Are the incentives aligned correctly? The choice of employee participation is crucial for the success of your company - Part 1
The following two-part article is intended to provide an overview of the most important forms of employee participation programs that can be considered for Swiss growth companies. The primarily focus will be on the tax and social security aspects. This two-part article is intended to help you decide on the option that best meets the needs of your company, your employees and other stakeholders.
While the first part deals with the motives for employee participation, the types of employee participation commonly used in Switzerland and their Swiss tax consequences, in the second part we will look at the treatment of employee share ownership under Swiss social security laws and regulations and give tips on the design of employee participation programs.
Why employee participation programs?
Young, fast-growing companies (growth companies) and startups are in competition with established large companies. Due to their more limited financial resources, it is often not possible for these companies to pay their employees the same high wages as the powerful competition. However, growth companies usually offer employees a great deal of room for maneuver and often have great potential - but they also play very high stakes. In many cases, the goal of growth companies is a so-called exit, i.e. a sale or IPO of the company. If a growth company is successful, the shareholders realize a significant increase in the value of their shares.
Successful growth companies therefore need outstanding and motivated employees who are prepared to share the company risk to a certain extent and to commit themselves to the company's success not only as employees but also as entrepreneurs. Employee participation programs help to recruit such employees and support their motivation to achieve a defined, long-term goal together.
There is no such thing as the ideal employee participation program
Compensation models are dominated by four key parameters:1
- fixed vs. variable;
- short vs. long term;
- cash vs. equity investment (direct or indirect);
- Individual vs. firm-wide goal achievement.
The choice of the form and design of employee participation program along these parameters depends on the company, its owners, the employees and the goals to be achieved with employee participation.
Typically, the following questions need to be considered:
Company: Is the company a startup with a clear exit strategy, a successful private company with a growth strategy, or a publicly traded company that wants to use employee participation to retain staff?
Holders: Direct employee participations, such as shares, result in the shares of existing shareholders being diluted. Their share in the company therefore decreases. The participation of employees in the company by means of equity instruments such as shares also means that the previous shareholders can no longer make decisions on their own, but that the employees also have a certain say. Are the owners willing to share capital and influence with the employees?
Employees: Do the company's employees tend to be young and willing to take risks, or are they not in the economic or personal position to take risks? What do employees understand by fair compensation?
Other stakeholders: How is the employee participation program perceived externally, for example by (future) investors? Do investors accept that employees participate in the company as minor shareholders or that, in the event of a sale of the company, there may be a cash outflow to employees due to employee shareholdings?
What types of employee participation programs are common in Switzerland?
In our practice, we see in particular the following forms of employee participation programs, whereby the entry into these employee stock options is usually made dependent on conditions, e.g. minimum duration of the employment relationship:
Employee options: An employee option is the right granted to an employee, usually on preferential terms, to acquire an equity security of the employer (shares, participation certificates, common stock) within a defined period (exercise period) at a specified price (strike price) in order to participate in the company and its success.
Unrestricted direct employee participations: Free direct employee participations are shares, ordinary shares, participation certificates issued by the employer or companies closely associated with it, which are transferred to employees by the employer on the basis of an employment relationship, usually on preferential terms. Whereas shares and ordinary shares give the holder a say in company decisions and give him or her a share in the company's capital and profits, participation certificates only give the holder a share in the company's capital and profits without a say. After receiving the employee participation, the employee can dispose of it freely, i.e. sell it or give it away.
Restricted direct employee participations: In contrast to unrestricted employee participations, the employee can only freely dispose of the shares, ordinary shares or participation certificates after the expiry of a predefined vesting period. If the employee leaves the company before the end of the vesting period, the company usually has the right to repurchase the awards at market value or a lower value, e.g. the original purchase price. Restricted employee participations therefore have a lower value (discount) compared to freely tradable employee participations.
