Employee Stock Ownership Conference (ESOPe)

We like to do things differently, we even enjoy doing things differently. And obviously this approach proved to be successful when we organized a conference on ESOP – employee stock and stock options in Slovak companies. In a packed half-day programme, we wasted no time with theory, but brought practical insights and actionable information for entrepreneurs based on our years of practical experience and linking the key areas of law, tax and accounting.

In three entries, we focused on best practices in Slovak companies, starting with the process of setting up a functioning ESOP program with creative suggestions for types of employee compensation and the associated minimization of tax and levy implications. We also covered approaches to properly valuing a company when issuing an ESOP, seamlessly moving on to the topic of current trends associated with issuing employee stock to the setup (different approaches) and managerial handling of Good Leaver/Bad Leaver situations.

For those who missed the conference, this article provides a small taste of what we covered at the ESOP conference. If you are interested in the topic in more depth, there is a video recording of the conference, which you can find here.

In particular, we present how important it is to set up the whole structure correctly at the very beginning of the ESOP program, taking into account the potential growth of the company, the entry of an investor or even legislative innovations, which can make the existing ESOP program more effective if set up correctly.

What to consider in an ESOP?

ESOPs are a complex topic that is not enough to look at only through a legal and tax lens. In the first step, of course, it is important to work with the ESOPist’s vision and knowledge of the company that intends to set up an ESOP program. Subsequently, other issues such as:

• Economic setup – psychology and management, Good Leaver / Bad Leaver, vesting / cliff period, option / stock / shadow stock;
• Tax setup – company valuation, taxation moments, strike price;
• Legal set-up – administration, flexibility and protection of founders/company, voting and economic rights.

Our task is therefore for the client “under one roof” to take into account all relevant facts and provide the most ideal economic, legal and tax-tax setup of the option program, including service such as:

• drafting the so-called. ESOP contracts;
• drafting the so-called. “drawer contracts”;
• Tax-tax assessment and design of a specific ESOP structure;
• suggestions to minimise the risks of a possible tax audit;
• the actual execution of corporate changes;
• setting up an ESOP structure using a foreign company; or
• Prevention as well as eventual resolution of Bad Leaver situations.

ESOP Basic Conditions

The ESOP concept brings with it many concepts, and it is necessary for the client to think about them before we start setting up a specific strategy for him or her. It is mainly a decision on what conditions will be set in the ESOP. It mainly concerns:

• ESOP pool – A percentage of the total number of shares of a company’s outstanding stock that is offered to employees as a recruitment and/or retention tool.
• Strike price – also known as strike price. The price (determined at the time of grant) at which an employee can purchase shares.
• FMV – fair market value – the price that would be agreed between a potential buyer and a potential seller, neither of whom is under any obligation to act and both of whom have reasonable knowledge of the relevant facts. Three methods are commonly used to determine FMV, namely Discounted Cash Flow, Public Market Comparables, Precedent Transactions.
• Vesting period – the period during which shares “mature”. It is up to the company to choose the period of time – for example, 4 years is standard.
• Cliff period – holding participation in an ESOP, for example, in the case of a new employee. Thus, a company may determine that the vesting period will only begin after a certain period, e.g. by a year.
• Good leaver/ bad leaver – a bad leaver clause allows the company to recover vested options of an employee who leaves under pre-determined conditions. In a good leaver, the action is essentially “maturing”.

What can cause a poorly set ESOP?

An ESOP acts as a powerful motivational and rewarding tool to attract and retain employees or reduce turnover in the company. At the same time, it motivates employees to perform better at work, which is also linked to the growth of the company. However, this is only true if the ESOP is set up correctly and efficiently. In practice, we also encounter the opposite situations where we have to deal with “dead equity” in the company, namely a “non-working ESOPist” who has already been assigned a real, tangible stake in the company.

A poorly set up ESOP can also have a demotivating effect on employees, which is the opposite of the purpose of such a program. For example, after the vesting period, an employee may lose the motivation to perform his or her job as effectively as during this period of share maturation. Therefore, it is necessary to set up the ESOP in such a way that the employees have an incentive to work or stay in the company even after the “vesting period” has expired.

