What's this all about?
Employee participation programs – whether equity-based (ESOPs) or virtual (VSOPs) – are a standard feature for German start-ups. They’re designed to incentivize and retain talent, and they play a crucial role in aligning employee interests with those of founders and investors. As the VC saying goes, "Culture eats strategy for breakfast, but equity eats culture for lunch."
But when it comes time for an exit – be it a share sale, asset deal or IPO – these programs can add layers of complexity for both sellers and buyers. In this Snapshot, we break down what you need to know about settling employee participation programs in an exit scenario, with a focus on the German market.
For a comprehensive guide on how to prepare for, successfully structure and efficiently implement German Start-up M&A projects see our 2025 Guide OLNS#13 – M&A in German Tech.
Quick Recap: The Basics of Employee Participation in Germany
Employee participation is now a must-have for German start-ups. These programs come in two main flavors:
1. VSOPs (Virtual Share Option Programs)
Still the most common in Germany, VSOPs do not grant real shares but simulate equity by giving employees a cash claim against the company in the event of an exit. The payout is typically pegged to what a common shareholder would receive (or a certain fraction thereof and minus a base price, the latter economically mirroring the strike price in case of a typical stock option). VSOPs are easy to implement and maintain, but payouts are subject to high income and wage taxes, with no capital gains tax treatment.
2. ESOPs (Equity-based Programs)
More tax-advantageous but also more complex and costly to run, ESOPs grant employees "real" shares (or similar equity instruments). In German GmbHs, this usually means either "growth shares" (a.k.a. hurdle shares) or shares or (as the new kid on the block) profit participation rights issued under the wage tax deferral pursuant to sec. 19a German Income Tax Act ("EStG").
- Growth shares only participate in value created above a certain hurdle, offering capital gains tax treatment and sidestepping the dreaded dry-income tax trap if structured right.
- Sec. 19a EStG instruments (thanks to the Future Financing Act, effective 2024) defer wage tax on the spread between grant price and fair value until a liquidity event, with subsequent gains taxed as capital gains.
If you are interested in sec. 19a instruments and growth/hurdle shares, we kindly refer you to our detailed guide OLNS#14 – Growth and Hurdle Shares in German Start-ups.
No matter the structure, these programs must be considered in any exit. They affect incentives, deal structure, and ultimately, the payout mechanics for everyone involved.
Incentive Considerations for the Sellers
In many M&A transactions, the fact that a target company is for sale will eventually leak. There are usually too many people involved to keep an ongoing acquisition process secret for long. Sellers, particularly the founders, need to have a clear communication plan addressing how to manage uncertainty among their employees. At some point, employees will start wondering what will be in it for them under the target’s employee participation programs and what will come thereafter, i.e., what employee incentivization will look like in the post-acquisition phase.
Morale and Retention
A target company's ESOP and VSOP can be a crucial factor when preparing and implementing a sale of a target company. Here are some of the top considerations that should be kept in mind.
- The sellers must understand the vesting schedules, conditions for exit and any acceleration provisions that might be triggered by the sale. In particular, do any unvested shares or options accelerate by their terms as a result of the deal? Some may be subject to a "single trigger" (accelerate solely by reason of the exit deal closing). Others may be subject to a "double trigger" (accelerate following the closing only if employment is terminated by the target company without cause or by the employee without good reason within a period of usually around twelve months following closing).
Ensuring that employees perceive the payout as fair is essential to maintaining morale and avoiding disputes. Also, consider how much of the payout will be immediate versus deferred (assuming that a deferral is possible under the plan or can be agreed on a case-by-case basis). This can impact employee retention post-exit.
- The sellers also need to consider how the participation programs will integrate into the buyer's structure and what incentives to offer to retain key employees.
Overall, clear communication with employees about how the exit will affect their participation plans is crucial. This includes timing, how they will be paid out, what will happen to unvested options or shares and what may be on offer from the target company's new owners.
Consider Alternative or Additional Exit Incentives
Under certain circumstances, the sellers should consider offering additional exit incentives to key employees. Such scenarios might include cases where the key employees have only a relatively small (vested) allocation under the ESOP / VSOP or where it can reasonably be expected that given the existing investors' liquidation preferences, there will be little to no pay-outs under the ESOP / VSOP. In one of our next Snapshots we will deal with incentive structures for key employees in the case of a not-so-fun exit.
Settlement and Retention Agreements
It's important to avoid arguments about payout sums and mechanisms and to implement an economic roll-over of a portion of the exit proceeds to be paid out under the ESOP / VSOP or to implement other retention elements. Entering into adequate settlement and retention agreements with key employees is an effective way to achieve that goal.
Incentive Considerations for the Buyer
The buyer will also be interested in understanding the existing employee participation programs for a variety of reasons:
- The financial obligations triggered under the employee participation programs will be relevant for its valuation of the target company. For example, in the case of a VSOP, the beneficiaries hold cash compensation claims against the target company that the buyer will need to factor into its calculation of the target company's equity value. That is true unless the existing shareholders (i.e., the sellers) have agreed to indemnify the target company for obligations under the VSOP. (see below for more on the various options for treating VSOP in an exit).
