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How to implement a standard US venture capital term sheet in Germany

German corporate law is quite different from US corporate law, but all the material terms and conditions of a standard US venture capital transaction may be carried in a German VC investment. The mechanisms differ but the economic substance is the same, say Dr Hurbert Besner and David Ayres of Brobeck Hale and Dorr.

It has often been said that Silicon Valley venture capitalists (VCs) will not invest in any company they cannot drive to in 45 minutes. There are so many opportunities available on their doorstep that it is not worth their time or effort to look elsewhere. But in the past couple of years something has changed. The wealth of new technologies being developed in Europe has been hard for even the Californians to ignore, and they have been hopping on planes and coming in droves to check out the European markets. And many of them have stayed, opened offices, begun to invest and even to raise funds in Europe.

The influx of US VC funding has begun to change the way in which VC deals are getting done in Europe. Whether it is because they are convinced of the superiority of their time-tested methodology, or simply because they wish to bring some uniformity to their investments, the US VCs often seek to impose their Delaware-type corporate structures and other elements of their US term sheets on their European investments. This has succeeded to a large extent in the United Kingdom, where corporate structures and investment contracts are not dissimilar to those in the United States. As a result, U.K. VC investing is rapidly becoming more like US VC investing. Imposing US-style term sheets has proven more difficult in continental Europe, where the laws governing corporate structure and contractual rights are in some ways fundamentally different from those in the United States.

The purpose of this article is to describe how to implement a standard US-style VC term sheet in the context of an investment in a German company. This article will highlight certain difficulties and obstacles under German corporate law, as well as suggesting possible solutions to those difficulties. Our goal is to provide a short roadmap to accomplishing the business goals of a US-style VC transaction, even if some of the forms diverge from those the US VC investor is accustomed to seeing.

Choosing the right corporate vehicle

US VCs are intimately familiar with the ins and outs of Delaware corporate law, since the vast majority of their US investments are into corporations registered in Delaware. Although Delaware permits businesses to operate in many different legal forms, from general partnerships to limited partnerships to limited liability companies, most operating companies are organised as stock corporations. In Delaware (and other US states) there is only one type of stock corporation. Every company, from the smallest start-up to Microsoft Corporation, is a stock corporation. There is no difference in legal form between a private company organized as a stock corporation and a public company organised as a stock corporation.

In Germany, two very different kinds of corporate structures are in common use: a limited liability company (‘GmbH') and a stock corporation (‘AG'). Most privately owned German companies are organized as GmbHs; all public companies are AGs. A GmbH is easier to manage, because it has only a single board of directors, typically consisting of the company's owner/managers. An AG has a two-tier structure, with a management board (consisting of members of management) that runs matters on a day-to-day basis and a supervisory board (consisting of outside directors) that oversees the activities of the management board and approves certain major business transactions. The members of the management board are chosen by the supervisory board. Although the GmbH structure is favored by management, it has one significant drawback for a VC investor looking for an exit route - a GmbH cannot go public and must be converted to an AG before an IPO. This can take several months and considerable effort to accomplish. As the German public securities markets have warmed to newer technology companies, entrepreneurs have increasingly tended to set up their companies in the form of an AG in the hope that they can one day go public. VCs seeking to invest in an existing GmbH should consider causing the target GmbH to convert into an AG at the time the investment is made to avoid the disruption of converting to an AG during the IPO process. This article will speak only about venture investments into an AG.

Legal documentation

A typical German venture capital transaction includes only two documents:
1.  A stock purchase agreement between the issuer and the VCs, which includes key provisions relating to the capital increase and the purchase price of the shares being is-sued, representations and warranties by the issuer and, sometimes, the founders, and closing arrangements; and 

2.  A shareholder agreement among the VCs, the founders and the issuer, which includes rights of first refusal over issued shares, co-sale and drag along rights, liquidation preferences, a vesting schedule for the shares held by the founders, anti-dilution pro-tection, voting and veto rights, registrations rights and lock-up arrangements and non-compete clauses.

The issuer's by-laws, which include a description of the authorised share capital, typically remain unchanged except for the increase of the share capital.

