How share plans relate to European tech M&A and the digital skills shortage

Out-Law Analysis | 15 Oct 2021 | 10:29 am | 8 min. read

The shortage of digital skills in Europe is encouraging an increasing number of Europe’s technology start-ups to turn to special share incentivisation schemes as a means of attracting and retaining staff.

A study carried out by Pinsent Masons, the law firm behind Out-Law, in partnership with other firms in its European network, identified the trend as well as associated risks that must be navigated by European technology companies when involved in mergers or acquisitions.

Share plans and the digital skills shortage

Access to skilled labour is imperative to the success of any business, particularly in the technology sector where innovation is so vital to a business’ ongoing competitiveness, growth, attractiveness and value. However, across Europe, demand for digital skills outstrips supply.

The European Commission has said that 70% of businesses report a lack of staff with adequate digital skills as an obstacle to investment. Its ambitious vision for digital transformation in the EU by 2030 includes increasing the number of ICT specialists in jobs across the trading bloc from 7.8 million currently to 20m by the end of the decade.

For its part, the UK government acknowledged, in its recently published national AI strategy, that there is a “growing skills gap in AI and data science” and that the UK “needs a larger workforce with AI expertise”. A separate report published in May 2021 confirmed that the government estimates there to be around 178,000 vacancies in relation to “specific data specialist roles and those that require ‘hard’ data skills”.

There are many initiatives being run by policymakers and industry leaders to address the digital skills gap. This includes a renewed focus on upskilling existing staff, promoting the study of science, technology, engineering and maths (STEM) subjects, and seeking to encourage more women and people of black and minority ethnic backgrounds to pursue careers in technology. Employee incentivisation also has an important role to play.

Caroline-Regitze Elstrøm

Junior Associate, Bech-Bruun

Talent attraction within the tech space is virtually impossible without offering equity upside potential

There are a range of ways that European technology companies can incentivise employees. Many start-ups either grant or offer employees a chance to acquire shares in the company. This provides the employees with scope to benefit financially from growth in the value of the shares over time, including in cases where a company elects to go public or seeks fresh private investment. As Caroline-Rigetze Elstrøm from Danish law firm Bech-Bruun puts it, “talent attraction within the tech space is virtually impossible without offering equity upside potential”.

According to Rafal Rapala and Adam Czarnota of Kochański & Partners in Poland, such schemes can be important for retaining existing personnel too. They said: “Management incentive plans are far more common, often introduced for upcoming initial public offerings (IPOs) of developing companies. These plans are directly connected to successful execution of the introduction of the company to the regulated market and usually are meant to keep the key managerial employees on board after the IPO. This way, the company can secure a steady course and encourage potential investors to make significant bids.”

Rapala and Czarnota said that a company that implements an employee stock ownership programme can enhance its image in Poland. They said such companies are “perceived as being modern, and as a result will stand out positively on the market when it comes to the package of non-salary-related benefits provided to employees”.

Issues arising in the context of M&A

In many cases, prospective buyers will encounter a scenario where the target company already has a share-based remuneration scheme in place. This reflects the fact that share incentive plans can help technology start-ups to offer competitive remuneration packages to important personnel, reducing the risk of poaching by other businesses in the process, while limiting the impact on the business’ vital cashflow.

Due diligence of these often-complex arrangements is vital to understand any potential liabilities arising.

“The terms for employee stock option schemes often contain provisions on accelerated vesting in the event of change in majority ownership, but it is also possible to have provisions which ensure survival of the programme also after a change in ownership,” said Niclas Hermansson of Swedish law firm Setterwalls.

“In our experience, tech companies often have a number of different incentive schemes and a purchaser generally tends to ensure that the target company, before closing, has no outstanding obligations under any employee incentive schemes. However, it is also common for the purchaser to offer key management of the target a possibility to either reinvest or to retain them over a period subsequent closing with earn-out provisions connected to the share sale,” he said.

A major factor in whether to retain incentive schemes will be the commercial terms on which they are offered.

Niclas Hermansson

Partner, Setterwalls

It is common for the purchaser to offer key management of the target a possibility to either reinvest or to retain them over a period subsequent closing with earn-out provisions connected to the share sale

“It is very common when purchasing a company that the acquiring business discovers that the variable compensation plans in place are too generous for employees,” said Valérie Blandeau of Pinsent Masons in Paris.

“Most of the time, these variable compensation schemes have a contractual value, meaning that prior consent of the employees must be sought before implementing any change. This requires negotiations with employees and triggers costs which may be important depending on the seniority of concerned employees,” said Blandeau.

Legal and tax considerations

Beyond the commercial considerations, however, there are issues of regulatory compliance. Blandeau said that in France, businesses need to ensure that variable compensation plans are translated into French, for example. Other local law requirements apply in other jurisdictions.

