Nuno Serrão Faria
PLMJ, Lisbon
nuno.serraofaria@plmj.pt

Introduction

Although not a fresh topic, Portuguese companies have been paying increasing attention to their internal incentive plans and compensation schemes for employees/collaborators/staff and management teams (hereinafter, ‘beneficiaries’) and private packages have become more and more sophisticated and creative.

Long-term incentives other than cash awards or performance bonuses have recently been included on the agenda of Portuguese firms. Over the past few years, we have witnessed some reshaping of remuneration schemes, ranging from traditional share award programmes and popular stock option plans to hybrid remuneration instruments of a variable and financial nature.

These instruments have been mainly implemented by companies belonging to international groups, especially in the financial and technology sector, and targeted at senior management. However, they are not widely used by small and medium-sized enterprises (SMEs) (the vast majority of businesses in Portugal).

Startups have also brought stock option grants back into the spotlight, which are seen as a good alternative to monetary benefits, especially by startups at growth or developmental stages. At the same time, such grants keep employees motivated to give their best in terms of performance based on the prospect of future profit.

It is clear that virtual stock and financial benefits schemes have gained increasing popularity in recent years in Portugal and other jurisdictions compared to traditionally more common equity grants or stock option plans, mainly due to their flexibility and simplicity in regard to implementing, structuring and executing such schemes.

Reasons for implementation

Although the underlying motives for the use of compensation tools vary, there is a general consensus around the idea that companies will benefit from the alignment of incentives between those of the company’s key providers and decision-makers and the goals of the firm, and from keeping all the stakeholders committed to the same performance goals.

Among the objectives pursued by firms when adopting remuneration schemes, one usually finds the following: (1) alignment with the medium and long-term interests of the shareholders/stakeholders; (2) an incentive to boost management performance; (3) a way of attracting, retaining and motivating employees, consultants and service providers, by providing an additional incentive and reward/compensation opportunities tied to the company’s performance; (4) enhancement of the company’s profitable growth and competitiveness; (5) the creation or increase of the shareholder wealth/value; as well as (6), the long-term sustainability of the company’s financial results.

Firms tend to look at incentive tools differently in terms of their goals. Big corporations, listed companies and settled financial institutions typically aim to ensure their management team is strongly committed to the company’s corporate goals by linking compensation to the related ongoing and long-term company performance. Startups are usually more focused on incentives at the exit stage, in order to align their collaborators and employees with the vision of the management team and accelerate growth in view of a successful sale.

Types and features

A wide range of compensatory packages have been used over the years in Portugal to remunerate employees and executives and incentivise their performance. While these schemes vary significantly in accordance with a company’s specific legal and commercial evaluations, such selection also depends on a careful assessment of the tax, labour and social security situation, which will ultimately dictate how the remuneration scheme is shaped. The type of company and its particular goals will also play a role in the final decision.

More commonly adopted policies in Portugal include fixed and variable remuneration and fringe benefits packages. Among other incentives, this type of package may include personal use of a company car, health and life insurance and contributions to pension funds.

The main decision for companies when implementing incentive plans often revolves around whether to award a non-monetary equity participation with associated vesting provisions (either directly in shares or through stock option plans) or a cash-based premium form of variable remuneration (even if mirroring equity forms of remuneration, as in phantom share schemes). In both cases, the calculation of variable remuneration is usually based on previously defined company key performance indicators (KPIs), which are assessed on an annual basis.

The fact that the equity participation route will not entail the use of any of the company’s funds (contrary to pure monetary benefits, for eg, salary, pension contributions, healthcare) is generally valued and has been a key underlying motive for resorting to stock awards, option plans or other tools of a financial nature, especially by early-stage startups. They have also been increasingly favoured over pure cash-based incentives or tangible benefits because employees will have more skin in the game, since their profit will depend on the company’s ongoing performance (eg, an increase in the value of the shares). Among the tools available, virtual plans have been generally preferred over the common stock option route, due to a certain appetite for unvoting schemes.

Recent trends

Market practice in Portugal has shown that decisions by firms in relation to their incentive plans and compensation schemes will typically revolve around the following: shares awards, stock option plans, virtual (phantom) plans and ad hoc remuneration plans. There are variations in terms of the main instruments, which are often combined into a larger package, mainly by international and more sophisticated companies.

Outlined below are some of the main features, advantages and drawbacks commonly associated with each type of incentive scheme.

