Feeling like a co-owner changes a great deal. It adds motivation and strengthens responsibility for the outcome of one’s work. It is hard to imagine a company that has not at least briefly considered some form of management or employee options. For startups built from scratch, attracting truly talented people without ensuring they share in the rewards now seems almost impossible.
How do options work?
In New York, Larry Page, wearing a suit bought at Macy's, rang the NASDAQ bell with Eric Schmidt. They then went to Morgan Stanley to see the opening share price. (…) By the end of the day, Page and Brin were each worth USD 3.8 billion. On the Monday after Google shares began trading, Schmidt gave a recap at the company's weekly meeting. 'All the employees screamed at the top of their lungs for a while,' Schmidt recalled.
Simply put, an option is a contractual commitment granting a right, but no obligation, to acquire a specified number of company shares at an agreed price. It must be exercised within a predetermined period, after which it expires.
Options allow participation in the gains from growth in company value when an IPO takes place and the shares are listed. A financially advantageous exercise may also be possible when the company is sold to a fund or industry investor, or on other liquidity events (hyperlink to the article on 'liquidation preferences').
However, if the company remains private and is not sold, and its articles or agreements between owners do not require regular dividends, for example, the benefits of holding options may be illusory.
Making a gain or avoiding a loss?
Management took steps to prevent the toxic behaviour seen during the recent technology bubble, when new millionaires paid more attention to newly acquired luxuries than product development. On IPO day, engineering chief Wayne Rosing addressed an all-staff meeting holding a baseball bat. He told Googlers that if he saw a new BMW or Porsche in the company car park over the next few days, he would smash its windows with the bat.
From a capital-structure perspective, there are several substantially different models for granting rights to gains from growth in company value. Alongside the share-option model described above, there is its mirror image.
Here, company shares are acquired immediately but cannot be sold and are subject to compulsory repurchase or cancellation if employment ends before a specified period has elapsed ('reverse vesting'); this model is known as Restricted Stock Awards (RSA).
If employees are expected to value only financial benefits and not corporate rights, a plan providing solely for cash settlement can be introduced.
One example is a phantom share. Its holder is not formally a shareholder and, in particular, has no vote. Exercising contractual rights against the company amounts to cash settlement and receipt of an appropriate bonus. Such cash-settled rights are known as Stock Appreciation Rights (SAR).
In practice, Polish law offers joint-stock companies a wide range of legal structures for incentive plans. Almost all have at some point been tested extensively by private and public companies.
These range from cash-settled financial derivatives to conventional option agreements between company and employee using treasury shares. Article 362 § 1 point 2 KSH allows a company, subject to conditions, to acquire its own shares for offer to employees or former employees who worked for it or an associated company for at least three years.
Companies can also use more complex arrangements involving subscription warrants or convertible bonds, enabling subscription for new shares not yet existing when those instruments are granted, or option plans involving third parties such as financial intermediaries and ESOP vehicles.
Introducing an incentive plan in a Polish limited liability company requires greater creativity because of the restrictions inherent in its legal form. Reverse-vesting arrangements are often used, particularly compulsory cancellation of shares if the conditions for permanent entitlement are not met.
'But share ownership affected Google's employees (…) Google statistician Bo Cowgill conducted a series of studies of his colleagues' behaviour. (…) He found that “daily share-price movements affect employees' mood, engagement and decision-making”. As expected, rising prices made people happier and more optimistic, but also more cautious about innovative ideas: as Google employees became wealthier, they became more conservative. This was precisely the adverse consequence of the IPO that the founders feared most.'
Three key concepts
Option plans involve several stages of acquiring and exercising rights. Once a person qualifies for the incentive plan, options are awarded („grant”), initially on a conditional basis.
Besides a basic length-of-service requirement, acquiring shares may depend on the company achieving specified financial results or the participant meeting individually agreed objectives and tasks.
Meeting every condition permanently secures the right to acquire a specified number of shares („vesting”). Ultimately, the option holder must decide whether to exercise it before expiry („exercise”).
Tax, tax, tax
As so often, the option-plan model is driven primarily by tax consequences and how income is determined and classified. The most favourable arrangement defers recognition of option income until cash is received from selling the shares acquired or from cash settlement of the options. The income source should be unambiguous.
For the company and the plan's costs, there is a fundamental difference between treating options as employment remuneration and treating them as capital income or income from 'other sources'. In the first case, the company would have to perform income-tax withholding duties and pay social insurance contributions, among other things.
For the employee, this means less favourable taxation under the general progressive scale. Although established administrative court case law appears to make such adverse consequences much less likely today than a few years ago, the tax authorities' position remains inconsistent.
(…) Six years after the IPO, an impressive number of important early employees, including Susan Wojcicki, Salar Kamangar and key engineers Amit Singhal, Ben Gomes and Jeff Dean, still work hard for Google despite fortunes rivalling those of Saudi princes. Nevertheless, personal wealth inevitably changed the early employees' lifestyles. (…) Even Google's official massage therapist noticed money's impact, particularly the gulf between early employees with valuable option packages and later arrivals. 'While one checked local cinema times on a monitor, another booked a weekend flight to Belize.'
All quotations following the subheadings come from Steven Levy's excellent book, In the Plex: How Google Thinks, Works, and Shapes Our Lives (the article author's own translation of selected passages).
Further posts will continue the options theme, including an analysis of possible arrangements under Polish company and tax law. Using real market examples and our own practice, we will examine the most common incentive-plan models in detail. We will also explain how tax authorities' treatment of options has evolved and possible directions for tax-law developments.
