Employee Incentive Schemes: The Good, the Bad and the Grey

Employee incentive schemes, often also referred to as employee share option plans (ESOP), can be tricky. Besides the company’s jurisdiction, which oftentimes brings an additional layer of complexity, there are numerous rules to be navigated that determine the amount, type and timing of any ultimate payout. In this post, we want to set out our thinking (and in a best case give some guidance) on the key commercial terms that determine the plan’s success*. One could think “what’s the problem, why not simply give the beneficiary some shares like any other shareholder?”. Well, while this is a possibility, it would cause quite a few tax headaches (see below) and defeat the main purpose of the ESOP, which in a nutshell is rewarding future value-added.

Incentive plans need to find a delicate balance between attracting, motivating and retaining key employees, advisers and other supporters of the company (we’ll refer to them collectively as “beneficiaries” or “employees” in this post) and ensuring that if things don’t work out as planned the company has the ability to recover at least some of the options to avoid undue dilution of existing shareholders (including other ESOP holders). The rules that try to achieve this can largely be summarised under the buzzwords “vesting” and “leaver provisions”.

For context: Tax and governance

Before diving in we’d like to take a very quick look at the two key “external” factors that determine the basic structure of an incentive plan in most jurisdictions. These are somewhat less exciting and much more technical, but bear with me, they are important, and I’ll keep it short:

• The single biggest driver of ESOP structures is tax. The challenge is that in most Western jurisdictions payments to employees that are not clearly capital gains are taxed as normal income and hence at a (much) higher rate. This is why there often is a wish to receive “real” shares early on — which however can lead to an immediate tax liability as the award is treated as income (or the need to pay an adequate purchase price). Most incentive plans focus on avoiding taxation of such “dry income” at the time of award even if this means somewhat less advantageous tax treatment later on, i.e. there is a preference for options or “virtual” shares rather than real shares. In some jurisdictions, esp. the US and the UK, there are also special option plans that are privileged tax-wise without the need to transfer “real” shares at time of award, so if their specific requirements are met the awkward question of early payments vs. lower capital gains taxation later on can be avoided altogether**. Even if such a special structure is not available there may be other ways to optimise employee awards from a tax perspective — do check with a specialist if the question comes up. A relatively simple way to at least provide more flexibility in case of an option plan is to allow an “early exercise”, which means exercising stock options before they are fully vested***.
• The second aspect is governance. If a beneficiary receives shares, he/she will also automatically have certain statutory rights as a shareholder (esp. information and voting rights). Involving ESOP beneficiaries in the governance of the company is neither the idea of an incentive plan (which is all about providing a share in the economic value creation) nor is it desirable as it can make governance more tedious, lengthy and expensive. In some, mostly Anglo-Saxon jurisdictions this is not a big issue as minority shareholder rights are limited and/or can be excluded or waived in the relevant documentation, but in others, workarounds need to be found, e.g. by putting the incentive shares in a trust (such as a Dutch STAK) or structuring the ESOP as a merely virtual share plan (e.g. in Germany this is the most common approach for start-ups, even if less beneficial from a tax perspective).

Commercial terms

Now to the main commercial value drivers of incentive plans. Since they reflect general principles of employee incentivisation, they are similar in most incentive plans, irrespective of their (mostly tax and governance driven, see above) structure and the type of benefits granted (stock options, “real” shares or virtual shares — which we’ll collectively refer to as “benefits” or “options”).

It’s usually uncontroversial that a beneficiary is required to pay a purchase or exercise price upon exercise of a share option (in case of virtual shares the exercise price is simply a deduction from the eventual payout). Rationale, besides potential tax considerations****, is to account for value created prior to the time of grant*****. Likewise, a vesting period of (around) 48 months with monthly or quarterly vesting and a so-called “cliff” (which for almost all plans means the first batch of vesting only occurs after 12 months) can be considered standard.

Things get more complicated when it comes to situations, as happens all the time, where the beneficiary leaves the company before an exit. Obviously, he/she will lose any unvested benefits in such a case, but there is more to be considered:

- What about the vested (and, in case of stock options, not yet exercised) benefits? Should these remain with the beneficiary, even if the exit may still be far away and he/she is no longer involved in future value creation?

- Let’s say the beneficiary leaves on his/her own accord, i.e. voluntarily: Should he/she be treated the same as a beneficiary who is dismissed by the company, or is he/she less “worthy of protection”?

- Under what (if any) circumstances is the beneficiary a “really” bad leaver who forfeits all his/her options, vested and unvested, no matter what?

In the (simplified) chart below we’ve tried to illustrate the most common scenarios:

The most straightforward case is where the beneficiary is still employed by the company at the time of an exit (see right hand side of the chart): all vested benefits can be sold (in case of options after exercise) or are automatically paid out. If there are unvested options, these will generally not become payable or may even forfeit as they have not been “earned” yet, unless something else has been agreed at the time of allocation or the board allows a different treatment. The buzzword here is ”accelerated vesting”, which either means the immediate vesting of all unvested benefits when the exit occurs (“single trigger”) or guarantees full vesting if the beneficiary is laid off without cause within a certain period (“double trigger”).

