ESOP

What is an ESOP?

ESOP (Employee Stock Option Plan, Mitarbeiterbeteiligungsprogramm) denotes a programme with which a company gives employees and managers a share in future growth in value. This is done either through options, that is, the right to acquire real shares later at a fixed price, or through virtual shares. Virtual shares establish a claim to a payment on exit, the sale of the company or the IPO. In German usage the abbreviation serves as an umbrella term, also for virtual programmes (VSOP) without real options. Mitarbeiteroptionsprogramm (employee option programme) is also used as an equivalent term.

The programme is set up by the company, as a rule on the basis of a shareholders' resolution. Investors usually have to consent, because they have secured a consent right for this in the shareholders' agreement. The programme consists of plan terms that apply to all participants and of individual grants. In funding rounds, the size and timing of the pool, that is, the shares reserved for the programme, are negotiated in the term sheet, the declaration of intent setting out the key terms of the round. In the US market, the same abbreviation stands for the Employee Stock Ownership Plan, a company pension model; option programmes for employees are usually called stock option plans there.

Forms of employee participation in Germany

Real options and direct participation

Real options give the right to acquire shares in the company at a fixed price. For a GmbH (German limited liability company) this is cumbersome. If existing shares are to be transferred, even the option grant must be notarised as an obligation to assign under Section 15(4) of the German Limited Liability Companies Act (GmbH-Gesetz, GmbHG). The later assignment also requires notarisation under Section 15(3) GmbHG. If new shares are to be created, a capital increase is needed, which takes effect only on entry in the commercial register. An authorised capital under Section 55a GmbHG, that is, an authorisation of the management in the articles of association, saves the separate shareholders' resolution, but not the notary and the registration. Every participant becomes a shareholder, with voting rights, the rights to information and inspection under Section 51a GmbHG and the power to challenge resolutions.

With a larger group of participants, direct participation is therefore often pooled through a holding vehicle, for example a GmbH & Co. KG, which in turn becomes the shareholder. For tax purposes, the discounted acquisition of real shares leads to employment income to which no liquidity initially corresponds. Section 19a of the German Income Tax Act (EStG) can defer the taxation and was significantly extended from 2024; the details are explained in the entry Taxation of Options.

Virtual programmes (VSOP)

Under a virtual programme (Virtual Stock Option Plan, VSOP), employees receive no share in the company but a contractual claim against the company. The payment is calculated as if they held a certain number of shares. It generally falls due only on an exit: the sale of the majority of the shares, the sale of the business operations or an IPO. The articles of association and the list of shareholders remain unaffected, no notary appointment is needed, and no shareholder rights arise.

German growth companies rely predominantly on virtual programmes. The payout is employment income and is subject to wage tax withholding, but no tax arises before money flows. Virtual shares therefore do not need the tax deferral under Section 19a EStG, and it does not apply to them either. The claim is, however, worth only as much as the rules by which it is calculated on exit and the company's ability to pay. For individual managers, virtual and real participations are also combined.

The levers of an ESOP

The economic substance of a programme is determined by a few provisions in the plan terms, for real options and virtual shares alike:

• Pool: the total number of shares reserved for the programme, measured against the fully diluted capital (fully diluted). This means the number of all shares including the promised and reserved programme shares. All individual grants are served from the pool.
• Strike price: the amount per share that is deducted from the payout or paid on exercise. It determines from what value the participants benefit; details under strike price.
• Vesting: the schedule on which a grant is earned, usually over four years with a twelve-month cliff (vesting).
• Trigger: the definition of the exit. In addition to the sale of shares, it must also capture the sale of the business operations, mergers and the stepwise acquisition of a majority.
• Leaver rules: the consequences of departure for earned and unearned grants, graded by the reason for leaving (good leaver or bad leaver).
• Rank in the proceeds: virtual shares generally participate in the proceeds like ordinary shares, that is, only after the liquidation preferences have been served. These are investors' priority rights to receive a fixed amount first on exit, usually their investment.

These levers explain the most common disappointment with employee participation. A high percentage is of little use if preferences claim a large part of the proceeds. A high strike price can consume several years of value growth. And without an exit, virtual programmes produce no payment.

ESOP pool: size and dilution

Pools in the range of around 5 to 15% of fully diluted capital are common. The right value follows from the hiring plan: how many key positions are to be filled in the coming years and to what extent participation is meant to replace part of the salary. In later rounds, the pool is often topped up when earlier grants have largely exhausted it.

More important than size is the question of who bears the pool. The answer depends on the pre-money valuation, the company value before the investors' payment. If the pool is created before the round and included in this valuation, it dilutes only the existing shareholders, in practice above all the founders. If it is set up only after the round, the dilution is spread proportionately across all shareholders including the new investor. Investors therefore regularly demand a pool before the round.

