ESOP/VESOP

January 19, 2024

Giving employees a stake in the financial success of a company can be a good way to motivate and retain employees and make remuneration models more attractive. Especially for start-ups and young companies that cannot yet afford top salaries.

ESOP/VESOP

Employee stock option plans mean that employees participate either in the capital or in the profits of the company they work for. Employees can receive real shares, i.e. shares in a public limited company or shares in a limited liability company. In recent years, start-ups have helped employee stock options to take on new forms, with a clear influence from the US jurisdiction. In particular, so-called virtual employee stock option programmes have become increasingly popular, as they do not give employees any co-determination rights in and to the company, but can only give rise to so-called contractual claims, i.e. payment claims against the company, in narrowly defined cases.

ESOP and VESOP

Firstly, the terms: ESOP means "Employee Stock Option Plan". The "V" in VESOP stands for "Virtual". Both terms describe the process of employees acquiring shares in the employing company when certain conditions are met. The difference lies in the fact that the ESOP involves a genuine shareholding in the company, whereas the VESOP only involves the acquisition of virtual shares that give rise to a cash payment entitlement. It is therefore not a genuine option programme that gives the employee voting rights and thus co-determination opportunities.

Why employee share ownership programmes at all?

Participation in the company can compensate for a lower salary. New employees can thus be recruited and retained by the company. Because the acquisition of shares requires the fulfilment of certain conditions and, above all, the economic success of a company, an incentive function is also created. This can increase employee productivity and thus the value of the company. Fixed salary costs are also saved.

Good leaver/bad leaver - the conditions

The acquisition can be linked to various conditions, which are stipulated and agreed in the respective shareholder agreement or the conditions of the option programme. In order to bind the employee to the company on a long-term basis, a certain period of employment with the company may be required. The achievement of certain target figures, such as a certain turnover or profit, can also be relevant. A distinction is often made between so-called "good leaver" and "bad leaver" clauses when the employee leaves the company as a condition.

So-called leaver clauses regulate the departure of shareholders from a company. Various scenarios are defined according to which the departure has different consequences for the possibility of acquiring or retaining shares in full.

In practice, there are various forms of expiration clauses: depending on the individual case, those affected lose their shares in full or in part and receive no, reduced or full compensation for the lost shares.

"Good leavers" leave the company without any particular reproach being levelled at them. For this reason, the "good leaver" should be in a better financial position than a "bad leaver". In the case of gross breaches of duty that lead to extraordinary dismissal, for example, the case of a "bad leaver" often exists. For this reason, employee participation agreements usually also include corresponding grounds for termination, which fulfil the "bad leaver" requirements. Such clauses must be examined on a case-by-case basis and may be invalid if they are unreasonably unfavourable, as a "bad leaver" often loses their shareholding completely.

Vesting

A "vesting" clause is also common, which stipulates the period of time in which shares are saved up and thus acquired in full, the date from which the right to exercise the acquisition exists and what happens to the options that have not been saved up when the employee leaves the company.

Vesting periods of several years are common, during which shares are accumulated on a monthly basis. In the case of a vesting period of two years with monthly savings, an employee would receive 1/24 of the total achievable shareholding each month. There are different forms of vesting: forward vesting and reverse vesting.

In the case of reverse vesting, the shares are initially allocated in full. If the employee leaves the company before the end of the vesting period, they are obliged to sell the unvested shares back to the company. This form of vesting is usually chosen for founders of a company in order to ensure that they remain with the company, as the founders are usually decisive for the success of the company and its continued existence.

With forward vesting, the option holder is granted options in stages. In some cases, the options do not vest until the employee has reached a corresponding cliff, which is defined in the share option agreement. If the employee leaves the company before the cliff expires, the unvested options expire, whereby attention must be paid to the effectiveness of the relevant clauses.

The aim of option programmes is always to bind employees/option holders/shareholders to the company in the long term and to keep motivation high, whereby the economic goal targeted by an option programme is always the so-called exit. An exit is an exit scenario in which shares can be sold at the highest possible price. If an employee is to receive all shares in the event of an exit that occurs within the vesting period, this is referred to as accelerated vesting.

Tax issues with employee share ownership programmes

As the legislator wants to pave the way for such employee share ownership schemes, it introduced Section 19a of the German Income Tax Act (EStG) on 1 July 2021.

Until this date, unfavourable regulations applied to employee share ownership schemes in Germany. The main reason for this was the so-called "dry income" problem, which describes taxation without an inflow of liquidity. This means that employees had to pay tax on their shares immediately from the moment they received them, without receiving any money. If the shares are sold, tax is payable again. This represented a financial burden for the shareholders.

The change in the law creates better conditions in various respects. Taxation now begins at a later point in time, namely when there is a change of employer or sale, but no later than 12 years after the acquisition. An amendment to Section 3 No. 39 EStG has increased the tax-free allowance for shareholdings from 360 euros to 1440 euros.

The privileged treatment applies if the asset participations are granted in addition to the salary. Companies that are more than 12 years old or do not fulfil the European Union's criteria for small and medium-sized enterprises (SME criteria) are excluded from the regulation.

Would you like to set up a participation programme for your employees or have you been offered an ESOP and would like to have it reviewed? We can provide you with detailed advice and draw up the right contractual documents for your situation.