An Employee Share Option Is An Effective Way To Retain The Employee

In the past, companies expected job loyalty but today we hear stories of employees accepting other job offers only a few months after being hired. This is especially painful for start-ups that are building organizations and processes on the go and typically do not have sufficient resources to constantly train new people and rely significantly on the loyalty of employees to retain the knowledge. Competitive base salary is not the only mean of encouraging an employee to dedicate themselves to work required for fast-paced company growth. As employers are aggressively competing for the best talent by offering remote work opportunities, discounted meals, football tables, and many more short-lived excitement opportunities, the long-term solution is an employee share option scheme. This is an excellent tool to align the founder’s, management team’s, and employees’ interests and for everyone to have a collective investment in the company’s future.

  • What is the share option?

The share option is a right to buy a certain amount of the company’s shares after some time in the future at a pre-agreed price or free of charge. So the employees receive a right to exercise their share options, i.e., to buy the shares after a specified period of time at the price fixed at the date when the options were given to the employee regardless of the prevailing market price. The employer can make the granting and exercising of share options dependent on certain targets such as performance indicators, sales targets, i. e., the employee will have a right to exercise their share options provided that the set targets are met at the agreed rate for that period.

  • How share option is beneficial both for the employer and the employee?

By offering employee share options, employers typically see increased loyalty, longer employment tenure, and more active participation in the company’s success. Many international examples show that it is one of the best tools in building a motivated team. Some companies choose to offer share options to the key employees ensuring that the company’s strategy is executed by the team that has a long-standing history with the company while others offer share options to all employees. The common goal of both parties of the share options agreement is to motivate the employee to take a long-term approach, thus increasing the value of the employer as the company, and aligning the interests of the parties. The share options are of a purely personal nature and is inextricably linked with the employee as the employee of the particular company. The company is willing to have the employment relationship as long as possible, therefore, usually, the crucial condition is to set forth the long-term after which the employees may exercise their right to acquire the shares of the company.

Joining a newly created start-up can be a very fulfilling but risky career move. For early-stage start-ups that in most cases offer share options, it is the only way to attract top talents as some time later a new company may not be able to offer a competitive salary. The company’s benefit, in this case, is also evident – the possibility to attract various specialists while preserving their loyalty, real involvement in activities, and motivation is highly ensured.

Taxation

Share options are taxed as fringe benefits.

  • Applicable taxes are paid by the employer.
  • Applicable income tax and social security contributions - the same rates that are applied to salary, except tax exemption.
  • Applicable tax exemption is applied for income tax and social security contributions if a share option is held (but not exercised) by an employee for at least 3 years. The fringe benefits from share options are exempt from personal income tax provided that a share option agreement is concluded after 1 February 2020.
  • Taxation is applicable not at the moment of granting the share option but only when the share options are exercised.
  • Taxable value is a difference between the fair market value of the shares and the price paid by the employee for the shares.

Capital gain received by the employee after selling acquired shares is taxed.

  • Applicable taxes are paid by the employee.
  • Applicable personal income tax. Capital gain is taxed at 15/20% of the personal income tax compared to 20/32% applicable to the salary.
  • Taxable value is a difference between the sale price of the shares and the price paid by the employee for the shares. In case the employer has paid the applicable taxes for the shares upon exercise of the share options then the taxable base is the difference between the price at which the shares are further sold and the value of the shares from which the employer has paid the applicable taxes. For example, the employee received the shares for 1,000 EUR and later he/she sold them for 2,500 EUR, which means that the taxable value is 1,500 EUR.

Law firm ECOVIS ProventusLaw has over 10 years of experience in labor and corporate law consulting, dispute resolution among shareholders, drafting shareholder options. If you are considering introducing an employee option scheme and realising employee retention and motivation benefits associated with it, do not hesitate and contact us for advice on how to best structure and duly implement such scheme.

The content of this article is intended to provide a general guide to the subject matter. The expert’s advice should be sought about your specific circumstances.

Prepared by an attorney at law Mrs. Loreta Andziulytė and senior associate Ms. Milda Šlekytė.

More Favourable Conditions for Investment in Startups

Since 2020, an amendment to the Corporate Tax Law initiated by the Ministry of the Economy and Innovation has entered into force, allowing Lithuanian and foreign investors to more flexibility invest in start-ups. The corporate tax relief now applies to venture capital and private equity entities which invest in both shares and convertible bonds. This amendment is expected to encourage increased investment by private and venture capital funds in early-stage start-ups.

Until now, only venture capital and private equity entities that invested 70 % of the capital value in equity securities (shares) have benefited from the corporate tax relief. Under the newly adopted legislative amendment, the 70 % limit applies to both equity securities and convertible bonds together or if the investment portfolio is formed by only one of these investments.