Departure before exit

If the beneficiary departs before an exit some (mostly virtual) incentive plans foresee that the vested benefits become subject to a “negative vesting”, which means they lapse in increments over time until there is an exit or they hit an agreed minimum, in a worst case zero. Since this conflicts with the basic premise that vested options are (more or less) to be treated like real shares from an economic perspective, we consider such a rule surprising and unfair.

There is of course an argument that the options were granted in exchange for the (future) contribution of the beneficiary and that any value increase after his/her departure does not meet this test. Quite a few, mostly European, incentive plans therefore include a right of the company to purchase the vested benefits at fair market value within a certain time after the beneficiary’s departure. This is not uncontroversial, however, as it makes the plan less attractive. It’s also little relevant in practice as poorly performing companies generally don’t have the cash and/or incentive to exercise the purchase right and well-performing companies will want to avoid any restiveness amongst their (remaining) employees.

Another structuring tool esp. in US and UK stock option plans is a provision that requires the beneficiary to exercise his/her vested options within a certain time period after departure, commonly 3–12 months (with the longer period reserved for cases of illness and the like). Because this means that the beneficiary has to pay the exercise price (plus potentially taxes) out of his/her own pocket he/she may be forced to let the options lapse. As a result there often is discussion over the length of the exercise period and several companies have extended it considerably, e.g. Coinbase and Pinterest (to 7 years).

Circumstances of departure

Another question is whether there may be circumstances of the departure under which the beneficiary loses not just the unvested options, but also some or all of the vested options, i.e. whether there should be a distinction between a “good leaver” and a “bad leaver”. It makes sense, and is reflected in almost all incentive plans, that all (vested and unvested) benefits forfeit if the beneficiary is fired for cause. Yet such cases rarely become relevant in practice, as in most jurisdictions a termination for cause requires a gross violation of duties, e.g. fraud against the company.

More relevant is a violation of a (post-contractual) non-compete obligation or the usage (disclosure) of trade secrets. If the non-compete obligation is limited to a reasonable amount of time there is a good argument to allow the forfeiture of vested benefits if the non-compete obligation is broken. This obviously requires the “non-compete clause” to be valid — which may not be the case in jurisdictions where post-contractual non-competes are unenforceable such as California.

In practice, the probably most important question around good/bad leaver is whether an employee who resigns voluntarily should be treated differently from one who is dismissed without cause. Employers often wonder why they should “reward” someone who “deserts” them. Accordingly, there are some incentive plans, especially in Continental Europe, that treat voluntary resignation as a bad or “grey” leaver, meaning that the beneficiary also loses all or some of the vested benefits or that he/she can be forced to sell them at a discount.

We don’t think this is a good idea for various reasons: For employees who quickly change their mind after joining, there is the cliff. In other cases an employee’s motivation to leave may be the result of a frayed relationship which both sides have contributed to. In such a case it hardly makes sense to make the treatment of vested benefits a decision factor in whether to end the relationship, confining both sides to inaction even though this is not in the best interest of the business. And where the employee is an outperformer whom the employer would like to retain it does not feel right to punish his/her high value-added relative to an underperformer who is fired. We believe the starting point should always be that vested options are earned and unvested options are not earned, and only in extreme cases one should deviate from that.

What it comes down to

As mentioned, employee incentive plans and the associated structuring elements and value judgments are complicated… Still, there is no need to throw in the towel and hand the thing in its entirety to your lawyer. As long as you make yourself clear what a seemingly convoluted clause is for, it’s normally not too hard to focus on the key terms of the plan (esp. vesting, departure consequences, payout/exercise terms, see above) and leave the rest to the specialists (or a trusted template). And where you come across a (potentially) controversial provision (e.g. the discrimination of a voluntary leaver) it often helps to put yourself in the position of the employee and ask yourself whether the provision appears “tough, but fair” or rather “surprising and unfair”. If in doubt, side with the beneficiary, because remember, every employee, freelancer and adviser, whether still employed or not, is or may become an ambassador of your brand and corporate culture.

Notes:
* For a comprehensive overview of ESOPs including guidelines on size, allocation principles and communication with employees, check out the excellent employee equity primers of Balderton and Index.
** In the US these plans are called Incentive Stock Options (“ISOs”) and in the UK Enterprise Management Incentives (“EMIs”).
*** If you have a knack for tax and structuring: If shares are granted before they are vested, they are restricted, i.e. subject to a purchase option of the company that can be exercised in case of a leaver event. In terms of taxation, some jurisdictions, first and foremost the US and the UK, give the beneficiary a choice: If he/she pays a market-adequate price for the shares or, if the price is lower, income tax on the difference to fair value, he/she can opt for capital gains taxation on the eventual sale of the share, otherwise the gains are taxed as income (the keywords here are “Section 83(b) election” and “Section 431 election”). Note that the above description is highly simplified and really just intended to provide a very brief overview, and obviously cannot replace qualified tax advice. But hey, on the other hand we don’t throw a 5 kilo tax bible at you either. :-)
**** See above; e.g. in the US an adequate exercise price is required to avoid immediate taxation, hence the so-called 409A valuations.
***** There are also plenty of — mostly virtual — incentive plans esp. in Continental Europe that do not require any (material) consideration, esp. if the company is still at an early stage. Aim is to maximise the attractiveness of the plan while taxes generally do not play a role here.