By Kartik Krishnan (Director of Growth, Capdesk) and Stephan Meyer (Senior Legal Counsel, Billie).
Germany regularly tops leaderboards. From its GDP (#1 in Europe) to the freedom of its press (#11 in the world), this economic powerhouse is impressive, and progressive, in many regards.
But a different kind of ranking recently placed Germany at the other end of the spectrum. A recent analysis of stock option treatment by Not Optional, an initiative from Index Ventures, found that Germany ranks 22nd in a list of 24 western startup ecosystems. The criteria? How well equity is used to empower and incentivise employees.
This does not bode well at all for this key market, and with Germany being the largest economy in Europe, it also raises flags for the future of the entire continent’s ecosystem. But perhaps Germany’s score does not need to be quite so low. To understand how, first let’s look at how the score came about.
Not Optional’s analysis considers six parameters:
How is Germany tackling the situation?
The low scores on parameters one to four can all be tied to Germany’s tax laws and the lack of special considerations around it. To quote a December 2019 article in the Financial Times:
“In Germany, giving employees a stake in the business through stocks is all but impossible. Tax is the main obstacle: under German law, an employee is required to pay tax on the difference between the strike price and market value of the option the moment he or she receives the initial award. The fact that there is no cash benefit is immaterial. Nor does it matter that the options will be worthless if the start-up turns out to be a failure (as many do).”
German legislators have recognised that this tax burden may be a major obstacle, effectively hindering employees from participating. Earlier this year, the German fund location act (Fondsstandortgesetz) was adopted, which aims to increase the attractiveness of shares or stock options being granted to employees by removing the employee’s obligation to pay taxes upon grant of such shares and options.
The company’s obligation to pay social security contributions for such grants, however, remains intact – as the grants are still considered to be part of the employee’s income. This creates its own difficulties as the value of the grant needs to be estimated which proves difficult for many startups. The company’s valuation manifested in financing rounds can hardly be used, as this valuation takes into account that an investor is betting on the company growing a certain amount in the future. Hence, a major obstacle for startups to granting equity to their employees remains.
When it comes to the individual employee’s tax declaration, the new section 19a of the German Income Act (Einkommensteuergesetz, EStG) provides more clarity. Instead of being taxable upon grant, stocks and stock options granted to employees shall be considered to be taxable income only when the employee sells them, leaves the company or after a maximum of 10 years has passed.
As a result, the so-called “dry income” effect, in which an employee has to pay taxes on assets while not gaining any cash to actually pay those taxes, is avoided. However, the original downside for employees – that granting shares or stock options to an employee creates a heavy tax burden – remains. Taxing the grant of shares or stock options however, can ease some of the tax burden. In this case, only the original value of the equity granted would be considered as taxable income, and only the original value would be taxed with the employee’s individual tax rate, while the increase of the equity’s value would be treated as capital gains from a disposal of shares.
However, the second improvement for startups as implemented by the German fund location act, seems to only be of minor significance. This is because the tax-free amount of income generated from the grant of stocks or options is increased from EUR 360 per calendar year to just EUR 720.
While granting equity to employees proves to be difficult in Germany from a tax law perspective, the process of actually granting the equity is by no means simple in comparison. Unlike stocks in (listed) stock corporations that can be traded freely on the stock exchange, the transfer of shares in a GmbH must follow a formal set of rules. The same is true for the creation of new shares in a GmbH. Unfortunately, the granting of stock options – which is possible for a German stock corporation – is not possible for a German limited liability company (LLC).
But Berlin-based fintech Billie believes there’s a workaround
Billie’s Senior Legal Counsel Stephan Meyer explains:
“In Germany, whenever you want to issue or transfer real shares the purchase agreement needs to be notarised. The notary then submits the files to the commercial register. A change in the shareholder structure only becomes valid when it’s displayed in the register, so you can’t do it without a notary.
“However phantom shares, unlike options, are a financial obligation rather than official equity in the business, so do not require notarisation. Phantom shareholders are treated as option holders though, in the event of an exit or IPO.”
While not removing the tax burden, the usage of phantom shares at least removes the “dry income” effect that occurs when stocks or options are granted to employees. In the case of phantom shares, taxes only have to be paid when the employee actually receives some cash.
Without an alternative to the tax implications of granting regular stock, Germany’s score on employee tax (timing), would probably be even lower, pushing the country’s overall rank lower still.
Yet such schemes are often prohibitively expensive for a typically cash-constrained startup. Added to these problems is the heavy bureaucracy involved in creating and managing such a scheme.
Moving existing phantom shares to Capdesk’s digital platform has helped Billie manage their scheme
When Stephan joined Billie at the start of 2020 the company was already using Capdesk, but it was him who spearheaded moving phantom shares onto the platform.
“I was impressed and surprised by how helpful Capdesk’s customer success team was. Our point of contact Sindy was really invested in helping us – she discussed every single detail and walked me through the process. It was a really good experience.
“Now we issue and keep track of all our phantom shares on Capdesk, whereas before we were printing allotment letters and offers and then physically storing them somewhere. At the time, those documents were the only way we knew how many shares were given and the vesting schedule of them. On Capdesk, it’s faster to search and much easier to find what I’m looking for.”
This not only allows Billie to record the data in one up-to-date location, ready for investors and other equity holders at a moment’s notice; it has another major benefit too. Rather than issue the phantom shares once or twice a year and largely forgotten about, it vests month by month, meaning that employees are much more aware of the equity being issued to them and thus much more likely to be motivated by it.
“Capdesk has made equity simple for every stakeholder to understand. They can see their shares, the scheme they’re on, the vesting schedule and the terms and conditions of the phantom share agreement. Essentially, they can check at any time how many shares they have and what their shares are worth.”
If you want to understand how Billie set up phantom shares, how that helps alleviate Germany’s legal barriers to leveraging a startup’s unfair advantage (issuing equity and thus motivating its employees), and how Capdesk can help, please contact kartik@capdesk.com.
