Employee participation - financing options for companies in crisis

(Last update: 29 April)

Little attention has been paid to employee participation to date in the context of the corona pandemic and the accompanying economic crisis. Employee participation offers various possibilities to provide the company with liquidity or to reduce wage expenses, and at the same time to create an incentive to increase the company’s success beyond the mere preservation of jobs.

Companies should not stop at creative solutions to combat the corona crisis and its economic impact. Especially in times of crisis, employee share-ownership schemes offer companies the opportunity to strengthen their liquidity in addition to or instead of equity capital, and to avoid external financing and the associated provision of collateral. The participation of employees in the company can thus help to overcome financial bottlenecks and contribute to the company's continued existence as well as to bind employees to the company and provide incentives to increase the company's success. 

In contrast to other countries such as France - where corresponding employee share-ownership schemes also contain more far-reaching tax and social security incentives, however - this possibility is still greatly underrated and neglected in Germany, primarily because it subsidized to only a limited degree. The ownership of shares by employees does not automatically mean a restriction of entrepreneurial rights. Employee participation in the company does not only have to take the form of a share in the equity capital, it can also be in the form of a share in the borrowed capital or a hybrid form between the two.

The right choice of employee participation depends on many factors. In the current situation, in which quick action is required, there is much to be said for employee participation models on a contractual basis. The most important forms of employee share-ownership schemes are:

1. Granting of borrowed capital

A particularly recommendable “entry model” into employee participation schemes in the company is the employee loan. With an employee loan, the employee acts as lender vis-à-vis the employer. By granting borrowed capital, the employee has a less far-reaching commitment to the company than in case of a participation in its equity capital, as the employee is not granted any right of say under company law. The capital is only available to the company for a limited period of time and generally does not participate in any losses of the company, but may, under certain circumstances, earn interest depending on the company’s results. In order to create special incentives, a profit-based or turnover-based interest rate can be agreed (so-called profit-sharing loans).

It should be noted, however, that the repayment of the employee loan generally has to be secured; be this to enable a subsidy under the German Capital Formation Act [Vermögensbildungsgesetz] or for banking law reasons. For employees, the risk of the employer’s insolvency can therefore be excluded; for the employer, however, the attractiveness of employee participation decreases in comparison with debt financing on the free market.

The interest income on an employee loan is basically classed as income from capital assets for employees, which is subject to flat rate withholding tax plus related taxes. Please note: If no interest rate is agreed, then this is not an employee loan, but just a simple deferral of salary.

2. Hybrid instruments

Also conceivable are contractually arranged hybrid forms between equity and borrowed capital. Depending on the contractual term and conditions, such as subordination, these schemes concern equity capital, or otherwise borrowed capital.

Profit-participation rights are pure property rights that can be issued regardless of the legal form of the company. They offer great flexibility with regard to the detailed arrangements for repayment and current interest returns. By concluding a profit-participation agreement, the holder of the profit-participation right (the employee) undertakes to make the capital arising from his participation available to the issuer of the profit-participation right (the company). In return, the holder of profit-participation rights is granted shareholder-equivalent property rights, such as profit rights and participation in liquidation proceeds. A loss-participation avoids it being classed as a deposit transaction here. Depending on its structure, the profit-participation right can also have the character of equity capital.

With a silent participation, the employee participates in the trading activities of the company and shares in profits and losses (insofar as this is not a deposit transaction) without acting as a shareholder at the external level. The silent partner typically has certain rights of inspection; however, he is not regularly granted a right of say.

Inflowing profit shares are generally also subject to flat rate withholding tax plus related taxes as preferential income from capital assets. In the context of an overall assessment, however, there is also a risk that (non-preferentially taxed) wages will be assumed.

3. Equity participation

The participation of employees in the company’s equity through the granting of shares in the company is the most far-reaching form of employee participation, in which the employee participates fully in the profits and losses of the company and is granted all membership rights under company law. Particularly in times of crisis, this is difficult to implement in case of a broad circle of employees, as shares first have to be created via a capital increase. At the same time, valuation issues arise that lead to tax risks, especially in case of non-listed companies. The advantage is that liquidity is acquired without the company having to grant anything in return. Only the current shareholders "dilute" their share quota in the company as a result of the newly issued shares.

