Cliff and Vesting Period: Basics of ESOPs and VSOPs

With employee stock ownership plans, start-ups in particular create attractive incentives for employees in key positions not to leave the company early. At the same time, ESOPs and VSOPs (real and virtual shareholdings) are a proven means of increasing motivation and loyalty to the employer. However, for them to actually have their effect, cliff and vesting periods play important roles.

The Cliff Period

Cliff, as it were, refers to a "magic threshold" that the employee must cross in order to receive any shares in the company at all. The VSOP agreement, for example, stipulates that the employee will be credited with one percent of the share capital virtually over five years. After one year, he is entitled to the first percent, after the second year the second, and so on.

If it is specified in this example that the cliff period lasts two years, the employee only acquires the right to purchase shares after two years of service. If he leaves after one year and six months, he is not entitled to any shares - because he has not exceeded the agreed threshold, even if he could mathematically already hold a one percent share.

However, if the employee reaches the cliff, he or she receives two percent directly as an employee participation after two years. If the employee now leaves the company (without a bad leaver), he or she generally retains these shares.

Due to the freedom of contract, employer and employee are quite flexible (exceptions apply in cases of unreasonable disadvantage within the meaning of the AGB-rechtliche Inhaltskontrolle, § 307 BGB, of the VSOP provisions in court) as far as the agreement of the cliff period is concerned. For example, it is also possible that one percent of the shares are transferred after the first year. These must then be returned to the founders or shareholders if the time of withdrawal is before the two-year threshold is reached.

In addition, it can be specifically regulated for what other reasons shares are to be transferred back in full or in part. Examples of so-called "bad leaver" cases are:

• Leaving the company without good cause through self-termination
• Termination without notice by the employer, for example due to gross misconduct
• Deliberate or grossly negligent breaches of other obligations under the agreement, such as failure to meet targets because the executive is "resting" on the shares he or she has already received

A reduction in working hours (part-time employment) may not be the sole reason for a retransfer of shares if the employee was employed full-time at the time the claim arose. This is because the shares received have already been "earned" and a subsequent reduction would possibly represent an unreasonable disadvantage within the meaning of the above-mentioned review of the content of the General Terms and Conditions in accordance with Section 307 of the German Civil Code (BGB).

However, it is possible to make future share purchases dependent on part-time or full-time employment. In the ESOP or VSOP agreement, for example, the contracting parties can stipulate that the cliff period will be extended accordingly if working hours are reduced by 50 percent.

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Example: The cliff is reached after two years of full-time work. Now the employee reduces his working hours by 50 percent after the first year. Half of the cliff period has already been reached, but he now needs two years for the other half, as he is only performing half of the work. Alternatively, the cliff period remains the same, but the employee is only credited with half of the shares. Mathematically, after two years, 1.5 years have then been worked full time, as a result of which the employer transfers only 1.5 percent to the employee instead of two.

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The Vesting Period

This phase immediately follows the cliff period or overlaps with it in the first few years. For better illustration, here is a somewhat more detailed example.

Employer and employee agree on a cliff period of one year and a vesting period of five years. Each year, the employee is to have the option of acquiring a further percent of the company shares, up to a maximum of five percent:

1. After one year, the employee receives one percent of the shares. If he leaves before then, he receives nothing.
2. After the second year, the employee receives a further one percent, meaning that he now owns two percent of the share capital. If he leaves the company, he retains these shares (exceptions are possible, for example in "bad leaver cases").
3. After the third, fourth and fifth year, a further percent is added in each case. The comments on point 2 apply accordingly.
4. From the sixth year, the vesting period ends. Even if the employee continues to work for the company, he or she will no longer receive any further shares or share options.

ESOPs and VSOPs are usually structured as option models. The employee can decide for himself when to exercise the option, i.e. when to buy the shares. Alternatively, the employer can transfer the shares directly to the employee.

The vesting period therefore consists of several thresholds which the employee must exceed in order to receive further shares after the cliff. Once the vesting period has expired, i.e. once the employee has received the maximum of the agreed shares or the options on them, remaining with the company no longer plays a role.

Cliff period and vesting period: Attention to the agreement!

Employee stock ownership plans, or more precisely the underlying ESOP or VSOP agreements, can only be effective if both sides have thought about the specific terms and conditions. Since cliff and vesting are key elements in any participation, this should be the focus.

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Disclaimer: The contents of the information offered at vsop-direkt.de do not constitute legal advice. If you need a legal examination of your individual case, please contact our specialized team: beratung@esop-direkt.de

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