Consider the following dilemma: a start-up typically wants to grow and expand its business or bring its products to market as fast as possible. This requires in particular the best talent on the market to do the job. However, a start-up typically lacks the cash to attract talent. To solve this dilemma, start-up founders often try to incentivize talent by offering them a participation in the future success of the start-up. Such incentives are commonly structured via so called "employee participation programs".
Which employee participation programs are typically implemented in practice?
The two main types of programs are: equity programs and virtual programs.
Equity programs grant employees and other beneficiaries (eg independent contractors, consultant) a "real" share in the start-up. This means that the beneficiary becomes a shareholder of the start-up company, with all rights and obligations attached (eg having the right to attend and vote in the general assembly, to receive certain information, to receive dividends, etc). "Real" shareholders of an Austrian LLC also are recorded in the public commercial register.
Virtual programs are essentially a contractual promise of the start-up vis-à-vis the beneficiary to pay the beneficiary a bonus at certain trigger events (eg an exit or distribution of dividends). In a virtual program, the beneficiary has no rights other than an entitlement to receive payments in the future.
There are also variations and hybrids of these programs. For example, a beneficiary may receive a "real" share, but for administrative purposes, the share is legally held by a trustee on behalf of the beneficiary. The beneficiary thus becomes a trustor, who has no direct claims vis-à-vis the start-up company; still, the beneficiary is economically treated as shareholder (which, among others, has certain tax impacts). In other cases, the founders establish holding companies that hold the shares dedicated to the beneficiaries and in which the beneficiaries receive a share (so as to avoid direct shareholdings in the start-up). A hybrid for example is an employee participation program that is structured via equity participation rights (Substanzgenussrechte), which are based on a contract (and therefore are like virtual programs), but that confer certain rights that only shareholders have (eg dividend rights, but no voting rights), with the benefit that they are treated like "real" shares from a tax perspective.
In both cases, equity and virtual, as well as for any variation and hybrid, beneficiaries are typically subject to certain vesting terms. This means that beneficiaries receive the entitlement under the programs only after a certain time (eg at the end of the vesting period or throughout the vesting period on a monthly or quarterly basis) and provided that they do not leave the start-up. In many cases, the so called "reverse vesting" is applied, in which case the beneficiary receives the full entitlement upfront and only earns the right to retain the entitlement the longer he or she stays with the company during the vesting period.
Participation programs often differentiate between good leaver and bad leaver cases. A good leaver case for instance occurs if the beneficiary leaves the company for reasons not attributable to him or her. A bad leaver case, in turn, occurs if the beneficiary voluntarily leaves the company. The different leaver cases typically trigger different consequences: in a bad leaver case, the beneficiary loses (all or part of) its entitlement whereas in a good leaver case, the beneficiary may still lose (all or part of) its entitlement, but will be appropriately compensated.
Are there any potential obstacles to be observed with regard to employment law?
Yes. Obstacles may particularly arise (i) as the so-called "principle of equal treatment" needs to be observed and (ii) in case the employment of an employee having rights under an employee participation program is terminated.
Why does the "principle of equal treatment" need to be observed?
According to the principle of equal treatment, employers must not unjustifiably discriminate against certain employees or unreasonably favor a majority of employees thereby adversely affecting a minority.
Consequently, eligibility to participate in an employee participation program must generally be determined by objective reasons. If not, excluded employees could still be entitled to all benefits arising from the employee participation program.
Which problems may arise in connection with a termination?
Generally, any part of the employee's periodic remuneration must be granted on a pro-rata basis if the employment is terminated prior to the due date of this remuneration. As employees' rights under an employee participation scheme may be – depending on the individual case - considered periodic remuneration, this may be especially problematic if the plan provides for vesting:
Generally, clauses stipulating that the employee’s rightsunder an employee participation plan will lapse if the employment is terminated within a certain period will be considered null and void if they are found to be unjust or immoral. Thus, the longer the vesting period, the likelier they may be deemed to be inadmissible and therefore void.
Also, provisions in an employee participation program under which any rights acquired thereunder will generally lapse in case the employment is terminateddue to certain specified reasons (eg "bad leaver" regulations) might be considered to be unjust and therefore not be enforceable. In both cases, the employee may – at least – be entitled to a pro-rated amount of his rights acquired until the termination date.
Are there any tax issues related to employee participation programs?
The individual design of employee participation programs is crucial from a tax perspective since it may have a huge impact on the taxation of the employee and the employer. It generally makes a difference whether the employee receives beneficial ownership in shares or participation rights or not (as in the case of virtual participations).
The benefit from the grant beneficial ownership in real shares or participation rights for no consideration or below the market value to the employee may result in additional employment income. Such income may be subject to withholding tax, wage taxes and social security contributions. The benefit is taxable when the employee participates in the change in value of the company and may dispose of the participation as owner. Tax exemptions may apply for certain types of employee participation programs. Subsequent income from such participations and capital gains from the sale may be regarded as income from capital assets subject to preferential taxation.
In case the employee does not receive beneficial ownership in participations, the grant of such participations generally does not trigger taxes since the employee does not receive an asset which he may dispose of. Subsequent cash payments received on certain events (profit distributions, exit) are treated as employment income and taxed as such (progressive income tax rates, wage taxes and social security contributions may apply).
The design is also relevant for the employer since only expenses are deductible from (corporate) income taxin order to reduce the employer's tax burden. The issuance of new shares or the distributions of profits are tax-neutral and therefore not deductible.