Since January 2018 there are new and more beneficial tax regulations for Swedish startups giving qualified employee stock options (“QESO”, Swedish: kvalificerade personaloptioner) to employees. This is a guide to the new law and how you can create stock options meeting the criteria for lower taxes.
First, a summary will give you an overview of the new law and the whole process. Next, different kinds of employee incentive programs will be discussed, followed by a deep-dive into the criteria for lower taxes and how to set up an option pool. We’ll then discuss vesting before finally walking through a step-by-step process: how to implement a stock options program.
If you know the theory already, you can of course just skip to the document template download section.
Note #1: Perhaps you’ve read in media that the Swedish tax agency (Skatteverket) has flagged some issues with the new law. Don’t let media scare you. The tax agency has just said that when you create options under the new law, you should use the kind of document called contractual option (which of course is what we use here at StartupTools) and not any other method.
Note #2: If you are looking for the “old” way to issue market level warrants (Swedish: marknadsmässiga teckningsoptioner) to employees, or if you are a company outside the scope of the new law’s criteria (see below), you should instead go to the warrant guide for Swedish startups. However, I still recommend you to read this guide as it contains general discussions about setting up employee incentive programs as well.
Disclaimer: This web site and the documents that can be downloaded from here contain general information, which is not advice, and should not be treated as such. The information is provided “as is” without any representations or warranties, expressed or implied.
Following the new law in January 2018 regarding reduced taxes on qualified employee stock options (QESO), most Swedish early-stage companies are now able to give stock options to key employees in a tax-efficient way.
In short, if the company and the employee meet certain criteria, the company can give stock options to the employee for free, which gives the employee the right (but not the obligation) to purchase newly issued shares in the company for fixed price (“strike price”, typically almost zero) at a fixed date some years into the future (“expiration date”, 3-10 years).
The future value increase of the shares are only taxed as capital gains (often 25%) when the employee sells the shares, compared to traditional warrants, which are taxed as salary (~55% income tax for the employees plus ~31% social security contributions for the company).
The stock options are tied to the employment and cannot be sold to anyone. If an employee quits earlier than expected, some of the stock options will become invalid. This is accomplished through a vesting schedule whereby the employee gradually earns the right to retain more and more of the stock options.
When setting up a stock options program, you simply sign a stock option agreement between the company and each employee. That’s all! Later, when the employee (eventually) wants to purchase the shares, a general meeting in the company must issue the shares.
Remember that the new rules are still not thoroughly tested in the real world. Even though experienced lawyers and tax advisors have reviewed the StartupTools documents, I recommend that you consult legal, tax and financial advice before implementation. No one will be able to provide definite answers to all questions regarding the new law until the courts have had their say, which probably won’t happen until around 2024(!).
Also please note that the information in this guide applies to employees who are Swedish tax subjects who are working and living in Sweden. If that’s not your case, this may not apply to you. Also see the discussion below regarding strike price.
Employee Incentive Programs
Do you really need an employee incentive program? Why? Do you want to incentivize employees to work harder? To sell more? In those cases perhaps it’s better to use a standard bonus program giving short-term incentives for certain behavior.
Ownership-related incentive programs may require more bureaucracy and can become complex to administer, so use with caution. There are of course several reasons why it’s a good idea to give employees long-term incentives in the company (e.g. company culture, aligned interests, competitive situation, big potential long-term upside etc.) but there are also downsides (paperwork, tax risks, somewhat complicated etc.). This guide will not discuss all the pros and cons, but assumes that you have decided to implement such a scheme or that you are curious on how it works.
There are three main ownership-related kinds of incentive programs:
- Shares. Let the employee buy shares, either from one of the existing shareholders or through a new share issue. Remember that the transaction has to be on market terms or the tax agency will give you a hard time. If the company valuation is very low, this is possibly the best incentive program.
- Everyone is aligned from day 1.
- No future paperwork, everything is settled here and now.
- The employee must pay market price for the shares immediately, i.e. potential liquidity problem.
- If share price drops, loss can be greater than if using stock options or warrants.
- Employee receives formal rights as a shareholder.
- Qualified employee stock options (“QESO”, Swedish: kvalificerade personaloptioner/KPA). This used to be a bad alternative due to tax implications, but now this is expected to become the new standard for startups meeting the law’s criteria (see below). The employee receives a right to purchase shares almost for free at a later date. The employee can make a profit (by selling the shares) or becoming a long-term shareholder.
- Clean cap table.
- Not so much paperwork.
- No initial investment from the employee.
