the statutory limitations of Section 422 of the Code. We understand that this recommendation is consistent with the structuring of the option grants made to the CEO and CFO.
Vesting Schedule. The stock options would vest over a four-year period, with the following schedule:
(i) 25% of the options (62,500 shares) vesting on the first anniversary of Dr. Elliston's proposed start date of November 1, 2022 (i.e., the "cliff" vesting date of November 1, 2023); and
(ii) the remaining 75% of the options (187,500 shares) vesting in equal monthly installments over the subsequent 36 months, such that the options are fully vested on November 1, 2026, subject to Dr. Elliston's continued employment with the Company through each applicable vesting date.
This vesting schedule is consistent with the vesting schedules applied to the CEO and CFO option grants and is a standard market practice structure for executive equity awards in private equity-backed companies. We confirm that the Plan grants the Compensation Committee discretion to establish vesting schedules for awards, and that the proposed schedule is within the scope of such discretion.
Exercise Price. The exercise price per share will be set at 100% of the FMV of a share of AHT common stock as of the grant date, as required by Section 6(a) of the Plan and as necessary to ensure exemption from Section 409A of the Code. As noted in Section II.E above, an updated Section 409A valuation will be required to establish the exercise price.
Option Term. The stock options would have a maximum term of ten (10) years from the grant date, after which any unexercised options would expire. This is the standard maximum term provided under Section 6(c) of the Plan.
Treatment on Termination of Employment. The Stock Option Award Agreement will specify the post-termination exercise periods applicable to various termination scenarios. Based on the Internal Term Sheet and the precedent terms in the CEO and CFO option award agreements, the proposed terms are as follows:
(i) Termination without Cause or Resignation for Good Reason (other than in connection with a Change in Control): Vested options remain exercisable for 90 days following the date of termination. In addition, as described below under "Acceleration Provisions," 25% of unvested options would accelerate and become vested upon such termination.
(ii) Voluntary Resignation (without Good Reason): Vested options remain exercisable for 30 days following the date of termination. All unvested options are forfeited.
(iii) Termination for Cause: All options (whether vested or unvested) are immediately forfeited and cancelled as of the date of termination.
(iv) Death or Disability: Vested options remain exercisable for 12 months following the date of termination. Unvested options are subject to acceleration provisions as determined by the Compensation Committee.
The specific terms governing post-termination exercise periods are set forth in the draft Stock Option Award Agreement dated August 12, 2022, which is being prepared separately and should be reviewed in conjunction with this memorandum.
Acceleration Provisions. The Internal Term Sheet contemplates the following acceleration provisions for the stock options:
(i) Non-Change in Control Acceleration: Upon termination of Dr. Elliston's employment by the Company without Cause or by Dr. Elliston for Good Reason (in each case, other than within the 24-month period following a Change in Control), 25% of the then-unvested stock options would accelerate and become immediately vested and exercisable as of the date of termination. This is consistent with the acceleration terms in the CEO Employment Agreement.
(ii) Change in Control Double-Trigger Acceleration: Upon a qualifying termination (i.e., termination by the Company without Cause or by Dr. Elliston for Good Reason) that occurs within 24 months following a Change in Control, 100% of the then-unvested stock options would accelerate and become immediately vested and exercisable as of the date of such qualifying termination. This "double-trigger" structure — requiring both a Change in Control and a qualifying termination — is consistent with prevailing market practice and with the approach adopted for the CEO and CFO equity awards.
We confirm that the Plan grants the Compensation Committee authority to provide for acceleration of vesting upon termination events and changes in control, and that the proposed acceleration provisions are within the scope of such authority. The specific definitions of "Cause," "Good Reason," and "Change in Control" are addressed in Section IV.C below and in Devon Archer's change in control analysis memorandum dated July 28, 2022.
Plan Compliance. Based on our review, each of the foregoing proposed stock option terms is consistent with and authorized by the terms of the Plan. We do not identify any Plan compliance issues with respect to the proposed stock option award, subject to the following caveats: (a) the exercise price must be set at no less than FMV as of the grant date, which requires an updated 409A valuation; (b) the Compensation Committee must formally approve the award and its terms; and (c) the applicable consent requirements under the Stockholders' Agreement must be satisfied.