Dr. Joël Hofmann of Pinsent Masons in Munich said: “Often, US, UK or other foreign share incentive structures are not in line with German law requirements, so it is important to evaluate such structures as soon as possible to avoid any exposure, in particular provisions concerning leaver events, pay out regulations and vesting. In the context of long vesting or retention periods especially, there is potential that such periods are deemed as putting unfair limitations on resignation and that they are deemed void under German law.”

One of the reasons share-based remuneration schemes have grown in popularity has been the potential tax advantages they can provide to both employers and employees. However, the tax treatment of employee stock options around Europe varies.

Gian Marchet Kasper of Blum & Grob in Switzerland said complexities may arise around tax and social security liabilities if employees are not domiciled in the same country as the employer.

SRS Advogados in Portugal said that “ratchet arrangements” designed to align the amount of equity held by senior managers with the performance of the company “are not regulated under Portuguese law” and that the question of whether the gains obtained from such arrangements are taxed as labour remuneration, subject to personal income tax and social security, or as capital gains is “currently still under discussion and may vary according to the particular structure implemented”.

In Sweden, ‘personaloptioner’ – employee stock options – “can prove costly from a tax perspective, both for the employee incentivised as well as for the employer granting the benefit”, according to Setterwells’ Niclas Hermansson.

Hermansson said: “In accordance with the provisions of the Swedish Income Tax Act, an employee is liable to pay income tax at often high rates on the date of exercise of an employee stock option, i.e. when the option is utilised to purchase shares below market value. The fact that tax liability occurs in connection with the exercise of the options and not in connection with a subsequent sale of the acquired shares has been recognised as problematic, often resulting in the employee having to sell part of the shares purchased just to finance the tax payment. An employer is also liable to pay social security contributions on the benefit received by the employee, i.e. the difference between the option strike price and the fair market value at the date of exercise.”

Yann Payen and Thomas Biermeyer

Wildgen

Beneficiary units can be issued with similar or the same characteristics as normal equity against a 'sweat' contribution, which is otherwise only possible in restricted ways under Luxembourg company law. This allows, for example, for an effective incentivisation and compensation mechanism for software engineers or similar.

Hermansson has said that SMEs in certain sectors of the Swedish economy can benefit from tax reliefs in relation to employee stock options and reduce their income tax and social security payments. However, he said the Swedish tax relief scheme has been criticised for being “unclear and too limited” in its scope and that Swedish law makers are exploring further legislative intervention in relation to the tax treatment of employee stock options.

“In light of the high taxation costs related to normal stock option schemes – and the limitations on applicability of qualified employee stock options – key employees, in our experience and if possible, often can benefit from a direct share or warrant purchase at an early stage in a company’s life cycle,” Hermansson said. “According to Swedish case law, direct share- or warrant holders can generally be retained by utilisation of reverse vesting mechanisms connected to the continued employment of the share- or warrant holder, without triggering unwanted tax consequences.”

Hermansson said that, in the context of technology mergers and acquisitions, earn-out provisions are popular among buyers. However, he said there are “substantial tax risks” involved with such provisions as Sweden’s tax agency “has been known to consider earn-out offered to management owners as salary and not consideration for equity”. This tax risk can be reduced by offering earn-out provisions to all owners – management owners and passive investors – on equal terms, he said.

Italy has a special tax regime for new resident workers as well as special tax rules relevant to share-based compensation that innovative start-ups can benefit from in particular, according to Lorenzo Stellini of Gatti Pavesi Bianchi Ludovici.

Stellini said that no tax is payable by innovative start-ups on their grant of shares to employees, irrespective of the value of those shares. A recent change also means that capital gains realised on the sale of shares in innovative start-up companies is exempt from taxation, provided that such participations are acquired through subscriptions of share capital between 1 June 2021 and 31 December 2025 and are held for at least three years.

In the case of other employers in Italy, Stellini said that tax is payable on the grant of shares to employees where the value of the shares granted by an employer exceeds €2,065.83 and provided that such shares are not repurchased by the issuing company or transferred before three years have passed.

There are also solutions to address potential tax liabilities that might arise in Luxembourg too. David Maria of Wildgen said that the allocation of free shares can be tax efficient in the country – for both resident and non-resident employees – “if well-prepared, organised and structured”. He highlighted the importance of the legal framework in Luxembourg around ‘beneficiary units’ in this context.

“A beneficiary unit is a title that can be issued by a company similar to a share or a bond, with the difference that rights and obligations can be attached in a flexible way to such beneficiary unit,” said Wildgen's Yann Payen and Dr Thomas Biermeyer.

“For example, it allows to issue beneficiary units with similar or the same characteristics as normal equity against a sweat contribution, which is otherwise only possible in restricted ways under Luxembourg company law. This allows, for example, for an effective incentivisation and compensation mechanism for software engineers or similar. The beneficiary unit at the same time also allows for a flexible adaption of governance rights, for example by restricting or enhancing voting rights,” they said.