Shares awards

Shares or equity awards are still commonly implemented in the country and entail the granting of a certain percentage of the company’s share capital to beneficiaries, usually over time and subject to a given vesting schedule and/or the meeting of performance targets. These are sometimes granted by means of a promise to transfer shares in the future when predetermined commercial conditions are met.

Stock is frequently allocated to beneficiaries at a discount, ie, at a price lower than the fair market value or even by means of sweet equity instruments.

These instruments are usually implemented by firms through the sale of their own shares (treasury stock) or through the allocation of shares by the beneficiaries, due to a capital increase in the company.

The right to participate in the incentive plan is typically granted as a one-shot attribution for engagement and collaboration in a given project (upon, or sometimes after, the commencement of an employment contract/management office), but may be structured differently (eg, as an annual grant).

The participation of beneficiaries may be structured on the basis of different classes of shares, with founders keeping a special class (senior) with a payment preference and a coupon (hurdle rate), and beneficiaries being granted a different category of shares (junior), in which the attached rights (voting and dividends) can be designed with some flexibility, despite the need to comply with certain mandatory corporate rules.

General provisions on categories of shares, voting and dividend rights and shares amortisation events (bad leavers) may be included in the company’s bylaws and more detailed provisions may also be included in a shareholders’ or investment agreement, which deals with the applicable lock-up provisions, pre-emption rights at exit, profit-sharing mechanisms, cash flow rights and hurdle rate principles.

The award of equity interest would then, within a specific period and subject to certain conditions, grant to the beneficiaries a set of rights to participate in the company, including the right to dividends, voting and accessing information about the company’s corporate and management affairs. However, the possibility of the disposal (through a sale or otherwise) or encumbrance (through the pledge of others) of the shares by the beneficiaries is often restricted and allowed only after a certain vesting period is achieved (a lock-up provision). Among the advantages underlying this type of scheme, the following are often highlighted: (1) the promotion of stronger long-term engagement by beneficiaries due to their participation rights; as well as (2) the fact that some mechanisms (eg, bad leaver solutions, amortisation of shares, voting rights) may be implemented and regulated via a company’s articles of association in a stable and sound way.

A pure equity instrument is usually interesting in terms of its ability to ensure a greater level of commitment from beneficiaries, who will be able to participate in the decision-making process of the company to some extent. On the flip side, however, such intervention can also be seen by stakeholders as a drawback, to the extent that they may not wish to give away any type of control in the company, even if of a residual nature, nor see their equity ownership diluted and transferred to others.

Stock option plans

In regard to this type of incentive scheme, beneficiaries are granted an option to purchase or subscribe to a certain amount of shares (acquisition or subscription rights) in the future, at a set price and during a predetermined period. These are usually granted on a free-of-charge basis or at a symbolic price, thus avoiding an initial investment by beneficiaries.

Share options are then granted upon the commencement of an employment relationship/management office or shortly after, to be exercised and settled at the end of the vesting period, at a certain pre-calculated price (grant/option/exercise or strike price).

The expectation is that beneficiaries will be able to buy shares (upon option exercise) at a strike price that is lower than the market value and make a profit at exit through the sale of their shares at a higher value.

Stock option grants then result in the attribution to beneficiaries of a right to purchase shares, which is conditional upon certain KPIs being met and/or a vesting period elapsing, following which the beneficiary may potentially become a shareholder of the company.

Key elements of share option plans are: the exercise price, vesting regime or schedule and the exercise period, ie, the time period for the exercise of the option before its expiry. In some cases, the plan will also set out a time period for beneficiaries to sell their acquired shares after exercising their options.

For listed firms, strike prices will typically follow the current market price of the shares at the grant date. The situation for unlisted companies is more intricate: lacking a market price, the exercise price must be expressed as objectively as possible and may be in line with the current equity value of the company or a discounted price in relation to such value; a given symbolic price; or, otherwise, the value that would have been agreed on for the transfer of shares between independent parties in good faith (arm’s length).

The same as with equity interest, the vesting and exercise of options may be and usually are subject to certain conditions (eg, investors being repaid their investment or simply a certain period of time elapsing). In terms of the settlement of stock options, two scenarios are usually considered: (1) financial settlement: in pure cash-settled options, beneficiaries will receive the difference between the share price on the exercise date and the strike price (if positive), without becoming shareholders of the company, and (2) physical settlement: the most common route whereby beneficiaries become owners of shares upon the shares being exercised.

