Startups often incentivise employees by granting them a share in the (future) success of the company by issuing equity. Such compensation schemes play a crucial role in enabling start-
ups to attract and retain highly qualified talents. Our partner Alain Friedrich has drawn up a guide that summarises the most important types, structures, and tax as well as legal issues of employee participation plans of Swiss startups.
If you are interested download the PDF.
Introduction
Startups often incentivise employees by granting them a share in the (future) success of the company by issuing equity. Such compensation schemes play a crucial role in enabling start-ups to attract and retain highly qualified talents.
The aim of this guide is to help founders and investors of Swiss startups better understand the types, structures, and tax as well as legal implications of the most common employee participation plans and to provide them with an initial overview of the most common structures. The guide does not only deal with the legal framework of employee participation plans, but also describes how employee participation plans influence exits and financing rounds.
Please note, however, that this guide does not replace legal or tax advice and only serves as a first introduction to the complex topic of employee participations programmes.
Now, let’s start with the basics.
1. What are employee participation plans?
In this guide, the term "Employee Participation Plan" serves as a generic term for the instruments used by Swiss startups to incentivise employees. These are essentially (i) employee shares, employee options (also called Employee Stock Option Programme, ESOP) and (ii) virtual shares (also called Phantom Stock or Virtual Stock Option Plan [VSOP]).
All types of employee participation plans have the common goal of motivating employees to join the startup, show full commitment, remain in the company for a certain period and ultimately participate in the realised value of the company through a so-called exit or liquidity event.
2. Why are employee participation plans popular with startups?
Employee participation plans are particularly popular with startups for several reasons.
First, such programmes serve to attract employees. Highly qualified employees usually have an above-average compensation and attractive fringe benefits when employed at large companies. Startups usually lack the liquidity or the will to pay a similarly high cash compensation. Therefore, instead of cash compensations, startups use employee participation programmes and compensate highly qualified employees with shares or options, thereby allowing them to participate directly or indirectly in the success of the company.
Furthermore, employee participation plans serve the purpose of employee retention. Simply hiring talent is not the end of the story for startups. The real skill lies in retaining key people in the company. This is where employee shares or options, which vest over several years and allow the beneficiaries to participate in a (hopefully) steady increase in the value of their company, come into play. In addition, employee participation plans align the interests of the founding team, the investors, and the employees.
Lastly (and most importantly), employee participation plans are also meant to motivate and incentivise employees. It is assumed that employees work particularly hard when they do it for "their" company and are able to participate in the success of the employer.
Startups also sometimes use shares, options, or virtual participations selectively to compensate consultants and service providers. Even though the legal consequences of issuing shares, options as well as virtual participations to non-employees do not differ massively from those of employee participations, it should be noted that this guide only refers to employee participations. In case a startup is issuing shares, options or virtual participations to advisors, the legal and tax consequences must therefore be examined separately.
3. Structuring of employee participation plans
Swiss startups use different forms of employee participation plans. Either shares are directly allocated to certain employees (employee shares), options on shares of the startup are granted (ESOP) or a virtual employee share participation programme (so-called phantom stock, VSOP) is implemented.
The first two options are equity-based, whereas the third is a purely virtual participation whose value is usually dependent on the exit proceeds.
The three forms of employee participation can be summarised as follows:
- Employee shares: Employee shares grant employees a direct participation in the startup. The employees therefore become shareholders of the startup with all rights and obligations according to Swiss corporation law.
- Employee stock options: Employee stock options grant employees the right to acquire shares of the startup. Consequently, employees receive a (mere) contractual entitlement to the allocation of a certain number of shares in the company at a certain point in the future, if the options are exercised.
- Phantom stock or virtual participation: Virtual shares grant employees a contractual right to receive a payment upon an exit event. The amount to be paid to the holder of virtual participations is generally determined by the amount a shareholder receives for one share in the event of an exit. The employees’ right to the compensation is directed towards the company. Thus, a virtual participation is basically bonus payment upon exit.
Issuing employee shares normally costs the company – except for the costs associated with the notarisation and the application to the commercial registry - nothing (in some situations social security contributions may be due, more on this later), but dilutes the participation of existing shareholders.
