The Klarna case and employee shares in the German Startup Strategy

With its startup strategy, the German government has set itself the ambitious goal of strengthening the startup ecosystems in Germany and Europe. The following measures– often looking at successful entrepreneurship lessons from the USA, however with a very German social democratic twist– are supposed to help:

1. Strengthen financing for startups

2. Help startups to attract talent including through improved employee ownership opportunities

3. Develop a spirit of entrepreneurship and facilitate the setting up of new businesses including digitally

4. Strengthen female entrepreneurs and support diversity in startups

5. Facilitate startup spin-offs from science and universities

6. Improve the policy environment for startups which serve the common good

7. Mobilise startup competencies for public contracts

8. Make it easier for startups to access data

9. Strengthen regulatory sandboxes and facilitate access to them for startups

10. Put the focus on startups

 (vgl. Start-up-Strategie der Bundesregierung, Artikel BMWK vom 27.07.2022) 

 Since quite a while, the startup scene in Germany demands material aleviations in the taxation of employee shareholdings in startups and less bureaucracy when issuing "real" company shares in German limited liability companies. However, the former Federal Minister of Finance had only raised the tax allowance for certain forms of employee shareholdings and ensured that employees no longer have to pay tax on their shareholdings immediately, but on the occurrence of certain events before exit. The actual status quo of the legal and tax landscape for employee shareholdings in Germany requires i.a. a taxation in case of a transfer of the shares, in any case after twelve years (without any liquidity event) or and in case of a change to another employer; for details see below.

The starting point for the improvements in taxation as intended by the startup strategy of the German government is supposed to be a corresponding amendment to income tax law with the clear aim of basing taxation as far as possible on the actual flow of liquidity:

• The tax-free allowance for employee shareholdings (Section 3 No. 39 of the German Income Tax Act (EStG)) is to be significantly increased. According to the Key Points for a Future Financing Act as published by the German Federal Ministry of Finance end of June 2022, this is to be increased from currently EUR 1,440.00 to EUR 5,000.00.
• The provisions on deferred taxation of non-cash benefits from employee share ownership (Sec. 19a of the German Income Tax Act (EstG)) are to be extended.
• The German government wants to examine the amount and timing of the SME thresholds and changes to subsequent taxation.
• Possible extension of the 12-year period.
• Clarification of the question of how taxation in the event of a change of employer can be structured in a more practical manner without creating loopholes for tax avoidance.

The recent happenings at the Swedish FinTech startup Klarna by mid-August 2022, obviously illustrate the absurdity of the current ecosystem around employee share ownership: On the one hand, the company lured employees with profit-sharing schemes worth millions of euros in order to attract top talent and retain them. On the other hand, participants had to pay thousands of euros in taxes and duties for their participation program without having received any monetary benefits to date. Instead, immense amounts were deducted directly from their net wages - and now, due to the sharp devaluation of the company, some of the employees' shares are worth less than the taxes they have already paid for them. Following Klarna's announcement in 2019 that employees would participate directly in the company's success story through shares, the employee share ownership program was introduced in 2020 and the shares were distributed at historically high valuations: after Klarna was valued as high as $45.6 billion in 2020, however, the valuation today is only $6.7 billion. As a result, employees are suffering significantly under the participation program, which is said to have been poorly constructed by Klarna. The German participants already had to pay several thousand euros in taxes and duties when they signed the contract, directly from the often more than their shares are actually worth. This is because Klarna chose the international standard form of "restricted stock units" (RSU), whereby employees receive real shares after a certain period. The problem here is that payroll taxes and duties must be paid on the shares immediately upon allocation. The example of Klarna shows that employees in this ecosystem are not protected against loss of value and in fact bear a considerable risk of loss. This is clearly contrary to the understanding of an attractive employee share ownership scheme, making an RSU program unattractive in Germany. For (mostly) internationally active companies, it would of course be more attractive to be able to offer a uniformly structured participation program from which employees can benefit equally. 

