Trouble in the Tranches, An Update on the German VC Market

Dr. Johannes Maidl, Hale and Dorr (Munich)

The following article was previously published in Full Ratchet(TM), the Trans-Atlantic Venture Capital Review, which is published by Hale and Dorr. If you would like to receive future issues of Full Ratchet, please send an e-mail to

In venture capital transactions, it is a common practice to structure an investment by way of milestones or tranches whereby, after an initial investment, any further investment is made by the VC only upon the successful satisfaction by the company of a specific or defined milestone. In fact, many VCs consider milestones to be an effective way for an investor to manage the risk of investing. In Germany, however, VC investors may need to reconsider this structure in light of a recent court decision.

Typically, in German VC transactions with a milestone investment structure, the investment agreement provides that the VC will pay at the time of the first closing. Due to the issues related to increasing share capital in German companies, at the time of the first closing the VC is issued all of the shares they are entitled to receive in all of the tranches (as if all of the milestones have already been achieved). To ensure that the VC only has the rights attaching to the fully paid shares, contractual provisions are often implemented with respect to the shares that remain subject to the satisfaction of the milestones. If and when the company achieves the specified milestones, the VC is then contractually obliged to pay an additional agreed amount (equal to the original purchase price, less the nominal value per share that has already been paid). In practice, these additional payments have been characterised as "payments into the free capital reserves" (Zuzahlung in die freie Rcklage) and not as "share premium" (Agio). However, amongst lawyers handling VC investments, there has always been a question regarding whether a milestone payment was in fact a payment of share premium rather than a payment into free capital reserves. The validity of the issuance of the shares by the company to the VC depends upon this characterisation because, under the German Stock Corporation Act, any share premium has to be paid into the company's bank account before the shares are actually issued.

A recent German court decision has asserted that a milestone payment under an investment agreement is in fact a payment of share premium rather than a payment into free capital reserves. This suggests that, under the typical structure, the initial issuance of shares for which only the nominal value has been paid is null and void, as the share premium was not paid prior to the issuance of the shares. Although the court was not directly faced with the issue, the court also noted in an aside that, if the obligation to make the milestone payments was set forth in a shareholders' agreement to which the company was not a party, then the payments might be viewed as payments into the free capital reserves rather than share premium. Assuming that the court's latter view is correct and accepted by other courts, it is nevertheless a very undesirable result for VC-backed companies. If the company is a party to the shareholders' agreement, then the milestone payment would be deemed to be share premium (and the issuance of shares would be null and void). If the company is not a party to the shareholders' agreement, then the milestone payment would be deemed to be a payment into the free capital reserves (and the issuance of shares would be valid), but because the company is not a party to a shareholders' agreement, the company cannot legally force a recalcitrant investor to make the milestone payment that has become due. The company would have to rely on the other shareholders who are parties to the shareholders' agreement to enforce the milestone payments for the benefit of the company. Because under the law the validity of using a shareholders' agreement to make the milestone payments is far from certain, even without the company as a party, VCs will also run a significant risk if they were to rely on this structure.

This recent court decision does not necessarily mean the end of structuring venture capital investments in German companies by way of milestones. One potential alternative method to achieve a similar result would be the use of convertible bonds as an appropriate substitute.

A convertible bond could be issued at a nominal value and provide for an additional payment in the event of conversion. Upon the achievement of the milestone, the additional payment would be required for the bond to convert. However, because a convertible bondholder does not have voting rights, voting arrangements between the VC and the other shareholders would have to be provided by means of a voting agreement.

We expect to see significant modifications in the structure of typical German VC transactions in the coming months as parties adjust to this new development.

Dr. Johannes Maidl ( is a Junior Partner in the Munich office of Hale and Dorr.