Restricted stock units: Restricted stock units offer employees the prospect of acquiring or receiving a certain number of direct employee participations at a later date, either free of charge or on preferential terms. Like employee options, restricted stock units represent compensation for future services.
Non-direct employee participations: In the case of non-direct employee participationss, employees never receive direct equity securities, but only cash payments. Non-direct employee participations are, for example, virtual shares (phantom stocks) or stock appreciation rights (SARs). Phantom stocks are fictitious equity securities that reflect the value of a specific share and place their holders on an equal footing with shareholders in terms of ownership rights, but not in terms of participation rights. Accordingly, the holders generally receive payments equivalent in amount to dividend distributions or capital gains on the sale of the shares. Stock appreciation rights entitle employees to receive the appreciation in value of a certain underlying security, often shares, from the employer in cash at a future date. In contrast to phantom stocks, no payments are made which correspond to the respective dividends in terms of amount - the payments are limited to the increase in value of the underlying security.
Cash bonuses (Cash Bonus): Cash bonuses, colloquially referred to simply as bonuses, are cash payments made to employees for achieving agreed individual or company-wide goals. These targets are usually defined annually with the employee as part of the performance review. Bonus payments must be distinguished from gratuities. Whereas bonus payments entitle employees to payment of the bonus upon achievement of the agreed targets, gratuities are voluntary special payments made by the company to employees. Gratuities are often paid out on the basis of special occasions, e.g. a company anniversary or an exceptionally good financial year, etc. The decision on whether or not to pay a gratuity is at the discretion of the company.
Important terms in connection with employee participations
Employee participations originally come from the Anglo-American world. Therefore, the English terms are often used instead of the German ones. The most important terms are the following:
Grant Date and Vesting Period: The date on which an employee award is granted is the grant date. Often, however, the company only gives the employees a written promise (grant notice) at this time that the employee will receive employee shares over a certain period (vesting period), e.g. 4 years, if certain conditions (vesting conditions) are fulfilled during this period, e.g. non-terminated employment with the company. If these conditions are met, the employees receive a generally irrevocable right to the promised number of participations at that point in time (vesting date). The participations often vest quarterly over the entire vesting period, e.g. over 16 quarters in the case of 4 years.
Exercise Price: If options are issued as employee participations and these options have vested, the employee can decide for themself whether and when (exercise date) the option is to be exercised and thus the employee participation, e.g. a share, is to be acquired. The price to be paid for the acquisition of the employee participation is called the exercise price. Typically, the exercise price is below the market value - often the nominal value of the shares - of the award to compensate employees for past service. The company is free to set the exercise price.
Blocking period: Period of time during which the employee cannot freely dispose of the employee participation or during which the company has the right to repurchase the employee participation at a predefined price.
Market value or formula value: If an employee participation, e.g. stock, is traded on a stock exchange or if a sale of a significant participation in the company has recently taken place between independent third parties, there is an objective market value of the employee participation. However, startups often lack such a market value. In this case, the value of the employee participation must be determined using a formula. The value determined in this way is then called the formula value. In principle, the employer, i.e. the company, is free to decide which formula should be used to value the employee participation. However, it must be a method that is suitable for the employer and generally accepted. In practice, we often see that companies use the wealth tax value of the employee participation as the formula value, as this value is accepted by the tax authorities and calculated by them on an annual basis. However, the use of the tax value is sometimes not optimal in terms of the tax consequences for employees - we will discuss this in the second part of our article.
What are the tax consequences of employee participations?
The profit that accrues to the employee from the receipt of the employee participation is basically a salary, i.e. income from employment. If the employee is resident in Switzerland, this income is taxable in Switzerland and subject to Swiss social insurance.
When this income or non-cash benefit accrues to the employee and is therefore taxed depends on the type of employee participation (see table). If, for example, employees receive shares in a startup that is not yet listed on a stock exchange, they may even have to pay taxes on the value of these shares even though they cannot sell them (so-called "dry income").
