Lithuania: Employee Stock Options - An Incentive for Employees?

More and more often Lithuanian companies face with a problem as to how to attract and retain qualified employees. In order to compete successfully with foreign employers, Lithuanian companies will not merely have to offer their employees competitive remuneration, but make active use of other incentives. One of the most widely used incentives for employees, which could be used by Lithuanian companies, is employee stock options.

A stock option gives the recipient (the "optionee") the right to buy a certain number of shares in the granting company at a fixed price for a certain number of years (e.g., 5 years). When the term comes, the employee will have an option to buy shares or not. Usually, the price at which the employee will be entitled to acquire shares is set at the market price of shares at the time when the options are granted. If at the time of exercising stock options (i.e., at the moment the employee decides to purchase stock pursuant to an option) the market price of shares has increased, the employee can achieve financial gain from acquiring shares at a lower price and selling them at a market price. Thus, as the value of the stock increases relative to the option exercise price, the employee has the potential to benefit from the increase in the option stock's value over the option exercise price.

1. The employee is interested in working more efficiently and enhancing corporate value as the value of shares will increase accordingly;
2. The employee is interested in retaining his/her position in the company so he/she would be able to exercise the right to acquire shares of corporate stock;
3. The right to exercise a stock option (acquire shares) may be related with the achievement of targets set for the employee;
4. The employee who has acquired shares not only participates in corporate capital, but in corporate management, too.

Therefore, employee stock ownership, when combined with an effective communications program that is designed to create an employee ownership culture, can be a very dynamic tool for improving employee productivity and thereby increasing profitability and value of the company.

One of advantages of employee stock options is that at the time of allocation of options the company does not need any monetary funds, which are necessary in case of implementation of other incentives (e.g. payment of bonuses, ensuring additional life insurance, etc.). Therefore stock options particularly fit developing companies which invest all their monetary funds in developing business (e.g., startup businesses, dotcom companies, etc.).

Yet stock options are more widely operated in large companies, especially those whose shares are publicly traded. Employee shares make an insignificant part in the company’s stock capital therefore as a result of stock option the share of shareholders in the capital decreases insignificantly. Some foreign capital companies operating in Lithuania grant their employees the right to acquire shares in its parent company whose shares are usually listed on a stock exchange, rather than its own shares.

However, stock options are less attractive for small "family business" companies which do not intend in the future to trade in their shares publicly or transfer them to investors.

Before granting stock options, an employer has to decide about the purpose of this incentive. Are the stock options intended to motivate all employees or merely executive officers? Is it a one-time incentive or permanent incentive scheme? Does the employer wish that the employees become shareholders of the company and participate in corporate management or merely make additional financial profit? Answers to these questions are important in setting out stock option grating conditions: who will be granted stock options (all employees or only company officers), how they will be allocated (e.g. by decision of the board or special commission), whether the right to acquire shares is related to the achievement of certain targets or any other conditions, for what term options will be given, what the purchase price of shares will be, etc.

An employer must with due care consider how many shares it can allocate to employees and how the number of option holders will increase. The most frequent mistake is to make a too hasty decision and to allocate too many options without leaving any to future employees.

In most foreign countries such means of motivating and giving incentives for employees has been known for several decades already and it has sound coverage by special laws. Whereas Lithuanian legal acts do not specifically regulate these issues, therefore:

1. There are no restrictions as to the type or class of shares;
2. There are no restrictions as to the companies that can offer such securities;
3. There are no restrictions as to the validity term of stock options;
4. There are no restrictions as to the employee’s right to transfer stock options to other persons;
5. There is no requirement to get a permit or approval from regulatory authorities.

An employer may at its own discretion decide on most of these issues and specify them in the stock option granting conditions.

Nevertheless, by granting options an employer must observe the following requirements under Lithuanian law:

The criteria for selecting employees to be given incentives must be of non-discriminatory character – it is not allowed for objectively invalid reasons to establish different conditions for the employees of the same category (i.e. doing the same job, etc.).

One of the basic concerns of employers is whether stock options would constitute a part of the employee’s salary, which is important in calculating severance pay, other payments, etc. Pursuant to Lithuanian laws, an employee’s salary also includes other payments directly related to work and provided for in the collective bargaining agreement and employment contract. However one-off and other payments from the sources other than the company’s remuneration and profit funds, which are intended for employee benefits, are not included into the salary.

Thus, if such incentive is not permanent and it is not contemplated in the collective bargaining agreement and employment contract, or in the company’s bonus scheme, the right to acquire the company’s shares on preferential terms (difference between the market price and agreed price) will most presumably not be included into the salary.

The determination of the salary also affects the amount of state social security contributions, which is calculated based on the insurable income composed of bonuses, benefits and other payments. Yet, there is no definite answer if a stock option (property right to acquire shares) may be recognized as other payment to be included into the salary.

No less important is the levying of employee stock options with the inhabitants’ income tax. Even if it is not included into the salary, it may be levied with income tax (15 per cent rate) as the employee’s income in kind, the size whereof would be equal to the difference between its acquisition price and its market price at the time of acquisition. The very acquisition of the right is not likely to be deemed as a basis for taxation. Tax consequences will only arise after exercising the right.

Besides, income from securities acquired after 1 January 1999 and sold earlier than 366 days after their acquisition are subject to the inhabitants’ income tax.

Another important question is whether upon termination of employment, the employee will retain the right to acquire the company’s shares in the future. Even if the stock option granting conditions expressly indicate that upon termination of employment the employee’s unexercised right disappears, the employer is vulnerable to court disputes. In the court the employee may try to prove that the cause of termination of employment was an increase in the price of shares and the company’s intention to make profit from selling such shares at a fair market price.

Sometimes, the stock option granting conditions provide that an unexercised right to acquire shares disappears if the employee gets employed with a competitor. The court may recognize such provision as a non-competition agreement, legal recognition and enforcement whereof is yet not clear under Lithuanian law.

Pursuant to the Lithuanian Law on Securities Market, options and awards are qualified as securities (i.e. tradable securities that grant the right to acquire the shares in the public joint stock companies by subscription or exchange, including equivalent cash-settled instruments). However, the granting and allocation of stock options to employees are not subject to the requirement under the securities market law to have them registered with the Securities Commission, prepare prospects, etc.