The Ten Most Important Questions About ESOPS
You have founded a startup and hired the first employees. Because employee salaries in startups are often – lower than they might be in more established companies, you want to incentivize and compensate the employees through participation in the growing value of the startup. What do you do? The most common method of giving employees a share in the company's success is a virtual stock option program, also known as virtual shares, VSOPs or ESOPs.
1. What are virtual shares?
Virtual shares are a partial replica of a real shareholding in a company. In other words, although the employee does not acquire a true participation in the company, he or she is placed in the same economic position (at the time of an exit). In contrast to a real shareholding, employees do not make any contribution or other payment and do not acquire any shareholder rights such as voting or information rights. Instead, employees acquire contractual payment claims against the company in the event that the company is sold – similar to an exit bonus. At the time of exit, employees thus benefit from the increase in the company’s value to which they have contributed through their work.
2. How does the granting of virtual shares work?
The granting of virtual shares usually is done as follows:
- The founders ask a lawyer to draft the terms of a virtual stock option program for the company. Similar to general terms and conditions, these are the standard terms under which virtual shares are then issued.
- The shareholders pass a resolution to set up the virtual stock option program in accordance with these terms and determine the maximum number of virtual shares that may be issued. To make it easier to calculate, each virtual share is assigned a virtual nominal value of EUR 1, as is the case with real shares. It is common practice to issue 5% to a maximum of 10 % of the share capital to employees as virtual shares.
- Tip from the field: It is better to start with a smaller program and issue fewer virtual shares to individual employees. You can always increase the number of virtual shares. However, if you have distributed all virtual shares early during the company’s development, there may be no more virtual shares available to incentivize additional employees. Then there is often no choice but to create more virtual shares for which the founders bear the economic burden.
- With the shareholder resolution, the program is in place. Virtual shares can now be issued to individual employees. To this end, the employee receives a grant letter setting out the key points of his or her virtual shareholding. These are:
- Number of virtual shares (with a virtual nominal amount of EUR 1).
- Vesting period, i.e., the period over which the virtual shares gradually vest (more on this in a moment under section 3).
- Cliff, i.e., the first part of the vesting period in which no virtual shares have yet vested (effectively the trial period).
- Grant date on which vesting period and cliff begin.
- Issue price, i.e., the notional value of a virtual share at the time of allocation. Unlike with real shares, the employee does not have to pay this amount, but it is deducted from the proceeds to which the employee is entitled on exit.
3. How does vesting work?
The employee is allocated a certain number of virtual shares right from the start. However, these do not yet fully “belong” to the employee. Rather, the employee must first earn them over a certain period of time – the vesting period. At the beginning of the vesting period, there usually is a cliff during which the employee does not earn any virtual shares. If the employee leaves the company before the end of the vesting period, he or she loses all or part of the virtual shares.
Example: Employee A is allocated 500 virtual shares with a vesting period of 48 months and a cliff of 12 months.
In the first 12 months, the cliff, no virtual shares vest. If the employee leaves the company, e.g., by giving notice, he or she loses all virtual shares. At the end of the cliff, 12/48 or 125 virtual shares in our example, vest all at once. If the employee now leaves the company, he or she can keep these shares (for exceptions see below) and the remaining 75% are forfeited. Subsequently, at the end of each month, 1/48 of the virtual shares vest (i.e., “belong” to the employee permanently). Finally, 48 months after allocation, the employee can keep all virtual shares.
But beware: This only applies if the employee leaves due to a so-called good leaver event. For example, if the employee is dismissed due to illness or terminates for good cause for which the company is responsible. However, if the employee terminates the employment at will, this often constitutes a so-called bad leaver event. As a consequence, if the employee leaves the company during the vesting period for a reason such as wanting to take another job, he or she often loses all virtual shares.
Note: Vesting periods of 36 to 48 months and a cliff of 6 to 18 months are common. If the employee has already been with the company prior to being granted virtual shares, the cliff may not apply at all.
4. Do virtual shares dilute in a financing round?
Yes and no. In percentage terms, virtual shares are dilutive, but not in economic terms (which is what matters).
Back to our Example: A limited liability company has a share capital of EUR 25,000 with 25,000 shares at EUR 1 each and has issued an additional 2,500 virtual shares (with a virtual nominal amount of EUR 1 each). This means there is a total of 27,500 (real and virtual) shares. Our employee with 500 virtual shares therefore would have a participation of 500/27,500 or ~1.82%.
If the share capital is now increased by EUR 6,000 as part of a financing round, there then will be a total of 33,500 (real and virtual) shares. As a result, our employee would only have a participation of 500/33,500, i.e., ~1.49%. In percentage terms, the employee’s shareholding was diluted.