- Employee still gets similar incentives as actual shareholders.
- Fewer rights than for shareholders, e.g. no dividends, no voting rights etc.
- Fewer rights than for shareholders, e.g. no dividends, no voting rights etc. (Yes, this can be both an advantage and a disadvantage.)
- The employee may feel less involved compared to being a direct shareholder.
- Only works well tax-wise if all criteria are met (including the 3 year employment rule).
- Market level warrants (Swedish: marknadsmässiga teckningsoptioner, described in more detail in the warrant guide). This used to be the most common scheme for companies with existing or soon-to-be investors. This is similar to stock options, but the employee pays for a right to purchase shares at a fixed valuation (not very low) at a later date. If the actual share valuation at that date exceeds the fixed valuation, the employee will presumably exercise the right to buy shares, thereby either making a profit (by selling the shares) or becoming a shareholder (at a reduced cost).
Pros (compared to stock options):
- The company gets some initial funding from the employees (typically 10-20% of current share price).
- Can be used by all companies, not only those meeting the criteria for lower-tax stock options.
Cons (compared to stock options):
- If the share valuation doesn’t increase as expected over time, all incentives (and the initial investment) are lost, which is not the case if the employee is a shareholder.
- Employee needs cash to pay for warrant today, and to buy shares later.
- Much more paperwork and higher costs to implement.
Whatever type of program you choose, and no matter if it’s share based or bonus based, it’s never a good idea to simply copy-and-paste someone else’s incentive program since it may not give the same result for your employees.
Criteria for Lower Taxes
The updates (law 2017:1212) to the income tax law chapter 11 a (Swedish: Inkomstskattelagen 1999:1229) contains a list of rather detailed criteria that must be met by the company, the employee and the stock options themselves, in order to avoid taxation completely when converting the stock options into shares.
Taxation only happens when the employee later sells the shares, and the profit will then be taxed “only” as capital gains (typically 25-30%, compared to salary taxation up to 55%). Note: if the company is a close company (Swedish: fåmansbolag) and the employee’s shares are qualified (Swedish: kvalificerade andelar, “3:12-reglerna”), to avoid higher tax levels, the employee may first have to start a holding company and transfer the shares to the company before selling them. This is usually not a big problem and can be a solved later.
If any of the criteria is not met, completely different tax rules apply. In that case, I do not recommend you to use stock options, but to use market level warrants instead.
The following summary of the criteria is not 100% complete as there are some exceptions to the main rules. If you are in doubt, please read the law (it’s only 18 clauses) and/or consult a lawyer.
- The company must be a Swedish limited company (Swedish: aktiebolag) or a similar foreign company with a permanent establishment in Sweden.
- The average number of people working in the company the previous fiscal year must be lower than 50.
- The previous fiscal year’s revenue or assets must be below SEK 80M.
- The business must be a maximum of 10 years old.
- Public bodies cannot control 25% or more of the company.
- No shares of the company can be traded on a regulated market.
- During the first three years, the main business cannot be:
- banking or financing (note: fintech should usually be fine),
- coal or steel production,
- trading of land, real estate, commodities or financial assets,
- long-term leasing of premises or housing, or
- legal, accounting or auditing services.
- The company cannot be insolvent or similar.
- The employee must be employed by the company for at least three years from the signing date, and during these 3 years:
- work in average at least 30 hours per week, and
- receive salary corresponding to at least 13 income base amounts (Swedish: inkomstbasbelopp, about SEK 820k, so about SEK 23k/month).
- The employee (including family) cannot own more than 5% of the company already.
- The employee should be a Swedish tax subject. This is not a specific criteria by law, but if the employee is taxed in another country, Swedish tax rules don’t apply to the employee. The (Swedish) company is still taxed according to Swedish rules though. Read more below regarding employees moving abroad.
Stock Options Criteria
- As of the signing date, the value of the employee’s total stock options in the company cannot be more than SEK 3M, and the total value of all employee’s stock options cannot be more than SEK 75M. In this context, the value of a stock option is defined as the value of the underlying share.
According to the new law the share value is based on the fair market price transactions of the company’s shares during the latest 12 months. If no such transactions have taken place, you use the equity in the latest established balance sheet and divide by the number of shares in the company. If there is no established balance sheet yet, you use the shares’ nominal amount (Swedish: kvotvärde).
- If using the stock options to buy shares, the employee must do so between 3 and 10 years from the signing date.
