The Evolution from V/ESOPs to EIPs under § 19a EStG in Comparison to Profit Participation Rights and Hurdle Shares

In the war for top talent, offering incentives for employees can be a key differentiator for start-ups and small- and medium-sized enterprises (SMEs) alike. Until now, the German companies weren’t really able to compete in the global comparison because of the unfavorable legislation. That’s why employers had to get creative which resulted in legal constructs like VSOPs, Hurdle Shares and Profit-Participation Rights. But recent legislative changes — most notably through the “Zukunftsfinanzierungsgesetz” (Future Financing Act) and the updated §19a EStG — have fundamentally altered the taxation landscape for equity-based employee incentives. With these changes Germany now is able to compete for key talents on the global scale, but self-evidently the way employee incentives are handled needs to change as well.

Here is why we at GAIA believe Employee Incentive Programs (EIPs) are the way to go:

Key Takeaways:

• What is the “dry income” issue?
• How did VSOPs, Hurdle Shares and Profit Participation Rights avoid the “dry income” issue?
• How did the the Future Financing Act change all of it?
• Why is the new Employee Incentive Program (EIP) the superior choice now?
• Which changes occur with the draft of the Annual Tax Act 2024 and the “Konzernklausel”?

Before the Future Financing Act

The reasons why employers use incentives can be summed up with mainly three reasons:

• The participation aligns the employee’s interest with the company’s growth.
• This provides for the employee a meaningful long-term incentive.
• Reduces short term salary expenses while still attracting key talents.

The solution given by the legislation are Employee Stock Option Plans (ESOPs)

Under an ESOP, employees receive the right to acquire actual shares in the company’s capital. Traditionally, Germany’s tax rules made ESOPs less attractive, due to so-called “dry income” taxation, which forced employees to pay wage taxes (up to 45%) on shares before receiving any real monetary benefit. Because only after an increase in value of the shares the employee got a monetary advantage that in the event of a cash-out could be taxed with the preferable capital gains tax (25% plus solidarity surcharge). In addition to this, regular notary appointments are needed for the execution.

In reality no employee was ready to pay the taxes upfront since the risk of loss because of value decrease of the shares was to high.

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The ESOP arrangement typically includes:

• Cliff Period: Employees must stay with the company for a set minimum time (e.g., one year) before earning the right to acquire shares.
• Vesting Schedule: After the cliff, additional shares “vest” over time, potentially providing employees with a substantial equity stake if they remain long-term.

Therefore VSOPs, Hurdle Shares and Profit Participation Rights were introduced - treating the symptom rather than the disease?

To avoid foremost the “dry income” issue, different legal constructs were used. In this, they were successful, but still not competitive on a global scale.

Virtual Stock Option Programs (VSOPs)

VSOPs mimic the financial benefits of share ownership without granting actual equity. Employees receive “virtual” or “phantom” shares that pay out the equivalent of shareholder proceeds upon an exit or liquidity event. Basically, it is a contract under the german law of obligations where the position as a shareholder is contractually fictitious. Like ESOPs, VSOPs can have cliffs and vesting schedules, but do not require issuing new shares. Therefore they also do not require notarization.

The main downsides: Taxwise, VSOPs need to be treated as compensation, meaning payouts are taxed at personal income tax rates (up to 45%), rather than at the favorable capital gains tax rate (25% plus solidarity surcharge).

Hurdle Shares

Hurdle shares (a.k.a. Growth Shares or Zero Shares) set a performance threshold (“hurdle”) that must be exceeded before the shares participate in any upside. Usually, they are shares which are excluded form participating in the existing value of the company and only participate in the future increase in the value of the company. Simply put: The employee receives shares with no value, but profits from the increasing value over time, which are also taxable as capital gains (25% plus solidarity surcharge).

The main downsides: There is a larger need for coordination, especially with the tax authorities. Determining the right “hurdle” and establishing the conditions can be administratively complex and often requires valuation expertise. Therefore, hurdle shares usually are only issued when there is a valuation or financing round. There’s also a need for legal and notarial steps, adding to complexity and cost. Because of this, hurdle shares are usually suited for (late) founders and leading positions in the company and not so much for a multiple employees.

Profit Participation Rights

Profit participation rights are not explicitly defined by German law, making them highly flexible instruments. They grant the holder a share in the company’s profits and potentially its exit proceeds, but without granting voting rights or formal shareholder status. This allows companies to create tailor-made agreements aligning financial incentives without diluting control.