The question therefore arises as to how large an employee participation pool (pool) needs to be. The recommendation of the American Venture Capital Fund Balderton Capital can serve as a rough guideline. They recommend that startups should allocate the following percentages to the option pool:
The above values must be taken with a grain of salt. Each company has its own needs and goals and must therefore decide for itself what option pool it wants to implement. In any case, the size of the pool should be reviewed regularly in the context of the startup’ s hiring and growth plans.
In addition to the overall size of the pool, there is always the issue of which employees should be entitled to a participation. Particularly in the USA, there are voices that advocate the broadest possible employee participation. Others consider only the involvement of the most valuable employees to be appropriate. Ultimately, the question must be decided by each startup. According to my experience, in Switzerland, only key people usually participate in the employee participation plans. A participation of all employees is rare.
As a rule, early employees (founding employees) are granted a stake in the company amounting to 1-1.5%. In later financing rounds, this participation is diluted unless there is a refresher and additional options, or shares are granted to people who already have employee shares.
Employee shares
In the case of employee shares, employees are granted a direct stake in the start-up’s equity. The corresponding shares are usually issued as part of a capital increase or transferred from existing shareholders to employees. A buy-back of its own shares by the startup and a subsequent issuance to employees is generally not an option due to legal reasons.[1]
When transferring employee shares, it should be noted that the employees become shareholders and possess the usual shareholder rights (participation rights, property rights as well as information and protection rights) and the more employees become shareholders, the more tedious the decision-making process may be.
This can be particularly disruptive in financing rounds, as all existing shareholders usually need to sign an investment agreement. This is the reason why employees are often not only party to a shareholders' agreement, but also to a pooling agreement, according to which a designated person is authorised to exercise the shareholders' rights on behalf of the employees. This authorisation is common but can - in principle - be revoked by any employee at any time if Swiss law is applicable.
[1] Art. 659 OR para. 1 provides that own shares may only be acquired if, among other things, freely usable equity capital is available. Depending on the financing situation, however, a startup often does not have such freely usable equity capital.
Employee Stock Options (ESOP)
With employee stock options, employees acquire a right (option) but not the obligation to purchase shares at a specific strike price during a so-called exercise period. Depending on the plan, options can be exercised immediately upon allocation or only after the expiration of a certain period during which the exercise of the option must be earned (vesting period).
From the perspective of existing shareholders, employee options have the advantage that the holders of options do not become shareholders until the option is exercised. As a rule, an option will always be exercisable in case of an exit.
Virtual Participation Plans
In practice, virtual participation programmes have various names. Common terms are phantom shares, virtual shares, exit/dividend participation rights or virtual stock option plan (VSOP).
Virtual participation plans are essentially contractual rights of employees to future cash payments based on certain parameters. With the granting of virtual participation rights, a beneficiary acquires a claim against the company in an amount that is determined according to certain metrics.
The beneficiaries of virtual participation plans are not entitled to any shareholder rights. Their right is solely based on a contractual agreement between the employees and the company. Since the beneficiary's entitlement is usually related to a part of the exit proceeds, people with virtual shareholdings will be economically diluted in future financing rounds - as will existing shareholders.
The issuance of virtual participations is relatively straightforward, simple to implement and flexible. Neither a public notarisation nor an entry in the commercial register is required.
Documentation and important terms
Employee participation plans usually consist of two main documents.
- Employee Participation Plan: The Employee Participation Plan contains general rules about the programme (such as the eligibility, general vesting and forfeiture regulations, the trigger events and other common provisions that apply to all employee participations). The plan thus sets out the rules that apply to all participants of the programme.
- Allocation letter: The allocation of the employee participations usually takes place in the form of a separate contract between the startup and the employees. In this separate contract (the allocation letter), the number of allocated shares or options, the start of the vesting period and the exercise price are agreed upon. In some cases, the allocation letter sets specific individual performance targets, which the beneficiary is required to achieve before he or she receives the shares or options.
Vesting and Cliff
As a rule, all employee participation plans include vesting provisions. In simple words, vesting means that the beneficiary needs to earn the participation. The vesting period is the period over which a beneficiary acquires the right to keep the granted employee shares in economic terms. In the instance of employee shares, this is often referred to as reverse vesting. Themechanism of reverse vesting is substantially the same as the vesting mechanism.
