June 5, 2017 | Jon Hautamäki
How to Commit the Employees of a Startup
The startup world can be a ruthless place for an early-stage startup starting its journey to world domination. Everything is new and the legal do’s and don’ts can be found around each corner. One key element that often defines the future of an early-stage startup is evolving around the team – I bet you didn’t expect that one, but the significance of the actual team cannot be overly emphasized. We at Nordic Law have met many startups, which have had a brilliant business idea – on paper – but when the actual team has failed to deliver, the business idea has not reached its full potential.
The follow-up question is, how do you then make sure that you have got a team filled with A-class professionals? If we knew the answer, believe me, we would tell all our clients of the secret formula. Although the building of the team can be challenging, the committing of the team to the startup is fortunately much simpler. A startup, as an employer, can develop various employee benefit plans and the actual legal limits are few.
As startups, especially in the early-stages, fight constant battles with the cashflow, startups need to develop alternative ways to commit employees instead of the traditional salary. The fact is that many startups rarely have got the liquid assets to pay – normal – salary to key employees. Also, if the startup has already got investors on board, it is likely that the investors do not appreciate that their invested money is spent on employee salaries without the long-term commitment of the employees to the startup. As the oldie, but goldie, saying goes, the core team should have some “skin in the game”. Well, how can startups solve this problem you may ask? The common solution is either a share purchase, where the employees from the get-go purchase a part of the company or then the employees are included in an employee stock option plan (in the oh so dreaded legal lingo, an ESOP).
Below we will in a short and sweet manner present the key elements regarding both alternatives, so that the next time your startup is planning similar actions, you will know what to do.
With a share purchase the employees are offered an opportunity to purchase shares of the startup. The normal way to carry out this alternative is a private offering to the employees in question. Simplified, the startup issues new shares to the employees, who then immediately become shareholders of the startup.
This alternative has quite a lot of positive upside, especially for the employees, who immediately become shareholders of the startup. The arrangement is easy and flexible to set up, which means, for example, less legal costs and paper burecraucy. The startup merely issues new shares and the employees subscribe to the shares – easy, transparent and cost-effective.
What comes to the purchase price, the recommendable solution is that the employees pay in accordance with the fair market value of the startup. If the purchase price is below the fair market value, the purchase price is under-priced, which can result in tax consequences for the employees. The employees can be given a 10% discount regarding the purchase price in connection with a private offering provided that the shares are offered to the majority of the employees. As you want to commit your team early on when the fair market value is low (most likely the company’s worth is the share capital), the employees do not even have a need to commit large amounts of money to purchase shares of the company.
Also, as the startup is issuing new shares to the employees, the employees do not need to pay capital transfer tax, which normally is payable when shares are transferred.
An Employee Stock Option Plan – the ESOP
With this alternative we come to the exciting world of options and option programs. Simply stated, with options are meant the right to subscribe to shares if certain requirements are fulfilled, which means that the ownership of shares is possibly realized sometime in the future. Most likely, if you have been a part of the startup scene for a while, it is almost certain that you have stumbled upon options as well.
One of the main reasons behind options is that employees do not need to commit capital in the startup right from the get-go. In the above discussed share purchase alternative, the employees must pay a subscription price equaling the fair market value to avoid tax consequences. If the company at that point has steady business operations, the fair market value can be quite significant, which means that employees would need to commit more capital to the company. As for options, if combined with a long subscription period, the possible subscription can be pushed back all the way to the possible exit. In that situation, the employee in possession of options can be certain that the valuation of the shares exceed the subscription price. Finnish legislation does not restrict the length of the subscription period, which means that in theory the employee in possession of options can wait even until the possible exit. That way the employee can decide if the subscription of shares is lucrative.
There also certain additional elements that need to be taken into consideration regarding options. The offering of options requires a decision of the General Meeting of the startup. As a starting point, the registered option program contains only the minimum terms and the detailed terms are decided in non-public agreements.
Option programs normally also include vesting terms, which means that options entitle to share subscriptions only if the options have been vested. The average vesting time ranges between 2-5 years (incl. a cliff) meaning that a certain amount of the options entitle to share subscriptions after the cliff. Then the remaining part of the options are vested in regular intervals.
Options and Finnish taxation
Lastly, you cannot talk about options without a few words regarding the tax perspective. The custom is that options meant to commit employees are given free of charge. That means that the employee has a payment obligation only if the options are converted into shares. Currently Finnish legislation does not set requirements of a minimum subscription price. Normally the subscription price is lower than the fair market value of the options, especially regarding option programs for startups. The difference between the fair market value and the subscription price is taxed as normal income.
From the startup scene’s perspective, the current taxation is not favorable as it does not go hand in hand with the fact that startups rarely achieve any real financial result before an actual exit (i.e. liquidation event). That means for employees in possession of options that if and when they subscribe to shares, the tax burden can become heavy. So, in the interest of the employees, the subscription of shares should not occur before an exit as that is also the moment when the employees’ commitment is rewarded. Along with the exit, the employees also receive the necessary capital for the tax consequences. What is then the recommendable solution to the current issues with Finnish option taxation? If a startup offers option programs to the employees, the subscription period should either be very long (up to 10 years) or with an infinite maturity. That means for employees that they can postpone the subscription of shares all the way to the possible exit. The taxation will occur at the moment of subscription, but in that situation, the employees should also have the necessary capital to pay the taxes.
The Shareholders’ Agreement
Finally, when you have committed your core team to your startup, you need to make sure that all shareholders follow the basic rules. That is why all employees becoming shareholders must before subscribing to shares join the shareholders’ agreement of the startup by signing a separate adherence agreement. That way you can make sure that the ownership of your startup is secure and predictable.
So, what are you waiting for? Go and build and you dream team and start your journey towards world domination!