B. Restricted Stock Unit Award Terms
The following summarizes the key terms proposed for the RSU grant to Dr. Elliston:
Grant. An RSU award covering 100,000 shares of AHT common stock, representing approximately 0.50% of the Company's fully diluted equity. The RSUs would be evidenced by an RSU Award Agreement between the Company and Dr. Elliston.
Vesting Schedule. The RSUs would vest over a three-year period, with the following schedule:
(i) 33.33% of the RSUs (33,333 units) vesting on the first anniversary of the grant date;
(ii) an additional 33.33% of the RSUs (33,333 units) vesting on the second anniversary of the grant date; and
(iii) the remaining 33.34% of the RSUs (33,334 units) vesting on the third anniversary of the grant date.
This annual cliff vesting schedule is somewhat more accelerated than the four-year option vesting schedule, which is intentional and reflects the supplemental retention value of the RSU award. The three-year vesting period is within the range of market practice for COO-level RSU awards in companies of AHT's size and is consistent with the RSU grants made to other members of AHT's senior leadership team following the May 2021 Amendment.
Settlement. Unless a deferral election is made in accordance with Section 409A of the Code, each vested RSU will be settled in shares of AHT common stock delivered to Dr. Elliston as soon as practicable following the applicable vesting date, and in no event later than 30 days following the applicable vesting date (or such other settlement date as is specified in the RSU Award Agreement to comply with Section 409A). We note that the settlement timing is a critical Section 409A compliance issue, and we defer to Gregory Tan's forthcoming memorandum for a detailed analysis of the permissible settlement mechanics.
Treatment on Termination of Employment. All unvested RSUs will be forfeited upon termination of Dr. Elliston's employment, except as modified by the acceleration provisions described below. This forfeiture-on-termination feature is consistent with the treatment of RSU awards under the CEO and CFO employment agreements and the Plan's default provisions.
Acceleration Provisions. The acceleration provisions for the RSUs mirror the acceleration provisions for the stock options:
(i) Non-Change in Control Acceleration: 25% of the then-unvested RSUs would accelerate upon termination without Cause or resignation for Good Reason (other than within the 24-month period following a Change in Control).
(ii) Change in Control Double-Trigger Acceleration: 100% of the then-unvested RSUs would accelerate upon a qualifying termination within 24 months following a Change in Control.
Plan Compliance. RSUs are an authorized award type under the Plan (following the May 2021 Amendment), and the Compensation Committee has discretion to establish the vesting, settlement, and acceleration terms for RSU awards. We confirm that the proposed RSU terms are consistent with and authorized by the Plan, subject to the same caveats noted above with respect to the stock option award (i.e., Compensation Committee approval, consent requirements, and Section 409A compliance).
C. Change in Control Definition — Plan vs. Employment Agreement
A threshold issue for both the stock option and RSU acceleration provisions is the definition of "Change in Control" that will govern the determination of whether a triggering event has occurred. This issue is addressed in detail in Devon Archer's memorandum dated July 28, 2022, and we provide only a summary analysis here.
The proposed Employment Agreement between AHT and Dr. Elliston will contain its own definition of "Change in Control," which has been drafted to be consistent with the definitions used in the CEO and CFO Employment Agreements. Separately, the Plan contains a definition of "Change in Control" in Section 2(c), which applies to all awards granted under the Plan unless the applicable award agreement specifies a different definition.
Upon comparison, we note the following material differences and alignment considerations:
Ridgeline Carve-Out. The Employment Agreement definition of "Change in Control" contains a critical carve-out for transactions by Ridgeline Capital Partners, LP and its affiliates (including Fund IV and any successor funds managed by Ridgeline). Specifically, the Employment Agreement provides that a Change in Control shall not be deemed to have occurred as a result of (a) the acquisition of additional AHT equity by Ridgeline or its affiliates, (b) any internal reorganization or restructuring involving Ridgeline and its affiliates, or (c) any sale, transfer, or other disposition of AHT equity by Ridgeline or its affiliates, to the extent that Ridgeline or its affiliates control the terms and conditions of such transaction. This carve-out is essential to prevent Ridgeline's existing ownership, and any subsequent changes in Ridgeline's investment structure (such as a transfer from Fund IV to a successor fund), from inadvertently triggering acceleration of Dr. Elliston's equity awards.
