LTIs come in various different forms, but usually fall within one of three categories:
Market value-based LTIs
These are either restricted shares or stock units which confer commitments or entitlements to receive shares or cash in the future under certain conditions, or “phantom shares” which are virtual shares that give the holder the right to future cash out in the amount of the valid share price of the company. Unlike share options, phantom shares do not only contain the increase in value, but the entire share value as return. Since only fictitious shares are issued, this method can be suitable for unlisted companies.
Option-based LTIs can be structured as stock options or stock appreciation rights. While stock options grant the holder the right to buy shares at a fixed price – the exercise price – on or up to a certain date after expiry of a waiting period, stock appreciation rights are virtual stock options. The financial benefit that an employee would receive by purchasing shares in stock options is paid out in cash.
This form of LTI can grant employees a performance cash plan, which awards a bonus linked to the long-term company success. At the end of a fixed term, usually at least three years, the amount of the cash payment is determined based on predefined performance targets – whether an internal target, such as return on capital expenditure, or an external target, such as share price. Alongside the structuring of a cash plan is the performance share, which grants employees shares of the company free of charge according to pre-defined performance targets. The term also usually lasts at least three years.
Stock option plans
The most commonly used LTI is a stock option. Where employers are exploring granting stock options, they should consider a number of issues.
An agreement on the granting of stock options made between an employer, or an affiliated company on its behalf, and employee is, in principle, part of the employment contract. However, for stock option plans there are some specific regulations to be considered.
If an employee is rewarded with a stock option of the parent company or a group company of the employer, only the respective company that issued the stock may be obligated towards the options. In the case that only the parent or group company is obligated towards the employee, the obligations do not pass to the acquirer of the business in the event of the sale of the business because no claims under the option plan existed against the employer prior to the transfer of the business.
In general, two models: either the employer acts as the contracting party of an LTI, or another group company. The legal differences can be quite significant. If an LTI stands independent from the employment contract, it might not be subject to German employment law, which can be an advantage in case of legal disputes. However, to disconnect an LTI from the contractual entitlements towards the employer, it is essential to make this distinction very clear and transparent to the employee from the very beginning.
Principle of equal treatment
The employer must keep the principle of equal treatment regarding labour law in mind. This states that the employer must treat employees or employee groups that are in a comparable situation equally, when applying a self-imposed rule. The principle of equal treatment under labour law not only prohibits the arbitrary discrimination of individual employees within a group, but also the formation of groups without any objective purpose. If the employer decides to only grant share options to certain groups, these groups must be distinguishable from those who are not entitled to obtain share options.
Commitment and expiry clauses
For the event of termination of the employment contract, share option plans usually contain expiry and leaver clauses. These clauses can govern a loss of rights from the original agreement, an obligation to reimburse the shares acquired, or even an obligation to pay back any profits made. The consequence depends on the time of the termination of the employment – where the employment is terminated while the employee is still in the waiting period for stock options, the employee loses the rights from his stock option plan, whilst a termination after the employee has already received stock usually leads to the obligation to return the stock.
The German Federal Labour Court generally considers such clauses admissible due to the speculative nature of stock options. However, there are strict legal limits under German employment law. Therefore, it can be worth considering whether LTIs can be disconnected from the German employment contract.
Co-determination rights of the works council
As LTIs are voluntary benefits, the works council does not have any general co-determination rights regarding their implementation. However, they can have rights regarding the distribution frameworks and conditions if an LTI is offered directly by the employer. If LTIs are issued by a foreign group company, the German employer will usually not have any scope for designing the conditions and, as a result, the works council cannot co-determine the LTI conditions effectively.