ESOP Employee Incentive Plan and its benefits

Quick overview

• An ESOP motivates employees to participate in the success of the company.
• It most often works in the form of virtual shares or options.
• In the Czech Republic, proper tax and contractual setup is key.
• ESOPs help startups and growing companies retain key employees.
• An incorrectly set up program can lead to double taxation or disputes when an employee leaves.

If you are considering implementing an ESOP in your company, it pays to set up the entire program legally and tax correctly from the start. We can help you prepare ESOP documentation, set up shareholder relationships, and protect the company when employees leave.

What is an ESOP?

The word ESOP originated as an abbreviation of the English phrase “employee stock option plan.” At first glance, the English name may bring to mind the possibility of acquiring employee stock. However, this is not what an ESOP is all about (or it may be one possible form, but not the only form). An ESOP is an incentive scheme that can be introduced into any type of company, not just a public company. In particular, it includes a form of employee profit-sharing.

What does an ESOP mean in practice?

An ESOP is the distribution of a certain proportion of the company’s profits (in the form of real or virtual shares) to key employees. The employer determines who can become such a key employee. The criteria for selection can vary, whether it is the length of employment, the position in the company’s management or the need for an initial investment by the employees. It is also common for the bonus component of the salary to be rolled over into a share of the company’s ESOP performance.

What are the benefits of an ESOP?

Are you considering whether an ESOP is a good choice for your company? There are a number of arguments to consider. Some of those that might convince you include:

• In a situation where quality employees are still in short supply, an ESOP can be your ace in the hole against competing companies. For employees, such an employee benefit can create a strong incentive to be loyal and not leave elsewhere.
• With an ESOP, you encourage teamwork in which everyone has a stake in promoting the success of the organization. It is actually a “win-win” situation. You get quality employees with a long-term incentive to stay and contribute to the company’s best possible economic performance. For the employees, it’s an interesting financial incentive that translates into quality work.
• ESOPs can also bring interesting financial benefits, as they offer the possibility of obtaining external funding from your own employees.

In practice, ESOPs are most often encountered in startups and technology companies that want to retain key employees without significantly increasing fixed salaries. However, a common mistake is underestimating the contractual setup or a situation where an employee leaves the company before he or she is fully vested.

In fast-growing companies, a properly set-up ESOP is often more important than the salary level itself. If you want to set up a program that truly motivates employees while protecting the company, it pays to consult with an attorney when drafting the terms.

What might deter you from an ESOP?

• An ESOP requires experience in setting up and ongoing maintenance of the entire system, whether it is administered internally or externally.
• With any legal version of the system, it represents a fairly significant investment of time and money for the company.
• Taxation – The taxation of ESOP plans has been subject to several legislative changes in recent years, and the specific tax implications depend on the setup of the plan as well as the type of share or option. Taxation may arise on the acquisition of a share, the exercise of an option or the subsequent sale of a share, and in some cases a deferred tax regime may be available.

It is the tax setup that tends to be the riskiest part of an ESOP in practice. Companies often struggle with when an employee’s taxable income arises or how to set up option agreements correctly. We can help you with that too.

ESOP legal forms

In Czech law, the ESOP program setup is most often based on the Business Corporations Act and the Labour Code. The Income Tax Act also plays an important role, as the method of taxation of employee options and shares tends to be one of the most sensitive topics in practice.

Within the legal environment of the Czech Republic, we find two basic options for dealing with the ESOP system:

1) Real share in the company’s assets in the form of shares or shareholdings

The advantage of this option is that it represents a more tangible form of shareholding for the employees , but at the same time it is more difficult to process for the employees themselves and brings an unfavourable fragmented shareholder structure for the company. In the event of an employee leaving the company, it is then necessary to set up a relatively complex share buy-back system.

For the above reasons, it is generally not desirable for employees to be part of the shareholder base. In practice, this can be solved by setting up a separate company (Ltd.) in which employees are allowed to vote in the company’s bodies according to their shareholdings. However, the absence of a real share buy-back brings this option closer to the next legal form, i.e. a virtual shareholding.

2) Virtual (phantom) share

This does not involve the ownership of real shares, but the creation of a kind of “shadow shares” or the creation of a bonus scheme to be exercised when the company is sold.

This option is usually not linked to voting in the company’s organs. It is usually a contractually enshrined share of the positive economic result

Implementation of the ESOP system in practice

As can be seen, in reality, the system can have many modifications depending on many of the factors mentioned above. We will try to summarise at least what all these variations have in common and how the ESOP is implemented step by step in practice: First of all, the ESOP program has to be written down in the organization – all the above conditions and procedures are described transparently, along with the conditions for allocating shares to employees.

Subsequently, a share is allocated to a specific employee on the basis of a separate contract in the form of a share, a share in the narrower sense of the word, or a virtual share. The draft contract specifies the price at which the share can be acquired, the period within which the share option can be exercised and, as a rule, the period within which the share is subsequently acquired progressively. This part has a strong incentive component to discourage employees from leaving early. The period for the full vesting of the share is usually set at several years (approximately 5 years).

If the option period is fixed, it is advisable to address the relationship of the employee’s departure before the option is exercised in the contract, thus clarifying whether and how the right can be exercised after leaving the company.

At the same time, various objectives can be included in the contract, the fulfilment of which brings an additional incentive effect.

The most important part is the content itself , i.e. the value that the employee receives. For start-ups, this is usually a share of the purchase price on the sale (exit) of the company. A profit share or an extraordinary bonus is also a common form.

However, creating and setting up a transparent incentive system is not the end of the story. An important part of this is to make all employees aware of the plan and motivate them to participate in it. This is the only way the program can be truly effective and deliver what is expected of it.

In practice, we recommend preparing ESOP documentation individually according to the structure of the company and the type of employees. One-size-fits-all templates often do not address situations such as an employee leaving, a sale of the company, or a dispute between shareholders.

Summary

ESOPs are an effective tool for motivating and retaining key employees, especially for startups and fast-growing companies. A properly set up program can motivate employees over the long term while helping the company compete in the job market. But the key is a good legal and tax setup that addresses vesting, vesting conditions, employee departure, and taxation treatment. In the Czech environment, a virtual ESOP tends to be the most common option because it reduces the complications associated with the transfer of real shares.