Virtual share plans: the right tool for Hungarian startups to attract and keep talent?
March 2017 | SPECIAL REPORT: EMERGING MARKETS – OPPORTUNITIES AND RISK MANAGEMENT
Financier Worldwide Magazine
Recent success stories of Hungarian IT companies, such as Prezi or Ustream, have attracted more interest from Hungarian and international investors to the growing Hungarian startup scene.
Depending on where a startup stands in its growth phase, its shareholders typically consist of a small number of founders, angel investors and seed investors. Now, the further a startup grows, the more complicated the shareholder and governance structure becomes. Percentages of shares, voting majorities and other preferential rights granted to some shareholders are reached only in long and tough negotiations and the compromise is cemented into shareholders’ agreements and articles of association. Those compromises leave little to no room for any changes until a next investment round.
A shareholder compromise can easily lead to a fundamental conflict of the interests between shareholders who are in, and those who are out. For example, key employees who are not shareholders. The shareholders are obviously interested in maintaining the compromise and the status quo until the next investment round, while those on the outside may feel that they are not participating properly in the company’s success. Needless to say, those feeling left out may soon end up considering other opportunities. With the growing startup and IT scene, and the current shortage of talent within the Hungarian labour market, a competitor will use any opportunity to entice talent away from, and ‘hurt’, a competitor. Thus, the following question arises: how can a startup ensure that key employees are incentivised and motivated to stay, while the compromises that the shareholders and investors have already achieved among themselves are also maintained?
An answer we have recently seen in Hungary is the implementation of virtual share plans (VSPs), or so-called phantom share plans.
Basically, a VSP is an incentive scheme for selected key employees and selected external advisers of a startup. The VSP allows the beneficiaries to participate in the startup’s financial success as if they were shareholders, though they do not become ‘real’ shareholders. Under a VSP, the beneficiaries receive only virtual shares. A virtual share has a nominal value and is treated as if it represented a certain percentage of the startup’s total stock, but, again, it is not part of the real stock. A virtual share, then, is essentially a method for calculating a cash bonus granted to its holder. The obvious question is: when is such a bonus payment triggered? This, of course, depends on the exact provisions of the VSP, but there are typically two triggering events. The beneficiary becomes entitled to a bonus if some (usually the majority) of the startup’s present shareholders sell their shares to an external investor. In the event of such an exit, the beneficiary will receive a part of the purchase price that the external investor pays to the shareholders. The beneficiary’s bonus will be calculated proportionally as if the beneficiary’s virtual shares had been part of the transferred stock.
Another, although less typical, event that can trigger a bonus payment is if the startup declares a dividend to its shareholders. In this case, the beneficiary will receive a proportional part of the dividend that is disbursed to shareholders. Again, the beneficiary will be treated for this purpose as if their virtual share were part of the stock.
It is important to point out the striking difference between ‘traditional’ bonus schemes and VSPs. Under a traditional bonus scheme, employees receive a part of the company’s extra results, normally on the condition that both the company and the employees personally exceed certain annual targets. A bonus from the VSP, however, is not directly tied to the startup’s financial results or the individual’s personal results (naturally, indirectly it is indeed dependent on the company’s perspectives and success, which will ultimately lead to the sale of the startup). Instead, the VSP entitles the beneficiaries to receive parts of monies normally due to the shareholders. This means that the bonus is not necessarily paid from the startup’s own cash: in the event of an exit event, which is by far the more significant triggering event, as many startups usually make losses and are not in a position to disburse large dividends, the beneficiaries receive a part of the purchase price that the acquiring investor pays to the shareholders. As the ‘real’ shareholders give up in the VSP parts of the proceeds that they would normally be entitled to, it is essential that the VSP be regulated in a written document and be adopted with the consent of all shareholders.
If a virtual share entitles the beneficiary to receive parts of the company’s purchase price and disbursed dividends, what differentiates a virtual share from a real share? Most importantly, the beneficiary of a virtual share does not become a shareholder of the startup. This means, the beneficiary is not entitled to participate at shareholders’ meetings and in the making of some of the startup’s most important strategic decisions (such as the appointment and removal of directors or the approval of the sale of the company’s shares to an external investor). Also, the beneficiary of the virtual share will not have the right to demand information from management about the company’s business and financial situation, like normal shareholders do. To summarise, the beneficiary of the virtual share will, in certain events, be treated as a shareholder for the allocation of certain monies, but is denied all other shareholder’s rights (right to participate and vote at shareholders’ meetings, right to information, right to make petitions, and so on).
This leads us directly to the biggest advantage the VSP offers to startups: it provides financial incentives tied indirectly to the startup’s success, whereby the right to make strategic decisions remain fully with a handful of founders and investors. Apart from the fact that sensitive decisions and information remain with those who put their own money into the startup, the governance of the startup also remains simpler with, for example, five shareholders as opposed to 15. This latter can be an important aspect for an investor considering investing in a startup in upcoming investment rounds.
Another significant advantage of a VSP is that it can be implemented at startups with different legal forms. A VSP can be translated to fit with limited liability companies, which is the dominant legal form of Hungarian startups in earlier growth phases, and also for private limited companies, which is a company form with real stock, and is more typical for startups that have attracted significant investor participation.
As noted, the exact terms and rules of the VSP should be regulated in a written document, and this document should be approved by all or a majority of shareholders. The first basic topics to be regulated in the document are the maximum amount of the total ‘virtual stock’ and the maximum amount of the virtual share that one single beneficiary may receive. The circle of potential beneficiaries should also be regulated precisely – is the plan open to employees of the startup only, or also to external advisers and consultants, who are actively contributing to the startup’s growth and success but for whatever reason do not choose to become employees of the company? If the plan is open also to external consultants and advisers, can they participate only as private individuals, or also through their own companies? The latter question should be measured very carefully, as the purpose of the VSP is to give personal incentive to selected key people. Therefore, virtual shares are normally not transferable by their beneficiaries. If an external adviser is allowed to participate in the programme through their company, the non-transferability of the virtual share, or the terms of the shareholders’ agreement, can be circumvented if the beneficiary sells their firm to an external investor who thus acquires a certain interest in the startup in an indirect manner.
Another typical provision of the virtual shares programme is the vesting. Virtual shares are not only a tool to give a financial incentive to key people, but also to bind them to the company for a longer term. Typically, the beneficiaries do not receive the entire virtual share at once when they enter the plan. Instead, vesting periods of three, four or five years are typically determined, and the beneficiary receives a proportional part of their virtual share quarterly, semi-annually or yearly. For example, in the case of a four year vesting period with quarterly vesting, the beneficiary will receive one-sixteenth of their virtual share at the beginning of each quarter. As a result, the beneficiary may enjoy the full financial benefit of the virtual share when the vesting period is over and the beneficiary has spent the relevant time contributing to the startup’s growth. Given that VSPs are laid out for a longer period of time, what qualifies as ‘good leaver’ and ‘bad leaver’ event of the beneficiary should also be noted, as well as whether the virtual shares are withdrawn or are allowed to remain with the beneficiary in such an event.
Gábor Kordoványi is an attorney at law at Schoenherr. He can be contacted on +36 1 8700 700 or by email: firstname.lastname@example.org.
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