Fair structuring of ESOPs and VSOPs: What do entrepreneurs need to consider?

Nowadays, employee participation is an essential part of a modern corporate culture and plays a central role in attracting and retaining managers. In the start-up world, ESOPs (Employee Stock Option Plans) are often referred to in general, but employees and managers are usually involved via Virtual Stock Option Plans(VSOPs). This means that they receive financial compensation from the company when a so-called exit takes place.

Virtual shares have established themselves primarily because the transfer of actual shares is associated with considerable expense and difficulties, particularly from a tax perspective. Even the amendments to the Future Financing Act do not solve all of these challenges. In addition, a notary is always required for the transfer of real company shares.

A thorough understanding of the mechanism behind virtual shares is crucial, as ignorance can quickly lead to disappointment. The principles applied here also apply in a similar way to real shares in the context of an ESOP.

Strike price as a decisive criterion

The strike price of a virtual participation is decisive for the amount of the subsequent exit compensation. The beneficiary only participates in any increase in the value of the company that exceeds the strike price defined in the virtual participation program.

If the strike price is EUR 100.00 per virtual share, this does not automatically mean that the virtual share has a value of EUR 100.00. The value of a virtual share is zero as long as the value of a real share in the company does not exceed the amount of EUR 100.00 mentioned in our example.

However, if the value of a real share increases to EUR 101.00 at a later date (e.g. because an investor pays exactly this amount per share), the beneficiary participates (simplified calculation) in the amount of the difference, i.e. in the amount of EUR 1.00 per virtual share.

Setting the base price very high or even too high can therefore have a detrimental effect on the employee. The lower the base price of a virtual share, the easier it is for the beneficiary to participate in the exit at a later date. The probability of actually being able to benefit from a later exit increases if the base price of the virtual share is set lower.

However, the hasty conclusion that virtual shares are unfair is misleading. The reason is obvious. In the case of a transfer of actual shares, the beneficiary would also have to pay the actual value of the shares in cash, as otherwise gift tax would be due on the difference corresponding to the monetary benefit. In contrast, virtual shares are issued as so-called additional remuneration without a cash payment to be made by the employee. It is therefore perfectly fair to set a well-chosen, i.e. realistic, base value as long as this is communicated clearly and openly. Transparency is therefore of great importance in this context.

Nevertheless, in cases similar to the example described above, it is not uncommon for people to wrongly assume that the virtual shares have an intrinsic value of € 100 when they are allocated. In order to clear up this misunderstanding, it is necessary to understand the meaning of "intrinsic value" in this context. Only when an exit actually occurs, i.e. a payment claim arises, do the virtual shares also have a real value. In addition to the total exit proceeds, the strike price, i.e. the base value, then comes into play as an elementary calculation parameter.

Information asymmetry: liquidation preferences

Another key issue is the limited access to key information, particularly that which is important for calculating the exit compensation. As a rule, investors' so-called liquidation preferences are deducted from the total proceeds generated when a company is sold. These preferences favor investors in the distribution of profits - in concrete terms, this means that investors first receive their invested capital back before the remaining proceeds are distributed among the other shareholders.

The structure of these liquidation preferences is often more investor-friendly. Investors thus receive certain privileges for their previous investment without the beneficiaries of VSOPs or ESOPs having any influence on these processes. In some cases, liquidation preferences can mean that even founders receive little or no share of the sales proceeds. The structuring of these preferences, which take place without the participation of the VSOP beneficiaries, can therefore be highly disadvantageous. As a rule, the beneficiaries are only granted insight when both the liquidation preferences and the exit amount are either communicated by the founders or made public.

Fairness and flexibility: compensation without exit

Over time, both the company and the interests of shareholders and investors can change. For this reason, most virtual participation programs provide for holders of virtual shares to receive a financial settlement before an exit. It is important to precisely define the criteria according to which this compensation is calculated. As a rule, this is based on the valuation of the company after the last financing round. If there has been no recent financing round or if this was a long time ago, it is advisable to determine the company value using classic company valuation methods.

However, caution is required: It must be ensured that the company or the founders do not circumvent their obligations to the holders of the virtual shares by making a lower settlement payment in the knowledge that an exit is imminent. Therefore, the possibility of compensation should be regulated in such a way that it cannot be exercised in a fixed period before an exit (e.g. within six months). Here, too, it is crucial to strike a fair balance between the interests of the company and those of the beneficiaries. A fair balance in the regulations is essential in order to achieve the objective of the virtual participation program: to increase the motivation of the beneficiaries.

Vesting: Fade-Out?

Vesting is often a topic of discussion. It determines the conditions under which virtual shares - or more precisely, the entitlement to exit compensation - are lost if the beneficiary leaves the company. Bad leaver and good leaver clauses are usually used here, which regulate either the complete or partial loss of shares in the event of an exit. These are often supplemented by so-called grey leaver clauses, which take into account the fact that not every situation is clear-cut. The aim of these clauses is to avoid unfairly disadvantaging the beneficiaries, as this could legally invalidate the clauses. At the same time, they serve to bind the beneficiaries to the company in the long term and make them part of the entrepreneurial vision until the exit.

However, employees should always ask themselves whether the vesting regulations contain so-called leaver events that they can control and what effects a leaver has - or whether the regulations can also lead to a forfeiture of virtual shares that are beyond their control.

However, it is important that employees always consider whether the vesting conditions include leaver events that they can influence and cover the consequences of leaving the company. They should also consider if and when provisions will lead to the loss of their virtual shares in situations beyond their control.

Such a case can occur, for example, with so-called "fade-out" clauses. Here, virtual shares that have already been earned(vested) can be partially forfeited again if the sale of the company (exit) takes place many years after the beneficiary leaves the company. These provisions often stipulate that the virtual shares are reduced to a minimum value (floor). If this clause is not negotiable, care should be taken to ensure that this floor is appropriately high - for example, it should be at least 50 or 80 percent of the virtual shares already vested.

Conclusion - finding fair compromises

Virtual participation models remain the preferred means of venture capital and start-ups in Germany. They can be implemented quickly for companies of any size and offer extensive customization options thanks to the flexible contract design.

Although participation programs should be designed in such a way that they serve the interests of the company and the investors, they must not be to the detriment of the beneficiaries. If the terms of a virtual participation program are disadvantageous to the beneficiaries and depend solely on the decisions of the company or the investors, without the beneficiaries being able to influence them, the program fails to achieve its actual purpose and benefit.

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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