The success of a startup stands and falls with an innovative business idea and with qualified and motivated employees. Especially at the beginning, it can be difficult for startups to retain highly qualified personnel with below-average salaries. This is exactly where the possibilities of employee participation come into play. With the help of various employee participation programs, startup founders can grant their employees “real” or “virtual” company shares. In this way, the highly qualified specialists participate directly in the success of the company, which compensates for the “low” salary. Apart from the financial aspect, the participation leads to the employees feeling more connected to the company.
What forms of employee participation are there?
Let’s take a closer look on to the two most popular forms of ownership. There is a distinction between “true” and “virtual” employee stock options.
The most common “real” employee option is the ESOP (Employee Stock Option Program). This option gives employees a stake in the startup as shareholders immediately after they exercise it. The option is granted in addition to salary and usually partly as a supplement to salary. An exercise price is usually demanded when the option is exercised, but this often only corresponds to the nominal value. However, the ESOP or the exercise of the options involves a legal and bureaucratic effort, which is often perceived as problematic.
The “virtual” employee options, on the other hand, require much less effort. Thus, the modern alternative to the ESOP, the VSOP (phantom shares “virtual shares”) has established itself as a favorite in recent years. This option does not involve employees directly as shareholders in the startup. They receive an entitlement to payment in the event of a successful exit event. It is important to clearly define the potential exit events from the beginning (e.g.: What counts as an exit event, does the entire company have to be sold or only a majority of the shares) and also to regulate the determination of the base price and the share quantity.
Problem
The complexity of the ESOPS in Switzerland is increased by tax law conditions. Abroad, the problem often does not exist because no tax-free capital gain is possible at all (not even for founders). Thus, it is not the case that the framework conditions in Switzerland are worse. It is rather the case that if the tax potential is to be exploited, it can become relatively complicated and administratively burdensome.
While founders do not have to pay income tax on the purchase of shares and generally realize a full tax-free capital gain on the sale (there are exceptions here as well), employees must pay income tax on the proceeds in connection with employee stock options (or at least a part thereof) (since the employee stock option is a substitute for income). The possibility of deferring taxation until disposal has existed at national level since 2013. It should be noted that young startups are not listed on the stock exchange and thus usually have no fair market value. Without corresponding precautions (ruling by the cantonal tax authority), this leads to uncertainties regarding the calculation methods for the company valuation. In some cases, for example, financing rounds were also assumed as fair value.
Kreisschreiben Nr. 37, which applies throughout Switzerland, offers companies (with and without fair market value) the option of carrying out a company valuation based on a formula value for the purposes of employee share ownership. This could and can reduce the taxable income on the acquisition of the employee shares. Until now, however, this has generally led to the sale proceeds being qualified as taxable income to the extent that they exceeded the formula value at that time. The circular thus allowed (a) a postponement of the taxation date and (b) a tax-free capital gain to the extent that the formula value increases between acquisition and sale.
Does employee ownership have a significant impact on the success of startups?
Considering the many issues involved in exercising employee stock options, it is even more important to show the benefits of this option. We, EquityPitcher Ventures, see it vital that our portfolio companies engage their employees with an employee ownership. The reason is that employee ownership gives employees a share of the company, individual employees will directly benefit from the success of a company and will feel a sense of ownership. This can lead to an increase in productivity and an overall performance improvement for companies with employee stock plans. In addition, employee ownership also has an essential impact on the startup ecosystem. In Silicon Valley, for example, these “real” and “virtual” options are catalysts for the funding and innovation cycle within the startup ecosystem. There, proceeds from the equity program are either invested in the company’s own newly formed startups or reinvested in other startups.
Conclusion
Today, it is complicated and administratively burdensome to exploit the tax potential of employee stock ownership. Currently, the VSOP appears to be the simpler alternative. However, unlike the ESOP if the options are exercised early, this does not contain any tax optimization potential for employees. With the updated Kreisschreiben Nr.37, the Zurich method is specified throughout Switzerland, but it should be noted that this specification is implemented differently in the cantons and that there are also various reservations in the canton of Zurich. Nevertheless, it is great to see that politicians are dealing with startup issues and actively looking for solutions.
Critically, however, it seems important to see that there is still no clear demarcation between startups and SMEs and that Swiss politicians also consider SMEs in these issues. Also important for us is that income and income substitutes are taxed fairly for all.
We are happy to receive feedback and questions and look forward to sharing the best practices of our portfolio companies in our next blog.
