Participation Agreement

What is a participation agreement?

Participation agreement (German: Beteiligungsvertrag, often called an investment agreement in English) refers to the contract in which an investor undertakes to take up new shares in a company against payment. The company and the existing shareholders commit in it to the steps required for this. For a GmbH (German limited liability company), it governs above all the capital increase, that is, the creation of new shares (Geschäftsanteile), and their take-up by the investor. In addition come the additional payment beyond the nominal amount, warranties on the condition of the company and closing, that is, the point in time at which money and shares actually change hands.

The parties to the contract are the company, its existing shareholders, that is, founders and earlier investors, and the new investors. The contract implements the economic key terms of the term sheet in binding form. Together with the shareholders' agreement, the amended articles of association and the capital increase resolution, it forms the contract package of the round, for which the collective term investment agreement (Investitionsvertrag) has become established. The participation agreement and the shareholders' agreement are sometimes combined in one deed. Outside funding rounds, the contract on a silent partnership, for example in a sole proprietorship, is also called a participation agreement; no shares arise in that case.

Participation agreement, shareholders' agreement and articles of association

The participation agreement governs the investor's entry, the shareholders' agreement the relationship of the shareholders afterwards. The differences show in term, parties and effect:

• Participation agreement: a contract relating to the entry. Its main obligations are fulfilled on closing; what continues to operate are above all warranties, liability rules and instalments still outstanding (tranches).
• Shareholders' agreement: a long-term contract of all shareholders on consent requirements, advisory board, rights of first refusal and tag-along rights, vesting (gradual earning of the founders' shares), leaver rules for early departure, distribution of proceeds and anti-dilution protection. It binds only its parties; future shareholders must accede to it.
• Articles of association: the constitutive contract of the GmbH and thus its basic order. It operates for and against all future shareholders and can be inspected by anyone in the commercial register. Confidential provisions are therefore usually in the shareholders' agreement.

Content of the participation agreement

Capital increase and take-up

The existing shareholders undertake to vote for the capital increase and to admit only the investor to take up the new shares. At the same time, they waive any subscription right, that is, the right to take up new shares themselves in proportion to their holding. The resolution requires a majority of three quarters of the votes cast and notarisation (Section 53(2) of the German Limited Liability Companies Act (GmbHG)). The investor undertakes to take up the shares; under Section 55(1) GmbHG, its declaration of take-up requires notarisation or notarial certification.

The nominal amount of each new share must be in whole euros, that is, at least EUR 1 (Section 5(2) and Section 55(4) GmbHG). Growth companies usually form their shares at EUR 1 each. Before registration in the commercial register, at least one quarter of the nominal amount of each new share must be paid in (Section 56a in conjunction with Section 7(2) GmbHG). In funding rounds, the nominal amount is generally paid in full immediately.

Additional payment into the capital reserve

The largest part of the investment amount is usually a contractual additional payment, that is, a payment obligation arising solely from this contract. It is allocated to the capital reserve as another additional payment under Section 272(2) no. 4 of the German Commercial Code (Handelsgesetzbuch, HGB). The participation agreement sets the amount, due date and conditions: the additional payment can fall due at closing, after registration of the capital increase or in tranches tied to milestones. Because it is not part of the contribution on the nominal amount, such conditions do not affect the capital increase itself. If, by contrast, the premium is fixed in the capital increase resolution (Section 272(2) no. 1 HGB), it belongs to the company-law contribution obligation, and tranches are harder to structure.

Warranties and liability

The company and often the founders as well warrant the legal and economic circumstances of the company. Warranties are given on, for example, proper formation and capital contribution, ownership of the shares, annual financial statements, rights in software and trademarks, material contracts, employment relationships, taxes and litigation. Legally, these are regularly independent warranty promises whose conditions and legal consequences the contract fixes conclusively. Exceptions are recorded in a disclosure schedule (disclosure schedules); what is disclosed there generally gives rise to no claim.

Payments by the company to a shareholder are restricted: assets needed to cover the share capital may not be paid out to shareholders (maintenance of capital, Section 30(1) GmbHG). Participation agreements therefore often provide that claims against the company are settled primarily by issuing additional shares to the investor at the nominal amount. The founders' liability is limited in practice: by de minimis thresholds below which there is no claim, a liability ceiling (liability cap) and separate limitation periods.

Closing

Signature (signing) and closing can coincide or be apart. In the second case, conditions to closing must first be met (closing conditions). These include, for example, clearance in merger control or investment screening, new managing director contracts, the transfer of a founder's intellectual property rights to the company or the consent of third parties. The investor then pays in the nominal amount, the managing directors register the capital increase with the commercial register (Section 57 GmbHG), and with registration it becomes effective. If the conditions are not met by an agreed cut-off date, the contract provides for rights of withdrawal.