One of the reasons for employee demotivation can be the poor setting of Good Leaver / Bad Leaver conditions. In practice, we often deal with a variety of “bad leaver” situations, most of which require a sophisticated and complex approach. Therefore, it is most ideal for companies to set these conditions upfront as a precaution in clear and practically enforceable language and manner. Of course, setting a fair playing field also applies to the “good leaver” situation.

When setting up an ESOP, it is more than desirable to comprehensively anticipate all potentially problematic situations and one of them is the possible dispute about the value of the share and therefore how to determine the “fair market value” (FMV), what methods to use to value a company or, for example, a Start-up with a unique product and difficult predictability of its development in the next stages, and who to contact to develop the FMV for your business model.

Types of employee “shares”

The company has a choice as to what kind of “shares” it offers to its employees. In the conditions of the Slovak Republic it is in particular:

• Share options;
• Shares and business holdings;
• Shadow business holdings/shares.

Already at this step, when choosing the type of shares, it is necessary to consider the economic and tax-tax implications. The choice of the type of shares is undoubtedly linked to the choice of the legal form of the ESOPist, where our legislation gives us four options to choose from, the choice of which depends on the specific realities of the intended structure, namely:

• Limited liability company (s. r. o.);
• Joint stock company (a. s.);
• Simple stock corporation (j. s. a.);
• Cooperative; or
• Alternative forms.

Each legal form has its specifics, or its advantages and disadvantages. Already at the conference we outlined the essential advantages of the less used legal form of the cooperative, as well as the use-cases of the correct set-up in practice. It is important to note, however, that there is no such thing as the “most correct” choice of legal form, but in any case it is very important to make a comprehensive assessment of which legal form is the most “ideal” choice for a given case.

In practice, it is relatively common to encounter the creation of an ESOP structure abroad. There are a number of legitimate reasons for this:

Standard ESOP milestones

ESOPs entail certain “milestones” which also need to clearly set the conditions under which they occur. We mean the following:

• Option grant;
• Exercise of the option;
• Acquisition Action;
• Sale of shares.

In the case of employee shares, a fundamental problem arises in practice from our point of view, namely the question of the timing of taxation. The Income Tax Act provides for the accrual of non-cash income – taxation – at the time of acquisition of employee shares by the employee. In the case of options, there are views that the moment of taxation occurs even a little earlier. However, such a procedure contradicts the principle of taxation, where taxation on the acquisition of employee shares is to occur at a point in time when neither the employer nor the employee has cash income on which tax and levies can be paid.

For our clients, we therefore try to find legal ways to set up the ESOP structure so as to divert the moment of taxation to the moment of actually received cash income, or to reduce the rate of taxes and levies, or to minimize the risks of a possible tax audit.

As we said in several case studies at the conference, each client needs to be considered on an ad hoc basis, and there is no sort of one-size-fits-all template that just rolls over to the firm without knowing the client’s requirements. In any case, we will be happy to create and run a tailor-made solution for your business with an optimal mix of legal and tax-efficient structure.

Taxation of employee/contractor ESOPs

The recently adopted amendment to the Income Tax Act has at least triggered a positive response within the startup environment. Under the rules in effect prior to this amendment, a critical portion of shares awarded to an employee or contractor had to be taxed as non-cash income. In practice, therefore, various arguments and structures have been devised to eliminate this risk. The amendment was intended to shift this taxation to the moment of realisation of income in the form of an “EXIT” share.

However, despite the certainly noble motive, the amendment does not fully address this need and it appears that it may be unused in practice without fiscal risks. It is therefore possible that the new legislation will still be subject to some changes.

Airdrops for employees/contractors and other forms of remuneration

As the ecosystem around crypto assets develops, we are increasingly seeing the distribution of various crypto assets to team members. This was also addressed at the conference.

If you are interested in this topic and would like to know more about it, a video recording of the conference is available right here below the article.

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If you are interested in this topic, please do not hesitate to contact us.