Employee incentive plans Part I: Introduction
Employee Participation Plans have long been an integral part of the start-up culture in Silicon Valley. Start-ups need motivated and committed employees to be successful. At the same time, in the beginning, they usually cannot offer competitive salaries – and talent is expensive. It is, therefore, necessary to explore other ways to attract and incentivize the right employees without draining the much-needed liquidity. Both the Employee Stock Ownership Plans (ESOP) and the Phantom Stock Ownership Plans (PSOP) provide start-ups with powerful tools to meet the needs of both the company and the employees.
This blog series will help you understand the different options that are available for your startup, how they compare to each other, and how to choose which is the most suitable for you.
We first give an overview of the most common forms of employee participation. In the second part, we will focus on the allocation keys (or who gets what). After that, we will do a deep dive into the ESOP and the PSOP. The last part will give an overview of the key differences between an ESOP and a PSOP from a tax perspective.
This series is created in collaboration with Michele Vitali of LEXR. The abbreviated version is posted here. The detailed version – focusing on the legal and tax implications as well – is published here.
1. Introduction
There are multiple options when it comes to what you want to share with your employees:
- You can decide to share profits (if you have any) in the form of bonus payments;
- you can decide to share profit (in the form of dividends) and have employees participate in the value increase (i.e. participation) of your company via phantom shares (PSOP); or
- you can decide to share profit (in the form of dividends), have employees participate in the value increase of your company, AND ownership (including decision rights) via employee shares (ESOP).
Within this spectrum there are of course other forms of employee participation – for your orientation, we decided to focus on the main types depicted below.
2. How do they compare?
The following table compares these three main forms of employee participation, where the colour code represents the perspective of the company.
To help you decide which form of employee participation is right for your start-up, we created a decision tree.
3. Summary
The three main forms in the spectrum of employee participation schemes are:
Bonus, i.e. purely profit-sharing;
PSOP (phantom shares), i.e. profit sharing and participation in the value increase; and
Since the bonus usually qualifies as a variable salary component and is therefore unconditionally owed by the company, this form of employee participation is in most cases less suitable for start-ups. In addition, the retention and motivation effect is lower compared to the other forms of employee participation.
The PSOP has the advantage that it is relatively easy to implement. Employees can benefit from the financial advantages of a shareholder without becoming a shareholder. This means that there is no need for a capital increase or adjustment of the shareholders' agreement or a cumbersome transfer of shares. The disadvantage is that in the event of an exit, the employee cannot realize a tax-free capital gain and the profit is instead taxable as taxable income. In addition, the employee is less linked to the company than with real shares.
Under an ESOP, employees become the co-owners of the company, increasing their loyalty and motivation. Employees can participate in the shareholders' meeting, have a say in who is elected to the board of directors, and vote on important business matters. In addition, the tax burden in case of an exit or dividends is lower than under a PSOP. On the other hand, the setup and implementation are comparatively complex. For example, the pool of shares available to employees consists either of so-called conditional share capital or shares held by the company itself (treasury shares).