‘This is a more flexible and attractive investment instrument and we hope that these regulatory changes will encourage Lithuanian and foreign investors to invest more in innovative early stage companies,’ says Vice-Minister of the Economy and Innovation Marius Skuodis.

Business practice shows that previously the way of investing in equity securities was not attractive to start-ups or investors because the start-up would lose part of the company’s control and the investor faced the risk that, in the event of a failure of the start-up, it would be difficult or practically impossible to recover the investment.

Currently, the model of investment in convertible bonds is widespread, which is particularly attractive to growing companies which seek to attract investors but do not have much capital yet. The acquisition of convertible bonds gives the right to convert them into shares in the company, so this type of securities may have significant potential in case of the company’s success. Such a model allows start-ups to retain more control over their company, facilitates the valuation of the company and enables investors to better protect their investments.

According to Director of the Lithuanian Private Equity and Venture Capital Association Skaistė Budbergytė-Zabielaitė, efforts made by the State to improve the legal and fiscal environment for venture capital and private equity entities make a significant contribution to the development of investment.

‘In recent years, the State has made significant efforts to improve the legal and tax environment for venture capital and private equity entities. This significantly contributes to the development of investment, i.e. every year we monitor the increasing volume of investment from venture capital and private equity funds. I am delighted that this year an improved Law on Corporation Tax has entered into force, which extends the scope of the corporate tax relief. For risk management and other reasons, convertible bonds (rather than shares) are the financial instrument that makes it easier for start-ups to raise investments from funds,’ says Ms Budbergytė-Zabielaitė.

Roberta Rudokienė, Head of the start-up ecosystem development department Startup Lithuania at public body Enterprise Lithuania, also agrees that the amendment to the corporate tax law will bring significant economic benefits to both Lithuania and start-up companies. She says that future investments in high value-added enterprises (start-ups) will help create new jobs, increase the amount of taxes paid into the state budget and open up opportunities for start-ups to expand in Lithuania and beyond.

‘We welcome the initiatives by public authorities to improve the business environment of Lithuanian start-ups; initiatives like this strongly contribute to the growth of the start-up ecosystem. Today, we already have more than 950 start-ups in Lithuania, which are attracting more investment every year and, as tendencies show, Lithuanian and foreign funds are increasingly competing for innovative businesses established in our country. We believe that this amendment to the law will make it easier for Lithuanian venture capital and private equity funds to invest even more in early stage start-ups,’ adds Ms Rudokienė.

It is preliminary estimated that venture capital and private equity entities are now ready to invest EUR 22 million in start-up convertible bonds. It is also calculated that the funds that currently form capital for investment may be ready to invest up to EUR 56 million in start-ups in the form of convertible bonds.

According to the Lithuanian Private Equity and Venture Capital Association, in 2018 alone, start-ups which received investments form venture capital and private equity funds paid more than EUR 271 million of taxes to the national budget. The entry into force of more favourable conditions for investment in start-ups will further increase budgetary benefits.

What investors are looking for in early stage startups

Investing in a start-up can be a rewarding experience for everyone involved – both personally and professionally. It’s an opportunity to help an entrepreneur take an idea and develop it into a commercially viable business. Yet the amount of risk involved is palpable, and those who invest at the early stages are wading into uncharted territory. The fact is, many start-ups fail.

Ernst & Young has spoken with Blue Lime Labs about their investing experience.

Right investment? Right investor?

Angel investors are ultimately looking to invest in ideas they believe will become profitable in the long term. But finding those start-ups isn’t easy. The key, when investing seed capital into a new company or idea, is the ability to spot a market opportunity and then develop a relationship with the entrepreneur that allows for close collaboration.

One company doing just that is Blue Lime Labs. Based in Lithuania, the company was founded by EY alumnus Per Møller, and Gytenis Galkis. Blue Lime is a pre-accelerator, meaning it invests in ideas and not products. It comes in at the very early stages and works with the entrepreneur on validating their business idea. If the idea is found to have traction, Blue Lime then enters into the development and sales phase of the process.

“Our ideal sweet spot is where one founder, or two founders, have an idea and come from that industry. So they have some industry expertise but they need some help developing the product. They need some help with sales, and maybe they have a rough idea of what the product should look like but not necessarily how it can be developed,” Gytenis says.

By using their connections and industry knowledge, Per and Gytenis are able to assess a business idea by testing it out directly on the market. If they find early adopters that are interested in the product, they then invest their time and money to work with the start-up on product development and sales.

How to spot the next big thing

But validating the idea is only half the battle. They must first spot the potential – in both the opportunity and the entrepreneur. Both admit they are always on the lookout for the next unicorn, but are realistic in their goals.

