Leaver Clauses: Good leaver & bad leaver
Under what circumstances are leaver clauses invalid in Germany?
Leaver clauses in investment agreements are of great importance in venture capital structures and private equity transactions in german practice today. Leaver and vesting agreements in Germany are used by financial investors to secure the activities of the management team for a certain period of time. Leaver and vesting clauses create incentives for the managers and employees concerned in the form of a financial penalty for their premature termination of employment with the german limited liability company.
As a shareholding in the company often represents a high value for the shareholders, the loss of the shareholding via the leaver systems not infrequently leads to serious disputes with investors and co-partners. The loss of a shareholding is subject to strict judicial control, as the German Federal Court of Justice generally disapproves of a free termination.
In the following, we will show you which leaver clauses are legally contestable under german law. These requirements should be taken into account when drafting participation agreements in Germany.
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More information on vesting clauses used in startups and VC investment agreements can be found here: Vesting Clauses
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Our team of M&A specialists, certified specialists for german corporate law and tax advisors has many years of expertise in transactional business and in managing disputes between shareholders and investors. The lawyers at our offices in Hamburg, Berlin, Munich, Frankfurt and Cologne advise on investment agreements and leaver and vesting clauses with a focus on the following areas:
- Drafting and negotiating venture capital participation agreements and private equity transactions
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- Advising founders of start-ups and investors on financing rounds
- Legal and tactical advice in shareholder disputes in connection with vesting and leaver provisions in participation agreements
- Tax advice in connection with employee participation programs
How do leaver clauses work in german practice?
In german practice, leaver clauses are currently widely used in VC and PE structures. They are not only found in traditional participation agreements, but also in employee participation programs. They regulate the equity participation of founders and co-partners as well as virtual participation of employees.
Investors use leaver systems to tie high potentials to the company. Leaver clauses regulate company exclusions, especially if founders or employees give up their participation prematurely. In legal terms, in Germany this is done by share transfer offers in the form of mostly conditional or open-ended transfer offers, known as call options. These call options are included in various forms in participation agreements and in employee stock option programs in the form of an ESOP or VESOP. In this regard, legal mechanisms of leaver clauses in VESOP investments differ greatly from equity investments.
Although there is some diversity in leaver clauses in german contractual practice, they all share the following common features:
- Leaver clauses ask for the reason for the exit and then usually provide for different consequences. Internationally, good leaver, bad leaver and sometimes also grey leaver have established themselves as categories.
- Leaver clauses are usually limited in time. In german practice, they generally have a term of 3 to 5 years. In the VC sector, the investments are granted to the participants in the form of a vesting. The vesting clauses have the effect that an investment grows for the participant during a vesting period, i.e. it is "vested".
Good leaver vs. bad leaver in german practice
In german leaver systems, the participation agreement categorizes certain behaviors of the participants as good leavers or bad leavers.
The good leaver loses its participation and in return receives the fair market value or a high value close to the fair market value. In some constellations, in the case of a vesting program, the good leaver retains the shares that have already vested.
A classic case of a bad leaver occurs, for example, when a serious breach of duty by the shareholder-managing director leads to damage to the GmbH and the damaging party's management contract is therefore terminated for cause. As a rule in german practice, the bad leaver loses his shareholding completely. In addition, the bad leaver is financially penalized and receives an equivalent value for the loss of his shareholding which is far below the market value of the shareholding.
In german practice, good leaver and bad leaver systems are used in different forms. In some cases, grey leaver categories are even created for certain case constellations as a compromise solution to take account of the different interests of the parties involved.
Incorrect dispute management ends up in german court
If a leaver clause takes effect, it is often a matter of all or nothing for the party concerned, especially if a shareholder or employee is categorized as a bad leaver. Both bad leaver and good leaver situations, which also lead to a withdrawal from the GmbH, are very prone to disputes in Germany. The dispute resolution clauses contained in the participation agreements and GmbH partnership agreements often fall short in the case of leaver situations. In most cases, it is precisely the shareholder dispute that cannot be resolved quietly and is settled in german court.
