In Spain, start-ups have not only revolutionised the technological innovation and investment processes, but also the way to remunerate talented employees. The lack of liquidity available to pay employees requires entrepreneurs to find new ways of attracting and keeping talent, inspired by the stock option plans used by American start-ups. The majority of our start-ups use phantom shares model, as a consequence of tax and legal matters.
Origin of phantom shares
The Spanish entrepreneur movement is influenced by start-ups in the US, where the flexibility of their corporate laws and an adequate tax framework allow remuneration of talented employees through plans to acquire shares of the start-up. Stock option plans have two main benefits: (i) attracting talent without impacting the company's cash flows and (ii) aligning employees with the interest of equity holders. US start-ups use stock option plans to remunerate the entrepreneurs and the team (typically between 10 and 20% of the share capital on a fully diluted basis), where the options exercise is subject to certain permanence requirements (in Silicon Valley, usually 4 years with a 1-year cliff). However, the legal and tax differences with the US system make it difficult to implement these plans in a Spanish private limited liability company (S.L. or sociedad limitada), which is the legal form used by start-ups in our country. Therefore, in Spain, unlike other jurisdictions, employees do not receive stock options but phantom shares, that is, the right to a cash payment based on the price of the common shares of the company at a given moment.
What are phantom shares?
Like all private limited companies, a start-up's share capital is divided into shares (participaciones sociales). Using shares as a method to remunerate employees in a private limited liability company is subject to several legal obstacles, such as limitations on the acquisition of treasury shares; limitations on the sale price of such treasury shares; approval by the general shareholders' meeting to create new shares; or formalization of resolutions to increase the share capital by means of a public deed that needs to be subsequently registered with the Commercial Registry. All these requirements increase the cost and complicates the use of regular stock options to reward employees. Additionally, certain scholars consider that stock option plans are exclusively reserved for public limited companies (S.A. or sociedad anónima), an opinion we do not share.
In any case, even though the aforementioned limitations greatly complicate the implementation of stock option plans in private limited companies, the main obstacle is tax related, since the remuneration through stock options is considered as salary income and, therefore, it is subject to high tax rates. To make things worse, upon exercise of the options, the employee usually receives illiquid shares, but is required to pay taxes (at the general rate of salary income) for the difference between the strike price and the fair value of the shares at the time they are delivered to him.
Therefore, the way to remunerate talented employees in Spanish start-ups, is through phantom shares plans, by means of which employees receive a bonus or cash payment based on the price of the common shares at the time of the liquidity event or sale of the company. This sidesteps the corporate complexity of implementing a regular stock option plan, as well as the tax issue derived from a lack of liquidity to pay the corresponding income tax.
How do phantom shares commonly vest?
Phantom shares, like any other incentive plan, are subject to the fulfilment of certain milestones, usually permanence in the company. Thus, rules on bad leavers and good leavers are common practice. Generally, a bad leaver is someone who voluntarily leaves the company or is terminated by cause before the end of the permanence period. Contrariwise, an employee who leaves the company for any other reason (unfair dismissal, retirement, illness…) is considered a good leaver.
The importance of the distinction between good and bad leaver lies in the fact that a bad leaver usually loses all his phantom shares (even those that have already been vested) and, consequently, all remuneration rights deriving from said phantom shares. However, the good leaver usually keeps all phantom shares vested until the date on which the employee leaves the company, only forfaiting unvested phantom shares.
How are the proceeds distributed in case of an exit or liquidity event?
Upon a liquidity event or sale of the company, the holders of phantom shares are entitled to receive a bonus per phantom share based on the price of common shares. In practice, a phantom share plan has an impact on the overall company value, because the buyer will usually deduct the payment of the phantom shares remuneration from the purchase price.
The effect on the price per share of the remaining shareholders and investors is practically equivalent to such produced by a stock option plan that would allow its beneficiaries to receive shares, which would subsequently be sold, upon consummation of the liquidity event. Because of this, each investor takes into account the existing number of phantom shares in a company at the time of establishing the pre-money valuation of the investment.
Main differences between phantom shares and stock options plans
Although this has already been mentioned, it is worth remembering the reasons why the phantom shares are considered as the most suitable way to remunerate talented employees in Spanish start-ups:
- Legal reasons
Unlike regulation on treasury shares in public limited companies, Spanish Companies Law only allows a private limited company to acquire treasury shares in limited cases and they are subject to certain restrictions in terms of transfer price and holding periods which prevents them from being used to implement stock options plans.
The difficulties of using treasury shares to fund stock option plans requires implementation of those plans through the approval of specific share capital increases (more of less matching the exercise of the corresponding options by the beneficiaries) with all the complexities and costs involved.
- Governance reasons
The beneficiaries of phantom shares are not and have no right to become shareholders. This facilitates the governance of the company, the adoption of resolutions by the general meeting and the execution and management of shareholder's agreements, by reducing the number of shareholders. However, holders of stock options, upon exercise, become actual shareholders and, as such, have the right to participate in the governance of the company.
- Tax reasons
Although in both cases, the gain obtained through stock option and phantom shares plans is taxed as salary income, in the case of phantom shares such income is always generated when a liquidity event occurs and the beneficiary receives a remuneration that allows him to pay taxes. This does not necessarily happen with stock option plans, where the beneficiary must pay taxes (at his maximum personal income tax rate) for gain obtained, which may result in a so-called "dry income" (taxable gain with no cash), to the extent the shares are not listed in a secondary market and their transferability is very limited.
Therefore, phantom share plans have become the tool commonly used by Spanish start-ups to remunerate employees' talent in line with regular stock option plans.