Virtual ESOP in the Czech Republic, or when shares remain in the shade. Imagine a world where you can offer employees a share in the company’s success without having to become actual co-owners. A world where remuneration is transparent and performance-based, but without a complex share transfer process and with far less administrative burden. Welcome to the world of virtual ESOPs.
At first glance, this concept may sound too futuristic, but it is actually an innovative solution that offers tangible benefits for both startups and established companies looking for flexible ways to motivate their personnel and encourage loyalty. Although these are not real shares, their impact on corporate culture and employee motivation is more than real.
In our previous blog about ESOPs, we introduced you to the basic concepts you will encounter when preparing virtual ESOP plans. In today’s blog, however, we will delve deeper into the world of “shadow” ESOPs and explore how these plans can affect corporate dynamics in the Czech Republic. The subject of today’s blog is the so-called virtual (shadow) ESOP. We will focus on its basic parameters, briefly discuss its tax regime and try to list its basic advantages and disadvantages compared to a standard (equity) ESOP.
Based on a virtual ESOP, the ESOP participant acquires so-called virtual shares (phantom shares) in the company. A virtual ESOP plan is also commonly referred to as a shadow or non-equity plan, or also as an employee bonus plan.
The name of this share already implies that it is not a standard share in the company. An employee under a virtual ESOP plan does not acquire an ownership interest in the company upon meeting the conditions of the ESOP plan (particularly the Vesting period). Hence, the participant does not become a co-owner (member or shareholder) of the company. The benefit of a virtual share is the ability of an ESOP participant, without actually owning a share in the company, to participate in some of the privileges typically accruing to the company owners.
What is the subject of a virtual ESOP?
A virtual ESOP is a plan under which an ESOP participant acquires a virtual share in the company that carries a number of rights described in the ESOP plan.
The subjects of this relationship are usually the company and an employee or other person working with the company. Company founders may also be party to the ESOP plan. In terms of form, there are basically two types of ESOPs.
Either an ESOP designed by the company that employees join based on their consent to the plan, or a separate (innominate) ESOP agreement between the company and the ESOP participant.
In the case of ESOP agreements, the advantage lies mainly in the greater individualisation of ESOP plans for individual employees. While in a standard ESOP the joining participants have, as a rule, the same terms and conditions, in ESOP agreements these terms and conditions may be modified differently for a particular ESOP participant. There is also more room for negotiation with the ESOP participant, which can ultimately be beneficial to the company as well. An ESOP participant will certainly see the fact that he or she was able to influence the creation of the ESOP plan as more advantageous than simply signing an already created plan, which is akin to signing standard form contracts.
Whether a company implements across-the-board ESOPs that employees join, or whether individual ESOP agreements are entered into, depends primarily on the number of employees and the strategy the company chooses. In most cases, and especially in the early stages of a startup’s life, key employees are the most motivated and ESOPs are thus more individualised. On the other hand, startups that are in a later stage of their life (e.g. Series B) and have more employees tend to choose across-the-board plans that are easier administratively and for legal implementation. Finally, we may also see combinations between virtual ESOP plans themselves, which may be a combination of across-the-board and individualised plans.
In both cases, these are essentially bonus schemes where the employee (or other co-worker) is paid a certain amount of money calculated according to the value of the virtual share (shares) upon prearranged events, such as the sale of the company, distribution of profit, etc. (exit event).
Implementation of the ESOP
The actual implementation of ESOPs can vary significantly from case to case. In practice, the most common are (see our previous blog for more detailed information on the terms below):
a) Vesting grant – an ESOP agreement under which the ESOP participant is promised to receive a cash benefit (bonus) from the company upon exit if certain conditions are met.
b) Virtual vesting – the ESOP participant gradually acquires the promised virtual share (shares) according to an agreed mechanism (vesting). In order to acquire the virtual share (shares) in full, there is a defined period during which the ESOP participant works with the company (Vesting Period). In addition to the temporal aspect, other requirements (e.g., related to the performance of the ESOP participant) may be part of the conditions for obtaining the virtual share(s).
c) Exit event – a pre-defined event (or events) to which the employee’s entitlement to a bonus payment is linked (see the next point), e.g. sale of the company (or business), listing of the company’s shares on the stock exchange, etc. A potential exit event may also be, in some cases, the termination of the ESOP participant’s engagement with the company for excusable reasons (Good Leaver).
The most common (and indeed desirable) exit event is the sale of the entire company (i.e. 100% of the shares) to a third party – an investor or another corporation that implements the company into its own ecosystem (e.g. a bank buys out a fintech project to implement a new tool/service).
d) Payout – based on the exit event, a bonus is paid to the ESOP participant, with the amount of the bonus corresponding to the value of their virtual share(s) at the time of the exit event.
Forms and payout of virtual shares
From the definition of payout, let’s take a shortcut to the topic of the forms and methods of paying out virtual shares.
