Cramdown

What is a cramdown?

Cramdown refers either to a financing round at a sharply reduced valuation, the terms of which are dictated by new investors, or to the overriding of dissenting groups in an insolvency or restructuring plan. The spelling cram-down is also in use, and for the financing round the term cramdown round. In venture capital financing, the existing shareholders are heavily diluted in the process: their share shrinks because many new shares are issued at a low price. In insolvency and restructuring law, a reorganisation plan takes effect even though individual creditor or shareholder groups have not agreed to it; the German Insolvency Code (Insolvenzordnung, InsO) calls this the prohibition of obstruction (Obstruktionsverbot). The English verb “to cram down” means roughly “to force something on someone”.

What both meanings have in common is that those involved have to accept a capital measure that they cannot prevent on their own. The financing round rests on the majority rules of German limited liability company law (GmbH law) and on the shareholders' contracts. The overriding in the plan rests, for an insolvency plan, on Section 245 InsO, and for a restructuring plan outside insolvency, on the Act on the Stabilisation and Restructuring Framework for Businesses (Unternehmensstabilisierungs- und -restrukturierungsgesetz, StaRUG). In both cases the court must confirm the plan. Founders, investors and acquirers encounter both forms mainly in companies with tight liquidity whose last valuation is no longer tenable.

Cramdown in a financing round

Every round at a lower price per share than the previous one is a down round. One speaks of a cramdown when the price discount and the terms go so far that the existing shareholders lose most of their economic position. Typical is a tight runway: liquid funds last only a few more months, and alternative capital providers are lacking. New investors then usually attach several conditions:

• Sharply reduced price per share: often only a fraction of the price of the last round.
• New senior preference: a multiple liquidation preference ranking ahead of all earlier rounds.
• Waiver of anti-dilution protection: compensation shares from a full ratchet, in weaker form also from a weighted protection (weighted average), would otherwise devalue the new investor's stake.
• Pay-to-play: Existing investors keep their preferential rights only if they take part in the round.
• New management programme: It re-ties the diluted founders and key people and is usually set up before the round, that is, at the expense of the existing shareholders.

Legal framework in the GmbH

The capital increase requires a resolution amending the articles of association with three quarters of the votes cast, notarisation and registration (Sections 53 and 55 of the German Limited Liability Companies Act, GmbHG). According to the prevailing view, the existing shareholders have a subscription right, that is, the right to take part in the increase in proportion to their shares. Its exclusion must be objectively justified. In addition there are consent requirements under the shareholders' agreement.

Existing shareholders cannot be forced out of the company this way. Shares cannot be withdrawn unilaterally; compulsory redemption (Einziehung) needs a basis in the articles of association (Section 34 GmbHG) and generally leads to compensation. The lever of the cramdown is dilution through new shares. In a restructuring situation, the shareholders' duty of loyalty can, in an individual case, prevent a shareholder from blocking a sensible restructuring supported by a majority without reason; the threshold for this is high.

Cramdown in an insolvency plan and a restructuring plan

Insolvency plan under Section 245 InsO

The insolvency plan is a statutory alternative to break-up in insolvency proceedings, with which the company can be restructured and continued. The parties vote on it in groups, such as secured and unsecured creditors and, if their rights are included, the shareholders. Creditor groups approve by a majority of heads and of claim amounts, the group of shareholders by a majority of the holdings. If a group refuses its consent, it is nevertheless deemed given under Section 245 InsO (prohibition of obstruction) if

• the group is not expected to be worse off under the plan than it would be without a plan,
• it participates appropriately in the economic value that is to flow to the parties under the plan, and
• the majority of the voting groups has approved.

Since 2012 the plan can also interfere with shareholder rights, for example through a capital reduction, a capital increase and the conversion of claims into shares (Section 225a InsO). Shareholders can thus be outvoted, whereas a creditor does not become a shareholder against its will. The plan requires confirmation by the insolvency court.

Restructuring plan under the StaRUG

Since 2021 the StaRUG has made restructuring possible outside insolvency proceedings on the basis of a restructuring plan. The prerequisite is threatened illiquidity (drohende Zahlungsunfähigkeit, Section 18 InsO); where the company is already insolvent, insolvency proceedings generally remain the only route. Those affected by the plan, that is, the creditors and, where applicable, shareholders whose rights the plan interferes with, vote in groups; in each group three quarters of the voting rights are required. The cross-class majority decision under Section 26 StaRUG is tied to the same three conditions and requires court confirmation of the plan. Shareholder rights can also be included here.

Worked example: cramdown round with a two-times preference

A GmbH has 100,000 shares on a fully diluted basis. The founders hold 60,000 (60%), the Series A 40,000 (40%). The Series A invested EUR 12 million at EUR 300 per share, that is, at a post-money valuation of EUR 30 million, and holds a simple preference that is credited against its share of the proceeds. Liquid funds last another three months. A new investor offers EUR 5 million at a pre-money valuation of EUR 5 million, including a new management programme of 10% after the round. It demands a two-times preference with seniority and a waiver by the Series A of its anti-dilution protection.

