Happy employees ensure happy customers. And happy customers ensure happy shareholders – in that order.
It is quite obvious and provable that nowadays any company that is aiming at becoming successful must take good care of its employees, because without a happy employee, there is no quality service. For this reason, companies try in various ways to keep quality staff long term, through bonuses, ways of organizing work, training and development, more days off a year, and better work conditions in general.
However, as of 1 April 2020 in the Republic of Serbia amendments to the Law on Business Companies (hereinafter: LoBC) introduced a new possibility - Employee Stock Ownership Plan (ESOP).
Pros and Cons
Before we explain how an ESOP works, i.e. how is it realized, we will outline its advantages and disadvantages. The benefits are:
- - by acquiring a share in the company, employees have the right to share the profit that the company makes and voting rights in the company, as well as to sell the share;
- - by binding employees to the company in this way, the employees become particularly interested in the success of the company, because by realizing a higher profit, their profit also increases (in proportion to the share they have), so their commitment also increases;
- - the company provides itself with additional financing;
- - the company can use this institute instead of paying bonuses to employees when the possibility of paying bonuses is reduced due to the economic crisis;
- - it can also be performed to third parties who are not employees;
- - tax benefits (which will be discussed separately).
The most notable flaws are:
- - impossibility to adequately determine the share value, bearing in mind that LLC shares are not publicly traded on the stock market, so there is no clearly expressed share market value;
- - the employee can decide to sell the share and thus withdraw from the company;
- - the procedure of allocating shares through an ESOP is more complicated than the conclusion of an Share Transfer Agreement. It is easier for members to conclude a Share Transfer Agreement with an employee, so that by reducing the percentage of their shares and transferring them to the employee, they will get a new member.
The ESOP is still a rarity in Serbia and the companies that use it can be counted on the fingers of one hand. The reason is that many companies are family-owned, where there is no interest in third party members, insufficient awareness of companies about this possibility, the complexity of the procedure in relation to Share Transfer Agreement, etc.
However, the mentioned benefits and benefit for both parties in the long term are greater, which is why we believe that with adequate professional and legal help, the mentioned institute has a wide space and fertile ground for future application.
Realization of ESOP
In order to realize this possibility, it is necessary to carry out a certain procedure which is regulated by the LoBC.
First, it is necessary to pass a Decision on the Formation of a Reserved Treasury Share (hereinafter: RTS). The RTS is a share that the company acquires from its members free of charge, which must be registered with the commercial register. RTS exists solely for the purpose of allocation of a financial instrument to a certain person – Stock Option (hereinafter: Option).
The Decision is passed at the General Assembly by a two-thirds majority of all votes and one or more RTS can be formed. However, certain conditions must be met: 1) members must transfer part of their shares to the company free of charge, 2) the company can acquire RTS only from members whose contributions have been fully paid, 3) members who did not vote for such Decision cannot have their shares reduced and 4) RTS cannot exceed 40% of the total registered share capital of the company. The consequence of the adoption and registration of such a Decision is that the share of members who voted for the Decision is reduced.
Essential characteristics of the RTS are that there can be one or more of them (thus deviating from the rule that one owner cannot have more than one share in an LLC), they do not give voting rights, participation in profits, etc. while being company-owned, and they can also be acquired by single-member companies that otherwise cannot acquire their own shares (the latter for the reason that a single-member company will become a multi-member company thorugh an ESOP), they cannot be pledged or disposed off.
Upon registration of the said Decision, the Assembly of the LLC passes the Decision on the Issue of Stock Options, and it is registered in the Central Registry, Depository and Clearing House of Securities in Belgrade (hereinafter: CSD). Pursuant to that Decision, Options are issued.
Option is a non-transferable financial instrument that allows a certain person to acquire a share in the LLC in a certain percentage, on a certain day and at a predetermined price, without the possibility of other company members to use the pre-emption right. The price that is due to be paid for Option can be symbolic and amount to 1 dinar.
When Option becomes due (that is the day determined in the Decision on its issuance), and in order for its holder to acquire a share in the LLC, it is necessary to pay the agreed price. After that, the Option is deregistered from the CSD, and its holder is registered as a company member at the commercial register. Since the share is acquired in a certain percentage, at the same time the registration of the RTS reduction is made in the same percentage amount in which the share was acquired on the basis of an Option. Therefore, by the percentage by which the share was acquired based on an Option, the RTS is reduced.
Important note - Options are stricty personal, so they cannot be pledged, transfered or inherited. Restrictions on who can be the owner of an Option the Law does not stipulate, so it can be both foreign and domestic natural persons and legal entities, but this possibility is usually foreseen for employees.
Acquisition of shares through an ESOP by an employee has the tax treatment of salary. Therefore, and taking into account the circumstance that employees pay a price that is lower than the market price, the logical conclusion is that payroll tax and social security contributions must be paid, which is in this case calculated and withheld by the employer. The tax base is the market value of acquired shares minus the price paid.
The ESOP, however, is an exception because the shares acquired by employees in this way are not subject to the payment of tax duties, it is a tax exemption. In order for the ESOP to enable this, certain conditions must be met, i.e. tax exemption is in effect:
- 1. if the employee does not sell the share within two years from the acquisition date (lock-up period);
- 2. if the employer or related party does not buy the share from the employee (regardless of two-year period, even upon its expiration);
- 3. if the employee does not terminate the employee agreement or gets dismissed by employer prior to the expiry of said lock-up period, except for reasons that are indpendent of their will.
The aforementioned exemption applies only to employees, not other persons for whom this tax applies.
Anyhow, should the employee and any other person who acquired shares through an ESOP decide to sell their share and makes profit - they will be obliged to pay capital gains tax. Certainly, capital gains tax is never paid (not even in this case) if a person holds a share in his property continuously for more than 10 years.
In conclusion, an ESOP is a mechanism which represents a kind of stock option from developed countries. Although not overly present in Serbia, it is a mutual benefit for both the employer (company) and the employees - the employer binds a great employee and "rewards" him for his contribution, while the employee is maximally engaged and incentivised so that the company achieves the best possible result because his participation in profit depends on it. If, however, he/she decides to sell the share, there is a high probability that it will be sold for much more than it was paid. Add to that the aforementioned tax benefits and we have an additional argument in favor of an ESOP.
Of course, it is up to each employer to assess whether an ESOP is worthwhile, which he will do through a comprehensive legal, business and strategic analysis. This method is especially suitable for startups that can thus realize their enormous development potential and accelerated growth, yet have limited funds at their disposal in the initial phase of doing business.
Miloš Vučković, Senior & Managing Partner
Aleksandar Čermelj, Associate
*The information in this document does not represent legal advice and is provided for general informational purposes only.
**Partner, Senior Associate, Associate and/or Junior Associate refers to Independent Attorney at Law in cooperation with IVVK Lawyers.