Employee Participation: Forms, Structuring and What You Should Know

• Under an employee participation (Mitarbeiterbeteiligung), employees receive a share in the economic success of their company – either through real shares in the company or through contractual participation models without shareholder status (Gesellschafterstellung).
• The principal forms are the direct participation, employee shares (Mitarbeiteraktien), options and virtual participations – they differ above all in whether and when real shares are transferred.
• Employee participations are almost always subject to conditions, for example a minimum period of employment (vesting) or provisions governing the case in which the employee leaves the company.

What is an employee participation?

An employee participation (Mitarbeiterbeteiligung) is an arrangement under which employees are given a share in the economic success of their employer – in addition to their regular salary. Depending on how it is structured, two fundamental routes are available:

• Real participation: The employee receives actual shares in the company and thereby becomes a shareholder in their own right.
• Contractual participation: By means of a contract, the employee is placed economically in the same position as if they held a participation, without actually becoming a shareholder.

Employee participations offer companies two advantages in particular. First, they serve to retain employees (retention): since many participation models only become genuinely valuable in economic terms after a certain period with the company, employees have an incentive to remain with the company for longer. Second, they create an incentive structure: since the value of the participation rises with the success of the company, employees benefit directly when they commit themselves to the company – their interests are thereby aligned more closely with those of the shareholders.

What forms of employee participation are there?

There is a wide variety of participation models, which differ above all in whether real shares in the company are transferred and at what point this happens.

• Direct participation: The employee receives real shares in the company directly (for example GmbH shares) and thereby actually becomes a shareholder with the corresponding rights, such as voting rights at shareholders' meetings. This form involves the greatest legal effort, since every transfer must be notarially recorded. In the case of a public limited company (AG), employees receive so-called employee shares (Mitarbeiteraktien) instead of GmbH shares; unlike with the GmbH, these can be transferred without any formal requirements, which makes this form more practicable for larger companies with many participants. However, since most start-ups are established as a GmbH rather than as an AG, direct participation via shares occurs in practice only at large companies.
• Options (ESOP – Employee Stock Option Plan): The employee receives the right to acquire shares at a later point in time at a price already fixed today. If the value of the company rises in the meantime, the employee can buy the shares cheaply and benefit from the increase in value – if the value falls, they simply do not have to exercise the option.
• Virtual participations (VSOP – Virtual Stock Option Plan): Here the employee does not receive any real shares, but only a contractual claim that is based on the value of the company – for example a payment calculated as if it were a participation, without shares actually being transferred. This model is legally simpler to implement, since no shareholder status arises.
• Profit participation rights, silent partnerships and debt-capital models: Profit participation rights (Genussrechte) and silent partnerships (stille Beteiligungen) grant the employee a contractual claim to a share in profits or in value, without any shareholder status arising. Debt-capital models – for example an employee loan bearing profit-dependent interest – function similarly in economic terms, but are structured legally as a loan rather than as a participation. Which model is appropriate in an individual case depends heavily on the legal form, the size of the company and the objectives of the company.

How are employee participations structured contractually?

Employee participations are almost never unconditional – the contracts usually contain several clauses governing when and in what circumstances the participation actually takes economic effect.

• Vesting period: The participation usually does not arise in full immediately, but accrues over a certain period – four years is customary, often with a one-year waiting period (cliff) before any shares at all are “earned”. If the employee leaves the company before then, the portion not yet earned lapses. In concrete terms, this accrual over time usually means the following: with a four-year vesting period and a one-year cliff, the employee receives 25% of the promised participation in one go after the first year; thereafter the entitlement continues to accrue monthly or quarterly in equal steps until the full 100% is reached at the end of the four years.
• Drag-along and tag-along clauses: These clauses govern what happens when the company is sold. A drag-along clause obliges the employee to sell their shares along with the others if the majority shareholders dispose of the company. A tag-along clause, conversely, gives the employee the right to join a sale and to sell on the same terms.
• (Bad) leaver clauses: These provisions determine what happens to the shares when an employee leaves the company. In the case of a “good leaver” (for example retirement, illness), the employee usually retains better terms, whereas a “bad leaver” (for example termination for cause) is frequently placed in a considerably worse position, for instance through a lower repurchase price.
• Distribution of proceeds: On a sale of the company, this clause governs the order in which, and the terms on which, the various groups of shareholders and employees share in the proceeds. Investors frequently receive priority rights here (liquidation preferences) before it is the employees' turn. In simplified terms, a liquidation preference means that, on a sale, investors first receive back the capital they invested (or a multiple of it) before the remaining proceeds are distributed among the other shareholders and the employees – where the sale price is lower than hoped for, this can mean that considerably less is ultimately left for employees than the pure participation percentage would suggest.

These clauses often appear technical, but ultimately they determine how much an employee actually benefits from their participation – a close look at the contract is therefore worthwhile in every case.

How are employee participations taxed?

The taxation of employee participations is a complex subject that differs considerably depending on the model chosen – only a brief overview is therefore given at this point.

As a matter of principle: if an employee receives shares or a benefit in kind from a participation, this can qualify as employment income (Arbeitslohn) and thus be subject to income tax – in some cases as early as the point at which the employee receives the shares, even though they have not yet received any money from them (the “dry income” problem). In order to mitigate this disadvantage at young companies, § 19a EStG was introduced: subject to certain conditions (including the size and age of the company), it allows taxation to be deferred to a later point in time, for example to the actual sale of the shares – so that tax does not have to be paid as early as the receipt of the participation, even though no money has yet flowed.

The specific taxation differs considerably depending on the model:

• Direct participation (GmbH shares, employee shares): Where shares are granted at a reduced price, the difference from the fair market value is taxed as employment income already on acquisition – even though no money has flowed at that moment (dry income risk).
• Options (ESOP): Taxation regularly arises only on exercise of the option: the difference between the fair market value and the exercise price is then recognised as employment income.
• Virtual participations (VSOP): Here the tax liability arises only on actual payout, usually in the context of an exit.
• Profit participation rights, silent partnerships and debt-capital models: The tax treatment here depends on the specific contractual structure.