Incentive Plans for Startups - How do you do it right?
A well-designed LTI can boost your business when you plan ahead and prevent adverse consequences for your startup, shareholders and employees. But how to do it right?
Options, tokens, deferred cash plans – long-term incentive plans (LTIs) come in many forms. A well-designed LTI can support a startup’s agenda by attracting, retaining and motivating talents, supporting business goals but also increasing tax/cost efficiency. However, whereas the definition of the right design is already challenging, the implementation (such as drafting legal documents) is equally important to avoid nasty surprises. Setting up an LTI correctly spares startups from potential issues in the future, such as employees claiming irrevocable promises resulting in unpleasant (and often costly) challenges.
To ensure that your LTI is an asset rather than a pain, we recommend considering the following:
How do you design a “fit for purpose” LTI?
Startups often seek best practices, but what characterises a well-designed LTI? There are many possibilities and what works for others may not be ideal for you. As a first step, it is key to articulate the general direction, i.e. choosing between cash and equity:
Cash LTIs allow more flexibility, are simpler to administrate and preserve the ownership structure. However, such LTIs are a liability for the company.
Share LTIs create strong alignment and allow for tax-free private capital gains in Switzerland. The accounting treatment can be more beneficial. On the other hand, such LTIs impact the ownership structure and are more complex to administrate.
Based on the decision regarding whether a cash or share LTI will be implemented, the design criteria such as instrument, eligibility and vesting conditions need to be defined. For share LTIs, the determination of a tax-relevant share value is crucial. This is especially important to avoid negative surprises upon sale of the shares, i.e. to prevent a portion of the sale proceeds from qualifying as employment income
Why are proper plan documents key?
Plan documents provide employees with the relevant information on the design of the LTI, but also protect the employer from risks. Therefore, these documents should be on your radar as of day 1:
- Term sheet: “skeleton” of the plan rules, which is used to define the design; to be discussed with relevant stakeholders (shareholders, BoD, etc.)
- Plan rules: Contractual basis and essential to protect against risks; critical to balance general vs. specific wording, e.g. allowing for company discretion but ensuring legal certainty, defining termination provisions
- Tax ruling: Obtain clarity on tax treatment and employer obligations, especially focusing on the tax-relevant share value (tax-free private capital gain)
- Shareholder agreement (SHA): Long-term risk prevention, e.g. right of first refusal and tag along/drag along rights
Anything else to consider?
It is crucial to keep the big picture in mind:
- Existing shareholders and founders may be affected, e.g. potential impact on their wealth tax needs to be analysed
- Monitoring of affordability and cash flow
- New and past agreements need to be harmonised, e.g. other SHAs and valuation methods
- Communication is key to help stakeholders (i.e. shareholders and employees) understand and appreciate the incentive