“The first thing I do when I look at an investment pitch is to see myself as the customer. So will I use this myself, or would I have used it in my previous professional capacity? That is where I start from. If I don't see myself as a user, I pass,” says Per.

Gytenis adds that it’s important for the entrepreneur to have the right attributes: “When we look for these companies, it's important for the person to have a combination of things. One is an entrepreneurial mindset, or willingness to experiment and listen. Another thing is – are they able to sell? If the founder cannot sell, then the whole product is in danger, because all the salespeople that you hire won’t be that passionate. And then commitment is very important. The founder has to be committed.”

Invest in what you know

Per also believes it’s vital to invest in what you know. “When I make investment decisions, I typically look for something in the area where I have been myself,” says Per. “So I am looking for business-to-business start-ups. At the moment, I am looking at HR tech.”

One entrepreneur who is currently working with Blue Lime Labs is Monika Brazdžiūtė. A former HR manager, Monika met with Per and Gytenis to brainstorm an idea on how to gather employee feedback effectively. After that initial discussion, they tested their business plan and received positive feedback from the market. Their latest investment, called PulseTip, was born.

PulseTip is a terminal that enables companies to measure employee feedback in real time. After two years, the product has been sold in five European countries and sales are continuing to grow. Monika believes Blue Lime Lab’s expertise and network of contacts were crucial to the company’s success: “It's my first start-up, so I didn't have experience of creating things from scratch. Blue Lime Labs helped with establishing processes from the very beginning.” Blue Lime worked with Monika to build a software development team, find the right hardware suppliers and create an effective sales workflow.

Gytenis is very proud of PulseTip’s success: “The most rewarding experience in working with start-ups is actually seeing how you can improve their process. You're looking for different solutions, and then you're coming back and saying, 'Let's maybe try this,' and if the approach works, it's very rewarding.”

As for the elusive hunt for the next unicorn, Per is optimistic that one of their investments may end up surprising them all. “I hope I have the next big thing in my portfolio already. Being in the space I am, of business-to-business start-ups, it is a bit harder to explode from nothing. But I think I have it already, I just don't know which one of them it is.”

Business Angels Investment. Who, why, what?

While European private-equity firms sit on record setting piles of “dry-powder”, local startups are searching for the most attractive financing solutions. In these circumstances co-investment funds have become increasingly popular among both private investors and startup founders. Such funds present a different approach to Venture Capital (VC) investing. “We are all about bridging the gap between the startup companies and the business angels.” says Jonas Vitkauskas – Investment analyst at Koinvesticinis fondas.

Focus

Koinvesticinis fondas (The fund) is working closely with startups and business angels. Since its start in 2017 the Fund  together with business angels has completed 11 investments into 10 companies and continues searching  for companies with disruptive potential to invest in. The fund’s current portfolio is comprised of investments ranging from artificial intelligence based radiology solutions to food-tech companies.

Average startup does not have a lot of runway, therefore fast decisions often are a matter of life and death to early stage growth companies. “Business angels together with the Fund must react quickly and make timely decisions in an extremely dynamic environment” - notes Jonas. Illustrated by the fact that usual co-investment deal takes up to 3 months to close.

The fund’s investment to medium, small or micro-enterprises is capped at EUR 800k, however the average investment is EUR 300k. Koinvesticinis fondas invests exclusively with business angels and has an average investment intensity of 60-70%.

Process

Investment deal usually begins with a startup pitch to the private investors in specialized events such as Startup Fair Vilnius, monthly Litban Pitch events or simply emailing us its business case in search of funding. Consequently, business angels from the Fund’s approved list of private investors are eligible to bring forward an investment case of their choosing to the Fund, which also evaluates the business case independently. In case of an attractive business idea, a non-binding agreement outlining the general terms & conditions of an investment (Term Sheet) is signed by all the interested parties. The final stage - deal finalisation – includes legal due diligence, signing of investors and shareholders agreements, etc.

Benefits for the business angels

Koinvesticinis fondas acts as a “silent investor”, thus business angels investing together with the fund receive a variety of non-monetary benefits such as delegation of voting rights in the company. Furthermore, the fund caps its maximum possible return at 6% compounded yearly interest with any potential surplus in case of a successful exit flowing to the investing business angels.

Criteria for the startups

In order to be successful in raising funding the startup must meet the standards set by the fund. Team’s expertise, market’s attractiveness, problem-solution fit, business model and investment readiness are the criteria most commonly used in startup’s evaluation. Startup can increase its chances of successful fund raising if it has a minimum viable product (MVP), which already has proven its market fit. Furthermore, the startup's chances are solidified if the team has a proven track-record in the industry and presents a business idea which is scalable. After all, startups should ideally target high growth numbers in its early stage.