The Plan's definition of "Change in Control" does not contain an equivalent Ridgeline carve-out, which creates a potential inconsistency between the Plan and the Employment Agreement.
Four Triggers. The Employment Agreement definition of "Change in Control" includes the following four triggering events, each of which is subject to the Ridgeline carve-out:
(i) The acquisition by any person or group (other than Ridgeline or its affiliates) of more than 50% of the combined voting power of the outstanding voting securities of AHT;
(ii) A merger, consolidation, or business combination involving AHT, or a sale of all or substantially all of AHT's assets, where the existing stockholders of AHT immediately prior to the transaction retain less than 50% of the combined voting power of the surviving or acquiring entity immediately following the transaction (in each case, excluding transactions in which Ridgeline or its affiliates control the terms);
(iii) A complete liquidation or dissolution of AHT approved by the stockholders of the Company; and
(iv) A change in the composition of the Board such that the individuals who constituted the Board as of the Effective Date of the Employment Agreement (or who were subsequently elected or nominated with the approval of a majority of such individuals) cease to constitute a majority of the Board (the "Incumbent Board" provision).
The Plan's "Change in Control" definition contains substantially similar triggering events but, as noted, does not include the Ridgeline carve-out and may contain minor differences in thresholds and mechanics.
Recommendation. To avoid ambiguity and ensure consistency, we recommend that the Stock Option Award Agreement and the RSU Award Agreement expressly incorporate or cross-reference the definition of "Change in Control" set forth in Dr. Elliston's Employment Agreement, rather than relying on the Plan's default definition. This approach is consistent with the treatment of the CEO and CFO equity awards, in which the award agreements reference the respective Employment Agreement definitions. We further recommend that the award agreements include a provision stating that, in the event of any conflict between the Change in Control definition in the award agreement and the Change in Control definition in the Plan, the award agreement definition shall control.
D. Section 409A Considerations (Cross-Reference)
As noted throughout this memorandum, the proposed equity awards raise a number of issues under Section 409A of the Code. Gregory Tan, Partner, Tax Group, Calderwood & Harkness LLP, is preparing a separate detailed Section 409A compliance memorandum, which is expected to be delivered on or about August 22, 2022, and which will address the Section 409A implications of the proposed awards in full. We provide the following preliminary observations for reference:
Stock Options. Stock options are generally exempt from Section 409A if (a) the exercise price is set at or above FMV as of the grant date, (b) the option does not contain any deferral feature (i.e., the option is settled in shares upon exercise, without any right to defer receipt of shares), and (c) the underlying stock is "service recipient stock" within the meaning of Treasury Regulation Section 1.409A-1(b)(5)(iii). Provided that these requirements are satisfied — and we expect that they will be, assuming an appropriate 409A valuation is obtained and the option is structured as a plain-vanilla NQSO — the stock option award should be exempt from Section 409A.
RSUs. RSUs typically constitute "deferred compensation" subject to Section 409A, because the participant has a legally binding right to receive shares at a future date upon satisfaction of vesting conditions. To comply with Section 409A, the RSU Award Agreement must provide for settlement upon a "permissible payment event" as defined under Section 409A, such as (i) a fixed date or schedule of dates, (ii) separation from service, (iii) death, (iv) disability, (v) change in control (as defined under Section 409A, which may differ from the contractual definition), or (vi) an unforeseeable emergency. The settlement timing provisions in the RSU Award Agreement must be carefully drafted to comply with these requirements.
In addition, if AHT were to become a publicly traded company during the vesting period of the RSU award (for example, through an initial public offering), the six-month delay requirement of Section 409A(a)(2)(B)(i) for "specified employees" would apply to any RSU settlement triggered by Dr. Elliston's separation from service. While a public offering is not currently anticipated, the RSU Award Agreement should include a standard provision addressing this contingency.
We recommend that both the Stock Option Award Agreement and the RSU Award Agreement include standard Section 409A savings language providing, among other things, that (a) the award is intended to comply with or be exempt from Section 409A, (b) the award agreement shall be interpreted in a manner consistent with such intent, and (c) any payments that are subject to Section 409A shall not commence until a permissible payment event has occurred.
We defer further analysis of these issues to Gregory Tan's forthcoming memorandum.
V. Ridgeline Capital Partners Consent Requirements
A. Board and Compensation Committee Approval
As discussed in Section II.A above, the Plan is administered by the Compensation Committee of the Board. The grant of equity awards to Dr. Elliston will require formal approval by the Compensation Committee, and given the magnitude and C-suite nature of the proposed grants, we recommend that the grants also be approved by the full Board.
The Compensation Committee currently comprises Thomas R. Glenwood (Board Chair and Ridgeline Managing Partner), Jennifer M. Torres (Ridgeline Vice President), and Dr. Anand Krishnamurthy (independent director). Two of the three Compensation Committee members are Ridgeline designees, which means that Ridgeline effectively has a de facto veto over any Compensation Committee action, including the approval of equity awards. In practice, the Compensation Committee does not take action on material equity grants without the prior concurrence of the Ridgeline investment team.
Thomas R. Glenwood serves both as Board Chair and as the senior Ridgeline professional responsible for the AHT portfolio company investment. Accordingly, any Board or Compensation Committee approval of the Elliston grants will, as a practical matter, require the concurrence of Mr. Glenwood and the Ridgeline investment team. We understand from Aaron Whitfield that Mr. Glenwood has been briefed on the proposed Elliston hiring at a high level and is generally supportive, but that the specific equity terms have not yet been formally presented for approval.
We recommend that AHT prepare draft Board and Compensation Committee resolutions approving the Elliston grants, and that these resolutions be circulated to Mr. Glenwood and the Ridgeline investment team for review and comment prior to formal adoption.
B. Stockholders' Agreement Provisions
In addition to the de facto approval requirement arising from Ridgeline's Board representation, the Stockholders' Agreement contains express contractual provisions governing the issuance of new equity securities by the Company. Based on our review of the Stockholders' Agreement, the following provisions are relevant to the proposed Elliston grants:
Equity Issuance Consent Right (Section 4.3). Section 4.3 of the Stockholders' Agreement provides that the Company shall not issue, sell, or grant any equity securities, or any rights, options, or warrants to acquire equity securities, representing in the aggregate more than 1.0% of the Company's fully diluted equity in any single transaction or series of related transactions, without the prior written consent of Ridgeline (acting through its designated representative on the Board or otherwise). This consent requirement applies to all equity issuances, including grants under the Plan, and is not limited to primary issuances to third-party investors.
The proposed Elliston grants would represent 1.75% of the Company's fully diluted equity in the aggregate, which exceeds the 1.0% threshold set forth in Section 4.3. Accordingly, the prior written consent of Ridgeline is required before the Elliston grants may be made. We note that because Ridgeline controls the Compensation Committee and Board, obtaining this consent should be a procedural formality rather than a substantive impediment, provided that Ridgeline's investment team concurs with the proposed terms. However, we recommend that the consent be documented in writing in the form of a written consent of the majority stockholder under the Stockholders' Agreement, to be executed by Fund IV's authorized representative.
Plan Amendment Consent Right (Section 4.4). Section 4.4 of the Stockholders' Agreement provides that any amendment to the Plan, including any amendment to increase the share reserve, requires the prior written consent of Ridgeline. As discussed in Section III.C above, we do not believe that a Plan amendment is necessary to accommodate the Elliston grants, but we note this provision for completeness. If a Plan amendment were to become necessary in the future (e.g., to increase the share reserve for additional grants), Ridgeline's consent would be required.
C-Suite Compensation Approval (Section 4.5). Section 4.5 of the Stockholders' Agreement provides that the compensation (including equity compensation) of the Company's Chief Executive Officer, Chief Financial Officer, and Chief Operating Officer shall be subject to the approval of the Compensation Committee and the Board, with the concurrence of Ridgeline's designated Board representative(s). This provision reinforces the requirement to obtain Ridgeline's approval of the Elliston equity grants and, more broadly, of Dr. Elliston's total compensation package.
