Management shareholding under german law
Co-investment agreements, MBO/LBO transactions in Germany
Because of the associated incentive effect, many german companies decide to give their managing directors and senior executives a direct share in the company's assets. Particularly in private equity transactions, management participations have become indispensable in german practice.
The business model of private equity investors aims to acquire a target company at a low price in order to then increase its enterprise value. To do this, however, the financial investors regularly need the expertise of the target company's managers. Without their special knowledge of the product or the business model, it is seldom possible to sell the acquired target company profitably in the course of an exit (trade sale) or to take it public with a high return (IPO).
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Legal expertise in german management investments in the context of private equity transactions
The lawyers, certified specialists for german corporate law and tax advisors of ROSE & PARTNER assist managing directors, shareholders and investors in M&A transactions and provide comprehensive advice on participation agreements and shareholders' agreements, in particular with regard to the following main topics:
- Structuring of management shareholdings in preparation for MBOs in the context of private equity transactions
- Advising managing directors on co-investment agreements and shareholder agreements
- Adjustment of employment, director service and partnership agreements in connection with planned management participation
- Review of existing management participation agreements, enforcement and defense of claims arising from participation agreements (e.g. in connection with call options or other exit-related claims)
Background
Since the 1990s, it has been common practice in german private equity takeovers for the management of a company to acquire a capital interest in the company as part of the takeover, which often involves the use of a high leveraged buy-out (LBO). Such management participations regularly require multilayered regulations in german practice. Their complexity increases further if the participation extends across a group of companies and involves many contracting parties.
It is not uncommon for management participation to be structured only indirectly, e.g. via an exogenous employee pool company. Through the equity participation of management and directors in the context of MBO transactions (Management Buy Out), they participate directly in the capital gain in the event of a successful exit. The management thus has the opportunity to multiply its investment. On the other hand, in the event of a failure of the company, there is always the threat of a total loss of the investment.
Areas of application of management shareholdings in Germany
In large listed companies, the direct equity participation of management has become an important component of compensation. Employee shareholdings and management shareholdings in the company are also increasingly common in medium-sized companies.
In the venture capitalsector, managing directors are either directly involved in the company or virtually via so-called phantom stocks (virtual stock options). In the private equity sector, management participation is now standard. The members of management taken over with a target company become co-investors. The purpose of equity participation is to ensure that the interests of the management and the financial investor are aligned.
The following description refers primarily to the management participation agreements commonly used in german private equity transactions.
Typical structure of management participation (MBO) in Germany
Target companies are usually not acquired directly, but via an acquiring company (so-called NewCo / New Company). The managers acquire their stake in the NewCo through purchase or a capital increase. In addition to the purchase price or subscription price including premium, the participating managers, board members and other key employees are sometimes also required to take out shareholder loans. Because of the usually limited financial resources, the investment burdens are financed via banks or the financial investor itself. In some MBO agreements, the purchase prices are also deferred.
SECURING THE EXIT IN GERMANY
The acquisition of the equity stake, the specifications for the participating members of management and directors, and the common goals are precisely regulated in participation agreements under german company law. With the participation agreement, the financial investor secures itself vis-à-vis the participating managing directors: The profitable realization of the target company in the context of an exit is prioritized contractually. The management is subject to a so-called drag-along obligation: If the financial investor intends to sell the german target company to a third party, the management is obligated to sell its shareholding unconditionally. On the other hand, the manager is granted a tag-along right: under this right, the manager can demand that the financial investor sell his shareholding to the willing buyer on the same terms.
DILUTION PROTECTION UNDER GERMAN LAW
Management participation agreements usually also provide for special anti-dilution protection mechanisms. These ensure that shareholding quotas are safeguarded, for example by establishing subscription rights in the event of capital increases. Such provisions are of central importance, as the distribution of proceeds in the event of a sale of the target company is largely based on the shareholding.