As we noticed, majority of successful startups follow a well beaten path of funding rounds which follow the following order: Founder’s investment, Startup accelerator investment, Business angels, VC funds.

How To Negotiate With Angel Investors?

Nearly everything is a matter of experience and style with angel investors. Some will negotiate the terms of the deal, while others have a no-negotiation policy. So, what do we need to know when negotiating with the investors and what are the main aspects we have to follow?

Key elements:

  • The economic terms and terms granting control are the most important ones, don’t spend too much time on terms that do not create value;
  • Be aware of the liquidation preference which defines how much money must be returned to the investors;
  • Think about the ESOP and find the optimal solution for your employees;
  • Be prepared for dilution and anti-dilution provisions. It is really needed for investors.

A startup usually attracts capital by issuing convertible bonds or shares. In doing so, it may enter into a convertible bond subscription agreement, a share subscription agreement, or an investment agreement, as appropriate. We can generally refer to all these agreements as an investment agreement. It is important to understand the economic terms and terms granting control because they are material ones in the negotiations.

Let’s take a look at the preferences in a little more detail:

The process begins with the so-called term sheet. The term sheet is presented by investors to the founders, outlining the terms they expect to see in the investment agreement. The term sheet is a non-binding document, whereas the investment agreement already creates an obligation.

The share value is probably the key economic term. It is this value that the founders and the investors have to agree upon. It is not that easy, because the usual business valuation methods such as the multiple methods or cash flow methods do not apply here. After all, usually, the cash flows are negative and the company does not generate any profit yet. That is why the parties are looking for other criteria, usually by assessing the product as such, looking at the market situation, and, of course, the team. Once the parties reach an agreement on the share value, they also need to decide on the necessary amount of investment in the company, and the method of investment – by issuing convertible bonds or shares. This, too, depends on the stage.

If the company is in an early stage – the so-called pre-seed or seed – stage, convertible bonds are usually the preferred option. This favors the investor because convertible bonds are basically an interest loan that must be repaid or may be converted into shares, should the value of the shares go up. The investors may decide if they would benefit more from converting bonds into shares.

Whereas in later-stage companies, investments usually are made into shares. And investors become shareholders and receive partial control as of the day X. The most common type of share in Lithuania is the ordinary share; however, preferred shares are sometimes issued as well. The only difference between the two is that preferred shares are tied to a fixed dividend, which can also be cumulative. And the preference means that this amount would be paid out to holders of preferred shares before payment is made to holders of ordinary shares. So here we have the so-called preference established by the law.

In the investment agreement, we can find a term liquidation preference. In essence, it indicates the amount of money to be repaid to the investor. It means that, if the company is sold (liquidation event), the investor would receive out of the share price, say, twice the amount invested, if the multiple is two, and the remaining portion of the share price would be distributed among other shareholders – the employees and the founders. Therefore, one should really scrutinize this provision and consider the amount of money that will ultimately go to investors.

Another important economic condition is the employee share option pool (ESOP). Usually, it ranges from 10 to 15 percent. Understanding from which capital it is formed is very important as well. If it is made from the capital before investment (pre-money), the founders’ shares shall be diluted. Whereas if it is made out of capital after investment (post-money), the founders’ and the investors’ share of the capital will go down in proportion to the number of shares issued to incentivize employees. Thus, it would seem that the smaller the pool, the better; however, one must estimate the optimal amount of shares required to incentivize employees.

That process we have just mentioned is in fact called dilution. When new investors appear, new shares are issued to them; accordingly, the current shareholders’ share of the capital shrinks. This is a normal situation. But the existing shareholders have the pre-emption right to purchase shares of a new issue and to keep their share of the capital if they make additional cash contributions to participate and to secure their share of the capital. If they decide not to participate and not to make additional cash contributions, their share of the capital decreases appropriately, even though the number of shares held by them remains the same.

More problems occur with the down rounds – dilution in value when shares to new investors are issued at a price lower than that of the issue price of the previous round, which drives the value of the previous investment down. In that case, the so-called anti-dilution provisions are applied to protect the previous investors. This could be achieved by granting additional shares to the investors or by altering the rate at which their bonds are converted into shares.

Well, if you have reached this stage, you should already have a pretty good idea of what you are getting yourself into with the investor. Remember, each investor will have a different approach. Find the investor whose approach works best for you and your ventures.

Thanks, Rūta Armonė, Associate Partner at Ellex Valiunas, for sharing this with the startups’ community!

Also, we invite you to take a look at the video made by Ellex Valiunas, regarding this topic: https://youtu.be/8F1zhHzDrm4