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

Introduction

Although not a new topic, Portuguese companies have been paying increased 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 in the agenda of Portuguese companies.^[1] Over the past few years, we have witnessed some reshaping of remuneration schemes, ranging from traditional shares 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), which make up the vast majority of businesses in Portugal.

Startups have also brought stock option grants back into the spotlight, and these 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 provide their best performance based on the prospect of future profit. This trend has also been fostered by some recent European Union (EU) regulation.^[2]

While incentive packages have been quite common in the United States (US) for some time now, European countries are still taking steps towards a stronger form of implementation. Studies show that ‘European companies tend to allocate a high proportion of their stock options to executives – approximately 2⁄3 of the total in late-stage startups. In the US, this ratio is reversed, which seems to reflect the fact that many European employees receive no options at all’.^[3]

Laws and regulations in Portugal are almost non-existent for unlisted companies. Other than tax laws, there are no specific corporate rules governing or restricting the implementation of non-cash-based awards.^[4] Therefore, generally there is plenty of flexibility when structuring variable remuneration and incentive schemes, and private companies are free to create packages tailored to their specific corporate goals. This is less true for financial institutions and publicly listed companies, where some key regulation is in place to define the general principles on the remuneration structure, approval, disclosure and payment deferral.^[5]

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 company, and from keeping all the stakeholders committed to the same performance goals.

Among the objectives pursued by companies 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.

Companies 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 strongly vary in accordance with a company specific legal and commercial evaluation, we will see that 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.

The more commonly adopted policies in Portugal include fixed and variable remuneration and a fringe benefits package. 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), 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, eg, salary, pension contributions, healthcare) is generally valued and has been a key underlying motive for resorting to stock award, 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, as better detailed below.

When deciding on which type of plan will fit best, companies tend to consider the following main topics, among others:

1. specific terms and conditions – for example, (i) dependent on the signing by beneficiaries of confidentiality, non-compete or non-solicitation agreements, or (ii) triggered only after the founders are repaid their investment, or (iii) dependent on other company key financial indicators;
2. whether any financial effort will be required from the beneficiaries of the plans to benefit from the remuneration;
3. vesting schedule, meaning the period of time which must elapse before the beneficiaries become entitled to or the owner of the granted incentives, which is typically set out in option scheme, but is also often replicated in other types of compensation;
4. early/automatic vesting of attributed options/shares in the case of certain liquidity events (eg, merger or demerger, third-party offer to acquire shares, direct or indirect change of shareholder control arising from public takeovers or delisting from trading on regulated market) and which rights are to be granted to beneficiaries, for instance, in case of an exit event transferring the control of the company;
5. option exercise period (a given period for beneficiaries to exercise their options, with a long-stop date or similar), as well as any exercise triggering events or conditions (eg, takeovers, sale, admissions), including provisions to deal with unexercised vested option shares within the period;
6. period for the sale of stock after options or other similar instruments are exercised;
7. whether the right to compensation will be based on the company’s future positive performance or whether the situation will also be dependent on the individual performance or ongoing good behaviour of the beneficiaries;
8. whether compensation will expire if the beneficiary leaves the company before the maturity period (and under which conditions) and whether beneficiaries that leave the company will be allowed to retain vested options or will be required to exercise them within a certain period of time or not exercise them until they exit the company;
9. A bad leaver mechanism and the consequences, for instance, (i) specific events that allow for share amortisation without the beneficiary’s consent; (ii) redeemable shares; (iii) company or founder call options to buy back the beneficiary’s shares at a nominal amount, discounted price or no cost at all;
10. the plan’s termination or expiry conditions, other than due to good/bad leaver events, and the consequences thereof, for instance, repurchase of the shares by the company at market value or regarding the compensation due to beneficiaries;
11. lock-up provisions, preventing the disposal and encumbrance of the granted equity interests due to the intuitu personae feature and the consequences in cases of non-compliance;
12. whether any security solution will be implemented to deal with exit events (especially in bad leaver situations), allowing the company or founders to enforce a repurchase of the granted shares (eg, call option, escrow of shares, irrevocable powers of attorney) and also to enforce the lock-up provisions;
13. liquidity events triggering a remuneration award or expiry of the plan (eg, positive net results of the company after a given period, the actual distribution of dividends, sale, takeover, liquidation, other restructuring events);
14. the need for the creation of provisions in the balance sheet of the company and, in general, the accounting treatment of the instruments; and
15. the dilution of the ownership of shareholders or anti-dilution protection mechanisms.

