There are several core differences between Employee Stock Ownership Plans (ESOPs) and Virtual Stock Ownership Plans (VSOPs):





1. Ownership interest: ESOPs provide employees with actual ownership interest in the company, in the form of shares of stock or a cash equivalent. VSOPs, on the other hand, provide employees with a virtual ownership interest in the form of virtual stock units or options, which represent an ownership interest but do not involve the issuance of actual shares of stock.



2. Tax treatment: There are relevant tax differences between ESOPs and VSOPs: Firstly, ESOPs are typically taxed at the moment the shares are transferred (exception: see below). VSOPs are taxed only when a cash event occurs. Secondly, they are taxed as different types of income: ESOPs are taxed as capital gains, VSOPs as incomes and the income tax rate applies.



3. Regulation: ESOPs in the EU may be subject to different regulatory requirements depending on the specific country in which the plan is established. In general, ESOPs in the EU are subject to certain requirements regarding the appointment of fiduciaries to manage the plan and the provision of financial and other information to plan participants. VSOPs, on the other hand, may not be subject to the same regulatory requirements as ESOPs, as they do not involve the issuance of actual shares of stock.



4. Administration: ESOPs can be complex to set up and administer, and may require the assistance of legal and financial professionals. VSOPs may be simpler to administer, as they do not involve the issuance of actual shares of stock and may not be subject to the same regulatory requirements as ESOPs.





ESOP participants are receiving actual shares as part of the incentive program and therefore have all the rights that a shareholder of the company is entitled to. These include above all:





• Information and voting rights: the shareholder participates in determining the future of the company.



• The shareholder has rights to participate in the annual profit of the company in accordance with the provisions of the Articles of Association and other shareholders' agreements.



• In the event of a total or partial sale of the company, he or she shall participate in the sale price in proportion to the amount of his shares. 



• - As a shareholder, the participant's rights are specially protected by law: He or she may only be deprived of his shares again under certain special conditions. He must be paid appropriate compensation for this. 





VSOPs are trying to achieve a similar outcome but without actually transferring shares to the employee. In the case of virtual shares, information and voting rights are typically not granted. Some VSOP programs offer profit sharing but many don't and focus more on an exit event: In case of an exit or a share sale VSOP-holders receive a share in the sales proceeds that is proportional to their (virtual) share percentage. However, this is not a genuine equity participation, but only a claim to premium payment under the law of obligations. Requirements and conditions vary greatly between the various VSOP programs in practice.



Overall, the key difference between ESOPs and VSOPs is the type of ownership interest provided to employees. ESOPs provide actual ownership interest in the form of shares of stock or a cash equivalent, while VSOPs provide a virtual ownership interest in the form of virtual stock units or options.

Employee Stock Ownership Plans (ESOPs) and Virtual Stock Ownership Plans (VSOPs) may be subject to different tax treatment depending on the specific terms of the plan and the type of benefit received by the employee. Generally, benefits received under an ESOP or VSOP are considered taxable income for the employee. However, there may be some tax benefits available to employees who receive stock or stock options as part of an ESOP or VSOP.



The major advantage of VSOP shares is tax-related: if they are constructed correctly (exceptions may apply in the case of profit sharing and in individual cases), they are generally not taxed until the employee receives the money - namely in the exit or profit sharing case. Taxes that he or she has to pay on his virtual shares can then simply be deducted from the exit proceeds. Considering the fact that the virtual shareholding is usually to an employee in return for his or her labor (as a wage or wage surrogate), it is regularly classified as income from employment and taxed accordingly. This is helpful since in many cases a VSOP participant would not be able to finance the tax burden due to the lack of an inflow of liquid funds.



While ESOPs offer a more direct participation in the company ESOP-shares also are subject to taxation at the moment they are received: Under ESOP, employees receive shares at a lower price - typically without any cash payment - than the current market value. The difference between market value and exercise price is effectively a payment by the employer. This benefit is to be taxed as a non-cash benefit with income tax. The tax is incurred at the time the options are exercised and the shares are purchased. This is a problem. At this point, employees do not actually receive any money. On the contrary, they pay for the shares. They also have to pay the tax out of their own pockets. This effect is called "dry income".



In Germany, in order to remedy this shortcoming, Section 19a of the German Income Tax Act (EStG) was updated as part of the so-called Fund Location Act. It has applied since July 1, 2021 to small and medium-sized enterprises that are no more than 12 years old. If their employees now acquire shares, the tax does not have to be paid until later:





• Either when the shares are sold or transferred,



• or when employees leave the company,



• or after 12 years at the latest.





However, this new regulation does not help start-ups sufficiently. The problem is merely postponed until later. If employees leave the company and keep the shares, this in turn creates "dry income": they have to pay the tax without actually receiving any money. If the company therefore buys back the shares, liquidity flows out there; in the case of larger shares, this can threaten the existence of the company.



Another tax difference between ESOPs und VSOPs is that they are typically taxed as different types of income: VSOPs are taxed as deferred income and the income tax rate is applied. ESOP-related gains are treated as capital income and are taxed as such (e.g. by the capital gains tax in Germany which is 25% + solidarity levy 2.5% + church tax (2-2.25%) = 27.5% - 29.75%).

