H. Specific Investment Scenarios
I. Venture Capital
The term venture capital refers to capital provided to companies as seed, start-up or growth money for the financing of early stages of the company's development. Companies seeking venture capital are often young and innovative businesses considered to have a high growth potential (e.g. companies from the IT or technology sector). However, those companies initially cannot cover the financial requirements for the implementation of their business models or their growth strategies with internal financing and have no access to affordable credit because of a lack of collateral. In contrast to typical bank financing, a venture capital investor offers unsecured long-term financing provided to the company as liable equity capital. Another main difference between typical debt financing and venture capital financing is the provision of support and managerial know-how to the management of the target company by the investor.
As consideration for the provision of venture capital, the investor is usually granted a minority equity stake in the target company’s share capital, which is, in most cases, organized in the legal form of a German limited liability company (GmbH) or, less commonly, a German stock corporation (AG). The investment strategy of acquiring such minority shareholding is not to receive regular dividend or interest payments. Instead, a venture capital investor intends to hold its minority shareholding for a certain investment period only and to benefit from the increase of the company’s inner value within an exit transaction to be consummated within or after the expiry of such investment period (see Part I. below for possible exit scenarios).
2. Transaction Procedures
a) Acquisition of Shares
In order to fund the target company directly and to avoid share transfers that are taxable on the level of the existing shareholders, the acquisition of the (minority) participation in the target company is not effected by way of an acquisition of existing shares from the founders, but by way of a capital increase in cash in the target company and the subscription of newly issued shares by the venture capital investor. According to section 55 et seq. German Limited Liability Companies Act (GmbHG) and section 182 et seq. German Stock Corporation Act (AktG), the consummation of a capital increase in both a GmbH and an AG requires a notarized resolution of the shareholders’ meeting and registration in the commercial register.
b) Contractual Basis
In practice, the investment and the acquisition of the participation in the target company is based on an investment and shareholders’ agreement governing the terms of the investment, the rights and obligations of the parties, as well as other aspects regarding the legal relationship of the parties inter se. In addition, most venture capital investments require an amendment of the target company’s articles of association, e.g. in order to implement transfer restrictions on shares, different classes of shares or special investor rights and to comply with the corporate governance provisions agreed upon in the investment and shareholders’ agreement. The amendment of the articles of association is effected by a shareholders’ resolution, which ￼requires notarization and registration in the commercial register and which is usually resolved upon and filed for registration together with the capital increase resolution.
c) Investment and Shareholders’ Agreement
aa) Investment Provisions
The investment and shareholders’ agreement entered into between the existing shareholders, the investor and the target company initially regulates the terms and conditions of the investment and therefore contains provisions with respect to the size of the participation offered, the pre-money valuation of the target company and the amount and due date of the contributions to be made by the investor (e.g. based on the achievement of certain business milestones). In order to implement the investor’s participation, the existing shareholders undertake to resolve upon the necessary capital increase, to issue the relevant amount of shares and to admit the investor to subscribe to such shares. Further, the existing shareholders are usually asked to waive any rights to subscribe to the newly issued shares, as well as any applicable anti-dilution protection. In return, the investor undertakes to subscribe the newly issued shares (which are usually issued at nominal value) and to make a further contribution (usually in cash) into the target company’s capital reserves (section 272 para. 2 no. 4 German Commercial Code (HGB)) in accordance with the terms agreed upon (e.g. conditional upon the fulfillment of milestones).
bb) Investor Rights, Corporate Governance
A venture capital investor that provides fully liable equity capital to the company participates in the successful development of the company, but bears an entrepreneurial loss risk equal to that of the founders of the company at the same time. The investor will therefore insist that the investment and shareholders’ agreement contains provisions on reporting obligations for the management and information rights by the investor, as well as corporate governance provisions that provide the investor with a sufficient level of passive control over the management and thereby over the development of the company. Typical corporate governance provisions within an investment and shareholders’ agreement are the establishment of a supervisory board (including delegation rights of the investor) and approval requirements for fundamental shareholders’ decisions and business transactions. Furthermore, it is common for the investor to ask the existing shareholders, the management and/or the company to represent and warrant the company’s status at the time of the investment (e.g. with respect to certain business matters as well as title guarantees regarding the ownership in the existing shares in the company).
