The granting of stock options to top-tier executives in Argentine privately held companies is becoming increasingly frequent, despite the labour legislation failing to regulate such benefits specifically.
Stock options give executives the right to purchase, in the future and subject to certain conditions, a specific number of shares of the company where they work (or those of the company's parent) at a specified price per share, known as the 'strike price'. The strike price is linked to the value of the company on the date that the executive begins to work for the company. The right to exercise an option is subject to varied conditions, the most important of which is to continue in employment with the company for a specified period, known as the 'vesting period'. The vesting period can be three years, five years or more.
Stock options create incentives for executives in strategic areas to stay in the company long enough to be able to exercise the option. They also align the interests of the company and of key executives in the creation of value for the company. If the company grows, the shares increase in value - executives can therefore make a profit by buying shares at the strike price and selling them later at the increased value.
In addition, stock options are a particularly useful instrument in private equity investments where investors (shareholders of privately held companies) invest in a company with a view to exiting in five to 10 years' time. In this case, stock options completely align the interests of the executives with those of the investor-shareholders.
In contrast to the situation in privately traded companies, executives that hold stock options in publicly held companies can:
- track the price of the shares constantly;
- know if it is convenient to exercise the option; and
- keep or resell the underlying shares as they deem convenient.
From the company's and shareholders' perspective, a publicly traded company's shares are so atomised that the coming on board of new shareholders has no impact on the company's management. However, this is not the case in privately held companies. Instead, because there is no public market for the shares, executives do not know the exact value of the underlying shares. Therefore, if they exercise the option and pay the strike price, they run the risk of the investment having few exit probabilities and remaining a shareholder with very limited rights. On the other hand, the company and the shareholders of privately held companies do not normally welcome new shareholders as it can become an issue to have a dissatisfied shareholder in the company (in particular, if the company fires the executive in the future).
Therefore, in privately held companies, it is recommended that the exercise of the option is tied to the occurrence of a liquidity event such as an initial public offering (IPO) or a change of control of the company's shareholders. Stock option plans should be drafted to regulate a procedure for the company to inform the optionees of the occurrence of a liquidity event and to grant the executive the possibility to exercise the option and participate in the liquidity event. The company should always reserve the right to terminate the options by paying the executives the difference between the strike price and the price of the shares resulting from the IPO or the third-party offer.
Because the exercise of the stock options is subject to conditions related to the executive's work in the Argentine company (eg, continuing in employment with the company), they can be considered under Argentine labour law as a work-related benefit. Under that interpretation, the difference between the strike price and the market price of the underlying shares (ie, the benefit) could be considered as 'salary'. If the executive is able to exercise the options on several occasions (eg, if the stock options are vested annually), the amount of the benefit will be subject to the payment of social security contributions by the Argentine company, which will increase costs substantially. If the benefit can be attributed to a one-off extraordinary payment (eg, if vesting occurs only upon a liquidity event), in principle such benefit would not be subject to social security contributions by the company.
With respect to Argentine income tax law, the benefit is expressly considered as income derived from its employment relationship. The local Argentine company is therefore obliged to make a withholding, even if such benefit is granted by the parent of the Argentine company abroad. The amount of the withholding can be as high as 35% of the benefit, depending on the amount of the benefit and the executives' other income. The breach by the local company to make the withholding will subject the local company to penalties ranging from 50% to 100% of the amount not withheld.
To avoid the income tax and labour contingencies, start-up companies can sell their shares to an executive for a nominal amount. This sale must be done before the first round of financing and is subject to a repurchase option (for the same or a similar nominal amount) by the company that mirrors the effect of vesting (ie, if the executive leaves in year one, the company can repurchase all the shares; if the executive leaves in year two, the company can repurchase a specific number of shares; and so on). Before the first round of financing, start-up companies are typically undercapitalised and thus their shares can eventually be valued at a nominal amount (by assessing how much the company is worth if it would enter into liquidation if financing was not obtained).
Stock options will continue to grow in use in Argentina as they are an excellent instrument to align the top executives' interests with those of the company. However, companies intending to implement stock options should consult legal counsel and be aware of the risks and contingencies involved in Argentina due to the lack of specific regulation on the matter.
For further information on this topic please contact Raúl Granillo Ocampo at Estudio Garrido Abogados by telephone (+54 11 4850 4000), fax (+54 11 4850 4001) or email ([email protected]).