#ESOP: How to Deal with the New Case Law on the Forfeiture of Vested Virtual Shares – A Practical Update for Employers and Employees | Legal Ninja Snapshot

Incentive programs like an employee stock option plan or a virtual stock option plan ("VSOP") are widely used by young technology companies ("Company") to reward and retain talent ("Beneficiaries"). A key feature in these programs is vesting – a process where the Beneficiaries "earn" rights to specific benefits over time. However, a recent and still unpublished ruling by the German Federal Labor Court (Bundesarbeitsgericht – "BAG") has created uncertainty about how vesting rules in VSOPs are to be structured under German law. The ruling has been presented in our previous Snapshot, so in this instalment, we want to focus on what can arguably still be done to ensure that a VSOP is not only initially attractive (the hiring aspect), but also provides extra incentives for the Beneficiary to stay with the Company (the retention element).

The Two Main Assumptions Shaping the Discussion

While the full reasoning behind the BAG judgment is not yet available, legal professionals are already working with a few key assumptions – based on the BAG's press release – regarding its impact on the validity of VSOP regulations. In particular, two core assumptions are emerging:

1. "Voluntary Leavers" Cannot be Classified as "Bad Leavers"

In the past, in Germany it was not uncommon for VSOPs to include a clause stating that a Beneficiary's termination of the employment relationship with the Company through ordinary resignation (ordentliche Eigenkündigung) would qualify as a so-called bad leaver event (though that practice had already changed to some extent in the most recent past). This classification had the consequence that even the already vested options of such Beneficiary would forfeit upon his or her resignation without compensation. The intention behind this classification was to discourage the Beneficiary's early exit and to ensure long-term retention.

However, the BAG has now taken a clear stance against this approach. According to its current judgment, taking vested options away simply because the Beneficiary chooses to leave the Company – without any misconduct – will cross a legal line. Such a clause shall now be invalid as it constitutes an unreasonable disadvantage to the Beneficiary.

2. "Negative Vesting" Periods Cannot be Shorter than the Actual Vesting Period

Some VSOPs include provisions under which vested options gradually forfeit after the termination of the employment relationship. The effect of such provisions is that the longer the Beneficiary has been separated from the Company, more of the vested options will be forfeited and, therefore, cannot be exercised.

According to the BAG's judgment, such clauses shall be invalid if they fail to fairly account for the length and value of the Beneficiary's service for the Company. Specifically, the BAG takes issue with negative vesting schedules under which vested options forfeit quicker than they are vested. For example, a clause that causes virtual shares to forfeit within a two-year period after employment ends – when those options were earned over a four-year vesting period – is therefore invalid. Consequently, the Beneficiaries can keep the vested options.

Current Responses by Some Practitioners

These working assumptions are driving new questions – and new strategies – about how to structure VSOPs in a legally sound and fair way. In particular, the following two practical responses are currently under discussion:

Buy-Back Rights

One practical response to the legal limits on forfeiting vested options, as outlined above, is to implement a buy-back right in favor of the Company. In this case, the VSOP grants the Company a time-limited option to buy back the Beneficiary's vested options at the fair market value when the Beneficiary leaves the Company. This approach can effectively limit the Beneficiary's economic upside and makes a VSOP less attractive for Beneficiaries.

Longer Negative Vesting Periods

To address the legal concerns outlined above regarding the invalidity of negative vesting arrangements, a common practical response is to extend the duration of the negative vesting period. By aligning it closer to the duration of the original vesting schedule, this approach seeks to preserve the retention effect without violating Beneficiary protection principles. But similar to the one-sided buy-back options, negative vesting provisions make VSOPs less attractive to a (potential) employee. Negative vesting can create the impression that what a Beneficiary considers as a reward for services already rendered is being taken away.

Is it Time to Rethink the Current Practice?

Most of the practical responses, such as those outlined above, are more or less explicitly based on a common underlying assumption: That Beneficiaries who leave the Company voluntarily prior to the expiration of their vesting period should be "penalized" in some way by forfeiting at least a portion of their economic benefit. That raises a fundamental question. Should we really focus so much on clawing back what was given? Why not follow a simpler principle that one of the author's toddler would summarize as follows: "What is mine is mine – and taking it is crime"?

This is especially relevant when we consider that long-term incentives are supposed to be just that – incentives. They should encourage Beneficiaries to stay and contribute, not threaten them with loss if they leave. So instead of building in penalties, maybe we should focus more on the retention value of these instruments.

