Virtual employee stock ownership plan (VSOP) in german legal practice

VSOP, virtual stock options, virtual shares - Law firm for startups in Germany

There is a wide range of different employee participation models in german SMEs and start-up companies. Start-up companies financed by venture capital are also increasingly setting up participation programs for their GmbHs, which are referred to as virtual stock options or virtual employee participation in Germany. Since startups have limited financial resources to employ qualified staff, virtual stock options give employees a share in an (uncertain) future sale of the company. An overview of the most important information on virtual shares is provided here by our attorneys, certified specialists for german corporate law, tax law & tax advisors:

1. What does a virtual shareholding (VSOP) mean under german law?

A virtual shareholding (VSOP for short) is a contract under the german law of obligations under which german employees are in certain cases placed (in part) in the same position as shareholders in a company. In this way, the (partial) legal position as a shareholder is practically fictitious by contract (hence: virtual), often in order to compensate for a lower fixed salary. The bet is: if in german practice the exit is successful (this is referred to as a build-to-sell policy), the employees will receive a considerable financial share of the exit proceeds via the virtual participation programs.

The legal construction is quite complex, and many points of the contracts commonly used in german practice are doubted by many legal experts and have not yet been adequately examined by the courts in Germany.

2. Difference from the real participation (ESOP) in german practice

In order to understand the differences and the construct of virtual shareholding as opposed to genuine shareholding, one must first consider the legal positions of a genuine shareholder in Germany:

A person who receives a transfer of genuine business shares (ESOP) has all the rights to which a shareholder of the german company is entitled. These include above all

1. Information and voting rights: the shareholder participates in determining the future of the german company.
2. He has rights to participate in the annual profit of the company in accordance with the provisions of the articles of association and other shareholders' agreements.
3. In the event of a total or partial sale of the company, he shall participate in the sale price in proportion to the amount of his shares.
4. As a shareholder, his rights are specially protected by german law: He may only be deprived of his shares under certain special conditions. In german legal practice, he must be paid appropriate compensation for this.

Information and voting rights are not granted in the case of virtual shares in Germany.

Only a few VSOP programs offer profit sharing in german practice.

Instead, only a share in the sales proceeds in the event of an exit or a payout of the shares after a certain period of time is regularly regulated. However, this is not a genuine equity participation, but only a claim to premium payment under the german law of obligations. The requirements and conditions vary greatly between the various VSOP programs in german practice.

Whether and to what extent virtual participants are subject to protection corresponding to the legal protection of shareholders has not yet been clearly clarified by case law in Germany. This means greater legal uncertainty for the participants, especially if certain clauses in the contracts stipulate that shares can be withdrawn from them again without further ado and/or that they cannot receive appropriate compensation.

Balanced programs nevertheless ensure a certain degree of transparency in favor of the employee in Germany, at least in the event of an exit, enabling him to calculate his participation quota. The holder of the virtual shares generally retains the legal status of an employee within the meaning of german labor law, tax law and social security law. However, atypical participation arrangements are also conceivable  in german practice (constructions under german company law, dormant holdings, etc.).

3. Advantages and disadvantages of virtual participation in Germany

3.1 Advantages for Startups & Founders under german law:

For founders and investors, virtual equity investments have key advantages in german practice:

Advantage No. 1: Indirect funding, financial flexibility in german practice

Since startups have limited financial resources to employ qualified employees, virtual equity programs make it possible to attract qualified executives to the german company while saving resources. Therefore, virtual equity investments are also and primarily a form of indirect financing for the startup in Germany: by issuing limited virtual shares, capital is saved at the beginning, i.e. gained.

Advantage No. 2: Binding employees to the german company

However, all forms of company participation always have the common goal of tying managers and specialists to the company in the longer term. With a special incentive structure in the event of an exit, virtual employee participation programs give qualified employees in Germany a share in the company's success - and thus ensure that they are more motivated to work on the project over a longer period of time. Employees see the german company as "their" company and feel a certain sense of belonging and responsibility.

Advantage No. 3: Differentiated transfer of individual rights under german law

Finally, virtual participation programs allow a great deal of flexibility in contract design in german legal practice: Since the legal limits for real shares do not apply, the entrepreneur in Germany can decide very independently exactly which rights he wants to grant to employees and which not. At the same time, virtual shareholdings in particular also allow the greatest possible differentiation between different employees in german practice, such as so-called key employees, important executives and other important employees.