Capital increase

A Delaware corporation normally has authorised capital that is many times larger than its issued capital. A typical VC-backed company will have a large number of authorized, but un-issued and ‘undesignated', shares of preferred stock. The board of directors typically (though not always) is granted the authority to designate the terms on which new issuances of preferred stock will be made, and to issue the new shares without further approval by the shareholders. A standard contractual restriction on this authority is to prohibit the board from designating and issuing new classes of preferred stock that have rights superior to the rights of the already issued preferred stock without the consent of the holders of the issued preferred stock.

Any issuance of shares by a German AG requires an increase of the issuer's stated (ie issued) capital and therefore an amendment to the issuer's by-laws. An increase of the stated capital may be accomplished by (i) a shareholder resolution or (ii) a resolution of the management board, approved by the supervisory board, if the by-laws of the company provide for authorized but un-issued capital. The maximum amount of authorized but un-issued capital may not in any case exceed 50 per cent of the stated capital (e.g., if a company has a stated capital of Euro 100,000, its authorized but un-issued capital may not exceed Euro 50,000). Note that an AG may issue shares with par value or without par value, but in either case the minimum stated capital for each share (and therefore the minimum purchase price) is one Euro. This means that an AG cannot issue shares to management or employees at a very low nominal price (eg $0.01) as in the United States, somewhat lessening the incentive value of options granted to employees.

Completing a capital increase is more complicated than in the United States, where the documentation can be filed and effective in minutes. The documents confirming any capital increase in an AG must be certified by a notary. The investors must then pay the purchase price into a bank account of the issuer, and the bank must provide written confirmation of the funds' receipt. All of this documentation must then be filed with the commercial register in order to register the capital increase. The issuer may not issues shares before the capital increase has been registered with the commercial register, which takes typically between one and four weeks after the application has been filed.

In order to bridge the gap between payment for and delivery of the shares, it has become standard VC practice to purchase the shares to be issued at par value (at which point they are considered paid) and to pay any additional  premium upon delivery of the share certificates. This procedure also reduces fees paid to the notary and the commercial register, which are based on the amount paid up front.

Preferred shares

In the United States, VC investments are almost always based on preferred stock. Under the German Stock Corporation Act, an AG may issue preferred shares that provide for preferred dividend rights, voting rights, liquidation preference, etc. However, VCs investing in Germany usually prefer to purchase common shares but receive certain preferential rights in the shareholder agreement rather than purchasing preferred shares. This is principally because the conversion of preferred shares into common shares at the time of the IPO requires a formal amendment of the by-laws of the company. This requires holding a shareholder meeting, receiving a 75 per cent majority vote in favor of conversion, filing and registration of the amendments with the commercial register. Including the meeting notice period, the whole conversion process can take up to three months, which can compromise the timing of the IPO.

One of the principal reasons for using preferred stock in the United States is absent in Ger-many. The US Internal Revenue Service will generally accept the differential in valuation placed on shares of common stock and shares of preferred stock, permitting the grant of options for common stock to management at prices far below the price currently being paid by investors for preferred stock. This is the origin of the ‘option mania' in the United States which has driven so much of the entrepreneurial spirit. In Germany the taxing authorities will generally not challenge the valuation placed on any shares sold by an issuer, whether common or preferred. So, while there is no reason not to follow the practice of issuing common shares to employees/founders and preferred shares to inves-tors, there is no tax incentive to do so. Because of the timing complications of converting the pre-ferred shares to common, the practice of issuing preferred shares to VC investors has generally not developed.

Preemption rights and anti-dilution protection

The German Stock Corporation Act grants a mandatory statutory preemption right for all shareholders. This preemption right may be waived by the shareholders (acting by a 75 per cent majority), who authorise the management board to issue shares without further shareholder approval. This authority is generally limited to allowing the management board to issue shares amounting to less than ten per cent of the total issued share capital and at a purchase price not significantly below fair market value. Because the statutory preemption right may be overridden by a 75 per cent shareholder majority, a VC taking a stake of less than 25 per cent should ensure that the shareholder agreement prohibits waiver of the pre-emption right without the VC's consent.

Rights providing the economic equivalent of US anti-dilution protection are common in German VC transactions. In US deals, if a company issues shares in any subsequent financing round at a price per share that is lower than the price that was paid by the VC for its preferred stock, the conversion ratio of the VC's preferred stock is changed so that the VC will receive more shares of common stock upon conversion. This increases the percentage of the issuer owned by the VC (following conversion) and effectively reduces the price per share paid by the VC. In an AG, a capital increase may be effected only by paying in additional capital, so the issuer may not agree to simply issue additional shares to the VC at no consideration to provide anti-dilution protection. Instead, the VCs and the founders agree in the shareholder agreement that, if shares are issued at a lower price in a ‘down' investment round, the founders will transfer shares to the VC (for no consideration) and thereby adjust the percentage holding of the VC in the company.

