Why ESOP is better than VSOP

Corporate 11.04.2023

Employee stock option plans are used in growth companies and startups to compensate for lower cash salaries and to grant employees a share in the company's success.

In Germany, the most common forms are Employee Stock Option Plans (ESOP) and Virtual Stock Option Plans (VSOP).

But what are the advantages and disadvantages of both programs? How do ESOP and VSOP differ? And why do we usually recommend an ESOP as an employee stock option program to companies?

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PXR team portrait overview daniel
Corporate/M&A Lawyer and Authorised Signatory

You will learn in this article

  • What ESOP means

  • What VSOP means

  • Differences and similarities between ESOP and VSOP

  • Similarities between both programs
  • Why we regularly recommend ESOP as an employee stock option program

Employee stock option programs play an important role especially in venture capital funded startups. Young startups rely on highly qualified employees at an early stage but are usually not able to pay the same cash salaries as mature companies.

Employee stock option programs such as ESOP and VSOP are able to fill this gap. Such programs offer employees the opportunity to participate financially in the company's performance. This enables startups to attract, retain and reward talent.

Differences between ESOP and VSOP

The terms ESOP and VSOP are often used interchangeably, although the two programs are based on different mechanisms.

ESOPs – Employee Stock Option Programs

ESOPs are employee stock ownership plans that grant the employees the option to acquire actual shares in a company.

Normally, employees can only exercise their options upon a successful exit, such as a sale or IPO of the company. In connection with such exit, the employees may sell their shares received upon option exercise.

ESOPs may also be designed in such a way that options may be exercised prior to the occurrence of an exit event. It is common that ESOPs are vested with an exercise price (also known as strike price), which is to be paid as a purchase price for the shares when the options are exercised.

VSOPs – Virtual Employee Stock Option Programs

In Germany, VSOPs are quite commonly used by startups as their default employee incentive scheme. The key characteristic of a VSOP is the fact that shares are only virtually replicated. Hence employees cannot become shareholders in the company through a VSOP.

A VSOP entitles an employee only to a claim of a cash payment in the event of an exit. The payment amount is generally based on the proceeds that employees would have received if they had exercised actual options instead of virtual options and sold their shares in the company by way of an exit. From the employee's perspective, such payment may be compared to a bonus payment.

Similarities between ESOP & VSOP

Although the two programs presented differ in their general structure, they do have one thing in common: the receipt of actual or virtual options is usually linked to certain additional conditions.

Both programs regularly provide for so-called vesting clauses. The options are regularly only vested over time (e.g., monthly or quarterly), which is linked to the duration of the employee’s employment agreement. A total vesting period between three and five years is commonly used in practice.

Furthermore, ESOP/VSOP agreements regularly provide for a cliff period. This refers to an initial period during which the options are not yet gradually vested (comparable to a probation period). A common cliff period would be one year.

Leaver clauses are also important provisions in ESOP and VSOP agreements. These clauses determine what happens to the (vested and unvested) options in case an employee leaves the company prior to the end of the vesting period. In such events, employees are normally classified as either a “bad leaver” or a “good leaver”.

A bad leaver event normally includes an extraordinary termination of the employment relationship of an employee. In such a case, it is usually stipulated that the employee loses all options (i.e., irrespective of being vested or unvested).

A good leaver event includes all other reasons of an employee leaving the company (e.g., in the context of an ordinary termination or permanent incapacity to work), in which case the employee may retain the options already vested.

VSOP versus ESOP: advantages and disadvantages

A common reason referred to for the implementation of a VSOP is a larger liberty of legal design. Furthermore, arguments mentioned include that no formal requirements must be met (e.g., notarization) and employees cannot become shareholders in the company.

However, (justified) criticism is also frequently voiced about VSOPs. Such programs are largely unknown and uncommon abroad, especially in Anglo-Saxon countries.

Hence VSOPs may be an obstacle for highly qualified and international employees, who are accustomed to attractively designed and structured employee stock option programs.

The contractual claim to payment of a VSOP is often not treated in the same way as the co-sale of actual shares under certain tax law jurisdictions.

In addition, VSOPs are not suitable for capital markets. In the event of an IPO, a VSOP is to replaced by another program, e.g. an ESOP. With an ESOP, options would simply need to be exercised, and the shares received could be sold via the stock exchange.

The remaining advantages of a VSOP (employees not to become shareholders of the company, flexibility) may also be achieved with an ESOP.

Why do we recommend an ESOP to startups?

Contrary to the widespread belief that ESOP contracts are more complicated to set up, ESOPs offer serious advantages over VSOPs.

1. ESOPs are internationally recognized and flexible

Unlike a VSOP, an ESOP offers the company the flexibility to allow "early exercise" of options in exceptional circumstances. Such flexibility may prove beneficial to attract top talent, especially to fill C-level positions.

To early exercising employees leading to a fragmented shareholder structure and cap table, exercising employees could be pooled in a joint pooling vehicle.

2. ESOPs can be designed not to require notarization

The argument that VSOPs are easier to set up and manage can also be mitigated. Both programs usually consist of a contractual document that sets out the general terms and conditions for the program and individual agreements with the respective beneficiaries.

The conclusion of these contracts is subject to the same formal requirements for ESOPs and VSOPs: Both do not have to be notarized - if they are structured accordingly. Simple written form is sufficient.

3. ESOP can remain an option and be linked to exit

Often a VSOP is used to avoid a fragmented cap table and manageable shareholder base: a similar outcome can be achieved in an ESOP by limiting the exercise of options to exit events.

Employees then only become a shareholder for the legal second between the exercise and the sale of their shares. To further simplify this process, the company could also be granted the right to settle the claim for the issuance of shares to the employee in cash (cash settlement).