The main downsides: Profit Participation Rights often require a cash contribution from the beneficiary, introducing upfront risk as well a right to the companies profit which may not be wanted. Also in this scenario, a valuation and individual agreements are necessary which drives up costs as well as coordination with tax authorities, since it can be complex and needs individual solutions. Without legal standardization, the process of granting participation rights may involve more administrative hurdles and ongoing company valuations.

Changes Under § 19a EStG and Introduction of EIPs (Employee Incentive Plans)

Previously, Germany’s tax regime was a significant barrier to offering employee equity. Thanks to the “Zukunftsfinanzierungsgesetz” and the related reforms, especially the updated §19a EStG, several key changes have been introduced:

Deferral of Taxation on Actual Shares:

Eligible companies can now issue genuine equity to employees without immediate taxation. Employees are taxed only when they sell their shares, eliminating the “dry income” issue. However, it is important to note that social security contributions may be due immediately. This aligns taxation with cash realization and allows employees to benefit from capital gains tax (25% plus solidarity surcharge) rather than wage tax rates (up to 45%).

Expanded Eligibility for SMEs:

The Future Financing Act also widened the criteria for companies eligible to benefit from §19a EStG. Now, not only very small start-ups, but most SMEs (with up to 1,000 employees, revenues up to €100 million, and a balance sheet total up to €86 million) are able to take advantage of these reforms.

Grace Period and Time Since Foundation:

• The grace period was extended from 1 year to 6 years. In this period companies are allowed to exceed the thresholds and still issue EIPs.
• The permissible time since foundation is increased from 12 to 20 years.

Taxation Timeline:

• Only upon sale of shares, initial wage taxation (45%) is due.
• Gains beyond the initial share grant value are taxed at the more favorable capital gains tax rate (25% plus solidarity surcharge).
• Losses are fully recognized, providing downside protection.

Introduction of Employee Incentive Programs (EIPs)

To fall under the benefits of the new legislation, companies need to transition to a new form of employee incentive: The Employee Incentive Program (EIP). Now, real shares are issued to employees. This shift may necessitates a reevaluation and restructuring of existing incentive schemes.

Adopting an EIP requires careful planning and execution. It involves understanding the legal nuances, aligning with tax regulations, and communicating effectively with employees to ensure they are aware of and understand the benefits and implications of the new scheme. It's a transformative process, but one that can yield substantial rewards in terms of employee motivation, retention, and alignment with company goals.

EIPs actually are a step-back to what the legislator actually had in mind regarding employee incentives. This means, there is no need anymore for complicated legal constructs that are not found in the law. Thanks to the tax reform the benefits of VSOPs are combined with the preferable capital gains tax (25% plus solidarity surcharge) instead of the wage tax (up to 45%).

The only downside could be seen in the dilution of voting rights and a messy cap table. For this GAIA offers an elegant solution:

The Pooling-Model

Here the beneficiary are not directly involved in the start-up, but rather through a pooling entity as a limited partner (which means, no voting rights), which in turn has a real stake in the start-up.

By pooling employees in a separate entity, companies can avoid direct entries on their cap table, maintaining a clean and straightforward shareholder structure. This approach not only complies with the new legislation but also preserves the organizational integrity of the company and avoids the voting rights of employees.

For a more in-depth insight on how to transition from V/ESOP to EIP check out our other blog post.

Important Changes in 2025: What is the “Konzernklausel” and its Significance?

With the Annual Tax Act 2024 “Jahressteuergesetz”, which came into force on December 2, 2024,  and the introduction of the “Konzernklausel,” the tax deferral rules now apply to shares or participation rights granted not only in the direct employer company but also in affiliated group companies. This means:

• Employees now receive beneficially taxed equity instruments related to a parent or another group entity, broadening the scope of eligible instruments.
• This represents another step toward more flexible, internationally competitive employee incentive frameworks in Germany.
• But to be eligible under § 19a EStG the parent company and subsidiary need to be under the set thresholds.

On another note, we are now left with a few open questions:

• It is unclear whether the requirements are met if the company in question was founded less than twenty years ago, but a group company acquired through acquisition has existed for a long time.
• The shareholding must still be issued to the employee “by his employer or a shareholder of his employer”. In cases where the employee is to receive shares in his employer's direct parent company, this requirement can easily be met. However, this causes difficulties with more complex group structures and longer investment chains.

At GAIA we offer you EIP solutions, regardless of your current incentive scheme. You don’t know were to start?

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