Option-based incentive programs, known as Employee Stock Option Plans (ESOPs), have been gaining popularity in CEE in recent years. But can ESOPs, which are well-known and widely used in the West and in the cradle of the startup community in Silicon Valley, be readily reflected in a CEE legal reality?
ESOP Genesis
The construction of ESOPs originated in the United States, and incentive programs based on it quickly became one of the key elements of motivating employees to actively participate in building company value and developing mutual relations between co-employees and their companies around the world.
With the development of the startup market and the increased number of investment rounds involving foreign investors - the construction of ESOPs in CEE has been gaining in popularity. ESOP is particularly well-known amongst this group of entrepreneurs - it allows for the increase of commitment of employees/co-workers of the company through the motivation of an additional bonus, related to the possibility of participation in the profits of the company or obtaining equity rights in the company. It also ensures that key people will remain in the company and the key milestones will be achieved. Often, the implementation of an ESOP is also a requirement of an investor participating in an investment round.
ESOP programs and their benefits are also appreciated by larger and more developed companies, which aim to reward key personnel with an additional discretionary bonus, and are frequently used as a strategy to compete for qualified employees that may otherwise be attracted by foreign, larger corporations.
As such, "ESOP" is considered desirable and a catchy slogan for the above-mentioned groups of companies, associated with the conviction that it is easy to transfer simple and proven foreign models to the CEE markets.
So why does ESOP in CEE raise so many questions and doubts?
The first reason is the lack of complete and unambiguous legal regulation. This legal situation is the same in other countries of Central and Eastern Europe, such as Hungary, and the Czech Republic.
Models used in Silicon Valley are fully regulated, available for any type of company and based on commonly used uniform documentation, which makes their implementation standardized, and legal and tax consequences clear and predictable. These incentive programs are most often based on the construction of Stock Options, which are allocated to the beneficiaries, vested, and then executed.
In CEE, there are no such uniform rules, and many of the institutions do not have a straightforward replication relevant to CEE companies. The situation is not facilitated by the fact that most startups in CEE operate in the form of a limited liability company, in which there are restrictions related to (i) the amount and necessity of share capital, (ii) the principle inability to have own shares and (iii) rigors related to the sale of shares.
Some of the above rigors are mitigated at the level of a joint-stock company, which, due to such institutions as (i) issuance of warrants or (ii) acquisition by the company of its own shares, is indicated in many publications as the most favorable type of company for the introduction of an ESOP. On the other hand, the joint-stock company is not a form often chosen by CEE startups, due to its other, more complex operational requirements.
In Poland, the most ESOP-friendly form of company is considered to be a simple joint-stock company, but due to its relatively young regulation and the turbulence related to tax issues, this form is cautiously accepted on the market.
In addition, the proverbial "icing on the cake" is tax issue - tax regulations concerning ESOP programs are also laconic, and the position of authorities is still being worked out. An ESOP model should be verified from the perspective of future tax burdens for the employee and the company, so that it fulfills the role of an incentive and benefit for the employee and at the same time does not burden the company.
So how do ESOP programs function in CEE and how can they be effectively introduced in a company?
Currently, ESOP programs are carried out in CEE on the basis of existing legal constructions. For example, a CEE limited liability company may implement an ESOP based on (i) stock options (the most similar method to the popular Western model), (ii) real shares with a resale option and (iii) phantom shares.
Options On Shares
An ESOP based on options is the most similar model to Western standards. In this model the ESOP is based on giving participants the right to acquire shares in the future. Such entitlement is usually subject to the expiration of a vesting period, meeting certain milestones (KPIs), or the absence of bad leaver conditions.
Grant Of Corporate Rights (Shares)
An ESOP based on an upfront allocation of shares (newly created or from a pool of existing shareholders) is based on the transfer of a certain number of newly created shares to be acquired by participants in the program (or the sale of a portion of the shares held by existing shareholders). This type of program may be of interest to companies that wish to reward key associates for past work. In other cases, the model requires the development of mechanisms for the repurchase of shares where there is a failure to meet the objectives of the program in the future.
Phantom Shares
Phantom shares are the virtual equivalent of real shareholding rights. In reality, the benefit for this ESOP model’s participants is a claim to the cash equivalent of the value of the shares. The acquisition of full rights resulting from the phantom shares is also subject to at least the expiration of the vesting period.
Each of the mechanisms described above will pursue different company objectives and will involve different structural challenges and tax consequences.
As you can see, what at first glance may appear to be a drawback, in some cases companies can turn into an advantage. Thanks to the lack of a single regulation concerning incentive programs - you can try to create a "tailor-made" program. A good ESOP is one that addresses the needs of the company and its employees/co-workers at a given stage of development. Therefore, it is worth, despite the initial discouragement to this unregulated and non-obvious topic, to look deeper into the possibilities brought by the available legal regulations and try to create a solution that meets your needs.
We will write about what to do to make the ESOP meet its objectives and at the same time fit into the framework of legal regulations in the following articles.
Related Posts:
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)
How ESG Will Affect VC Funds And Startups? (by Ewa Chronowska, Partner, Next Road Ventures)
