Q&A: process for venture capital investments in Germany

Process

Do parties normally use term sheets? If so, what is normally covered in such term sheets?

Yes, the term sheet is a key document in venture capital transactions. It is a preliminary agreement containing the declaration of intent by the investor(s) to invest (subject to satisfactory results of the due diligence), and sets out the major proposed deal terms including pre-money valuation, proposed investment amount and resulting share price. Although a term sheet does not create a legally binding obligation to invest, it is nevertheless considered as proof of the investor's intention to make the proposed investment and proceed with spending the required time and costs to finalise the investment process.

The key terms of the funding and conditions of the subsequent investment agreement that have already been negotiated are summarised in the term sheet, such as the amount of investment, valuation and share price, class of shares to be issued, expected percentage of ownership in the company to be granted to the investor, any special rights of the investor (eg, veto rights, liquidation preference, co-sale rights and obligations, and dilution protection), vesting provisions and, if applicable, non-competition and non-solicitation clauses. The term sheet is not legally binding as a rule, with the exception of the confidentiality, choice of law, jurisdiction and exclusivity agreements. However, in practice it is difficult for the investor to deviate from the agreed terms summarised in the term sheet during subsequent negotiations of the investment agreement.

What are the standard documents for a venture capital transaction, and who prepares them? Are there popular forms for such documentation in your jurisdiction?

The key documents for each financing round are the investment agreement and the shareholders' agreement. These can be structured either as two separate documents or as a single document with separate sections for each part. Whether the transaction documents are drafted by the company counsel or the investor’s legal counsel is a matter of negotiation.

The investment and shareholders’ agreement (which also contains the applicable amended articles of association of the company) is central to the financing round and is often negotiated between the parties in detail, since it forms the basis of the financial investment and the investor’s stake in the startup. The investment agreement sets out the key economic and legal provisions of the financing (ie, how much money each investor is committing to invest in the round, the applicable share issue price, the class of shares issued and the percentage stake in the company that they will receive in return). The investment and shareholders’ agreement also contains detailed provisions relating to the future relationship between the founding shareholders and the investors as shareholders of the startup company (eg, specific investors information rights, approval rights for certain management measures, veto rights, restrictions on share transfers, founder vesting regulations, exit agreements for investors, etc). Rules of procedure for the management and the advisory or supervisory board are attached to the shareholders’ agreement. In the investment agreement, the founding shareholders – and possibly the company – typically provide guarantees to the investors on points such as the current shareholdings in the company, the company’s good standing (eg, absence of insolvency issues), the completeness and accuracy of the most recent balance sheet, intellectual property (IP) ownership of the company and the absence of unusual risks associated with the business of the startup company.

The reason for putting a separate shareholders’ agreement in place outside the articles of association is to avoid publication of negotiated key terms in the commercial register; while the articles of association are on public file for German corporations and may thus be publicly accessed by third parties, the shareholders’ agreement is not. This way, the shareholders and investors achieve confidentiality regarding the major financial, legal and commercial terms agreed between them.

In the course of a financing round, additional contracts are often concluded with the management, particularly new employment contracts for managing directors and, where applicable, arrangements for bonuses.

The German Standard Setting Institute publishes a set of standard venture capital documents and agreements (including the term sheet, convertible loan agreement, financing round documentation, exit documentation, etc) on its website, which are downloaded thousands of times a year by the startup community in Germany.

What is the normal process and timing of venture capital investments in your jurisdiction?

After first contact has been initiated, the venture capital investor will typically make a preliminary assessment of the startup and its business idea and model. If the investor is interested in investing in the startup, the key points of the venture capital financing will be set out in a term sheet. Prior to investing in the startup, the investor will conduct due diligence on the company and, if it is satisfactory, will enter into negotiations with the founders regarding the investment (including the investment and shareholders’ agreement). The length of time between the initiation of talks and the signing and closing of the investment can vary significantly depending on a variety of factors, such as the maturity of the company, the market environment and the willingness of investors to move quickly. However, as a rule of thumb, a typical venture capital equity financing round will take between three to six months to complete, although it may be faster if the company urgently requires new liquidity to avoid insolvency issues.