If the parties agree on a vesting period, the employee must earn their shares over a certain period (Vesting Period). This reduces the risk of employees leaving the company early or for the wrong reasons without having to return any of their shareholdings.
Employee participation plans often also provide for a so-called cliff. A cliff means that the employee must remain with the company for at least the duration of the cliff for the first portion of the employee participation to be vested.
My experience shows that employee participation programmes of Swiss startups often have the following parameters:
- The vesting period is generally 48 months, although shorter and longer periods are possible as well.
- Vesting is typically linear on a monthly basis, sometimes quarterly.
- The cliff is usually 12 months. A cliff period of 12 months means that in a typical vesting period of 4 years with linear vesting, 0% of the participation vests in the first 12 months, then 1/4 of the participation is vested at the end of the twelfth month and an additional 1/48 of the participation vests in each following month up to the 48th month.
It is important to note that vesting periods are usually agreed upon under the assumption that the beneficiary will work for the company as a full-time employee during this period. As a result, the plan should also include a provision that provides for a solution if the employee reduces his or her workload instead of leaving the company.
In general, startups have a great deal of discretion in determining the cliff and the vesting period. There are, for example, companies that have longer cliffs in their employee participation programmes and therefore try to bind the employees to the company even longer. Back-loaded vesting goes in the same direction. Here, the company wants that most of the holdings will only vest near the end of the vesting period. For example, it could be agreed that only 10% of the participations will vest after the first year, another 20% after the second year and the majority of the participations will not vest until after the third or fourth year.
Performance-based vesting is also a possibility. In this case, the employee shares vest if certain sales, growth, or other targets are achieved.
Accelerated Vesting
Employee participation plans usually also address the question of whether and under what circumstances vesting can be accelerated (Acceleratedvesting).
Accelerated vesting puts beneficiaries in the position where even unvested participations (or at least a part of them) are considered to have vested early, i.e., accelerated, on the occurrence of certain events. This issue is particularly important if an exit, i.e., a sale or IPO of the company, arises during the vesting period.
Events leading to accelerated vesting are called trigger events. A distinction is made between single trigger and double trigger acceleration.
- Single trigger acceleration: Provisions according to which the occurrence of an exit event by itself is sufficient for accelerated vesting are referred to as "Single trigger acceleration", since only one trigger (the exit) is required for accelerated vesting.
- Double trigger acceleration: In case of double trigger acceleration, it is agreed that in the event of an exit (trigger number 1), all shares vest if the corresponding employee is terminated without cause within a predefined period after the exit (trigger number 2). The relevant period is usually 12-24 months.
The Double trigger acceleration is justified by the fact that a single trigger accelerated vesting can negatively influence the valuation of the company. The reasons are the following:
Full vesting of all options reduces the proceeds going to shareholders, as a buyer will include such liabilities in its purchase price calculation (if the startup must bear the economic burden of the programme itself). In addition, it is a risk for a buyer if certain employees "cash out" at exit and may no longer work for the company. After all, employees are one of the most significant value drivers of an acquisition. Accordingly, double trigger acceleration arrangements are more popular with investors.
Leaver rules
Leaver provisions cover the question of what happens when an employment relationship is terminated. Often, when the employment relationship is terminated, not only is it stipulated that vesting ends, but depending on the circumstances of the termination, further consequences for the employees are defined. D
All employee participation programmes are identical in the sense that when a leaver event occurs, all unvested shares are forfeited. However, the question of what happens to the vested participations remains.
As a rule, there is a distinction between good and bad leavers. Good leavers are allowed to keep their vested holdings, while a bad leaver loses the vested shares. In most cases, the loss applies to all holdings of the bad leaver. However, it is also possible that a bad leaver "only" loses part of the vested shares.
- Good leaver: A good leaver event typically occurs when the beneficiary dies or becomes permanently incapacitated, is dismissed by the company without good cause, or leaves the startup for a reason that the employee participation plan defines as a good leaver event (e.g., reaching retirement age).
- Bad leaver: On the other hand, a bad leaver event occurs when the company must terminate the employment agreement for good cause or when the beneficiary violates company regulations or the employment agreement and, as a result, the employment relationship is terminated.
Probably the most frequently discussed question is whether employees who leave the startup voluntarily should be regarded as bad leavers and be treated differently from those who have been dismissed without good cause. There are various arguments both for and against qualifying such people as bad leavers. As a compromise, there is the possibility of agreeing on a so-called grey leaver arrangement. Such arrangements allow employees to keep at least part of their shares in the instance of a voluntary departure.