Notarisation of the participation agreement

The capital increase resolution is an amendment to the articles of association and must therefore be notarised (Section 53(2) GmbHG). For the participation agreement itself, the notarisation requirement follows above all from obligations to transfer shares (Section 15(4) GmbHG). It and the shareholders' agreement regularly contain such obligations, for example as drag-along obligations, rights of first refusal or retransfers under leaver rules. The formal requirement in principle covers all arrangements that form a single transaction with an obligation requiring form. Side agreements that are not notarised therefore endanger the validity of the contract. In practice, the resolution, declaration of take-up, participation agreement and shareholders' agreement are notarised in one notary appointment.

The notary reads out the deed including its annexes (Section 13 of the German Notarisation Act (Beurkundungsgesetz, BeurkG)). Extensive annexes can be moved to a reference deed drawn up in advance, to which the main deed refers; they then do not need to be read out again (Section 13a BeurkG). Notary costs are governed by the German Court and Notary Fees Act (Gerichts- und Notarkostengesetz) and rise with the transaction value.

Practical example: participation agreement for a Series A with two tranches

A software GmbH with 50,000 shares of EUR 1 each concludes a Series A of EUR 5 million with a leading investor (lead investor). A price of EUR 400 per share is agreed, which corresponds to a pre-money valuation of 50,000 × EUR 400 = EUR 20 million. The participation agreement provides for:

• Capital increase: EUR 5 million / EUR 400 = 12,500 new shares; share capital rises from EUR 50,000 to EUR 62,500, the investor's stake is 12,500 / 62,500 = 20%
• First tranche at closing: EUR 12,500 nominal amount and 12,500 × EUR 199 = EUR 2,487,500 additional payment, together EUR 2.5 million
• Second tranche: EUR 2.5 million as a pure additional payment into the capital reserve, due if a contractually defined revenue target is reached within twelve months
• Warranties by the company and the two founders; the founders' liability limited to EUR 100,000 each, de minimis threshold EUR 20,000 per individual claim, limitation period 18 months after closing, longer for tax warranties
• Conditions to closing: assignment to the company of the rights in software that a founder developed before the formation, as well as new managing director contracts

If the revenue target is missed and the second tranche is not paid, the investor has, on paper, acquired its 12,500 shares at EUR 2.5 million / 12,500 = EUR 200 instead of EUR 400 per share. Whether this is compensated, for example by retransfer of part of the shares, must be expressly regulated in the participation agreement. Without such a provision, the advantage remains with the investor. The founders bear the consequences. Their stake in the share capital falls with registration to 50,000 / 62,500 = 80%, even if in the end only half of the agreed amount flows.

Distinctions: participation agreement, investment agreement and company purchase agreement

• Investment agreement: collective term for the entire contract package of the round. The participation agreement is its core for the investor's entry.
• Company purchase agreement: In the purchase of existing shares (share deal), the purchase price flows to the selling shareholders. In the participation agreement, new shares arise, and the money flows into the company.

Common mistakes

• Warranty catalogue adopted unchecked. The draft often comes from the investor's law firm. Each warranty must be reconciled with the actual position and, where necessary, restricted through disclosure.
• Disclosure started too late. A disclosure schedule that is created only in the last days before notarisation remains incomplete; what is missing remains a warranty with liability consequences.
• Founder liability without a cap. If there is no maximum amount, de minimis threshold and limitation rule, founders are personally liable to an extent that is unusual in growth financings.
• Tranches without a compensation rule. If it remains open what happens to the shares already issued when a milestone is missed, the investor acquires them at a lower effective price.
• Conditions to closing without a cut-off date. Without an end date (drop-dead date), the company remains bound for an indefinite period to a contract whose closing is not foreseeable.

Frequently asked questions

Must a participation agreement be notarised?

As a rule, yes. It contains or accompanies obligations to transfer shares and is notarised together with the capital increase resolution, which requires notarial form in any case.

Why are the existing shareholders parties?

Because their votes are needed for the capital increase and they waive their subscription right. Founders often also give their own warranties and commit to vesting and non-compete clauses.

How long does it take from term sheet to closing?

Often two to four months. Most of it goes to review and contract negotiation; registration of the capital increase after filing usually takes a few days to a few weeks.

Is there a template for a participation agreement?

Yes. Law firms, investors and specialist publishers publish templates, some free of charge, and many lead investors present their own. The warranty catalogue, tranches, liability limits and conditions to closing must, however, be tailored to the round in question.

Who bears the costs of the participation agreement?

The term sheet already regulates this. It is common for the company to bear notary costs and the investor's advisory costs up to a maximum amount at closing and for each side to bear its other costs itself.

The Roemer Capital view

With the participation agreement, we concentrate on the points with economic effect: the split between nominal amount and additional payment, tranches and their conditions, the liability limits of the warranties and the timetable to registration. For each tranche, we calculate the effective price per share in case it does not materialise. This way, a compensation rule is negotiated on the basis of numbers.

We build the disclosure schedule with the company in parallel with the review from the answers in the data room. The legal drafting of warranties and the notarisation lie with the company's law firm. Our fee agreement (Honorarvereinbarung) is already concluded by this point, because it is signed before the investment agreement.