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  • From employee to company co-owner or implementation of stock options to LLC employees
Publication:

From employee to company co-owner or implementation of stock options to LLC employees

22 April 2021

Trends in the labor market show that to retain skilled and enthusiastic employees, in addition to benefits provided by employers such as health insurance or contributions to pension funds, employees are increasingly offered the opportunity to get stock options, which entitles employees, management board and council members to become co-owners of the company in the future.

Over the past year, this motivation instrument for employees has been increasingly discussed, and thanks to the involvement of various associations and the perseverance of some MPs, amendments to the Commercial Law and the Personal Income Tax Law were made in early 2021,  which finally facilitate the granting of share options also to limited liability companies’ (“SIA”) employees, members of the management board and the council members, as well as allow to use the established tax benefits, which were previously possible only for joint stock companies (“AS”).

It is an outdated opinion that such a motivation instrument is only interesting for large companies - joint stock companies. In Latvia, the start-up company ecosystem has been rapidly growing and improving, and more and more start-ups are now using this opportunity, as it allows attracting highly qualified employees at an early stage of company development without additional investments (for example, in high salaries) only with the promise that In case of the growth of the company, the employee will be able to receive a part of the profit or will be able to sell the shares at a higher value, if the company will be sold or its shares will be listed on the stock exchange.

Amendments to the Commercial Law

Initially, this motivation instrument in the Commercial Law and the Personal Income Tax Law was intended only for joint stock companies («AS»). However, this does not mean that the employees of a limited liability company («SIA») could not have been granted shares or the right to purchase shares in the company in the future. This has already been done before, by concluding a private contract with each employee. However, the lack of regulation not only prevented the employees of SIA from receiving tax benefits by using the right to purchase shares, but also created a lot of uncertainty and risk for the company. Up until now, the Commercial Law did not provide the possibility to allocate shares of different categories and each employee who acquired at least 1 % of the share capital became a full shareholder with all the rights arising from it - the right to receive dividends, receipt of a liquidation quota, voting rights at the meeting of shareholders. 

Addressing the issue of the lack of regulatory framework, at the end of 2020 the Saeima adopted amendments to the Commercial Law (“Amendments”), that provide the right of SIA employees, management board and council members to allocate company capital shares, determining various share categories, as well as reducing share nominal value to 1 cent.

Various categories of shares

Prior to the Amendments, any employee, management board member or council member who was admitted to a SIA became a full-fledged shareholder and could exercise all rights arising from the status of the shareholder - the right to receive dividends, receipt of a liquidation quota, voting rights at the meeting of shareholders. Considering the rights of a shareholders enshrined in the Commercial Law, as well as instruments for the protection of the interests of minority shareholders, which may reduce the control of founders and major investors over the company, these circumstances often deterred companies from admitting employees.

The Amendments provide that it will be possible in the Articles of Association to define different categories of shares, thus allowing the division of shareholders into categories and providing that the company's founders and major investors have wider rights than employees, for example:

A Category of a share

Shareholder status

Rights

A

Founders + major investors

All – right to receive dividends, liquidation quota, voting rights

B

Employees

Only the right to receive dividends

When deciding whether to allocate shares to the employees or the management board and council members, an enterprise should consider the extent to which it expects them to be involved in the company's governance and decision-making. It is precisely because of this factor that the extent of the rights granted to the holders of the various categories of shares and laid down in the Articles of Association must be carefully determined.

Reduced minimum nominal value of a share

Within one category, the shares will have the same nominal value, and the minimum nominal value of the share may in future be one cent (previously 1 EUR).

Registration of shares in the shareholder’s register

The registration of the number of shares, payment and disposal transactions of the company is provided in the shareholder’s register. In the future, it will also have to provide information on individual categories of shares, with different designations.

In addition, there is an obligation to list the rights granted to the company's shares (options) and to ensure the accounting of the following information:

  • Individuals who have been granted the rights to the company's shares;
  • The number of shares to be allocated by exercising this right;
  • Requirements for the acquisition of shares in the company by exercising the granted rights.

Although it is not clear from the wording of that provision if there is a precise requirement as to the form in which those records are to be provided, that information is normally reflected in the register of options.

It should be noted that various tools and applications have now been developed to help track the granted options to the employees, remind them of the end of their retention periods, and generally allow a company to track the execution of an option plan (e.g., Capshare, Carta, etc.).