Strike Price
The allocation letter generally determines the exercise or strike price. The exercise price describes the monetary amount that people holding employee options must pay to exercise an option and to receive a share in the company. In the case of employee shares, the exercise price generally corresponds to the compensation paid for the transfer of a share.
Whether the beneficiary must pay the exercise price in cash or otherwise depends on the respective employee participation programme. It is possible to pay the exercise price by offsetting a wage claim of the beneficiary. In addition, it is also possible to transfer an existing share held by the company to a beneficiary.
In virtual participation programmes, the participants generally do not have to pay anything to receive the payment since the beneficiary "only" receives a payment upon an exit or liquidity event. The amount to be paid to the beneficiary is usually derived from the amount a shareholder receives for a share in the company minus the exercise price set for the respective virtual share. As such, the pay-out is reduced by the exercise price.
A startup has a wide discretion in setting the exercise price. Often, the exercise price is equal to the nominal value of the shares. After the seed phase, however, startups often set the strike price at a specific percentage of the pre-money valuation of the last financing round, sometimes combined with a valuation increase.
Since the exercise price has a large impact on the tax consequences of employee participations, startups need to be particularly wary when thinking about exercise prices. More on this later.
Early redemption of options
In certain employee participation plans, when they leave the company, employees have a limited window of time to decide whether to exercise vested options.
In other plans, vested options can be held until an exit even. This essentially allows beneficiaries to build up a portfolio of options by changing jobs every two years or so and hoping the value of the options will increase. By doing this, such may secure a portfolio of options from different employers.
To prevent this, some companies allow employees to keep options when they leave but limit the potential upside of such options. Such a limitation can be achieved by allowing the startup to redeem options within a certain period after the occurrence of a leaver event.
Implementation of employee participation plans
The introduction of employee participation plans generally requires the consent of the shareholders. I therefore recommend that the implementation of an employee participation plan and the size of the entire pool is agreed upon in the shareholders' agreement.
Including the size of the employee participation plan in the shareholders’ agreement ensures that no discussions arise when issuing the shares or creating the statutory basis (conditional or authorised capital increase).
However, shareholders do not usually have a say in the individual allocation of shareholdings or the terms and conditions of the employee participation plan. Such details are generally the responsibility of the board of directors unless there is another contractual arrangement between the parties.
Tax consequences
Employee shares
Moment of taxation
For tax purposes, employee shares allocated to employees residing in Switzerland are taxed at the time of allocation. The difference between the market value (or the formula value) and the purchase price is taxable as income from employment and is subject to social security contributions.
Contractual agreements that oblige the startup to transfer the employee shares at a later point in time does not lead to taxation. The employees are only taxed when the employee shares are actually allocated or transferred.
If the employee shares are subject to a transfer restriction (blocking period), during which the employee may not exercise, sell, pledge, or otherwise burden the allocated employee shares, the market value is discounted by 6 per cent per year for the purpose of calculating the taxable income. The discount applies for a maximum of 10 years (even if the blocking period is longer). The following table shows the reduction of the market value for the purpose of calculating the taxable income:
Tax consequences of holding employee shares
If the startup distributes dividends, these are subject to taxation as investment income at the time of receipt. Social security contributions are not due. Furthermore, employee shares are subject to wealth tax which must be determined at the end of each year.
In principle, the methods recommended in KS SKK 28 (value according to the practitioner method or net asset value for startups) are applied when valuing the startup
To avoid different values for wealth and income tax, the formula value as agreed with the cantonal tax administration can generally also be used for wealth tax purposes. More on the formula value later.
Tax consequences in case of a sale
The tax consequences in case of a sale of the employee shares depend on whether the shares were issued at fair market value or at a formula value.
- Allocation at fair market value: If the allocation is made at fair market value, the employee generates a tax-free private capital gain on the sale. Tax consequences may arise if the initially agreed lock-up period expires prematurely. If the lock-up period lapses early because of a sale, the employee must pay tax on the difference between the undiscounted market value of the share upon lapse of the lock-up period and the discounted value corresponding to the remaining lock-up period.
