Employee participation in a company’s success is a central element of startup culture and plays a crucial role in attracting and retaining talent over the long term. Especially in the dynamic startup scene, it is essential for startups to build a motivated and committed team. Since startups often cannot compete with established companies in terms of market-standard salaries, employee participation schemes are of critical importance.
From an investor’s perspective, the implementation of employee participation schemes is also highly significant. An investment in a startup is always an investment in the team, which is primarily responsible for the development and success of the startup. Innovative ideas and scalable business models can only be implemented sustainably if founders and employees are motivated and committed to the startup in the long run.
Well-structured employee participation schemes are often a decisive factor in later financing rounds or an exit. They help ensure that the team remains stable during phases of growth and change, and that the interests of founders, employees, and investors are optimally aligned.
A key concern in structuring such schemes is the tax treatment of participations. Many employees expect preferential taxation of their participation as capital income. In practice, however, the tax classification is often more complex than assumed and can lead to surprises – for example, when participations are fully subject to wage tax contrary to expectations. While other jurisdictions have already created attractive tax frameworks for employee participation, the situation in Germany remains challenging and fraught with uncertainties.
Against this background, the following article provides an overview of the common employee participation schemes at German startups, highlights typical pitfalls, and examines the most important tax and legal aspects. The aim is to foster a better understanding of the different schemes and contribute to a more objective discussion about the “right” form of employee participation. It should always be borne in mind that each scheme has individual advantages and disadvantages that must be carefully weighed in each specific case.
Below is an overview of employee participation schemes at German startups:
The following section explains the main similarities and differences between the various structuring options listed above.
A. Virtual (Phantom) vs. Real Equity Participation
Employee participation schemes can generally be divided into virtual (phantom) and real equity participation schemes, each of which comes in various forms.
If founders or employees (hereinafter: beneficiaries) are granted a real equity participation, they receive actual shares and thus generally become shareholders of the startup, with all associated rights (e.g., voting and information rights).
From a tax perspective, the decisive factor is the price at which the beneficiary receives the shares. If shares are granted at a price below their actual value (fair market value) – i.e., free of charge or at a discount – the difference between the actual value and the price paid constitutes a so-called “monetary benefit,” which may be taxed as employment income at up to 45 % (plus solidarity surcharge) at the time of grant. At this point, the beneficiaries have only received the shares, but no liquid funds to pay the resulting tax. This is known as “dry income”, which is usually a significant burden for beneficiaries, as they must pay the tax from their other assets (unless they make use of the tax deferral under Section 19a EStG, see below).
In the event of an exit, the beneficiary of a real equity participation can benefit from preferential taxation of the proceeds as capital income, i.e., taxation at the flat rate of 25 % (plus solidarity surcharge) or, for participations of at least 1 %, a 40 % exemption, or (if the shares are held via a holding company) even a 95 % exemption.
With virtual participations, beneficiaries are, in the event of an exit, economically placed in a similar position as if they were shareholders of the startup. The beneficiary is generally treated as the holder of (real) shares without special preference rights. However, virtual participation does not grant shareholder rights. The tax treatment of virtual participation also differs fundamentally from real equity. The mere grant of virtual shares generally has no immediate tax consequences for the beneficiary, particularly no monetary benefit is assumed. Thus, dry income is avoided. Taxation only occurs at the time of payout, i.e., in the event of an exit. All proceeds from virtual participation are then taxed as employment income at up to 45 % (plus solidarity surcharge).
Granting real equity participations leads to dilution of the other shareholders. In contrast, virtual participation creates a (payment) claim against the company. From a tax perspective, it is important to ensure that the payment does not constitute a so-called hidden profit distribution. This can be avoided if it can be demonstrated that the payment is in the company’s interest. To further reduce any remaining tax risk, it is common practice to agree that the shareholders indemnify the company from any payment claims or assume the payment obligations to employees themselves. In this case, the company is not economically burdened by the payment claims arising from virtual participation, which is intended to prevent the assumption of a hidden profit distribution from the outset.
B. Variants of Real Equity Participation Schemes
In practice, the following three variants of real equity participation are particularly relevant:
- Hurdle Shares
- Participation under Section 19a EStG
- ESOPs
Details:
1. Hurdle Shares
Hurdle Shares offer an attractive alternative to classic real or virtual participation schemes, although their implementation requires increased coordination. In particular, coordination with the tax authorities can be time-consuming and should be factored into the timeline.