A bonus can take basically 2 forms – a contractual bonus, and a dividend paid to the employee as a non-shareholder. It is important to note that, for the employee, both of these forms are considered as income from dependent gainful activity for the purposes of tax regulations and, as such, are subject to the same tax regime as the employee’s regular income.
a) Contractual bonus
- In this case, it is the most common form of bonus paid under ESOPs. This term essentially includes any cash benefit that an ESOP participant receives upon an exit event (other than dividend payments – see the point below).
- The method of calculation may vary. However, its amount generally depends on the value of the participant’s virtual share(s).
- Czech corporate law allows dividends to be paid to persons other than the company’s members (shareholders).
- Hence, this option is also available for ESOPs. However, this is a less favourable option than a contractual bonus, mainly because of the tax aspects. The payout of a dividend, unlike the payment of a contractual bonus, is not a tax deductible expense for the company. The option of paying out a virtual share in the form of a dividend is therefore the least recommended option from this perspective, and therefore the least used.
How does such a bonus payout work in a virtual ESOP? In the case of the most desirable exit event – the sale of the entire company – a portion of the purchase price for 100% of the shares is distributed to the shareholders, investors who hold equity interests in the company, and ESOP participants who hold virtual shares. A portion of the purchase price, representing the payout of all virtual shares in the company, will be paid directly by the purchaser to the company (instead of to the selling shareholders), and the company will distribute the money in accordance with the ESOP to the participants entitled to the virtual share payout.
As an example:
- Purchase price for the sale of the entire company – CZK 100,000,000
- ESOP Pool – 10% virtual shares
- Grant Size per employee – 2%
- Number of employees – 10
With the above parameters, the shareholders (founders) will receive 90% of this purchase price, i.e. CZK 90,000,000, and 10% of this purchase price, i.e. CZK 10,000,000, will be paid through the company to the participants in proportion to their virtual shareholding (or in accordance with the ESOP pool).
For clients – startups and founders, to maintain a healthy cash flow, we always recommend that the payout occurs only when the company receives the exit proceeds.
Advantages and disadvantages of a virtual ESOP
As a matter of fact, virtual ESOPs are the most commonly used option plans in the Czech Republic. The mere fact that by acquiring a virtual share, an ESOP participant does not acquire an ownership interest in the company, may be an advantage to the company. On the other hand, from the participants’ point of view, this can also be seen as a disadvantage, because such a scheme weakens the motivational function.
Advantages of a virtual ESOP (especially for the company):
- No ownership interest in the company: Participants do not become actual shareholders in the company, which makes the ownership and management structure simple. Thus, the company does not have to create special types of shares that do not carry all the rights of shareholders.
- Flexibility and simplicity: Compared to traditional equity-based ESOPs, a virtual ESOP may be easier to implement and administer.
- Reduced costs: It is less administratively and legally burdensome for the company to administer a virtual ESOP.
- Better control over the company: The founders and owners of the company are able to maintain firmer control over the decision-making process because virtual shares do not carry voting rights and/or decision-making rights over the governance of the company. The participants are thus completely separated from the corporate governance.
Disadvantages of a virtual ESOP (especially for participants):
- Limited ownership feeling: Employees may experience less of an “ownership feeling” because they do not have a real stake in the company and may be thus less motivated to be loyal in the long term.
- Potentially lower value for employees: Virtual shares do not have the same capital growth or dividend potential as real shares.
- Complexity of communication: Explaining the concept of a virtual ESOP and its value to some employees may be more difficult than a traditional ESOP.
- Absence of real shareholder rights: Employees cannot vote at general meetings or otherwise participate in the company’s decision-making processes.
- Risk of default: If a company is facing financial difficulties, it may be more difficult for employees to receive a payout under a virtual ESOP compared to real stock.
- Taxes: From a legal perspective, this is always a salary bonus, which makes the bonus subject to the same taxation as the employee’s other regular incomes.
While virtual ESOPs offer a number of benefits, it is important to consider both sides of the coin when deciding if they are the right choice for your company.
In a nutshell, the virtual ESOP not only represents a new and flexible way to reward employees and other co-workers, but also symbolises a strong trend in human resource management and corporate culture. Today, as technology and innovation accelerate changes in the business environment, it is essential to have tools that allow companies to adapt quickly while keeping key talent motivated.
Shadow ESOPs can be an ideal solution for some businesses, combining the benefits of share ownership with the flexibility of a modern compensation scheme. And while these may seem to be just “virtual” shares, their impact on the real world – on motivation, loyalty and overall company growth – is undeniable.
Whether your company opts for a virtual ESOP or another compensation model, the key is to always focus on what is best for your employees and the future of your business. Because, as it is often said, the true success of a company is a reflection of those behind it.
In the upcoming blog, we will focus on the standard (equity ESOP). We will also discuss its advantages and disadvantages compared to a virtual ESOP.