However, the economic value of each real and virtual share has not changed as aresult of the capital increase because the value of the entire company has increased. To illustrate this, let us assume that the company was worth EUR 5,500,000 before the capital increase (i.e., pre-money). Then the value of a share, considering the virtual shares (in VC-speak fully diluted), would be EUR 200. The investor who takes over the new shares with an aggregate nominal value of EUR 6,000 therefore must pay EUR 1,200,000 to the company.
After the capital increase (i.e., post-money), the company is worth EUR 5,500,000 + EUR 1,200,000 = EUR 6,700,000. Thus, the value of each of the 33,500 real and virtual shares remains at EUR 200.
It is therefore important to understand that a virtual shareholding does not give you a certain percentage of the company’s share capital but a certain number of virtual shares. Incidentally, this is no different from a real shareholding: A shareholder also holds a certain number of shares and not a fixed percentage in the company. If he or she wants to avoid dilution in percentage terms as part of a capital increase, he or she has the right to acquire new shares against payment of the issue price – in our example EUR 200. If the employee does not pay, his or her shareholding is diluted in the same way as with virtual shares.
5. What happens in the event of an exit?
In an exit, the employee shares in the exit proceeds. The most important aspects are:
Generally, the following events are considered exits: (1) sale of a majority stake in the company, (2) sale of almost all assets, (3) IPO, or (4) liquidation.
Transaction costs are first deducted from the purchase price received by the shareholders.
If the shareholders’ agreement contains so-called liquidation preferences infavor of investors (i.e., a preferential allocation of the exit proceeds in the amount of the cash investment of each investor), these are served first. What then remains is distributed to all shareholders and the virtually participating employees. In most cases, whatever amount was paid to the investors under the liquidation preference is then set-off against additional payments. Thus, the investors only receive more money after all other shareholders have received the same amount as the investors (so-called catch up).
The employee must then deduct from this the issue price that was determined when his or her virtual shares were allocated.
6. Is it possible to participate in current profits in addition to exit proceeds?
Yes, this is possible. However, this option does not play a role for most startups because they do not generate profits – at least in the first few years – or profits are not distributed but invested in further growth. In the case of companies that expect to break even in the first few years after their founding and are not only designed for growth, virtual profit sharing is also by no means uncommon.
7. How is the whole thing taxed?
Because the employee receives the virtual shares in return for his or her work performance – as a quasi-wage substitute – inflows from the virtual shares (e.g., upon exit) are treated as wagesand are subject to income tax. In addition, social security contributions are levied.
However, the tax is not due when the virtual shares are granted, but only when the employee actually receives money. The employer must then withhold wage tax and social security contributions, as with normal wages.
Unfortunately, the tax burden cannot be reduced by granting the virtual shares to a UG/GmbH of the employee instead of the employee himself/herself. In this case, the inflows likewise would be treated as wages and salaries.
8. Are there any other liability risks for employees?
Apart from the obligation to pay wage tax and social security contributions on inflows, there are no liability risks for employees.
9. What impact do virtual shares have on the balance sheet?
During the term of a virtual stock option program, it may be necessary to establish provisions forthe possible claims of employees. This applies at least if an exit is very likely.
It is therefore possible that the company will become overindebted on its balance sheet as a result of the investment program. But do not worry: This does not mean that an insolvency application must be filed, because insolvency law requires more than over-indebtedness on the balance sheet for an insolvency application.
Rather, the impact on the balance sheet is more of a “cosmetic” issue – over-indebtedness just does not look good and could possibly scare off contractors as well.
10. How much does a virtual stock option program cost?
The costs are limited to the invoice of the lawyer who sets up the program. Specialized law firms that have a lot of experience, i.e., for whom virtual stock option programs are part of their “bread and butter business,” are often somewhat less expensive and sometimes even offer flat rates. This avoids nasty surprises when it comes to the bill.
One final tip from the field:
If you decide in favor of a virtual stock option program, keep an Excel spreadsheet from the very beginning showing how many virtual shares were issued to which employee. Also keep record of the date the vesting ended in case an employee leaves that company. In addition, save the associated documents (i.e., grant letters and termination notices) as a pdf in a folder. Experience has shown that if your startup grows, hires many employees and issues virtual shares (and some employees may leave), then after some time there may be no clear record to provewho is entitled to what. Uncertainty leads to disputes and scares off both investors and potential buyers.
You want to know more about virtual shares? Then send us an e-mail at firstname.lastname@example.org and we will arrange a (free) telephone call.
Good luck with your startup and your virtual stock option program!
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