What closing conditions are common in venture capital transactions?

Following negotiations, the investment and shareholders' agreement will be signed. In the standard case of a limited liability company, this requires a notarisation ceremony before a German notary public. Apart from acquisitions or M&A deals, venture capital investments in the German market are not normally subject to major closing conditions, because the financed company needs certainty as to whether or not an investment will go through. Otherwise, the company runs the risk of pursuing a deal with an uncertain outcome (due to the agreed closing conditions) while letting other opportunities pass by. In practice, therefore, the main closing condition for the investor to pay in the balance of their committed equity capital is the registration of the corresponding capital increase with the commercial register, upon which the new shares issued to the investor legally come into existence. Other closing conditions may include changing the company’s articles of association to reflect the agreed terms of the funding round, the establishment of an advisory board and the appointment of board members to secure the investor’s future influence in the company, and transfer of IP rights from founders or employees to the company. The consent of public authorities (eg, German or European cartel authorities or the Federal Office for Economic Affairs and Export Control) may occasionally be required to complete the investment legally, which would then also become a closing condition.

Are venture capital transactions ever divided into multiple closings? If so, how and why?

Yes; it is not uncommon in the German venture capital market for a financing round to be split into several separate closings. The reason for this is often timing considerations. For example, investors who have completed their due diligence and internal approval process (eg, investment commitment approval) and are ready to move forward and pay in their committed investment often prefer first closing. The financing round can then be extended further in the form of a second closing (or further subsequent closings) to take on board additional investors whose investment and due diligence processes may have started later, and who therefore require more time.

The option to extend a financing round by adding more closings is regulated by the investment agreement, which sets out the time frame and terms that apply to the issue of shares in such additional closings (including the total round size that must not be exceeded).

Economic terms

How is the company valuation and investors’ purchase price usually determined in venture capital transactions?

Startups typically have no significant company history and often pursue an innovative and disruptive business model, making their valuation extremely difficult. Established methods of capitalised earnings value (eg, discounted cash flow) are generally not suitable for valuation.

Various alternative approaches and methods are used to value startups, resulting in a wide range of company valuations. Typically, a combination of quantitative analysis, industry benchmarks, market insights and negotiation is used. Data on recent investment deals in the same industry and market can be used as a basis, while the valuations of similar startups can be analysed to understand prevailing trends. Startups with strong traction, such as user engagement, revenue growth or partnerships, are more likely to command higher valuations. The quality and expertise of the founding team can also influence the valuation; an experienced team with a successful track record can inspire confidence and lead to a higher valuation. Intellectual property, patents, proprietary technology or innovative solutions can likewise contribute to a startup’s valuation, while unique assets that provide a competitive advantage are valued positively.

For startups that generate material revenues, a combination of the discounted cash flow method and the multiples method can be used. Initially, sales or earnings before interest and taxes are estimated for future years based on the company’s business and financial plans, and the forecasted turnover or profit is measured against the current and known turnover of companies comparable in size and sector. The value is then calculated based on a multiplier for turnover or profit that is customary in the industry. This expected value is the basis for the subsequent discounting.

What do investors typically require for option pools or equity incentive arrangements in connection with venture capital transactions?

The choice of a suitable employee participation scheme must be made individually for each startup. The occurrence of an exit event (eg, sale of the company or initial public offering) is of particular importance in the usual models, since it reconciles the interests of the shareholders and the employees of a startup by allowing the latter to participate in the value increase of the company rather than just in the profits, as is usually the case with (success) bonuses. Typically, a three- to four-year vesting period and a 12-month cliff is agreed. Most of the programmes contain customary provisions for good leavers, bad leavers and sometimes grey leavers.

Real employee limited liability company (GmbH) shares give the beneficiaries a share in the startup under corporate law. Considering increased administrative burden and tax risks, this model is usually chosen only before the first financing round and only for a small circle of the core management team. If the intention is to involve more than a handful of key employees, such employee shares are often pooled in a vehicle (eg, in the form of a limited partnership, a GmbH & Co KG). The tax risk for beneficiaries was reduced with the implementation of the German Fund Location Act and the German Future Financing Act. These laws include provisions that, in certain cases, allow the deferral of taxation for employees until the taxable income becomes liquidised. However, tax risks for existing shareholders of the startup may still arise upon issuance of shares below market value.