- Allocation at formula value: If at the time of allocation, a formula was used to value the company, which should be the rule for startups, the employee will only realise a tax-free private capital gain in the amount of the increase in value when applying the formula value. The difference between the proceeds and the formula value at the time of sale constitutes taxable income. However, after the expiry of a five-year period after the allocation of the shares, the capital gain on the employee shares is tax-free, irrespective of the value the shares were allocated at.
Employee options
Moment of taxation
The mere allocation of employee options is not subject to income tax, nor does the expiry of the vesting period trigger to taxation on the employee’s level. For employees residing in Switzerland, employee options are only taxed when the options are exercised (and thus when the shares are allocated).
When an option is exercised, the difference between the fair market value (or formula value) and the exercise price of the shares is subject to income tax. This difference constitutes income and is subject to social security contributions.
Tax consequences of holding employee options
Until options are exercised, employees do not receive any dividend income and there are no income tax consequences during the holding period. Once the option is exercised, employees receive shares, and any subsequent dividend income is subject to income tax.
Employee options are not subject to wealth tax. However, as of the allocation of the employee options, they need to be declared pro memoria in the list of securities and assets in the tax return. When the options are exercised, the employees become shareholders and the principles applied to employee shares apply.
Tax consequences on exit
As a rule, employees are usually not allowed to sell employee options. If the sale is nevertheless permissible, the proceeds of the sale would in principle be subject to income tax (income from employment).
After exercising the options, the employees receive shares. Therefore, the same tax consequences occur upon exit as with the sale of employee shares: Any capital gain from the sale of the shares is a tax-free unless the allocation occurred at a formula value.
Virtual participation programmes
Moment of taxation
In virtual participation programmes, employees do not acquire equity participation rights in the company, but a right to future cash payments.
Issuing virtual participations plans does not trigger any tax consequences. The taxation only takes place when cash payments are made. Accordingly, there are no valuation issues since virtual participation programmes usually only offer a cash benefit.
Tax consequences of holding
If the virtual participation plan provides for a virtual dividend. taxation takes place at the time of the payment of such virtual dividends. It is subject to income tax and social security contributions.
In principle, virtual participations are not subject to wealth tax. They represent rights to cash benefits and are pure entitlements and not assets that have been acquired by the employee.
Tax consequences of the exit
Since virtual participations only lead to tax consequences if there is an effective inflow of cash, an exit only leads to tax consequences if the employees receive a cash benefit. If there is a cash benefit, such payment is subject to income tax (income from employment) and social security contributions.
Determination of the fair value of the startup
Income tax
Income taxes and social security contributions are calculated on the difference between the market value and the acquisition price.
The term “market value” corresponds to the company value determined at arm’s length, i.e., based on a relevant third-party transaction.
The price paid by investors in a financing round can usually not be considered the market value for income tax purposes. The valuation in a financing round is usually higher than the price that an investor would be willing to pay for existing shares of an existing shareholder. However, it should be noted that if existing shareholders sell shares to investors in a financing round (i.e., no new shares are issued), the corresponding price may be considered a "relevant third-party transaction" and therefore be regarded as market value of the shares.
If the fair value cannot be determined from a relevant third-party transaction (which is usually the case for startups), the market value is to be determined by a suitable valuation formula (formula value).
The formula value can be determined by applying the circular no. 28 of the Swiss Tax Conference of 28 August 2008 (Guidelines for the valuation of securities without market value for wealth tax) (SSK-KS 28). The rules described in these guidelines are considered a suitable and recognised method according to the tax authorities.
Other valuation methods are also possible. In fact, there is a relatively large margin of discretion on the part of the company. In most cantons, however, a valuation method that is based on a forecast of future performance is not considered a suitable method.
If no formula or market value has been determined, the tax authorities generally apply the methods described in SSK-KS 28 ex officio. The minimum value in each case is the net asset value. If the net asset value is lower than the nominal share capital, the nominal value is used as the minimum enterprise value.
Once chosen, the valuation method, must always be used for the corresponding participation plan (formula congruence).
In principle, a formula value can be used if there is an effective market value. However, this requires that the employer (or another shareholder) has an unrestricted purchase right to buy back the shares at the formula value.
Restricted employee shares will be taxed at the time of acquisition of the right.
