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ESOP vs. VSOP: What Investors and Founders need to know

Legal Know-How
May 16, 2023

Introduction

Employment incentive schemes are proving to be invaluable tools for startups looking to attract and retain top-tier talent. These schemes not only offer financial incentives to employees but also foster a sense of belonging and heightened motivation. Start-ups and young companies often utilize programs like ESOPs (Employment Stock Option Program) and VSOPs (Virtual Stock Option Program) to lure in and retain employees, particularly when high salaries are not a feasible option during the startup phase. Often, the existence of these programs can influence whether or not key hires decide to come on board. But how do these incentive schemes differ, and what are the pros and cons of each? Let's delve into the intricacies of ESOPs and VSOPs.

What is an employee incentive scheme?

Employee Incentive schemes is a general term for programs implemented at a company to allow employees, freelancers, advisors or other relevant stakeholders to participate in the financial success of a company in a similar way as a regular shareholder would. Employees are granted shares, options or virtual options which entitle them to participate in exit proceeds and - sometimes - even in dividends a company distributes to its shareholders.

With these programs companies - most of them startups - try to address the following needs:

  • Attract the best talent to their company while not using to much of their budget: Employee incentive schemes are very helpful when you are on a tight budget but still want to attract the best talent. You can save some of your cash and instead grant (virtual) options or shares.
  • Align the interests of your shareholders' with the interests of your employees: (Virtual) options help to align the interests of all relevant stakeholders. Shareholders benefit from increasing the value of the company, because thats directly increasing the value of their shares. Employees without shares or options do not directly benefit from an increase in company value. At the same time employees are the ones who are the key driver in making the increase in company value happen. (Virtual) Options are a great way to align both shareholders' and employees' interests.

When to implement an employee incentive scheme?

So now you understand the main benefits of employee incentive schemes. But what is the best time to implement one? We at GAIA think every startup should implement an ESOP with the first hire. Especially your first employees are super critical for your startups success. Every great candidate will expect to participate in the success in the startup. Plus especially at the beginning of your startups journey you will be on a tight budget.

Understanding ESOPs

An ESOP - an Employment Stock Option Program is a straight option program. This means that in certain cases the option holder is entitled to exercise their options and receive real shares in the company.

Under an ESOP, employees are granted the right to subscribe to a certain number of shares in the company at a predetermined price. This option can be exercised under specific circumstances, for example in case of an exit event. Exercising these options provides the employees with actual, real shares in the company making them a shareholder in the company.

Key benefits of an ESOP are:

  • Common program type outside of Germany: An ESOP is the standard program used outside of Germany, especially in the united states. If you intent to attract international talent, the ESOP should be your go to-option.
  • ESOPs are the standard prorgam prior to an IPO: If your long-term goal is an IPO of your startup the ESOP is the go to program, as all virtual stock option programs will have to be replaced by a VSOP prior to an IPO which can create a costly and time-consuming process.
  • More flexibility: If an ESOP is structured right you as the company owner have more flexibility in making employees real shareholders eventually.
  • No complex formulas needed: Under an ESOP all option holders are simply treated as common shareholders in an exit, because they receive real common shares. You don't need to add any complex formulas in your program to calculate entitlements of the option holders.

What is a VSOP?

A VSOP, or Virtual Stock Option Program, on the other hand, functions slightly differently. Under a VSOP an option holder is never entitled to receive real shares, instead it only grants a claim for a cash payment in case of an exit event. A VSOP typically tries to mimic an ESOP without creating any actual ownership.

VSOPs are quiet commonly used in Germany but rare in other jurisdictions. They came up in the past because founders and investors tried to avoid actual ownership in the company and where afraid of notarization needs for ESOPs. This argument for a VSOP does not hold up anymore, as a ESOP structured right does not require any notarization.

Conclusion: ESOP is the go to program for startups

If it comes to creating an employee incentive scheme more arguments speak for using an ESOP. With GAIA you can create your own ESOP in minutes and issue and track options you created.

Janina Möllmann

CEO @ GAIA

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