Recommendation. We recommend that AHT obtain the written consent of Ridgeline under the Stockholders' Agreement prior to extending a formal offer of employment to Dr. Elliston that includes the proposed equity terms. This consent should be documented in a written consent executed by Fund IV's authorized representative, referencing the specific grant terms (number of shares, award type, vesting schedule, and acceleration provisions). We further recommend that AHT coordinate with Board Chair Thomas R. Glenwood to ensure that the Ridgeline investment team has reviewed and approved the terms before the consent is executed.
C. Drag-Along and Tag-Along Provisions
The Stockholders' Agreement contains standard drag-along and tag-along provisions that are relevant to the equity award structuring analysis, particularly in connection with the change in control acceleration provisions discussed in Section IV.C above.
Drag-Along Rights (Section 6.1). Section 6.1 of the Stockholders' Agreement grants Ridgeline the right to require all other stockholders (including management stockholders and Helix Ventures) to participate in a sale of the Company to a third party on the same terms and conditions as Ridgeline (a "drag-along sale"). If Ridgeline exercises its drag-along rights to effect a sale of 100% of the Company's equity to a third-party acquirer, all stockholders, including Dr. Elliston, would be required to sell their shares in connection with such transaction.
A critical question is whether a drag-along sale initiated by Ridgeline would constitute a "Change in Control" for purposes of the equity award acceleration provisions. As discussed in Section IV.C above, the Employment Agreement definition of "Change in Control" contains a carve-out for transactions by Ridgeline or its affiliates "to the extent that Ridgeline or its affiliates control the terms and conditions of such transaction." In a drag-along sale, Ridgeline is by definition controlling the terms and conditions of the transaction; however, the ultimate acquirer is a third party, and the practical result is a change in control of AHT from Ridgeline to the acquirer. The carve-out language is arguably ambiguous in this scenario.
We recommend that the award agreements include a specific provision addressing the treatment of equity awards in a drag-along sale scenario. One approach would be to provide that a drag-along sale constitutes a Change in Control (notwithstanding the Ridgeline carve-out) if the transaction results in a third party acquiring a majority of the Company's equity, but to clarify that the acceleration provisions are subject to the double-trigger requirement (i.e., acceleration occurs only if Dr. Elliston experiences a qualifying termination within 24 months following the drag-along sale). This approach is consistent with the treatment applied in the CEO and CFO award agreements and provides appropriate protection to Dr. Elliston while preserving Ridgeline's ability to effect a portfolio exit without incurring immediate acceleration obligations.
Tag-Along Rights (Section 6.2). The Stockholders' Agreement also provides tag-along rights to minority stockholders, including management stockholders, in the event of certain transfers by Ridgeline. These provisions are less directly relevant to the equity award structuring analysis but should be considered in the broader context of Dr. Elliston's stockholder rights.
VI. Helix Ventures Fund III, LP Anti-Dilution and Consent Provisions
A. Minority Investor Rights
Helix Ventures Fund III, LP holds approximately 14% of AHT's equity and is a party to the Stockholders' Agreement. As a significant minority investor, Helix Ventures holds certain protective rights under the Stockholders' Agreement that are designed to protect its investment from dilution and to give it a voice in material corporate decisions. The following analysis addresses the Helix Ventures rights that are implicated by the proposed Elliston equity grants.
B. Anti-Dilution Protections
Section 5.2 of the Stockholders' Agreement contains anti-dilution protections for Helix Ventures. Based on our review, Helix Ventures holds weighted-average anti-dilution protection (rather than full-ratchet protection) with respect to certain issuances of equity securities by the Company at a price per share that is below the price per share originally paid by Helix Ventures for its investment in the Company.
The anti-dilution provisions of Section 5.2 are structured as adjustment mechanisms that apply to the conversion ratio of Helix Ventures' preferred stock (if any) or, in the case of common stock holdings, to the number of shares held by Helix Ventures, in the event of a "Dilutive Issuance" (as defined in the Stockholders' Agreement). A Dilutive Issuance is generally defined as the issuance of shares of common stock or securities convertible into or exercisable for shares of common stock at an effective price per share that is less than the applicable anti-dilution reference price.