- The buyer will also want to understand how much money the target company's key employees will pocket in the acquisition. This will help the buyer determine how to retain such employees. If the buyer is a financial investor, such as a PE fund, it will often offer key employees the option of reinvesting or rolling a portion of their proceeds from the employee participation program into a new incentive scheme the buyer will set up.
- Employee participation programs can come back to haunt the sellers if they have a single trigger acceleration (in a sale of the target company) or a plan without a claw-back option (in a voluntary early departure of the beneficiary).
- The existing VSOP / ESOP may not align with the buyer's compensation and incentive structures. This misalignment can lead to challenges in integrating the target company into the buyer's broader organization and culture as the existing compensation packages will be the mental reference frame and point of departure for the target company's workforce. The integration plan should include a strategy for harmonizing these incentive structures.
How to Settle Employee Participation Programs in Case of a Sale
While the treatment of equity instruments issued under an ESOP is relatively straight-forward, there are basically two options to deal with a VSOP.
1. Settlement of ESOPs
Sec. 19a EStG Incentives
When a seller sells shares in a GmbH for which they have benefited from the tax deferral pursuant to sec. 19a EStG, there are specific tax implications to consider. We will limit ourselves here to cases where the ESOP beneficiary (directly or through a pooling partnership) sells real shares. The latest variation of sec. 19a EStG incentives, i.e. profit participation rights which mirror the economic rights of common shares, follow a similar logic but with some deviations in detail we will point out as we go along.
Sec. 19a EStG provides that taxation on the benefit derived from employee shares can be deferred until a later event, such as the sale of the shares. This deferral is designed to alleviate the immediate tax burden on employees when they receive shares treated as part of their compensation at a discount or free of charge (dry-income taxation). In the absence of the deferral, wage tax would be due on the difference between the amount the seller paid to receive the employee shares (often the exercise price of the options or the nominal value of the shares) and the fair value of the employee shares at the time of issuance (referred to as "spread"). The target company should determine the fair value of the employee shares upon the time of the transfer to the respective beneficiary (the later seller) carefully (ideally by obtaining a third-party appraisal) to calculate the spread. The initial value of the spread represents employment income that has to be recorded in the payroll account. It serves as basis to calculate the amount of social surcharges (which the target company will have to pay immediately upon transfer of the shares to the beneficiary).
Profit participation rights suitable to make use of sec. 19a EStG operate similarly to employee shares within the scope of application of sec. 19a EStG. Employees typically need to make a modest cash contribution to the target company to obtain the profit participation rights (commonly an amount mirroring the nominal value of a common share with corresponding economic pro rata rights). The difference between the amount paid to the target company and the fair value of the profit participation rights is the spread referred to above in the context of employee shares. Wage tax would become due on this spread but is deferred pursuant to sec. 19a EStG. As in case of employee shares, the target company has to determine the fair value of the profit participation right upon the time of the transfer to the respective beneficiary (ideally by obtaining a third party appraisal) to calculate the amount of spread which has to be recorded in the payroll account and serves as basis to calculate the amount of social surcharges becoming due immediately upon transfer of the profit participation rights to the beneficiary.
The sale of the shares or the profit participation rights, respectively, is considered a triggering event for the deferred wage tax on the spread. This means that the deferred wage tax becomes due at the time of the sale. The wage tax is calculated based on the standard income tax rates applicable to the respective seller, which can be progressive and reach up to 45 % for high-income earners, plus the solidarity surcharge thereon and potentially church tax. The applicable wage tax amount is subject to the wage tax withholding, i.e., the target company is obliged to withhold the applicable wage tax amount from the remuneration paid to the seller under the employment relationship. If no such withholding is possible (e.g., because the respective seller is not an employee at the time of the sale any more or the cash wage is insufficient to cover the wage tax liability), the seller has to provide the target company with the applicable wage tax amount. If the seller fails to do so, the target company will report the wage tax shortfall to the tax office to avoid liability.
In practice for employee shares, the share purchase agreement will often stipulate that the buyer, on behalf of the respective seller by means of an abbreviated payment, shall pay a part of the purchase price that is equal to the amount of the seller's wage tax liability to the target company with debt discharging effect. Employees holding profit participation rights participate in an exit by selling their profit participation rights to certain shareholders (not the target company itself) designated by the target company (such exit structure will regularly be backed up by way of a call option to be granted by the respective employee). The buyer will acquire the shares in the target company as well as the profit participation rights from the shareholders (or the profit participation rights will be settled in another form as part of the exit). As in case of employee shares, the share purchase agreement may stipulate that the buyer, on behalf of the respective seller by means of an abbreviated payment, shall pay a part of the purchase price that is equal to the amount of the employee's wage tax liability to the target company with debt discharging effect.
