What start-ups should keep in mind when it comes to employee shareholdings

ESOPs, VSOPs or rather RSUs? Giving your employees a share in the company's success is complicated. Here are the best tips.

It could all be so simple. If you work for a start-up, you get the opportunity to acquire shares in the company in addition to your salary. If an exit is imminent or the valuation of the start-up increases, employees would also benefit directly.

However, the whole act can also backfire, as Klarna's employees in Germany recently found out. They had to pay thousands of euros in taxes and duties for their participation program - even though the fintech's shares were often worth less than the taxes paid after a devaluation anyway, as Finance Forward reported.

The Klarna case makes it clear why founders, but also employees, need to pay attention when it comes to employee share ownership in Germany. A look at the various options, advantages and disadvantages, as well as regulatory pitfalls - and a warning: no founder should draft participation agreements without a lawyer.

What is employee share ownership?

Strictly speaking, there are two ways to give employees a stake in the company: tangible and intangible. Material means a share in the company's capital or profits. This is usually what is meant by employee share ownership. Immaterial simply means that founders involve their employees in the decision-making processes in a company.

What is the difference between employee share ownership and profit-sharing?

Those who share in the company's success receive a bonus in addition to their salary, for example, if the company has had a good fiscal year. From a legal point of view, this is easy to do, and there is no need for an elaborate contract.

Things only get complicated when it comes to equity participation. Here, founders have the option of letting their employees participate in their company through equity. In other words, they issue shares. This works with a limited liability company or a stock corporation, either a European one (SE) or a German one. Since other legal forms make little sense for startups anyway, this article focuses here on these forms of corporations.

What are the benefits of employee ownership?

Daniel Breitinger, responsible for startups at the digital association Bitkom, is one of those in Germany who has been involved with employee share ownership for many years. "Especially when startups want to attract experienced employees, they can rarely compete with a DAX company in terms of salary," he says. That's where employee shareholdings are a good way to go, he says. According to him, founders should start thinking about employee ownership early on.

What are the disadvantages of employee share ownership?

The recent case of Klarna has made it very clear what can go wrong. On the one hand, the fintech relied on so-called restricted stock units (RSUs). Start-ups pay out part of their salaries in shares. However, employees only receive these if they remain with the company for a certain period of time. The moment they receive the shares, they are subject to a tax - and that tax can be very high. The amount depends on the employee's tax bracket and how much money they could theoretically make from their shareholding. Often, they then face the top tax rate, currently 42 percent. "Giving employees a stake in the form of RSUs is widespread abroad, but in Germany it doesn't make sense due to regulatory requirements," Breitinger therefore also says.

Another disadvantage of employee stock ownership plans: There are no standardized procedures in Germany for drawing up corresponding contracts. So the risk of making a mistake is high - especially if founders want to go through with it without a lawyer.

What do employee shareholdings typically look like?

The common employee stock option is also called Employee Stock Option (ESOP). Under this program, employees receive either limited liability company shares or stock, depending on the legal form of the startup they work for. In most cases, employees can earn the right to it by staying with the company for many years or achieving certain goals. Companies have the advantage with this form of payment that they can save on salary and still express their appreciation to their employees.

How exactly do ESOPs work?

Ideally, employees accept an ESOP offer in addition to their salary when they first join a new company. The subsequent phase in which they earn these options is called vesting. Once they have completed this, they can purchase the shares at the price set at the time. If the start-up has already increased in value over the years, this can be worthwhile. If the company's valuation has tended to go down, employees can simply let the options lapse.

The moment they exercise the option, the employees become shareholders in their company, either as shareholders or as partners in a limited liability company. If the company is a limited liability company, the first bureaucratic hurdle arises. Only a notary can register them as shareholders. So founders who have set up an employee stock ownership program for 50 employees have to run to the notary with all of them when they exercise the option. If the company is a stock corporation (AG) or a European stock corporation (SE), there is no need to go to the notary.

Once employees have acquired shares in their company, they also have voting rights. In the case of stock corporations, for example, at the shareholders' meeting. If founders want to prevent this and their start-up is a GmbH (limited liability company), they can agree from the outset that employees can only acquire silent participations via the ESOP program.

What are the legal problems with ESOPs?

The biggest problem is so-called dry income. This always arises when employees have to pay tax on their initially only theoretical profit from the participation program. Ideally, they will have acquired shares in the company at a lower price than they are currently worth. In a sense, this difference is payment to their employer. And it is precisely this so-called non-cash benefit on which income tax is levied, with a top tax rate of 42 percent if the employee is unlucky. Since employees have not received a traditional payment, but on the contrary have also spent money on their shareholdings, they have a problem. Income tax becomes due after twelve years at the latest, or when employees change employers.

What are associations demanding from policymakers?

The last German government already reacted to the problem and, among other things, increased the tax allowance to 1,440 euros per year. But that is not enough for the associations. Christian Miele, President of the Federal Association of German Start-ups, called an initial draft of the Fund Location Act, which was supposed to bring about improvements, a complete washout.

Bitkom, for example, is calling for income to be taxed only after employees have sold their shares. In addition, the planned increase in the tax-free amount to 5,000 euros is not enough to enable startups to recruit skilled workers abroad. This is because the relevant legal rules there are significantly less stringent than they are in Germany at present. The association points to Spain, among other countries, where the annual tax-free amount is 50,000 euros.

Nevertheless, the current German government has again promised improvements, as can be seen from its start-up strategy. However, the scene does not seem to have too much hope. "Obviously, the coalition partners could agree on the central issue of avoiding the so-called dry-income taxation in the case of a change of employer and after twelve years only on a test order," criticized the start-up association. For an effective improvement, much more is needed than a simple increase in the tax allowance.

Can the problems with ESOPs be circumvented?

Many start-ups in Germany rely on virtual company shareholdings, so-called VSOPs, precisely because of the dry income. In this case, employees do not receive options on real company shares, but on virtual ones. They usually get them free of charge with their salary, so they don't have to buy them from their company. Employees do not become co-owners of the start-up for which they work. They are guaranteed by contract that they will participate in the success of the start-up in certain cases as if they were the owners. This can be the case, for example, in the event of an exit.

This rule has several advantages: Since employees do not become real co-owners, they are spared the need to go to a notary. They also do not have to pay taxes until a payment is actually due. The dry-income problem is therefore eliminated.

But there are also some disadvantages: Since employees don't become true co-owners, they also don't have voting rights, unlike with normal company holdings. "Some problems can be circumvented with VSOPs, but they are not known at all abroad," Breitinger also says. "As a result, they make it difficult to attract skilled workers from other countries." So for those who are desperately looking for new employees, especially in Germany itself, VSOPs could be a good solution. But founders who also want to woo skilled workers abroad must hope above all for an improvement in the legal framework for ESOPs.