What Germany can teach us about employee ownership

Nigel

We currently have a German legal trainee, Sonita Roth, working with our Incentives team at Burges Salmon. One of the pleasures of meeting overseas (trainee) lawyers is that you start comparing things you would not ordinarily think to compare.

Believe it or not, our conversation did not begin with share plans. We were talking more generally about the different economic traditions of Germany and the UK: ownership, participation, the relationship between employees and companies and where remuneration ends and investment begins.

Eventually - perhaps inevitably - we realised that we were really talking about employee equity. We were not quite at Hegelian levels of dialectic: thesis, antithesis, synthetic equity (lol). But the contrasts seemed worth exploring.

I had started with an instinct often encountered in UK incentives practice. If we want employees to participate in the value they help create, genuine equity feels like the natural destination. Options, growth shares, EMI, CSOP and similar arrangements are different legal routes through which we often seek to give employees exposure to equity value, sometimes culminating in ownership.

Virtual equity can then look like an approximation. Give the employee the economics of shares without actually giving them the shares.

Sonita, quite rightly, challenged that premise.

Why assume ownership is the thing we are trying to reproduce?

Perhaps the more useful starting point is to separate four things that equity incentive arrangements often bundle together:

• legal ownership

• economic exposure

• remuneration character

• tax character.

They overlap, but they are not the same.

An employee can acquire shares as remuneration and then receive subsequent growth as a return on capital. A virtual award may remain employment remuneration while giving the employee substantial exposure to the future value of the business. An option can create powerful alignment long before the employee owns a single share.

Even the UK provides obvious counterexamples to the idea that ownership must be the destination. An EMI option holder may participate economically for years before becoming a shareholder, perhaps exercising only immediately before an exit. A phantom plan may be chosen deliberately because the owners want employees to participate economically without sharing the equity itself.

So perhaps the interesting question is not whether the UK believes in ownership while Germany believes in remuneration. It is what German practice can teach us about which elements of ownership an equity incentive actually needs.

Sonita

That feels closer to the German experience.

Virtual equity - virtuelle Beteiligungen - is particularly familiar in German start-ups and private companies, including companies structured as a GmbH. There are practical reasons for that.

Giving an employee genuine GmbH equity does more than give them an economic interest. It brings the employee into the corporate structure as a shareholder. The acquisition and transfer of GmbH interests can involve notarial formalities; changes in ownership interact with the shareholder list; and shareholders have statutory information and inspection rights.

Those consequences can, to some extent, be managed through the company’s constitutional and contractual arrangements. But if the commercial objective is simply to allow an employee to participate in value created before an exit, genuine ownership may import considerably more legal architecture than the economics alone require. 

A virtual share plan can take a different approach. It can provide wirtschaftliche Teilhabe - economic participation - without gesellschaftsrechtliche Beteiligung: formal participation as a shareholder.

But our discussion also made us wary of describing this as “the same economics without the legal complexity”. It is not.

A conventional virtual award is a contractual claim. The employee is not a shareholder, which changes the nature of the risk as well as the rights. The plan must decide what it means to replicate equity: whether dividends are reflected, how dilution is treated, how preference rights affect value, what constitutes an exit, who funds the payment and what happens if the obligor cannot pay.

Real equity answers some of those questions through the capital structure itself. Virtual equity must recreate, through contract, whichever answers the parties want.

Virtual equity is not ownership with the inconvenient features removed. It is a different instrument.

The tax treatment reinforces the distinction. A conventional virtual award will generally operate as a contractual compensation arrangement rather than an investment in the company. German wage tax will ordinarily arise when the eventual cash payment is received, with the employer responsible for withholding. Social security contributions may also arise, subject to the applicable rules and contribution ceilings.

There is no acquired shareholding whose subsequent growth can be separated from the employment reward. The cash payment remains employment income.

Genuine equity requires a different analysis. Where an employee acquires shares, an employment tax charge may arise on any benefit received on acquisition, while subsequent appreciation may potentially represent a return on the asset. German tax analysis must therefore distinguish the employment-related benefit from any later investment return.

Germany has also sought to make genuine employee ownership more workable. The Zukunftsfinanzierungsgesetz - the Future Financing Act - increased the tax-free allowance for qualifying employee share awards from €1,440 to €2,000 and widened the scope of the deferred-tax regime under section 19a of the German Income Tax Act.  That regime applies to qualifying capital participations transferred to employees and does not simply extend to every arrangement linked economically to share value.

Conventional virtual awards fall outside those employee capital-participation rules. The German Finance Ministry’s guidance expressly excludes virtual interests consisting of contractual bonus promises.

So what are we actually trying to say?

We started by wondering whether Germany and the UK had different philosophies of employee ownership.

We ended up somewhere more interesting.

Take the same commercial problem in each country. A growth company wants 30 senior employees to participate meaningfully in value created between today and an exit. It does not particularly want those employees involved in current governance.

There is no single answer called “equity”.

The company could issue shares now. It could grant options, so that ownership arises later. It could create a growth instrument exposing employees only to value above a hurdle. Or it could promise a cash payment calculated by reference to the value shareholders eventually receive.

Each choice creates a different combination of ownership, economic exposure, tax, funding, accounting, governance and employee protection.

The optimal answer may differ between a UK company and a German GmbH. But that does not necessarily reveal competing national philosophies. It may simply reflect the different costs each legal system attaches to the available choices.

And that distinction matters when designing global plans. The question should not be: how do we reproduce our UK equity plan in Germany? Nor should it necessarily be: how do we give everyone shares?

A better question is: which characteristics of ownership does this incentive actually need?

That returns to the four things we started with. Legal ownership raises questions about voting, information and governance - precisely the features our hypothetical growth company did not particularly want its employees to acquire.