How Do Employee Participation Schemes Work in German Startups?

​The competition for talent has become a major challenge for many start-ups in Germany. As a result, employee share ownership programs can provide a strong tool for success.

There are many forms of employee participation. The choice of a suitable employee participation scheme must be made individually for each start-up. The occurrence of the so-called exit event—for example, sale of the company or initial public offering—is of particular importance in the usual models, as it reconciles the interests of the shareholders and the employees of a start-up by allowing the employees to participate in the value increase of a company rather than just in the profit, as is usually the case with bonuses. However, the content of the programs is similar across all models, in particular regarding the vesting and leaver arrangements.

Here is a short summary some of the available forms of employee participation schemes in Germany.

Participation in Form of GmbH Shares

Real employee GmbH-shares give the beneficiaries a share in the start-up under corporate law. In light of increased administrative burden and tax risks, this model is usually chosen only before the first financing round and only for a small circle of the core management team. GmbH is a German abbreviation for a "Gesellschaft mit beschränkter Haftung," which means "company with limited liability" and is the most common form of incorporation in Germany, according to Investopedia.

If the intention is to involve more than a handful of key employees, such employee shares are regularly pooled in a vehicle (e.g. in the form of GmbH & Co. KG). KG is an abbreviation for Kommanditgesellschaft—a limited partnership legal form and a GmbH & Co. KG is a limited partnership. One of the advantages of this structure is that the other shareholders, especially in decision-making processes, and future investors, especially in financing rounds, of the start-up are dealing only with the pooling vehicle and not with a larger number of employees. 

Although employees are in general contractually not allowed to directly sell the shares after receiving them, the noncash benefit (discount on issued shares) is usually subject to income tax upon receipt of the shares (so-called dry income). With the German Fund Location Act (Fondstandortgesetz) (in effect) and the future German Future Financing Act (Zukunftsfinanzierungsgesetz) (federal government draft, not yet in effect) this tax risk is and will be further reduced to a certain extent as it includes provision deferring the taxation in certain cases for employees until the taxable income is liquid again. The latest legislative initiative will make real employee participation more attractive for start-ups.

Options to Acquire Real GmbH Shares (ESOP)

Employee stock ownership plans (ESOPs) are stock options that give the beneficiary a right to receive a certain number of shares in a GmbH at the exit event. Frequently, the employee is given the opportunity to buy the shares at a fixed price (strike price). At the exit event, it is either allowed or required to immediately sell the shares. Another method is to receive a cash payment amounting to the difference between the strike price and the proceeds attributable to a common share. The reason for this type of settlement is that, except in the case of an initial public offering, the investors usually want to avoid including the option holders in the direct shareholder circle of the start-up, as this could complicate the management of the company or the implementation of an exit.

Virtual Share Option Program (VSOP)

In contrast to real equity participation, employees never receive real shares in the start-up under a virtual share option program (VSOP). Instead, the beneficiaries receive a contractual payment claim in case of an exit event. The amount of the payment claim is variable and is based on the proceeds the employees would have received if they had exercised "real" options instead of "virtual" options or how much a holder of a common share would have received in the exit event, taking into account a strike price agreed for the virtual share at the time of issue. Ultimately, this is a complex calculated exit bonus.

What Are Growth Shares?

Modelled after the British growth share approach, German (real) employee share schemes use negative liquidation preferences to avoid dry-income taxation. To this end, the beneficiary shall participate only in earnings from a sale of the company or in the distribution of dividends once a certain hurdle value has been exceeded, which corresponds to the share of the company value attributable to the growth shares at the time they were issued to the beneficiary. The use of growth shares is currently still subject to major uncertainties due to a lack of uniform administrative practice by the German tax authorities.

Louisa Graf is an attorney with Bird & Bird in Munich. © 2023 Bird & Bird. All rights reserved. Reposted with permission of Lexology.