Introduction
Welcome! If you’re reading this, you might just have accepted a new job at a startup – a job that offers you the chance to benefit from the company’s growth by awarding you virtual shares. Or, you might already own some virtual shares, and you’re wondering exactly what they mean for your compensation.
When you’re granted virtual shares in a company, you’re not just taking home a salary each month – your compensation is tied to the long-term growth of the business. But for many people, their virtual shares create lots of new questions about compensation. When do I get to cash out my virtual shares? Why do my virtual shares ‘vest’? What happens if and when I leave the company?
This one-stop guide to virtual shares and virtual share option plans (VSOPs) will help you answer these questions, and many more besides. Remember: this is just a guide. You should always check with your employer to find out exactly what your company’s VSOP and virtual share agreements mean for your compensation
What are virtual shares?
You might see people talk about ‘virtual shares’ and ‘phantom shares’. Don’t worry – these terms refer to the same thing. You may also see references to ‘stock appreciation rights’, or SARS; this is a very similar type of virtual share plan.
Virtual shares are used around the world as a way to reward employees for their contributions to building early-stage businesses. Unlike actual or ‘real’ shares, virtual shares do not give the holders any owner ship of the business. Instead, virtual shares translate to a cash value the employee will receive when there is an exit event like a public listing or acquisition.
Like any type of share, virtual shares have a nominal value, which is paid by employees when their company exits and they exercise their right to their cash settlement (more on this later). The full monetary value of your virtual shares is tied to your company’s share price. Assuming your company grows in value over time, your virtual shares will increase in value as your company’s valuation increases.
Share classes and voting rights
Companies often have different classes of share represented on their cap tables. Virtual shares or phantoms are almost always classed as common shares in your company. Common shares differ from preferred shares, which are usually the class of share held by investors. In case you’re wondering, it’s typical for founders to also hold common stock.
In most companies, shareholders get to vote in annual general meetings and when there are particular events that are important to the company, like when board members and/or company directors change. Share options don’t come with voting rights, and even when you convert your options into shares, it’s rare for common stockholders to have the right to vote on these kinds of resolutions.
Virtual shares usually form part of a virtual share option plan (VSOP). Let’s learn a bit more about VSOPs.
What’s a VSOP?
Your share options will be part of your company’s virtual share option plan (VSOP). A VSOP is a type of employee participation plan that distributes virtual shares to team members. Some companies choose to grant equity to all employees, while others restrict virtual share awards to select groups of employees.
There are a couple of different ways for companies to set up VSOPs. One popular route is for the founder (or founders) to set aside some of their own shares to create a VSOP for employees.
When this happens, the founder retains their equity stake, but it is established that a pre-defined portion of their equity will be set aside as virtual shares for employees as and when the company exits.
Alternatively, the board can decide to allocate a pool of shares specifically for a VSOP, either by issuing new shares or by convincing existing shareholders to set aside some of theirs. Again, your virtual shares will only ‘convert’ into cash when the company exits.
Virtual shares and share options: what’s the difference?
A liquidity event is an action or occasion in the life of a company where investors, founders and employees can ‘liquidate’ their investment positions and exchange their holdings for cash. Examples of liquidity events include listing on public exchanges, a merger or acquisition of the business, or secondary share sales.
There are lots of ways to reward employees with equity in a company. While virtual shares are popular in certain markets, such as Germany, share options are much more popular in other markets like the UK.
Share options give employees the right to buy a set amount of shares at a fixed price at some point in the future. They’re often part of an Employee Stock Ownership Plan (ESOP). When the time comes for employees to exercise their share options, they own shares in the company. It’s then up to them when they cash out their equity stake.
There are three major differences between virtual shares and share options:
Ownership
Virtual shares are not designed to give you an ownership stake in the company: they simply represent your right to benefit from the cash value of your virtual shares when the company sells or lists publicly.
When you can cash out
Holders of virtual shares have no choice over when they receive their cash settlement. You have to wait fora liquidity event. In contrast, people who hold shares as part of an ESOP can elect when to cash out. They can hold on to their equity stake after a liquidity event, for instance, if they think the share price will increase further.
What you pay up front
It doesn’t cost anything to acquire virtual shares, while it will always cost money to buy shares in a company. If you own virtual shares, the only payment you’ll need to make is the tax due when a liquidity event happens and a cash settlement takes place.
Vesting and dilution
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If you have virtual shares in your company, you’ll see that you don’t get awarded all your shares immediately after signing the contract. Instead, your virtual shares will vest over time.
Equity is designed to reward employees for their efforts over time, unlike, let’s say, bonuses which are paid out as a lump sum. Your company will set out in your contract how many of your virtual shares will vest each month, quarter, or year (vesting normally happens in monthly increments). But pay attention, because you’ll only start to see these regular vesting schedules once you’ve passed your cliff…
What’s a cliff?
A cliff is the period of time you have to work before being granted rights over any of your share options. The cliff is designed to prevent people qualifying for equity without making a significant contribution to the growth of the business.