Perhaps you’re planning to issue stock options to future employees, not only existing ones. Maybe you’ve heard of option pools. Swedish companies cannot easily create a pool of stock options to give to employees later on. Luckily, you can achieve essentially the same effect in an even simpler way.
If you’re discussing with potential investors and want to include an option pool in the financing round, there is a workaround. When communicating the cap table, simply include a virtual option pool as if they were already converted into shares. This is not a real pool, it’s just a way of communicating the intention and letting everyone calculate on dilution effects etc. When doing the formal investment paperwork, just remember to remove the non-existing stock options and perhaps add an intentional clause about everyone agreeing to issue more stock options soon.
Vesting defines what happens if the employee quits earlier than expected. A typical setup forces the employee to return some stock options (the “unvested” options) if the employee quits for whatever reason. The earlier, the more stock options are returned. After some time (typically 3-5 years), all stock options can be kept (i.e. are “vested”) even if the employee quits.
Example: Using 5 years vesting could mean that if the employee leaves after 48 months, he/she can keep 48/60=80% of the stock options.
Three Years Cliff
Remember the criteria that the employee must be employed for at least 3 years to avoid high taxes (both for the company and for the employee)? What should happen if an employee leaves within 3 years? The normal case will probably be that the employee simply loses all stock options. This is often referred to as a cliff.
Example: Using the 5 years vesting period mentioned above and 3 years cliff, nothing will vest during the first 3 years, but after 36 months, the accumulated 36/60=60% will vest and the remaining 24/60=40% will vest over the following 24 months, typically 1/24 every month.
Is it Fair?
Should the employee really lose all stock options if they leave after e.g. 2.5 years? Is it fair? It think it depends. If the employee voluntarily quits or is dismissed for a good reason, it can be fair. After all, it can cause severe tax consequences for the company (and the employee) if he/she would get to keep the stock options. But if the employee works a couple of years and is then dismissed without cause, it can be unfair to deprive the employee of all options.
There is no clear answer to what is fair here, so make sure to think carefully about it. The proposal used in the StartupTools document template is trying to balance between the company’s and the employee’s interests, as well as taking the tax implications into consideration. The proposal in the template is:
- First 12 months: If the employment is terminated for whatever reason, the employee loses all stock options.
- 12-36 months:
- If the employee is a bad leaver (i.e. leaves voluntarily or is dismissed due to cause), all stock options are lost.
- If the employee is a good leaver (i.e. dismissed without cause, stops working due to illness etc.), he/she can keep a proportionate part of the stock options, namely as many options as would have been vested if there was no cliff at all. Please note however, that these options, when later converted into shares, will be taxed as salary both for the company and the employee (since the law’s 3 year employment rule was not met).
- 36+ months: The employee keeps all vested stock options and enjoys the lower tax. If the employee is a bad leaver, the Company also has the choice to purchase the vested options for fair market value.
What if the company is acquired before the end of the vesting period? If the employee is still in the 3 year cliff, perhaps the employee should be allowed to keep a proportional number of stock options even though 3 years haven’t passed yet, i.e. the cliff is disregarded. But, to avoid high taxes according to the new law, the employee must wait at least 3 years to buy shares. So, how do you deal with an early exit? I see mainly three options:
- Ignore cliff: One solution is simply to just disregard the cliff, let the employee buy shares for the vested (but not unvested) stock options and accept the higher taxes. At the time of the exit, the employee will have to declare an income of labour and pay taxes on the full value of the shares, as if it were salary. The company will have to pay social contribution fees based on the same amount. On the other hand, since an exit just happened, there should be liquidity to pay the taxes.
- Accelerated vesting: Same as above, but both the vested and unvested stock options can be used to purchase shares.
- Don’t touch the stock options: If the startup, after the exit, continues to run a business with the same key employees, why not let them keep the stock options and later let them buy the shares? The acquirer (who by this time owns a majority in the startup) should then be obliged to purchase the employees’ newly bought shares for a defined fair market value. This way, the criteria in the law are met and both the company and the employee avoids high taxes. This setup must be negotiated by the company in the exit.
The StartupTools document template allows all scenarios. Upon signing the stock option agreement you must decide if you prefer to use accelerated vesting or just to ignore the cliff. No matter what you choose, the company will always have the option to leave the stock options untouched.
There is an exception to the 3 year rule. If you can make a formal merger (Swedish: fusion) you may be able to keep the low tax rate, see §§ 17-18 in the law. I’ve never heard of a startup exit in the shape of a formal merger (where the acquired company is automatically dissolved) but perhaps we will now see more acquisitions of Swedish startups happen this way? Perhaps the acquirer will start a new Swedish daughter company and merge this with the startup?