Wealth tax
Employee shares are subject to cantonal wealth tax. The valuation is generally carried out according to the market value. In the case of participations in startups, the fair value is generally determined in accordance with SSK-KS 28, i.e. the company is valued according to the standard method described in SSK-KS 28 (weighted average of earnings and net asset value), unless there is a significant change in ownership.
In the case of startups, the following principles generally apply. However, the details should be clarified with the relevant cantonal authorities:
- Until representative business results are available, the wealth tax value of shares corresponds to the net asset value.
- A price paid by investors in financing rounds is only taken into consideration if it is paid after completion of the startup phase (or when representative business results are available).
If a formula value is used for income tax purposes, the respective value can generally also be used as the wealth tax value.
Tax obligations of the startup
If a startup implements an employee participation programme, it has various disclosure obligations:
- If the granting of employee participations is taxable, the startup is obliged to certify the corresponding salary components in the salary statement.
- In addition, a supplementary sheet must be provided with the salary statement, which contains the information required in accordance with the Employee Participation Ordinance. The supplementary sheet is intended to elaborate on the salary component in a more detailed and standardised manner.
- Finally, the salary statement must include a reference to the formula value approved by the tax authorities (tax ruling) and/or the clarification that no taxable income has (yet) been earned from the employee participation plan.
If the employee participation is taxable at the employee level, the startup must keep in mind to pay the corresponding social security contributions and any withholding taxes and to take these payment obligations into account in the (liquidity) planning.
Foreign employees
In practice, it is not uncommon for Swiss startups to recruit talent abroad and sign employment contracts with them or use the services of an employer of record. Some of these foreign employees are also granted employee shares. To understand the tax implications of granting employee participations to people domiciled abroad, it is strongly recommended to seek tax advice in the respective country of residence of the employee. Since the taxation of these employees is generally carried out abroad, the principles presented under Swiss law cannot be adopted in their entirety.
Employee participation in financing rounds
In financing rounds, employee participation plans are of great importance as the size of the employee share ownership pool and agreements on a possible increase of the pool may have influence on the valuation of a company share.
This is for the following reason:
The pre-money valuation of the startup is the company valuation before the new round of financing, i.e., it represents the company valuation before the new investors have invested. This amount is then divided by the fully diluted number of shares in the company to determine the price per share. This is the price the investor then pays for a share.
"Fully diluted" in this context means that the pre-money valuation is divided by the sum of (i) shares already issued, (ii) shares issued upon conversion of convertible loans and (iii) shares issued and issuable based on an employee participation programme.
For founding teams, it is crucial whether a possible employee participation programme is already included in the pre-money valuation (and thus only dilutes their share) or whether the employee participation programme or its increase does not influence the pre-money valuation and consequently dilutes the founding team and the investors.
If investors demand an increase in the employee share ownership pool prior to their investment, their demands lead to a decrease in the price per company share as only the existing shareholders become diluted.
Employee participation in an exit
An employee participation programme is also of great importance in case of an exit for several reasons as well.
Firstly, the financial liabilities from an existing employee participation programme are of relevance for the valuation of the startup. This is particularly true if a virtual participation programme has been agreed and, in the event of a sale, the beneficiaries are able to claim a cash settlement.
Further, the buyer will want to know how much compensation is paid to the employees. This figure may be relevant for the buyer to develop an appropriate strategy for approaching these employees as a means of retaining and further motivating them beyond the transaction.
Here, employee stock option programmes with a single trigger acceleration clause may indeed have negative consequences. With single trigger accelerations, there is a risk that the buyer will have to create new compensation packages after the transaction to motivate affected employees to stay with the company. Of course, this will ultimately have an impact on the purchase price.
Concluding remarks
Startups have various ways of letting their employees participate in the success of the company. The different types of employee participation plans have different advantages and disadvantages from a business, taxation, and legal perspective.
Depending on the results the company wants to achieve with the employee participation plan, one or the other form of employee participations should be chosen. For example, if employees do not want to take any entrepreneurial risk and only want to pay taxes if they receive cash, virtual participation programmes or options with exercise in the event of an exit are suitable. In this case, however, the employees also have no possibility of a tax-free private capital gain. If, on the other hand, employees are prepared to bear the tax consequences at the time of acquisition, they take the risk of loss but benefit from the possibility of achieving a tax-free private capital gain.
