The pros and cons of an ESOP

It is a well-known and often seen dilemma: In order to compete in the market and against already established companies, start-ups depend on top-talented employees. At the same time, start-ups usually have limited financial resources, which they first and foremost need for the (further) development of their products or services and thus cannot pay competitive wages. In order to still be competitive in the labour market, start-ups frequently offer their employees options or shares as part of their salary. In the event of a later exit or IPO of the start-up, these shares will often be worth more than at the time of issue. For this chance at a high future profit, prudent employees accept lower salaries than what established companies would pay.

The right tool for this is an Employee Share Option Plan ("ESOP"). An ESOP is a programme that allows employees to acquire options to buy shares in the start-up at a price that is often much lower than the issue price of previous and future financing rounds. Employees can earn these options, for example, by staying with the company longer or by achieving certain key performance indicators ("KPIs").

Advantages of an ESOP

An ESOP has many advantages. Here are the most important:

• Attraction: Options and Shares can be a valuable tool for attracting talented employees to a start-up.
• Retention: Options and Shares can incentivize employees to stay with the start-up longer.
• Motivation: Employee shares provide employees with a sense of ownership in the start-up and can increase motivation and job satisfaction.
• Alignment of Interests: Options and Shares align the interests of employees with those of shareholders, as employees benefit when the start-up performs well.

Disadvantages of an ESOP

On the other hand, the potential disadvantages of an ESOP must also be taken into account such as:

• Complexity: ESOPs can be complex and difficult for employees to understand and time-consuming for the start-up.
• Risk: Shares in an start-up can be risky for employees, as the value of the shares is dependent on the performance of the start-up.
• Vesting periods: Employees may need to wait for a specified period of time before they can exercise their options, which can limit their flexibility.

In summary, it can be said that ESOPs can offer many advantages for both start-ups and their employees. However, it is important that the possible disadvantages are carefully weighed, and the plan is designed in such a way that the advantages are maximised and the risks for the employees are minimised. It is no less important that employees are made aware of the plan, how it works, its benefits and potential risks, so that employees really understand it and it functions as a tool for retaining top talent in the first place.

Tax Perspective

From a tax perspective, it can be summarised that an ESOP usually only triggers tax consequences at the level of the employees and the start-up when the options are exercised and shares in the start-up are acquired. At this point, it is relevant at what value the shares are purchased by the employees and what the other circumstances are that may have an influence on the value of the shares of the start-up, such as financing rounds or share transfers. In order to protect the employees as well as the start-up from undesired tax consequences (or social security contributions in the case of the start-up), it is therefore advisable to agree on the tax value of the shares with the tax authorities on the occasion of a tax ruling, whereby the formula value method is often used.

We are happy to support you in drafting and implementing a balanced ESOP tailored to the needs of your start-up and will also coordinate the obtaining of a tax ruling with a tax expert from our network.

You can take the first steps towards your personalized ESOP right now here or simply give us a call – we're here to help!