• Shares after the round: The existing 100,000 shares correspond to 40% (100% minus 50% for the investor minus 10% for the programme). There are therefore 250,000 shares in total, of which 125,000 for the investor and 25,000 for the programme.
• Price per share: EUR 5,000,000 / 125,000 = EUR 40 instead of EUR 300, a discount of about 87%. Of the pre-money valuation, EUR 4 million is attributable to the existing shares and EUR 1 million to the programme.
• Stakes after the round: founders 24%, Series A 16%, programme 10%, new investor 50%.
• Preferences: EUR 10 million for the new investor plus EUR 12 million for the Series A, EUR 22 million in total against a post-money valuation of EUR 10 million.
• Sale for EUR 20 million: The new investor receives EUR 10 million, the Series A the remaining EUR 10 million, the founders and the programme nothing. Only above EUR 22 million do the proceeds reach the common shares.
• Without the waiver: A full ratchet would have entitled the Series A to 12,000,000 / 40 = 300,000 shares, that is, 260,000 compensation shares. Of then 510,000 shares, the Series A would hold about 59%, the new investor only about 25% instead of 50%. The round would not come about on these terms.

The notional value of the founders' shares falls from EUR 18 million (60% of EUR 30 million) to EUR 2.4 million (24% of EUR 10 million). In a sale, the founders receive something only once the proceeds exceed the preferences of EUR 22 million in total. The round thus secures the continued existence of the company but shifts the economic value largely to the investors.

Negotiating practice and alternatives to a cramdown

A cramdown is often the consequence of a financing begun too late. Before it is accepted, the alternatives should be examined. These include a bridge by the existing investors (bridge round), growth loans from specialised lenders (venture debt), a sale of the company or a procedure under the StaRUG. If the round is unavoidable, the multiple and ranking of the new preference, the size and vesting of the management programme and a subscription right of the existing shareholders at the new price remain negotiable.

If the new investor acquires more than half of the shares within five years, unused tax losses are in principle forfeited under Section 8c of the German Corporate Income Tax Act (KStG). Whether Section 8d KStG or another exception helps must be clarified before the resolution. The management's duty to file for insolvency (Section 15a InsO) continues unchanged during the negotiations.

Distinction: cramdown, down round and recapitalisation

• Down round: any round at a lower price per share than the previous one. The cramdown is its most drastic form.
• Recapitalisation: the umbrella term for restructuring the capital structure. A cramdown can be part of it, for example when the preferences are reorganised at the same time.
• Dilution: the dilution that results from any capital increase without one's own participation. In a cramdown it is particularly high because of the sharply reduced price.

Common mistakes

• Financing begun too late. If liquidity lasts only a few more months, alternatives are lacking, and price and terms are set by the new investor alone.
• Contractual rights not checked in advance. Anti-dilution protection, consent requirements and subscription rights determine who can block the round or demand compensation.
• Subscription right excluded without objective reason. The capital increase resolution thereby becomes open to challenge and delays the round.
• Tax consequences overlooked. An acquisition of a majority can cause loss carry-forwards to lapse that had been planned in the financial model as future tax relief.
• Management programme without retention effect. Without vesting and leaver rules, a new programme does not secure the continued presence of key people.

Frequently asked questions

Is a cramdown in a GmbH possible against the founders' will?

Only if the other shareholders reach three quarters of the votes cast and no contractual consent rights of the founders stand in the way. If the founders hold more than a quarter of the votes cast, they can prevent the capital increase; in a restructuring situation, the duty of loyalty can limit this blockade in an individual case.

How does a cramdown differ from a down round?

In degree and in terms. A down round lowers the price per share; a cramdown combines a steep price discount with new senior preferences, the waiver of protective rights and a reorganisation of the holdings at the expense of the existing shareholders.

Can shareholders be outvoted in an insolvency plan?

Yes. If their shareholder rights are included in the plan, they form a group of their own whose missing consent can be replaced under Section 245 InsO. The plan can then interfere with their holding, for example through a capital reduction and the issue of new shares to creditors or new investors.

What does cramdown mean in US insolvency law under Chapter 11?

In US insolvency law, Chapter 11 of the Bankruptcy Code allows the court to confirm a reorganisation plan over the objection of a dissenting class of creditors. Among other things, it is required that at least one impaired class has accepted and that the plan treats the dissenting class fairly and equitably (fair and equitable). This includes the absolute priority rule: junior classes, such as the shareholders, may in principle keep nothing as long as the dissenting senior class has not been paid in full. Section 245 InsO and Section 26 StaRUG pursue the same purpose.

What majority applies in a restructuring plan under the StaRUG?

In each group, three quarters of the voting rights. If this majority is missed in a group, the court can nevertheless confirm the plan under the conditions of the cross-class majority decision.

The Roemer Capital view

The most effective protection against a cramdown is sufficient lead time. A financing round typically takes 6 to 8 months. Roemer Capital therefore advises starting the process when there is a runway of 12 to 18 months, so that negotiations are not conducted under the pressure of tight liquidity.

If a round at a sharply reduced valuation can no longer be avoided, Roemer Capital calculates for founders and existing shareholders what the proposed terms mean in different sale scenarios. It also takes part in negotiating the economic parameters. Insolvency and company law questions, for example on filing duties or the exclusion of subscription rights, are clarified by the company's law firm.