cc) Incentive of Management
The commitment and the incentive of the management are particularly important factors for the successful development of the target company. In order to commit the management to the company, investment and shareholders’ agreements frequently contain so-called vesting clauses, according to which a founder who resigns as managing director of the company shall be obliged to fully or partially resign as a shareholder of the company and shall therefore transfer his shares in the company to the company and/or the remaining shareholders of the company. The amount of consideration to be paid commonly depends on the reasons for resignation (e.g. a good leaver shall typically receive the fair market value for the transferred shares, whereas a bad leaver might only demand the nominal value of the transferred shares).
Early stage investments imply enormous difficulties in properly assessing the valuation of the target company. Such difficulties can be countered by so-called anti-dilution or valuation adjustment clauses, through which the investor is entitled to subscribe for further shares in the company at nominal value (without any premiums) in case a further financing round with third party investors is consummated based on a lower valuation than that upon which the investor’s investment was based.
e) Exit-Related Provisions
Even more important for the safeguarding of the investment are so-called liquidation preferences, according to which the investor shall be, in case of an exit event, accorded a preference over remaining shareholders to receive certain amounts out of the exit proceeds. The amount of such preference payment depends on the bargaining powers in each individual case. Typically, the investor is entitled to the sum of his total investment, but the liquidation preference clause might also provide for a minimum interest or even entitlement to a multiple of the investment amount. The return of the investor can be further leveraged by allocating the remaining proceeds after the preference payment not only to the remaining shareholders (so- called non-participating preference), but to all shareholders, including the investor, pro rata according to their shareholdings in the company (so-called participating preference).
The power to enforce an exit transaction, notwithstanding the opposition of the other (majority) shareholders, is an equally important aspect for a venture capital investor, that intends to hold its (minority) participation for a limited investment period only. The investor may achieve this by so-called drag-along clauses, under which the remaining shareholders are obliged to sell their shares in the company along with the investor’s shares in case a third party intends to acquire the company and the investor supports such exit transaction. In return, the remaining shareholders are often granted so-called tag-along rights (co-sale rights) that protect them against a unilateral withdrawal by the investor. Since the transfer of shares in a German limited liability company (GmbH) requires notarization, the whole investment and shareholders’ agreement needs to be notarized if drag-along and tag-along rights are implemented.
II. Bank M&A
Bank M&A in a narrow sense is the investment of a third party (including foreign investors) in German credit and leasing portfolios or special German purpose vehicles pooling such credit and leasing portfolios (irrespective of whether the portfolio to be sold and transferred contains performing and/or non-performing credit agreements).
1. Common Deal Structure
Normally, this special kind of a portfolio transaction is structured as a
- customary asset deal by which either the credit/leasing agreement itself and all agreements in connection therewith (transfer of contracts) or as a minus all rights resulting from those agreements are transferred; or
- sometimes as a spin-off of the total portfolio to a new special purpose vehicle combined with a transfer of all shares of those company
to the (foreign) investor or any of its affiliated companies.
2. True Sales
Since the financial crisis 2008/2009 the securitization of portfolios by transferring the credit- and leasing portfolios to a new special purpose vehicle and issuing bonds or promissory notes which can be sold to (foreign) investors (so-called true sale) has declined strongly.
3. Banking Supervision Law
In addition to normally applicable fields of M&A law, e.g. corporate (see A.II.), finance (see C.), antitrust and competition (see F.1.), labor (see G.1.) and general tax law (see D.), banking supervision law is to be considered. If the acquisition of a credit portfolio acquired by a special purpose vehicle or directly by a (foreign) investor specific German or other foreign banking supervision law may be applied, i.e. in special constellations the acquirer has to have a banking license to continue the acquired business unless the acquirer has such license already.
