Share-based incentive programs for employees

Why enter into options agreements?

The main reason for entering into option agreements and establishing other incentive programs in employment relationships is to achieve a shared economic interest between the employee and the company. Through ownership the employee could have increased motivation to stay with the company and to work for the company’s best interests.

A company has a dynamic lifecycle, where the company’s needs change as it develops, hires more employees, increases turnover, experiences downturns, ownership changes, stock listings, etc. The type of incentive scheme the company chooses will largely depend on the company’s situation at the time of implementation, as well as where the management envisions the company in the future. Therefore, there is a need for specific assessments and customization. For a startup, an incentive scheme can, for example, help attract employees with expertise that is initially too expensive for the company, but the employee might accept a lower salary than his/hers market value if he/she can instead be offered ownership. An incentive scheme could minimize the company’s liquidity requirements while contributing to the company’s development.

Management must consider which criteria must be met for the employee to participate in an incentive program. Should all employees be included, only certain selected groups, a few key personnel, etc.? Furthermore, it must also be considered what conditions must be met for the employee to exercise rights under the incentive program/agreement. Should it be linked to the company’s results, individual goal achievement, the time the person has been with the company, or another of countless other criteria.

Some overarching differences

A company goes through different phases. A newly started company will often not have significant liquidity and will seek to achieve good solutions without large payouts from the company. Here, the difference between share-based solutions and regular cash bonus schemes becomes clear, as the company in bonus programs under certain conditions is obliged to pay a sum of money to the employee. With a share-based scheme, it is mainly the company’s existing shareholders who pay the price, as they normally are diluted by having to give up parts of their ownership to the employee. At first glance, this may seem impractical, but it is useful to keep in mind that it is better to own a small piece of a large cake than a large piece of a small cake. If the conditions for the incentive scheme are met, the company will presumably be worth more than it was at the time of the establishment of the share-based incentive scheme.

For the employee, however, the question of financing the shares will arise. The person must somehow pay for the shares, whether it is a matter of share purchase or options. This is solved in various ways where imagination largely sets the limits, but often the company can provide financing assistance to the employee. It is important to be aware that there are quite complex corporate and tax rules in this area that must be taken into account.

Allocation

When a employee wish to exercise his/her right to shares in the company, there are several ways to do this. It can be done, for example, by acquiring existing shares either from the company or from existing shareholders, or by being offered to subscribe for shares in the company through a capital increase. Corporate law sets out a number of formal requirements that must be followed in connection with the allocation of stock options, so it is important to be meticulous. Examples of issues can include;

• which corporate body is legally competent to decide on the scheme, which depends, among other things, on which persons are covered by the scheme (only employees, or also board members?)
• whether there are board authorizations issued by the general meeting related to issuances, the scope and validity of the authorizations, etc.

It is important that correct documentation is prepared for this. It is recommended to seek legal advice to avoid mistakes that can have significant consequences for both the employee and the company.

Tax issues

There is quite complex tax issues related to share-based incentive schemes.

Employment income and capital income are taxed differently. The legal distinction between these two concepts is often a central issue when it comes to incentive schemes. This is partly because tax on employment income has a greater impact on both the employee and the company than tax on capital income. It is therefore often appropriate to make arrangements that make the tax burden as favorable as possible for both parties.

Discount on shares

It is often seen that the employee is allocated shares at a discount as part of the implementation of an incentive program. In this context, it is important to be aware that the difference between the market value of the share at the time of purchase and the price the employee pays is considered employment income, and thus becomes taxable as such, with the corresponding employer’s social security contributions and withholding obligations.

Pricing issues

Another point is the valuation of the shares. If it concerns listed shares, this will usually be quite clear. It can be more challenging if it concerns unlisted shares. Questions that arise are:

• which valuation method should be used,
• are there reference points such as recent transactions in the shares,
• who should set the price, the board or an independent third party?
• are the shares subject to transfer restrictions that must be taken into account when pricing?

These and many other questions will need to be clarified.

The value of the shares in the employer company can, under certain conditions, be reduced by 20%, up to a maximum of NOK 3,000 per income year. The value of the underlying object after any reduction cannot, however, be set lower than the exercise price. If the employee does not have to pay anything for the shares upon exercise, the market value of the shares will constitute the taxable benefit.

It is not uncommon that it immediately appears as if the employee has paid market price, but that there are circumstances surrounding the acquisition that makes it questionable whether the conditions for the acquisition are market-based. The tax authorities closely monitor such situations and are not hesitant to consider reclassifying capital income to employment income with the corresponding tax rules. The Supreme Court has on several occasions ruled on such cases, and very simply put, when assessing whether there is a basis for reclassification, a holistic assessment must be made of whether the employee has made a real investment, i.e., has taken a real risk of loss, and not only has a potential upside.

Share options

The employee can also receive share options in the company they are employed in. There are special rules for the taxation of options in employment relationships. According to this special rule, taxation does not occur until the option is exercised or sold. Without a special rule, the tax liability would have arisen already upon receipt of the option. The special rule applies to options that have shares or equity certificates as the underlying object, and also applies to convertible loans.

The rule apply to both options for listed and unlisted shares. The employee’s benefit upon exercise or sale of the option is taxed as employment income. The taxable benefit is calculated based on the value of the shares at the time of acquisition (entry value) minus the exercise price. If the employee has paid an option premium for the option, the option premium should be deducted when calculating the taxable benefit.

Special rule for small start up companies

In 2018, a new rule was introduced regarding the timing of taxation for options and shares in what is defined as “small startup companies.” For such companies, there are even more favorable rules. The benefit from acquiring share options will first be taxed at the time of realization of the shares acquired upon exercise of the option.

When acquiring an option, the employee has the opportunity to await the development of the company before possibly exercising the option into shares. The employee thus takes on a risk of loss only after the option is exercised. On the other hand, if the employee waits to exercise, they may risk missing out on the increase in value of the shares during the period from acquiring the option until exercise occurs.

The above are just examples of tax-related issues. The tax aspect related to this topic is extensive, and it is recommended to contact an advisor with expertise in the field both to ensure that the intended scheme does not involve unexpected consequences, and to get tips and advice on which schemes may be beneficial for the individual company.

How should an incentive scheme be implemented?

There are several different ways to implement an incentive scheme. Therefore, it is important that the management takes some time to assess what the specific company can achieve by granting various rights in the company to employees and/or other key individuals. Our experience is that with the right choice of incentive scheme, this can contribute to a significant increase in motivation among the workforce. After all, it is the people in a company who are crucial to the company’s success, so those leaders who acknowledge this fact and act accordingly will often experience extensive positive results for their company.