3.2 Advantages for employees in Germany:

Virtual shares also have some advantages for german employees:

Advantage No. 4: Advantageous timing of taxation in Germany

Initially, virtual shares were developed in german practice primarily to avoid the tax disadvantages of real shares. For more details, see the section on the taxation of virtual shares later on. This advantage has now been relativized in most cases by the reform of the taxation of share transfers to german startups. For more information, see our page on (real) employee stock ownership in german legal practice.

Advantage No.5: Fewer formalities under german law

Unlike the transfer of a real GmbH shareholding, the establishment of a virtual employee shareholding eliminates the need to go to a notary in Germany when transferring the shareholding to the employees.

3.3 Disadvantages of virtual shareholdings in german practice:

The main reason why VSOP programs have enjoyed great popularity among german employees to this day is - in effect, the same as with ESOP programs - the so-called "bet on the exit", i.e., the hope that the company will increase enormously in value during one's employment and that a significant sum of money will accrue when the shares are redeemed. Whether and how often this dream comes true certainly depends on the specific startup and the conditions in each individual case.

On the other hand, many employees in Germany are not aware of the many disadvantages that virtual shares have compared to real shares (no information, monitoring and profit rights under german company law, see differences above).

4. Excursus: special advantages in the taxation of VSOP shares in Germany

The major advantage of VSOP shares in german practice is tax-related: if they are constructed correctly (exceptions mainly in the case of profit sharing and in individual cases), they are generally not taxed until the employee also sees money - namely in the exit case. Taxes that he has to pay on his virtual shares can then simply be deducted from the exit proceeds in Germany.

With real shares, on the other hand, the value of the shares generally accrues to the employee at the time of transfer - in other words, often long before the employee even sees the first money. However, many employees  in Germany cannot afford to pay their taxes early. Only recently, an exception was made here for german startups, but it only applies at the very beginning of the company up to a certain size.

5. How are virtual participations structured in the german GmbH?

The virtual participations are concluded by means of a contract under the german law of obligations between the startup and the participating employees in Germany. Lawyers have developed widely differing programs for this in german legal practice. The german employee typically receives an entitlement to premium payments in the event of an exit (sale of the company by transfer of shares, conversion, asset deal or IPO).

Through the participation agreement, the employee thus participates in the future increase in the enterprise value of the GmbH in the event of success. As a rule in german practice, the participation agreement contains a formula according to which the employee is granted a certain number of book units linked to a nominal amount of the GmbH's share capital.

6. Typical contract mechanisms: vesting, leaver, anti-dilution, down-rounds, exit under german law

In most german participation agreements, employees are not granted the promised participation in full immediately upon conclusion of the agreement. Various contractual mechanisms in german practice ensure that the shareholdings are granted on a staggered basis and only if certain conditions are met. These include in particular:

1. Vesting clauses
2. Differentiated settlement provisions, so-called good & bad leaver clauses
3. Dilution protection, so-called anti-dilution clauses
4. Down-rounds
5. Liquidation preferences and settlement mechanisms on EXIT

We will now explain what this means under german law.

6.1. Vesting-Clauses in german practice

In this case, german employees earn the participation in a staggered manner ("vesting") - after the expiry of a so-called waiting period ("cliff") - within an accumulation period of regularly up to five years ("vesting period").

In some cases, the participation agreements also provide for accelerated vesting, which allocates the full amount of the promised participation to the employee in Germany if the exit event already takes place within the vesting period.

6.2. Good & Bad Leaver in german practice

In german legal practice, the vested shares may be forfeited if the employment or management relationship between the employee and the company is terminated due to a circumstance for which the employee is "responsible". Once an effective forfeiture clause has come into effect in Germany, payment of the bonus is then ruled out and the wager is effectively lost.

The shareholding programs contain the good leaver and bad leaver mechanisms customary in german M&A practice, which determine whether an employee who has left the company can retain his shareholding at all, in what amount and for how long. Overly narrow and unilateral regulations in the interests of the company may be open to challenge under german labor law or the general law governing general terms and conditions.