Some advantages associated with stock option grants relate to the flexibility of the regime, which allows for a free definition on the price and time conditions for the exercise of the option rights. In addition, some companies value the fact that, up to the exercise date, beneficiaries will not be entitled to any shareholders’ rights (and may never become shareholders).

A common provision in a stock option package is one stating that the company has the discretionary right to deliver, in lieu of the shares, the equivalent amount in cash. The fact that this type of settlement may be determined at the sole discretion of the company provides an extra element of flexibility to these schemes.

Virtual (phantom) plans

This form of variable compensation (also known as ‘shadow stock’) consists of the attribution to beneficiaries of remuneration units or virtual quotas, representing a certain percentage of the company’s share capital, with a predetermined value (by appraisal or set by a formula). This value is usually linked to the value of the share itself at the granting date and is calculated in accordance with a certain method of valuation of the company’s equity.

What is then granted is an economic benefit attached to the company’s positive performance under certain conditions, which will equal a set fraction of the company’s shares multiplied by the current share price. In short, this is a pure financial scheme, with no equity participation attached.

In terms of a virtual scheme, the cash amount will be paid out at the end of a specified period of time (usually settled on vesting). For unlisted companies, with no market price available, a strike price will be freely determined and is often linked to the value of the shares or takes into account the company’s equity valuation.

This type of remuneration is akin to so-called share/stock appreciation rights, which reward beneficiaries with compensation tied to the company’s performance (the increase in the value of a given number of shares over a certain period of time), as opposed to granting stock.

In terms of the structure and mechanics, this type of remuneration also resembles a stock option scheme with financial settlement: there is no attribution of rights to purchase shares, which means that beneficiaries will not become shareholders, but rather they will be entitled to receive a monetary benefit if and whenever certain conditions are met, ie, a credit right is granted against the company. Such a right is one of a contractual nature and not a security interest, which means that a phantom stockholder will have no rights other than those of a general unsecured creditor under the applicable law.

It follows that a phantom stockholder will not have any dividend or distribution rights, voting rights, liquidation rights, pre-emptive rights or other economic or administrative rights common to the holders of equity interests.

In some cases, however, especially in regard to unlisted companies, a phantom award will offer to beneficiaries dividend equivalent payments upon vesting, ie, the right to receive dividends and other assets, as may be distributed from time to time by companies to their shareholders, which means that the award will mirror the economic rights (participation in distributions) granted to share owners, with the board proceeding to issue cash payments as if the phantom share owners were shareholders.

No financial effort is usually required from beneficiaries to benefit from virtual plans, which means that no cash inflow is produced for the company (as opposed to share options).

The same as with equity grants and stock option plans, the right to compensation will usually be based on the company’s future positive performance and the individual’s performance, or often the ongoing good behaviour of the beneficiary is set as an additional eligibility criterion.

Also, like a true option, phantom units are frequently awarded according to a vesting schedule (tied to the company’s performance goals), so only when vested will a credit right arise for the beneficiaries.

An example of the flexibility associated with this type of scheme is the fact that one may establish that virtual shares can only be exercised in case of an exit (an acquisition or initial public offering (IPO)) or after the end of the employment relationship and that a vesting schedule may or may not apply (even though one generally applies).

Many advantages have been underlined in relation to phantom-type shares, such as the fairly simple and straightforward to set up; even greater flexibility when compared to stock options; the fact that beneficiaries will not become shareholders, so no ownership dilution or dispersion of capital occurs; and no mobilisation of the beneficiary’s own funds is needed to acquire units.

These compensation schemes also have some drawbacks, such as by receiving a cash benefit and not shares, there might be a reduced level of commitment by beneficiaries in relation to the company’s growth; the need to determine the equity value of the company at the time of allocation of the units and at the end of the grace period (ie, the price is determined at inception, the same as with stock options); the final cost is difficult to estimate a priori, depending on the valuation criteria of the remuneration units; and the need to make a provision for the potential costs of the plan, which might negatively impact the company’s profits.

Ad hoc remuneration plans

The same as with phantom shares described above, this scheme is also a type of variable cash-based remuneration. However, it is one that is calculated on the basis of objective growth indicators on the company, such as the earnings before interest, taxes, depreciation and amortisation (EBITDA), turnover, sales volume, a third-party firm offer to purchase shares in the company or other accounting figure linked to the company’s performance. Hence, this is not necessarily an equity-linked form of compensation.

This type of plan bears the distinctive feature of not being linked to the underlying price of the shares, which may ease the valuation process and, as a result, the determination of the compensation.

