Make Your Best Employees Your Partners with ESOP

17
Aug 2020

employee stock, esop shares

’’Everyone talks about building a relationship with your customer. I think you build one with your employees first’’

According to Angela Ahrendts, the VP of Apple, this is what the focus of companies should be.

There is no doubt that motivated and capable associates are the essence of every business. During the dot-com revolution in the late 90s among startups and companies in the USA (especially in the IT industry) the possibility of employee stock ownership became common. Employees, consultants, and management became partners to founders and company owners.

Specifically, almost 6500 companies in the USA have an Employee Stock Ownership Plan (hereinafter: ESOP) and about 14 million American employees are part of the ESOP system.[1]

What is this really about? ESOP (similar to “stock options” in the US practice) is used as a term referring to every arrangement in which an employee of a company owns shares in the capital of the said company. In practice, this broad concept can have different forms, from simple acquisition of shares to highly structured plans.

With the accelerating development of the IT industry, and especially with the strengthening of startups, a need for ESOP has emerged in Serbia as well. Still, the appropriate legal framework was not created. Same as before, the legal system once again, hinders the functioning of companies and contemporary development.

However, in April 2020, certain changes regarding the Company Act were enforced (hereinafter: CA) and Serbia became one of the countries where companies offer their employees and other partners the option to become a shareholder under preferential conditions after a certain set deadline.

In other words, on a precise day in the future, your employees will be able to become shareholders in your company at a discounted price (which could be only symbolic), instead of the market price which can be significantly higher, and in return, employees will be motivated to work harder and thus, increase the value of your company.

In the conditions of the economic crisis caused by COVID-19, when possibilities for other benefits (such as salary increases, bonuses, etc.) are reduced, this option could be the savior of your company.

How to Acquire a Part of the Shares?

employee owned business, stock ownership

If you consider that this kind of employee incentive would work for you, it is crucial that you enforce the entire procedure in accordance with the Law.

Specifically, the CA is the one which in detail stipulates the possibility of employees acquiring shares. Below, we will try to explain the key terminology and steps on how to implement this plan.

However, before all of that, it is necessary to reach a Decision about establishing the Reserved Own Share. The Reserved Own Share (hereinafter: ROS) is the share which the company gains from its members in order to give out as a financial instrument – these are the so-called rights to acquire shares (hereinafter: RAS). Thus, by establishing ROS you will allow other entities to acquire a certain share of your company.

The right to acquire shares i.e. RAS is a non-transferable financial instrument which, for example, allows an employee to acquire a certain percentage of company’s shares on a certain day at a certain price, without the possibility of the other members of the company using their pre-emptive rights to purchase shares.

The Acquisition Rights of Shares Can Cost You Only 1 Dinar

Therefore, the company will issue RAS out of ROS by deciding about the RAS. It should be noted that the company can acquire ROS only with the shares of members whose deposits were entered/paid fully and can be formed only with the shares of those members who have voted for rendering that decision. The consequence of the General Assembly’s decision about the acquisition of ROS was that shares of members who have voted for, will decrease, and the company acquires ROS from which they will decide upon the division of RAS.

The decision about the acquisition of ROS is made by the company’s assembly if the majority vote for.

After you have taken the previous steps, the decision about ROS is registered in the Business Registers Agency (hereinafter: BRA), while the RAS i.e. the decision about RAS is registered in the Central securities depository and clearing house (hereinafter: CSDCH).

After the RAS and the amount agreed upon is paid out, the financial instrument is crossed out from CSDCH and the owner of the financial instrument – for example, your employee, is registered as a member of the Company in the BRA. Simultaneously, the decrease of the ROS is entered, with the same percentage of the shares acquired by the establishment of RAS.

ESOP, employee stock ownership plan

Watch Out for This!

Besides the complex procedure, CA prescribes a number of specifications of this action and the treatment of ROS, i.e. RAS.

Namely, in comparison to common shares, i.e. the common regime in which you have the freedom to pledge and own shares, ROS cannot be pledged or sold.

