With a rapidly evolving labor market, employers need to stay competitive regarding compensation and benefits. Equity participation schemes or other incentive plans are gaining popularity in this respect. Key purposes of such schemes are acquisition, reward, and, above all, retention: creating a long-term bond between the employee and the employer. But what if things don’t go as planned, and the employment comes to an end?

This article is written by Maxim Boschman ([email protected]). Maxim is a Tax Lawyer and part of RSM Netherlands International Consulting Services, focusing on Global Employer Services.

In a previous article we pointed out some general considerations from a tax perspective regarding the termination of employment contracts. In this article, we focus on settling equity (incentive) plans after employment has been terminated. Later, we will dive deeper into international tax aspects of employment terminations.

Different types of (equity) incentive plans

Equity (incentive) plans come in many shapes and forms. They can be broadly divided into two categories: cash-based plans and equity-based plans. Cash-based plans are relatively easy to implement and also easier to settle if an employee leaves. Examples include Stock Appreciation Rights (‘SAR’) plans, phantom share plans, and profit-sharing bonus schemes. The defining feature of cash-based plans is that they result in a cash transaction to the employee.

Equity-based plans are more complex because they involve some form of ownership in the company. Examples include the acquisition of ordinary or preference shares, depositary receipts/certificates, stock option rights, and restricted stock units (RSUs). A key characteristic of such equity-based plans is that the equity is transferred to the employee, and any purchase price, if applicable, is paid to the employer. Once the employee owns the equity, the proceeds are generally for the employee’s account. 

Conditions and Critical moments

Almost all employee incentive plans, both cash and equity-based, are conditional. In other words, certain conditions must be met before the employee can benefit from the granted incentive. There are some important moments to identify:

  1. Granting date. This is the date on which the benefit is granted to the employee. It can be seen as an agreement between the employee and employer that, if certain conditions are met, the employee will receive the payment or equity.
  2. Vesting date. On the vesting date, the granted payment or equity becomes unconditional, meaning that the agreed conditions are fulfilled, and the employee is legally entitled to the payment or equity. Vesting usually depends on staying employed for a certain time and/or meeting company/employee key performance indicators (KPIs).
  3. Exercise date. Applicable to option rights. After an option right is vested, the employee has the opportunity to exercise the option and buy the shares at the agreed price. 

Given these important moments, employers should create and maintain an overview of all granted and/or vested and/or exercised incentives for employees who are leaving. The status of the incentive determines how it should be treated. 

Leaver clauses

It is highly recommended to include clauses in the incentive plan that dictate what will happen if, for whatever reason, an employee leaves the company. For example, most employers find it undesirable for former employees to remain shareholders of the company or to retain certain rights after their employment has ended. Therefore, a quality requirement could be incorporated into the incentive plan. This means that the incentive plan only applies to individuals with a certain qualification (e.g., employees), making it impossible for outsiders to participate. Individuals who used to qualify but no longer do usually have an obligation to offer. This means they must offer their shares or rights to specific groups or individuals.

In our experience, employers want to distinguish between the reasons for employment termination. They identify good leavers, bad leavers, and sometimes neutral leavers. For example, a bad leaver might be an employee who is summarily dismissed after an incident or someone who resigns within a certain period. A good leaver might be an employee who must leave due to long-term disability. A neutral leaver might be an employee who must leave due to an internal reorganization or someone who resigns after a certain period. To avoid any ambiguity, leaver clauses should always be mutually exclusive so that a former employee can only be classified as one type of leaver.

Different leaver categories have different consequences. In most cases, the leaver classification affects the price the ex-employee receives after the mandatory offering. Depending on the details of the applicable plan, bad leavers usually must sell their shares at the original purchase price, nominal value, or fair market value if lower. Good leavers are typically allowed to make a profit and may sell their shares at the fair market value. Some good leavers may even keep vested shares or exercised rights. For neutral leavers, they may profit pro rata depending on the time elapsed.

For leverage in negotiations or discussions, employers often leave some discretionary room in incentive plan rules to overrule leaver clauses or offer obligations.

Forward thinking

Terminating an employment agreement triggers a complex chain of events, especially concerning (equity) incentive plans. An ounce of prevention is worth a pound of cure, so consider different leaver scenarios and consequences when designing and implementing an (equity) incentive plan. If the time comes and a participant leaves the company, make sure to follow the incentive plan rules.

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