Any form of penalties for a behavior that the Beneficiary would consider legitimate can be a disadvantage in the fight to retain 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).

Alternative Structures That Prioritize Retention Over Punishment

There are various tools and structures available that emphasize positive incentives rather than clawbacks. Here are a few approaches that can be easily combined:

Ensuring a Minimum Stay Period: Extending the Cliff Period

Extending the cliff period delays the commencement of the vesting of the options. However, once the cliff period expires, the options that would have been vested during that time (if there was no cliff period) will vest all at once.

Consequently, Beneficiaries are incentivized to stay longer with the Company in order to receive these options at all. If Beneficiaries leave the Company during the cliff period, they will not receive any options. However, since the options have not yet vested, nothing is "taken away" from them.

It is important to ensure that the extension does not unduly disadvantage the Beneficiary. A 12-month cliff is typical in many VSOPs. We believe it is a sound approach to extend the cliff period from 12 to 24 months. Unfortunately, we will need to wait for the courts to provide some guidance on what maximum cliff periods are acceptable.

Spreading the Allocation Over a Longer Period: Agreeing on Refresher and Top-up Grants

Instead of a large one-time allocation of virtual shares at the start of employment, refreshed and top-up grants offer incremental allocations over time. This strategy provides ongoing incentives for employees to remain with the Company, ensuring continuous engagement and motivation.

Recent data by Carta for U.S. start-ups showed that nearly half of all Beneficiaries receive equity refresher grants by the end of their second year, and this figure jumps to almost 70% by the end of their initial four-year vesting period. Structuring these grants around performance milestones or regular reviews can enhance their effectiveness, providing flexibility and sustained motivation.

This structure incentivizes Beneficiaries to remain with the Company, while ensuring that their already vested options remain unaffected. Furthermore, by allocating virtual shares in smaller, incremental tranches, Companies can offer continued incentives without increasing their overall economic burden and address situations of (perceived) premature voluntary departures of the Beneficiary and also limiting the Company's exposure.

Moving the Lion's Share of the Allocation into the Future: Back-Loaded Vesting

In deviation from the classical linear vesting (e.g., 25% per year over four years), back-loaded vesting allows the Beneficiaries to accumulate the larger portion of their options only in the second half of the vesting period. For instance, 10% of the options vest after year one, another 20% after year two while the bulk of the options would only vest in years three (30%) and four (40%).

For example, at some point, Snapchat, Amazon and Farfetch have used such back-loaded vesting schemes.

Longer Vesting Periods

So far, we have rarely encountered vesting periods in excess of the standard four-year model (apart from the customary tolling provisions if a beneficiary shouldn't work full-time during such period, of course). However, every now and then, a start-up decides to break new territory and in recent years, we have seen an increasing (though admittedly still small number) of our clients opting for a six- and in some cases, an eight-year vesting scheme.

Breaking with the Time-Based Approach I: Performance-Based Vesting

Rather than vesting purely over time, some Companies tie vesting to performance milestones—such as achieving revenue targets, product milestones, or successful financing rounds. Companies like Uber and Palantir have used milestone vesting structures for executive teams. In our experience, in Germany, this approach is still relatively rare.

Breaking with the Time-Based Approach II: Pure Loyalty Vesting

Another approach could be to tie only a portion of the VSOP (<25% of total compensation) to pure time-based vesting (i.e., only loyalty). In the case of special payments, case law allows for repayment clauses with graduated vesting periods. This approach could be applied to VSOPs if they are granted solely to reward loyalty to the Company. However, the program would then have to be written accordingly, i.e., for these loyalty VSOPs, a mere reference to the existence of the employment relationship, full consideration of periods without salary, parental leave, sabbaticals, illness, etc., which not every company will want to do.

Retention Bonuses (Cash or Hybrid)

While not an equity tool per se, structured cash-based retention bonuses—often paid out after 12–24 months—can be layered with vesting models to strengthen commitment. In some cases, hybrid structures (cash + equity) are offered to reduce dilution while still offering an upside. However, the downside is that these bonus schemes will put some drain on the Company's liquidity.

Conclusion

The legal environment around vesting in Germany is changing and clarity is still missing while we wait for the BAG to publish its full decision. But already, it is clear that 'penalizing' voluntary leavers will be severely limited. But arguably these traditional approaches weren’t the best idea to begin with when looking for structures to retain talent.

Companies should think beyond defensive structures and instead focus on designing incentive systems that align long-term Beneficiary value with long-term Company success. In the end, a talent does not need threats to work – it needs trust, transparency, and real rewards.