Traditionally, companies have used employee stock option plans (ESOPs) or phantom stock programmes (VSOPs) to incentivise their employees and give them the opportunity to participate in the company's long-term success. The current draft bill to adapt Section 19a of the German Income Tax Act (EStG) to practical requirements and international standards underlines the relevance of employee participation programmes at the present time. However, traditional employee share ownership programmes come with various disadvantages. They are complex to implement, cannot grant voting rights and are subject to personal tax rates. An alternative to ESOPs and virtual instruments are hurdle shares, which will increasingly replace traditional ESOPs.
The participation of employees in the economic success of the company can be structured in various ways in practice. The most common instruments that avoid the so-called dry income problem, i.e. tax-damaging salary inflows without a corresponding cash inflow, are (i) "real" ESOPs and (ii) virtual shareholdings (VSOP, phantom stock programme).
ESOPs
A "genuine" ESOP structure is characterised by the fact that it grants the beneficiaries the right to acquire real company shares at a defined point in the future. The legal implementation takes the form of an ESOP programme, which initially defines the framework conditions for employee participation. Among other things, this defines the vesting period and the conditions for exercising the purchase options.
Based on this ESOP programme, employees are then granted options by means of separate allocation letters. The allocation letters also contain the so-called base price or strike price. This is the amount that the employee must pay for a share in the company if the option is exercised. The strike price can therefore be used to control the company valuation from which the employee participates in the economic success of the company.
As the ESOP programme is aimed at granting genuine shares, a corresponding capital measure is required to create these shares when the option is exercised. In practice, authorised capital is created at the same time as the ESOP programme is implemented in order to secure the rights of the ESOP beneficiaries. ESOPs cannot convey voting rights. Until the option is exercised and the shares are actually granted (although this rarely happens), ESOP beneficiaries have no partner or shareholder rights.
The ESOP therefore entails a certain amount of implementation and administrative effort, which is manageable but often not justified. As a rule, employees are not interested in becoming shareholders, but in receiving the equivalent value of the shares (less strike price). Companies also have little interest in putting a large number of small shareholders on the cap table. For this reason, ESOP programmes usually include the option for the company to satisfy the ESOP beneficiaries in cash (cash settlement option).
In the event of an exit event, the purchase agreement will regularly provide for the existing ESOP programme to be replaced in full by a portion of the purchase price. The buyer will often implement a new ESOP programme after the closing in order to incentivise employees again.
Under tax law, ESOP payments to employees are subject to taxation at the personal tax rate (up to 45 % plus solidarity surcharge).
Virtual participations
Virtual shareholdings are generally more flexible. These are purely contractual obligations on the part of the company to pay employees an amount of money under certain conditions that corresponds to the equivalent value of real shares less a strike price. Virtual shareholdings are therefore not aimed at the employees becoming partners or shareholders at the end of the day.
Legal implementation also takes place on the basis of a participation programme and individual allocation letters. As there is no need for a capital measure to satisfy the claims in this case, there is also no need for statutory protection in the form of authorised capital or similar. However, it is advisable to include regulations within the group of shareholders as to which shareholders are to be burdened by the virtual participation and to what extent. In the exit event, the company's payment obligation is recognised as a "debt" or "debt-like" item, reducing the purchase price and reducing the exit proceeds to be distributed. If no other arrangements are made, e.g. in the shareholders' agreement, the shareholders are all diluted pro rata in proportion to their shareholding.
The implementation and administration costs of a virtual participation are lower. In practice, you therefore see more virtual participations than real ESOPs. However, they also cannot convey voting rights and, like ESOPs, are subject to taxation at the personal tax rate.
Hurdle shares as an alternative
Hurdle shares are initially understood to be "normal" shares that are issued to employees at a nominal amount of EUR 1. Unlike ESOPs, employees receive these shares immediately and not later when they exercise a purchase option.
However, these shares differ from other shares in one respect in particular: They are provided with a so-called negative liquidity preference. Similar to the strike price mechanism, employees should not participate in the value of the company at the time the hurdle shares are issued, but only in the future increase in value. The negative liquidation preference therefore stipulates that the hurdle shares only convey a right to any exit proceeds if and to the extent that the company valuation has exceeded a certain value (i.e. the hurdle).
Therefore, there is no taxable non-cash benefit at the time the hurdle shares are granted. Although the employees receive the shares immediately, they do not convey any rights to profits or exit proceeds. Consequently, there is no dry income problem. Close consultation with the tax advisor is strongly recommended when determining the hurdle.
Example: At the time the hurdle shares are issued, the valuation of the company is EUR 100m. However, any exit proceeds or profits of the company are only allocated to the hurdle shares if and to the extent that the valuation of the company has risen to EUR 100m+. Prior to this, hurdle shares receive nothing.
Another tax advantage is that the exit proceeds from hurdle shares are subject to taxation as capital income at the flat-rate withholding tax rate (25% plus solidarity surcharge). This should be a key argument for employees, but above all for founders. Hurdle shares have a higher economic motivational effect with the same dilution effect.
Another bonus is the possibility of being granted voting rights. In principle, each share grants one vote. However, hurdle shares can also be structured as non-voting shares in accordance with the articles of association. They therefore offer full flexibility in this aspect.
However, hurdle shares have one disadvantage. Every employee who receives hurdle shares is included in the list of shareholders and on the cap table. However, if desired, this can be avoided by pooling hurdle shareholders in a new company created for this purpose. However, the formation or purchase of a new company for the purpose of pooling does not make hurdle shares a less costly variant of employee participation.
Conclusion
The tax advantages of hurdle shares and the additional flexibility with regard to the granting of voting rights regularly make hurdle shares a preferable instrument compared to ESOPs or virtual participations. To avoid the dry-income problem, the definition of the hurdle should be closely coordinated with the tax advisor. It can be assumed that hurdle shares will replace traditional ESOPs or virtual participations more frequently in the future.