Incorporating Employees Effectively: Startup Best Practices

The Typical Situation

Start-ups are particularly popular among graduates and young professionals as employers. Being part of a small team actively involved in building a company is an invaluable experience. Nowhere else does the saying "The journey is the reward" apply more than in the startup environment. However, this journey can be challenging. This applies to the employees as well, whose support as a well-functioning team is incredibly important. Employers are often willing to let them share in the company's success in recognition of their tireless effort and motivation.

In addition to traditional profit-sharing methods such as granting salary bonuses, it is worth taking a look at the Silicon Valley. ESOP models have long been commonplace there and are becoming increasingly popular elsewhere, including here. This is especially true for startups looking for alternatives beyond cash payments. But what exactly does the term mean? Which participation model is right for your company? And what legal considerations do you need to keep in mind as an employer? We have delved into these questions for you.

ESOP: What's Behind It

ESOP stands for Employee Stock Ownership Plan. This term encompasses various participation models aimed at allowing employees to share in a company's capital.

The Different ESOP Models

Below, we have compiled an overview of the various participation models and their fundamental characteristics.

a) True Employee Participation

Silent Partnership

In this model, employees receive a share of the company's profits. The employee deposits a financial contribution for this purpose. The amount is often flexible, and the minimum participation is relatively low. Profit shares are credited to the employee after the annual financial statements. The handling of potential losses can be contractually flexible and limited. The employee's financial contribution is similar to debt capital. The term "silent partnership" stems from the fact that although employees officially become shareholders, they do not have any voting rights.

Direct Participation Option: Employee Shares for PLCs

In this model, employees of a stock corporation are offered the option to purchase employee shares. These are often offered to them at a discount. In return, employers often reserve a higher percentage of profits for themselves. This creates a win-win situation. Employees receive a corresponding dividend and contribute to the company's value growth.

Employee shareholders can also determine their own risk. They benefit from limited liability, which is based on their financial contribution. In theory, they have both information and voting rights. However, most companies often exclude both through corresponding contractual clauses.

Direct Participation Option: Allocation of Shares for Ltd.'s

An Ltd. also has the option to directly involve its employees by selling shares in the company. It should be noted that notarial certification is essential for the transfer of company shares. As part of this, the buyer becomes a shareholder with corresponding voting rights, but also with corresponding liability and risk.

Employee Credit

In this option, employees receive special payments. However, the amounts are not paid out directly but credited as balances. The payout is then delayed. This type of employee participation primarily serves the employer's side, as it results in tax advantages. However, in practice, entrepreneurs rarely choose this model.

Profit Sharing Rights

In this model, employers benefit from profit sharing. However, they do not become shareholders in this case and have neither voting nor information rights. In the event of insolvency, employees also lose out, as they are last in line among creditors. The company must pay them out only after other creditors.

It is also good to know that there are some requirements for making such capital valid as equity. Among other things, a minimum five-year lock-up period must be set, and the participation affects both profits and losses.

Employee Loans

Employee loans are also known as personal loans. For the employer, this option can be an alternative to a regular bank loan. This is advantageous, for example, when the company finds it difficult to obtain a bank loan. Employee loans are secured against the company's insolvency through a bank guarantee. Employee loans are also fixed-interest, like regular loans, and have a limited term. However, the interest rate is typically lower than that of a bank.

Debenture

In the case of a debenture, the employee buys certificates from their employer, which make the employer a debtor of a certain amount plus interest. This amount must be paid to the employee at the end of the term.

b) Unreal Employee Participation

Phantom Employee Share Agreement und Virtual Share Program (PSOP)

As an alternative to real participation models, there are also fictitious models. You may have heard of "Phantom Stocks." These are a kind of phantom share. In this case, the employee does not acquire a real share but is treated as if they had, without receiving shareholder-like status. Profit sharing is regulated in a written agreement. The payout is made at the agreed-upon time, with the real share's market value applied to the phantom share at that time.

Such unreal participation models have the advantage of being less complex overall. For example, there is no need to go to a notary, which is necessary when transferring real company shares. PSOPs are subject to taxation, but taxes are only payable upon payout. From an employee's perspective, PSOP is a worthwhile employee participation model to consider.

Decision Making and Support

Unfortunately, there is no one-size-fits-all answer to which participation model is right for your company. The selection is vast, and efficient management in practice is complex. Above all, it is important to always keep track of the detailed legal, tax, and social requirements. We would need a separate article just for the tax details alone.

But in principle, participation models are a great thing. They are also - or especially - recommended for startups. Studies have repeatedly shown their positive effects on motivation, engagement, and employees' better identification with the company. The government has long recognized this and offers attractive subsidy programs. These are definitely worth a closer look.

Furthermore, an experienced lawyer is always a recommended addition. They have the qualifications to assist you in setting up a necessary, comprehensive participation plan and to provide advice on general questions during payout and acute issues afterward. GetYourLawyer is happy to assist you in finding a suitable specialist. Contact us for free via the online form and receive your individual offers promptly.