Virtual employee ownership – 10 facts start-ups and their investors should know!

Start-up companies, as well as medium-sized enterprises, now offer a wide variety of employee participation models. Even though employee participation programs differ in their designs, they nevertheless have the common goal of retaining managers, executives and, in particular, skilled personnel in the company in the medium term. In this connection, virtual employee share programs attempt to create a special incentive for qualified employees to contribute to the economic success of the company at lower wages and increased commitment, by giving them a share of this success in return.

Especially in the area of venture capital, virtual stock option plans are currently becoming increasingly popular, in particular among financed start-ups. Since the financial resources available for hiring qualified employees are limited, especially in the case of start-ups, the assurance of a share in a future, albeit uncertain, sale of the company (exit) in the form of a bonus payment with a virtual shareholding is a popular alternative.

As a business owner, do you also intend to implement a virtual employee stock option program? If so, it is imperative that you follow the 10 points below!

Virtual Stock Option Plan (VSOP), Phantom Shares & Co. as “Scene Instruments” of the Venture Capital Community (Copyright: WrightStudio/adobe.stock).

Fact 1: virtual employee participation in a limited liability company

In start-ups, which are often not as financially strong, qualified employees are recruited or retained with the prospect of a future share in profits in order to achieve a rapid increase in the value of the company and thus a successful sale (exit) in the shortest of time (build-to-sell). In conclusion, if the exit is successful, the employees will participate financially in the exit proceeds via the virtual participation programs. Therefore, it is of great importance for employees as holders of the virtual shares to understand how the increase in value of the company arises and how the employee can contribute to ensure continuous growth of this value.

The granting of phantom shares is not limited to (future) employees of the start-up, but can also be granted outside the circle of managers and employees, for example to key contractual partners.

In the case of a German limited liability company (GmbH), the virtual company shares are granted exclusively by means of a contract under the law of obligations between the start-up German limited liability company (GmbH) and the employees benefiting from the phantom shares. Due to the simple contractual nature of VSOP, the content of the individual employee participation programs vary widely. Generally, in the event of an exit (share deal, asset deal, change of legal form or IPO), the beneficiary employees are at least regularly entitled to premium payments from the virtual shares in the German limited liability company (GmbH).

As a result of the contract under the law of obligations concerning the virtual shares, the employee thus participates in the future increase in the value of the company. The participation agreement will typically grant the employee a certain number of virtual shares, which are linked to a nominal amount of the German limited liability company’s (GmbH) share capital.

Fact 2: VSOP vs. ESOP

It is not uncommon for the employee to be „lured“ into becoming a virtual shareholder of the start-up company upon signing the contract for the provision of phantom stock. It has to be noted, that the employee does not receive a genuine equity stake, but merely a claim to premium payment under the law of obligations. In contrast to Employee Stock Ownership Plans (ESOP), the employee does not have the genuine shareholder status of a German limited liability company (GmbH) shareholder. Consequently, they are not entitled to the information, monitoring and profit-sharing rights enjoyed by a genuine German limited liability company (GmbH) shareholder.

Even if the employee has no information rights under company law, the participation agreement regularly provides for a certain degree of transparency in the event of an exit. This results from the contractual assurance, that the employee will be able to calculate his participation correctly even when he leaves the company.

Unlike in the case of an ESOP, the phantom stockholder generally retains the legal status of an employee without restriction for the purposes of labour, social security and tax law. However, the situation is different in the case of atypical shareholding arrangements (silent partnerships, etc.).

Fact 3: benefits of the virtual employee stock option programs

From the perspective of the start-up and its investors, virtual stock option plans create a high degree of flexibility in personnel costs and financial planning. This is because qualified employees can be tied to the start-up company, at least in the medium term, through the virtual shareholding, despite a regularly below-average compensation basis. It is precisely because of the virtual shareholding that employees go without high compensation and speculate instead on the big profit in the event of a successful exit in the future.

Another advantage through the legal lens is certainly that the creation and granting of VSOP – unlike the ESOP – does not require notarization. Virtual employee stock option programs thus save time and, above all, costs!

