Employee stock options in private gaming companies: Corporate aspects
Company shares are seen as an important element of the overall remuneration for professionals in the IT industry. This is also the case in companies developing video games. Prospective employees or contractors expect to be able to take a stake in the rapidly growing company as part of their remuneration package.
ESOP and company type
In Poland, a pool of stock options is most often found in joint-stock companies (spółki akcyjne) or simple stock companies (proste spółki akcyjne). ESOPs are rarely used in limited-liability companies (spółki z ograniczona odpowiedzialnością), although they are the most common type of company in Poland and many game studios operate in this legal form.
The main problem for implementing an ESOP in a limited-liability company is the small number of shares and the minimum value of shares (PLN 50) required by the Commercial Companies Code. A consequence of the small number of shares is a “shallow” cap table, meaning that each ESOP share allocation makes a fairly significant change in the company’s cap table (sometimes by as much as 1% per allocated share). As a result, the pool of shares that can be distributed among key personnel is small. Additionally, the code requires a shareholder joining a limited-liability company to file a declaration in the form of a notarial deed, which can be an impediment, especially for foreigners cooperating with the company who reside abroad.
Most often, in limited-liability companies, incentive programmes are adopted in the form of a virtual options scheme, where key personnel are granted certain cash benefits, rather than allocating them shares in kind.
In this article, we focus on ESOPs in a joint-stock company which (like most gaming companies at the early development stage) is not listed on the stock exchange. Nevertheless, all the mechanisms described here will apply to ESOPs adopted at any stage of the company’s development.
Basic terms of an ESOP
The ESOP’s basic conditions are most often adopted by a resolution of the company’s constituent body (e.g. general meeting of shareholders). Implementation of the ESOP (selection of personnel, determination of the pool of options per participant, etc) is usually entrusted to the management board or supervisory board.
The ESOP’s main terms are:
- Size (the number of shares allocated for distribution among eligible participants)
- Price (the option exercise price)
- Vesting criteria (the criteria for acquiring rights under the scheme).
The size of an ESOP refers to the number of options that will be allocated for distribution to participants over the duration of the programme. It is customary to aim for 10% of shares to be held by key personnel (other than the founders).
It is worth remembering that issuance of shares under an ESOP dilutes the stake of the founders and existing investors. Therefore, the size of the ESOP should be agreed with the investors.
A common mistake by startups is to think of an ESOP in terms of granting the right to participate in a company’s valuation, and not granting shares. In our practice, we often encounter provisions that, for example, grant rights to a certain pool based on a multiple of EBIDTA or some other financial indicator. This financial approach to an ESOP is partly justified, as granting shares under an ESOP is a form of financial gratification. However, the size of the ESOP should be defined so that it clearly indicates what pool of shares will be issued under it, without reference to variable financial ratios. This approach is particularly important for investors.
The option strike price is the ESOP’s primary business criterion, and it is what determines whether the scheme will be attractive to key personnel. Here, various solutions are possible, from the right to purchase shares at face value (the most favourable option for the participant), to the right to purchase shares at a discount against the latest round of funding (e.g. 10% lower than investors paid in the last round).
Another important condition of an ESOP is the vesting criteria. Vesting means acquiring rights, but can also refer to a period after which a participant acquires a particular right (the vesting period). The criteria that must be met to acquire the right to shares are referred to as vesting criteria or key performance indicators. The KPIs depend on the position and function performed by the category of participants. To determine the size of the option pool to be taken up by a given participant, it is possible to combine team KPIs (team performance) and individual KPIs. The most common KPI is the increase in revenue generated by the company or team. In companies at an early development stage, the only criterion for vesting may be working with the company for a certain period (time criterion).
Most often, silent (non-voting) shares are offered as part of an ESOP. This is because the shares allocated under the ESOP are essentially additional remuneration, so they should allow economic participation in the increase in the company’s value but not necessarily participation in the company’s management. In Poland, under the Commercial Companies Code, silent shares must be preferred shares. Thus, in practice, a token preference is often introduced, such as a slight increase in the dividend per silent share, or the right to be paid dividends first (before other shareholders).
Implementation of an ESOP
When adopting an ESOP, it is also important to remember that this is a scheme adopted for several years in a rapidly changing industry. ESOPs are usually adopted for four to five years, a period that happens to correlate with the typical duration of venture capital funds’ investment in a video game company.
Over the course of the ESOP, participants may cease working with the company, and the scheme should reflect this eventuality. The terms and conditions should include provisions for both “bad leavers” (a person leaving the company in bad faith, e.g. due to poor contract performance) and “good leavers” (a person leaving a company in good faith, for legitimate purposes). As a rule, good leavers will retain the right to exercise their vested options, and bad leavers will not.
Recently, an obligation to return or resell the acquired shares has been introduced into many incentive schemes, when the participant is found to have caused significant harm to the company after acquiring the shares. This is known as a “clawback” provision.
How the options pool available to respective groups of participants is determined is vital for the company’s continued operation and maintaining good relations within the team. The size of the pool should be determined by the potential of the participants and their contribution to development of the company’s products. It is possible to adopt two schemes: an ESOP for employees and associates and a management stock option plan (MSOP) for managers and senior executives. The two schemes may involve different criteria and conditions.
As mentioned, an ESOP “dilutes” (effectively reduces) the remaining shareholders’ stake in the company’s share capital. Therefore, it is important to regulate what will happen to shares not allocated under the ESOP. It may happen that during the course of the programme some of the original participants leave, or KPIs are not met and a certain pool of shares is not allocated. Here, various solutions are possible, e.g. the remaining options may be distributed among the best-performing participants, or they can be distributed at the discretion of the management board or the supervisory board.
Why is a well-thought-out ESOP important?
Before introducing an ESOP, it is worth analysing the tax implications of taking up shares by the participants. Tax rulings regarding ESOPs change frequently, as this is a relatively new instrument in Polish market practice. A tax analysis is also needed to properly present the ESOP’s economic impact to participants.
Even in mature gaming companies, the terms of stock option plans are not always carefully thought-out, and may generate many problems in investment rounds or during implementation of the scheme. A well-considered and well-tailored ESOP is vital, as it ties the key personnel to the company. A good ESOP is also a strong signal to potential investors, demonstrating the founders’ business savvy and concern for long-term growth in the company’s value.
Hubert Bińkiewicz, attorney-at-law, M&A and Corporate practice, Wardyński & Partners