Furthermore, the intention of an investor to acquire a significant amount of shares in a financial institution may be notifiable in advance under banking supervision law.
4. Value Added Tax Law
In case the seller does not transfer its entire (portfolio) business the deal has to be structured in accordance with the European Court of Justice jurisprudence to ensure that the tax authorities do not see the transfer of parts of its (portfolio) business to a third party as a factoring subject to the German VAT.
III. Acquisition of Distressed Companies
An investor seeking to acquire a distressed target in Germany should place careful time and consideration in deciding on the timing of the acquisition. There are four stages at which the target may be acquired: (i) prior to filing for insolvency proceedings, (ii) during preliminary insolvency proceedings, (iii) after the commencement of insolvency proceedings and (iv) as part of an insolvency plan after in-court insolvency proceedings have been terminated. Significant legal and factual considerations to be aware of in respect of the different scenarios will be outlined in this chapter.
2. Acquisition outside Insolvency Proceedings
Usually, the transaction is structured as an asset deal and in principal the same rules apply as when acquiring a non-distressed target. However, if the seller of the target company/assets is distressed then insolvency proceedings may eventually be started, in which case the investor runs the risk of an insolvency administrator either exercising its right to refuse performance of the purchase agreement or to contest the transaction. These special rights of an insolvency administrator are designed to serve the purpose of enabling the administrator to increase the value of the insolvency estate in order to generate the highest quota possible for distribution to the creditors.
a) Refusal of Performance
If the transaction contemplated under the purchase agreement is not fully consummated by either party, the insolvency administrator may review the transaction and, if he comes to the conclusion that the transaction is not favorable for the insolvency estate, choose not to fulfill the purchase agreement. If the investor has made advance payments to the seller and the insolvency administrator refuses to fulfill the agreement, the insolvency administrator is not obligated to refund the investor's advance payments, but instead the investor’s repayment claim is treated as an ordinary insolvency claim and will be settled at the end of the insolvency proceedings with a quota.
Alternatively, the insolvency administrator may contest the transaction. The transaction is most vulnerable if it took place during the last three months prior to the request to open insolvency proceedings. The insolvency administrator can contest the transaction if the seller was insolvent at the time of the agreement, or when the seller disposed of the target business and the investor knew about this fact and the acquisition directly, respectively, or indirectly discriminates against the other creditors. A direct discrimination can be assumed if the purchase price is considered inadequate. For instance, price reductions because of the liquidity crisis are not accepted and may lead to a direct discrimination. In addition, it can be considered an indirect discrimination against the other creditors if the purchase price is no longer available in the insolvency estate of the seller and the insolvency estate is no longer enriched.
Nevertheless, if the investor wants to acquire the target during this time because, for instance, reputational damage of insolvency is reduced, there are ways to mitigate the risks connected with the insolvency administrator’s right to refuse performance or contest the contract, inter alia, by structuring the acquisition as a cash transaction or by making the purchase agreement subject to the condition precedent of full payment of the purchase price.
3. Acquisition after Commencement of Insolvency Proceedings
Once the application for insolvency has been filed the insolvency court will appoint a preliminary insolvency administrator and assign them certain rights. Insolvency applications can be made on the basis of threatened illiquidity, illiquidity and over indebtedness of a company.
Normally, the debtor retains the authority to dispose of its assets during the preliminary insolvency proceedings. In this case the preliminary insolvency administrator’s position is considered a weak one.
However, the court can also choose to appoint a strong preliminary insolvency administrator with the authority to dispose of the debtor’s assets, although this is not very common.
