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Preparation of Voluntary Agreements in Estonia
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Options are a very good way to motivate employees and bind them to the company - the employee will not look so easily at the labor market and develops a sense of "ownership," which is reflected in the employee's best results at work.
An option, in essence, is a derivative instrument that gives an employee the right to receive a share in the future, depending on certain conditions specified in the vesting agreement. For the employer, the participation option is the possibility to pay wages not with money, but with a promise. Therefore, the positive effect of the option on the company's cash flow is clear. The content of this commitment is to give the employee a share in the employer's company in the future.
Unlike wages, options are not subject to tax. The option is not subject to a fringe benefit tax. Therefore, if an additional labor tax is required for the payment of wages, there are no tax costs for the option.
The most important and best condition for an employer is the so-called vesting period - an employee receives a share only if they work for their employer for a certain minimum period. This gives the employer the opportunity to connect with good specialists for a longer period, and there is no need to use other options that usually accompany the hiring of senior managers.
The Estonian tax law requires the employer and the employee to agree on a vesting period of at least 3 years. Specifically, the income tax law regulates that the exercise of an option, i.e., the conversion of a commitment given to an employee into a share, may not be considered a fringe benefit if at least three years have passed between the granting of an option. If the option is fulfilled before the end of the 3-year period, it will usually be subject to preferential taxes, which means that the tax efficiency of such a performance will also be lost.
In some exceptional cases, it is also possible to avoid paying preferential tax when converting an option into a company share within the 3-year period. For example, this is the case if all of the employer's shares are sold. In this case, tax will not be levied in proportion to the time that has passed after three years from the exercise of so many options.
The employee and the employer agree on the participation option, the eligibility period is 3 years, and the employee is offered the option to receive a nominal share of 100 euros. A year and a half later, the employer's shareholder sells their entire share to a foreign investor, which results in a new shareholder for the employer. In this case, the employee can realize half of the options and receive a portion of the nominal value of 50 euros without fringe benefit tax. Typically, a new employer's shareholder requires that they can also buy shares from employees when purchasing a share; in this case, the employee can sell their share to a new investor at the same time.
For an employee, the option choice is a good solution if they plan to be associated with their employer for a long period (at least three years of cooperation). For an employee, this option gives them the opportunity to join the employer's shareholders with full shareholder rights, such as voting at the shareholders' meeting, receiving dividends, influencing the company's strategic decisions, and eventually selling the company's shares. When receiving dividends, the employee's remuneration no longer depends only on their contribution to the company's success, but also on the contribution of all their colleagues and the growth of their employer's business as a whole.
The positive aspect of receiving dividends is that the state has to pay a much smaller tax on them than on wages. Dividends paid by an Estonian employer are taxed on income at a rate of only 20% at the employer level, or at a rate of 14% income tax at the employer level and 7% income tax at the employee's level. For foreign employers, these rates may differ.
The transfer of a company share creates a tax credit similar to a dividend payment, as it is passive income, unlike wages. In the transfer of a share, the employee has to pay income tax at a rate of 20 percent of the profit obtained, no social tax liability arises in the transfer of a share. It is clear that this benefits the employer, who pays the social tax in the case of wages.
To offer an option, an optional contract is made with the employee, which must be digitally signed or notarized. The form requirement should also be considered when options are provided through other documents, for example, by participating in an optional program.
When it comes to options, it is usually agreed that in their performance, the employer issues an additional share to the employee, and the authorized capital is increased by the nominal value of the corresponding share. From a company law perspective, it would be prudent to provide for the share capital at the company's formation not as a specific amount, but as a range, as this is the simplest way to issue a vesting period.
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Since one of the purposes of providing a vesting period to an employee is to bind the employee to the company for a longer period, the employer should consider the options in the contract and determine its duration. To be allowed to participate fully in the company, an employee must work for the same employer for the entire duration of the vesting period. After this period expires, the employee has the right to purchase a part of the company or company shares.
The most favorable situation from a tax perspective arises if the period for granting the right to the vesting period lasts at least three years, and then the employee has the right to fully purchase the options granted.
Alternatively, it can be stated in the contract that the employee continuously receives vesting period for a proportional period during which the employee works. This means, for example, that although the entire duration of the option is three years, the rights do not have to wait until three years have passed, and the employee is entitled to an earlier vesting period taking into account the time already worked.
For example, in the case of a three-year grant period, an employee is entitled to one-third of the options one year after the start of the grant period. After the second year, there is a two-thirds right, etc. If the optional contract is signed, the employee loses all vesting period rights. Since the employer's interest in providing a vesting period is to ensure the employee's long-term commitment, it is unreasonable to include the option to purchase shares after only a few months of work in the contract.
The option contract should specify when and how the options can be exercised. One option is to set a time limit by which an employee must declare that they are interested in actually purchasing a share. This can be, for example, one year after the vesting grant period. At this stage, it is advisable for the employer to consider how the option program for employees should be organized in general so that it does not create an excessive administrative burden, and accordingly write the time and order of purchasing the options in the contract.
In order for an employee to convert the options they have earned into a share, the employer must make an application stating that the employee wants to purchase the options. It is recommended to add the application form to the end of the optional contract to avoid misunderstandings regarding the creation or purchase of shares.
Although both parties are only in good faith at the time of signing the optional contract, sometimes life makes corrections, and the employment relationship does not continue until the end of the vesting period. In such cases, the vesting contract specifies exactly which exits of the employee retain a right to a vesting period and which do not.
Every employer should carefully weigh this in cases where it is not possible to continue with the optional contract and reflect this accordingly in the vesting contract. If an employee resigns during the employment period through no fault of their own (illness, death, or a serious violation of the law by the employer), it is generally accepted that the employee has options in proportion to the time already worked.
If a company is planning to sell all or most of its company, these future plans should be reflected in a vesting contract. You should consider what the employee's right to receive a vesting period will be in the event of the sale of the employer company. Sometimes it is stipulated that in the event of the sale of the company, the employee has the right.
They should exercise their options immediately and not wait until the end of the vesting period. However, if the employee is key to the company and the employer's buyer may have an interest in a company with key employees, it can be foreseen that the employee can obtain some of the capabilities in the event of the sale of the company. In any case, future plans should be taken into account and, if necessary, reflected in a vesting contract.
In recent years, offering employee options has become increasingly popular. This means that if an employee is hired by an employer after a certain period of time, they have the opportunity to acquire shares in the employer's company in Estonia.
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