CAUTION WITH REGARD TO LIQUIDITY PREFERENCES
In deviation from the proportionate distribution of proceeds provided for by german law, so-called liquidation preferences (proceeds distribution agreements) are regularly included in the investment contracts / coinvestment agreements in favor of the financial investors. These grant the financial investors privileges in the distribution of the proceeds in various ways. In the case of participating liquidation preferences, the proceeds preferences are not taken into account in the proportionate distribution of proceeds across the entire shareholder group. Such non-creditable preferences can be very detrimental financially to the remaining shareholders in Germany. Managers negotiating an investment agreement should pay attention to how high the specific preference might be. A preference equal to several times the financial investor's investment or a high rate of return on the investment may inappropriately erode the manager's proceeds received on exit.
SEPARATE WAYS: ROLE OF CALL OPTIONS IN GERMANY
In the event of a dispute or termination of the manager's employment, investment agreements provide for special purchase rights (call options). For a long time, the common purchase rights of financial investors were legally controversial. Now that the highest court has ruled that termination clauses can be effective in special cases, private equity initiators are regularly taking advantage of the legal leeway this opens up. However, private equity practice is still subject to legal and tax law limits when it comes to the question of whether a shareholder-director can be excluded from the german company and how high his compensation (purchase price or severance payment) should be.
EXIT AT WHAT PRICE?
In accordance with standard participation agreements in german practice, the buy-back price in the case of a call option triggered by a third-party investor is typically based on the respective reasons for withdrawal (leaver cases). In the bad leaver case, the managing director often receives only a low settlement amount (e.g. acquisition costs), whereas in the good leaver case he receives the current market value of his investment. In german contractual practice, the leaver cases are often combined with vesting arrangements lasting several years: As a rule, the managing director then only receives the higher good leaver repurchase price for vested shares and only the lower bad leaver repurchase price for unvested shares.
Managing directors involved in a german company are therefore advised to take a detailed look at the individual bad leaver cases and the level of the respective buyback prices and to run through all conceivable variants. The regulation of arbitrarily far-reaching bad leaver cases with financial disadvantages to the detriment of a participating managing director may violate german company law.
INVESTMENT POOL IN GERMANY
In some cases of larger MBO transactions, the managing directors, board members and other key employees involved in a german target company do not participate directly in the operating business in terms of capital, but indirectly via intermediary companies. The shareholdings of several managers are, for example, held in a GmbH & Co. KG or via a trust structure. With a pooled shareholding, the financial investor attempts to control or limit the influence of the managers at shareholder level and to protect the operating business in the event of a dispute (shareholder exclusion). Bundling managerial shareholdings also ensures that all employees involved in the german company "speak with one voice". An investment pool also facilitates management at the company level, especially in the event of an exit.
Tax treatment of exit proceeds in the case of german management shareholdings
For a long time, it was not clear under german tax law how the capital gain following an exit in connection with a management stake would be taxed. Managers with an interest in a german company could never safely rule out the possibility that the sales proceeds realized on an exit would be classified as wages by the tax authorities. This question is of central economic importance because of the different tax rates in Germany. In german practice, income from non-independent work is subject to an income tax burden of up to 45% at the peak. In contrast, capital income - typically subject to a final withholding tax of only 25% - is favored.
The German Federal Fiscal Court (Bundesfinanzhof, BFH) has finally clarified that proceeds from management participations, which frequently exist in german private equity practice, can also be taxed as capital income. According to the BFH, the management participation can represent a special legal relationship that exists independently alongside the employment relationship. Nevertheless, the BFH decision does not grant a "persil certificate" under german tax law. In individual cases, the overall contractual structure is always decisive for the question of the classification of the type of income. A harmful connection to the employment relationship is adjusted by the shifting of risks and opportunities in the participation contract. The closer a manager - in terms of value - comes economically to a typical investor (e.g. acquisition and sale of his investment at market value, existence of a risk of loss), the more likely it is to be assumed that the proceeds generated can be taxed as investment income.
Since the structure of management participations in Germany is often complex in nature and can have far-reaching financial consequences, participation agreements should be examined intensively in advance. We recommend that the agreements are also calculated economically in several realistic variants, taking into account different exit scenarios, possible buy-back prices and liquidation preferences of the investors and their respective tax consequences.