Virtual shares: still a ‘shadow’ among the classic stock options?

Monday 3 April 2023

Carmen Peli
PeliPartners, Bucharest

Delia Dumitrescu
PeliPartners, Bucharest

Concept and mechanism

A virtual stock option, also known as ‘shadow stock’ or ‘phantom stock’, is a contractual agreement wherein the beneficiary is granted the right to cash the financial benefit from the shares at a specific term or upon the occurrence of a specific event in the future, without the beneficiary receiving actual equity in the company.

Typically, virtual stock is used as an incentive for the employees or management team of a company, and it provides the company with the benefit of offering an incentive through cash compensation without the drawback of yielding part of the control over the management of the business or over the decision-making process, as is the case with classic stock option plans.

The mechanism is becoming rather popular, especially in startups financed by venture capital. In addition to this, private equity firms have also shown an interest in using this mechanism. Granting virtual shares is viewed as a compromise solution to offer employee incentives without affecting the company’s prospects in subsequent financing rounds.

However, a mechanism may be imagined where the benefit of virtual shares is also granted to other parties, such as vendors, collaborators and external advisers. The incentives offered by virtual shares can be in the form of:

  • virtual dividends, in which case the generating event is the end of the financial year or the completion of financial reporting; the dividends attributed to the virtual shares are computed by dividing the amount of distributable profit to the amount of actual stock plus virtual stock, to establish a dividend per share; and
  • virtual exit proceeds, when the generating events are exit events, such as the sale of all or substantially all the shares or assets in the company, liquidation or an initial public offering (IPO). The attributable benefit consisting of the exit proceeds shall be determined in this case similarly to the case of virtual dividends: the total proceeds shall be divided into the total amount of real shares plus the virtual shares, thus determining an exit price per share. Next, depending on the type of virtual stock, the beneficiary may receive either the difference between the total exit value of the virtual shares and their value upon being granted (‘appreciation only’ virtual stock) or the full exit value of the shares (‘full value’ virtual stock).

Implementing virtual stock

The virtual stock mechanism is not currently regulated under Romanian law. In practice, several similar models have been implemented especially in the IT startup sector, with companies granting virtual shares to key employees, with an attached right to receive a financial bonus at a future designated moment, generally connected to an exit by the company’s shareholders.

The mechanism is a contractual one, without a legal source. The party to this contract is, of course, the beneficiary of the virtual stock option, whether it is a key employee, director, external adviser or a key collaborator contributing to the business.

The beneficiary of a virtual stock plan is generally granted a fictive number of shares, without effective existence and without correspondent equity in the company. The virtual shares are attributed at a certain nominal value and shall be considered as part of the share capital, solely for the purpose of computing the financial benefit attached thereto. The dividend proceeds or exit proceeds will be determined pro rata, according to the percentage of virtual shares held by the beneficiary compared to the total number of real shares plus the virtual shares.

However, in case the shareholders have implemented a liquidation preference mechanism, which is generally provided to the benefit of investors, such preference will be observed with priority. The liquidation preferences of the shareholders shall first be deducted from the exit proceeds, while the holder of the virtual shares shall only participate in the distribution of the remaining proceeds according to the amount of their pro rata virtual contribution.

Virtual shares may be allotted directly and effective immediately or under a vesting schedule, either through tranche vesting (shares vest gradually over a certain period of time) or through cliff vesting (all virtual shares vest after the passing of a certain period). The vesting may also be conditioned, apart from the temporal element, by predefined key performance indicators and/or retention. If the beneficiary of the virtual shares leaves the company within the cliff period, no virtual shares are vested and no benefit is acquired. Similarly, if the beneficiary of the virtual shares leaves the company after only part of the milestones/tranches have been completed, then only the corresponding vested part of virtual shares is acquired.

Virtual shares may also be an interesting mechanism when considering dilution of the beneficiary. Some mechanisms offer to the beneficiaries a fixed benefit, such as ‘dividends and or exit proceeds in relation to [10 shares]/[one per cent of the shares issued by the Company]’. Others may offer a benefit that is determined depending on a shareholder benefit (usually, the founder), such as ‘dividends and or exit proceeds in relation to five per cent of the shares issued by the Company and owned by the Founder as at the reference date’.

Potential difficulties

Tax matters

Employee and management benefits are within the scope of income tax and social contributions (social security, mandatory health insurance, contributions to the unemployment fund etc). Combined, these elements amount to almost half the value of employee pay. Regular stock employment plans have received preferential treatment under the fiscal code.

However, virtual stock plans do not benefit from preferential tax treatment. If the beneficiary is an employee, the financial benefit of the virtual stock may work as deferred compensation and be taxed similarly to wages, including social contributions, upon pay out. Hence, the cash benefit granted to the beneficiary should also factor in the fiscal burden of the corresponding taxes.

A different question arises with respect to the applicable taxation if the beneficiary is not part of the company’s personnel, but a third-party collaborator. Such a collaborator would have to be either a company or an authorised natural person, as a natural person cannot receive contractual compensation from a company without an employment relationship, especially since it is assumed that virtual shares are granted in exchange for a certain contribution by the beneficiary (work, services, added value through experience etc). As virtual stock options increase the compensation received by such a collaborator, the tax authorities may argue that VAT applies: compensation for services is subject to VAT when exceeding certain thresholds.

