The founding of a startup is typically a turbulent process. An existing idea has to be transformed into a business model, the team has to be assembled and investors have to be found for the financing. The focus in this phase is on driving the project forward and the practical implementation of the business model - less on contracts and tax optimization. However, effective contracts and forward-looking tax planning are a must for every startup in the medium and long term - especially if it is successful! The VISCHER Startup Desks's three-part series Focus on Taxes is dedicated to the tax aspects and related entrepreneurial considerations that have to be addressed for a successful startup from the various points of view of investors and founders, employees and the company:
- Focus on Taxes - Investors and Founders: Tax-free Capital Gains
- Focus on Taxes - employees: Participation in the success of the startup
- Focus on Taxes - Company: Setup and operation of the startup
Four reasons why employee participation makes sense for startups
Employee participation schemes enable employees to participate in the success of the company. For the best chance of success, startups need motivated and well-trained employees. However, they often do not have the financial means to compete in the employment market with established companies. For startups, employee stock ownership plans ideally offer the following advantages:
- They strengthen employees' identification with and loyalty to the company;
- They increase employee motivation, commitment and performance;
- They increase the attractiveness of the company as an employer; and
- They offer an opportunity to raise additional capital.
Before employees can participate in the company, the conditions under which this is possible must be defined. If participation in the capital of the company is planned, this is done through a so-called employee stock ownership plan (ESOP). In other cases, it is advantageous to include the relevant conditions in an employee regulation. In this way, the basic conditions for all employees are defined in a single document and do not have to be defined individually in the employment contract or renegotiated with each employee. This also creates transparency among employees and uniform application without preferential treatment. Changes to the employee regulation or employee participation plan require significant effort once they have come into force. The initial formulation should therefore be carefully thought through.
Employee participation instruments
An employee's identification with the company is closest and their motivation strongest if these are self-perpetuating, because they find their work interesting and ideally meaningful. However, financial instruments can also support the achievement of these objectives.
Profit-sharing: Classically, any bonus payment in addition to the salary is agreed with the employee in the employment contract. The amount of the bonus can be made dependent on the achievement of certain targets (turnover, profit, specific performance). The bonus payment is taxed as a wage component for employees and as this is a wage component, additional social security contributions are also payable. The startup can claim the amount of the profit share as a tax-deductible personnel expense.
Non-genuine employee participation schemes: Non-genuine employee participation schemes such as phantom stocks or virtual shares are equity or share-price-related incentive systems that offer employees the prospect of a cash payment based on the performance of a basic share, e.g. a startup share. However, they do not provide a share of the employer's equity. In simplified terms, non-genuine employee profit-sharing schemes are therefore profit-sharing schemes whose amount depends on the development of the value of the company. The implementation of such an employee participation program is therefore easier than with genuine employee participation programs.
As this is basically a form of profit-sharing, non-cash benefits received from non-genuine employee shares are not taxed until they are received (cash benefit). They are taxed as a wage component (also subject to social security contributions). The startup can claim tax-deductible personnel expenses accordingly.
For employees, this type of employee participation is rather uninteresting from a tax point of view, as the entire inflow always remains taxable: A tax-exempt capital gain can never result from non-genuine employee participation schemes. After all, the employee receives a payment without having to sell or IPO the company.
Genuine employee participation schemes: Genuine employee participation schemes allow employees to actually participate in the employer's equity. The participation can be made directly by granting equity securities or indirectly by granting options or entitlements to subscribe to equity securities. The most common are employee shares and employee options. Genuine employee participation schemes require an employee stock ownership plan. For their implementation, genuine employee participation schemes require a publicly certified ordinary or conditional capital increase and their review by an accredited auditor or even audit expert. Genuine employee participation schemes grants the participating employees information and participation rights. In order to safeguard the startup's ability to act and to reconcile the interests of all parties involved, we therefore recommend that the employees be included in a shareholders' agreement.
The (positive) difference between the market value (after a deduction for a possible blocking period) and the selling price represents a monetary benefit for employees and thus taxable income or a wage component (plus social security contributions).
