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Incentive Plans for StartupsShares, options or phantom instrument – what fits best for me?

Swiss Startup Day 2019Tuesday, 28 May 2019 – Bern

www.pwc.com

Swiss Startup Day 2019 Incentive Plans for Startups May 28, 2019

2

Speakers

Karim Maizar

Dr. iur. / Attorney at LawPartner, Head Startup DeskKellerhals Carrard

Raemistrasse 5P.O. Box8024 Zurich

Tel: +41 58 200 39 42Email: [email protected]

Remo Schmid

PartnerLeader Compensation ConsultingPwC Switzerland

Birchstrasse 160P.O. Box8050 Zurich

Tel: +41 58 792 46 08Email: [email protected]

AppendixQ&A SessionIncentive PlansTax ImplicationsEmployee Participation ProgramsAgenda


Employee Participation Programs 4

1 Relevance for Startups 5

2 Forms of Participation 6

3 Common Instruments for Startups 7

4 ESOP and PS(O)P 10

Tax Implications 11

5 Overview 12

6 Shares 13

7 Options 15

8 Phantom Shares/Options 16

Incentive Plans 17

9 Considerations and Takeaways for Startups 18

Q&A Session 26

Appendix 27

10 Taxation Details 28

Agenda

3



Employee Participation Programs

4



Relevance for Startups

1 Relevance for Startups

5

What are Startups’main reasons to

implement employee participation

programs?

• Typical element of compensation in startups in order to attract, motivate and retain key employees (can also be used for late co-founders); particularly nowadays in times of “war for talent”

• Offering compensation schemes that are competitive with those of other (leading) startups

• Aligning employees’ interests with the strategy of the startup (“skin in the game”)

• Letting employees participate in the long-term success of the startup

• Startups usually do not have sufficient cash available to pay market-based salaries (let alone bonuses)

• Venture capitalists require it



Forms of Participation

2 Forms of Participation

6

Real equity participation (equity-settled) Phantom participation (cash-settled)

DefinitionEmployee will receive real shares, i.e. becoming a shareholder

Economic effects of an equity instrument are mirrored in form of a cash payment

Considerations

• Direct link between company performance and employees’ value creation

• High retention due to long-term participation• Shares either with full or limited shareholder rights

(e.g. no voting rights)• Real equity instruments may allow for favourable

tax treatment in Switzerland (note: valuation of non-listed shares needs careful consideration)

• Employee participates in the success of the company• No real participation is possible, potentially reducing

the employee retention factor• Higher flexibility and simpler to administrate• Preserves the ownership structure of the business• Any payment is considered gross employment

income, being subject to income tax and social security contributions

Examples

• Share purchase plans (discount on purchase price)• Free allocation of shares• Option plans • Restricted/Performance Share Units (RSUs/PSUs)

• Phantom shares• Phantom options (SARs)• Cash deferral models



Common Instruments for Startups (1/3)

3 Common Instruments for Startups

7

Options (real equity participation) Shares (real equity participation)

• Right, but not obligation, to subscribe (purchase) shares of the company at a pre-agreed exercise price at any time during a determined exercise period

• No shareholder rights until the exercise of the options

• Subject to a vesting period (staggered or cliff vesting)

• Upon termination of employment during the vesting period, options are generally forfeited

• Free allocation of shares: no purchase price

• Share purchase plan: acquiring shares at beneficial conditions

• Shares can have a blocking period (“blocked shares”); tax discount for blocking period of 6 % per blocking year (maximally 10 years)

• Employee becomes a shareholder (shareholder rights)

ESOP = Employee Stock Ownership/Option Plan





8

Phantom shares/options (phantom participation)

• Virtual stake in the company with the aim to be treated like a shareholder when it comes to monetary gains upon an exit (or possibly other liquidity events)

• Employee can benefit either from the full value of the virtual shares granted (phantom shares) or from the value created since the date of grant (phantom options)

• Subject to a vesting period

• Upon termination of employment during the vesting period, phantom shares/options are generally forfeited

PS(O)P = Phantom Stock (Option) Plan





9

Which instruments are most commonly used

among Swiss startups?

