VC investment contract in Germany

Strategy, design, examination under german law

Venture capital (or risk capital or short VC) is not only of great importance in the german start-up sector, but has also developed into an important form of financing for companies in the SME sector, in addition to other forms of financing. It should be noted that the classic VC capital providers pursue an exit-oriented investment strategy ("marriage for time"). This means that their investment horizon is only limited in time. Founding and existing shareholders should therefore check for themselves in advance of a VC investment whether they can also reconcile their own corporate strategy with a future exit-oriented mindset. This is the only way to ensure that a venture capital investment is the right form of corporate financing in german practice.

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Legal expertise in the field of venture capital in german practice

Our lawyers, certified specialists and tax advisors in Berlin, Hamburg, Munich, Frankfurt and Cologne provide comprehensive advice to founders, shareholders, employees involved and investors on the subject of VC investment agreements in the context of german law:

1. Advice on deciding on the appropriate form of financing 
2. Drafting, reviewing and negotiating term sheets (e.g. NDA etc.) 
3. Drafting, review and negotiation of investment agreements 
4. Drafting, adaptation and review of the comprehensive contractual documentation associated with participation agreements (articles of association, directors' agreements, rules of procedure, employee participation agreements) 
5. Extrajudicial and judicial enforcement of rights under participation agreements 

Participation Agreement, Investment Agreement and Shareholders' Agreement in Germany

In german practice, various german and english terms are used in connection with participation agreements for startups - partly synonymous, partly antonymous.

• Investment Agreement, Shareholders Agreement, Investment and Shareholders Agreement

Here is a little clarification of terms: 1. The terms contract and agreement can be used synonymously. 2. Aninvestment agreement is usually made up of two components: the investment agreement in the narrower sense and the shareholders agreement. 3. the entire participation agreement - i.e. investment agreement + shareholders agreement are usually found in practice in one document, a notarial deed.

1. Investment agreement in the narrower sense  under german law

The investment agreement in the narrower sense mainly regulates the following aspects under german law:

• Increase of share capital at par value, exclusion of subscription rights
• Additional payments by the investors into the free capital reserve ("premium")
• Possible amendment of the articles of association
• Use of funds, distribution of profits
• Guarantees, Representations & Warranties ("Reps & Warranties")

2. Shareholders agreement in german practice

The shareholders agreement, on the other hand, regulates the following aspects of the interaction between the shareholders in Germany:

• Shareholders' meeting, shareholders' resolutions
• Information and inspection rights
• Dispositions of shares
• Pre-emptive right, right of tag along, drag along obligation
• Non-competition clause, non-solicitation clause
• Protection against dilution
• Distribution of proceeds / liquidation preferences
• Virtual shareholding programs

In principle, the aspects mentioned can also be regulated in the startup's articles of association. In german practice, the parties involved shy away from the "light of the commercial register" (public), so that aspects outside the articles of association are regulated or agreed in a shareholder agreement.

Basic structures of an investment contract in Germany

There is a wide range of different types of VC investors. On the one hand, there are classic VC investment companies, which mainly manage and invest the capital of private investors in Germany. In addition, there are public-private cooperations such as the "High-Tech Gründerfond" (HTGF). Increasingly, public institutions or investment companies of larger industrial groups and service companies are also appearing on the german venture capital market.

What all these VC capital providers have in common is that the investment contracts used to have a comparable basic structure, which can be taken from the following descriptions.

Equity or mixed forms of financing 

A VC investor can bring his capital into a company in different ways in Germany. Usually this is done via a convertible loan or a premium on newly issued shares. In simplified terms, a convertible loan is an ordinary loan that gives the investor the option to convert the debt capital (loan) into equity capital (real shares) under certain conditions. In the case of a premium, an investor acquires new shares in the german company as part of a capital increase, whereby a premium is paid into the company's assets over and above the nominal amount of the shares.

Company valuation in Germany

A central component of an investment contract in Germany is always (directly or indirectly) the contractual regulation mechanism according to which the valuation of the company is to be carried out. The valuation method stipulated there is decisive for the "price" which the investor has to pay to the company for the share to be acquired. The valuation of the company is undoubtedly an essential question for both sides - founder on the one hand and investor on the other - in the context of VC financing. The question is particularly exciting because - at least for young companies and start-ups in Germany - no uniform valuation method has yet become established.

Traditional valuation methods such as the capitalised earnings method or classic multiplier methods are not regularly applied. Instead, VC investors usually rely on a mixture of objectively available information such as the technology underlying the business concept, the company's product and its industry. The future prospects of the market as well as the potential of the founding team are also used for the valuation, here often mixed with the investors' own intuitive empirical values. In the evaluation at an early stage of development, german venture capital funds also repeatedly refer to the principle "It's all about people".

Vesting in german practice: distinction between good leaver and bad leaver 

As a rule, founders and other key employees are of particular interest to VC investors, as they have the necessary know-how and insider knowledge to successfully run the german company. Since the capital contributed by the investors is worth less or even lost without the relevant knowledge, they try to prevent staff departures as far as possible. For this purpose, participation agreements in Germany usually provide for so-called vesting regulations, which are intended to achieve a positive or negative incentive for the staff ("It's all about people") to remain in the german company.

The central core of a vesting provision are the conditions under which the founders or key employees may retain all or part of the shares they hold in the german company after leaving. In particular, a premature termination of work for the company leads to a loss of company shares for the founders and key employees at a fixed (comparatively low) price. Differentiation is made primarily according to whether or not the withdrawing shareholder is himself responsible for his withdrawal. In this context, in german practice, a distinction is made between so-called bad leavers, grey leavers and good leavers.