Nevertheless, it may make sense to exercise options early and pay taxes on the value of the shares received (in the case of options: minus the exercise price). Since Switzerland does not tax private capital gains, this gives you the opportunity to realize a tax-free capital gain on a later sale - but of course there may also be a capital loss that is not tax-deductible. However, this only applies if, at the time of receipt of the shares, the market value of these shares was known and thus the market value of the shares was used to determine the taxable income.
In the case of companies not listed on a stock exchange, there is often no market value. The value of the shares must then be determined by the company itself, whereby the company is basically free to choose this formula value as mentioned above. However, the cantonal tax authorities do not accept valuation methods with a future hypothesis, such as discounted cash flow valuations and similar methods. They require that the chosen method has an income value component. The net asset value of the company forms the lower valuation limit.
If there is no market value and the shares were valued at a formula value upon allocation, the shares must be held for at least five years prior to sale in order for the capital gain on sale to be fully tax-free. In addition, no change from the formula value valuation to the market value valuation may have taken place during these five yearse.g. the company may not have gone public during these five years (depending on cantonal practice). If the shares are sold within five years, the formula value is determined at the time of the sale. Only the increase in the formula value is tax-free. The gain in excess of this, i.e. the difference between the sales price and the formula value at the time of sale, is taxed.
The following chart shows the relationship between the holding period and the tax consequences for direct employee participations:
We recommend obtaining a ruling from the relevant cantonal tax administration to confirm the applicable formula value and the expected tax consequences. In certain cantons, a market value can also be confirmed for companies not listed on the stock exchange if a valuation from an experienced valuation company recognized by the tax administration is available. It should be noted that for the confirmation of the tax consequences for taxes on profits, the ruling must always be obtained from the cantonal tax administration of the company's canton of domicile, whereas for the purposes of the employees' income taxes, a ruling must be obtained from the respective tax administration of the canton of their domicile. If an employee is resident in a canton other than the canton in which the company is domiciled, two tax rulings must therefore be obtained. The reason for this is that the tax administrations of the cantons are not bound by a tax ruling of the tax administration of another canton.
The treatment for wealth tax differs depending on the type of employee participation. For example, options have no wealth tax value - unless they are tradable on the stock exchange.
In order for the tax administration to be able to verify the correct tax treatment of employee participations by the company, the company must document the information required for taxation purposes on the employee's salary statement or on an additional sheet for this purpose.
Employee participations are therefore a salary component. Employees therefore usually hold the participations they receive as private assets.
An overview of the tax treatment of privately held direct and non-direct employee participations can be requested here.
Recommendation
There is no such thing as "the" best way to involve employees in the success of the company. What is important is that the type of employee participation is in line with the corporate culture and attracts those employees that the company needs for its further development. The four parameters for compensation models must be taken into account.
It makes sense to take your time setting up the employee participation program. In Switzerland, many types of employee participation programs are possible. An off-the-shelf employee participation program is typically the wrong choice. The program, the plan and the form of employee participation must be adapted to the company's strategy and objectives and take into account the specific tax and social security circumstances of the company and its employees. If the employees receive shares in the company, it is also worth drawing up a shareholder agreement tailored to the employee participation program.
As soon as the value of the shares, ordinary shares or participation certificates issued to employees cannot be based on a stock market price and the formula value is not to be determined on the basis of the tax value, it is worth obtaining a tax ruling to confirm the formula value or a market value of these employee participations.
VISCHER will be happy to advise you on the choice of employee participation program suitable for your company and assist you in setting up of your individual program including a suitable shareholder agreement and the clarification and confirmation of the tax and social security consequences of your program.
Footnote
1. Cf. Matthias Staehelin, Driving Performance: Incentive Structures from an Entrepreneurial and Legal Perspective, in: A wonderful world: New opportunities, new law, new challenges by Dieter Gericke, Tagungsband 2022 zur 8. Tagung zu Private Equity, p. 82 f.
Originally published 19 September 2023
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