Employee stock ownership plans are share options that give the beneficiary the right to receive a certain number of shares in the GmbH upon an exit event. Often, the employee is given the opportunity to buy the shares at a fixed price (the strike price) or to receive a cash payment amounting to the difference between the strike price and the proceeds attributable to a common share. Investors usually try to avoid including the option holders in the direct shareholders’ circle, as this could complicate the management or implementation of an exit. Venture capitalists prefer to create an option pool before financing, to prevent dilution of their own shares.

As part of a virtual share option programme (VSOP), employees receive a contractual payment entitlement in the event of an exit instead of a real shareholding. The amount of the payment claim is usually based on the proceeds that the employees would have received if they had exercised real options instead of virtual options, or on how much a holder of a common share would have received in the exit event, considering the strike price agreed for the virtual share at the time of issue. Ultimately, this is a complex calculated exit bonus. The downside of this model is the relatively high tax burden on exit payments for the beneficiaries. Proceeds from VSOPs are normally taxed based on the personal income tax tariff that applies to the beneficiary, which can be up to 50%. However, as VSOP programmes are very cost efficient to set up and are easy to administer and maintain, they are still the most commonly used employee incentive structure applied by startups in Germany.

Modelled after the British growth share approach, some (real) employee share schemes in the German venture capital market use negative liquidation preferences to avoid dry-income taxation for employees. To this end, the beneficiary must only participate in the proceeds of a sale of the company or in the distribution of dividends once a certain hurdle value attached to the growth shares has been exceeded, which usually corresponds to the share of the company value that is attributable to the growth shares at the time they were issued to the beneficiary. The use of growth shares by German startup companies is currently still subject to uncertainties due to the lack of uniform administrative practice by German tax authorities regarding their taxation.

What are the normal provisions governing dividends, distributions, redemptions or other profit distributions in venture capital transactions? Are there any legal limits thereon in your jurisdiction?

Typically, investors do not want the portfolio company to pay out profits to their shareholders until an exit event (eg, a trade sale, asset sale or initial public offering) occurs. The goal is to capitalise on the investment within an exit, and profits are therefore reinvested in the business. If a portfolio company distributes profits, according to a typical shareholders’ agreement these would be paid in preference and with priority to the investors.

Under German corporate law, profits are generally distributed pro rata to all shareholders according to their shareholding in the share capital. However, German corporate law also allows disproportionate profit distributions if a corresponding clause is set out in the articles of association. A disproportionate distribution of profits (ie, non-pro rata) reflects the preferences of the investors and is normally governed by the waterfall provision in the articles or the shareholders’ agreement.

The regulations on dividends and profit distributions depend on the corporate form of the company. In the case of a German stock corporation (AG), the distribution of dividends must be approved by the annual general meeting. Only the balance sheet profit may be distributed, and mandatory balance sheet reserves must be considered. In the case of a GmbH, the shareholders' meeting decides the appropriation of profits. Profits can only be distributed if they are recognised as such in the company’s annual financial statements, and no losses can be carried forward.

Under German corporate law, the principles of capital maintenance apply to both AGs and GmbHs. Accordingly, distributions may only be made from the balance sheet profit and not from the share capital. Furthermore, reserves must be established prior to the distribution of a dividend, and no distributions may be made if this would result in the insolvency or over-indebtedness of the company.

As a rule, a redemption of shares is only permissible within certain limitations set by German corporate law and within the regulations set out in the articles of association.

How are venture capital investments treated in portfolio company sales or liquidations?

A "liquidation preference" is a clause in investment and shareholders’ agreements that determines the order and priority in which proceeds from an exit (eg, a trade sale, asset sale or initial public offering) are distributed among the shareholders holding different share classes (common shares, preferred shares series seed, preferred shares series A, etc, whereby each share class usually ranks higher than the share class created previous to it and shares among the same class have the same pari-passu rank in the distribution of proceeds). Preferred shareholders benefiting from this clause are typically investors who injected capital into the company during the financing rounds.

