Employee participation: Why start-ups should read this guide

One question many start-ups as well as SMEs and large companies are concerned with: How can I attract, motivate, and retain employees for my company?

Start-ups, young companies, or SMEs in particular often don’t have the same financial resources as large companies to convince professionals. Here’s where employee participation comes into play. What is very popular in Silicon Valley is becoming increasingly popular here too. 

But what are employee participations? What possibilities are there for a start-up, a GmbH, and also large companies? And what tax pitfalls should be considered? This guide to employee participations provides the most important answers: 

What are employee participations?

Employers give their employees a stake in the company by issuing participation rights. Companies have various options for this. For example, employee shares can be issued or sold or the employee can be promised a participation in the success or the increase in value of the company. 

From a tax perspective, a distinction is made between genuine and non-genuine employee participations. Genuine employee participations give employees a direct or future stake in the company’s equity. For non-genuine employee participations, employees receive fictitious or virtual participation rights. 

The various forms of employee participation are explained in more detail in the section «The different employee participation options» and their tax consequences.

What are the benefits of employee participation?

Employees have a stake in the success and increase in value of the company through participations. This results in advantages for both employees and employers:

• Increased motivation and long-term commitment: Particularly in times of lack of skilled personnel, it is difficult to find motivated employees or to bind them to their own start-up or company in the long term. The employee participation gives employees an incentive to support the company’s success in the long term.
• Liquidity-saving wages: Start-ups and young companies cannot always pay market-rate wages. Employee participation offers companies a liquidity-saving option for wage payments and an attractive, long-term wage model including profit sharing for employees. 
• Promoting entrepreneurial thinking: By participating in entrepreneurial development, employees get the opportunity to take the entrepreneurial perspective and to help shape entrepreneurial development. 
• Succession planning: Many SMEs and family businesses also use employee participation as part of succession planning. This means that employees can be successively involved in the company – up to one company succession. 

The employee participation also has certain pitfalls – especially from a tax perspective. In order to better understand the disadvantages of employee participation, it is worth taking a look at the different forms.

The forms of employee participation: Genuine vs. non-genuine employee participations

The tax perspective differentiates the different forms of employee participation. The reason: The amount and time of the taxes due differ depending on the form of participation. A distinction is made between genuine and non-genuine employee participations: 

Genuine employee participations:

In the case of genuine employee participations, employees become participants (shareholders/equity holders) of the company by participating in the company’s equity. This can be done, for example, by directly issuing shares or through the acquisition of options that can be exercised later. 

Forms of genuine employee participation: 

• Employee shares or employee equity interests: By employees participating in the company’s equity, they become shareholders (shareholders or equity holders). 
• Employee options: Here, employees are given the option to participate in the company after a defined period of time (exercise period) at a defined price (exercise price). 
• Entitlements to share rights (shares/equity interests): Employees are promised a defined number of participation certificates at preferential conditions after the expiry of a period, the so-called vesting period. The employee must fulfil certain conditions at the time of transfer.

Non-genuine employee participations: 

In this form of participation, employees do not become shareholders or equity holders, but are nevertheless involved in the economic success of the company. 

In other words: With non-genuine employee participations, employees do not participate in the company’s equity and thus do not receive any voting rights or any right to a dividend. However, they are contractually involved in the performance and also in the respective annual profit of the company. 

Fictional, virtual, or imaginary equity securities are also said to be non-genuine employee participations. Even in the case of non-genuine participations, a claim can be made directly or promised in the future. From a tax point of view, most non-genuine participations are equal to entitlements. There are different forms of non-genuine employee participations such as phantom stocks (contractual equal to shareholders) or stock appreciation rights (rights to cash payments of the increase in value).

Lock-up period and conditions for employee participation

There is often a lock-up period agreed to in the case of employee participations. During this time, employees may neither sell nor pledge their participation. The lock-up period also reduces the amount of taxes to be paid in the event of an issuance by the employer at no or reduced cost.

Employee participation is generally issued at preferential conditions. In other words: Participation certificates are issued at a reduced price as the actual value of the participation. 

Taxation of employee participation: Companies must be aware of this

Issuance of employee participations without market-rate consideration results in the employees owing income taxes and the employer and the employee having to pay contributions for social insurance, since the difference between the issue price and the market value is a salary component. 

