The entrepreneurial journey is full of surprises, and progressing "according to plan" can sound like an oxymoron. Nevertheless, a flexible plan helps founders anticipate potential scenarios rather than merely react to them.
This blog sets out to address selected legal and tax topics affecting the shareholdings of founders in early stage startups in Switzerland. It assumes they will incorporate a Swiss company1, allocate initial common shares among themselves, and be granted during the startup's development phase the rights to acquire additional common shares as part of an employee stock option plan ("ESOP").
1. When should founders formalize their contractual relationships?
Prior to the startup's incorporation, the degree with which founders choose to address (or not) their contractual relationships depends on factors such as prior experience (first-time founder or repeat entrepreneur), risk tolerance, initial funding, and business knowledge. These arrangements can be memorialized in a written document sometimes referred to as a "founders' agreement" before or after the company is formed.
The incorporation of the startup is made before notary in a formal meeting during which the founders determine their share entitlement and adopt the startup's initial articles of associations. It requires them to pay-in at least CHF 50'0002 or CHF 20'0003 towards the company's initial share capital. This milestone may serve as trigger to establish a legal framework that reflects the founders' shared vision.
A shareholders' agreement ("SHA") is an effective instrument for this purpose. It can be tailored to the startup's initial situation, typically with a single class of common shares held by the founders. A clear, transparent SHA outlining the project's vision, implementation, and handling of changing circumstances helps identify and resolve misalignments early on. This approach reduces the risk of future disputes that could stall the project or deter investors, who value cohesion among founders.
If founders do not adopt a SHA, the legal framework will likely be established during the startup's first financing round with experienced investors. By that point in time at the latest, the startup will typically have market-standard articles of association, a SHA, and employment or consultancy agreements with key individuals. Other arrangements may include an ESOP, possibly supported by conditional capital in the case of a Swiss corporation.
Takeaways and practical tips:
- Founders should understand the available contractual and corporate law mechanisms and how to adapt them to their needs.
- Before incorporation, commitments among founders are purely contractual. They can anticipate the company's formation by including it as a party "in formation" in their agreements, with rights and obligations transferring to the startup upon its effective incorporation.
2. Which contractual tools can regulate relationships among founders?
Founders can use various tools to regulate their shareholdings and the startup's governance, including qualified majorities, share transfer restrictions, and a dynamic equity split.
Qualified Majorities
The Swiss Code of Obligations requires simple or 2/3 qualified majorities for certain shareholder decisions and simple majorities for board decisions. A founder's initial shareholding therefore plays a determining role in this context.
With a view towards benefiting from more leverage and flexibility beyond the mere participation in the startup's share capital, founders can establish qualified majorities for decisions to be passed by the shareholders or board of directors, thereby complementing the catalogue of decisions or increasing the majority threshold set forth by law.4 Examples include issuing new shares or changing the rights or preferences of any shares (shareholder decisions) as well as approving major strategy changes or an annual budget (board decisions).
Transfer Restrictions
Founders typically have a long-term vision, which requires stability in the founding team and their shareholdings. It is therefore important to regulate the terms for transferring shares held by a founder.
Corporate law allows the articles of association to subject share transfers to the approval of the board of directors for a corporation and of the shareholders in a limited liability company. A SHA can add further restrictions, such as rights of first refusal, tag- or drag-along rights, and purchase options.
A purchase option is particularly useful for anticipating changes in circumstances that may materially affect the founders and their project. It grants parties to the SHA an irrevocable option to buy another party's shares in predefined situations. Oftentimes, the availability and exercise terms of the purchase options differentiate between scenarios along the lines of a bad or good leaver concept. For instance, if a founder seeks to transfer shares in violation of the SHA or commits a criminal act against the interests of a party to the SHA or the startup, the purchase option may apply with a punitive purchase price (e.g., the lower of the fair market value and the nominal value of the shares held by such founder). Conversely, if a founder dies and his shares are transferred by law to his heirs, the option might not apply, provided the transferees adhere to the SHA. Similar rules may apply to other cases, such as a change in matrimonial regime, judgment or in case a founder becomes insolvent.
Dynamic Equity Split
At incorporation, founders allocate among themselves the rights to subscribe shares based on their past or anticipated contributions towards the startup's development. In this context, a large array of contributions comes into play. For example, founders can contribute their (co-)ownership rights in a patent or other key intellectual property, their expertise in business/technology development or management, or initial funding. For the avoidance of doubt, it is assumed that each of the founders pays-in in cash the amount required to receive their portion of the startup's shares at incorporation in accordance with their internal allocation; as used in this blog, the term contribution does not refer to a liberation of the startup's share capital by way of a contribution in kind (Sacheinlage / apport en nature), which raises other legal and tax questions.