Germa courts have set narrow limits for the termination of shareholders, including leaver situations, at an early stage. Especially in VC-funded GmbHs, such court cases are particularly damaging. If the german startup management team, in its "race against time" (the investment horizon of VC funds is very narrow), has to manage a long-running court case in addition to its day-to-day business, the prospects of a lucrative exit can be thwarted by a long and noisy court battle. All sides, but especially the GmbH and investor side, are advised not to let the dispute with a leaver party escalate and to seek an out-of-court, financially fair settlement.
Judicial evaluation of leaver clauses in Germany
After several decisions of the German Federal Supreme Court (BGH) on the subject of the termination of a shareholder, it is generally accepted: Investors and shareholders do not have free discretion to exclude co-partners from the GmbH without objective reason. The courts consider contractual clauses that establish a lever for the free termination of a shareholder to be void because the shareholder concerned may be prevented from exercising his membership rights at his own discretion. The possibility of termination acts as a sword of Damocles on the shareholder.
This case law also covers purchase and assignment agreements in the form of call options if the termination is to be carried out by the beneficiary without any objective reason. Only the mere loss of the managing director position is not sufficient as an objective reason according to a highly regarded decision of the OLG Munich.
German case law: manager model is permissible
In its decision, the BGH (Urt. 19.09.2005 - II ZR 173/94) deemed the so-called manager model to be permissible. In the following case, the BGH affirmed an objective reason for the exclusion of shareholders: The managing director concerned had been transferred a smaller shareholding by the majority shareholder at nominal value and was obliged to transfer the shareholding back upon termination of his managing director position. He was to receive a distribution of the GmbH's annual profits and benefit financially from this in addition to his managing director remuneration.
In this narrow constellation of cases, the BGH considered the small and weak shareholding to be merely an annex to the position of managing director. No undue pressure could be exerted on the managing director with regard to the exercise of shareholder rights, as the group of shareholders consisted of only two shareholders and the majority shareholder dominated the shareholders' meeting with his shareholding of over 90%. The managing director also did not have to bear any financial risk, as he acquired the shareholding at nominal value and was promised an annual profit distribution with the shareholding. The participation merely served as a quasi-managing director bonus and was exhausted in its incentive function.
Leaver clauses in german VC and PE investment contracts
Contractual arrangements that deviate from the criteria relevant for decision-making in the manager model of the BGH and constitute a leaver event should be examined for their effectiveness. Points of attack are often found in the classic leaver provisions of VC and PE contract documentation. In particular, the leaver and vesting clauses to which the founders of startups are subject should often be critically scrutinized against the background of the applicable BGH case law in Germany. The founders are usually closely associated with the GmbH, have provided considerable services and resources to the company, and ultimately control the startup for a very long time.
The criticality of many leaver mechanisms is also illustrated by a decision of the OLG Munich (judgment of 13.05.2020 - 7 U 1844/19), which did not want the participation of a managing director to be assessed as a mere annex to the managing director position.
Leaver agreements in Germany are likely to be particularly open to challenge if the shareholder concerned has opportunities to exert influence in the shareholders' meeting, bears a genuine entrepreneurial risk and the shareholder participation is not exhausted in its incentive function. The question of whether there is an objective justification for the leaver case depends crucially on the overall circumstances. Relevant is not only the time frame of vesting structures, but also the influence and contribution of the participant as well as the amount of compensation for the lost shareholding. Significance of the reason for the leaver case.
Further information on the value of the lost participation or severance value under german law can be found here: Severance value
Have your clauses checked!
Investors, founders and employees in Germany who use Leaver clauses in their participation contracts are called upon to have the contracts reviewed, which also takes into account german case law. If the leaver and vesting contracts are invalid, there is not only a high potential for dispute, but also a risk for the entire german company. This is not about stakeholder-oriented management, but about investment logic.
If you are looking for advice or representation by one of our experts in german corporate law, please contact our lawyers in our offices in Hamburg, Berlin, Munich, Frankfurt or Cologne. Our team of lawyers is entrusted with shareholder disputes throughout Germany and internationally.