GERMANY Law and Practice Contributed by: Carsten Berrar, Florian Späth and Heiko Blaut, Sullivan & Cromwell LLP
weighted-average method which calculates the subscription price in a subsequent down round as an average of the financing round the exist - ing investor actually participated in and the val - uation implied in the down round. Full-ratchet clauses, on the other hand, effectively ensure that investors maintain a relative shareholding equal to their initial investment value irrespec - tive of the valuation underlying the down-round. Full-ratchet protection tends to be “off market” , and can only be secured in rare (distressed) circumstances. “Pay-to-play clauses” , which incentivise existing investors to participate in a new financing (down) round by granting them the economic rights, privileges, and obligations to which they agree during the previous financing round, are less commonly used in Germany than in the US market. Liquidation preferences have evolved to become market standard and determine the order of pay - out in a liquidation event (or a deemed liquidation event, which typically includes exit scenarios). They entitle investors to receive a certain mul - tiple (although the German market standard is 1x) of their investment or a specified preference amount before other shareholders receive any distributions. Recently, preferred amounts that annually accrue interest, payable in kind, have become evident in the German growth market, while participating liquidation preferences are still an anomaly. Remaining funds/assets are dis - tributed proportionally – ie, on a pro rata basis. This preference can be structured as “participat- ing” in the “second step” pro rata distribution or “non-participating” , with the latter being more frequently seen in later-stage enterprises. Unlike the non-participating liquidation preference, the participating liquidation preference is not lim - ited to hedging against the negative scenario of an exit below expected value, but rather also serves to secure the investor a premium over
their investment. Non-participating liquidation preference holders have the option to receive value on a per share “as converted basis” so that in an upside scenario pro rata allocation is the norm. 3.6 Corporate Governance Since start-ups are typically structured as GmbHs, the shareholders’ meeting has the authority to issue binding directives to the com - pany’s managing directors. The GmbH comes with no statutorily mandatory bodies other than the shareholders’ meeting and its managing directors, but typically does set up an (advi - sory) board where investors are represented. Certain transactions will require the approval of the shareholders’ meeting or the board prior to execution – whether by statutory law, AoAs or, most notably, shareholders’ agreements. These reserved matters typically include amendments to the AoAs, alteration of the rights attached to or issuance of new shares/instruments, signifi - cant corporate transactions and changes in the capital structure of the company. Shareholders’ agreements often set out informa - tion rights to regular reporting which go beyond statutory information and inspection rights. 3.7 Contractual Protection Fundamental guarantees granted to inves - tors relating to existence, title, the absence of encumbrances and conflicts, etc, are all but ubiquitous in German market practice. In addi - tion, business-related representations, notably concerning the company’s financial statements/ status and adequacy of IP assets, are increasing - ly frequent, particularly in late-stage financings. However, warranties do not typically extend to the business plan, as inherent risks remain with the investor as part of a VC investment’s nature.
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