Driven by the legal and tax requirements, a distinction must be made between the following forms: (i) so-called "real" employee share ownership plans in the sense of granting shares in a company (usually shares in a GmbH or UG), (ii) so-called ESOPs - i.e. the granting of option rights to shares in a company, and (iii) so-called VSOPs, the granting of virtual participation rights in an exit and, if applicable, other liquidity distributions.

The legally standardized taxation date of "real" employee shareholdings is far removed from the real needs of the startup scene. Since July 1, 2021 (by the so-called "Fondsstandortgesetz"), employees of startups have been able to benefit from certain tax advantages (avoidance of "dry income") compared to the status quo applicable until then, but the tax burden on the employee participation is incurred in full when the employee changes employer or after twelve years at the latest. As a result of this well-intentioned but unrealistic regulation, the time of taxation still does not fall on the exit - i.e. no longer on the time when there would normally be cash to distribute. The recently published startup strategy by the German government shows at least a reflectionto extent the 12-year period but doesn’t give any indication of how taxation in the event of a change of employer will be structured in the future. The Key Points for a Future Financing Act as published by the German Federal Ministry of Finance end of June 2022 do not even mention such reflections.

However, the timing of taxation for ESOPs is also far removed from reality. Such share options entitle employees to receive "real" shares in the company in the future. For this purpose, an exercise price is usually fixed at the time the option is granted, based on the market value at the time the option is granted. If ESOP employees then exercise their option rights, they typically pay only the contractually agreed exercise price for the shares they receive. However, the shares usually have a significantly higher market value (in the meantime) - otherwise exercising the option would not make economic sense. The difference between the (low) exercise price and the meanwhile higher market value of the shares represents a non-cash benefit which the employees must immediately pay tax on as income - even though the benefit has not yet been realized in cash; to this extent alone, there may be constitutional reservations about taxation at this point in time from the point of view of performance.

In order to pay the tax, many employees would have to (partially) sell their shares. In the case of startups, however, two serious problems arise: (i) firstly, how can the value of the shares be determined if there is no market value at the moment and (ii) secondly, how can shares be sold in the absence of a market (i.e. in the pre-IPO phase) in order to bear the tax burden. Thus, the tax claim would mean private insolvency for most employees in the worst case. For employee shareholdings in startup companies, the current taxation timing is therefore obviously unsuitable. At best, it can be understood as a means of generating taxable substrate at an early stage while not being exposed to any further risks to the economic development of the company, i.e. the state does not want to bear the risks to which the employees are exposed. A more effective approach would be to follow the realization principle and thus the ability-to-pay principle and have taxation take effect only when the acquired stake is sold. The government is now trying to approach this goal with its strategy.

Benefits from employee participation programs are qualified as an outflow of employee activity and are therefore subject to wage tax regulations, which results in taxation at the personal progressive income tax rate of up to 45 percent. This ignores, at least in the case of startups, the character of participation from one's own entrepreneurial efforts and the bearing of the corresponding risks arising from this. However, this should rather justify a taxation comparable to that for entrepreneurs. Foreign countries (e.g. Great Britain, Israel, France, Canada, Sweden and Italy) could be a model in this respect. A comparable situation had already arisen with regard to the taxation of participations received by managers in private equity in the context of so-called carry participations. In this respect, the German legislator, also following foreign models, had granted a taxation similar to that of an entrepreneur, in which the income from the sale of the participation was favored through the application of the partial income procedure.

Legislators have already recognized that reinvestment is the best driver of further sustainable growth. Comparable to the tax benefit of retained earnings for reinvestment (Thesaurierung) as well as the so-called Sec. 6b of the German Income Tax Act (EStG) reserve, income derived from employee participation programs should be temporarily exempted from taxation if it is reinvested in companies or business startups within a reasonable period of time.

