Points in time of valuation and receipt for employee participation plans
A start-up’s most important asset, other than its founders, are its employees. Start-ups are certainly hip and brilliant minds are deciding more and more in favour of a career in an ambitious start-up rather than for a career path in a large corporate. However, these employees also want to be paid appropriately for their performance. In its early stages, a start-up will not normally have the capital to pay salaries at the going market rate. Accordingly, employee participation programs are often the instrument chosen to provide employees with sufficient incentive and ensure that they play their part in the development of the company.
Market standard, especially for exit oriented start-ups, is the use of virtual employee participation programs. Each beneficiary receives virtual shares in the company, through which he or she is granted a right to payment of the share of the proceeds equivalent to the share that a "real" shareholder of the start-up would receive when a defined trigger event occurs (normally the exit – whether the sale of the company or its listing on a stock exchange). This puts the employee on equal terms with the founders and, accordingly, provides the incentive for them to work together with the founders towards their common exit.
For the company, the major advantage of virtual employee participation programs is that the employees do not have any “real” shareholder rights (e.g. no rights to information or voting rights) and these purely contractual agreements do not change the shareholder structure. Employee participation programs have one major advantage for employees, too: tax is only payable for the grant of a virtual share at the date of the transfer, i.e. an actual cash payment is made or shares in the company are transferred to the employee.
A major disadvantage lies in the fact that the calculation of wage resp. income tax and social security contributions is also based on the point in time of the transfer. All increases in value in the period before the transfer are therefore subject to wage resp. income tax (with a personal tax rate of up to 47.5%) and additional social security contributions may also have to be paid. In the case of virtual shares in a start-up, where a rapid increase in the company value can be expected, this can lead to a high burden for personal income taxes and social security contributions, which could make employee participation schemes unattractive. Employees may not know, whether they will have to pay a largest part of the intended incentive to the State.
Example: The employee is issued 100 virtual shares in the first fiscal year with a market value of EUR 200. The vesting period is three years. By the end of the vesting period, the market value has increased to EUR 1,000.
Result:The non-cash benefit subject to income tax and social security contributions is EUR 1,000.
Against this background, a number of our clients have inquired about "classic" but more complex employee participation programs for granting employees from the beginning "real" shares in the start-up directly or indirectly through a company founded for this specific purpose. As the point in time when the shares were transferred is decisive for the assessment of the non-cash benefit, the personal income tax and social security contributions will accordingly be lower. The subsequent increase in the value of the start-up until the sale of the shares by the employees is then only subject to a withholding tax of 26.375 %.
Result in the example: The non-cash benefit relevant for wage resp. income tax and social security contributions amounts to EUR 100.
One disadvantage in this case could be that the obligation to pay wage resp. income tax and social security contributions already arises at the point in time when the shares are transferred. Wage tax and social security contributions needs to be withheld by the employer or the employer needs to request the required amounts from the employee. If the employee has to observe a vesting period for the shares, this would mean that he or she has to pay tax before they can turn the shares into cash. In this instance, therefore, the shares are unlikely to provide much incentive for the employee.
The art, therefore, is to draft these "classic" employee participation programs in a way that the earliest possible point in time (e.g. when the employee joins the employee participation program) is used for the assessment of the non-cash benefit, while the latest possible point in time (e.g. the end of the vesting period) applies for the withholding of wage tax and social security contributions.
In an individual case, this could be done by transferring the shares in the company to the employee in principle upon joining the employee participation program in exchange for a cheapened price, while still ensuring that the employee cannot dispose of or otherwise profit from the shares during the vesting period.
Result in the example: The non-cash benefit applicable to the calculation of wage resp. income tax and social security contributions amounts to EUR 100. However, the wage tax and social security contributions are only payable after the end of the vesting period, so that the employee can finance the payment of these taxes from the sale of the shares at the end of the vesting period (if required).
We successfully advised on such a program at the start of this year. If you therefore have any questions about this topic, please feel free to contact us.
(Lawyer, Tax Advisor)
Lawyer, Tax Advisor
Christian Philipp Kalusa