The incremental value of the shares or profit participation rights after its initial transfer to the seller will be subject to the more favorable capital gain taxation.
For an overview outlining the key features of a profit participation right designed for employee incentivization, see this Insight.
Hurdle/Growth Shares
Growth shares only participate in the proceeds of a sale or liquidation beyond a certain hurdle amount. This means that these shares only receive proceeds after other shareholders have received a certain amount (economically, you can think of this as a negative liquidation preference). The share purchase agreement will usually stipulate a purchase price for each share in the target company that gets sold irrespective of what the sellers have agreed internally regarding positive or negative liquidation preferences. In a second step, the sellers will usually instruct the buyer to make payments to them according to the distribution of the exit proceeds following the allocations of positive liquidation preferences (if relevant) and the negative liquidation preferences for the growth shares. The latter usually results in the holders of "normal" shares (or a sub-group) receiving their pro-rata portion of the hurdle amount to which the growth shares are not entitled. Only after the hurdle amounts are surpassed do the growth shares start participating in the distribution of exit proceeds.
German tax law shall recognize the limitation of the proceeds participation of the growth shares and subject the proceeds allocated to the growth shares to capital gains taxation. Likewise, the redistributed hurdle amount shall also be subject to capital gains taxation for the shareholders that stand to benefit from such reallocation.
For some empirical data on the size of growth and hurdle share programs, the company’s stage at implementation of such programs as well as the hurdle amounts, please see this edition of our Legal Ninja Snapshot Series.
2. Settlement of VSOPs
Beneficiaries have cash payment claims against the target company in an exit. One option to deal with these claims is for the parties to treat them as a debt item and have the buyer deduct such debt item from the equity value that determines the purchase price the buyer has to pay for the shares in the target company. It would then be the buyer's responsibility to ensure that the target company has sufficient liquidity to settle such claims after closing, including any wage tax amounts and social surcharges becoming due at the time of the settlement.
There is some uncertainty whether such treatment might give rise to tax concerns. One could argue that burdening the target company with payment obligations under the VSOP might be considered a hidden profit distribution. (Such payment obligations are triggered by the sale of shares in the target company, i.e., a transaction only on the level of the sellers). The buyer is keen to avoid any hidden profit distribution by the target company since such distributions are not tax deductible as a business expense, which increases the taxable profit of the target company. Furthermore, hidden profit distributions are subject to German withholding tax and a non-compliance with this obligation can result in compliance issues.
In practice, it is often advisable to have the sellers assume the obligations under the VSOP with debt-discharging effect before the closing or at least to agree with the target company that the sellers will indemnify the target company from all obligations under the VSOP. Economically, this should lead to the same outcome for the sellers. In the latter case, the buyer will not deduct the VSOP obligations from the purchase price. Rather, the sellers will instruct the buyer to pay a portion of their purchase price in the amount of the VSOP obligations on behalf of the sellers to the target company, i.e., such amount will not end up in the sellers' coffers but will be received by the target company. That will give it sufficient liquidity to make the payments under the VSOP as paying agent for the sellers and to fulfill its wage tax and social security contributions withholding obligations.
Wrapping Up: Employee Participation and Exits – What Really Matters
Employee participation programs have become a cornerstone of the German start-up ecosystem, and for good reason: they help attract the best talent, keep them motivated, and align everyone’s interests for the long haul. But as we’ve seen, when it comes to an exit – whether it’s a share deal, asset deal, or IPO – the devil is in the details.
For founders and sellers, the key is to plan ahead. Understand your ESOP or VSOP structure, know your triggers (single or double), and communicate clearly and early with your team. Remember: a well-managed participation program can be the difference between a smooth exit and a messy, morale-sapping process. Consider whether additional retention or settlement agreements are needed to keep your key people on board and motivated for the next chapter.
For buyers, diligence is everything. Know what you’re inheriting—financially, culturally, and in terms of employee expectations. Factor participation program obligations into your valuation and integration planning. And don’t underestimate the importance of harmonizing incentive structures post-acquisition; today’s payout is tomorrow’s baseline for your new team.
On the technical side, the German legal and tax landscape is evolving, but it’s still complex. Whether you’re dealing with growth shares, sec. 19a EStG instruments, or classic VSOPs, each structure comes with its own set of rules and best practices for settlement. Get expert advice early, and don’t be afraid to learn from international models—sometimes, the best ideas come from looking beyond your own backyard. While we can only provide a brief overview of relevant matters in this Snapshot, things can get pretty complex, especially in cases where a VSOP or profit participation rights program needs to be settled but the exit consideration is only partly in cash but (maybe predominantly) consists of shares in buyer.
Above all, remember that employee participation isn’t just a legal or financial checkbox. It’s a strategic tool for building resilient, high-performing companies. As Mark Twain (almost) said: “The secret of getting ahead is getting started.” And as Kermit the Frog wisely reminds us: “It’s not easy being green”—but with the right plan, it’s definitely worth it.
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