Employee share ownership without the tax pitfalls: Hurdle Shares as a smart solution for start-ups and medium-sized limited companies
Employee share ownership without the tax pitfalls: Hurdle Shares as a smart solution for start-ups and medium-sized limited companies
In growth-oriented companies, retaining key personnel in the long term is a crucial factor for success. This is particularly true for Start-ups Medium-sized limited liability companies (GmbHs) are often faced with the question of how employees and managers can be given a meaningful stake in the company – without immediate tax liabilities, cash outflows or an undue dilution of the existing shareholder structure. The model known as the Hurdle Shares, also known as Growth Shares.
This share ownership model makes it possible to give employees a targeted stake in the company’s future success – and, subject to certain conditions, on a tax-neutral basis at the time the shares are granted.
What are hurdle shares?
Hurdle shares are a special class of company shares that participate exclusively in a company’s future increase in value. The holder of such shares therefore only derives a financial benefit once a predefined company value – the so-called hurdle – has been exceeded. The aim is, on the one hand, to protect existing shareholders from new shareholders sharing in the value of the company that has already been built up. On the other hand, new shareholders should nevertheless be given the opportunity to benefit from future growth – in as tax-neutral a manner as possible.
By way of illustration: Let’s assume a company currently has an enterprise value of 5 million euros. An employee is granted hurdle shares with a hurdle set at precisely this amount (relative to their shareholding). If the company is subsequently sold for 8 million euros, the employee will only share in the capital gain of 3 million euros (proportional to their shareholding) – but not in the company’s existing value. This ensures that the new shareholder is truly rewarded only for the added value created collectively.
Tax-optimised investment – why the threshold is crucial
A key advantage of the hurdle share model lies in the tax planning opportunities it offers. If an employee is granted a stake in the company in the form of ordinary shares – i.e. without a hurdle – this generally results in what is known as a non-cash benefit. This is certainly the case if the company already has a significant market valuation.
The benefit in kind is taxable as remuneration, which results in an immediate liability for income tax upon the grant of the shares. For the employee, this may entail a considerable tax burden without any corresponding inflow of cash (so-called. Dry Income-Effect). The company also has a duty to assess this benefit, report it and, where applicable, deduct income tax.
In contrast, in the case of hurdle shares – provided the hurdle is structured correctly – no monetary benefit arises initially. If the value of the shareholding is effectively zero at the time of grant, because the shares only entitle the holder to a share of future capital gains, no income tax is payable.
Taxation is deferred until the time of a subsequent sale or distribution and is then applied – depending on the size of the holding and the holding period – either via the partial income method or through the flat-rate withholding tax. This results in a genuine ownership interest, where the tax liability is limited to what has actually been generated.
How will the model be implemented in legal terms?
Although the hurdle shares model originally stems from the Anglo-Saxon legal tradition, it can be applied in the German law governing limited liability companies (GmbH) implement in a legally compliant manner. The technical implementation is usually carried out by creating a new share class as part of a Amendment to the Articles of Association.
This new class – often referred to as ‘B’ shares or ‘H’ shares – is granted specific economic rights. Central to this is the contractually stipulated threshold which defines the company’s value at which a share in the profits or proceeds of sale actually begins.
The threshold itself may be set as a fixed amount in euros or determined on the basis of a well-founded company valuation. In some cases, interest is also applied to this amount, for example to reflect the time value or the existing shareholders’ interest in capitalisation. The specific terms and conditions – such as those relating to the transferability of shares, vesting periods or clawback rights in the event of early departure – are usually set out in a supplementary Shareholding Agreement regulated.
As the issue of new shares or the transfer of existing shares in a GmbH must always be notarised, careful legal guidance is also required in this instance. Furthermore, to safeguard against the tax authorities, it is strongly recommended that a transparent company valuation be carried out, which objectively underpins the set hurdle value; ideally, a financing round will have taken place shortly before the issue of the hurdle shares, the valuation from which can be used as a basis.
Which businesses is this model suitable for?
The hurdle-share model is particularly well suited to companies that wish to motivate entrepreneurial-minded employees or managers in the long term – without having to share existing equity or trigger any immediate tax consequences.
Start-ups benefit particularly greatly from this, as they often lack the financial resources to compete with market-rate salaries, but can offer the prospect of equity. However, medium-sized companies wishing, for example, to set up a management share scheme or incentivise external consultants can also use hurdle shares to secure their growth targets.
Similarly, hurdle shares are frequently used in the context of private equity investments, where senior management is to receive a share of the proceeds from a future exit – without this giving rise to any tax risks for the company or the investors.
Conclusion: Investment with a long-term perspective
Hurdle Shares offer a smart, flexible and tax-efficient way of giving key personnel a stake in a company. They create genuine performance incentives without unduly diluting existing share structures or triggering premature tax liabilities. They are therefore an ideal tool for any company seeking to grow – together with the people who make that growth possible.
However, the design and implementation of a hurdle-share model requires Expertise in company law, Tax Law and Valuation Practice. Only with sound contractual and tax structuring can the full potential of this instrument be realised – and risks avoided.
Our law firm provides you with comprehensive support throughout the process – from the conceptual design right through to the legal implementation. Please feel free to contact us, if you are considering offering staff or managers a stake in the business – we will work with you to develop a solution that suits your company.