• Most Swiss startups use either an ESOP or a PS(O)P

• There are only a few startups using share plans

• This is mainly due to the income tax implications that are triggered with a share plan because the grant of shares triggers income tax (and social security contributions) for the beneficiaries if granted free of charge or at beneficial conditions

• Whether an ESOP or a PS(O)P is chosen, largely depends on individual preferences and the overall (financing) strategy of the startup



ESOP and PS(O)P

4 ESOP and PS(O)P

10

ESOP PS(O)P

• Internationally widely accepted as most traditional means of incentivizing employees

• Easy to calculate the dilutive effects of options

• Tax optimization possible depending on time of exercise

• Employees usually wait with exercising options until an exit event

• No tricky tax implications, no burdensome administration

• Less costly to set up (but technical implementation can be burdensome)

• If options are exercised only upon an exit event, there is no tax optimization and the effects are comparable to a PS(O)P

• Handling of an ESOP is more burdensome than handling of a PS(O)P (funding, issuance of shares, tax ruling, etc.)

• Some (international) investors do not like/know it

• Setting up is “easy” but implementation (i.e. calculation) in an exit event can become very tricky

• May trigger accounting issues (liability)

• Internationally not always compatible (e.g. in France) due to adverse tax treatment



Tax Implications

11



Overview

5 Overview

12

Free Shares (no blocking

period)

Options (non-listed)

Allocation / Acquisition

Realization: Exercise / Sale

Instruments

Taxable MomentRealization:

Payout

Phantom Shares / Phantom Options

Share Value less Purchase Price

(if any)

Exercise Benefit / Sale

ProceedsTaxable Benefit Payout Amount

Blocked Shares

(blocking period)

Allocation / Acquisition

Share Value lessTax Discount* less Purchase Price (if any)

* For blocking period (6% per blocking year, maximally 10 years)



Shares (1/2)

6 Shares

13

Relevant points in time – share valuation: fair market value

$

t

Grant/acquisition of share Sale of share

Tax-free private capital gain upon sale*

Taxable employment income upon acquisition (assuming no purchase price paid)

1

2

3

Share holding period* Provided that the individual does not qualify as a professional securities dealer

Detailed information is provided in the appendix



Shares (2/2)

6 Shares

14

Relevant points in time – share valuation: formula value

$

t

Grant/acquisition of share Sale of share

Taxable employment income upon sale

Tax-free private capital gain upon sale*

1

2

3

Share holding period

Taxable employment income upon acquisition(assuming no purchase price paid)

* Provided that the individual does not qualify as a professional securities dealer




Options

7 Options

15

Relevant points in time

Exercise of option

Sale of share

Tax-free private capital gain upon sale of the share* (within the same valuation mechanics**)

Taxable employment income upon exercise of the option

Grant of option

Exercise price of the option

1 3 5

2 4

$

tVesting period Share holding period * Provided that the individual does not qualify as a professional securities dealer

** Share valuation: information is provided in the appendix




Phantom Shares/Options

8 Phantom Shares/Options

16

Relevant points in time

$

t

Grant of phantom share/option Payout

Taxable employment income at payout only (no possibility of a tax-free private capital gain)

1 3

* Since payout is settled in cash (and not in shares) share valuation is – from a tax perspective – not an issue

2 Vesting period




Incentive Plans

17



Considerations and Takeaways for Startups (1/8)

9 Considerations and Takeaways for Startups

18

When to create an incentive plan?

Stage Considerations Takeaways

Pre-seed

Typically too early, key employees are given incentives on an ad hoc basis (e.g. promise to be included in a future ESOP or legally questionable equity grants).

Try to focus on traction of the business rather than setting up a sophisticated incentive plan.

Seed

In the first outside financing round, institutional investors (if involved) will require an incentive plan.

Seed rounds can be closed without incentive plans in place; the benefit of doing so is that seed investors then share in the dilution.

Early-VC (Series A)

The first true VC round. Investors will require an incentive plan in place.

Incentive plans “must” be created.

Late-VC (Series B)

Flush with capital, startups at this stage begin to steadily ramp-up hiring, yet employees still want equity.

Important to have standardized the plan and the amount of equity granted to new hires at each level.