Liquidation preferences in german practice (distribution of proceeds preferences) 

Frequently, participation agreements in german practice also contain provisions relating to revenue sharing and liquidation preferences. These serve german investors to balance the frequent disproportion between their regularly high financing contributions on the one hand and their participation in the economic success on the other, in order to secure their investment including a certain return

From the point of view of the founders, old shareholders and virtual participants, particular caution is required in this context. Finally, in the event of an inflow of funds - be it through the entry of further investors, through a further financing round, through the sale of the german company or its IPO or similar - the investors are granted preferences over the old shareholders and other participants (employee participation, ESOP, VSO) with the proceeds distribution and liquidation preferences. The design of these proceeds distribution and liquidation preferences must therefore be examined with regard to their effects in all possible scenarios. Depending on the design, the founders may, in extreme cases, not participate at all in the corresponding proceeds if these do not exceed the investors' preferred claims overall. In Germany, no generally accepted standards have yet been established.

In german practice, financial investors try to enforce non-creditable preferences (participating liquidation preferences). This means that the investor's preference at the first stage is not taken into account in the profit distribution of the residual proceeds. The investor in Germany therefore participates again in the distribution of the residual proceeds with his full participation quota. From the founder's point of view, this can be seen as an unjustified double preferential treatment of the investor. Many detailed questions in this regard have not yet been finally clarified by the german courts. Especially in early financing rounds, founding shareholders should try to negotiate non-participating liquidation preferences under which investors are not given double preference in the distribution of profits.

Since these regulations are usually very complex, all shareholders in Germany should check the effects of the revenue distribution and liquidation preferences concretely in advance of signing the contract and calculate them on the basis of examples using several variants. In particular, it must be ensured that the scope of the chargeability of preferences is precisely fixed in the contract.

Information rights, co-determination rights, advisory board in Germany

Since the financial risk assumed by VC investors is usually high, they regularly insist on special information and control rights in their favour, i.e. rights that go beyond those provided for in german company law. This is often done by means of agreements according to which, for example, the taking of certain management measures requires the consent of the germaninvestor ("consent catalogue"), the investor is kept up to date by means of regular detailed reporting on the german company or persons of trust of the investor are represented in controlling and/or advisory bodies (advisory board, supervisory board) of the company.

It is precisely through the establishment of such advisory bodies that the venture capital investor in Germany is also put in a position to support the founders and existing shareholders through his network and know-how. In this respect, investor-friendly corporate governance is advantageous and a win-win situation for all parties involved.

Anti-dilution in Germany

Of equal importance to investors and founders in Germany are the usual anti-dilution provisions in participation agreements. These determine whether and on what terms the founders and (existing) shareholders can participate in further financing rounds.

The provisions are of particular relevance in the event of a decline in the company's value. If the company valuation falls between financing rounds, this leads to an economic dilution of the old shares, since the initial investor participated on the basis of a higher valuation. Investors in german practice therefore usually demand protection against such down rounds from the outset (down round protection), which allows them to acquire further shares at a lower value. A distinction is made between full ratchet clauses (initial investor can acquire shares at nominal value in a further financing round), weighted average clauses (weighted average price from both financing rounds) and broad-based weighted average clauses (inclusion of further factors).

In order to compensate for any negative effects of anti-dilution protection - especially for the german company and the founders - anti-dilution clauses are not infrequently supplemented by an additional obligation on the part of the initial investor to provide the company with further capital ("pay to play").

The strict anti-dilution and down round protection clauses are also often associated with a certain degree of legal uncertainty. Industry-specific market standards are lacking. In german practice, it is often the case that the economic implications of these complex regulations cannot be assessed in detail by the founders due to a lack of experience. On the investor side, on the other hand, there is a danger that if there is too much incentive to draft investor-friendly contracts, the incentive for the founding team may be lost.

Milestones in german practice

The main basis for the investor's decision to provide capital is the company's business plan in Germany. Furthermore, in many cases the business plan also serves as a guideline for the time dimension of the financing. Often the granting  /disbursement of further capital is linked to the achievement of certain economic key figures (e.g. turnover, user numbers, customers, employees, product development steps).

The definition of such milestones is a sensible means of controlling for both sides - investors and founders or existing shareholders alike. However, ("hard") milestones should be used with caution in german financing agreements. There is a risk of a decline in the company's valuation if the set milestones are not achieved - this outcome is not desired by any of the parties involved. For this reason, successful VC investors often do without milestones or use them only in very measured doses.

Guarantees, tag along, drag along in Germany

Incidentally, guarantees on certain key economic data of the german company can also be found in participation agreements. Since the investor does not know all the details of the company, he tries to protect himself from so-called window-dressing: In this process, founders and former shareholders make themselves and the company "prettier", i.e. more successful than they actually are, in order to obtain financing. A probable means of VC investors in Germany at this point are no-fault assurances of the founders/company on certain entrepreneurial key figures.  

Finally, regulations on co-sale rights and co-sale obligations (take and drag along clauses) are regularly included in german investment contracts. These clauses determine who among the shareholders has a right to a co-sale and under what conditions, or who among the shareholders can be forced to a co-sale and under what conditions.

All parties involved in a venture capital investment in Germany are advised to obtain clarity about the (possible) provisions of a participation agreement and to negotiate it in a way that is oriented towards the interests of the parties involved. Even though this applies in particular to seed financing as an important point of departure in the growth of a german company, this principle should also apply to every further round of financing, be it Series A, B or C. This is the only way to avoid unpleasant surprises and shareholder disputes.