Exercise Period

What is the exercise period?

Exercise period (German: Ausübungszeitraum) is the period in which the holder of a real employee option can exercise, that is, redeem, the option. The terms Ausübungsfrist and Ausübungsperiode are also used. Such an option is the right to acquire shares in the employer at a price fixed in advance, the exercise price. The holder can exercise only the part that they have already earned under the programme's schedule. Options that have not been exercised by the end of the period lapse, much like a voucher after its redemption deadline.

The exercise period is regulated in the plan terms of an option programme (ESOP). The exercise itself is a declaration to the company or to the shareholders who must deliver the shares. The exercise period is made up of several time limits. These include the earliest point of exercise, the time windows in which it is possible, the total term of the options and the period after leaving. The exercise period matters above all for real options. Virtual programmes usually have no act of exercise; they pay out on exit. In a company sale, the design of the exercise determines whether the acquirer receives all shares.

Components of the exercise period

• Waiting period: the earliest point of exercise. It usually follows vesting but can also be later. For a stock corporation (Aktiengesellschaft), Section 193(2) No. 4 of the German Stock Corporation Act (AktG) prescribes a waiting period of at least four years for subscription rights from conditional capital. For the GmbH (German limited liability company) there is no statutory waiting period.
• Exercise window: certain periods of the year, for example after the annual financial statements have been adopted. They bundle exercises so that capital increases and notary appointments do not arise one by one.
• Exit-linked exercise: in many GmbH programmes, exercise is possible only in connection with a sale or IPO. This avoids shareholders from among the employees and taxation without liquidity.
• Total term: after it ends, all options not exercised lapse. Terms of 7 to 10 years from grant are common.
• Period after leaving: unearned options lapse on leaving. Earned options can, depending on the plan, be exercised only within a short period, in the next exercise window or still until exit. For a bad leaver, who leaves because of, for example, a serious breach of duty, many plans provide for all options to lapse.

Exercise at a GmbH: form, tax and liquidity

Exercising an option on GmbH shares is a formal process. If existing shares are to be delivered, 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). If new shares are created, a notarised capital increase resolution, a notarially certified acceptance declaration under Section 55(1) GmbHG and entry in the commercial register are required. If existing shares are transferred, the assignment requires notarisation under Section 15(3) GmbHG. A new list of shareholders must then be filed, and the new shareholders usually accede to the shareholders' agreement, including the obligations to sell along (drag-along).

For tax purposes, the time of exercise counts. The monetary benefit, that is, the value of the shares acquired less the exercise price, is then treated as employment income and is subject to wage tax withholding, although no money flows. If current cash pay is not sufficient for this, the employee must make the shortfall available to the employer. Whether Section 19a of the German Income Tax Act (EStG) defers the taxation depends on the conditions of the provision in the individual case (Taxation of Options). Without deferral, exercise price and tax must be paid from own funds, although the shares cannot be sold. A short period after leaving therefore forces a decision that many holders cannot make financially.

Virtual programmes: payout instead of exercise

With virtual shares, nobody acquires a share in the company. Most plans therefore provide for no exercise: on exit, the claim is calculated and paid out. Earned virtual shares of departed good leavers remain in place until then. Some plans, however, require a declaration of exercise within a short period after notice of the exit event and otherwise let the claim lapse. A total term is also common: if no exit takes place by its end, the claims lapse or are settled under a rule set out in the plan.

Exercise in a company sale

An acquirer generally wants to take over all shares. Open options must therefore be exercised, settled or terminated before or at closing, the transfer of the shares to the acquirer. The plan should give the company three routes for this. It can demand exercise within a short period before closing, make a cash settlement instead of delivering shares, or let unexercised options lapse. Common is exercise without own funds, in which exercise price and tax are offset against the sale proceeds.

In the US market, a period of 90 days after leaving is common, going back to US tax rules for certain types of options; some companies have extended it considerably. For programmes of German companies, this period is no benchmark, because tax, form and exit linkage are regulated differently here.

