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Today, almost every start-up company offers option programs to its employees. Suppose, in the early days of a startup’s activity, it is either not possible to pay an employee’s salary at all, or it is not possible to pay a salary that meets market conditions. In that case, options are a good way to motivate employees.
What is an option?
An option is an instrument that gives the employee the right, but not the obligation, to receive some benefit in the future. Such a benefit may be, for example, a shareholding in a company or a sum of money. Options are intended for motivating employees and reducing labor turnover. Their main value is that the employee feels more connected to the company where he or she works and can become a shareholder in the future through the option or at least benefit from the company’s growth.
How to grant an option?
To grant an option, the company enters into an option agreement with the employee, which stipulates all the essential conditions related to the option.
For example, an option agreement stipulates a vesting period, i.e., the time after which the recipient earns the option. In the Startup Estonia option agreement, the vesting period is four years from the signing of the option agreement. The vesting period may also be divided into stages; for example, 25% of the shares will be earned in the first year after the conclusion of the option agreement (cliff), and the remaining shares shall vest in equal monthly installments over the next three years.
It is also common to stipulate that if during the vesting period an employee leaves voluntarily, their professional relationship is terminated, or they fail to perform their responsibilities, the company may request the employee to transfer all his shares back to the company against payment of the nominal value of such shares or for free, the so-called “Bad Leaver” situation.
However, suppose the reason for termination of employment is, for example, an employee’s illness, the so-called “Good Leaver” situation, it is common to stipulate in the option agreement that the company may request the employee to transfer his vested shares back against payment of fair value for such shares and unvested shares for the nominal value.
From a legal perspective, equally as important as the valid option agreement is the resolution of the shareholders to increase the capital in favor of the employee. Without the shareholder’s resolution, a situation may arise where the employee has entered into an option agreement. Still, at the end of the vesting period, he or she does not have the right to demand the option.
Different types of options
The most common option in Estonia is the classic share option which gives the employee the right to receive shares in the company after a certain period. For example, after three years, the employee has the right to acquire a share in the company with a nominal value of 50 euros at an agreed price. An alternative to the share option is an option that can only be exercised after an exit or when the company is sold. Other options enable us to receive a sum of money instead of a shareholding in the company.
What to consider from a tax perspective?
The vesting period of options also has implications from the tax perspective. Namely, the vesting period must be at least three years for an option to be exercised tax-free. The exercise of the option after three years is not considered a fringe benefit, meaning the employer does not incur a tax liability.
However, in the future, the employee will incur income tax liability from the transfer of securities. The employee’s gain or loss from the transfer of securities (acquired shareholding) is calculated as the difference between the sale price and the acquisition cost.
The exercise of the option before the expiry of three years as of the granting of the option is considered a fringe benefit, and the employer has to pay taxes on the fringe benefit.
As an exception, the acquisition of the holding constituting the underlying to which the option refers to the extent that corresponds to the proportion of the time of keeping the option before the entire holding in the employer or a company that belongs to the same group as the employer is transferred (the so-called full exit situation), or prior the incapacity for work or death of the employee, is not considered a fringe benefit. In practice, this means that the option agreements concluded with employees have a vesting period of at least three years.
In conclusion, options can be a good way to motivate and retain employees, but both the employer and the employee should also consider the legal and tax aspects of options.
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