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We analyze how employee compensation contracts of target firms affect merger terms and outcomes. Using unique data from merger agreements, we document that in 80.0% of all M\&A deals at least some of the target's ESOs are canceled by the acquirer and not replaced by new equity-based grants. Contract modifications reduce the value of employee stock options by 38.4% in the average M&A deal. Further, the combined merger returns are larger when employees experience greater losses. Overall, our results indicate that the benefits of reducing the number of employee stock options outweigh potential negative effects on firm value.

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