Also, in order to establish ROS, the company does not have to increase the primary capital, because the ROS will be established from the already entered/paid capital.

For example:

If your company has two members with paid shares of 50% each, ROS will be formed from the already existing shares of your members, so ROS will amount to, for example, 10%, while your existing members will have 45% shares left in the capital of the company. From the 10% of ROS will be issued to RAS (for example, 10 financial instruments from which each contains a right to acquire 1% of shares in reserved owned shares, in which there are no limitations that one entity can acquire multiple financial instruments) under which owners of RAS can on a particular day purchase shares for a specific price. It must be noted that members of the company do not have a right to remuneration from the company for the shares which were transferred to the company in the name of ROS acquisition.

Another particularity is the possibility that a single-member company can acquire ROS. Thus, even if your company has only one member, you still have a right to choose this option after which the final result will lead to creating a company with multiple members. You should also pay attention to the possibility of creating multiple ROSs which do not merge into one share, but rather different ROSs exist, with a restriction of the maximum percentage of shares of all ROSs in primary capital of the company which cannot exceed 40%.

stock ownership, employee share ownership plan

esop shares, employee owned business

One of the benefits defined by the CA is that there is no set deadline in which all registered ROSs must issue RASs, by which a possibility was given to the company to adapt the issuance to their specific needs. A completely realistic situation is one in which the company has quit the idea to issue financial instruments to create ROS. In that case, ROS from which the company hasn’t issued financial instruments can divide them into more, new ROSs or it can be canceled.

As for the entities which can be holders of RAS, the Law does not prescribe any limits that the entity must be your employee; it could be any entity outside of your company – external associates, business partners, friends, or completely unknown entities. Also, the holder of RAS can be any domestic as well as foreign natural or legal entity. Certainly, it is necessary to sort the relationship with the holder of RAS by an appropriate written agreement by which the conditions of share acquisition will be regulated.

Something that should be specifically noted is that RAS is bound to the owner of rights. In other words, RAS cannot be pledged nor inherited. For example, if you as the owner of rights of RAS have appointed your employee John Doe, that employee cannot pledge RAS.

The Advantages (and Drawbacks)

employee share ownership, esop example plan,

The primary advantage of this system is that it is designed in a way that increases the hard work and interest of employees to create the best results for the company.

Namely, additional stimulation of employees is done by giving them options to become members of the company, by which their involvement in case of selling or an increase of the value of shares, which they have acquired by a preferential price leads to profit gain.

Besides, if an employee owns a share in the company, they will probably feel motivated to make the company more successful since then, the value of the company as well as the value of shares increases.

Also, employees who own shares in the company have the interest to stay in that company, which would certainly lower the possibility of employees leaving your company. This is important especially for the IT sector in which companies fight to stop the loss of the best teams, so this mechanism can be extremely beneficial.

On the other hand, we could say that the main lack of this model is the price by which the employees will have the right to purchase a share. This price could be drastically lower from the market price in the time of acquisition. In other words, at that moment when you issue RAS, you can arrange with the employees that on May 2022, they will have the right to acquire a part of shares of the company for 50 euros. A realistic scenario is that that exact share is worth 500 euros on that same day, however, the employee will have a right to purchase that share under a preferential price.

Still, since you have got a motivated and productive employee in return, and that the value of the work they have put in is considerably higher from the preferential price and market value of the shares, we consider that there is no loss whatsoever.

A Win-Win Situation

It is certainly very important to consider in detail whether reserving shares pays out for your company and make an all-encompassing financial and strategic analysis of your business in order to make the right decision. Besides that, you have to take care specifically about the aspect of tax of this mechanism, since there is a disparate tax treatment depending on the specific model which you choose.

Still, you must have in mind that although the whole mechanism appears complicated because of the new terminology and complex procedures, with the help of professionals, you can easily come to a win-win situation.

As an employer, you will get employees who are motivated, and as an employee, you will have the possibility to gain profit by investing a small amount.

[1] Source: National Center for Employee Ownership https://www.nceo.org/articles/employee-ownership-by-the-numbers#1
retrieved on: 13 August 2020

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