Investment in Progress

Negative liquidation preference in connection with employee participation programs

Participation programs are an important instrument in the start-up world to attract and motivate qualified employees. The underpriced or free of charge granting of a shareholding to employees can basically lead to a taxable non-cash benefit (“Sachbezug”). In this context, the agreement of a negative liquidation preference could be considered. The relating tax consequences in connection with the agreement of a negative liquidation preference are discussed below.

1. The (tax) dilemma with ESOPs

In the case of ESOPs („Employee Stock Option Programs“; in short: ESOP), an employee receives a shareholding in an Austrian limited liability company (GmbH). If the start-up is later on sold by way of a share deal (exit), liquidated or distributes dividend, the employee as beneficiary participates in the success of the start-up through this shareholding (preferentially taxed with 27,5%).

An underpriced or free of charge granting of a shareholding can result in a non-cash benefit (market value of the shareholding granted less any purchase price) for the employees, which leads to income from employment. Such a non-cash benefit is generally subject to the progressive income tax tariff for the employee. This means that at the time the shareholding is granted without cash inflow, income tax has to be paid, although investments in start-ups are often exposed to a corresponding impairment risk at this time.

In addition, often the employee does not have the necessary liquidity to pay the corresponding taxes (so called „dry income“). In the worst case, a non-cash benefit is assumed at the time the shareholding is granted, but in the end the start-up does not achieve the breakthrough, so that the hoped-for inflow of liquidity does not occur. The employee can therefore face a double risk: on the one hand, advance taxation without cash inflow and, on the other hand, a too low cash inflow with regard to the originally taxed non-cash benefit.

2. Negative liquidation preference

The agreement on liquidation preferences is a revenue distribution agreement between the shareholders. The idea in connection with negative liquidation preferences is, that the shareholding of the ESOP participant concerned should participate in a liquidity event (e.g. exit, liquidation and distributions) only then and only to the extent that the shareholding has experienced an increase in value since it was granted.


An employee receives a 5% stake in a start-up. The shareholders agree with the employee that in the case of a liquidity event, the employee will only participate in the proceeds if the proceeds from the liquidity event – after satisfying senior investors – exceed the valuation of EUR 3 million determined at the time of issuance of the shareholding.

Therefore through a liquidation preferences, the beneficiaries thus receive a purchase price which is in any case proportionately lower than their participation in the start-up under company law.

3. Tax aspects

Therefore, if a shareholding in a limited liability company (GmbH) is ultimately granted free of charge or at a reduced price rather than at its objective market value, this is generally considered to be a non-cash benefit from the employee’s perspective. In this case, the question arises from a tax point of view whether the granting of a taxable non-cash benefit can be completely avoided by agreeing on a negative liquidation preference.

The granting of shares free of charge or at a reduced price is basically accompanied by two components of a non-cash benefit:

  • past increases in value

On the one hand, there may be a non-cash benefit with regard to an increase in value that has already occurred up to the time the shareholding is granted (resulting from the difference between the market value of the shareholding at the time of granting and any consideration to be paid). By agreeing on a negative liquidation preference, such a granting of a non-cash benefit can be avoided. On the basis of an appropriate current company valuation (e.g. as a result of a financing round that is or was carried out promptly, from which an arm’s length market value can be derived), the amount of the required negative liquidation preference can be derived.

  • future increase in value

On the other hand, the question arises if a possible opportunity for a future increase in value (from the time the shareholding is granted) without or without an arm’s length capital investment and thus without a corresponding risk at arm’s length could be seen as a non-cash benefit. A negative liquidation preference generally does not cover the opportunity for future appreciation. The tax issue is therefore highly sensitive here, as non-cash benefits from an employment relationship are subject to the current income tax tariff, while income from capital assets (profit distribution, capital gain, liquidation gain) is taxed at the special tax rate of 27.5%.

In this context, the assessment of the existence of a non-cash benefit will be based on the recoverability of the opportunity for a future increase in value at the time the shareholding is granted. Therefore a tax analysis must be carried out on a case-by-case basis considering (e.g. at what stage is the start-up at the time of the ESOP; is a fee paid by the ESOP participants; is an objective company valuation possible at the time of the ESOP; are there indicative company valuations close to the time of the ESOP; etc…).

Provided that an arm’s length fee (at least the nominal capital) is paid by the ESOP participant, there are no indications of a secure imminent positive development of the start-up (due to the statistics on start-ups, the downside risk regularly predominates or the upside and downside risk are balanced), an objective company valuation of the start-up is not possible, and there are no other known indicative company valuations close to the ESOP (which deviate significantly from the agreed negative liquidation preference and thus give rise to the assumption that an additional non-cash benefit is granted), this could be good reasons for not assuming an inflow of a possible non-cash benefit with regard to future value appreciation opportunities.

4. Wage tax information

However, since start-ups also need legal certainty, the obtaining of a wage tax information (“Lohnsteuerauskunft”) from the responsible tax office could be considered. Upon request, the tax office must provide information as far as possible within 14 days whether and to what extent a transaction subject to payroll tax exists in the individual case.

Due to the lack of the character of an assessment notice, the information provided by the tax office cannot be binding either for the taxpayer or for the tax authority. However, if the tax authority deviates from the information provided in the course of further proceedings, this unlawful procedure is to be assessed according to the criteria developed for the principle of good faith (“Grundsatz von Treu und Glauben”).

A written wage tax information received from the responsible tax office can subsequently be presented in a future due diligence (e.g. in a financing round or transaction) and thus a possible tax risk can be excluded.


Christoph Puchner, Managing Director and Tax Advisor & David Gloser, Partner, Chartered Accountant and Tax Advisor from ECOVIS Austria.