In addition, the law to further facilitate corporate restructurings (ESUG), which came into force on March 1, 2012, introduced an alternative proceeding. Upon a respective application by the debtor, the insolvency court may leave the debtor’s management itself in charge during the preliminary insolvency proceedings, who will be supervised by an insolvency monitor, and for restructuring purposes grant the debtor a protective shield. The protective shield acts to protect the debtor’s assets against compulsory enforcement measures by its creditors for a fixed period of time (maximum of three months), which is determined by the insolvency court. In this time the debtor has to prepare and subsequently present an insolvency plan to the insolvency court.
a) Acquisition from the Debtor
Acquiring a distressed company during preliminary insolvency proceedings from the debtor, even with the consent of the weak preliminary insolvency administrator or the insolvency monitor, is not advisable. The risks connected to an acquisition of a company out of a liquidity ￼crisis also apply in this situation. In addition to this, the insolvency administrator has greater ability to contest the transaction as knowledge of the insolvency application is deemed sufficient to satisfy the knowledge element required to contest, and furthermore, information on insolvency applications is publicly available on the internet at www.insolvenzbekanntmachungen.de.
However, the rights of the insolvency administrator to refuse the performance of the purchase agreement or to contest the purchase agreement are excluded in circumstances where to exercise this right would constitute a breach of trust.
b) Acquisition from a strong Preliminary Insolvency Administrator
In instances where a strong preliminary insolvency administrator has been appointed, they would assume the role of seller. The rights of the insolvency administrator to refuse performance or contest the contract are excluded in this instance.
4. Acquisition during Insolvency Proceedings
a) Regular Insolvency Proceedings
In general, no insolvency-specific risks have to be considered when acquiring a company out of opened insolvency proceedings. The insolvency administrator acts as the seller under the purchase agreement and subsequently cannot contest the purchase agreement.
The acquisition from an insolvency administrator is usually structured as an asset deal and has the advantage for an investor that at this stage the transfer of certain liabilities by operation of law (for further details please see Chapter A.I.2.) is excluded. This applies to business and withholding taxes accrued from the beginning of the last calendar year prior to the acquisition and to liabilities that have been created in the conduct of business prior to the acquisition if the investor continues the business under its previous name. Furthermore, the assumption of obligations under existing employment agreements is limited. The investor cannot be held liable for any employment claims (including pension claims) that arose prior to the opening of the insolvency proceedings.
In respect of the negotiations, the insolvency administrator will not be willing to give any guarantees about the target. This is because the insolvency administrator has limited knowledge about the target and might be personally liable in the event of a breach of any guarantee. In addition, the insolvency administrator will often seek a quick sale with limited risk. Accordingly, locked box clauses and exclusion of liability clauses are rather common in purchase agreements with insolvency administrators. The insolvency administrator will be required to obtain the creditors’ committee’s, respectively, the creditors’ assembly’s consent to the conclusion of the sale agreement and will usually make this consent a condition precedent.
In addition to debtors seeking to apply for self-administration during the preliminary stages of insolvency proceedings, debtors can also seek to apply for self-administration after insolvency proceedings have commenced. This option has been strengthened by the ESUG. If the creditors’ committee unanimously supports any such application, the court is unable to reject the application on the grounds that self-administration is likely to be disadvantageous for the creditors. In such instances of self-administration, the target is sold by the debtor subject to the consent of the insolvency monitor. The prerequisites for the acquisition are the same as those described in respect of the open insolvency proceeding.
5. Acquisition by way of an Insolvency Plan
The insolvency plan shall provide for a comprehensive restructuring plan which is designed to take the target back to solvency and may, in general, contain any action that could also be legally undertaken outside of insolvency proceedings, including the sale of the target.
The terms of an insolvency plan have to be agreed between the creditors of the debtor insofar as their rights are modified therein (e.g. by a haircut) and confirmed by the insolvency court. Once the insolvency plan has become binding, the insolvency court will then release the debtor from the in-court insolvency proceedings.<
As with the case of open insolvency proceedings, under an insolvency plan the transfer of certain liabilities which generally occurs by operation of law is excluded and there is no risk of refusal of performance or contestation by the insolvency administrator.
The law ESUG has improved the instrument of the insolvency plan by providing more freedom of action to the debtor and allowing for a more efficient adaption process. Furthermore, the ESUG introduced the option to include the target’s shareholder rights in the insolvency plan and to do a debt-to-equity swap without their consent. Under the ESUG any corporate measures included in the insolvency plan are considered to be made in statutory form once the insolvency plan becomes legally binding.