Critically, Section 5.2(c) of the Stockholders' Agreement contains a standard carve-out from the anti-dilution provisions for issuances of equity securities pursuant to an equity compensation plan approved by the Board and the stockholders of the Company (the "Equity Plan Carve-Out"). The Plan was adopted by the Board and approved by the stockholders (including Ridgeline and, by virtue of the written consent process, Helix Ventures) in 2020, and the May 2021 Amendment was similarly approved. Accordingly, issuances of shares pursuant to awards granted under the Plan should fall within the Equity Plan Carve-Out and should not trigger the weighted-average anti-dilution adjustments under Section 5.2.
We recommend confirming with Wentworth & Gage LLP that the Equity Plan Carve-Out extends to grants made under the Plan as amended by the May 2021 Amendment, and that the proposed Elliston grants would be covered by this carve-out. If the carve-out is limited to the original Plan share reserve of 3,000,000 shares and does not extend to the additional shares authorized by the May 2021 Amendment, additional analysis would be required to determine whether the anti-dilution provisions are triggered. Based on our preliminary review, however, we believe that the Equity Plan Carve-Out is broad enough to cover grants made under the Plan as amended.
C. Consent Rights on Equity Issuances
Section 4.3(b) of the Stockholders' Agreement provides that, in addition to Ridgeline's consent right discussed in Section V.B above, the Company shall not issue equity securities representing in the aggregate more than 2.5% of the Company's fully diluted equity in any single fiscal year without the prior written consent of any stockholder holding at least 10% of the Company's fully diluted equity (which includes Helix Ventures, given its approximately 14% stake). This annual issuance threshold is independent of and in addition to the per-transaction threshold applicable to Ridgeline under Section 4.3(a).
The proposed Elliston grants represent 1.75% of the Company's fully diluted equity. Whether the 2.5% annual threshold is triggered depends on whether any other equity issuances have been made during fiscal year 2022 that, when aggregated with the Elliston grants, would exceed the 2.5% threshold. Based on our review of the Plan administration records, we note that the Company granted approximately 85,000 shares of RSUs and 120,000 stock options to other employees during the first half of fiscal year 2022, representing approximately 1.025% of fully diluted equity in the aggregate. When combined with the proposed Elliston grants of 1.75%, the total fiscal year 2022 issuances would be approximately 2.775%, which exceeds the 2.5% annual threshold.
Accordingly, the prior written consent of Helix Ventures is likely required under Section 4.3(b) of the Stockholders' Agreement before the Elliston grants may be made. We recommend that AHT obtain written consent from Helix Ventures prior to making the grants. Failure to obtain the required consent could constitute a breach of the Stockholders' Agreement by the Company and could expose AHT to potential remedies available to Helix Ventures, including injunctive relief to prevent the unauthorized issuance, price adjustment claims, and potential contractual damages. While we believe that Helix Ventures is likely to consent to the proposed grants (given that they represent standard C-suite equity compensation and are consistent with the Company's talent acquisition strategy), obtaining the consent in advance is essential to avoid any contractual exposure.
We recommend that AHT General Counsel Aaron Whitfield coordinate directly with Helix Ventures' designated representative to discuss the proposed grants and to obtain written consent. The consent may be documented in the form of a written consent of the minority stockholder under Section 4.3(b) of the Stockholders' Agreement, referencing the specific grant terms and the aggregate fiscal year 2022 issuances.
D. Preemptive Rights
Section 5.1 of the Stockholders' Agreement grants Helix Ventures (and other stockholders holding at least 10% of the Company's fully diluted equity) preemptive rights with respect to the issuance of new equity securities by the Company. These preemptive rights generally entitle the holder to purchase its pro rata share of any new equity securities issued by the Company, in order to maintain its percentage ownership interest.
However, Section 5.1(c) of the Stockholders' Agreement contains a standard carve-out from the preemptive rights for issuances of equity securities pursuant to an equity compensation plan approved by the Board and the stockholders. Similar to the Equity Plan Carve-Out discussed in Section VI.B above, this exemption is designed to allow the Company to grant equity compensation to its employees, officers, directors, and consultants without triggering preemptive rights obligations to existing investors.
