How to set up employee stock options

Foreign companies seeking to open an R&D office in Ukraine often come to us with this question. While discussing legal structuring, they also bring up the subject of stock options as a way to attract and retain the best workers.

In Ukrainian IT business, this practice is not yet very common, in no small part due to the failings of Ukrainian law. At the same time, they can take advantage of the so-called phantom stock options, which is often more beneficial both to the employees and the company itself.

Let’s first take a look at the concept of stock options and how they can benefit companies with employees in Ukraine.

What is a stock option and how it works

Stock option is an agreement between a company and its employee that grants the employee the right to purchase a certain amount of the company’s stock at the price specified in the agreement, provided that certain conditions are met. These conditions usually involve the achievement of certain KPIs and working for the company for a certain period of time (usually 3+ years). In short, a stock option is a reserved right to purchase a company’s shares at a pre-agreed price, usually for cheaper than it’s going to be in the future.

The benefit for the company is that it incentivizes employees to:

a) work harder to move the company forward;

b) stay with the company for a certain period of time.

Also, if the company wants to attract top talent but it can’t offer them competitive pay just yet, it can offer them stock options, which are essentially a stake in the company. However, it mostly works for startups that could really take off in the future.

What does the employee get out of it? Let’s say, the price of one share is $100, but in 5 years it’s going to be $10,000. Stock options allow the employee to purchase those shares for $100 per share and then sell them at the market price for a profit.

Stock options are also usually vested. For instance, after working for the company for 1 year, the employee gets the right to purchase 30% of the option stock, after 2 years – 60%, etc.

So this is a win-win arrangement. The company essentially tells its employees: you are great and we want you to stick around. We’ll give you stock options. Our shares will keep going up in price. If we all give it our best, our company will grow faster, and soon its shares will be worth much more than they are now. You’ll be able to sell them and make good money on it.

What’s wrong with stock options in Ukraine 

Most IT companies in Ukraine that are not sole proprietorships are LLCs rather than OJSCs, which means they don’t have shares to offer employees. Moreover, legislation on stock options in our country is far from perfect and woefully incomplete, and what little there is simply doesn’t work.

For this reason, whenever stock options in Ukraine are mentioned, it usually has to do with foreign companies with an office in our country.

Now, picture this: a Ukrainian IT professional decides to exercise his stock option granted by an American company. This brings up all kinds of questions. How to purchase them, given that different countries have different corporate regulations. What taxes will he need to pay in the United States? Who should he pay them to and how to go about it?

Suppose he did purchase the shares – with the company’s help. How then to sell them, where to look for buyers? It’s not a sack of potatoes after all – you’ll need to hire a broker or some other middleman and pay him. You also need to know whether selling shares involves paying a tax in this country. If so, how much is it ? How to actually go about paying this tax? Finally, how to transfer the proceeds to Ukraine? With our banking system, it’s not as easy as it sounds.

In other words, to a Ukrainian, stock options mean additional administrative costs when buying/selling shares, as well as extra taxes in at least two countries (the company’s country of residence and one’s own).

The uncertainty and potential issues with exercising conventional stock options make many Ukrainian IT pros reluctant to accept them. This diminishes the effectiveness of stock options as a way to incentivize employees to do good work for your company.

That is why whenever companies ask Tretten Lawyers how to go give stock options to their employees, we recommend phantom stock. More on this below.

Why phantom stock options suit our realities better

With phantom stock, in contrast to regular stock options, the employee doesn’t actually purchase shares. Phantom stock options are rather a system of bonuses calculated using the same principle as regular stock options.

This option will also be useful to owners of IT companies that don’t want to dilute their stock or risk interference with company management by minority members.

So, a phantom stock option is an agreement between the company and its employee that entitles the latter to a bonus after working for the company for a certain period of time and achieving specific KPIs; the bonus is either a fixed sum or a percentage of the company’s value at the time of paying out the bonus (phantom stock option).

• with the fixed sum option, it of course should be significant enough to incentivize the employee to stay with the company and do his job as well as possible. 
• If you go for the percentage, you can use any method you like. Companies most often choose a certain share of 1% of the company’s value at the time of settlement or at some other date.

By this, you tell your employees: we plan to keep growing, and you play an important role in this. For this to work out, we need you to do your job responsibly and stay on the team for a long time. Right now, our company’s worth $2 billion. In the future, this figure could increase tenfold. Stay with us for 3 years, fulfill certain conditions – and you’ll get a tenth of 1% of what our company will be worth by that time.

It will be fair and appropriate to put in the agreement how exactly you’re going to calculate the company’s value. This figure is often arbitrary. Someone could be willing to pay $10 million for a certain startup while others wouldn’t give a dime for that same startup. Add to that a $1 million EBITDA. How then to determine the company’s objective value?

That’s why it’s best to specify in the phantom stock agreement how you will be evaluating the company in order to calculate the bonus. At the very least, it will spare you potential grievances and conflicts once it comes to paying out bonuses, phantom though they may be.

If you need help with giving bonuses (stock options) to your employees, contact us here.

How to grant phantom stock options to employees 

In order to incentivize employees with phantom stock options, the company should think through the terms for all calculations and payments, and then put them in the agreement.

Make sure to specify in the text:

• what exactly the phantom stock option is going to be (fixed sum, or calculation of the bonus);
• method for determining the company’s value if the stock option is a percentage or a fraction of a percentage of the company’s value;
• what conditions the employee must satisfy to be eligible for the phantom stock bonus;
• vesting schedule for the stock option, if applicable;
• dates, methods, and mechanisms for phantom stock payments.

 Next you discuss with your employees the terms on which you will be granting phantom stock options. Once you agree on everything, sign the agreement. That’s it – stock options have been granted.

Consult Tretten Lawyers here.

This arrangement, unlike conventional stock options, gets your employees money straight away. There’s no need to buy and sell shares. Also, with phantom stock options, the employee avoids tax consulting costs in two jurisdictions, as well as the need to declare additional taxes and issues associated with doing it in another country (the company’s country of residence). As mentioned above, phantom stock options are essentially a bonus system that includes elements of the financial instrument of stock options.