Employment matters

Standard stock option plans are only available to the employees and management of a company. An advantage of a virtual stock option plan is that it may be applied as a contractual mechanism in relation to a consultant of the company.

When designing a virtual stock option plan, companies also need to consider the events that would trigger the loss of benefits for the employees, such as whether the cash bonus is granted or not to a former employee (good or bad). Generally, bad employee leaving events concern cases where the relationship between the employee and the company ceases due to the fault of the employee and can lead to the loss of the financial benefit from virtual shares. Such a mechanism should be observed and intertwined carefully with the applicable employment law, as the cessation of a contract due to the fault of the employee may only be performed under employment law in limited circumstances. This is the reason why, in practice, the incidence of employment law may pose difficulties in drafting a commercially effective ‘bad leaver’ clause. Special care should be given to creating a coherent link between the virtual stock agreement and the employment agreement.

Company and contractual limitations

Ideally, the relevant parties (the company, founders, investors etc) should set aside a virtual shares pool to be used as additional remuneration for the relevant categories of beneficiaries. With the establishment of such a pool, it will become clear for all parties who offers the incentive and who incurs the cost and risk of that incentive. In many cases, the issuance of virtual shares is an afterthought and the interested parties need to retrospectively sort out whether the company or the shareholders will ultimately incur such costs.

The existence of a virtual stock plan should not affect the fixed costs (eg, costs with salaries) of the company, but only serve as a mechanism leading to increased company performance through the use of beneficiaries’ contributions to the business.

The outcome of implementing the virtual stock mechanism also depends on its structuring and the parties involved. A potential difficulty in the contractual alignment may arise from the identity of the counterparty to the virtual stock agreement. Three possible scenarios may be imagined.

1. A virtual stock agreement concluded with the company

Given that the entire mechanism is conceived as an incentive for key contributors to a business, the benefit of virtual shares will usually come from the company itself, which is the general view implemented in practice. However, in the case of an exit event (except dissolution or liquidation), it is not the company, but the shareholders who cash out the proceeds. The same is true for dividends: the company owes the shareholders the entire amount of dividends declared.

Virtual share plans implemented under this structure have not yet been tested in practice. In our view, when the trigger event occurs (either the distribution of dividends, or the exit), the company will find itself with an additional liability:

  • As regards dividends, the company will pay all the actual dividends declared to its shareholders and in addition, it will pay the ‘virtual shares pool dividends’ to the beneficiaries. Such payment translates, therefore, into an additional financial liability for the company. Simply put, the company will not pay the virtual dividends out of the amount of distributable proceeds from real stock, but from a separate ‘pocket’.
  • As regards exit proceeds, although the mechanism will be similar, the commercial impact will be higher. The company itself will have a contractual obligation towards the beneficiaries of the virtual stock option plan. The investor or buyer will have to factor into the deal the debt of the company to these virtual stockholders. To mitigate this effect, it is advisable for the company to carefully consider the amount of the option pool for virtual shares especially at startup level and, of course, for the investors to carry out due diligence before deciding to invest.

2. A virtual stock agreement concluded with the shareholders

An alternative contractual structure would be a virtual stock pool to be set aside by the shareholders (founders and initial investors) through an agreement concluded by the beneficiary directly with these shareholders. Several aspects may be debatable in such a case, such as whether a benefit (eg, ‘corporate benefit’) exists (cauza contractului) for the shareholders to enter into such agreement (indirectly, the contribution of the virtual shares benefits the shareholders by benefitting the business), or whether a triggering event in the form of an exit by the shareholders is valid (which depends on the will of the exiting shareholder).

When the trigger event occurs (declaration of dividends or exit), the relevant shareholders have to release the payment to the beneficiaries of the virtual stock option plan.

This structure is more advantageous to the investor or buyer of (real) shares in the company, as the actual payment of the benefit will come from the selling shareholders. Tax or employment risks may apply and, in such a case, new investors will benefit from an indemnity when acquiring the real shares.

3. A ‘tripartite’ virtual stock agreement

A sensible solution seems to be to add the initial shareholders (founders and, potentially, initial investors) to the virtual stock option plan and clarify how the company and/or the shareholders will shoulder the payment of virtual stock compensation.

Under such a structure, when declaring (real) dividends, the company could withhold the payment of the virtual pool dividends from the relevant shareholders and make the payments to the beneficiaries. The exit proceeds will have to be paid by the selling shareholders to the beneficiaries.

The legal documents (including the decisions by the shareholders declaring dividends) will have to pay attention to the relevant Romanian law rules on waivers or the distribution of profits in other quotas than the shareholding. Of course, ultimately, such an agreement is commercial and does not necessarily require regulation, but it might nevertheless be prone to challenges on these grounds.

As the benefit is incurred by the selling shareholders, this structure is also advantageous to the investor or buyer of (real) shares in the company. Tax or employment risks may apply (because, for example, the exit proceeds for the beneficiary might be considered an employment benefit and taxed accordingly) and, in such a case, new investors will benefit from an indemnity when acquiring the real shares.

Apart from the rather technical difficulties in securing effective implementation, virtual stock programmes offer an elegant solution at least for employee incentivisation and especially for startups interested in ensuring key personnel retention, while maintaining control over the evolution of the business. However, before structuring and adopting such programmes, companies should carefully assess the related corporate and tax implications.