Based on our review, the preemptive rights carve-out is broad enough to cover the proposed Elliston grants, which would be made pursuant to the Plan. Accordingly, we do not believe that the preemptive rights provisions of the Stockholders' Agreement impose any additional requirements with respect to the Elliston grants. We recommend confirming this conclusion with Wentworth & Gage LLP.
VII. Interaction with Existing Executive Equity Awards
As noted above, the CEO Employment Agreement (Priya Chandrasekaran) and the CFO Employment Agreement (Derek Solano) have been used as precedent templates for the structuring of Dr. Elliston's equity awards. It is important to ensure internal consistency across the C-suite equity awards to avoid creating disparate terms that could lead to administrative complexity, perverse incentive misalignment, or executive relations issues.
We have compared the proposed Elliston award terms against the terms of the CEO and CFO equity awards and note the following:
Vesting Schedules. The CEO and CFO stock option awards each vest over four years, with a 25% cliff at 12 months and monthly vesting thereafter. The proposed Elliston stock option vesting schedule follows the same structure. The CEO and CFO RSU awards vest over three years, with one-third annual vesting. The proposed Elliston RSU vesting schedule follows the same structure. The vesting schedules are internally consistent.
Acceleration Provisions. The CEO and CFO equity awards each provide for 25% acceleration of unvested awards upon termination without Cause or resignation for Good Reason (non-Change in Control), and 100% double-trigger acceleration upon a qualifying termination within 24 months following a Change in Control. The proposed Elliston acceleration provisions follow the same structure. The acceleration provisions are internally consistent.
Change in Control Definition. The CEO and CFO Employment Agreements each contain a Change in Control definition with a Ridgeline carve-out and four triggering events, as described in Section IV.C above. The proposed Elliston Employment Agreement will contain a substantially identical definition. The Change in Control definitions are internally consistent, and we recommend that the award agreements for Dr. Elliston cross-reference the Employment Agreement definition in the same manner as the CEO and CFO award agreements.
Post-Termination Exercise Periods. The CEO and CFO option award agreements provide for a 90-day post-termination exercise period for terminations without Cause or for Good Reason, a 30-day period for voluntary resignations, and a 12-month period for death or disability. The proposed Elliston terms follow the same structure, and the post-termination exercise periods are internally consistent.
Material Departures from Precedent. We have identified no material departures between the proposed Elliston award terms and the precedent terms applied to the CEO and CFO equity awards. The grant sizes (as a percentage of fully diluted equity) differ, which is expected given the different roles, but the structural terms are aligned. We flag this conclusion for discussion with Bernard Crawford and Aaron Whitfield to confirm that no intentional departures were contemplated.
VIII. Practical Steps and Recommendations
A. Share Reserve Sufficiency
Based on the analysis set forth in Section III above, the Plan's remaining available share reserve of approximately 1,450,000 shares is sufficient to accommodate the proposed Elliston grants of 350,000 shares without amendment. Following the Elliston grants, the remaining available reserve would be approximately 1,100,000 shares, or approximately 5.5% of fully diluted equity. We recommend that AHT confirm the current share reserve status with its Plan administrator and with Wentworth & Gage LLP to ensure that no intervening grants or forfeitures have altered the available reserve since the June 30, 2022 records provided to us.
If, notwithstanding the foregoing, the Company determines that a Plan amendment is necessary or desirable to increase the share reserve (for example, to preserve additional headroom for future grants anticipated in connection with the Company's 2023 hiring plans), the following steps would be required:
(i) The Board would adopt a resolution approving the Plan amendment and setting forth the increased share reserve;
(ii) The stockholders of the Company would approve the amendment, either by written consent or at a duly called meeting of stockholders;
(iii) Ridgeline's written consent would be required under Section 4.4 of the Stockholders' Agreement; and
(iv) Helix Ventures' consent would be required to the extent that the aggregate fiscal year issuances (including issuances under the expanded reserve) would exceed the 2.5% annual threshold under Section 4.3(b) of the Stockholders' Agreement.
B. Section 409A Valuation