It is challenging to accurately predict the value of each founder's contribution during the startup's initial growth phase, and thus the validity of the internal share allocation among founders. While they must agree on an initial share allocation, founders can also use a "dynamic equity split" by entering into agreements among themselves and the startup to readjust their shareholdings after a set period to fairly reflect each founder's actual contribution to the startup's value creation. This could be applied for instance if the contribution of one founder represents a larger opportunity for the startup's business than initially contemplated. Any increase of shareholding post incorporation may, however, qualify as taxable income triggering income tax and social security contributions without any corresponding cash income (see point 3. below).
Takeaways and practical tips:
- Establish a governance structure that avoids stalemates and provides a clear path for resolving disputes. Qualified majorities at the shareholder and board levels can enhance decision-making flexibility.
- Regulating the holding and transfer of shares is essential.
3. What is the difference between "founder shares" and "employee shares"?
Entrepreneurship is a high-risk, high-reward journey. Founders who are actively involved in the startup's development will typically receive a compensation accounting for the fact that the startup has limited funds available. Part of their compensation package may include equity or equity related rights to acquire additional common shares under the startup's ESOP.
In general, the primary financial incentive for founders is a successful exit transaction, such as a company sale (share deal) or an IPO. They are incentivized to create value for their startup, which increases the worth of their stake at exit, even as their initial holdings are diluted by new equity issued to employees and investors.
By the time of an exit, it is therefore not uncommon for founders to hold common shares issued at incorporation and additional common shares (or options to acquire such additional common shares) issued subsequently in connection with their employment relationships. While these participations may be of the same class of shares under corporate law, they are subject to a fundamentally different tax and social security treatment.
"Founder shares" are the initial shares issued to founders at the startup's incorporation. For Swiss-domiciled individuals holding these shares as private assets, any capital gain upon sale is tax-free, provided that certain conditions are met. In addition, timing is a determining factor: any reallocation of founder shares post incorporation bears the risk for the receiving part that such shares be regarded as compensation and not as "founder shares" based on the individual circumstances. This timing consideration would apply if co-founders implement the abovementioned dynamic equity split or if a co-founder is prevented to acquire her initial stake in the startup at incorporation (e.g., due to such co-founder being bound by a non-compete undertaking or an employment relationship terminating following the incorporation). For an overview of the relevant tax conditions pertaining to founder shares, see the blog "Fokus Steuern – Investoren und Gründer: Steuerfreier Kapitalgewinn".
"Employee Shares" are shares that do not qualify as founder shares and are granted as compensation for employment or other services. They are taxed as (employment) income. While a portion of the sales proceeds from employee shares in an exit can be a tax-free capital gain, the remainder is subject to income tax and social security contributions. The taxable portion depends on factors like the valuation methodology applied to the shares and a potential requirement of holding the shares during a 5-year period, which vary based on the founder's canton of domicile. In addition, founders must also comply with tax and social security obligations when they acquire these shares assuming that they have then earned a monetary benefit corresponding to the difference between the issue or exercise price and the market value of these shares. For an overview of the relevant tax considerations pertaining to participations of employees in startups, see the blog "Fokus Steuern – Mitarbeitende: Beteiligung am Erfolg des Startups".
Takeaways and practical tips:
- Founders should recognize the significant tax benefits of "founder shares" and manage them accordingly (e.g., by labelling them as such in tax returns).
- A tax ruling can confirm the qualification of "founder shares" and is generally recommended in complex situations.
- A startup establishing an ESOP should carefully comply with tax requirements to maximize the potential tax benefits for all beneficiaries.
Footnotes
1. As a corporation (Aktiengesellschaft / société anonyme) or limited liability company (Gesellschaft mit beschränkter Haftung / société à responsabilité limitée).
2. For a Swiss corporation, the minimum required share capital of CHF 100'000 can be paid-in at 50% at incorporation, with the founders remaining liable to pay-in the outstanding portion of 50% if called by the company.
3. For a Swiss limited liability company, the minimum required share capital of CHF 20'000 must be fully paid-in at incorporation.
4. Other tools exist to separate decision-making power from capital participation. For instance, founders of a Swiss corporation may find it useful to create shares with preferred voting rights (Stimmrechtsaktien / actions à droit de vote privilégié).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
