Employee participation, GESSI and fiduciary duties
The aim is to promote employee participation via a “real” shareholder position instead of the more common virtual phantom stock models. The legislator initially sought to solve the problem of dry income taxation of the non-cash benefit upon transfer of “real” shares with the Fund Location Act for SMEs by postponing wage taxation to certain later points in time, namely until the transfer of the shareholding, the termination of the employment relationship and no later than 12 years after the transfer of the shareholding. The weaknesses of this regulation are now to be remedied by the ZuFinG‑E: According to the draft bill, the SME criteria will be doubled, thus expanding the scope of application; companies founded 20 years ago will also be covered; in the case of a lower severance payment (e.g. in the bad leaver case), only this severance payment will be taxed, i.e. not the higher non-cash benefit in the case of a grant; taxation will only take place in the case of a sale in which the employee assumes liability for wage tax upon leaving. In addition, the possibility of lump-sum taxation at 25% is created for the employer.
All this leads to a high complexity of the control. The simplest approach would be to generally tax the proceeds from an employee shareholding at 25% only upon sale or transfer, and to include phantom stock as an asset holding with the same taxation. This also avoids the still unresolved problem of valuing the investment at the time it is granted, unless it is in connection with a financing round. In addition, for corporate governance reasons, genuine participation by several employees is only advisable if they are bundled in an investment company; Section 19a (1) 2 EStG expressly permits indirect participation via a partnership for this purpose. — In my opinion, it will certainly take time before genuine employee participation is considered as an alternative to virtual participation. However, it may be worthwhile to develop standard models for this as well. A proposal for the contract of an employee limited liability company can already be found in the appendix of the 7th edition. of my VC manual.
GESSI stands for the German “Standards Setting Institute”. Here, on the initiative of BAND and the German Start-up Association, German-English sample contracts with explanations are being developed, which are freely available for anyone to download. My ambition was to create a contract structure that was as simple and cost-effective as possible in the interest of business angels and start-ups. In Germany, the comparatively high notary fees for the notarization of an investment contract are a burden that does not exist anywhere else in the world. The notarial form is used when transfer obligations for shares are regulated in the participation agreement. According to Section 15 (4) GmbHG, this requires notarial form, which covers the entire agreement. Then the notary costs are calculated not only from the investment, but additionally from the post-money valuation minus the value attributable to the smallest investment, as this determines the value of the co-sale obligation. If, however, these rules are moved to the articles of association, the requirement for certification is satisfied and it remains solely to calculate the amendment to the articles of association, which is required anyway and for which a small fixed amount is to be applied. Because of the question of whether the separately agreed additional payment should also be applied to the nominal capital increase, I have filed a jump appeal with the Federal Court of Justice (BGH), on which a decision is pending.
In any case, however, the notarization requirement for shares in a GmbH and also a UG (limited liability company) is an alien concept, not only because no such form applies to share transfers, but also because sufficient legal certainty regarding share ownership is provided by the list of shareholders to be deposited with the Commercial Register. The ZuFinG‑E provides for the digitization of shares. However, no reform is being considered for the legal form of the GmbH and UG (limited liability company), which predominate in practice. In this context, the abolition of the notarial form requirement applicable there, already through the ZuFinG, would be a real “game changer”.
Thanks to government support measures, the VC scene remained stable during the pandemic. With the Ukraine war, the energy crisis and inflation with rising interest rates, but also with new uncertainties at U.S. banks, investors are holding back again. This leads above all to lower valuations, which in my impression are thus moving back towards a normal level. Nevertheless, one does not see multipliers or interest on liquidation preferences, nor does one see a reversal to the ineligibility of such preferences. Dilution protection also remains weighted in idR. Those who invest, therefore, usually do so according to the old rules. This is also a good thing, so as not to create an omen that burdens early-stage investors and founders for later rounds. A new investor will not submit to “pay to play”, which creates indirect pressure for follow-up investments, in these uncertain times.
It can be observed that considerable pressure in the sense of “reorganization or exit” is generated in start-ups close to insolvency by shareholders willing to finance against co-partners not willing to do so. However, an obligation to resign cannot be derived from the duty of loyalty in the case of a corporation. No capital measure may be blocked for self-interest unless it can be shown to lead to the rescue of the Company. The resulting dilutive effects, including risk-based compensation, are to be accepted. However, since the content of the general fiduciary duty is largely determined by what the shareholders have agreed, it is advisable to stipulate the conditions of further financing (such as the co-sale obligation) in advance, namely in the sense of a duty to cooperate if a majority of the shareholders/investors vote in favor, provided that no shareholder is imposed with an obligation to make additional contributions, no special rights are withdrawn and the principle of equal treatment is observed. The agreement of such a duty to cooperate is essential because the amendment of a participation agreement otherwise requires the consent of all contracting parties. As for the amendment of the Articles of Association, a qualified majority of 75% is required. If the financing serves to avert an imminent insolvency, however, a simple majority of the shareholders/investors should suffice. While this is not “self-executing” without a power of attorney provision, it at least creates clarity in the rules of the game.
About Dr. Wolfgang Weitnauer
Dr. Wolfgang Weitnauer focuses on advising investment companies and young technology companies on all legal aspects of financing rounds and sales transactions. His practice areas include corporate and commercial law, mergers and acquisitions, corporate finance and investments, fund structuring and regulatory matters.