5 minute read | July.25.2024
Case law about virtual employee participation programs (VSOP), which are still the predominant form of employee participation in German start-ups, are rare. Earlier this year, the Regional Labour Court of Munich upheld certain forfeiture provisions in a VSOP that originally dated back to 2016, notably a so-called negative vesting. While such provisions might arguably be legal (the decision has been appealed—BAG - 10 AZR 67/24), the question remains if such provisions are advisable if the start-up seeks to attract and retain the best talent.
What Is Negative Vesting? Negative vesting is a concept found in some VSOPs. It basically says that virtual options, which are considered vested when the beneficiary leaves the company, may still be subject to an incremental forfeiture over time after the leaver until either an exit event occurs or they reach a floor. For example, such provision can say that a beneficiary will lose 1/48th of his/her vested shares or options for every month after his/her leaver up until an exit and that he/she will only participate in the exit with whatever is left of his/her vested benefits (which might be nothing). The rationale is that an employee’s participation in the development of the company becomes progressively less relevant to the efforts of achieving an exit after the employee has ceased to perform services for the company.
What Is the Recent Court Decision About? A recent decision of the Munich Regional Labour Court (LAG München, 7 February 2024 - 5 Sa 98/23) upheld the validity and legality of a negative vesting clause contained in a VSOP. In the case at hand, the negative vesting clause foresaw a forfeiture of all vested virtual options in quarterly installments over two years after the leaver.
The court emphasized that virtual options are speculative in nature and do not guarantee a financial benefit. Although the virtual options granted are part of the contractual remuneration of an employment contract and thus legally qualify as wages, they are to be seen less as compensation for services already rendered, but, rather, as a profit opportunity and an incentive for future commitment. Therefore, the gradual forfeiture of these virtual options at the end of the employment relationship does not constitute a withdrawal of salary already earned, but only a reduction in the profit opportunity for the future. The court also ruled that as long as the forfeiture rate is clearly set out—for example, in a table—the forfeiture clause does not violate the transparency requirements for general terms and conditions since it should not come as a surprise to the employee that a future profit opportunity may be subject to fluctuation until its potential realization. In the same context, the court found that the forfeiture did not constitute an unfair disadvantage, as it was considered a balanced measure to encourage long-term commitment without being overly punitive.
The court’s reasoning doesn’t clearly distinguish between the negative vesting provision in the defendant’s VSOP (§ 4.5 thereof) and another provision in the VSOP pursuant to which a beneficiary voluntarily leaving the company before an exit event would forego all his/her vested shares (§ 4.2 thereof). When looking at the latter, the court could have argued that the negative vesting provision is not relevant, as plaintiff resigned from the start-up by himself (he wasn’t terminated) so should have forfeited everything anyhow. Some passages of the court’s reasoning indicate that the court would arguably have upheld the broad leaver provision. In today’s VSOPs, such treatment of voluntary leavers as bad leavers, especially for leavers outside of the vesting period, are less frequent.
What else is noteworthy: The VSOP was only set up in the English language. The court didn’t take issue with that but ruled that the plan constitutes general terms and conditions which need to be drafted in a clear and precise way. The court viewed the fact that the negative vesting consequences were set forth in a separate table favorably.
But Are Negative Vesting Clauses Really a Good Idea? Employee participation programs (whether equity-based or virtual), as the name suggests, are essentially designed to encourage (i) potential employees to join the company and add value to it and (ii) existing employees to continue contributing to the growth of the company, both in the hope of one day receiving their share of the exit proceeds (attract and retain talents).
Negative vesting provisions make programs less attractive to a (potential) employee. Negative vesting can create the impression that what a beneficiary will consider as a reward for services already rendered is being taken away again. That can be a disadvantage in the fight for international talent. For example and at the risk of oversimplifying matters a bit, in the United States, employee participation programs follow the premise that what has been “earned,” read “vested,” may only be taken away in very narrowly defined situations, read “bad leaver events” (and there, the voluntary leaver is treated as a good leaver, and so negative vesting provisions will arguably be even more off). Negative vesting also conflicts with many start-ups’ pitch to prospective employees that a virtual share shall be economically equivalent to (a fraction of) a common share held by a founder, and negative vesting for founders is, in our humble experience, a rare occasion.
Interestingly, the company in the aforesaid case amended its VSOP in 2022 and dropped the negative vesting provision.
If the start-up nevertheless feels that a negative vesting provision is called for, there are more modest approaches. For example, it could be provided that the forfeiture of virtual options in case of a leaver applies only to a portion of the virtual shares (e.g., 50%) so that the beneficiary will retain a portion of his/her vested virtual shares. Alternatively, the employee can be given the option to either accept a negative vesting upon his/her leaver (he/she would then participate with the non-forfeited portion in a future exit event, as the case may be) or to avoid a negative vesting and retain his/her vested portion but accept that in case of an exit event, his/her payments under the VSOP would be capped at the company valuation at the time of the leaver event.