It is conceivable to only issue options instead of the immediate issue of shares. This is established on the market for members of executive bodies, who are regularly remunerated through stock option schemes. Under certain conditions determined by the company, such schemes entitle the holder to receive shares in the company at the end of the term. In times of crisis, however, this is only sensible if the introduction of the scheme is accompanied by a reduction in salary in order to achieve liquidity effects. However, a waiver of already earned salary components in favour of company shares leads to wage taxation. Participation in the later success of the company through the increased value of the company shares is more advantageous from a tax point of view, however, as the sale is subject to the flat rate withholding tax plus related taxes.

4. Virtual replication

Finally, a conceivable option is to replicate the participation in equity capital with purely virtual company shares. The employee does not acquire any membership rights (rights to vote or participate in shareholders' meetings) through a virtual share in the company, just property rights. Depending on the structure, he participates in dividends, liquidation proceeds and also in the sale of companies or shares (the latter especially in the start-up sector) as a shareholder. The scheme may also provide for a payment at the end of the term that corresponds to the stock market price or proportionate enterprise value. Through the purchase of the virtual options, the company is immediately provided with liquidity, which only flows back to the employee in the event of future distributions and, if applicable, after the term of the scheme, in line with the increased or decreased share price or enterprise value. 

In the case of non-listed companies, the main problem here is the valuation of the company upon acquisition of the virtual shares and, depending on the structure, at the end of the term. Compared to the other participation schemes, however, the virtual arrangement has the advantage of an immediate injection of liquidity without having to increase borrowed capital and create company shares. 

Inflows to the employee are not tax-privileged, but are treated like regular wages.

5. Legal information

5.1 Corporate law

Depending on their arrangement, employee share-ownership schemes substantially interfere with the structure of a company. It therefore has to be ensured - even in the case of contractual arrangements - that the schemes are introduced in conformity with the provisions of the articles of association and that any rights of consent of the shareholders’ meeting are taken into due account.

5.2 Labor Law

First and foremost, employee share-ownership schemes can be concluded by individual contractual agreement with the employee.  

However, when granting such participation opportunities, the employer is bound by the principle of equal treatment, for the opportunity to participate in the company constitutes an advantage on grounds of the employment relationship if it is not also open to third parties outside the business on the same terms. This means that the employer must offer such a scheme to all employees.

Co-determination rights of the works council might also be affected by corresponding employee participation schemes of the company. A co-determination right of the works council pursuant to § 87 (1) No. 10 German Shop Constitution Act (Betriebsverfassungsgesetz - BetrVG) is particularly relevant here. However, the fundamental decision on whether and in what volume a participation is going to be granted is not subject to co-determination and is a voluntary decision of the employer.

Usually, such schemes are also concluded with the works council as voluntary shop agreements within the framework of § 88 No. 3 BetrVG.  

6. Acceptance by employees

In all events, such employee participation schemes regularly meet with great acceptance among employees, particularly because they can secure a job that might be at risk and, if the employees successfully survive the crisis, they can also participate in the upswing. In addition, there are at least some minor tax advantages. 

However, a wrongly structured model can also have negative effects. For example:

In the event of liquidity bottlenecks during the crisis, it is particularly interesting for companies to link employee participation to deferred compensation or salary waivers. Here, the employer can agree with the employee not to disburse the profit-sharing in cash, but to keep the capital in the company and have it granted to the company, for example as a low-interest loan. One problem that arises in this respect is that, even if the salary remains in the company, the employee regularly has a taxable inflow of salary because - from a purely economic point of view - the employee has already disposed of the sum of money. Especially in cases where the employee waives his salary completely, this tax burden can make corresponding participation models more difficult or even prevent them.

7. Conclusion

Employee share-ownership schemes can help the company to obtain liquidity quickly during a crisis. When choosing the scheme, the desired effects on both the employer and employees should be carefully considered to ensure a scheme is set up that meets the requirements.

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