ESOP, Virtual Stock Options, Virtual Shares
Employee participation programms in Germany
There is a wide range of instruments under German law to ensure employee participation in German small and medium sized entities (SMEs) and start-up companies. All forms of participation have the common goal of tying managers and specialists to the company and to retain required know-how. With a special incentive structure, virtual employee participation programmes attempt to involve qualified employees in the company's success.
Young companies backed by venture capital are also increasingly setting up participation programmes, which are referred to as virtual stock options or virtual employee participation. Since the financial means for employing qualified employees are limited in start-ups, employees with virtual participation are granted the right to participate financially in a (uncertain) future exit – most often by way of sale of the company, less frequent by way of the company going public.
Legal Expertise for Employee Participation Agreements (ESOP)
Our team of attorneys, certified specialist attorneys for corporate and tax law, and tax consultants regularly advises German and international clients on all matters related to employee participation programmes such as ESOP or VSOP plans. We plan and design employee participation programs in German and English and have extensive experience representing both employees and companies in connection with employee participation and claims resulting therefrom. With specialists in our offices in Hamburg, Berlin, Munich and Frankfurt we cover the most prosperous financial centres of Germany. Below, you will find a short summary of our advisory services in connection with Management Participation Plans and Employee Participation Plans:
- Individual analysis of our client’s specific situation and determination of the appropriate participation programme for such situation
- Planning and implementation of all individual steps required to set up a virtual employee stock option program in practice – we are a one-stop-shop and our services include the design and structuring of virtual stock options as well as adjustments of the respective employment contracts and managing director service contracts
- Training and information events for qualified employees who are to participate in the company’s success
- Thorough examination of existing virtual employee participation programs, judicial and extrajudicial enforcement of or defense against participation claims, representation before arbitral tribunals
Virtual participation programs are based on classic stock option plans for employees, which are frequently used by stock corporations.
Areas of Application of Virtual Participation Programs
Virtual participation programs are particularly common in the startup ecosystem. Due to the fact that most startup-companies in Germany are relatively weak from a financial perspective. Therefore start-ups often face challenges when trying to recruit or retain qualified employees. The prospect of a participation in future profits – especially in proceeds generated in case of an exit event – may be a greatly helpful tool to acquire the talent needed to build a successful company and actually accomplish a high-value exit for the funders. From the key employee’s perspective the bet is: If the exit is successful (one speaks of a build to sell policy), the employee will participate financially in the exit proceeds and attain a significant amount via the virtual participation program, thus offering a viable performance and success dependent bonus to their fixed income. It therefore is important for the employees who are new owners of the phantom stocks to understand how the increase in value of the start-up effects their virtual participation and earn-out potential and how each individual employee can best contribute. Only then can the employee gain the necessary level of identification with the company and feel like a co-entrepreneur.
Occasionally, virtual revenue sharing is also used outside the managerial and employee circle, e.g. with smaller investors or at the sales level – in each case in order to further incentivise important partners. As a result, any especially important contractual partner may be financially involved in the sale of a start-up company via its virtual shares.
What is the basic structure of virtual investments?
The virtual participation is a German law contract strictly following the law of obligations and concluded between the start-up and each participating employee. There is no actual participation in the company’s equity granted, just an obligation for payment dependent on certain prerequisite conditions is established. Programs developed by different attorneys may differ greatly from each other in practice. The employee is typically entitled to premium payments in the event of an exit (sale of the company by transfer of shares, conversion process, asset deal or stock exchange IPO). Through the participation agreement, the employee thus participates in the future increase of the company value in the event of a successful exit – which often is the ultimate goal of the founding shareholders and investors. The participation agreement regularly contains a formula according to which the employee is granted a certain number of book units that are linked to a nominal amount of the GmbH share capital – thus the name “virtual share option program”.