GrowthCompany is aggressively pursuing growth and hiring; likely to have exhausted most of the plan.

Plan is mostly gone, but remaining shares are more valuable; allow new hires to share in the upside.

Source: https://www.accion.org/sites/default/files/Accion%20Venture%20Lab%20-%20ESOP%20Best%20Practices.pdf





19

How are incentive plans funded?

Instrument Considerations and takeaways

Shares / Options

• Issuance of new shares via conditional/authorized or ordinary capital increase

o Dilutive effect on voting rights and capital quota of all shareholders

o Investors often shift the economic dilution to the existing shareholders by investing on the basis of a fully diluted share price (assumption: ESOP shares already issued)

Phantom Shares / Phantom Options

• Payment of the relevant amount by the firm, i.e. besides cash no special sourcing required

• The buyer in an exit will typically deduct the liabilities arising under a PS(O)P from the overall purchase price, in this way shifting the dilutive effects to all shareholders pro rata

• Investors often invest on a fully diluted share price





20

How much to grant?

A typical distribution schedule

Seniority Equity Allocation

First 10 employees 10 %

Next 20 employees 5 %

Next 50 employees 5 %

Early-stage equity grants are always a negotiation, but generally:• C-Levels: 1 - 5 %• Key developer or engineer: 1 - 2 %• Other functional team member: 0.5 - 1.5 %• No non-founding member of the senior team should receive more than 10 %





21

How to determine the amount of equity for an employee?

Steps Process

Step 1

Assess the market-based salary range for the employees.

Step 2

Determine the current valuation of the company.

Step 3

Make a one or multiple-year grant of equity to the employee covering the difference between the market-based salary and the salary you actual pay, thereby keeping in mind a “natural” cap of the participation in the company to keep the cap table in good shape.

Step 4

Assess on a yearly basis, by reference to the value curve, whether additional grants are warranted to keep the employee incentives.





22

What are the other main terms that need to be considered?

Share plan ESOP (option plan) PS(O)P (phantom share/option plan)

• Valuation and purchase price

• (Reverse) Vesting schedule, including proper definition of good and bad leaver concept and acceleration upon exit/IPO

• Blocking period

• Accession to SHA

• Repurchase window

• …


• Vesting schedule, including proper definition of good and bad leaver concept and acceleration upon exit/IPO

• Exercise price and exercise window

• Blocking period (for acquired shares)

• Accession to SHA

• …


• Vesting schedule, including proper definition of good and bad leaver concept and acceleration upon exit/IP

• Exercise price and exercise window, if phantom options

• Definition of triggering payment events and calculation of claims

• Grant structure in case of subsidiaries

• …





23

What exactly is “vesting” and how does

it work?

• Vesting = earning the instrument over time (and/or based on performance)

• Vesting period = time period in which an employee has to be continuously employed in order to earn the grant allocation of an award

• Accelerated vesting is typical upon a liquidity event

o Single-trigger: full acceleration of vesting upon liquidity event (employee-friendly)

o Double-trigger: acceleration only after (i) liquidity event and (ii) lapse of [12] months of continued service after liquidity event

• Standard vesting period: 3 to 5 years with a one-year cliff





24

Example: standard vesting with a cliff

• New hire is granted options for 1’000 shares with a 4-year vesting schedule and a 1-year cliff period, then:

o After 12 months, he or she has earned 250 shares; if he or she left before, he or she would lose all the options (cliff period)

o After the cliff period, he or she earns 20.833 shares per month

o If he or she leaves after 24 months (as a good leaver), 50% of the options lapse, the remaining 50% remain with the employee (subject to the provisions of the plan)

o If he or she leaves as a bad leaver, typically all options lapse

Cliff

0 month

12 months

48 months

24 months

36 months

250 shares

1’000 shares

750 shares

500 shares

Vested

Op

tion

s

Months on the job





25

How should the exercise price for

options be set (also for phantom options)?