Fact 4: tax treatment of virtual stock option plans

The virtual stock option plans are essentially employee compensation, which in some cases may give rise to difficulties in delimitation with regard to their tax location. In principle, virtual employee stock option plans do not constitute a co-entrepreneurship, which is why there is also no income from trade or business (cf. Section 15 German Income Tax Act (EStG)). Income from capital assets (cf. Sections 17, 20 German Income Tax Act (EStG)) is also ruled out regularly because a virtual participation in the company is not provided to the employee for free use in return for payment.

Instead, the phantom shares are granted to the employee in return for his or her work, which is why these virtual shareholdings are generally classified as income from employment (cf. Section 19 German Income Tax Act (EStG)). Therefore, from a tax perspective virtual participation programs should be structured in such a way no income tax incurs with the granting or successive vesting. An ordinary employee would simply not be able to bear the tax burden due to the lack of an inflow of liquid funds. Nor do the virtually participating employees benefit from Section 19a of the German Income Tax Act (EStG), which came into force on July 1, 2021: this new legal provision on tax relief only applies to genuine employee stock ownership plans (ESOP).

Participation with virtual company shares should therefore not be too similar to genuine Employee Stock Ownership Plans (ESOP), as these – outside the scope of the new Section 19a of the German Income Tax Act (EStG) – lead to an increase in the employee’s assets at the time of the share transfer and trigger income tax. Therefore, if the VSOP is too close to a genuine company shareholding, there is a risk that the employee with a virtual shareholding will incur income tax liability at the time the virtual shares are granted and thus well before the conditions for the premium payment are met.

For this reason, the structure of VSOP under the law of obligations should always be considered, evaluated and examined from a tax perspective as well.

Fact 5: risks for management and employees

Furthermore, virtual employee participation programs entail certain risks at the level of social security contributions if the respective employee’s current salary is below the annual contribution assessment threshold for health and long-term care insurance as well as pension and unemployment insurance. In this respect, care must be taken to ensure that virtual employee participation does not increase the current social security obligation unnoticed. Otherwise contributions would not be paid correctly by the employer and employee, which in turn could lead to significant additional payments and possibly criminal consequences. In many cases, this would also result in personal liability on the part of the managing directors.

Fact 6: typical contractual provisions of a VSOP

a) law of the general terms and conditions & labour law

A contract on virtual employee participation which has not been individually negotiated is generally subject to the law on general terms and conditions (§ 305 et seq. BGB) in favour of the employee. In particular, the area exception on general terms and conditions for the area of company law stipulated in Sec. 311 (4) Sentence 1 German Civil Code (BGB) will not apply; after all, the employee is not granted a real participation in the company.

Furthermore, participation agreements or individual contractual clauses based on employment law may be invalid or at least open to challenge if the employee is placed at too great a disadvantage and if there is a lack of transparency to the detriment of the employee.

b) content of the contract (breakdown)

As a rule, employees are not granted the full amount of the promised employee participation immediately upon conclusion of the contract. Instead, various contractual provisions ensure that the phantom shares are granted in stages and subject to the fulfilment of certain conditions.

• vesting clause:
  Employees generally earn their virtual shareholding in stages (vesting) – after expiry of a waiting period (cliff) – within a regular savings period of four to five years (vesting period). The participation agreements under the law of obligations between the Company and the employee may also provide for an accelerated vesting. This means that the employee is entitled to the full amount of the virtual employee participation even if the exit event takes place within the vesting period.
• anti-dilution rule:
  In the case of certain capital measures, there is no protection for the holders of the virtual shares in Start-up-German limited liability company (GmbH) against dilution (anti-dilution). This intends to ensure that investors can enter the company in future financing rounds without legal or factual obstacles. As a result of the anti-dilution provisions, the employee’s (virtual) shareholding is regularly reduced in its economic value by shares taken over by an investor as part of a capital increase at the German limited liability company (GmbH). If such regulations are included, the mandatory legal limits must be explored. This is because the waiver of protection against dilution is not appropriate for every capital measure and may be invalid under certain circumstances.
• down-rounds clause:
  For the employee participating in the virtual employee stock option program, it is also important to consider to what extent the investors have contractually secured themselves against down rounds in the event of a decline in the value of the company or whether there are contractual provisions (e.g., weighted-average) on the basis of which investors can take over company shares at a reduced price in future financing rounds. This also regularly leads to a dilution of the virtual employee’s shareholding.
• expiration clause and good & bad leaver provisions:
  The vested virtual shares (see above) may forfeit based on contractual provisions if the employment relationship between the employee and the Company is terminated due to circumstances for which the employee is responsible. If the forfeiture clause applies, the entire entitlement to the (earned) bonus payment forfeits. The departing employee thus has no claim to payment from his phantom shares and consequently loses his targeted profit.