Implementing a Stock Options Program
This section will guide you through the steps to set up an incentive program for employees using QESO.
Step One – Prepare Documents
- Define terms.
- Vesting. Following the discussion above, decide on a vesting period (3-5 years) and define what happens if the employee leaves early and in case of an early exit.
- Expiration date. When shall the employee have the possibility to buy shares? This is up to you to decide but should be between 3 and 10 years to take advantage of the new law, and not before all options are vested. To keep things simple, if you plan to create more stock options soon, you can set the expiry date to about one year after the vesting period ends. If you create more options within a year, they can have the same expiry date so all employees finally buy shares at the same day.
Also, you can use a long open window (e.g. 4-10 years) but remember that in order to benefit from the lower taxes, it’s not enough for the employee to notify the company of his/her intention to buy shares within 10 years, but the actual shares must be issued to the employee within 10 years. Typically, this will happen at the company’s next annual general meeting. In practice, the employee should therefore notify the company within 8-9 years, so there is plenty of time for an annual general meeting before the 10 year deadline is met.
- Strike price. This is the share price that the employee has to pay if exercising the stock option, i.e. buying a new share. This is also completely up to you. Most companies probably set this as low as possible, i.e. the shares are basically free. However, when buying newly issued shares from a company, the legally lowest price to pay is the nominal value (Swedish: kvotvärde) which is defined as the company’s share capital (often SEK 25k or 50k) divided by the number of shares in the company, so it’s a really small amount.
Note: If the employee is, or becomes, a tax subject in another country, the tax rules of that country applies to the employee’s stock options. Some countries (including the U.S.) have less favorable tax laws for stock options and may require the strike price to be at least the fair market value as of the signing date. So, for example, if an employee is an American citizen or if one of your employees may move abroad while owning the stock options, you should talk to an international tax expert and perhaps set the strike price to the fair market value, as well as change some other terms of the stock option agreement. If you’re confident that the employee will only be a Swedish tax subject and live and work in Sweden until the stock options are exercised, you can probably leave the strike at nominal value.
- Prepare the Stock Option Agreement. Download it below and fill in the blanks. Make sure you understand what you are doing. If in doubt, talk to your legal advisor.
I should mention that there are two ways to structure QESO. One is using the simple agreement used here on StartupTools (contractual options, avtalsoptioner), which is also what Skatteverket suggests. The other way would be to use warrants (teckningsoptioner) as an instrument for registering the QESO with Bolagsverket, but this is not allowed according to Skatteverket.
- Update SHA. Down the road, when it’s time for the employee to (hopefully) buy shares, the employee must adhere to the existing shareholders’ agreement (SHA). This is agreed upon in the stock option agreement. Also, the parties to the existing SHA must vote for the new share issue when the employee buys shares, and allow the employee to enter into the SHA. This is solved by a clause in the SHA, forcing the parties to vote for the share issue and to accept stock options holders to enter into the agreement. Make sure this is done right by asking a legal advisor for help, or use the StartupTools Shareholders’ Agreement template.
Step Two – Talk to the Employee(s)
It might seem obvious but it’s essential to involve the employee early in this process. After reading this guide you may understand how stock options work, but it’s not that simple! Make sure that the employee understands why you want to have an incentive scheme program using stock options, how it works and what the limitations are. Make sure to include:
- Why have a long-term incentive scheme program? What are the pros and cons?
- Why use stock options instead of just handing out equity?
- How does it work, from the perspective of the employee?
- What happens if the employee quits or is fired?
- What tax risks are associated with QESO?
- Stock options are not shares! No dividends and no voting rights.
- The employee may have to start a private company later, to avoid unnecessarily high taxes if he/she wants to sell the shares later.
While it’s important to communicate with the employee, it’s as important not to promise anything too early. Unless you’re really planning to implement the scheme very soon, don’t promise anything.
Step Three – Execute
- Hold a general meeting (annual or extraordinary). This is not required, but it’s always a good idea to include the shareholders in the process and have them approve the plan for stock options.
- Sign the agreement. The employee and the board sign the Stock Option Agreement (preferably digitally). If you have a big board and it’s inconvenient to have everyone sign it, the board can give a power of attorney to one of the board members to sign on its behalf.
That’s pretty much it! This guide will not cover how to buy shares using the stock options or the administration related to it. It’s very straight-forward and there is pretty much written about it already, e.g. at Bolagsverket.