As already described, as long as there is no real market value and taxation is to intervene prematurely, investments in startups give rise to an incalculable risk for employees in the valuation of the respective share value to be carried out for tax purposes. This applies in particular to the complex structures of VSOPs, the value of which is generally determined on the basis of income. Against this background, such employee programs are difficult to negotiate. If the current regulation is to be retained, a simple, comprehensible and rather general regulation is required.

In addition to the tax framework, corporate law also makes it difficult to implement and run an employee stock ownership program simply and cost-effectively at an international level. This applies both to the direct participation of employees under company law and to the granting of options on "real" shares.

So-called "real" participation is the least common, according to the startup association's survey (s. „Mit Mitarbeiterbeteiligung zur Start-up-Hochburg“ (handelsblatt.com)). The main reasons for this are as follows: According to company law, employees must be involved in all important decisions, for example in financing rounds. In the view of many founders, this is a hindrance to the development of the startup. Overall, this would result in high organizational, bureaucratic and financial costs for decision-making among the shareholders. The constant participation of employees proves to be impractical for the very dynamically operating startups, since rapid decisions are often necessary, especially in development phases, and the complex shareholder structure and compliance with formal requirements and deadlines can paralyze the process or even prevent it.

Up to now, attempts have been made to counter these problems under company law by means of trustee structures. Instead of this detour, it would be more expedient to permit a separate "employee share class" which, like preferred shares, only reflects passive capital participation without voting rights and whose issue and transfer is possible quickly, easily and digitally and, in particular, does not require notarization, even if this would mean a (sensible) paradigm shift in German corporate law. 

Due to the current legal framework, most German startups mainly use virtual stock options (VSOPs), which are rather unusual by international standards, as they are much less bureaucratic and employees are not liable for tax when they leave the company. VSOPs securitize claims to payment of a monetary amount on exit.

VSOPs actually no longer have anything to do with company shares. Rather, they are a form of financial bonus-like participation in the event of success. However, the individual regulations and mechanisms can be very complex and difficult to understand, and thus non-transparent for employees, the closer the compensation is to being structured like a shareholding. Complexity can also arise from the parameters of profit sharing and the share of participation (often including tax regulations at the level of the company). (in detail: "#ESOPasap - Fair employee participation in startups - accelerating innovation and growth with entrepreneurial spirit", June 2020, p. 48 - 49).

In this respect, however, the complex construct of VSOPs is the direct result of the framework currently in place. Despite their overwhelming practical relevance, VSOPs are not considered at all in the startup strategy of the Federal government. This is surprising. For although they solve the problems under company law, there is also a considerable need for action here, since VSOPs, like all participation-like models used to date, suffer from the fact that they are ultimately classified as wages and not as a participation. A solution to this dilemma could be seen, as has already been pointed out, in a comparable regulation that would apply to employees from private equity companies in the context of a carry, because there, too, compensation is ultimately classified not as a salary but as a shareholding in a company and subjected to the corresponding taxation principles of the partial income procedure. Another step would be for employees to be granted options and for only the premium to be classified as a salary, but not the possible return on the options, which could also be zero. In order to avoid any possible arrangements, strict requirements could be imposed with regard to the holding periods or the lack of a stock exchange listing, as is already typically the case with startup companies.

Ultimately, there are only small steps that would have to be taken to create attractive framework conditions for employee participation schemes:

• The timing of taxation must be aligned with the realization of income.
• Introduction of entrepreneur-comparable taxation instead of compensation/wage-based taxation;
• Granting of a taxation break in the event of timely reinvestment of income in startups;
• Creation of an "employee share ownership" share class comparable to preferred shares

These measures would make Germany much more attractive as a home for startups in terms of the strategy's goals in a short time and thus make it more competitive internationally. In its strategy, the German government has already identified a number of starting points that could help improve the employee participation ecosystem. The task now is to implement the precise elaboration of the measures in a practice-oriented manner and not to regard them as conclusive. Rather, the startup strategy should be seen as the first stone in a domino effect in which further measures for improvement will follow.