It’s becoming normal for virtual shares to vest over a period of four years with a 12-month cliff at the start of the vesting schedule
How vesting works
Following this schedule, you’d have 25% of your shares vesting in one go after one year, with the rest of your options vesting in regular increments over the next three years:
Example 4 year vesting schedule with a 1 year cliff
Dilution
Growing and raising capital from investors are generally positive signs for a business. But when companies raise money, there may be knock-on effects for the value of your virtual shares.
Dilution happens when new shareholders acquire stakes in a business, reducing the ownership percentages of the pre-existing shareholders. Although the number of share options each employee owns remains stable (outside of top-up grants), the percentage of the company those share options represent is reduced as the company issues additional shares to new investors. If your virtual shares come out of the founder(s)’ equity allocation, for instance, they will be subject to the same dilution as the rest of the founder’s ownership stake.
Cash settlements and tax
What’s a cash settlement?
Because virtual shares don’t involve actual company ownership, your payout when your company exits is known as a cash settlement.
When an exit event occurs, employees are paid the cash they’re due through payroll. Then, you’ll need to report your virtual share ownership to the tax authorities the next time you file your taxes. Your employer should give you a statement called a holding confirmation, which will have the information required to help you complete this step.
Let’s talk tax
When your business sells or lists publicly, tax will be due on any gains from your virtual shares. How much tax employees pay on their cash settlement varies by country.
In Switzerland, for example, the government gives a tax ruling on the nominal value of the virtual shares, which reduces the taxable amount. In the Netherlands, SARs are taxed as salary when the company exits, meaning that for people under pensionable age, at least 37% goes to taxes. In the UK, cashing out virtual shares comes under your income rather than capital gains, which leaves you with a larger tax bill (up to 45%).
Cash settlements and tax (cont.)
In Germany, employees with stock options are taxed twice: when the options convert to shares, and when the shares are sold. In contrast, the only time you’ll pay tax on your virtual shares is when there is an exit event. However, the recent introduction of ZuFinG (the Future Financing Act) aims to simplify/improve taxation around employee equity schemes in Germany.
Tax works differently in every country, and it’s important to consult with a legal advisor and/or tax professional when you’re thinking about your virtual shares.
What part of my cash settlement is taxed when my virtual shares pay out?
Moving on: what happens to your virtual shares?
In contrast, bad leavers lose the right to retain any shares or share options after moving on. Bad leavers often include employees who:
- Commit gross misconduct;
- Are convicted of a crime, such as committing fraud or embezzlement;
- Break a noncompete clause or violate the terms of a shareholders’ agreement;
- Voluntarily resign, or before reaching a certain milestone, e.g. before all their shares have fully vested.
Ask your company whether they treat people who voluntarily resign as good leavers or bad leavers. If you’re treated as a bad leaver when you resign, that means you’ll lose your rights to your virtual shares –even those that have vested.
Devesting
You should take care to check whether your company operates a devesting policy. Devesting is a process where employees lose their rights to their virtual shares over time after they leave the company, usually at the same rate they vested at while you were in your role. Devesting could have a detrimental effect on your eventual cash settlement.
Almost all of us will move on from businesses at some point. But how much of your equity stake you keep when you move on depends on the circumstances under which you leave the company, as policies often change depending on whether you’ve chosen to leave the company or if your role is being made redundant.
Good and bad leaver clauses
What makes someone a good or bad leaver?
Companies can define good and bad leavers however they choose, usually drawing on the advice of their lawyers.
The most common cases that see employees defined as a good leaver, and hold on to their vested share options after they leave the business, are:
- Retirement;
- Serious illness or death (in which circumstance the employee’s share options would transfer to the next of kin);
- Being made redundant through no fault of their own, e.g. as a result of a merger, or because the role is no longer necessary.
78%
of companies in the US have at least some shares vesting over four years with a 12-month cliff.
67%
of companies use this vesting model on average in the UK, Germany and France.
Final thoughts
We designed this guide to help anyone who’s ever read a clause in their share option agreement and thought ‘What on earth does that mean?’ Whether you’ve been granted share options for the first time, or learning more about what your equity means for you, we hope you found our overview insightful.
As the tech ecosystem creates more category-defining companies, more and more people are being compensated with share options, which we love to see. But too often, the important ‘fine print’ of equity is too opaque or too technical for people to quickly understand.
The solution demands input from companies and team members. Companies need to be transparent with their people, giving them the information they need to understand their equity stakes and make sound financial decisions. And you should feel confident that your package is commensurate with market standards and that you’re being compensated fairly. Because when you’re up to speed with your equity, you can get to work in the knowledge that you’re contributing to something great.
Ledgy is the equity management platform built for scaling companies. We work with more than 2,500 businesses in over 40 countries around the world, including many of Europe’s fastest-growing and most innovative scale ups:
If you have any questions for us, please get in touch: contact@ledgy.com