ESOP checklist: Typical mistakes when introducing employee stock ownership plans

More and more companies are relying on the introduction of employee share ownership programs such as ESOPs or VSOPs, and for good reason. A study conducted by the Institute of German Science in Cologne in 2018 revealed that companies that implement such programs have seen an average increase in the productivity of their workforce of around 23%. In addition, the employee turnover rate fell by around 14%. These results in terms of employee motivation and retention are particularly remarkable in light of the ongoing shortage of skilled workers.

However, despite the obvious benefits and increasing popularity of these participation programs, companies also encounter challenges that can compromise the effectiveness of such initiatives. There are specific mistakes that should be avoided to ensure the full effectiveness of employee share ownership programs.

1. no open communication - importance of transparency

When introducing employee participation programs, there is often a lack of clear communication to employees. A lack of understanding about the rules and conditions of participation leads to uncertainty among employees and, as a result, lower participation in the program. It is therefore particularly important to inform employees as comprehensively as possible, leave room for questions and create an understanding of the procedure, content and regulations of the employee participation program. Through open communication and transparency in employee participation programs, companies counteract mistrust and demotivation and thus ensure that the participation programs achieve the desired effect in the areas of employee motivation and employee retention.

2. insufficient consideration of employee interests when setting objectives

Another fundamental mistake is not adapting the participation programs to the interests and concerns of the employees or at least taking them into account appropriately. They should be individually tailored to the workforce or the employees concerned and their needs. Without this individual connection to the company's employee participation program, not only is there a lack of identification with the objectives of the program, but the actual aim of promoting motivation and loyalty falls by the wayside. A participation program that is individually tailored to the needs of the employees and the situation of the company is therefore preferable to a standardized "one-size-fits-all" solution in order to actually achieve the intended benefits.    

3. lack of information for employees - knowledge of strike price and liquidity preference

Other sources of error, in addition to insufficient transparency during the introduction or non-individualized target agreements, lie in neglecting to inform employees about the key technical content and terms of the participation program. For example, knowledge of the strike price and the concept of liquidation preference is fundamental.
Ignorance of the so-called strike price can quickly lead to disillusionment. This determines the value threshold above which employees can profit, or the options can be exercised, or above which economic participation occurs in the case of virtual participations. This means that before a personal profit can be made, the real shares in the company must exceed the value defined by the strike price. The higher the strike price, the more distant the actual profit of the participating employees. It is therefore not only important to set a fair strike price, but also to communicate the strike price clearly and comprehensibly to employees.
The concept of liquidation preference is similar. This describes the market-standard, preferred distribution of proceeds in favor of investors in the event of an exit. Liquidation preferences are nothing other than a preference for investors in the distribution of exit proceeds. Put simply, investors receive (at least) their investment back first before the remaining exit proceeds are distributed to the other shareholders, i.e. the employees involved but also the founders themselves.

4. inappropriate regulations on the duration of vesting

Another key element of employee participation programs isvesting. This is a staggering of the participation rights over time, which ensures that employees only acquire their shares in full after a certain period of service or the achievement of defined targets. This prevents employees from leaving the company shortly after acquiring shares and still benefiting from the shares they have received. When determining this vesting period, care should be taken to ensure that it is not unreasonably long, as this can create a feeling that the actual benefits of the shareholding are too far away. An appropriate vesting period should therefore have a motivating effect on employees and also take the interests of the company into account. Clear and fair rules on the vesting period and open communication about what happens in the event of an employee leaving early are essential in order to maximize the full impact of a vesting program.

5. disregarding legal and tax criteria

The tax and legal issues surrounding employee share ownership are complex and yet are often overlooked, even though they can have a significant impact on the effectiveness of a share ownership program. For example, the high taxation through payroll tax could come as a surprise to employees. There is also the risk that statutory regulations are disregarded, which can result in legal consequences or penalties.
It therefore makes sense to obtain detailed tax advice before concluding the contract. This is the only way for employers and employees to avoid potentially high additional payments and other disadvantages.

6. neglect of training and support services

As outlined in the previous sections, participation programs can be complex and require careful explanation and consultation. Another mistake would therefore be to neglect to provide appropriate training and support for employees to fully understand the opportunities and risks of participation and make informed decisions. Regular information events, training materials and open communication should therefore be a matter of course in the company in order to exploit the full potential of employee participation.

7. insufficient incentive effect of the participation program - low participation rate and restriction of participation rights

Employee share ownership schemes are intended to promote employee motivation and loyalty and thus contribute to improving company performance. Employee participation programs based on standard or model contracts often take insufficient account of the individual needs of employees and the company. A large part of the program's effectiveness is lost due to the associated incentives, which are not tailored to individual needs. Just like companies, employees have different financial expectations of participation or the associated objectives, meaning that a one-size-fits-all model is rarely a satisfactory solution for both sides. Only with a flexibly designed participation program can both the interests of the company be reflected and the incentive effect for employees be ensured. Flexible vesting periods (good, grey, bad leavers) or differentiated participation levels (or different strike prices) can be used, for example.

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