There are a number of common terms that are often found in Employee Stock Ownership Plans (ESOPs) and Virtual Stock Ownership Plans (VSOPs). Some of the most common terms include:





1. Vesting: This refers to the process by which an employee becomes entitled to receive and keep the benefits provided under an ESOP or VSOP. Vesting schedules typically award the shares over a pre-defined period of times, typically 3-8 years.



2. Stock allocation: This refers to the number of shares or virtual stock units that are allocated to an employee under an ESOP or VSOP. Stock allocations may be based on the employee's salary, length of service, or other factors.



3. Exercise price: This is the price at which an employee can purchase stock or virtual stock units under an ESOP or VSOP. Exercise prices are often set at a discount to the market price of the stock, and may be subject to certain conditions, such as a vesting schedule or a requirement to hold the stock for a certain period of time before selling it.



4. Optionality: Certain ESOPs / VSOPs leave participants the option whether to acquire the options or not. Participants can buy the shares at a predetermined price - but they do not have to. In most cases, they can decide within a set time whether they want to exercise the options or not. After that pre-set period the option expires.



5. Leavers: As a general rule, options that have not yet been exercised expire when employees leave a company. The ESOP contract must specify what happens to shares in a limited liability company that have already been purchased. In the case of stocks the situation is simpler: employees retain their vested shares.





Vesting



TESOPs or VESOPs typically vest over time - the so-called vesting period. The vesting period is the period of time after which shares are being allocated to the participants of the ESOP or VSOP if they meet certain conditions:





• Time-based: Employees must work for the company for a given period of time.



• Personal milestone-based: Employees must achieve certain milestones, such as completing a project.



• Company milestone-based: Options are granted only if the company has achieved certain targets, such as a certain stock market value, minimum sales or other metrics.





Most often options are granted gradually over time: e.g., 20% of the promised options per year of service. After 5 years, employees would then have reached 100% of the allocated shares. 



If the options are not granted gradually, but at a given point in time, this is known as "cliff vesting": only when employees have reached this "edge", e.g. after 3 years, do they become entitled to all or a portion of the shares - but not before.



The most common plan has a 1 year cliff with a 4 year vesting period.



Leavers



What happens to the options and shares under an ESOP or VSOP if employees resign or leave the company for other reasons? What happens then has to be 



Good and Bad Leavers: If employees leave a company, ESOP regulations often distinguish between so-called good leavers and bad leavers:





• Good Leavers: employees leave for good reasons, e.g. an employee who voluntarily separates from the company under certain predetermined circumstances, such as retirement or taking a new job.



• Bad Leavers: Employees leave for "bad" reasons, e.g. an employee who separates from the company under unfavorable circumstances, such as being terminated for cause or quitting without notice.





Between the clear cases there is a gray area that each company must make arrangement for as part of its own ESOP/VSOP. This includes, first and foremost, the case when employees resign for personal reasons, such as because their career plans have changed - which is typically still considered to be a "good leaver" condition.



In general, good leavers are entitled to receive a more favorable treatment under an ESOP or VSOP than bad leavers. For example, good leavers may be eligible to receive a larger severance package or may have more favorable terms for the vesting or exercise of their stock options.



Typical ESOP agreements make arrangements for the following situations:





• Options not yet vested: If employees leave a company before they have acquired options (the right to shares), they are left with nothing.



• Options not yet exercised: Options that have already been acquired but not yet exercised can either be lost or compensated with a certain price (usually a fraction of the fair value).



• Shares already acquired: Already acquired shares (i.e. exercised options) can be either retained by the employee or sold back to the company or to third parties. In the case of a startup a third party sale often is not possible or not wanted. Particularly in the case of ESOPs with shares in limited liability companies (e.g. GmbH or UG), it is necessary to define in detail what happens to the shares after the employee leaves the company since often, employees who leave the company should not continue to remain stakeholders. In the case of publicly traded companies the situation is simpler: Employees can keep the shares permanently or sell them on themselves.



There is no one-size-fits-all answer to this question, as the percentage of shares that a startup allocates to an employee stock ownership plan (ESOP) or a voluntary separation of employment program (VSOP) can vary widely depending on the stage of the company, its valuation and financial resources. A reasonable allotment size also depends on whether there are critical open positions that still need to be filled during the duration of the program, such as a CTO or CFO role.



In the USA and the EU the typical share allocation to ESOPs / VSOPs is 10% of the company’ total shares, although some startups opt to allocate as much as 20%. Typically the allocation increases with in later funding rounds: In the USA, it rises to 20% or even 25% by series D. Based on research by Index ventures, going forward, European startups are planning to allocate 12% of ESOPs / VSOPs in series A, 14% in Series B and 16% in Series C. According to Ledgy data, on average Swiss startups allocate 9.7% of shares to participation plans, German startups 11.1%, French startups 14.6% and the UK startups 12.8%.

You may find templates for the relevant documents to establish a VSOP on the GESSI (German Standard Setting Institue) webpage.