The contractual framework underpinning remuneration incentives may be leaner for some or look more complex for others (there is no one size fits all). These are usually created through a general regulation or plan, approved by the board and made publicly available to stakeholders, containing rules that are to apply to all beneficiaries alike, thus ensuring equal (non-discriminatory) treatment. The regulation or plan is usually complemented by a private agreement or adherence statement (eg, equity award incentive letters) between the company and the beneficiaries, which sets out the specific conditions applicable to the scheme (eg, percentage of granted shares, strike price). In the case of a shares award, one will usually see certain rules added into the company’s Articles of Association or the shareholders’ agreement (if any).

Recent trends

Market practice in Portugal has shown that decisions by companies 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 of the main instruments, which are often combined into a larger package, mainly by international and more sophisticated companies.

We outline below some of the main features, advantages and drawbacks commonly associated with each 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 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^[6]) or through the allocation of shares by the beneficiaries due to a capital increase in the company.^[7]

The right to participate in the incentive plan is typically granted as a one-shot attribution for the 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 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.^[8]

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, dealing with 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 (lock-up provision).Among the advantages underlying this type of scheme, we often see highlighted: (i) the promotion of stronger long-term engagement of beneficiaries due to their participation rights; (ii) clearer tax treatment at exit (capital gains); as well as (iii) the fact that some mechanisms (eg, bad leaver solutions, amortisation of shares, voting rights) may be implemented and regulated in a company’s Articles of Association in a stable and sound way.

A pure equity instrument usually looks interesting in terms of ensuring a greater level of commitment from beneficiaries, who will be able to participate in the decision-making process of the companies 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 of the company, even if a residual one^[9], nor see their equity ownership diluted and transferred to others.

Stock option plans (cash or physically settled)

In 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 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).^[10]

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.^[11]

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/o a vesting period elapsing, upon which the beneficiary may potentially become a shareholder of the company (yet not necessarily^[12]).

Key elements of share option plans are therefore: the exercise price, vesting regime or schedule, and exercise period, ie, the time period for the exercise of the option before expiry. In some cases, the plan will also set out a time period for beneficiaries to sell their acquired shares after exercising their options.^[13]

For listed firms, strike prices will typically follow the current market price of the shares at the grant date.^[14] The situation for unlisted companies is more intricate: in 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^[15] (if positive), without becoming shareholders of the company. In the absence of a market price in unlisted companies, these plans will establish the criteria for calculating the financial settlement amount; and
2. physical settlement: the most common route whereby beneficiaries become owners of shares upon the shares being exercised. This option is usually considered by firms whenever, often upon vesting, no issue (governance or dilution-related) would result from granting a minority stock to beneficiaries.

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 in these schemes.

Virtual (phantom) plans

This form of variable compensation^[16] 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 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^[17], which will equal a set fraction of the company’s shares multiplied by the current share price. In short, a pure financial scheme with no equity participation attached.

In 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.^[18]

This type of remuneration is akin to so-called share/stock appreciation rights^[19], 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^[20], 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 companies. 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 holders of equity interests.

In some cases, however, especially in 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^[21], 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 the ongoing good behavior of the beneficiary is often 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 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 (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 (iv) 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 above, this scheme also consists of a type of variable cash-based remuneration. However, it is one calculated on the basis of objective growth indicators of 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^[22] or other accounting figure linked to the company’s performance. Hence, this is not necessarily an equity-linked form of compensation.

It 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 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: the potential for less commitment by beneficiaries in relation to the company’s growth due to not being a shareholder with participation rights; the need to make a provision for the potential costs of the plan, which may negatively impact the company’s results; and its taxation as employment income when given to employees.^[23]

Comparison between 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.^[24]

Below we explore some of the key differences between the incentive schemes analysed so far in terms of engagement by beneficiaries and governance/agency issues, the flexibility of such plans and company evaluation methods. We will see that some of the solutions may look similar in terms of their structure, mechanics and outcome; however, some 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;
• under 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.^[25]

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 solutions, notably 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 physical or financial settlement at the sole choice of the company on the exercise 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: since those 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 financial settlement may present a difficulty around assessing the value of the company for the purposes of calculating strike and acquisition prices, which sometimes encompass a litigation risk involving the beneficiaries and even a potential tax risk^[26];
• 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 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, raise the need to make a provision for the potential costs of the plan, which may impact the company’s annual results.

Final thoughts and trends

Stock option awards and other incentive schemes have recently become a hot topic in Portugal due to their increasing implementation by startups and technology companies. This trend is expected to balloon in the coming years.

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 implementing, structuring and executing such schemes.

There is also an increasing trend to add environmental, social and governance (ESG) factors/criteria to executive compensation packages, particularly in listed companies, financial institutions and other big corporations. This is being driven, in particular, by recent EU regulation on these matters, ESG indexes and pressure on corporate boards from international investors and stakeholder groups supporting ESG causes. In fact, addressing ESG concerns through incentive awards (especially in regard to executive directors) are becoming more common than ever, with the aim of ensuring greater alignment of executives’ interests with those of investors.