In practice, the narrative used to advertise an employee participation program in Germany is that the employee becomes a "virtual shareholder" upon signing the participation agreement, i.e. is equated with a real shareholder. However, it must be taken into account that the employee does not receive any real equity or any corporate law instrument granting participation in such equity – which would be theoretically possible but very much impracticable under German law – but only receives a claim against the company to a premium payment under the German law of obligations. Only rarely do the virtual shares guarantee the right to a profit distribution, economically comparable with bonus regulations under the employment contract. The virtual employee does not become a GmbH shareholder with corresponding information, monitoring and profit rights under German company law. At the same time, balanced programs guarantee a certain transparency in favour of the employee, at least in the case of an exit, which enables him to calculate his participation quota. As a rule, the holder of virtual shares retains the legal status of an employee within the meaning of labour law, tax law and social security law. However, atypical forms of participation are also conceivable (company law constructions, silent partnerships, etc.) but, as mentioned above, rather impracticable under German law.
From the company's point of view, virtual employee programs lead to a high degree of flexibility in personnel costs and financial planning. Qualified employees can often be tied to the company through participation programmes despite a below-average remuneration basis. They accept the low remuneration as a "bet on exit" and hope to receive an above-average bonus for their work in the future. In contrast to the transfer of a real German limited liability company (GmbH) participation, the establishment of a virtual employee participation in Germany does not require a visit to a notary. Irrespective of whether the virtual participation programme is a direct component of the employment contract, the question of the GTC content control (§§ 305 ff. BGB) and thus the legal protection in favour of the employee may always arise. Financial investors, managing directors and founding shareholders should bear in mind that an exception for the area of company law (§ 310 Paragraph 4 Sentence 1 BGB) will likely not be applicable, as the employee is not granted any real participation with all membership rights and therefore remains a private person for matters relating to German law.
Tax treatment of virtual participations
Since virtual participations are a form of employee remuneration, questions may arise in connection with the correct tax classification. Employee participation proceeds may be considered as income from employment, income from business operations or as capital income. Generally virtual share option plans will not constitute a participation in the company for tax purposes (so called “Mitunternehmerschaft” under German law). Given that the virtual participation is made available to the employee for his or her labour (as a wage or wage surrogate), these are regularly classified as income from employment. From a tax point of view, therefore, participation programmes should be designed in such a way that no income tax is payable on the granting or successive vesting of the virtual stock options. An ordinary employee would not be able to bear the tax burden due to a lack of cash available. On the other hand, a genuine participation in a German law limited liability company ((GmbH) transferred to an employee free of charge or at a reduced price would lead to an increase in assets and trigger taxes at the time of the share transfer. The virtual investment should therefore not be too closely based on a genuine GmbH investment. Otherwise, depending on the contractual structure, the virtual employee may be liable for income tax at the time it is granted, i.e. well before the exit event that might trigger the premium in the future. The tax situation should in any case be assessed carefully for each virtual participation programme.
Liability risks for employees and management
In addition to the tax risks mentioned above, employee participation programs also entail risks at the level of social security contributions if the participant's current salary is below the annual income threshold for health/nursing care insurance, pension and unemployment insurance in Germany. It is important to prevent the ESOP from significantly increasing the current social security obligation and resulting in the contributions from the employer and employee not being paid correctly. The risks from the tax and social insurance area do not only affect the employee involved (increased, possibly unnoticed burdens), but can also affect the employee's social security contributions and may cause significant penalty payments for the company and the employee and even cause criminal prosecution if left unchecked.
Typical contractual mechanisms: Key points to be taken into account
In most German law employee participation agreements, employees are not granted the full amount of the promised participation immediately upon conclusion of the agreement. They earn the participation in a staggered manner ("vesting") - after a so-called waiting period ("cliff") - within a savings period of regularly up to five years ("vesting period"). In some cases, the participation agreements also provide for “accelerated vesting”, which assigns the full amount of the promised participation to the employee in case an exit event takes place within the vesting period – from an employee’s perspective, accelerated vesting should definitely be included in their management participation programs.