This non-cash benefit is generally taxed at the time of the delivery, i.e. at the time of purchase or receipt of the equity securities. An exception exists for blocked or unlisted options. These are not taxed until they are exercised, i.e. when the equity securities are finally acquired or the options are sold. If the employee participation scheme is structured correctly, the startup can claim a tax-deductible personnel expense accordingly. In any case, the equity capital of the startup company increases by the newly formed share capital and, under certain circumstances, by newly formed reserves.
If employees sell the shares acquired in this way at a higher price at a later date, they generally realize a tax-free capital gain (see Focus on Taxes - Investors and Founders: Tax-free Capital Gains). However, as will be shown below, this only applies to a limited extent for employees of startups.
The Federal Tax Administration practice discriminates against employees of startups
Shares in startups are not usually traded on a stock exchange. As a result, apart from a few exceptions, no third-party prices can be used to determine the market value of the shares. From the point of view of the Federal Tax Administration, there is therefore no market value at the time the employee shares are transferred. In such cases, the value of the shares shall be determined by a suitable and accepted method. This formula value can to a large extent be freely determined by the company. For example, this can be based on the net asset value, the capitalized earnings value, a revenue multiple or an EBITDA multiple. It is important that the same formula is used for the entire award plan.
When the shares are transferred to the employees, the difference between the price to be paid for the shares and the calculated formula value of these shares gives them a monetary benefit (taxable income). If the shares are subsequently sold, the value of the shares sold is determined using the same valuation method. This means that only the increase in value within the formula value valuation (difference between new and old formula value) remains tax-free. The surplus part, i.e. the so-called added value (difference between the higher selling price and the new formula value) is taxable as income at the time of sale. Thus, the possibility of achieving a tax-free capital gain is limited to the increase in value of the formula value.
However, in certain cantons, namely in the cantons of Zurich and Lucerne, the taxation of this added value is waived after a period of five years from receipt of the shares. Other cantons do not tax this added value at all or offer the possibility of determining the market value of the units in a binding preliminary tax assessment before they are sold, so that a tax-free capital gain can also be realized before the expiry of a five-year period. The cantonal practices are very different. The practice of the employee's canton of residence is decisive, which can lead to discriminatory treatment.
If the cantonal tax authorities do tax the added value and do not confirm a market value, the startup must decide on a formula value and document this internally and on the employee's wage statement. This ensures that at least the formula profit will not be taxed if the shares are sold at a later date. If no formula value is defined and the startup has not yet generated any significant income/profit, the tax administration will use the net asset value of the shares as the formula value. In the case of a start up this value usually does not increase significantly before to the exit therefore, in the worst case scenario, the entire proceeds from the sale would be taxable as income from employment if the shares were sold at a later date.
In order to benefit from the possibility of a tax-free capital gain, employees should participate in the company as early as possible. At the beginning, the value of the startup is still low and therefore the chance of later realization of a tax-free capital gain is high. This can be the case in particular if a meaningful formula valuation is carried out or a sale takes place after five years.
The choice of employee participation is complex
Profit-sharing and non-genuine employee participation schemes have the advantage that employees are only taxed at the time of and only to the extent of the receipt of the payment in kind. Employees therefore only pay taxes and social security contributions if they actually realize an inflow. These forms of participation are risk-free for employees. However, this also means that no tax-free capital gain can be achieved. For startups, however, they offer the advantage that they can be implemented quickly and flexibly, lead to little additional administrative effort and do not dilute the capital shares of the founders and investors. However, appropriate liquid resources are needed which could otherwise be used for research and development.
On the other hand, only genuine employee share ownership offers employees the opportunity to realize a completely or partially tax-free private capital gain. Monetary benefits from these genuine employee shareholdings are, however, already taxed when the shares are sold or purchased. The taxes are therefore payable at a point in time when it is not certain whether a capital gain can actually be achieved with these shares at a later date. Employees must therefore be prepared to take a certain amount of risk. Typically, the startup decides on the type of participation, the employees are hardly ever entitled to a choice. Finally, it should be noted that a tax-free capital gain is a Swiss phenomenon and is not relevant for employees and other shareholders living abroad.