Worked example: exercise after leaving or on exit

An employee holds 3,000 earned options on shares in the company with an exercise price of EUR 10. The value of one share is EUR 60. A marginal tax rate, that is, a tax rate on each additional euro, of 42% plus 5.5% solidarity surcharge on the tax is assumed. Church tax and a possible reduction under the one-fifth rule (Fünftelregelung) are disregarded. Social security contributions do not arise in addition, because the salary is already above the contribution ceilings. Section 19a EStG is assumed not to apply.

• Exercise price: 3,000 × EUR 10 = EUR 30,000
• Monetary benefit: 3,000 × (60 minus 10) = EUR 150,000
• Wage tax: 42% × EUR 150,000 = EUR 63,000; solidarity surcharge: 5.5% × EUR 63,000 = EUR 3,465; together EUR 66,465
• Exercise after leaving without a sale: funds required EUR 30,000 plus EUR 66,465 = EUR 96,465, without any ability to sell the shares
• Exercise on exit at the same value: proceeds 3,000 × EUR 60 = EUR 180,000, less EUR 30,000 and EUR 66,465 leaves EUR 83,535, without own funds

The result before tax is the same in both cases. The timing of payment and the risk differ: anyone who exercises before the exit bears the tax on a value that can also fall later. If the value rises further after exercise, this increase is no longer employment income; it is taxed on sale as a capital gain, depending on the size of the holding with flat-rate withholding tax or under the partial income method.

Distinctions: exercise period, vesting period and strike price

• Vesting (vesting period): determines when an option is earned. The exercise period determines when and for how long the earned option can be exercised.
• Strike price: the price to be paid on exercise. It sets the amount of the benefit, the exercise period its timing.
• Payout from virtual shares: takes the place of exercise and is tied to the exit, not to a declaration by the holder.

Common mistakes

• Short period after leaving without regard to tax. The holders must pay exercise price and wage tax from own funds and let earned options lapse.
• No rule for the sale case. Without an obligation to exercise, cash settlement or lapse on exit, the acquirer cannot be sure of acquiring all shares.
• Unclear start of the period. It remains open whether the period begins with receipt of the notice of termination, the end of garden leave or the legal end of the employment relationship.
• No notice to the holders. Without a reminder of the expiry of the period, disputes arise over lapsed options, especially with leavers.
• Total term shorter than the realistic exit horizon. If options lapse before the likely exit, the programme loses its effect.

Frequently asked questions

How long is a typical exercise period?

The total term is often 7 to 10 years from grant. The period after leaving depends on the plan and ranges from a few months to continuing until exit; there is no statutory requirement for the GmbH.

What is the difference between vesting period and exercise period?

The vesting period sets when an option is earned, the exercise period when and for how long the earned option can be exercised. Exercise begins at the earliest with vesting and often ends only years later.

What happens to options that are not exercised in time?

They lapse without replacement. Under many plans, the options released flow back into the pool and can be granted anew.

Is there an exercise period for virtual shares?

Usually not in the narrower sense. Virtual shares are paid out on exit; some plans, however, require a declaration within a set time or limit the term of the claims.

When does tax arise on exercise?

On exercise; what matters is the acquisition of the shares. The difference between their value and the exercise price is employment income, unless Section 19a EStG defers the taxation.

Can the company demand exercise before a sale?

Only if the plan provides for it. If there is no such provision, the holders must agree to a buyout, and the acquirer assesses the open options as a risk to acquiring all shares.

The Roemer Capital view

A company sale usually takes 6 to 12 months. We use this time to clarify, before the due diligence, whether the plan supports an exercise, a cash settlement or the lapse of open options at closing. At the same time we quantify the funds needed by the holders and by the company.

In preparing a funding round, we make sure that the total term and exercise rules fit the realistic exit horizon shown in the financial model. The amendment of the plan terms is handled by the company's law firm and tax adviser.