The same as virtual stock, this type of incentive is more commonly adopted by closely held firms (although it is also used by listed companies combined with other instruments in more complex packages).

These remuneration plans generally have several advantages, such as by having a value indexed not to the share price but to other financial indicators of the company or to third-party offers, it avoids any difficulties related to the company’s valuation; and it allows greater flexibility to shape the content of the plan when compared to virtual stock and option plans. In regard to the latter instruments, parties typically experience a lesser degree of freedom, either because a legal or regulatory framework may apply or because a certain market practice will often be used as a reference.

Ad hoc remuneration plans may, in turn, entail certain drawbacks, such as: (1) the potential for less commitment by beneficiaries in relation to the company’s growth, due to them not being a shareholder with participation rights; and (2) the need to make a provision for the potential costs of the plan, which may negatively impact the company’s results.

A comparison between the different incentive packages

The implementation of financial benefits schemes (such as phantom or virtual stock schemes) has been gaining traction in recent years, being favoured over conventional kinds of stock options, especially because they allow for a simpler structure. The fact that there is no granting of shares and, hence, no control granted to beneficiaries nor any intervention in the decision-making process of the companies, enables the implementation of simplified granting mechanisms. Since so many firms are keen on keeping their staff away from the company’s corporate affairs, non-voting-type structures tend to be welcomed.

Below some of the key differences between the incentive schemes analysed so far are explored in terms of engagement by beneficiaries and governance/agency issues, the flexibility of such plans and the applicable company evaluation methods. It will become clear that some of the solutions may look similar in terms of their structure, mechanics and outcome; however, some of them are legally construed in a different manner, with slightly different consequences.

Engagement by beneficiaries and governance/agency issues:

• equity participation tends to promote deeper and long-term engagement by beneficiaries and having them as minority stockholders may add extra value for firms;
• in regard to financial benefits schemes, such as virtual stock and ad hoc plans, the fact that beneficiaries do not become shareholders (no stock ownership) and remain simply entitled to a credit right towards the company may also be seen by stakeholders as positive in terms of the company’s governance and (no) dilution of their equity position (dispersion of capital);
• likewise, a pure financial settlement via a stock option scheme may lead to lower engagement by beneficiaries, whereas under cash-settled options the possibility of acquiring a stake in the company may provide an extra incentive to beneficiaries;
• shares awards, just like options with physical settlement (and as opposed to all other solutions), further leads to ownership dilution (through the company’s acquisition of its own shares or a subscription share capital increase by beneficiaries, as stated above) and beneficiaries are required to advance their own funds in regard to this form of shares acquisition; and
• even if beneficiaries become minority shareholders in the company, the board may tone down the involvement of beneficiaries in terms of their participation rights and voting power via the articles of association, in order to avoid or mitigate ownership-related governance and agency issues.

The flexibility of plans: 

• phantom units tend to be generally less rigid than traditional stock option plans, regarding which market price principles are followed;
• ad hoc schemes seem to offer even greater flexibility when compared to the other available solutions, notably in terms of the criteria for the calculation of remuneration, which can be composed of different financial and non-financial indicators;
• one generally finds less flexibility under the other schemes, either because there is an applicable legal/regulatory framework or because market practice is used as a reference point;
• stock options with a physical or financial settlement at the sole choice of the company on a specific date seems to offer even more flexibility to the board, in that they can opt for the type of settlement that suits the company best in different contexts; and
• flexibility also brings some challenges, namely since the instruments can be designed in different ways, key decisions need to be taken around topics like eligibility, vesting rules, liquidity concerns and rights regarding the interim distribution of profits, etc.

The evaluation of companies:

• stock options with a financial settlement may present difficulties around assessing the value of the company for the purposes of calculating strike and acquisition prices, which sometimes encompasses a litigation risk involving the beneficiaries and may even present a potential tax risk;
• in opting for the phantom share route, there is also the need to determine the value of the company at the grant date and at the end of the vesting period (ie, the price is pre-determined), which means that the final cost of the scheme may be difficult to estimate, since it will depend on the valuation criterion of the units;
• on the contrary, ad hoc plans may be used to help to overcome the difficulties related to the evaluation of the company, since there is no indexation to the value of the shares, but rather to different financial indicators of the company or to a share purchase offer; and
• in addition, both phantom and ad hoc schemes, in principle, require a provision for the potential costs of the plan to be made, which may impact the company’s annual results.