6.3. Anti-Dilution in german practice

In most cases, the virtual participant of the young german GmbH is denied anti-dilution protection for certain capital measures so that investors can be taken on without obstacles in later financing rounds, e.g. in the form of cash capital increases. This means that the employee's participation quota can be reduced - economically speaking - by a capital increase of the startup taken over by a (new) investor.

But beware: Not for every capital measure is the waiver of dilution protection in line with the interests of the company in Germany.

6.4. Down-Rounds in Germany

The employee is also interested in the extent to which investors have been granted down-round protection in the event of a declining enterprise value and can take over shareholdings at a discount in future financing rounds via full-ratchet, weighted-average and similar contractual constructs, which also lead to shareholding dilution for the virtual participants in Germany.

6.5 Liquidation Preferences and Compensation Mechanisms at EXIT in Germany

If the exit conditions are met in german practice, the employee receives a payment claim under the german law of obligations against the GmbH.

The amount of the bonus payment is based on a formula set out in the contract and is linked to the proceeds of an exit. In german practice, it is common for

1. so-called liquidation proceeds from one or more shareholders and financial investors are first deducted from the exit proceeds (often disposal and transaction costs).
2. The german employee then participates in the net proceeds (at the second stage) in the amount of his pro rata virtual shareholding.

Special arrangements are often found for partial company sales in Germany. If only 80 % of the startup is sold, the german employee must participate only with 80 % of his virtual shareholding in order to be treated in the same way as a real shareholder. The employee continues to hold a virtual stake of 20% in the company.

In some cases, participation programs allow the company to buy out vested shares. A company in Germany can then use this settlement right to buy out the vested virtual shares from an employee before the exit.

7. Risks for employees and management in the case of virtual shareholdings under german law

Because the contracts are very complex and the matter has not yet been decided by the highest courts in Germany, virtual participation programs carry many legal risks and uncertainties under german law for the parties involved. The top 10 risks of VSOP contracts are:

1. Tax trap in business valuation
2. Ineffective, highly disadvantageous leaver constellations
3. Non-transparent proceeds and liquidation preferences in favor of investors and existing shareholders
4. Increase in social security
5. Ineffectiveness of clauses according to AGB control in case of strong disadvantage of employees
6. Dilution of shares without anti-dilution
7. Expiration of rights after a certain time
8. Company value decreases, "bet on exit" does not pay off
9. Disadvantageous calculation of participation in exit proceeds
10. Unfair compensation arrangements

In addition to the contractual risks already discussed above, we would like to further discuss other important risks of VSOP programs in german practice here:

7.1 Risk: Social security contributions in Germany

In addition to the aforementioned tax risks, virtual employee stock ownership plans in Germany also entail risks at the level of social security contributions if the participant's current salary is below the annual contribution assessment threshold for health/nursing care insurance, pension and unemployment insurance.

It is important in german practice to prevent VSOPs from increasing the current social security liability without being noticed and the contributions then not being paid correctly by the employer and employee. The risks arising from tax and social insurance not only affect the employee involved (increased, possibly unnoticed charges), but can also lead to personal liability of the managing directors under german civil and criminal law.

7.2 Attention to investors' preferential rights in Germany

In particular, non-transparent proceeds and liquidation preferences in favor of investors and existing shareholders must not put employees at too great a financial disadvantage in Germany. Unlike shareholder agreements and participation agreements in connection with the entry of VC financial investors, many virtual participation programs in german practcice provide only for abstract preferential rights of investors and shareholders which are not comprehensible to the employee and which can have a strongly claim-reducing effect for the employee.

It should be kept transparent in the participation agreements to what extent transaction costs, fees, taxes and other items can reduce the employee's proceeds in the event of an exit. It must also be clear to the virtual participant in Germany whether non-creditable liquidation preferences (participating liquidation preference) lead to an additional financial malus.

7.3. Observe regulations of the german labor law

As a rule in Germany, the holder of the virtual shares retains the legal status of an employee within the meaning of german labor law, tax law and social security law. However, atypical participation arrangements are also conceivable (constructions under german company law, dormant holdings, etc.).

It should also be noted at this point that participation agreements based on german employment law and the law governing general terms and conditions can be legally challenged in the event of overreaching and lack of transparency to the detriment of the employee in Germany. In this case, it is absolutely advisable to consult a certified specialist for german labor law. In particular, the separation of the employment relationship and virtual participation stipulated in the employment contract is often invalid.

