Q&A: Employee stock ownership plans (ESOPs) in practice
An employee benefits trend of recent years has been employee incentive stock plans, especially in the technology sector. Find out the reason behind their introduction, what to look out for during the process, and what is the relevant legislative framework in the Czech Republic.
We have summarized the answers to the most important questions raised during our discussion ESOP in practice: experiences with the implementation of employee incentive programs at Avast, Cyrkl, and Mews.
What are ESOPs?
ESOP (Employee Stock Option Plan) is a collective term for various types of stock plans, which we use hereunder as an abbreviation already well-established in the Czech and foreign markets. In fact, however, there are several types of stock plans with ESOP representing only one of them.
In principle, the types of incentive plans can be distinguished primarily according to whether they provide employees with actual shares in the company (e.g. ESOPs or Restricted Stock Units) or whether they are paid cash bonuses linked to virtual shares (Phantom Plans or Stock Appreciation Rights) if certain conditions are met. This subsequently determines the legal setup and taxation of the related income on the part of the employees.
Reasons for Introduction of ESOPs
- Why should you introduce ESOPs? How do employees view these programmes?
The primary reason for the introduction of ESOPs by Czech companies is the retention and motivation of existing employees and the recruitment of new talent, not only from the Czech but also from the global labour market. It can be said that ESOPs are becoming a standard remuneration in technology companies, automatically expected by new hires.
An equally important reason for introducing ESOPs is to increase the interest of employees in the company’s affairs and to change their mentality and behaviour from the position of an employee to that of a co-owner. This change in mentality, however, must go hand in hand with a corresponding change in communication and transparency of management towards ESOP participants, which should focus primarily on the company’s strategy, the development of its performance, and the relation to the ESOP. Furthermore, the company should be similarly transparent with employees who cannot participate in the ESOP. Management should be able to satisfactorily explain, in particular, why they have not yet been able to participate and under what criteria they will be able to do so. Therefore, we recommend that the entire process and its impact on the company (including, for example, the employee evaluation process, the criteria for participation in the ESOP, and the necessary communication) be well-thought-out and planned from start to finish before implementing an ESOP.
- For which employees should you introduce an ESOP? For all, or rather as a reward for a select few?
There is no clear answer to these questions. It depends on what the company and its management want to achieve by implementing an ESOP. In most cases, ESOPs are provided to key employees only. However, there are an increasing number of companies that include virtually all of their employees in ESOPs. Even in such a setup, it is possible to differentiate the entitlements for individual groups of employees (e.g. according to their seniority, performance, or importance to the company) and thus reward key employees with a higher percentage than others. However, clear rules and transparent communication with employees are vital here.
ESOP: Employee Stock Option Plans. Find a new way to motivate employees
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Relation to the Company’s Business
- Does a company need to plan for a company sale (exit) or an IPO in order to implement a functioning ESOP?
The benefit to be received by employees from participation in an ESOP may or may not be tied to a planned exit or initial public offering (IPO). Under an ESOP, a company may sell or give employees shares of its own stock on the basis of which dividends will be paid to them on an ongoing basis, or reward them with a long-term bonus linked to the rising value of the company’s stock or other criteria (so-called Phantom Plans or SARs). The company may then pay the bonuses to employees from its own resources, thus exit or an IPO is not a prerequisite.
- Is it an advantage to have publicly traded shares? Does it lead to less administration for the company?
To a certain extent yes, there is no need to worry about valuation of shares or selling shares as they can be traded on the stock exchange. Also, the related administration can be outsourced relatively easily in such cases. On the other hand, however, the possible regulatory requirements of the individual stock exchanges (e.g. as regards the size of the share capital in the company offered to ESOP participants) must be considered.
- What percentage of the company’s capital should you provide for ESOP purposes?
In the Czech and the European market, it is common to provide around 10% of the share capital for ESOP purposes. Increasingly, however, there are companies that provide more, e.g. up to 25% of the share capital. Especially if you are recruiting talent in the global labour market, it is appropriate to consider providing higher shares. It is also a good idea to think about increasing the stake further for ESOP purposes in subsequent company funding rounds to make room for recruiting new talent.
- Can ESOPs also be set up for start-up companies, which often take the form of limited liability companies?
Yes, for start-up companies (including LLCs), the simplest solution is often to set up a type of Phantom Plan, under which participants receive their allocated shares in the company only virtually and are entitled to cash bonuses tied to the value of those shares if the terms of the plan are met. The clear advantage of this setup is its flexibility and a relatively low administrative complexity. On the other hand, there is a need to set up the valuation of the shares and the communication of the value of the shares to the employees so that they perceive their participation in the ESOP and the benefit derived therefrom as if they owned real shares.
Alternatively, it is possible to think within general business plans about the possible restructuring of the company / group of companies and the subsequent adjustment of the ESOP to the new structure (in the case of activities abroad, planned foreign expansion or e.g. an IPO, it is possible to consider the possibility of cross-border restructuring). This solution is usually more administratively and financially demanding than a Phantom plan but can bring advantages e.g. in the potential to extend the plan to other jurisdictions in case of company expansion etc. Depending on the specific set-up, the tax treatment of the related income may be more favourable than the first option, but on the other hand, it may entail a greater administrative burden for ESOP participants.
Regulation – Legislative Framework in the Czech Republic
- Is the Czech legislation adapted to the introduction of ESOPs? What are the barriers to the introduction of stock plans?
Unlike jurisdictions such as the USA, the UK or the Netherlands, where employee stock option plans are a long-standing and common practice, the Czech legal system does not provide a clear and simple legal framework for ESOPs. Its set-up and implementation to meet all the requirements of Czech legislation can therefore represent quite an administrative burden for Czech companies.
Unfortunately, Czech tax laws do not contain special provisions for ESOPs and do not provide participants with any special tax relief compared to the normal regime of taxation of employee income or income from the sale of shares. In practice, this means, for example, that participants may incur a tax liability during the ESOP even though they have not yet realised any cash income (e.g. when receiving shares for free or buying them at a discounted price compared to the market price). In addition, if participants work abroad during the ESOP, tax liability may also arise in those countries.
Obligations may also fall on the company or shareholders as the “payer” of such income, depending on the ESOP setup. Failure to declare and pay tax on the income can lead to penalties for the participants or the company, but often, unfortunately, to the participants questioning the benefit of the ESOP itself. We see these situations in practice, especially when foreign groups introduce option plans into existing Czech companies (e.g. when there is a change of ownership) as a new benefit for existing employees. However, they may also be relevant for purely local situations where the introduction of an ESOP has not been properly set up.
To avoid these situations, we recommend you analyse the legal and tax obligations for participants and the company prior to implementing an ESOP and plan the related processes and communications to participants well.
- Are there any planned legislative changes at the moment?
At the European level, there is an effort to coordinate and share “best practices” within the EU Startup Nations Standard initiative, which the Czech Republic has also joined. However, so far there have been no signs of this initiative being translated into more concrete steps or plans by the government in the Czech Republic.
Nonetheless, the absence of special legislation does not mean that the introduction of option plans in the Czech context is not possible, as evidenced by the discussion in which representatives of Czech and foreign companies shared their experiences with their implementation. Their experience clearly shows that there is no one standardised solution that could be implemented in all circumstances in any company. However, it is possible to find such a solution, either by introducing a scheme with virtual shares or by allocating real shares, which can help both to increase employee motivation and to retain them in the company.