Liquidation preference

In the US, a liquidation preference in favor of the preferred investors is included in the preferred stock terms. In Germany, this protection is included in the shareholder agreement, which provides that, upon a liquidation or winding up of the company, the VC will receive on a preferential basis its initial investment (or a multiple of its initial investment) before the other shareholders receive anything. As a technical matter, the other shareholders cause the issuer to distribute assets directly to the VC up to the amount of the liquidation preference. As in the US, a trade sale of the company is usually considered to be a deemed liquidation and triggers the same liquidation provision as an actual liquidation.

Dividend preference

As in the United States, a dividend preference is possible but is not normally a significant business issue. In view of the cash needs and anticipated losses of most start-ups, most VCs prefer to have the companies retain any profits that they might make to fund operations until the IPO. If a dividend preference is called for, this would go into the shareholder agreement.

Voting and veto rights

To protect VC investors, supermajority voting provisions may be included in the shareholder agreement. These typically require supermajority shareholder voting in order to increase share capital, to carry out a trade sale, or to amend the by-laws. Since the VC investors do not generally have a separate class of preferred shares, they would not have independent class rights to block these actions absent a special provision in the shareholder agreement.

The shareholder agreement often provides that certain types of business transactions, not requiring shareholder approval under the German Stock Corporation Act, may be taken only if approved by the VC or if approved by the unanimous vote of the supervisory board (which is typically controlled by the investors). The supervisory board may in its sole discretion designate business transactions that may be undertaken by the management board only with the prior approval of the supervisory board. This provides the VCs with effective control over the management of the company without having to resort to a shareholder vote.

Representations and warranties; information rights

Representations and warranties are typically provided by the issuer and by the founders or the management of the company. From a legal point of view, the enforceability of claims for breaches of the issuer's representations and warranties is questionable under the German Stock Corporation Act. Any payment made against such claims may be considered to be a repayment of capital, which is not permitted under the Stock Corporation Act. Nevertheless, the issuer is generally required to give standard representations and warranties.

One of the main principles of the German Stock Corporation Act is that all shareholders be treated equally. Any information or reporting rights given to a VC must therefore be granted to all other shareholders.

Supervisory board representation

The members of the supervisory board are elected by the shareholders, acting by a simple majority. Vacancies may not be filled by the supervisory board itself or by a single shareholder or group of shareholders. The shareholder agreement therefore typically provides that all of the parties to that agreement agree to vote for VC's nominees to serve on the supervisory board.

Registration rights and lock-up

If the German company has the potential for a US listing, the VC may wish to obtain US registration rights. These would be included in the shareholder agreement. The VC should also obtain a registration right for a listing on a German exchange since, under the applicable rules, the issuer itself has the sole discretion to choose which shares it lists on the German exchange. The principle of equal treatment of shareholders may force the issuer to list all of its shares but the contractual right is easier to enforce.

The Neuer Markt of the Frankfurt Stock Exchange requires that all existing shareholders agree to ‘lock up' (ie not sell)  their shares for a period of six months from the date of initial listing. To reduce the impediments to a later Neuer Markt listing, the VC should insist at the time of its investment that all shareholders agree in writing to the Neuer Markt lock-up.

Vesting provisions

Because an AG may repurchase its own shares only under certain limited circumstances, vesting of founders' shares is accomplished by requiring a departing founder to sell unvested shares at the initial purchase price to all of the other shareholders on a pro rata basis, rather than to the company itself.

Conclusion

Although German corporate law is quite different from US corporate law, all of the material terms and conditions of a standard US venture capital transaction may be carried in a German VC investment. The mechanisms differ somewhat, but the economic substance is the same.

Copyright © 2002 Brobeck Hale and Dorr

For more information please contact ayres@bhd.com or besner@bhd.com

Brobeck Hale and Dorr is an international law firm dedicated to advising
clients in the technology industry. It has more than 60 lawyers in its
offices in London, Munich and Oxford and an additional 1,500 lawyers
throughout the US