In Circulars 37 and 37A the Federal Tax Office has set forth in detail how employee participations are taxed. A possible lock-up period has an influence on the amount of the taxable income. For example, a reduction in value of 6% per lock-up year is granted to the market value for a maximum of 10 years.

Valuation questions and excess-profit taxation

In the case of non-listed SME companies, it is often difficult in practice to determine the third-party price (market value) of the participation rights. Therefore, participation rights are often given to employees at a value according to a certain calculation formula (formula value). In practice, the so-called indirect goodwill valuation method is often used. The formula for this is: (2x capitalised value + 1x intrinsic value): 3.

This method is generally also recognised by the tax and social insurance authorities. In this way, social insurance contributions can be settled and certification obligations in the wage statement fulfilled by the employer company. The formula value is often below a market value that an independent third party would pay.

The applicable tax practice states the following:

• If the employee shares are issued at a formula value (e.g., indirect goodwill valuation method) and sold within a five-year holding period at market value, there is a change in the valuation methodology. 
• Only the difference between the market value at the time of issuance and the market value at the time of sale qualify as tax-free capital gain.
• The difference between the formula value of the issuance and the market value at the time of the sale represents taxable excess profit.

Reason for the applicable practice: If employee shares are issued at a formula value and sold to a third party at a higher value within 5 years, the tax authorities assume that the “under-priced” acquisition at the formula value is related to the employment relationship. As a result, the profit from the sale is not a tax-free private capital gain, but taxable income.

Examples to illustrate employee participation taxation: 

Example I: Employee shares

The employees of SME FNIL participate in the company through employee shares. Employee N. acquires 10 employee shares at a discounted price of CHF 1,000 per share. The market value of the shares amounts to CHF 1,500 at the time of the sale of the employee share. 

The difference of CHF 5,000.00 is to be taxed as wage income and calculated with social insurance contributions. 

If a lock-up period of 5 years has been agreed, the market value is reduced by 6% per year and in this example still amounts to 74.726%, i.e., CHF 1,120.89 per share or a total of CHF 11,208.90 for the 10 shares. The income of Employee N. from the employee shares amounts to CHF 1’208.90 (difference between CHF 11’208.90 and paid discounted price for the 10 shares of CHF 10’000).

Example II: Applicable practice: Excess taxation (“Übergewinnbesteuerung”)

The start-up SIRDNEK decides to issue employee shares free of charge to the employees. A formula value is calculated for the statement with the social insurance and the certificate in the wage statement of the non-cash benefit.

At the time of issue, the formula value per employee share amounted to CHF 3,000, which is to be taxed accordingly as a salary and calculated with social insurance contributions.

Within 5 years after the issue of the employee shares the start-up was able to find a strategic partner, all the participation rights of the start-up to the latter are sold at a price of CHF 10,000 per share. The formula value (same valuation method as at the time of issue) is CHF 5,000 at the time of sale.

Employees earn a profit of CHF 7,000 per share sold. However, this profit is only a tax-free capital gain in the amount of CHF 2,000 (difference of the increased formula value from CHF 3,000 to CHF 5,000). In the amount of CHF 5,000 per share, there is a taxable excess profit that is based on the applicable practice of the tax and social insurance authorities in the employment relationship. The CHF 5,000 must be declared in the wage statement.
 

Conclusion employee participation: What needs to be considered 

Employee participation offers many benefits, but also some challenges. 

Companies should look out for these before launch: 

• Employee Engagement Strategy and Intention: What is the company’s strategy, where should it be in 5 years? What should be achieved with employee participation?
• Clarify the tax consequences and legal clarifications: It is mandatory that companies clarify the tax consequences of introducing an employee participation plan before they launch such a plan.
• Determine the value of shareholding calculation: Determining the value is challenging, especially for start-ups or young companies. The value of a start-up often results from the expectation of future successes and profits. This can result in the tax authority setting the value of the employee participation “too high”. This in turn can be disadvantageous for employees. You can also find more information on the valuation of start-ups in the article «Asset valuation of start-up companies»

​Our article «Employee participations in start-up companies» provides further matters that start-ups should deal with when introducing a participation plan.

Do you plan to introduce an employee participation programme, or would you like to transfer the participation rights you hold to an employee? The tax consequences in particular can be complex. It is worth talking to an expert. 

We would be delighted if we could take on this role for you. Do not hesitate to contact us.