Incentivizing employees to increase their performance is a basic management principle. Already decades ago, theory and practice have started to use incentives that align employees' with shareholders' interests to solve the principal-agency conflict described in corporate finance theory. One way to achieve this is to grant employees a participation in the shareholder value. Such schemes are commonly referred to as Employee Stock Ownership Plans (ESOP). ESOP are now as popular as never. There are various ways to implement such programs. The following paragraphs provide a brief overview on corporate, tax and commercial cornerstones of ESOP relating to small and medium enterprises (SME) and start-up companies in Austria in the most common form of an Austrian limited liability company (GmbH).

Why ESOP in SME and start-ups?

ESOP try to align employees' interests with the interests of the shareholders, thus to maximize the shareholder value. Being non-cash remuneration further increases the attractiveness of ESOP for companies. In certain structures, employees even have to purchase their own shares, thereby generating positive cash-flows for the company. These and other factors make ESOP a viable employee incentive scheme especially for early-stage start-up companies or established SME.

Below, we present common mechanics and tax issues of ESOP in Austria, followed by a short analysis of the most typical models: the direct or indirect ownership in real shares and contractual claims in the form of phantom stock.

Common mechanics of ESOP for SME and start-ups

The basic idea for ESOP in start-up companies and SME is that employees receive a participation in the (potential) future success. Employees take part in future value increases of the company by receiving a monetary benefit if the company finally succeeds.

The value of start-up companies or SME is not immediately available as is the case with publicly traded companies. Therefore, only certain models are appropriate for such companies. Stock option or virtual stock option plans generally require a reference share price and are for that reason not suitable. Employees of companies not publicly traded may therefore receive either a real share (directly or indirectly) or a virtual share in the company. To bond the employee to the company, such interests are often subject to future conditions, e.g. the continuous employment or a vesting period during which the interests fully accrue over time.

The realization of such future benefit generally depends on a predetermined trigger event. Since the interests in the company have to be valued, such trigger event is often an exit scenario where a change of control or a comprehensive asset sale of the company occurs at which the value of the entire company becomes available – in the form of the purchase price for the company's business or its shares. The amount of the benefit realized by the employee for such interest is in this case linked to the exit price of the (other) shareholders, resulting in an alignment of interests of the employee with the shareholders.

Companies may grant such interests only to executives or crucial employees. However, the inclusion of certain (but not all) employees into ESOP implies the risk of alleged discrimination. Consequently, also other employees could request being accepted to such scheme. Hence, the selection of beneficiaries under the ESOP should be objectively justified and documented thoroughly.

Common tax issues

Any benefit received by the employee upon grant leads to taxable employment income subject to progressive income tax rates (up to 50%[1] or 6% tax rate on bonus payments). Such benefit equals the difference between the consideration paid (if any) and the market value of the interest at the time the employee receives beneficial ownership of the interest.

Austrian tax law provides for an exemption for benefits received under an ESOP (ESOP exemption) in case the employee receives shares in the employer or a related group member of the employer (each being a corporation or cooperative). Any taxable benefit from such grant may be exempt from income tax up to EUR 3,000 annually if the ESOP and the employee meet certain requirements.[2]

Any (additional) benefit received after the grant date or at the trigger event is also taxable and either subject to progressive income tax rates or the preferential investment income tax rate of 27.5%[3], depending on the underlying interest.

Apart from taxable income of the employee, there are also other tax-related criteria not dealt with in this article, which determine the attractiveness of an ESOP. Further tax issues may be whether benefits to the employee are deductible by the employer for income tax purposes and whether the set-up or execution of the ESOP triggers additional taxes.

Real shares in a GmbH

The transfer of real shares in a GmbH requires the form of a notarial deed, transfer restrictions in the articles of association (AoA) must be complied with. Employees can be granted beneficial ownership in new shares (via capital increase) or existing shares (from current shareholders); each option requires the involvement of (usually at least the majority of) shareholders and a notary. The level of complexity at granting existing shares increases with the number of shareholders, in particular if they are expected to decrease their shareholding proportionally. Employees as shareholders are entitled to certain statutory information and control rights.