Hurdle Shares are shares that are granted with a so-called negative proceeds, profit, and liquidation preference in the amount of the value per share at the time of issue or transfer (minus the nominal amount to be paid by the beneficiary, usually EUR 1.00 per share). If structured correctly, the issuance of Hurdle Shares does not result in a monetary benefit and thus does not lead to dry income.
Future increases in value can then, in the event of an exit, be realized as capital income with preferential tax treatment (25 % instead of up to 45 % (plus solidarity surcharge)).
Example: In a financing round with a calculated share price of EUR 500 per share, Hurdle Shares are issued to a founder as a separate class at a nominal value of EUR 1 each. These Hurdle Shares only participate in the distribution of exit proceeds if the calculated share price attributable to each Hurdle Share in the exit exceeds EUR 499, and then only in the amount exceeding EUR 499. If the calculated share price per Common Share in the exit is EUR 1,000, each Hurdle Share receives EUR 501, which is taxed as capital income.
2. Participation under Section 19a EStG
Participation under Section 19a EStG also involves the grant of real shares. Unlike Hurdle Shares, the shares are not granted with a negative proceeds, profit, and liquidation preference, but are granted at a discount. However, the taxation of the monetary benefit can be deferred under Section 19a EStG, potentially until an exit. The amount of the monetary benefit is recorded in payroll accounting and confirmed by the tax office in a wage tax ruling, which can only be obtained after the grant.
This avoids dry income. In the event of an exit, the taxation of the monetary benefit is then made up for; the increase in value since the grant can be realized as capital income (25 % instead of up to 45 % (plus solidarity surcharge)).
Section 19a EStG can only be applied if, at the time of the grant of the shares or in any of the six preceding calendar years, the employer has not exceeded the following thresholds: 1,000 employees, EUR 100 million annual turnover, and EUR 86 million annual balance sheet total. In addition, the employer must not have been founded more than 20 years ago.
Since the introduction of the so-called group clause in Section 19a EStG, employees of subsidiaries and other affiliated companies within the meaning of Section 18 AktG can also benefit from the tax deferral when granted shares in startups, provided that the group as a whole meets the thresholds and none of the group companies is older than 20 years. The group clause is particularly important for foreign startups with subsidiaries in Germany.
It should also be noted that granting shares to a holding company of the beneficiary is not possible, as Section 19a EStG does not apply in such cases. Furthermore, Section 19a EStG does not provide for a deferral of any social security contributions, so the dry income issue remains in this respect.
Example: In a financing round with a calculated share price of EUR 500 per share, shares are granted to a founder at a nominal value of EUR 1 each under Section 19a EStG. One year later, an exit takes place at a share price of EUR 1,000 per share. The founder’s exit proceeds per share are taxed as employment income in the amount of EUR 499 (company value at grant minus nominal amount paid) (up to 45 % (plus solidarity surcharge)) and as capital income in the amount of EUR 500 (increase in value since grant).
3. ESOPs
If options to acquire real shares are granted (Equity Stock Option Program, ESOP), the exercise of the option results in a monetary benefit equal to the difference between the exercise price and the actual value of the shares at that time, which is taxed as employment income. In most cases, beneficiaries can sell their shares immediately after (or in connection with) exercising the options, so they have the liquidity to pay the tax. Thus, from a tax perspective, there are no significant differences compared to virtual shares, although implementing an ESOP is generally more costly and complex for a GmbH.
C. Profit Participation Rights (Genussrechte) in connection with Section 19a EStG
Profit participation rights (Genussrechte) offer a flexible and easy-to-administer way of employee participation. If the tax deferral under Section 19a EStG is used, profit participation rights provide an interesting alternative between virtual and real equity participation. They do not grant comprehensive shareholder rights to beneficiaries, but, via Section 19a EStG, avoid dry income and allow for capital gains taxation (25 % instead of up to 45 % (plus solidarity surcharge)) on value increases.
Before issuing profit participation rights for the first time, it is advisable to seek coordination with the tax authorities by obtaining a wage tax ruling to ensure that the profit participation rights to be granted actually fall within the scope of Section 19a EStG. This applies regardless of obtaining such a ruling after the grant under Section 19(5) EStG to confirm the amount of the monetary benefit granted upon issuance.
It also remains to be seen how, in particular, foreign employees and investors will deal with this participation scheme, as profit participation rights are relatively unknown internationally and may be less attractive for employees based abroad.
Further details on Hurdle Shares and profit participation rights can be found here:
