How can founders ensure to convert their time or monetary investment into liquidity despite the lack of an exit?
Financial security for entrepreneurs and employees in steward-owned companies
As with all other companies, the founders of steward-owned companies are often dependent on converting their monetary or time investments into liquidity at some point. They want to receive compensation in return for taking entrepreneurial risk, foregoing salary and putting a lot of energy in during the founding phase. The conventional way that many founders still choose today is to sell their shares profitably through an exit or IPO.
Since steward-owned companies do not seek an exit – at least not in the usual sense – alternatives are needed to provide financial security for the founders or early employees of such companies. In the following, several such founder compensation solutions will be presented.
The choice of the legal instrument depends strongly on when, how much, and how a possible compensation should flow back to the founders and therefore cannot be answered in general. In addition, the feasibility and legal implementation is highly dependent on the country / legal framework the company is set-up in.
For the German context we however know that debt-based instruments are in particular feasible for founders’ compensation. The individual implementation should in any case be developed or coordinated with a tax advisor and your lawyers.
In addition to actual company shares, virtual shares are a common way to compensate founders and early employees. The structure of virtual shares can be very similar to that of actual company shares. In conventional companies, virtual shares are usually structured in such a way that they receive a share of the sales proceeds in the case of an exit.
For steward-owned companies, the shares can be designed in such a way that the founder compensation can also take place without a conversion into actual shares or an exit in the classical sense.
In our experience, virtual shares are preferable to actual company shares for steward-owned companies as they are debt-based and can therefore be implemented in a simpler, more cost-effective and more individual way.
Virtual stock options, also known as virtual shares, are agreements under the law of obligations. For this reason, the legal and bureaucratic aspects of this form of employee participation are reduced. In contrast to actual shares/participations, there are also fewer obligations to provide information and no co-determination rights. There is a comparatively large amount of freedom when it comes to drafting contracts. Ultimately, virtual shares are particularly attractive because they are quite simple to implement and allow a great deal of leeway in contract design.
Typical silent partners with repurchase rights
Another possibility is to create only two classes of shares and implement the structure presented above alongside a silent partnership. This way could save notary costs and provide design flexibility.
The structure would then look as follows: A-shares for the stewards and B-shares for the veto-share foundation. The founders (and possibly the employees) can participate in the company as silent partners - at favorable conditions when the company is still young, i.e. by partially converting salary. This silent participation can then be equipped with a repurchase right analogous to the above case, so that the company must buy it back at a multiple if certain conditions are met (e.g., the company has reached a certain size and the person leaves). It can also include profit participation (and loss participation) as well as a fixed interest rate, both payable only upon termination. And it would run for a longer period of time and could also include a type of repurchase right (termination with compensation) for a certain amount.
- The silent participation can also continue after leaving and thus represent a kind of retirement provision.
- It is usually agreed that the repurchase right can only be exercised under certain conditions to prevent the company from becoming illiquid through repurchase.
Only applicable in Germany: Instruments such as silent partnerships, preferred shares (i.e. Genussrechte), or D-shares can also be implemented with an employee pool company (ideally KG or GbR): then these participations are not held directly by individuals, but are held in a KG/GbR, in which employees are involved for a certain period of time and must leave if certain conditions are met.
Typical company pension plans and pensions reserves
Like any other company, a steward-owned company may make pension promises to its employees or founders. For example, a certain pension for life could be paid that increases based on length of service.
In Germany, this company pension promise entitles the company to form reserves, which do not reduce profits but do reduce liquidity. The pension benefits are then taxed for the recipients only upon payment. If a person with such company pension commitments leaves the company or reaches a certain age, they can negotiate a severance payment with the company and receive one or more larger lump-sum payments instead of a lifelong pension. The company does not have to hold any liquidity for the reserves, but can leave the money in the company as usual. However, if it is desired to "secure" the company pension somewhat and make it independent of the success or failure of the company, all or part of the reserves can also be invested outside the company - in funds, financial products, or other companies. Insurance policies can also be taken out to ensure that the pension can be paid, regardless of how the company develops. The financial products/insurance policies purchased by the company can then be pledged to the pension holders/employees, so that even in the event of the company's insolvency, these investments and thus the pensions are retained.
Another solution is for the founders to remain in an official employment relationship with the company even after they leave, and receive a kind of basic income for their ongoing consulting services for an agreed-upon period of time. Since this is considered a salary, these payments are also subject to corresponding taxes. It is important that the entrepreneur does not completely sever ties with the company after leaving so that the continued payment of the salary can be justified (for example, the entrepreneur can provide consulting support to the company). However, in case of dispute, a settlement amount can be agreed upon.
Open-ended Process Agreement
The agreement between the founders and the company can also be designed to be more open-ended: no fixed payments but rather a process is agreed upon that ensures a good, fair solution when the founder(s) exit(s) and requires financial security for retirement. For example, the founders can ensure that the new steward-owners pay them a severance payment, lump sum payment, or pension before handing over voting rights. This solution is the most flexible in terms of the amount, which can vary greatly depending on the size of the company and is decided only when an exit is imminent. On the other hand, it provides founders/employees with less tangible options and security.
Property law solutions
Redeemable founder shares and early employee compensation shares
One possible solution to the described challenge is the issuance of special "compensation shares." While the company is still young, founders or employees can receive these shares for free or at a low cost, hold onto them, and when certain conditions are met (e.g. they leave the company or reach a certain age), the company must buy back the shares either entirely or in part. The repurchase price can either be predetermined to ensure a certain "pension sum," or it can be based on the company's performance. In any case, it should be capped at a certain level and not simply display the market value of the company: on the one hand, to ensure that the company does not face enormous obligations in the event of great success, and on the other hand to ensure that it is clear to all stakeholders that it is a compensation and not a lottery.
In concrete terms, the structure of a German GmbH/Limited/Inc in steward-ownership with this solution would look as follows: there would be a division of the share capital into several share classes with different rights within the veto-share model, such as with Sharetribe (Finland):
- The A-shares represent voting but no profit entitlements and may only be held by individuals active in the company. In the event that such stewards leave the company, the A shares must be returned to the company or passed on to new team members. It is possible to structure the model so that not only the founders but also employees can receive A-shares and thus be involved in the company's decision-making processes in an entrepreneurial manner.
- The B-shares are held by a veto-share foundation, which ensures compliance with the principles of steward-ownership by exercising the veto right. These shares have no entitlement to profits and only 1% of the normal voting rights.
- The D shares (or founder shares) are held by founders and possibly early employees. They have no voting rights but have repurchase rights, i.e. the company will repurchase the D-shares at a predetermined value (e.g. a multiple of the original investment or a value determined flexibly in another way), representing compensation for salary sacrifice and risk-taking in the early years of the company. The repurchase price is clearly capped at a certain level.
There are many different ways for steward-owned companies to provide founders and other early employees with a degree of financial security or retirement benefits. Both contractual and property law instruments can be chosen and flexibly structured. However, in Germany, contractual solutions are preferred for legal transition to a possible new legal form (that is currently debated in Germany).