Participation of Employees in Startup Companies with Virtual Options

The participation of employees is a key issue in young innovative companies. Often, these companies can initially pay rather low salaries only. In addition, employee participation in the business makes sense in order to promote their motivation and identification.

Regularly, employee participation in any future increase in shareholder value is sought. The early granting of participation gives employees extraordinary chances to profit if, later on, an exit through a business sale (Trade Sale) or IPO is successful. A classic bonus or profit sharing arrangement, however, plays virtually no role in a start-up com-pany where no profit is generated over a long period of time.

Employee participation schemes in start-up companies increasingly envisage participa-tion in the form of virtual options. With the virtual participation programme, a real partic-ipation programme directed at the participation of the option holder of the share capital is simulated. Unlike traditional real company participation, the virtual options grant the option holder upon exercise no right to acquire shares in the company, but grant him, in a subsequent exit, a contractual claim against the company for payment of exit pro-ceeds. Whether all or only some shareholders are economically responsible for the claims of the option holders upon an exit, is a matter of negotiation between the share-holders.

Advantages of Virtual Participation

The design of virtual participation as an option has the advantage that taxation is only taken first on the date of the cash inflows and the risk of loss in value of the participation for the employee is removed. Further advantages of the virtual design are that, even when being exercised, no shareholder rights arise and therefore the decisions of management and investors are not subject to co-determination, information and control rights of employees with real shareholder rights. In addition, administrative costs and other costs of a pure virtual participation are very straightforward since there are no shareholder agreements and no notary fees.

Contractual Design

The conditions for the granting of virtual options are usually configured in a separate contract, which regulates the following Points:

  • No shareholder rights: The virtual participation does not grant in general any in-formation or participation rights, voting or profit rights.
  • Vesting: The virtual participation gained by the employee is usually increased gradually in the form of a vesting depending on the duration of his/her work (saving up).
  • No dilution protection: Regularly, the virtual participation is not protected from a so-called dilution through subsequent financing rounds.
  • Good Leaver & Bad Leaver Mechanisms: These govern the circumstances un-der which an employee can keep his virtual shares, even if he leaves the company.
  • Participation in the exit proceeds: The employee as a rule participates in exit proceeds like a liquidating founder-shareholder, only after the deduction of transaction costs and the liquidation preferences of preferred shares (which are typically issued to investors).

Market Standards and Individual Negotiation

In some arrangements for virtual participation programmes, market standards have developed. For this reason, it is customary to provide for a vesting period of 2-4 years, or a so-called vesting cliff (usually between 6 and 12 months), the expiration of which  grants the option holder rights from the vested virtual options for the first time.

In addition, however, a variety of configurations and individual negotiation solutions are conceivable. Which schemes will be agreed on largely depends on the interests of the participants and which value is placed on the investment programme. For instance, it is to be considered whether, and to what extent, the sale through a section of shareholders leads to a claim to (pro rata) exit proceeds. Finally, it is to be negotiated which claims remain for the employee when he leaves the company before an exit (as a Good Leaver or Bad Leaver); attention should also be paid to a link to the respective service or employment contract.