How Germany Can Revive its Start-up Sector
Even though there are several renowned start-up hubs in Germany, the country is only home to twelve unicorns – start-ups with a valuation of at least 1 billion USD.[i] In comparison, there are more than 260 unicorns in the US and 204 in China. Even the UK, a country smaller than Germany in terms of GDP, hosts twice as many unicorns.[ii] To make it easier for start-ups to do business in Germany, the federal government must reform tax law for stock option plans. Failing to act will not only hinder innovation but will also make it more difficult for start-ups to attract and retain highly skilled workers.
What Germany is Doing Wrong
While there are many reasons why the German start-up economy has not produced more unicorns, such as a lack of access to capital, 50 percent of start-up businesses cite hiring as a key challenge. In fact, German start-ups have on average five vacant positions at any given time, most of which can be attributed to a scarcity of skilled workers and their high salary expectations.[iii],[iv] More than one in four German start-ups also struggle to compete with larger, established competitors that can offer higher salaries and better non-financial compensation schemes.[v] Employee stock option plans (ESOPs) could help solve this problem.
By issuing ESOPs, businesses hand over small parts of their company to employees as a form of compensation, benefitting both the company and its employees. Start-ups – which are notoriously drained on cash – do not have to pay high salaries and can incentivize long-term employee commitment and motivation. At the same time, workers can increase their returns as the company grows and get a right to codetermination. According to Tamaz Georgadze, founder of the German fintech start-up Raisin, “stock options are typically the reason why highly skilled engineers, developers and other workers join a start-up in the first place.”[vi]
To some, virtual stock option plans (VSOP) would be a more pragmatic solution since 80 percent of German start-ups already make use of this form of compensation.[vii] Under such schemes, workers receive cash payments in the case of so-called exits (e.g., when a business goes public or is taken over). VSOPs are, however, less attractive for employees. Since they are taxed as income, not capital gains, VSOPs are subject to social insurance and income tax, leaving workers with lower final returns than under ESOPs. In addition, VSOPs usually do not give workers voting rights, whereas ESOPs empower employees to support or block critical decisions made by both investors and owners.
A favorable legislative regime for ESOPs would benefit all parties. In an open letter in 2019, more than 700 CEOs, founders, investors, and employees from European start-ups called for a better regulatory environment. The signatories noted that ESOPs were one of the main levers that startups use to attract highly qualified workers.[viii]
Tax Little, Tax Late
Despite their many advantages, fewer than 30 percent of German start-ups use ESOPs.[ix] This is not the result of a lack of entrepreneurship. Instead, Germany has one of the least favorable legislative frameworks. According to a study by the venture capital firm Index Venture, Germany ranks second to last in a comparison of the regulatory and cultural environment for stock options in 22 European and North American countries. The study not only stated that startups faced a high administrative burden and favored issuing VSOPs over ESOPs due to established norms. It also criticized that Germany’s regulatory framework lacked tax benefits for ESOPs. [x]
Given this apparent legislative failure, the German federal government must improve the existing regulatory environment to make ESOP a more attractive form of employee compensation. Two issues are of primary concern. First, the German Income Tax Act (Einkommensteuergesetz, EStG) currently only exempts stock options up to €360 from taxation, compared to €1,200 in the Netherlands, €3,000 in Austria, and €3,500 in the UK.[xi] Two German opposition parties, the Greens and the Liberal Democrats, recently proposed tax exemptions of €5,000 annually.[xii],[xiii] Taking these figures and the multiple benefits of stock options into account, the Ministry of Finance and the Ministry for Economic Affairs and Energy must define a higher tax exemption rate.
Crucially, the government must also change the legislation on tax deduction. Under the current regime, stock options are taxed at the time of transmission, meaning that employees pay taxes when they receive stocks. This provision, however, counterbalances initial positive effects since it leaves workers with lower returns. Instead, employees who hold stock options that exceed the annual allowance should only be taxed when they sell their company shares.
To revive its national start-up economy, the German government must reduce the bureaucratic burden on start-ups and ensure that they can be more flexible in compensating employees. Introducing a better regulatory framework for employee stock options will not propel the country to the forefront of the global start-up scene. It will, however, create more worthwhile incentives for highly skilled workers to join start-ups.
[i] Anna Thorsen, “The 50 Best Startup Cities in 2019,” Valuer.ai, February 05, 2019, https://valuer.ai/blog/top-50-best-startup-cities/
[ii] Jennifer Rudden, “Number of unicorns worldwide as of January 2020, by country,” Statista, February 14, 2020, https://www.statista.com/statistics/1096928/number-of-global-unicorns-by-country/
[iii] “Start-Up Studie 2018,” PricewaterhouseCoopers, September 2018, https://www.pwc.de/de/startups/pwc-studie-startups-in-deutschland-2018.pdf
[iv] “Bitkom Startup Report 2019,” Bitkom, December 2019, https://www.bitkom.org/sites/default/files/2019-12/20191211_bitkom-startups_v12_ba.pdf
[v] Tobias Buck, “Germany’s tech scene lacks lure of stock options,” Financial Times, December 11, 2019, https://www.ft.com/content/5778f3d0-1b3c-11ea-97df-cc63de1d73f4
[viii] “Europe’s startups need talent to thrive. Help us make it happen.” Not Optional, January 2019, https://notoptional.eu
[ix] Tobias Kollmann et al., “Deutscher Startup Monitor 2019: Mehr Mut, neue Wege,” Bundesverband Deutsche Startups e.V., November 2019, https://deutscherstartupmonitor.de/fileadmin/dsm/dsm-19/files/Deutscher_Start-Monitor_2019.pdf
[x] “Rewarding Talent: A guide to stock options for European entrepreneurs,” Index Ventures, 2018, last accessed April 20, 2020, https://www.indexventures.com/rewardingtalent/country-detail-tables-germany
[xi] “Bundestagsdrucksache 19/14786,” Deutscher Bundestag, November 06, 2019, http://dipbt.bundestag.de/dip21/btd/19/147/1914786.pdf
[xiii] “Bundestagsdrucksache 19/15118,” Deutscher Bundestag, November 13, 2019, http://dip21.bundestag.de/dip21/btd/19/151/1915118.pdf
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