The vested shares generally will expire if the employment or management service relationship between the employee and the company is terminated due to circumstances for which the employee is "responsible", i.e. a so called “bad leaver” event. Should an expiration clause be applicable, a premium payment is excluded, i.e. the “bet on an exit participation” is virtually lost. Participation programs usually contain good leaver and bad leaver mechanisms customary in M&A practice, which decide whether an employee who has left the employment contract may retain his participation at all, to what extent and for how long. In Germany, too narrow and one-sided clauses catering mostly to the interest of the company may be open to challenge under labour law or general GTC law. In most cases, the virtual participant of a young company is denied protection against dilution (anti-dilution) in certain capital measures, so that investors can be taken up in later financing rounds without obstacles, e.g. in the form of cash capital increases. This means that the employee's participation rate may be reduced (“diluted”) by a capital increase of the start-up even after such start-up is taken over by a (new) investor. Besides the risk of dilution posed by capital measure, it is also in the best interest of the employee to consider carefully to what extent investors have been granted protection from down-rounds in the event of a decline in company value and at what fixed price they may be entitled to take over participations in future financing rounds at a discount, e.g. full ratchet, weighted average and similar contractual constructs, which also lead to a dilution of the participation of the virtual participants.
If an exit event occurs, under German law the employee receives a payment claim under the law of obligations against the company. The amount of the premium payment due is determined by a formula defined in the contract and usually will be linked to the total amount of consideration received in the course of the exit. In practice, it is common that the so-called liquidation proceeds of one or more shareholders and financial investors are first deducted from the exit proceeds (e.g. transaction costs). The employee then participates in the net proceeds (on a second level of the “waterfall”) in the amount of his proportionate virtual participation. Special regulations are often found for partial company sales. If only 80% of the start-up company is sold, in order to achieve an equal treatment as compared to a real shareholder, it is required that the employee participates only with 80% of his total virtual participation. He remains a virtual shareholder in the company regarding the remaining proportionate participation of 20%.
Some German law participation programmes give the company the opportunity to buy back vested virtual shares if an exit event occurs. A company can then buy the invested virtual shares from an employee before the exit actually happens utilizing a one-sided re-purchase right (i.e. an option right).
Contractual transparency and fairness
Virtual participation agreements are a useful instrument for young companies and qualified employees alike, if the necessary transparency and balance of interests between all participants is ensured. Generally, financial investors tend to be keen to secure their own interests as thoroughly as possible. This may, however, easily lead to imbalances in the design of employee programmes and may in the end pose the risk that a German court may hold parts of the agreement to violate the law due to the imbalance created. It should be taken into account that under German law, an employee participation scheme will usually be considered general terms and conditions and thus be subject to the rather rigorous fairness and balancing tests applied in this regard.
It has already been pointed out that virtual participation programmes are not the same as a real equity participation. The protection of minorities, which is a key factor in German corporate law, especially regarding the German limited liability company (GmbH), therefore does not apply to virtual participation agreements. Thus, a certain level of protection must be established in the programs in the interest of the employees on a contractual level. One important aspect in this regard is to include a minimum level of control and, especially so, information rights in order to create a level of transparency in line with German law. The purpose of the participation agreement is to ensure that the employee is incentivized as an entrepreneur would be incentivized. The employee also assumes corresponding risks with his or her commitment. The requirement of fairness stipulated by German law means that the virtual participant is provided with all required information regarding opportunities and risks involved.
In particular, non-transparent revenue and liquidation preferences in favour of investors and former shareholders must not place employees at too great a financial disadvantage. In contrast to shareholder agreements and participation agreements in connection with the accession of VC financial investors, many virtual share option plans (VSOP, also called employee share option plan, ESOP) only provide for abstract preferential rights of investors and shareholders which are not comprehensible to the employee and which may reduce the potential amounts payable to the employee in case of an exit event considerably. Transparency has to be ensured in a German law participation agreement in regards to what amount of transaction costs, fees, taxes and other items may reduce the employee's total consideration in the event of an exit. It must also be clear to the virtual participant whether a liquidation preference may lead to an additional financial penalty.
It should be noted that participation agreements in Germany may, on the basis of labour law and general terms and conditions law, be prone to legal challenge if they are overly favourable for equity investors as compared to virtual participants or lack a certain amount of transparency required under German law.
Our team of 11 corporate and M&A attorneys and tax advisors throughout our offices in Hamburg, Berlin, Frankfurt and Munich is available to advise on all matters connected to the planning, structuring and implementation of virtual stock option programmes under German law. Balanced contract structures that take into account the interests of all parties involved prevent expensive disputes and court proceedings. For a non-binding enquiry, please contact one of our senior attorneys directly via phone or e-mail or the contact form at the bottom of this page.