German lawyers for Venture Capital Investment
Participation agreements, financing rounds, employee participation
Venture capital (or venture capital / short: VC) is perhaps the most important form of financing for ambitious start-ups. In addition to the economic risks for investors, founders and the company itself, there are numerous legal and fiscal peculiarities to be considered in VC financing and it is necessary to balance the often conflicting interests of founders and investors.
Our attorneys have a high degree of experience in this regard and accompany both start-ups and investors throughout the entire process of a VC investment.
For a non-binding inquiry, please contact one of our lawyers directly by phone or e-mail or use the contact form at the bottom of this page.
Venture Capital as a field of advice in commercial law
The advice provided by our specialist lawyers for corporate law and tax law as well as our tax advisors in the VC area includes in particular
- Strategic support for investors, founders and start-ups in investment and tax matters (negotiation of termsheets, NDAs, employee shareholdings, etc.)
- Drafting and review of investment contracts and shareholder agreements
- Structuring of employee and management shareholdings (ESOP, VSO)
- Legal and tax support in the exit phase
- Disputed enforcement of rights from participation agreements, employee agreements and virtual participations
Below you will find information on selected questions in the field of venture capital. If you need advice, please contact one of our contacts in Hamburg, Berlin, Munich or Frankfurt.
For whom is venture capital financing suitable?
As young companies often do not have any profits or securities, they regularly have no possibility to obtain financial means in the normal way. Unlike classic medium-sized companies, start-ups are therefore dependent on corporate financing to a greater extent. Venture capital financing is suitable for you -- especially when financial resources need to be generated quickly in the face of great market pressure.
In contrast to other investors, however, venture capital investors are often prepared to take a particularly high financial risk, since the expected profits in the event of success are regularly also high and they spread their risk accordingly by diversifying their portfolio. These conflicting interests need to be weighed against each other before a contract is concluded.
Meanwhile, the legislator has also recognized the great importance of a functioning venture capital scene for the development and growth of young innovative companies and, for economic reasons, is promoting venture capital through financing initiatives (KfW) and tax privileges for investors.
How is the startup evaluated?
The question of how to correctly assess the enterprise value of a start-up arises for all parties involved in a VC investment in the context of each individual financing round. But how can a correct valuation of young companies without a longer company history be made?
"It's all about people" is often the blanket answer of VC financiers when the question of the basis of valuation is asked. Particularly in the start-up and venture capital sector, the greatest uncertainties in company valuation are to be found. The target companies of venture capital funds are young, rapidly growing, innovative and often technology-driven start-ups.
The valuation of these young companies is often not only difficult but sometimes simply impossible. In contrast to the private equity sector, for example, there is a lack of reliable data on the company's past success. The capitalized earnings value or other valuation methods based on the current economic success of the company regularly do not lead to any useful results for a start-up, since start-ups do not yet generate profits, especially in the start-up phase. When a venture capital fund invests in a start-up, there is therefore often no tangible planning security.
For these reasons, the assessment of the personality of the founders and their competencies is usually the first priority in the investment decision of VC investors. Therefore, the founders are often referred to as the key assets of a start-up.
Investments in start-up companies are made in different stages of development, so-called stages or rounds. The forms of financing provided by the venture capitalists range from debt capital to equity and mezzanine capital and in case of young startups often includes the participation of employees. The individual stages of financing involve different risks for the VC investors.
- The first and also most risky investor engagement is the so-called seed financing. In this first round of financing, the company is in the seed stage and needs funds for research and development of its products. Seed financing is often provided by so-called Business Angels or from the circle of Friends & Family (some also speak of the three "Fs" - Family, Friends and Fools).
- The subsequent financing is often already provided by professional VC investors. Early stage financing is usually intended to facilitate activities following product development, such as effective marketing.
- Finally, after a later stage financing, the company can organize its growth and further expansion after initial operational success. The risk of the investors is much smaller with an engagement at this stage than in the stadiums where no economic success has been achieved yet.
Protection against dilution, so-called anti-dilution clauses
The investors usually receive a corresponding share in the start-up for their financial commitment. This naturally dilutes the founders' participation in the company. Against the dilution of already involved investors, regulations can be created in the participation contracts (so-called anti-dilution clauses).
However, such protection does not always correspond to the interests of the parties. This should be examined in each individual case.
The disinvestment of the venture capital investors takes place through the so-called exit. The investors withdraw from the start-up after a few years.
In this process, the investments are disposed of through an initial public offering (so-called IPO) by selling them to other strategic investors (e.g. competing companies) by means of a trade sale. It is also conceivable that the founders buy back the VC investors' investment.
Conflicts of interest between founders and VC investors
Even though the founders are dependent on venture capital, they do not want to expose themselves to any contractual restrictions or even total control of the venture capital investors: As an argument, the founders repeatedly argue that too tight fetters in the investment contracts would kill off the required creativity. In summary, there is a classic principal-agent conflict between founder and investor.
The happy medium in a VC investment regularly consists of the interests and positions of both sides being adequately reflected in the investment agreements. An adequate regulatory approach is often to limit the control rights and approval requirements that hinder the founders too much in their day-to-day business and, in the event of success, to contractually secure the VC investor's financial profit interest to the necessary extent.
Experience shows that despite a tight control density and an exaggerated system of sanctions, an investor cannot save his investment anyway in case of failure of a start-up. The investor's perspective should rather be to secure his financial participation in a "flying" start-up. The participation contract should therefore not degenerate into a control instrument that disproportionately restricts the founders' radius of action.
The deal of any venture capital investment is that the founders invest commitment and time while the investors provide capital to the founders. Since an investor generally makes advance payments, he wants to contractually guarantee the founders' commitment, especially that they will not simply stop working.
Contractually, this is implemented by a partly complex incentive structure, which punishes leaving the start-up and rewards the growth of the company. These vesting regulations regularly provide that a founder, upon leaving the company within a certain vesting period, loses a quantum of shares or even all shares in his company. There are a number of standardized contract clauses for this purpose, which are individually designed to achieve a fair settlement for all parties involved.
Shareholder disputes in start-up companies
Dynamic developments in young technology-oriented companies can lead to conflicts between founders or across all levels of shareholders (e.g. founders vs. investors or individual investor groups). Legal practice shows that such conflicts can quickly become more acute and subsequently threaten the existence of the entire company.
Special designs of participation agreements with oversized bad leaver mechanisms can put founders and managers of young companies under too much financial pressure. With regard to the control and exclusion provisions in the participation agreements, the parties concerned should always check whether they comply with the highest court rulings. According to the Federal Court of Justice, the regulatory mechanisms transposed from Anglo-American law into German law cannot always be reconciled with the protection of minorities and shareholders enshrined in German company law.
In every shareholder dispute, all sides should first seek an out-of-court settlement of the dispute, since start-ups regularly cannot stand up to longer disputes due to often tight budget planning. On the investor side, the investment is threatened with a total loss in such a scenario, so that the fund managers are then accountable to their investors. The managing founders often even have to fear the civil and criminal law risks of an insolvency delay.