Recently, we have shared the genesis of ESOPs and its models. We also highlighted opportunities to make the best use of this legal tool, which can benefit all stakeholders: your company, employees and investors. In this article we will delve deeper into ESOPs, focusing primarily on the practical consequences of applying the chosen model of the incentive scheme – from the perspective of financing rounds, transactions, day-to-day operations of the company and tax.
As has already been mentioned in our previous article, there are three standard models of ESOP. For your convenience, let’s have a quick look at them once again:
Stock-based ESOP model
In this model, real shares are granted to the participants. The shares may be acquired by the ESOP participants in stages, according to an adopted vesting schedule – or they may be acquired in full at once, subject to the repurchase by the company of an appropriate portion of the shares (decreasing in line with the adopted vesting schedule; so-called reverse vesting).
Option-based ESOP model
In this model, only the right to acquire shares in the future is granted to the participants. At the moment of the grant, beneficiaries are not awarded any real shares.
Phantom-based ESOP model
An ESOP based on phantom shares entitles its participants to receive the cash equivalent corresponding to the value of virtual shares granted. Beneficiaries receive no shareholders’ rights or obligations.
The above mentioned models may be customized – for example, vesting may be time-based, back-loaded or performance-based. This and many other aspects should be taken into account at executive level when deciding on a particular ESOP to be introduced into a company. As such, the main question of interest arises: which model should I apply to my company? While it is impossible to answer this question in isolation from the specific ecosystem of a startup, we present below aspects that may help you decide which incentive program is the right one for your company.
It should be noted that the decision to choose a particular ESOP model depends on many factors, including the main objective to be fulfilled by the program, but also planned future events such as an investment round or exit.
ESOP model vs financing and M&A transactions
The assumptions of ESOP provided in the company are very important in view of future funding rounds. They may have an impact on the valuation of the company and its attractiveness from the perspective of investors.
From the point of view of funding rounds, it is necessary to reserve an adequate pool of shares for the ESOP. The standard nowadays is a 10% ownership stake of the beneficiaries in the company within a Seed round. This percentage should then – according to the latest indications and best standards from Silicon Valley – show an upward trend, up to even 25% of ESOP Beneficiaries’ ownership of the company within Series C round. If the company is before or in the middle of an investment round, it is a good idea to agree with the investor on the size of the ESOP pool and the rules of dilution.
Another important decision concerns the definition of the exit event. The company needs to think about this construction, so that it takes into account the vision of development adopted by the company. In this respect, it is necessary to determine whether the ESOP beneficiaries are to sell their grants during the exit or stay in the company, and how to safeguard the interests of the company and its plans for further operations and scaling. Typically, a cashless settlement with ESOP beneficiaries is most beneficial to the company. However, irrespective of the model adopted, it is important to adequately secure ESOP beneficiaries’ participation in the exit.
From the company’s point of view, it is therefore worth making a business decision in advance as to the portion of ownership in the company that will be given to the beneficiaries, and analyzing possible scenarios and the shape of the definition of the exit event, so that founders can present these issues to investors accordingly.
Consequences of the chosen ESOP model on corporate governance
The stock-based model has the greatest impact on the company and its corporate governance. Firstly, it may require frequent shareholders’ meetings to increase the company’s capital, which may create organizational problems as well as additional costs for the company. Optionally, if the shares for the beneficiaries are taken out of the pool of founders or other existing shareholders, this will necessitate the frequent signing of share transfer agreements.
Secondly, beneficiaries of a stock-based ESOP (or an option-based model, once exercised by the beneficiaries) will become company shareholders and therefore have all corresponding rights and obligations under the articles of association and common law. This means, inter alia, that they should, in principle, be a party to any investment and shareholders agreement that an investor may be interested in entering into.
Thirdly, beneficiaries of a stock-based ESOP (or an option-based model, once exercised by the beneficiaries) will also form a minority shareholding. This is an important issue for the operational freedom of the company and should therefore be analyzed in depth. Having a minority shareholding may create difficulties in making corporate decisions at the level of shareholders’ meetings. For example, under Polish law, shareholders in a limited liability company representing at least 10% of the company’s ownership have the right to demand that a shareholders’ meetings be convened.
The above-mentioned impact on corporate governance will not apply to an ESOP based on phantom shares in which beneficiaries will never receive any of the shareholders’ rights or obligations.
Last but not least, the structure of the ESOP also remains to be thought-through in terms of the articles of association of the company. Whatever model is adopted, it is highly likely that the content of the existing articles of association will be required to be adjusted. In particular, transfer restrictions clauses, as well as tag along and drag along clauses will need to be regulated.
Tax rules are ambiguous
Generally, there is no uniform European tax or regulatory regime applicable to ESOPs. Therefore, choosing the company’s headquarters is of primary importance. Taxes in CEE may be less favorable for ESOP beneficiaries and the company than in the US, which should be borne in mind. There may be different moments to pay the taxes due – either at the moment of a grant, vesting, exercising, or selling the grants. With that being said, in most CEE countries the moment of sale is taxed, also, different tax rates may be applied, most common being the income tax rate and capital gains tax rate. Moreover, in some European countries, for example, the Czech Republic, social charges may apply, including security and health contributions. In addition, tax issues may vary according to the form of cooperation between the beneficiary and the company.
As tax policy can make it unprofitable for employees to acquire their grants, savvy companies will always think several steps ahead. Choosing the right ESOP model will optimize tax issues, making the motivational role of the ESOP a reality.
ESOP at no risk
At the heart of any decision to grant rights of a company to anyone should be the concern of safeguarding its interests. In this respect, the interests of a company can be kept secure by only granting beneficiaries non-voting shares. Another step a company can take to protect its interests is to allow those leaving the company to retain vested options without exercising them, but to ‘cap’ the gains they can make – for example, applying the share price in the funding round immediately before or after leaving. Such a solution is designed to avoid situations where the leavers retain all the benefits of staying with the company at no cost.
However, an appropriate balance must be struck between safeguarding the interests of the company and making the ESOP program attractive to the best talent. Safe to say that the current trend is to have bad leavers provisions narrowed to allow full use of beneficial opportunities of the incentive programs. In assessing such a balancing framework, it is worth stressing again that the incentive program should be tailored in such a way that it does not constrain the company’s discretion as to the direction of its development.
Always ensure that your company has enough room to manoeuvre
As outlined above, companies have a lot to think about when implementing ESOPs. Depending on the CEE country, the simplicity and costs involved will vary. Regardless of the model chosen, care must always be taken not to impede the subsequent operational freedom of the company. In addition, due to the multitude of issues to consider, the best option for a company is to enlist the professional help of tax advisors and legal experts to help select a model that is most beneficial to the ecosystem of a particular business. Seeking professional advice at the initial stage of implementing an incentive scheme will avoid a range of potential unforeseen subsequent costs and problems.
Related Posts:
ESOP For Startups: Silicon Valley Standards And CEE Realities (by Teresa Pilecka, Senior Associate, B2RLaw)
Your Startup Needs To Be ESG-aligned To Be Investible (by Aleksandra Polak, Partner, B2RLaw)
ESOP For Startups: What is ESOP and how does it benefit startup? (by Marcin Laczynski, Partner, Next Road Ventures)
