Startups use employee participation programmes to retain key employees and let them share in the company’s economic success. Alongside direct equity and genuine options, virtual participation through a VSOP has become an important model. A VSOP generally does not transfer shares or shareholder rights. Instead, it creates a contractual claim to a future cash payment, typically upon an exit. Vesting, dilution, exit definitions and good-leaver/bad-leaver provisions are therefore central.
This article reflects the document position as of 8 February 2021. It is not a current tax or legal review of an employee participation programme.
1. Why startups offer employee participation
Startups often cannot compete with established companies on salary and benefits alone. At the same time, the success of a young company may depend heavily on a small number of key employees.
An employee participation programme can combine two objectives:
- employees share in the economic success of the startup,
- the company can attract and retain important employees over the long term.
A typical package combines a fixed salary with a variable participation linked to the company’s future value.
2. Main forms of employee participation
The main models are:
- direct equity participation,
- genuine equity options, often referred to as an ESOP,
- contractual or virtual equity options, often referred to as a VSOP.
Other structures include convertible instruments, silent partnerships, profit participation rights, employee loans and debt instruments.
The appropriate model depends on the startup’s legal form, financing structure, number of participants, administrative capacity and the applicable tax framework.
3. Direct equity participation
Under a direct equity model, the employee becomes a shareholder of the startup, directly or indirectly. If the startup is organised as a German GmbH or UG, the employee is recorded as a shareholder and the participation is reflected in the shareholder list.
The employee may receive shareholder rights, including information, voting and participation rights. This can make the model unattractive for founders and investors where a large number of employees would become shareholders.
The company may also face additional notarisation, register, administration and coordination costs. These issues often lead startups to consider contractual alternatives.
4. Genuine options and ESOPs
A genuine option gives the employee a contractual right to acquire real shares at a later date, subject to defined conditions. Under an Employee Stock Option Plan, the option may become exercisable upon a successful exit.
An exercise price is usually agreed. The employee must then pay the specified price for the shares when exercising the option.
The historical discussion also highlighted the potential tax risk of so-called dry income: a taxable benefit may arise when the option is exercised, even though the employee has not yet received proceeds from a sale.
The tax consequences depend on the structure and the law in force at the relevant time and must be reviewed separately.
5. Virtual participation and VSOPs
A Virtual Stock Option Plan generally does not transfer actual shares. The employee does not become a shareholder and does not receive shareholder voting or information rights merely by entering into the VSOP.
Instead, the employee receives a contractual claim to a future cash payment if a defined payment event occurs. The virtual units are a calculation reference and not shares in the company’s share capital.
If the startup grows and an exit occurs, the employee may participate economically in the increase in value. The payment is made in cash rather than by transferring real shares.
The payment is generally calculated by reference to the difference between the virtual base value at grant and the value at the payment event. The formula should be clear and capable of being checked by the parties.
6. What should a VSOP agreement cover?
A VSOP is not a statutory standard form. The agreement should address, among other things:
- the number and economic value of the virtual units,
- the grant and any later tranches,
- a possible cap,
- the absence of shareholder rights,
- dilution in future financing rounds,
- the vesting period and milestones,
- the definition of an exit,
- the payment formula,
- good-leaver and bad-leaver consequences,
- exercise notices and payment timing.
The company may grant the units once at the beginning of the employment relationship or through a staged programme over time.
7. Vesting, good leaver and bad leaver
Vesting describes the gradual earning of the virtual participation over time or upon the achievement of contractual milestones.
A bad leaver provision may apply where the employment relationship ends for reasons considered particularly adverse to the company, such as termination for serious cause. The agreement may provide for the loss of unvested units and, depending on its terms, may affect vested claims as well.
A good leaver provision may apply where the employee leaves for reasons outside or not fully within the employee’s responsibility, such as incapacity or an ordinary termination by the company. The agreement may allow the employee to retain vested claims while unvested units lapse.
These provisions require careful drafting because they directly affect the economic value of the programme.
8. Tax and practical challenges
Employee participation can support motivation, appreciation and retention. It may nevertheless involve significant legal, tax and administrative challenges, including:
- tax treatment of genuine equity,
- dry-income risks,
- taxation of payments under a VSOP,
- valuation of the company,
- dilution in financing rounds,
- treatment on termination of employment,
- allocation of transaction costs,
- the distinction between salary and participation proceeds.
A VSOP may avoid some corporate-law complications of direct equity, but it does not automatically eliminate all tax and contractual issues.
9. Practical checklist
Founders and companies should ask:
- Is the objective recruitment, retention or variable compensation?
- Should the programme use direct equity, an ESOP or a VSOP?
- How many virtual units are granted?
- Is there a cap or more than one tranche?
- How are future financing rounds and dilution treated?
- When does vesting start and end?
- What events qualify as an exit?
- How is the payment calculated?
- What applies to good leavers and bad leavers?
- Which costs and deductions reduce the payment?
- How are exercise notices and payments handled?
Employees should additionally ask:
- Do I receive actual shares or only a cash claim?
- When do the units vest?
- What happens if I resign or the company terminates my employment?
- What happens in the event of illness or incapacity?
- How is the company value determined?
- When is the claim payable?
- What tax consequences may arise?
Advice on startup employee participation
Stroschein & Makowka advises startups, founders, investors and key employees on direct equity, ESOPs, VSOPs, phantom-share agreements, vesting, leaver provisions, financing rounds, dilution and exit-related payments.
Would you like to structure or review an employee participation programme?
Frequently asked questions
What is virtual employee participation?
Virtual employee participation generally does not grant actual shares. It creates a contractual claim to a future cash payment, typically linked to an exit or another defined payment event.
What does VSOP mean?
VSOP stands for Virtual Stock Option Plan. It reflects the economic value of an equity participation contractually without making the employee a shareholder of the German GmbH or UG.
What is the difference between an ESOP and a VSOP?
An ESOP generally gives the employee a right to acquire actual shares at a later date. A VSOP generally creates only a contractual cash claim and does not grant shares or shareholder rights.
What does vesting mean?
Vesting means that the employee earns the virtual participation gradually over a defined period or upon reaching contractual milestones.
What do good-leaver and bad-leaver provisions do?
They determine what happens to vested and unvested participation when the employment relationship ends.
When is a VSOP paid out?
Payment typically occurs upon an exit defined in the agreement. The agreement may provide for additional payment events or conditions.