Many entrepreneurs I meet seem to believe that opportunities to grant attractive warrant incentives to their employees are limited or even non-existent. I disagree with that – at least when it comes to early stage companies. Below is a brief primer on a model for sharing upside through warrants which I‘ ve seen work very well in several Swedish companies I have been involved in.

Please note that the text below is of a general, informational, nature. It does not and shall not be construed as to constitute any legal, taxation or financial advice or recommendation by Creandum or the author(s), nor does it purport to be exhaustive in any way. Consequently, the information below shall not be relied upon as a substitute or replacement for individual legal and/or financial advice on any specific matter.

Shares / Founders’ stock
Ideally, you want your fellow co-workers to hold actual shares in your company. This is the most efficient way of distributing equity upside. Early on, with little business, proof or funding in your company, the shares are still cheap for others to acquire. Make sure you use this opportunity and spread the founders’ stock wisely. The vast majority should be on the field (those doing actual work), not on the bench (advisors, hangarounds, web agencies, etc). Make sure all shareholders sign a Shareholders’ Agreement that governs what happens when someone leaves or doesn’t meet others’ expectations, as well as secures the future exit possibilities (transfer restrictions, drag along, tag along, etc.).

Gains from shares are taxed as capital gains in Sweden, which means the holder is taxed 25% on the difference between purchase- and sale price, at the time of realization.

Warrants (sv: Teckningsoptioner) priced at market
The best proxy for shares is Warrants. If appropriately designed, they too are taxed as capital gains in Sweden (25% for employee, zero for company) as opposed to income (likely >50% for the employee + 31,42% social security for the company).

For gains from warrants to be taxed as capital gains, they cannot be more beneficial to an employee than to anyone else. This means that all transactions involving the warrants must be done at market terms (i.e. market price). In other words, if employees are to buy warrants, they need to pay market price for the warrants and they need to do it upfront: “Pay a small sum now to for the opportunity to buy shares later at a predetermined, hopefully at that time very beneficial, price”.

Pricing of Warrants
Under this regime, the pricing mechanism of the warrants is important to understand. The parameters of the warrants determine their value, i.e. for an employee: how much cash he or she needs to muster to buy them to be part of the equity upside down the road.

A widely accepted model for determining the market price of a warrant is the Black-Scholes formula. Listed below are the drivers of price for one warrant = the right to acquire one share at a later point in time at a pre-defined price, the strike price.

Let’s start with the parameters that most often are fixed, i.e. ones that you just have to accept:

+Share price today:
the higher the market price per share today is, e.g. as manifested by recent share transactions, the higher the warrant price.

the volatility of your shares, best established by looking at comparable listed companies. The spread here is large but to provide some point of reference, many companies in early stage tech (EV 20–400 MSEK) have been seen to use 35%.

+Risk free rate:
typically equivalent to government bond interest rates. In current climate (Sweden, 2014), 1.75% should be uncontroversial.

This leaves you with two very important parameters that you can control and need to choose wisely:

the longer the maturity (the longer the holder can wait before deciding to buy shares for warrants), the higher price of the warrant.

-Strike price:
the lower the strike price — i.e. the larger the potential upside — the higher the value of the warrant today.

My recommendation is to keep strike price at maximum 2x current share price and push maturity far out: 5 years if it is the first warrant program and slightly less if it is later stage programs. Low strike price means maximum upside for warrant holders. Long time to maturity means maximum chances of an attractive second hand market for the warrants:

When warrants mature, holders need to buy shares for their warrants at strike price. This involves a relatively large cash outlay, which — depending on how attractive the warrants are — can be financed through selling part of the warrant holdings (if financial investors are shareholders, they are then likely buyers).

The concept of employees “working to vest their warrants” needs special attention since — again — employees cannot be treated differently than any other individual. As manifested by rulings in the Supreme Administrative court [RÅ 2010 not 129], an acceptable solution is to allow the Company or other shareholders to buy back warrants in case an employee leaves his or her employment. This right can be structured so that it decreases over time, e.g. the right is for 100% of warrants during the first year, then only 75% for the following year, then 50% and 25% respectively for years 3 and 4. It is absolutely crucial that all transactions, also buy-back under these structures, are agreed to be made at market price. This means that the price of warrants to be sold back is re-calculated according to the Black-Scholes formula: time has decreased (meaning lower value of warrants) but value of the underlying share might have increased (pushing value of warrants up).

Other important warrant terms
Although it might be against the interest of shareholders in general, there can — again for tax reasons — be no prohibition against transferring the warrants, such as lock-ups. It is therefore important to include right of first refusal arrangements, so that the shareholders are given a first right to buy any warrants for sale. You want to control where warrants end up, just as you do with shares in your Shareholders’ Agreement.

You also need to think about exit horizon: you do not want a lot of warrants outstanding that are not exercisable in connection with an exit or not subject to drag along provisions. Therefore, it is important to where relevant include an early exercise right in case of an exit (i.e. the warrants become exercisable in connection with a sale of the company, subject to vesting). [An alternative is to make the warrants formally exercisable during the entire period, but limit the right to exercise unvested warrants in a separate agreement, with a right for the board to waive such restrictions. This gives more flexibility in an exit scenario, but should be verified from a tax perspective.]

Also, make sure that all warrant holders undertake to adhere to the Shareholders’ Agreement upon exercise, to ensure that the new shares are subject to exit control provisions and any liquidation preference.

From A to Z — steps to set up your warrant program
1. Lay down the parameters for pricing of the warrants. This spreadsheet can serve as a starting point for calculating the price and upside for warrants.

2. Present this to a lawyer (e.g. Pontus Röckert at Cederquist whom I have worked with many times) and ask them to draft the two important documents governing the scheme: (1) the warrant terms, and (2) the warrant holders’ agreement. Also have them prepare appropriate corporate docs such as summons to EGM where warrants are issued, minutes from that meeting, etc. Make sure that the EGM mandates the board to manage the subscription by individual warrants holders so that the EGM need not be involved.

3. If you want to be on the safe side regarding the pricing of the warrants, ask an accounting firm to validate the Black-Scholes calculation and the underlying parameters, such as volatility, risk-free rate, etc. I have worked with KPMG and Daniel Frigell who knows the drill.

4. Off you go. Combined 2–3, you should look not to spend more than say 40kSEK on external advice.