Tax questions

Simultaneously with the amendments to the Commercial Law, amendments have also been made to the Personal Income Tax Law (“PIT Law”). They stipulate that payroll tax will not have to be paid when exercising the right to purchase shares. However, the following preconditions must be met in order to use such relief:

  • The minimum holding period of options (the period between the grant of the options and the day when the employee is entitled to exercise the right to purchase) is at least 12 months (at least 36 months had to be waited before the amendments, which was considered too long);
  • The individual has been employed by the capital company that granted the options for the entire 12-month period (also applies to management board and council members);
  • The options must be exercised no later than six months after the date of termination of the employment relationship;
  • The company that granted the options to the employee has not issued a loan to the person during this period;
  • The company has submitted information to the State Revenue Service regarding the implementation plan of the share purchase rights.

 A step-by-step guide to implementation of the stock options system

While the implementation of the stock options to employees seems useful, it often seems to be very difficult and it is not clear where to start. In order to make the process of implementing options more transparent, we offer an insight into the actions to be taken or a step-by-step guide on how an employee of a company can become the co-owner of the company.

1

COMPANY MANAGEMENT LEVEL’S  CONCEPTUAL AGREEMENT

 

At first, it would be advisable to reach a conceptual agreement at management level - what level employees will be granted the stock options, what will be the minimum holding period, will the stock options be granted for a fee or free of charge, who will pay for the stock options at the time of purchase, if they are granted free of charge, the maximum purchase exercise period, deciding whether the options will be transferable to third parties and whether they can be inherited or pledged, etc.

2

DEVELOPMENT OF A STOCK OPTIONS (SHARE PURCHASE RIGHTS) EXERCISE PLAN

 

Once the desired conditions have been agreed upon, it is necessary to prepare an option implementation plan.

The plan is required for submission to the SRS so that the benefit from the exercise of the stock options right to purchase capital shares is not subject to payroll tax. It shall include information on the capital companies involved in the plan, the criteria set for the employees to qualify for participation in the plan - the conditions under which an employee may purchase shares at the time the stock option rights are exercised, the minimum option holding period, the possibility to exercise the share purchase rights if the employment relationship is terminated, the employee's ability to dispose of the granted share purchase rights or to inherit share purchase rights in case of employee's death; the conditions to exercise share purchase rights, information regarding the employees who have confirmed their participation in the share purchase rights exercise plan.

3

INFORMING AND INSTRUCTING EMPLOYEES

 

Once the stock options plan has been prepared, it is advised to hold a discussion with employees - to explain the benefits, rights and obligations of employees, conditions and procedure as an employee will be able to buy company shares in the future and find out which employees want to participate in the plan.

4

SHAREHOLDERS’ DECISION ON GRANTING THE STOCK OPTIONS; PREPARATION OF CORPORATE DOCUMENTS

 

Shareholders’ decision should be prepared in order to grant stock options to specific employees and to approve the option plan, to authorize the Board to enter into option agreements with employees and to amend the company's articles of association (if different categories of shares will be provided for). The Board prepares a register of stock options and a notice to stock option holders.

5

CONCLUSION OF A STOCK OPTIONS AGREEMENT WITH EMPLOYEES

 

The Board prepares and concludes stock option agreements with employees (in case the stock options are granted to the members of the board or council, the agreement is concluded by the shareholders). The agreement stipulates how the shares will be allocated, how they will be paid (by increasing the share capital or if an existing shareholder will give up his shares or give them to an employee), stipulating how the shares will be "returned" if the employment relationship is terminated, etc.

6

STOCK OPTION HOLDING PERIOD

 

The minimum holding period to be eligible for a tax relief is 12 months.

 

7

EXERCISE OF STOCK OPTION RIGHTS - ACQUISITION OF NEW SHARES

Generally, an option plan specifies a period within which employees may exercise the stock option rights (acquire shares), for example, within 30 days of the end of the holding period.

 

8

ALLOCATION AND PAYMENT OF SHARES

 

Existing shareholders may assign shares to employees:

  • By an increase in share capital (existing shareholders must waive from their pre-emptive rights);
  • Withdraw from the shares in favor of the company, which are then transferred / sold to employees;
  • Transfers (donates) or sells shares to employees.

9

ENTRY OF THE EMPLOYEE IN THE REGISTER OF SHAREHOLDERS

 

Preparation of corporate documents for entry of an employee in the register of shareholders, depending on the type of allocation of shares.

What can we expect from the application of the new regulation?

Certainly, the new regulation will encourage companies to review their employee motivation systems and try something new that has long been the norm elsewhere in Europe and America. It is possible that in Latvia soon the fact that an employee has the right to apply for a small share from his employer's company will be a very common practice.

In conclusion, the granting of options is a win-win situation, as there is a benefit for both parties - the employee will have the opportunity to receive financial benefits in addition to the salary in the future, while the employer acquires a loyal employee in the long run who has a direct interest in the company to make a profit and does not only come to work to receive a monthly salary.