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22 July 2022·6 min read

Joanna Markowicz

Partner, B2RLaw

ESOP for Startups: Shares, Options Or Cash Equivalent?

In the past weeks, we have explored many facets of ESOP and its implications for startup founders. We untangled the intricacies between its definitions, models, CEE realities and market benchmarks as well as shared tips on ESOP communication for employee inclusion. Now it is time to get practical and delve deeper into the question of ESOP structure - which is the right for your startup? Shares, options or cash equivalent? Let’s find out! 

ESOP structure solutions

There are no regulations in the Polish legal system that directly regulate the formation of incentive programmes. As the need to create such programmes emerged, solutions known in other jurisdictions were adapted to polish regulations. In practice, the most common programmes are those based on the following structures: 

  • the acquisition of real shares in the company's share capital;
  • option (promise) to acquire shares in the company's share capital in the future;
  • option (promise) to obtain a cash equivalent.

Each of these solutions has its own advantages and disadvantages, and the choice of one of them should be preceded by an in-depth analysis of the needs of a given company and the function that the incentive program is meant to perform. 

Real shareholding in share capital

The most classic and basic solution is to offer, as part of an incentive programme, the opportunity to acquire real shares in the company's capital. This is the most accessible formula for an employee incentive programme. In exchange for their loyal work for the company and the fulfilment of additional conditions such as the achievement of targets, the employee or associate is given the opportunity to join the limited liability company and own a share in the capital, and in the future benefit from the company's profits in the form of dividends. The assumption is that the employee receives a share in the company's capital immediately and can, over time, as long as he or she meets the conditions and continues to cooperate with the company, increase the number of shares held. It definitely is a motivating factor for long-term commitment and work devoted to the development of the company. On the other hand, in the event of leaving the company, the shares may be subject to a buyback option, which in turn safeguards the interests of the company and the majority shareholders. 

The disadvantage of this solution, mainly for the majority shareholders, is the dilution of capital and the risk that employees reaching a 10 per cent share in the company's capital will exercise the rights of minority shareholders, such as requesting shareholders' meetings. The multiplication of the capital structure and the breakdown of decision-making across more entities may also make it more difficult to manage. The tax aspects are also problematic and need to be analysed from the perspective of both the acquisition of the shares and their possible subsequent buyback, due to the employee's leaving and termination of cooperation with the company.  

Share purchase options

The incentive programme based on share purchase options is modelled on the Anglo-Saxon legal system, mainly the USA, where the regulations explicitly provide for such a solution. In Poland, it is possible to apply the construction of a civil law obligation consisting of the fact that an employee, as part of an incentive programme, receives the right to demand the acquisition of shares from one of the shareholders or to demand that the company (i.e. from all other shareholders) increase the capital and offer him new shares as part of the company's capital increase. This solution postpones the acquisition of real shares in the share capital by the employee. Acquisition of options is also linked to the fulfilment of conditions by the employee. Upon their fulfilment, the employee receives a greater number of options, but may also link the entitlement to acquire further options to the expiry of the time spent working for the company. This solution makes it possible to properly motivate the employee to work within the company and to verify their real interest in such cooperation and willingness to build the company's business. It is only after an agreed period of time and subject to the fulfilment of certain KPIs (if any) that the obligation becomes due and payable.

The disadvantage of such a solution is that it is only a civil obligation of the company towards the employee - and like any obligation, it may of course be secured by e.g. a contractual penalty, while its enforcement may be considerably more difficult. From the perspective of the company, this is a more favourable solution than the direct award of shares in the capital. When designing an incentive programme, the interests of both parties should be balanced and secured, so that the programme is friendly and encourages further cooperation.

"Phantom shares"

The concept of phantom shares also originated from Anglo-Saxon legal culture, where regulations explicitly provide for this type of shares in a company. In the Polish law, we have neither phantom shares nor virtual shares, but we can talk about additional remuneration for employees who are participants of an incentive programme, constituting an economic equivalent corresponding to the value of real shares in the company's share capital. 

When creating an incentive programme based on an equivalence formula, a mathematical formula is usually used to calculate such remuneration based on the market value of the company's shares. At the same time, as in the case of share options, an incentive programme structured in this way constitutes a contract between the company and the employees, based on a bilateral commitment, without any corporate entitlement. The motivation element for employees is the desire to increase the market value of the company in order to receive a larger bonus when exiting the company and settling the phantom shares. The use of "phantom shares" is also beneficial to the shareholders or founders, as the participants in the incentive programme do not receive real participation rights in the company, thus not diluting the company's share capital and not participating in the exercise of corporate rights. It is a much simpler mechanism for both the company and the participants of the programme, not least because they may leave the company during or after the programme. 

A universal incentive programme?

Compared to the USA, where incentive programmes have a standard formula, currently in Poland it is not possible to create a universal incentive programme for every company. Programmes are created in various formulas, and this is influenced by many factors, which require an individual assessment of a given company and its needs, as well as taking into account the interests of shareholders, founders and employees and associates, so that the goal of the programme, i.e. motivation for further development of the company, is achieved.

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