Drawing up an Optional Contract in Estonia

Drawing up an optional contract in EstoniaIn recent years, providing employee options has become increasingly popular.  This means that if an employee is hired by the employer after a certain period of time, the employee has the opportunity to acquire a share in the employer’s company. Options are a very good way to motivate employees and tie them to the company – the employee does not look at the labor market so easily, and he develops a sense of «ownership», which hopefully reflects on the best results of the employee in the Estonian company.

What is an option?

The option is essentially a derivative instrument entitling an employer to acquire a share in the future, subject to certain conditions stipulated in the optional contract. For the employer, the option of participation is the opportunity to pay wages not with money, but with promise. Thus, the positive impact of the option on the company’s cash flow is obvious. The content of this promise is to give the employee a stake in the employer’s company in the future.

Positive side of the option for the employer

Unlike wages, options are not taxable. The option is not subject to special 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 transition period – an employee receives a share only if he works for his employer for a certain minimum period of time. This gives the employer the opportunity to connect with good specialists for a longer term,  and there is no need to use other options that often accompany hiring top managers.

Estonian tax law requires the employer and the employee to agree on a payment period of at least 3 years. Specifically, the Income Tax Act provides that the exercise of an option, that is, the conversion of a promise given to an employee,  into a share, may not be regarded as a special benefit if at least three years have elapsed 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 tax efficiency will also be lost in such performance.

In some exceptional cases, it is also possible to avoid paying preferential taxes when converting an option into shares of the company within a 3-year period. This is the case, for example, in the case of the sale of the entire share of the employer. In such a case, the exercise of such a number of options shall not be taxed, which is proportional to the time elapsed after three years.

Example

The employee and the employer agree on the participation option, the eligibility period is 3 years, and the employee is given an option to receive a nominal 100 euro share. After a year and a half, the employer’s shareholder sells its entire stake 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 part of the nominal value of 50 euros without special tax. Typically, a shareholder of a new employer requires that it also be able to buy shares from employees when buying a share, in which case the employee can simultaneously sell his share to a new investor.

Advantages of the option for employees

For an employee the option option is a good solution if he plans to be associated with his employer for a long period of time (at least three years of cooperation). For an employee, the option gives the opportunity to join his employer’s shareholders with full shareholder rights, i.e. to vote at the shareholders’ meeting, receive dividends, influence the company’s strategic decisions and finally sell the company’s shares. When receiving dividends, the employee’s remuneration no longer depends only on his own contribution to the success of the company, but also on the contribution of all his colleagues and the growth of his employer’s business as a whole. This option is especially valuable when we look at how Estonian unicorns have grown and what opportunities they offer their employees at the moment.

The positive aspect of receiving dividends is that the state has to pay them a much smaller tax than the wages. Dividends paid by the Estonian employer are taxed on income either only at the level of the employer at the rate of 20%, or income tax at the rate of 14% at the level of the employer and income tax at the rate of 7% at the level of the employee. For foreign employers, these rates may differ.

The transfer of a company’s share creates a tax credit similar to the payment of dividends,  because it is a passive income as opposed to wages. When the share is transferred, the employee must pay income tax at the rate of 20 percent of the profit received,  the social tax obligation does not arise when the share is transferred. It is clear that this benefits the employer, who is the payer of social tax in the case of wages.

How to provide an option?

To provide an option, an optional contract is concluded with the employee, which must be either digitally signed or notarized. The form requirement also needs to be considered when options are provided through other documents, for example by joining an optional program.

In the case of 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 corporate law point of view, this is the simplest way to issue options, so it would be prudent to provide the charter capital in the constitution of a company not as a specific amount, but as a range.

Items that must be included in an optional contract

  1. Option contract duration
  2. Option procedure
  3. Buying Options
  4. Termination and options
  5. Company sales and options

Option contract duration and option transfer

Since one of the purposes of providing options to an employee is to bind the employee to the company for a longer period of time, the employer must consider and determine the period of working out options in the contract. To be allowed to participate fully in the company, an employee must work for the same employer for the entire period of the option. After the expiry of this term, the employee has the right to purchase a part of the company or shares of the company.

The most favorable situation from the tax point of view arises when the period of granting the right of option lasts at least three years, after which the employee has the right to purchase the given options in full.

Alternatively, it may be stated in the contract that the employee receives options on a continuous basis for a period of proportional time worked. This means that although the entire period of the option is three years, for example, rights should not wait until three years have passed and the employee is entitled to options earlier, taking into account the time already worked.

For example, in the case of a three-year endowment period, an employee is already entitled to one third of the options after one year from the beginning of the endowment period. After the second year there is a right to two-thirds etc. In this case, a clause in the defense of the employer is usually included in the contract, that if the employee resigns before, for example, six months or a year after the signing of the optional contract, the employee loses all rights to options. Since the employer’s interest in providing options is to ensure the employee’s long-term commitment, it is unreasonable to include in the contract an option to acquire a share after only a few months of work.

Option repayment

The option contract should specify when and how the options will be redeemed. One option sets a time limit within which an employee must declare an interest in actually acquiring a share. This may be, for example, one year after the period of option awarding. At this stage, it is advisable for the employer to consider how in general the program of options for employees should be organized, so that it does not create an excessive administrative burden, and accordingly write down the time and order of purchase of options in the contract.

In order for an employee to convert their earned options into shares, the employer must submit an application stating that the employee wishes to buy the options.  It is recommended that the application form be added to the end of the optional contract in order to avoid misunderstandings related to the creation or purchase of shares.

What happens if the employee leaves before the deadline?

While both parties may have only the best intentions at the time of signing the optional agreement, sometimes life does make adjustments and the employment relationship does not continue until the end of the option period. For such situations, the option agreement specifies exactly which exit the employee retains the right to an option and which does not.

Each employer should carefully weigh when it is not possible to continue the optional contract and reflect this appropriately in the option contract. If an employee resigns during the period of employment through no fault of his own (illness, death or serious breach of the law by the employer), the employee is generally considered to be entitled to options in proportion to the time already worked.

Sale of the company during the option period

If it is a company whose owner plans to sell all or most of its company, these future plans should be reflected in an option contract. You should consider what happens to the employee’s right to receive options in the event of a sale of the employer’s company. Sometimes it is stipulated that in case of sale of the company the employee has the right

Immediately redeem their options and should not wait until the end of the entitlement period. However, if the employee is of key importance in the company and the employer’s buyer may have an interest in a company with key employees,  it may be stipulated that in the case of a sale of the company, the employee may obtain some of its capabilities. In any event, plans for the future should be considered and, if necessary, reflected in an option agreement.

In addition to the topics mentioned in this article, of course, the basic terms of participation should also be written. You can read about them in the document «Conditions of participation» prepared by EMTA. It is also important to note that an optional agreement can be notarized or digitally signed.

If you are interested in drawing up an optional contract, please contact Wisor Group OÜ OÜ and receive information today.