If location, location, location is a property developers mantra, venture capitalists would surely place equal emphasis on the role of management. Thus, in structuring a transaction, venture capitalists need to ensure that gifted managers remain in place and are incentivized to build shareholder value once the investment is completed. Investors employ a combination of punitive and reward measures to achieve this end. The stick may consist of flip-overs rights or bad-leaver provisions which reduce a managers equity interest in the company in the event of dismissal for cause or departure in breach of his or her contractual obligations. The carrot is intended to align the interests of management and shareholders, and generally comes in the form of bonuses or the implementation of a stock option plan (SOP) with incentives linked to stock performance.
Although the mechanics of a SOP are complex as a result of corporate governance and tax issues, the concept is simple: managers are conferred with the option to purchase shares in the future at a strike price that is generally linked to the fair market value of the shares at the time of the grant. The right to purchase shares (referred to as the vesting of options) is ordinarily spread over a number of years, ensuring that managers reap greater rewards by staying with the company. If vested, a manager would exercise the option when it is in the money, that is, when the market price of the shares exceeds the strike price. If there is trading in the securities, options may be exercised with a view to immediate resale. In such cases, the company is generally authorised to effect the transaction and simply distribute to the option holder the difference between the market price and strike price. More commonly, given the illiquidity of private stock and venture capitalists preference to lock in managers, SOP shares may only be sold in certain circumstances (known as liquidity events). Liquidity events may include the partial sale by investors of their shares in the company, an initial public offering, a private placement of the companys shares or a change of control in the company.
Unfortunately, as venture capitalists quickly find out, SOPs do not function efficiently or simply in Hungary. In contrast with US corporations, which may authorise stock that is unissued, Hungarian joint-stock companies must look to repurchased (treasury) shares as the basis for the SOP. Even if treasury shares may be owned (assuming that there are at least two shareholders), Hungarian corporate law provides that no more than 10% of the registered capital may be held in such form for any one year period. But venture capitalists focus on seed or early funding targets, which often require SOP pools in excess of 10%. This fact, coupled with venture capitalists preference for reasonably long vesting periods (usually 2 to 4 years), means that reliance on treasury shares to stock a SOP may not necessarily provide a complete solution. An alternative, or ancillary, mechanism to the treasury share-based SOP is the issuance of new shares. However, the completion of a capital increase and the issuance of shares (whether in printed or dematerialised form) is time-consuming, requiring between 45-60 days, and involves transaction costs.
There are essentially three possible approaches to this problem. First, investors and managers are apprised of and accept the limitations of SOPs under Hungarian law. Negotiations about SOP sizes and strike prices may then implicitly incorporate a risk or nuisance premium to managers, to compensate them for the peculiar difficulties they may face in exercising their rights. Second, investors and the company may consider incorporating a holding entity in a jurisdiction that combines tax efficiencies with a liberal regulatory approach, and implement the SOP at that level. Third, good lawyers can always find solutions that reduce the restrictive impact of local regulation. For instance, investors may implement virtual SOPs, in which case option rights or warrants (as opposed to shares) are issued, priced and subsequently redeemed by the company. Investors may also grant virtual options on their shares such that the option rights accumulate as specific milestones are achieved, but may only be exercised during a liquidity event. Alternatively, so-called phantom plans may be established, which essentially distribute cash bonuses linked to the companys stock performance.
