A golden parachute is a compensation agreement guaranteeing significant financial benefits to a top executive who loses their job. It is traditionally offered to chief executive officers (CEOs), chief financial officers (CFOs), or other high-ranking employees who depart as the result of a merger or acquisition.
This type of executive compensation is called a golden parachute because it’s designed to provide a soft, safe, and lucrative landing for the recipient after they leave their current role. Some companies also offer golden parachute payments to execs who leave under other circumstances besides a merger or acquisition. This sort of severance package is sometimes called a golden handshake, particularly if it is not tied to a merger or acquisition.
On the other end of the golden compensation spectrum are golden handcuffs, a type of incentive that encourages execs to stay at their current company.
The purpose of a golden parachute
There are a few different reasons a company might include a golden parachute clause in the compensation packages for one or more of its execs.
Potential acquirers might be less inclined to pursue a transaction if doing so would require them to make a major payout to one or more departing execs, thus driving up the overall costs of the deal. In this use case, a golden parachute can be a version of a poison pill, defending the company against a hostile takeover or otherwise unwanted takeover attempt at an M&A.
Recruiting and retention
A golden parachute can help attract high-level talent to the C-suite. Offering one to an incoming hire can remove some of the downside risk that comes with taking a new job and provide financial security in the event of a takeover.
A golden parachute can align incentives between a company’s shareholders and its execs in the event of a proposed merger or acquisition. An exec might be less inclined to pursue a merger if they knew it would result in losing their job, even if the deal is in the best interest of the board and other shareholders. A golden parachute can help mitigate this version of the principal-agent problem.
Types of golden parachute compensation
A golden parachute can be structured in different ways and can feature a range of potential perks for departing execs. These can include:
Increased severance pay
A cash bonus
Accelerated vesting of retirement benefits
Criticisms of golden parachutes
Golden parachutes can be controversial. Critics have pointed to a few main reasons why these agreements might not always be in the best interest of companies.
A poor use of company funds
Some golden parachutes are so lucrative as to make a notable dent in a company’s finances. For example, former Yahoo CEO Marissa Mayer received a reported $187 million in compensation when the company sold its core business to Verizon in 2016.
An unnecessary inducement
All execs at public companies have a fiduciary duty to act in the best interest of their shareholders, and most of these executives are already well-compensated. Critics argue that company leaders should not need the added incentive of a golden parachute in order to fulfill their responsibilities.
A new principal-agent problem
One of the arguments in favor of golden parachutes is to incentivize company leadership to consider a potential merger or acquisition, even if they might lose their job because of it. However, a golden parachute that is too lucrative can create the opposite problem: An exec might be overly incentivized to pursue an otherwise unattractive merger or acquisition for their own financial benefit.
Golden parachute taxes
A golden parachute payment can create a substantial tax burden for both the company and the exec if it qualifies as an “excess parachute payment,” which the Internal Revenue Services (IRS) defines as a payment that is at least three times greater than an individual’s average annual salary over the previous five years. An excess parachute payment must also be related to a change in control at a company.
Section 280G of the Internal Revenue Code imposes a 20% excise tax on the recipient of any excess parachute payment. The payor of the golden parachute, the company, must withhold the excise tax if the payment is considered wages. In addition, the company cannot take a deduction for any excess parachute payment. However, most private companies can obtain shareholder approval of any such payments, which waives these restrictions and allows the excess parachute payments to proceed.
If the shareholder approval cannot be obtained, to account for this tax burden, some companies offer golden parachute recipients a form of tax reimbursement known as a “gross-up.” The company agrees to increase the size of the payment to offset the tax burden, assuring the recipient will walk away with the intended amount.