Under a fixed liquidation preference, holders of preferred shares participating in an exit receive a predetermined amount first (typically a multiple set at 1x, 1.5x or 2 their paid investment amounts per share), before the remaining proceeds are distributed among holders of lower ranking share classes.

The liquidation preference can be participating or non-participating. With a participating liquidation preference, preferred shareholders not only receive the fixed liquidation preference upfront, with priority over all other shareholders, but also a pro rate percentage of the remaining proceeds after all liquidation preferences have been settled. In the case of a non-participating liquidation preference, the investor is entitled to receive whichever amount is higher out of their fixed liquidation preference or their pro rata share of the remaining proceeds.

What anti-dilution protections are typically built into the terms of venture capital securities?

Investment and shareholders’ agreements typically contain a clause for down round protection, also known as anti-dilution protection. This clause protects investors from the negative effects of a subsequent funding round that values the company at a lower price per share. The anti-dilution clause gives protected investors the right to subscribe for further shares in the portfolio company at the nominal amount, without paying an additional premium to safeguard their equity interests when the company raises a new round of funding at a lower valuation than in the previous round.

There are different ways to calculate the number of anti-dilution shares that protected investors may subscribe for in the case of a down round. Most common in Germany are weighted-average anti-dilution formulas, which are either broad-based or narrow-based. For broad-based weighted-average anti-dilution, the number of outstanding shares includes all types of issued shares, including outstanding (virtual) options and warrants. Narrow-based weighted-average anti-dilution only takes into account the total number of outstanding preferred shares and excludes common shares or founder shares, (virtual) options, warrants and shares issued as part of employee options pools. Due to the design of the formula, broad-based anti-dilution results in a lower amount of anti-dilution shares that the protected investor may subscribe for than narrow-based anti-dilution, meaning the holders of lower share classes who are not protected by the anti-dilution provision experience less dilution as a result. Broad-based anti-dilution is therefore the most founder-friendly down round protection to safeguard investors’ equity interests when a company raises a new round of funding at a lower valuation than in the previous round.

The full ratchet formula, which is rarely used in venture capital transactions today, is considered purely investor-friendly and can lead to significant dilution for founders and other existing shareholders (known as a "wash-out"). The full ratchet formula retroactively adjusts the issue price of existing preferred shares protected by the anti-dilution clause to the price at which the new shares are issued in the down round. The goal of the full ratchet formula is to fully protect investors from the decrease in valuation.

Anti-dilution protection can be linked with a time limit for dilution protection or with a pay-to-play clause (ie, only investors investing fresh money in the down round will benefit from anti-dilution protection). Typically, anti-dilution protection comes with certain standard exceptions for issuances not undertaken primarily for financing purposes (such as share issuances under convertible loans or employee share option programmes).

What pre-emptive or pro rata investment rights do venture capital investors usually receive?

Under German company law, shareholders have the right to subscribe for new shares on the same terms as those offered to others in the event of capital increases. Consequently, investors can prevent dilution of their shares by investing their pro rata shares in any future capital increases. However, it is not obligatory for investors to utilise their statutory subscription rights.

In addition to the statutory pre-emptive rights, contractual pre-emptive rights are commonly included in investment and shareholders’ agreements, as are participation rights (right of first refusal) and obligations on shareholders to support – and not block – future financing rounds under certain circumstances, to enable venture capital funds to liquidate their investment after a certain period of time (drag-along).

What rights do venture capital investors normally have over insider sales of securities of portfolio companies?

Investment and shareholders’ agreements typically contain a right of first refusal (ROFR) clause. The ROFR gives shareholders control over any sales of shares in the portfolio company (subject to certain privileged transfers, which are exempt) and the ability to purchase the shares, or their relevant pro rata portion of the shares, on the same terms as those agreed between the selling shareholder and the third party. Although the primary purpose of a ROFR is not to restrict the ability of shareholders to transfer their shares, third parties may not take the time to negotiate a deal with shareholders if they believe that other shareholders can step in and accept their offer via the ROFR.