7.4 Attention: AGB control necessary under german law!

Irrespective of whether the virtual participation program is a direct component of the employment contract in german legal practice, the question of AGB content control (§ 305 et seq. BGB) and thus of legal protection in favor of the employee will always arise.

Financial investors, managing directors and founding shareholders should note that an area exception for the area of german company law (Section 310 (4) Sentence 1 BGB) is unlikely to apply as a rule, since the employee is not granted a genuine participation with all membership rights. An individual examination of the individual case under german law is absolutely necessary here!

8. Tax treatment of virtual participations in Germany

Since virtual shareholdings are a form of employee remuneration in german practice, delimitation difficulties may arise in individual cases with regard to the correct tax classification according to german tax law. In principle, employee stock compensation can be classified as

1. income from employment,
2. income from a trade or business, or
3. capital income.

As a rule in german practice, the virtual participants will not have a co-entrepreneurship, so that there will be no income from business operations. Since the virtual shareholding is not provided to the german employee for free use in return for payment, income from capital assets should also be ruled out.

In view of the fact that the virtual shareholding is made available to the employee in return for his or her labor (as a wage or wage surrogate), it is regularly classified as income from employment under german tax law. From a tax point of view, corresponding participation programs should therefore be designed in such a way that no income tax is incurred with the granting or successive vesting. An ordinary employee in Germany would not be able to finance the tax burden due to the lack of an inflow of liquid funds.

In contrast, a genuine GmbH participation transferred to an employee free of charge or at a reduced price will result in an increase in assets at the time of the share transfer and trigger taxes. In german practice, the virtual participation should therefore not be too closely related to a genuine GmbH participation. Otherwise, depending on the contractual structure, there is a risk that the virtually participating employee will incur income tax liability at the time of granting, i.e. well before the premium-triggering exit event. The tax risks should be examined for each virtual participation program in Germany.

9. Rights of the virtually involved employee under german law

It has already been pointed out that virtual participation programs in Germany are not to be equated with genuine participation as a shareholder. The protection of minorities, which is important in the german law of the GmbH, therefore does not apply to virtual participation agreements. Therefore, a certain level of protection in the interest of the employees must be stipulated in the programs at the individual contractual level. In particular, the regulation of a minimum level of control and information rights is central in german legal practice.

The aim of the participation agreements is for the employee to become, as it were, an entrepreneur through the special incentive system. With his commitment, the employee also assumes corresponding risks under german law. The requirement of fairness dictates that the virtual participant be granted the necessary transparency with regard to all opportunities and risks.

10. Legal expertise in german employee stock option contracts (VSOP)

The firm's team of attorneys, certified specialists for german corporate law and tax law, and tax advisors plan and design employee participation programs at our offices in Hamburg, Berlin, Munich, Cologne and Frankfurt. Below you will find our range of consulting services in connection with management shareholdings and employee share ownership in Germany:

1. Comparison of the various employee participation models and advice on the appropriate participation program in german practice
2. Planning and consulting on virtual employee participation in a GmbH (limited liability company)
3. Design and structuring of virtual stock options as well as adjustments to the respective employment contracts and management service agreements according to german law
4. Training and information events for qualified employees who are to participate in the german company
5. Examination of existing virtual employee participation programs, judicial and extrajudicial enforcement or defense of participation and profit claims, representation before arbitration courts.

Virtual employee participation programs are based on the classic stock options frequently used by stock corporations in Germany.

11. Contractual transparency and fairness necessary in german practice

Virtual participation agreements are a sensible instrument for young GmbHs and qualified employees in Germany if the necessary transparency and a balanced reconciliation of interests between all parties involved is ensured. A certain level of protection must be contractually established in favor of the managers and employees involved. As a rule in german practice, financial investors go to great lengths to ensure that their interests are implemented as far as possible.

However, this can easily lead to imbalances in the design of employee programs and, in the worst case, to the complete invalidity of the clause under german law.

Here you will find more detailed information on conflicts of interest in the german venture capital sector: Venture Capital

12. FAQ - Questions about VSOP to our german lawyers

We collect frequently asked questions from employees, founders and investors to our certified specialists for german corporate law, tax law & tax advisors here.