  In connection with the departure of the employee from the employment relationship at the start-up, the contract of participation under the law of obligations regularly contains good leaver and bad leaver provisions, which in turn determine whether a departed employee may retain his virtual participation at all and, if so, in what amount and, above all, for how long. At this point, compatibility with the law governing general terms and conditions and labour law must once again be strictly observed if the company and its investors do not want to experience any unpleasant surprises later on.

Fact 7: EXIT – liquidation preferences and severance arrangements

• If the exit requirements are met, the employee receives a claim under the law of obligations for payment of the bonus against the Company as the contractual partner.
• The amount of the aforementioned payment claim is based on a contractual formula and is generally linked to the exit proceeds. As a rule, liquidation proceeds from one or more investors/shareholders are first deducted from the exit proceeds (e.g. disposal and transaction costs). The employee then participates in the remaining (net) proceeds in the amount of his or her pro rata virtual shareholding in the company. In some cases, the participation agreements also provide that the shareholders or investors can buy the vested shares from the employee under certain conditions.
• In the case of partial company sales (share deal, asset deal), the participation agreement typically provides that the employee with the virtual shareholding also participates in the partial company sale only to the extent that the company was also sold on a pro rata basis.

Fact 8: rights of the holder of phantom shares

Since virtual participation in a company does not convey a genuine shareholder position, the minority protection anchored in company law (e.g., law of German limited liability company) does not apply to VSOP either. Instead, the employee’s protection must be defined in detail in the participation agreement under the law of obligations; these contractual rights primarily include the control and information rights of the virtually participating employee. Since the employee bears a personal risk, with his lower salary and his „bet“ on the premium payment from the virtual shares, that should not be underestimated, this in principle also needs to be taken into account appropriately in the contractual formulation of the participation program. In addition to the risk of invalidity of individual clauses, particularly on the basis of the law governing general terms and conditions and labour law, an employee program that is not structured „fairly“ fails to achieve the desired objectives and incentive effects.

Fact 9: preferential rights of investors

The existing proceeds and liquidation preferences in favour of the investors and (old )shareholders must not disadvantage the virtually participating employees too much. From a legal point of view it always becomes critical if the participation agreement only provides for abstract preferential rights for the investors and/or shareholders which are hardly comprehensible for the employee as the holder of the virtual participation, but which can have a strongly claim-reducing effect on the employee’s premium payment.

The participation agreements should therefore transparently regulate whether and, if so, to what extent transaction costs, fees, taxes, liquidation preferences or similar have a reducing effect on the calculation of the premium payment in the event of an exit. If this transparency requirement is not sufficiently complied with, there is a risk that certain provisions of the participation agreement will be invalid in favour of the virtually participating employee.

Fact 10: balance of interests, transparency and win-win situation

The virtual employee stock option programs have proven to be a charming instrument for start-ups and medium-sized companies as well as qualified employees to develop the company quickly and dynamically and to allow the employee to participate appropriately in its successful growth. In this respect, it is a win-win situation for investors, shareholders and employees. However, the prerequisite for this is that the necessary transparency, a balanced reconciliation of interests and an appropriate level of protection for the employee are created in the participation agreement.

If the participation agreement does not sufficiently take into account the interests of the virtually participating employee, this may lead to the clause disadvantaging the employee being invalid (see above). It is essential that the company and its shareholders and investors pay attention to this. Appropriate legal advice will generally be indispensable.

If you have any questions about real and/or virtual employee stock ownership programs (ESOP/VSOP) or intend to implement such a participation program in your company, please feel free to contact the author of this article. We will be happy to draft a custom-fit real or virtual employee stock ownership program for you and accompany you through all relevant steps.

Author: Lawyer Dr. Karl Brock, MEYER-KÖRING, Bonn