Good Leaver Bad Leaver provisions: A guide for employees

The tech industry – once an unstoppable engine of growth – has started to lay off people in large numbers. In 2024 alone, more than 100,000 employees were fired – and counting.  Increasingly, these layoffs are affecting key employees who have significantly contributed to the success of their companies – and who have often been granted equity as part of their compensation. For many top performers, equity-based compensation is the real incentive — because even with a good salary, one usually doesn’t get rich without options or shares. That can be different with options. However, employees who are laid off may also lose these valuable stock options. The following blog post explains good leaver / bad leaver provisions, and vesting rules and provides tips on how to avoid equity-related mistakes when your employment ends.

Stock Options as Incentive Tool

Working at startups and scale-ups can be exciting. Even more so if you have equity participation in an upcoming exit event. For startups and scale-ups, stock-based compensation conserves cash flow. It also ensures that the incentive systems for top performers, executives, investors, and founders are aligned. If the company is eventually sold or goes public (exit event), employees can cash in. However, if the company goes bankrupt, the shares/options are typically worthless.

The upside, however, is unlimited and often substantial. Employees at companies like DeliveryHero and Zalando have made millions from stock options in recent years. Another example might be Personio, where in the case of an IPO, based on the latest valuation, more than 100 employees would become millionaires overnight.

In the following blog article, we will explain the key terms of ESOPs and VSOPs. We will shed some light on vesting schemes as well as the general legal and tax framework. Last, but not least, we will provide tips on how to avoid disadvantages, especially when your employment ends.

Different types of equity-based compensation

There are many types of employee stock ownership programs. We will focus on the two most common variants in startups and scale-ups:

• ESOP (Employee Stock Option Plan): An ESOP is a program that allows employees to acquire real shares in the company. In ESOP plans, options on “real” company shares (stocks or LLC shares) are granted. Employees receive the option to purchase these shares from the employer’s company at a (often discounted) price. Employees typically earn the right to these shares through long-term employment or by reaching specific milestones
• VSOP (Virtual Stock Option Plan): A VSOP is a simpler form of ESOP. Employees don’t receive options for “real” company shares, but instead receive options for “virtual” shares (“phantom shares”). Important: Unlike an ESOP, no actual shares are granted in a VSOP. Employees generally receive these virtual shares as part of their compensation package at no cost and do not need to “buy” them. In most cases, VSOPs are the easiest and most common way to offer employee ownership
• Leaver provisions: Leaver provisions determine what happens to your shares when you leave the company. We’ll explain this in more detail below.

How Do ESOPs and VSOPs Work?

This can best be explained through the three typical phases of an ESOP or VSOP plan:

• Offer/Implementation Phase: When the stock option plan is established or the employee joins the company, they accept the ESOP offer as part of their contract. The plan contains a certain number of options, which are usually tied to certain conditions.
• Cliff Phase: During their time at the company, employees fulfill the conditions for the right to these options. However, a “cliff” often must be reached before they are eligible. This is typically a one-year period of employment.
• Vesting Phase (Accumulation Phase): The vesting period is the time frame in which employees must meet the conditions for share options. These are typically time-based, such as 25% of the promised options per year of employment. After four years, the employee would reach the maximum number of options. Vesting periods usually last 3-5 years. Vesting can be structured in a variety of ways, just like leaver provisions, which we will discuss further below. Some programs even stipulate that vested shares will expire upon voluntary resignation, while in other programs, only unvested shares are forfeited in cases of employer termination for cause. A four-year vesting period is pretty standard in both the US and Europe, and mostly regardless of seniority. Also, vesting tends to be linear in our experience, with 25% immediately following the one-year cliff, 50% after two years, 75% after three years, and 100% after four years of employment

How Are ESOPs and VSOPs treated in Germany?

Employers have high degrees of freedom to define the specific terms of their ESOPs/VSOPs, but are subject to a legal “content review” by the courts. However, the labor courts tend to be a lot less strict with options than with other forms of compensation,  since options are regarded as an incentive for future performance, less as a reward for work already performed. 

What is a “content review” of ESOPs and VSOPs?

The “content reviews” of the courts typically covers the following topics:

• Transparency Requirements: ESOP/VSOP plans must meet the transparency requirement, meaning the terms must understandably, and explicitly define the conditions and amount of the employee’s entitlement
• Fairness: ESOPs, for example, may be deemed invalid if leaver provisions unfairly disadvantage employees. This could be the case if a good leaver loses all shares or if a bad leaver forfeits shares for minor misconduct.
• Other Compliance: ESOP/VSOP plans must not violate other laws. For example, leaver provisions could violate anti-discrimination or labor protection laws

Leaver Provisions – What Happens When the Employment Ends?

A key question with ESOP or VSOP plans is often: What happens when an employee leaves the company? This is determined by the “Bad Leaver” and “Good Leaver” provisions in the ESOP or VSOP:

• Good Leaver:  A good leaver is an employee who leaves the company “on good terms,” without breaching contractual or legal obligations. Reasons might include regular resignation, retirement, or personal reasons. The good leaver usually retains their acquired shares and participates in the sale proceeds (“exit”). The ESOP/VSOP governs the details.
• Bad Leaver: In contrast, a bad leaver is an employee who leaves “on bad terms,” such as due to contract violations, dismissal, or a severe breach of duty. The details are also governed by the ESOP/VSOP.

What “Tax Traps” Exist in Employee Ownership Models?

As with many other forms of compensation, the tax implications – for instance, when negotiating a severance agreement – are often overlooked. This can have costly consequences because significant mistakes can occur:

• ESOPs, VSOPs, and other employee ownership models are subject to different tax regulations, leading to varying tax burdens.
• With ESOPs in particular, there is the risk of so-called “dry income.” This means employees are taxed on the granted shares at the time they are issued, even without receiving cash. No money flows in, but the tax still has to be paid.

Since 2021 (and esp. January 2024), a change in tax laws has relieved some of the “dry income” tax burden for ESOPs. This deferral rule, particularly aimed at startups, was intended to elevate ESOPs compared to the “virtual-only” VSOPs. 

However, ESOPs and VSOPs are still not entirely equal. ESOPs, with the more favorable taxation of exit proceeds as capital gains (tax burden generally 25% plus solidarity surcharge), offer significant tax advantages compared to VSOPs, which are subject to regular income tax (tax burden up to 45% plus solidarity surcharge).

How to Avoid Disadvantages When Ending Employment?

When leaving a job (through termination or  severance agreement), it’s crucial to review the terms of the employer’s ESOP/VSOP thoroughly. Carefully read the conditions for an early exit, and if necessary, consult with an expert. Be cautious: a comprehensive legal review can be expensive, and you may not need it yet. If a mutually agreed solution is being sought, the fate of already earned options can be made part of the severance agreement.

In the case of a severance agreement, it’s important to remember if a “catch-all” clause is included. With such a provision (also called a “general release” or “settlement clause”), the employer wants to ensure that no additional claims are expected from the employee. Often, severance agreements include wording such as, “All claims between the parties, regardless of legal grounds, are settled with the fulfillment of this agreement.”  

If vested options are not explicitly excluded here, the catch-all clause could also eliminate claims to already earned (vested) options. This could be a very “costly mistake” that should be avoided. Especially if the options are valuable, for example, if an IPO is being prepared and the vesting phase is (nearly) complete, it is worthwhile to consult an expert during a resignation or severance agreement. After all, this could involve millions of euros, which one might “accidentally” forfeit due to unfortunate wording in the severance agreement. Our partner lawyers can help prevent such mistakes.