First published here by Thomas Grota, VC at T-Venture
Lately I was asked by journalists and founders regarding the standards and usual metrics of ESOP Employee Stock Option Plan) for Startup companies in Germany.
I was a bit surprised that there is so much uncertainty and hidden knowledge on this topic. So here is my view on the topic from the portfolio companies we work with as a venture capitalists. From my perception this is in line with most of the companies and VCs I know.
Why doing an ESOP for your company?
Easy answer: motivate your employees and to make sure the important people in your organization will participate in the exit. You might also be able to save cash and increase your runtime. The first reason is why you should do it, the second is a positive side effect. It will keep the people you want to stay in the company and let them feel a bit more as founders themselves.
What is the legal background and who can help?
Any lawyer with experience in venture capital can support you in the setup of an ESOP framework and the needed contracts, shareholder resolutions. However, most lawyers will start by talking about different possible solutions to build an ESOP, but founders should insist on the well known Phantom Stock model and just ignore the rest. All of my companies are using this model and I haven’t heard from any other company successfully using another model. Lawyers are paid to give you your options and many are not mentally geared yet towards the startup mindset of starting out with Good Enough.
What are the reasons for the Phantom Stocks as ESOP?
Main reason for this model is German tax laws and shareholders legal framework of a GmbH. In Germany, the receiving of shares can become an issue for taxation in case you are not a founder of a company, so not being a natural shareholder in a company from the beginning. If you are a founder you own the shares at nominal valuation and the value of those shares grew over time. In case someone gives you shares in a company with a value already established by e.g. a financing round, the German tax office treats this as an earning similar to a salary (“Lohnsteuer”). The receiver of those shares becomes taxable based on the valuation of those shares. In german tax laws you are taxed when you are receiving value and as a valuation of the shares has been established, you just got something of value if you receive real shares.
Example: Founders establish the company together and put in the nominal value of EUR 1 per share. For simplicity, we have one founder owning 25.000 shares, having put in 25.000 EURs at founding. With the seed round of 200.000 for a valuation of 1.000.000 EURs post funding, the new shareholder gets 6.150 shares for 20% of the company. The value of the shares of the founder have increased to 800.000 EURs but she already had those shares. She didn’t receive anything, similar to stock price increases in the stock market. But if you then want to create another 10% shares (3125 shares) and give it to an employee, then those shares have a value far above 3125 EURs and that person is getting those shares, getting that value. To be exact, it’s over 90.000 EURs in value, something the employee has received. Hence, that value needs to be taxed as income. Just imagine you are at a 50.000.000 valuation and want to give your newly hired star developer 1%… she would need to tax 500.000 EURs. Clearly a nogo.
The model of Phantom Stocks will create a right to get a virtual share in the company only materializing at the time of the exit. In this moment shareholders will commit a defined amount of the exit proceeds to the employees who took part in the ESOP Program. At this points the employee will receive hard currency in his bank account which is only taxable then. So she needs to be pay taxes when she is actually able to pay those taxes from the cash received.
How to create the virtual share pool to be reserved for employees?
This process is a simple legal document signed by all shareholders in a shareholder resolution or in the shareholder agreement. All shareholders will commit a certain part of the exit proceeds to be paid to those employees. Think of it simply as a few extra shares created at a certain data, fully dilutable like all the other shares, that come into existence at Exit. Presuming you had created a pool of 10.000 phantom shares when you had 40.000 shares, and then raised other rounds leading to 90.000 shares existing. At the time of the exit all costs of the transaction as well as liquidation preferences will be paid out to investors, and then instead of distributing the rest to 90.000 shares, you are distributing them as if 100.000 shares existed, just that the 10.000 phantom shares are paid out as bonus to the employees. As such, this is a dilution of shareholding in a virtual way for all shareholders. Usually I see that the commitment to implement an ESOP at seed stage among the seed investors and angels. Latest in a Series A round the ESOP will be put into the contracts and employees will receive a legal document approving their rights on the proceeds from this program.
How big is the ESOP and what amount is to be expected?
In almost all of my portfolio companies the ESOP is around 10% dilution of the shareholders. That means if the remaining pro-rata amount is EUR 11mn the ESOP will take EUR 1mn from the amount. This EUR 1mn will be divided according to the % each employee has in the ESOP. Typical amounts of ESOP for employees are from 0.25% up to 2.5% for an employee where as the upper limit is mainly for the real important and hired personnel like CSO, CTO and such. The standard for an employee is something around the 0.25% – 0.75%. That leads to an assumption that around 15-20 employees in a company taking part in this program while typical startup companies in B-Round stage have between 80 – 150 employees in total. That means around 20% of all employees will have a level or importance for the business to award them with an ESOP program, or you might create a second ESOP plan which is always possible. Currently we see in Germany exit valuations from EUR 20mn to EUR 50mn up to EUR 100mn – taking out exceptions like Trivago or unicorns like Delivery Hero and Rocket Internet companies. So when focusing on the sweet spot of German exits I guess the exit valuations are between EUR 25mn and EUR 45mn. To reach this kind of exits companies will take on EUR 5 – EUR 10mn of capital on the lower and EUR 20mn – EUR30mn on the upper end of this valuation range. Taking into account 1x liquidation preferences as a standard this means pro-rata proceeds will be in total between EUR 10 – EUR 15mn on the lower end and EUR 20 – EUR 30mn on the upper end. Exceptions where those exit valuations were EUR 100mn the pro-rata amount would be in the range of EUR 50mn – EUR 70mn from a gut feeling. That results into ESOP amounts of EUR 700k-1mn up to EUR 2mn – EUR 3mn. An employee would get therefore following those assumption depending on the success of the company and his percentage in ESOP somewhere from EUR 50k – EUR 500k. Looking into the EUR 100mn exits the amount will be above the EUR 1mn but hardly over EUR 2.5mn from this model. Those numbers seem to be correct from the experiences I have seen in exits in our portfolio of German companies. As always there are exceptions of the rules.
Disclaimer: Please be advised to still talk to your legal and tax professional.