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Lex ESOP #2 | How to set up an ESOP without an equity interest?

Lex ESOP #2 | How to set up an ESOP without an equity interest?

In the previous article in the Lex ESOP series, we briefly introduced individual types of employee stock ownership plans (ESOPs). In this part, we will present one of them, namely an ESOP without a managers’ equity interest. This type of an ESOP can be established relatively easily in its basic set-up, through a standard contract on the performance of office. Contractual freedom allows both parties to set the terms of remuneration quite flexibly according to their needs. However, the law imposes certain specific requirements on the contract on the performance of office, which must be complied with when concluded, otherwise the managers will, for example, face the risk of performing the office for no consideration. In this part, we will therefore present what these requirements are, how an ESOP without a managers’ equity interest can work and how it can be modified into an ESOP with an equity interest.

Contract on the performance of office & setting remuneration of managers

A contract on the performance of office is a specific contract concluded between a statutory body member and the company governing the terms of the performance of his/her office in the company. The law imposes specific requirements on this contract - for example, it must be concluded in writing and must be approved directly by the supreme body of the business corporation (i.e., the general meeting, or the sole shareholder), including any amendments thereto. We have already summarised in more detail (not only) the issue of contracts on the performance of office in our brief guides on the office of a member of the statutory body, which contain more information on this subject and can be found, for example, here.

The contract on the performance of office normally serves to specify certain duties of the manager, to stipulate the terms and the manner of performance of the office, but above all to specify the amount of the manager's remuneration and to agree the terms of its payment. 

It is the area of remuneration of managers that needs to be given due consideration in the contract on the performance of office. If the contract does not provide for remuneration in accordance with the law, then the performance of office is considered to be for no consideration. This means that the manager will have to refund any remuneration that has been paid to him/her unduly; however, the appropriate setting of remuneration can be one of the main motivating factors and therefore needs to be given due attention so that the manager does not end up losing instead of receiving remuneration.

It is necessary to define the remuneration in the contract in a sufficiently specific manner and not to forget that in addition to the monetary consideration that the manager receives (i.e., monthly remuneration as an equivalent to salary or wages, financial bonuses, profit share, etc.), the remuneration also includes other non-monetary benefits that the manager receives from the company. 

These can be quite diverse and include, for example, the manager's possibility to use a company car or telephone for private purposes, to participate in training and development programmes that go beyond the normal standard of education, to obtain various types of insurance and supplementary insurance from the company, and so on. In addition, if any other consideration is to be provided to the manager beyond what is agreed in the contract on the performance of office, then this is also subject to approval by the company's supreme body or controlling body. Otherwise, he/she will have to return it or replace its value.

A separate topic is concurrence of functions, which can also ultimately deprive the manager of remuneration (for these we also refer to the guides above).

And how do ESOPs relate to this?

If the founder is interested in providing its managers with some form of an ESOP, but at the same time, for some reason, an ESOP with an equity interest or the issue of securities is not an option for the founder, it may be a suitable option to comprehensively provide for the manager's incentive remunerating directly in the contract on the performance of office. 

Such arrangements may replicate the situation as if the manager actually owned the shares in the company, but everything will take place only on the basis of a contractual relationship. Such a solution may also be referred to as phantom shares.

The manager's remuneration under the phantom shares plan can be set up in a comprehensive way so that he/she can receive much other consideration in addition to the regular monthly remuneration. For example, the manager can receive a share of the company's profits under predefined conditions or specific KPIs (key performance indicators) that ensure that the manager is sufficiently motivated to strive for the company's growth and at the same time that the manager's only goal is not the rapid profitability of the company, regardless of the long-term sustainability of this development. 

The incentive criteria can be extensive, and the contract on the performance of office allows providing for all these matters with great flexibility. In principle, this will simulate the possibility of receiving a regular dividend from the company depending on its success, without the manager having to receive an interest or shares. 

This step must be taken carefully in view of the relatively strict legal requirements, according to which the contract on the performance of office must define not only all components of remuneration, but also the conditions for determining its amount and the rules for its payment, including any special remuneration. If the manager received anything from the company in excess of the agreed remuneration, the manager could run the risk that such consideration would be unjust enrichment and the company could (and should) claim it back from him/her. Such remuneration includes, among other things, remuneration in the form of an option to acquire participating securities by the manager or a person close to him/her (the so-called option plan), which must also be part of the contract on the performance of office.

Option plans as an extension of an ESOP without an equity interest

Although ESOPs without equity interests are a relatively flexible instrument within the framework of incentive plan types, their disadvantage is the lack of possibility of keeping a capable and key manager in office - he/she can resign from it relatively easily and unilaterally. In order to strengthen the incentive element and reinforce mutual cooperation and its links, consideration could be given to linking contractual incentive with an equity interest, for example through an option plan.

Option plans allow a manager to acquire an equity interest (stakes or shares) in the company through the exercise of an option. As mentioned above, this form of remuneration is also subject to statutory rules and should therefore form part of the contract on the performance of office and is therefore subject to approval by the company's supreme body, including the need to comply with other statutory conditions.

Given that an option plan inherently carries with it the possibility of acquiring an equity interest in the company, it may be advisable for the terms of the option plan to include both a comprehensive arrangement of the shareholders' relationships after the manager acquires an equity interest in the company (through a shareholders' agreement) and the terms of how the option right arises and under what conditions it can be exercised. At the same time, it is also advisable to consider in advance how the option plan will be terminated should the parties finally break up.

This possible remuneration arrangement combines a variant of an (incentive) ESOP without an equity interest with setting in advance the conditions under which the manager may acquire an equity interest in the future if, for example, he/she meets certain performance indicators. It thus combines both the non-equity and equity interest versions of an ESOP together. 

This variant may be more motivating for the manager, as he/she knows that at the end of his/her efforts there may be an opportunity to acquire an equity interest in the company, while at the same time giving the founder enough room for the manager to actually receive this bonus after he/she has proven himself/herself in the management of the company. Generally, however, any participation in an increase in the value of the company that the manager would acquire by later selling the valued interest or share is not something that cannot also be ensured through the contract on the performance of office.

However, we will publish a separate post on option rights and option plans later this autumn.

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