• An employee will only be interested in exercising an option if the market value of the share is higher than the exercise price (i.e. if the option is “in the money”)

• A high (low) exercise price reduces (increases) the intrinsic value of the option

• Exercise prices can be set as follows:

o CHF 0 (i.e. zero strike option): this is rarely seen, not least because in the case of issuance of new shares, generally at least the nominal value per share must be paid

o At the (assumed) market value at the time of grant: this is sometimes seen but (wealth) tax implications should be checked

o At the nominal value or anywhere between the nominal value and fair market value: this is most often seen among startups

• How exercise prices are set should be discussed with the board and the counsel



Q&A Session

26

Answers for Questions



Appendix

27



Taxation Details: Shares (1/3)

10 Taxation Details

28

Point in time Income tax / wealth tax (non-listed shares)

Grant/acquisition of share

The taxable income corresponds to the value of the share, less tax discount for blocking period (if any) and less purchase price (if any).

Share valuation: FAIR MARKET VALUEActual third-party prices at/near the time of the employee transaction (and for the same share):

• Regular off-exchange trade• Relevant transfer of ownership (“massgebende Handänderung”) among independent third-parties• Financing rounds, but: for startups, share values resulting from financing during building-up phase generally

do not qualify as third-party prices

Share valuation: FORMULA VALUEIf no fair market value is available, the tax relevant share value needs to be determined by applying an appropriate valuation method. Accepted valuation methods are characterized by a clear, fixed formula without room for interpretation or adjustments and are based on historical (preferably audited) figures. Formula values are generally valid for 6 months (based on financial year end).

Tax authorities prefer the “practitioner‘s method“. However, with their pre-approval (tax ruling), other formulas may be used (e.g. EBIT, EBITDA, revenue or other financial indicators).

1




10 Taxation Details

29


Share holding period

For wealth tax purposes, all shares need to be reported in the asset statement (“Wertschriftenverzeichnis”) of the tax return (at their tax relevant value per year end).

Irrespective of the valuation method used for income tax purposes, the formula for wealth tax purposes is generally based on the Circular Letter (“Kreisschreiben”) No. 28, meaning that it generally corresponds to the “practitioner‘s method“. In the canton of Zurich, however, the valuation for wealth tax purposes follows the valuation for income tax purposes.

2




10 Taxation Details

30


Sale of share

The difference between the share value at date of grant/acquisition and at date of sale is generally tax-free within the same valuation mechanics (fair market value or formula value), provided that the individual does not qualify as a professional securities dealer.

The difference between formula value and fair market value upon sale generally qualifies as taxable employment income. However, in some cantons, e.g. Zurich, a tax-free private capital gain results if the holding period amounts to at least 5 years (with no fair market value available during this 5 years), again provided that the individual does not qualify as a professional securities dealer.

The sale of founder shares, held by founders, is generally tax-neutral. But shares granted/acquired by founders later on qualify as normal employee shares (note: different cantonal practices).

In case of a surrender of employee shares without consideration or below the current value, an expense can be claimed in the tax period in which the employee shares were surrendered (“Gewinnungskostenabzug“).

3



Taxation Details: Options

10 Taxation Details

31

Point in time Income tax / wealth tax (non-listed options)

Grant of optionNo tax implications.

Vesting periodFor wealth tax purposes, all unvested options need to be reported pro memoria in the asset statement (“Wertschriftenverzeichnis“) of the tax return (at nil value).

Exercise of optionThe difference between the current share value and the exercise price of the option qualifies as taxable employment income. For information on share valuation, please refer to the slides on share taxation.

In the case of a blocking period of the transferred shares, a tax discount can generally be claimed. For more information, please refer to the slides on share taxation.

Share holding periodFor wealth tax purposes, shares held need to be reported in the asset statement (“Wertschriftenverzeichnis“) of the tax return at their respective value. For more information, please refer to the slides on share taxation.

Sale of shareThe difference between share value at time of share transfer (exercise of option) and at time of sale is generally tax-free. For more information, please refer to slides on share taxation.

2

3

4

5

1



Taxation Details: Phantom Shares/Options

10 Taxation Details

32

Point in time Income tax / wealth tax

Grant of phantom share/optionNo tax implications.

Vesting periodFor wealth tax purposes, all phantom instruments need to be reported pro memoria in the asset statement (“Wertschriftenverzeichnis“) of the tax return (at nil value).

PayoutThe cash payment out of the phantom share/option qualifies as taxable employment income.

2

1

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