Germany's employee incentive landscape has changed dramatically. This article explains how recent legislative changes have reshaped equity-based compensation, creating new opportunities for companies competing for global talent.
In the war for top talent, offering employee incentives can be a key differentiator for startups and small and medium-sized enterprises (SMEs) alike. Until recently, German companies couldn't really compete internationally because of unfavorable legislation. Employers had to get creative, which led to legal constructs like VSOPs, hurdle shares, and profit participation rights. But recent legislative changes, most notably the "Zukunftsfinanzierungsgesetz" (Future Financing Act) and the updated § 19a EStG, have fundamentally changed how equity-based employee incentives are taxed. Germany can now compete for key talent on a global scale, but the way employee incentives are structured needs to change with it. Here is why, at GAIA, we believe Employee Incentive Programs (EIPs) are the way to go.
Before the Future Financing Act
Employers use incentives for three main reasons:
- Participation aligns the employee's interests with the company's growth.
- It gives the employee a meaningful long-term incentive.
- It reduces short-term salary expenses while still attracting key talent.
The legislative solution: 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 because of so-called "dry income" taxation, which forced employees to pay wage tax (up to 45%) on shares before receiving any real monetary benefit. Only after the shares increased in value did the employee gain a monetary advantage, which on a cash-out could be taxed at the more favorable capital gains rate (25% plus solidarity surcharge). On top of that, the execution required regular notary appointments.
In reality, no employee was willing to pay the tax upfront, since the risk of loss from a drop in share value was too high.
An 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 giving employees a substantial equity stake if they stay long-term.
So VSOPs, hurdle shares, and profit participation rights were introduced: treating the symptom rather than the disease?
To avoid the "dry income" issue above all, employers turned to different legal constructs. They worked, but were 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 on an exit or liquidity event. It is essentially a contract under German law of obligations, where the position of a shareholder is contractually simulated. Like ESOPs, VSOPs can have cliffs and vesting schedules, but they don't require issuing new shares, so they also don't require notarization.
The main downside: for tax purposes, VSOPs are treated as compensation, so payouts are taxed at personal income tax rates (up to 45%) rather than the favorable capital gains rate (25% plus solidarity surcharge).
Hurdle shares
Hurdle shares (also known as growth shares or zero shares) set a performance threshold (the "hurdle") that must be exceeded before the shares participate in any upside. Usually they are shares excluded from participating in the existing value of the company, sharing only in its future increase in value. Put simply: the employee receives shares with no value today but profits from the increase over time, taxed as capital gains (25% plus solidarity surcharge).
The main downside: there is a greater 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. As a result, hurdle shares are usually only issued alongside a valuation or financing round. They also involve legal and notarial steps, adding complexity and cost. For these reasons, hurdle shares tend to suit (later) founders and leadership positions rather than a broad group of employees.
Profit participation rights
Profit participation rights are not explicitly defined under German law, which makes them highly flexible instruments. They grant the holder a share in the company's profits and potentially its exit proceeds, but without voting rights or formal shareholder status. This lets companies create tailor-made agreements that align financial incentives without diluting control.
The main downside: profit participation rights often require a cash contribution from the beneficiary, introducing upfront risk, as well as a right to the company's profits that may not be desired. Here too, a valuation and individual agreements are necessary, which drives up costs, along with coordination with the tax authorities, since the arrangements can be complex and need individual solutions. Without legal standardization, granting participation rights can involve more administrative hurdles and ongoing company valuations.
Changes under § 19a EStG and the introduction of EIPs
Previously, Germany's tax regime was a significant barrier to offering employee equity. Thanks to the Zukunftsfinanzierungsgesetz and 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. Note that social security contributions may still be due immediately. This aligns taxation with cash realization and lets employees benefit from the capital gains rate (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 under § 19a EStG. Now not only very small startups but most SMEs (up to 1,000 employees, revenues up to €100 million, and a balance sheet total up to €86 million) can take advantage of the reforms.
Grace period and time since foundation:
- The grace period was extended from 1 year to 6 years. During this period, companies can exceed the thresholds and still issue EIPs.
- The permissible time since foundation increased from 12 to 20 years.
Taxation timeline:
- Initial wage taxation (45%) is due only upon sale of the shares.
- Gains beyond the initial share grant value are taxed at the more favorable capital gains rate (25% plus solidarity surcharge).
- Losses are fully recognized, providing downside protection.
Introduction of Employee Incentive Programs (EIPs)
To fall under 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 require re-evaluating and restructuring existing incentive schemes.
Adopting an EIP takes careful planning and execution. It means understanding the legal nuances, aligning with tax regulations, and communicating clearly with employees so they understand the benefits and implications of the new scheme. It is a transformative process, but one that can deliver substantial rewards in employee motivation, retention, and alignment with company goals.
EIPs are in many ways a step back to what the legislator originally had in mind for employee incentives. There is no longer a need for complicated legal constructs that aren't grounded in law. Thanks to the tax reform, the benefits of VSOPs are combined with the favorable capital gains rate (25% plus solidarity surcharge) instead of wage tax (up to 45%).
The only real downside could be the dilution of voting rights and a messy cap table. For this, GAIA offers an elegant solution.
The pooling model
Here, beneficiaries are not directly involved in the startup but participate through a pooling entity as a limited partner (which means no voting rights), and that entity in turn holds a real stake in the startup.
By pooling employees in a separate entity, companies avoid direct entries on their cap table and keep a clean, straightforward shareholder structure. This complies with the new legislation while preserving the organizational integrity of the company and avoiding granting voting rights to employees.
For a more in-depth look at how to transition from a V/ESOP to an EIP, see our article From ESOP to EIP.
Important changes in 2025: the "Konzernklausel" and why it matters
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 can now receive beneficially taxed equity instruments tied to a parent or another group entity, broadening the scope of eligible instruments.
- This is another step toward more flexible, internationally competitive employee incentive frameworks in Germany.
- To be eligible under § 19a EStG, however, the parent company and subsidiary still need to fall under the set thresholds.
A few open questions remain
- 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 an acquisition has existed for much longer.
- The shareholding must still be issued to the employee "by his employer or a shareholder of his employer." Where the employee is to receive shares in their employer's direct parent company, this is easily met. But it creates difficulties with more complex group structures and longer investment chains.