These rights make ESOP in the form of real shares in a GmbH for the majority shareholder(s) by far less practical than, for instance, in a stock corporation with publicly traded shares and more limited minority rights.

Being a shareholder does not automatically make the employee participate in any exit profit. In order for the employee to get a share of the pie, it must be ensured that he can sell his share at the same conditions as the other shareholders. For this purpose tag-along rights or put options can either be included in the company's AoA or in a shareholders agreement. The AoA's benefit of enforceability vis-à-vis third parties must be traded off against the disadvantage of publicity (in the companies register).

From an income tax perspective, benefits received by the employee at grant may qualify for the ESOP exemption. Any (remaining) taxable benefit is subject to progressive income tax rates. Subsequent income from holding (dividends) and from transferring the shares at exit (realized gains) results in investment income being generally subject to the preferential 27.5% tax rate.

Indirect (pooled) shareholding through a partnership

A further way to structure an ESOP – and which we see becoming more popular – is to pool employees' interests in a pure holding company (for tax reasons), which in turn owns shares in the GmbH. Thus, the employee holds shares in the operating GmbH only indirectly. For the following reasons, the holding company is typically a limited partnership: limited liability of employees (as limited partners), limited control rights of the employees towards the GmbH (through interposition of the partnership), transparency of the partnership for income tax purposes (treating employees under the ESOP as if they would hold shares in the GmbH directly).

The limited partnership requires at least one general partner, which is responsible for the management of the partnership. In order to facilitate entry and exit of employees to and from the ESOP, a "master limited partner" can pool, distribute to and redeem partnership interests from employees.

As with direct shareholders, being an indirect shareholder does not by itself create a participation in an exit profit. To realize any benefits in this case, the AoA of the GmbH or a shareholders agreement on the level of the GmbH can foresee tag-along rights or put options in favor of the limited partnership. Any profit of the partnership will be allocated to the employees as limited partners.

Income tax consequences for employees as beneficial owners of the participation are comparable to holding direct shares. Any benefit received at grant date is subject to progressive income tax rates. However, it is not entirely clear whether the grant of such participation qualifies for the ESOP exemption, since it may require a direct shareholding in the GmbH or a related group member. Subsequent income from holding (dividends) or transferring the shares (realized gains) results in investment income being generally subject to the preferential 27.5% tax rate.

Phantom stock

In the case of phantom stock (also called virtual shares), the employee does not get corporate ownership rights in the company. Instead, he receives a contractual claim against the company which becomes due upon a trigger event and the amount of which is based on the value of the company.

A phantom stock plan is implemented by an act of the managing directors, backed by a shareholder resolution (especially if the shareholders are obliged to fund the plan). To evidence the contractual right and to symbolically create phantom stock, companies typically issue physical certificates; these are, however, not tradeable securities. The issue of phantom stock requires no upfront payment by the employee.

Commercial terms under phantom stock plan can be detailed almost at will: vesting/cliff periods and good/bad leaver events are simply included in the plan's terms and conditions and determine if, when and to what extent payments will eventually fall due. In order to fund the payments in case of a share sale exit scenario (where not the company, but its shareholders receive the proceeds), the selling shareholders must be obliged to contribute part of their sale proceeds to the company. Payment streams may be short-cut if the purchaser is instructed to pay directly to the company. Such payments result in final shareholder contributions at exit.[4]

From an income tax perspective, the employee does not receive any benefit at the time of the grant, as she may not dispose of her claims under the phantom stock plan. The employee realizes a benefit only at the time she receives a cash settlement upon the trigger event. Such benefit is not exempt from income tax under the ESOP exemption, since no real shares are transferred. Any benefit is subject to progressive tax rates.

Summary of "Pros" and "Cons"

In case of real shares, the benefits of tax efficiency for the employee must be weighed up against the drawbacks regarding implementation and manageability. To the contrary, phantom stock plans do not provide tax efficiency for the employee, but are easier to implement and to manage. The indirect shareholding takes a middle position between direct ownership in real shares and phantom stock.

Click here to view table.