Virtual shares do not dilute in the company-law sense, because no shares are created. Economically they have the same effect: the payments on exit reduce the amount that reaches the shareholders. Investors therefore include virtual pools in the fully diluted cap table.

The ESOP in a funding round and a company sale

Before investing, investors check whether the programme has been validly resolved, whether every grant is documented and whether the plan terms match the shareholders' agreement. This includes an adjustment rule for capital measures, such as a capital increase from company funds, in which reserves are converted into share capital without new payment. It ensures that the value of the grants does not shift unintentionally.

In a company sale, the claims fall due at closing. The obligation to pay lies with the company, but the purchase price flows to the shareholders. The purchase agreement therefore regulates how the funds are provided. The purchase price calculation treats the payments, including employer social security contributions, as debt-like items that reduce the equity value, that is, the purchase price for the shares. It must also be clarified openly what happens to unearned grants and whether the acquirer offers a programme of its own.

Worked example: ESOP pool before or after the funding round

A software company with a pre-money valuation of EUR 16 million raises EUR 4 million of equity. The post-money valuation is thus EUR 20 million. After the round, an employee pool of 10% of fully diluted capital is to exist. So far there is no pool.

• Investor's share: EUR 4 million / EUR 20 million = 20%
• Pool before the round, included in the pre-money valuation: investor 20%, pool 10%, existing shareholders 100% minus 20% minus 10% = 70%
• Value of the existing shareholders: 70% × EUR 20 million = EUR 14 million; the effective pre-money valuation falls from EUR 16 million by the pool value of EUR 2 million to EUR 14 million
• Pool after the round, proportionate dilution: existing shareholders 80% × 90% = 72%, investor 20% × 90% = 18%, pool 10%
• Value of the existing shareholders: 72% × EUR 20 million = EUR 14.4 million
• Difference: 2 percentage points, on the post-money valuation EUR 400,000, on a later exit of EUR 100 million arithmetically EUR 2 million

The pool size is the same in both variants; only who pays for it differs. The question therefore belongs in the negotiation of the term sheet and not only in the contract drafts.

Distinctions: ESOP, vesting, strike price, retention bonuses and profit participation rights

• Vesting: the schedule within the programme on which an individual grant is earned. The ESOP is the framework, vesting one of its rules.
• Strike price: the base price of a grant. It determines which part of the future value reaches the participants.
• Retention bonuses: retention payments in a company sale. They are paid as a fixed amount for staying and do not depend on growth in value.
• Profit participation rights (Genussrechte): contractual participations in profit or proceeds that are also used for employees. They are legally structured differently from virtual shares and are less common.

Common mistakes

• Percentage grants without a reference base. One percent of the shares issued today and one percent of fully diluted capital are different amounts.
• Narrow exit definition. If the plan captures only the sale of shares, claims may come to nothing on a sale of the business operations or a merger.
• Financing of the payout left open. The company owes the payment but often does not have the funds on exit. If there is no provision, one must be found in the purchase agreement under time pressure.
• No adjustment for capital measures. Without an adjustment rule, a share split or capital increase from company funds changes the value of the grants.
• A grant without explanation. Employees who receive only a number and do not understand when and how much will be paid attach little value to the grant; the retention effect fails to materialise.

Frequently asked questions

What is the difference between ESOP and VSOP?

An ESOP in the narrower sense grants options on real shares, a VSOP only a payment claim that is calculated like a participation. In German usage, ESOP is often used as an umbrella term for both forms.

Do employees with virtual shares become shareholders?

No. They receive neither voting rights nor a shareholder's information rights and do not appear in the list of shareholders. Their claim depends solely on the plan terms and the individual grant.

How large is a typical ESOP pool?

Often between 5 and 15% of fully diluted capital. What decides is how many positions are to be filled with participation; a pool that merely reflects a market size is either too large or used up too early.

How is an ESOP taxed?

As employment income, but at different points in time. With real options, the tax arises on exercise, often without any cash inflow; with virtual shares only on payout on exit, from which the company withholds wage tax.

What happens to the programme in a company sale?

The earned claims are settled and paid out by the company, economically at the expense of the shareholders' purchase price. How unearned grants are treated is regulated by the plan; if it is imprecise on this, the question becomes part of the purchase agreement negotiation.

Does a virtual programme need a notary?

No. Because no shares are transferred or created, no notarisation is required. The resolutions and consents that the articles of association and shareholders' agreement provide for the set-up are, however, necessary.

The Roemer Capital view

We derive the size of the pool from the headcount plan in the financial model, which we build over at least three years with a base case, a cautious case and an optimistic case. Founders enter the term sheet negotiation with this figure instead of adopting a market size. Whether the pool is created before or after the round has been calculated before the question comes up.

In a company sale, we quantify the payments under the programme for every purchase price under discussion, including employer social security contributions, so that the sellers know their actual proceeds. The plan terms and their implementation are the responsibility of the company's law firm and tax adviser.