Germany Update: Employee participation in the start-up: ESOP, vESOP, Phantom Shares?

The issue of employee participation is not only important for capital market-oriented companies. In their particular situation, start-ups also benefit from the opportunities offered by an employee participation program. However, not every type of participation is equally suitable; there are significant differences, both legally and fiscally. The draft Fund Location Act (FoStoG), which was approved by the Federal Government on 20.01.2021, is supposed to provide tax relief for genuine employee participation in a start-up in the future. However, the legislative process is not yet complete.

The special situation of start-ups

The special situation of start-ups is characterized by the fact that there is a high demand for qualified employees right from the start in order to move the company forward. The right team is crucial for success. At the same time, start-ups usually do not have the financial means to pay competitive salaries. Variable remuneration models and the granting of shareholdings, both real or virtual, therefore make it possible for young companies to recruit and retain qualified staff. The company’s own participation in the success of the company increases the motivation of the employees and promotes a higher and long-term identification with the company and its goals. The corporate culture is strengthened. In the case of venture capital-financed start-ups, which are in any case geared towards an exit in the medium term, the issue of (virtual) employee shareholdings also regularly leads to a synchronisation of interests between investors and employees: all parties involved have a great interest in a rapid increase in the company’s value.

Real participation, ESOP or vESOP – what is particularly suitable?

However, not every form of employee participation is likely to be suitable for all constellations. Thus, it is possible to involve central employees directly in the company through the free or reduced grant of shares to the company. In the future, the employee will participate directly in the company’s success through profit distributions and in the event of an increase in value in the event of the sale of his/her share. However, according to the current legal situation, the actual share is subject to payroll tax at the time of acquisition (the granting of rights); in any event, in so far as the actual value of the shares granted exceeds the purchase price to be paid by the employee concerned or the contribution to be paid by him. Moreover, in many cases, from the company’s point of view, it may not be desirable to grant a (possibly new) employee the say and information rights associated with a genuine shareholder. It is also regularly agreed that the employee must relinquish his shares upon leaving the company, if necessary against payment of a (capped) severance payment. This may again lead to undesirable income tax consequences. In addition, the acquisition of shares and any re-transfer must be notarized by the GmbH, which triggers further costs. Direct participation is therefore often not the means of choice, especially for start-ups.

In order to avoid at least some disadvantages of direct participation, the way is often chosen through the granting of share options within the framework of a so-called ESOP (Employee Stock Option Plan). The call option is usually secured by the use of authorised capital or by a debt agreement (voting agreement) between the shareholders. In it, the shareholders undertake to decide on a capital increase to issue shares in the entitled persons in the event that the agreed terms and conditions occur (e.B. in the event of certain objectives or a certain company affiliation). The advantages, especially for the GmbH, are obvious: No notarial certificate is required at the time of conclusion of the option agreement. The employee’s monetary advantage, which is subject to payroll tax, is regularly created only when the option is exercised. The option can be granted with a specific term (e.g. .B only after the end of a vesting period) or on the exit.

In any case, in the case of GmbH shares, however, the disadvantage of the requirement of notarial verification after exercising the option remains. It should also be noted that employee participation schemes that are used to spend real share options regularly involve a high level of effort and significant (legal advice) costs in terms of their implementation. For future investors, they may also dilute their shareholding, which could deter them from investing. Such programmes should therefore be particularly suitable for public limited companies or only for the participation of individual selected employees. This is especially true if these represent significant added value for the company due to specific competencies and are therefore expressly desired as co-shareholders in the future.

“Virtual” employee participation programs (vESOP – Virtual Employee Stock Option Plans, Stock Appreciation Rights or Phantom Shares) do not grant any real corporate participation. They only contain the contractual commitment to pay the participating employee a sum of money corresponding to the fictitious share value upon the occurrence of the agreed condition. Such a condition can be, for example. B a multi-year affiliation, the achievement of certain milestones or the exit. The payment is usually made from the cash assets of the company. Here, too, payroll taxation at employee level is only carried out when the (virtual) share value is paid out. Notarial reporting is not required. It is true that agreements on the law are also complex contracts for a vESOP. However, their advantage is clearly that, in the end, only a payment of money is made and no other corporate transactions are connected with the granting of virtual (‘fictitious’) shares. Only labour law requirements may have to be observed, in particular as regards equal treatment of employees.

Planned tax advantage of employee shareholdings by FoStoG

Under the unwieldy name “Law on strengthening Germany as a fund location and implementing the Directive (EU) 2019/1160 amending Directives 2009/65/EC and 2011/61/EU with regard to the cross-border distribution of collective investment organisms”, the Federal Government adopted the draft fund location law (FoStoG) on 20.01.2021. Among other things, the draft contains provisions to increase the attractiveness of employee equity participation in start-ups: In the Income Tax Act, the Tax-Free Maximum is to be increased by the FoStoG from the current €360 to €720 in the future. In addition, a new Paragraph 19a of the EstG is to be introduced, which initially does not make the income from the transfer of shareholdings in the employer’s company to the employee subject to taxation. Taxing may not take place until a later date, usually at the transfer of the shareholding, after 10 years since the transfer or at the end of the employment relationship. The scheme will apply for the first time to capital investments transferred after 30 June 2021. This will make it more attractive for employees of start-ups and other small businesses to take shares in their company. However, the legislative process has not yet been completed, so that there may still be substantive changes. In any case, the draft statement states: “In the start-up and growth phase, startups are often unable to pay high remuneration slated for not yet generating profits. […] For this reason, the granting of employee equity participation in start-ups will in future be supported by a targeted special tax regime. […] Because every start-up often involves the assessment of the founder and his employees that they can take advantage of an innovative market opportunity.”

Conclusion:

From the employee’s point of view as well as from the point of view of the start-up founders, the company and for (future) investors, it plays a significant role in how an employee participation program is structured. Although the planned FoStoG could provide some relief in the future, tax consequences of the respective design must always be taken into account. Particular attention should therefore be paid to the design and implementation of an employee participation program in the early stages of the company, so that the founders and employees do not face unforeseen disadvantages in retrospect.

By Dr. Victoria Berger, Melchers, Germany, a Transatlantic Law International Affiliated Firm. 

For further information or for any assistance please contact germany@transatlanticlaw.com

Disclaimer: Transatlantic Law International Limited is a UK registered limited liability company providing international business and legal solutions through its own resources and the expertise of over 105 affiliated independent law firms in over 95 countries worldwide. This article is for background information only and provided in the context of the applicable law when published and does not constitute legal advice and cannot be relied on as such for any matter. Legal advice may be provided subject to the retention of Transatlantic Law International Limited’s services and its governing terms and conditions of service. Transatlantic Law International Limited, based at 42 Brook Street, London W1K 5DB, United Kingdom, is registered with Companies House, Reg Nr. 361484, with its registered address at 83 Cambridge Street, London SW1V 4PS, United Kingdom.