What makes a sustainable and resilient start-up and venture ecosystem? If you ask three different venture capital firms in three different European countries including the UK, you will get a different perspective. But one thing everyone will agree on is that 2018 was a record-breaking year for VC funding in Europe, surpassing €20 billion according to Pitchbook.
The deals were not concentrated in just a few big unicorns but spread across all types of transactions. And alongside the trend of larger seed and Series A rounds and the unprecedented growth of Fintech across Europe, the state of the European start-up and venture market is vigorous.
With the UK and Ireland still leading the pack in 2018, Germany came out in full force leading the way for both start-ups and investors in the DACH region. In 2018, Germany secured around €1.6 billion in commitments coming in third for fundraising behind the UK and France. German VC investors also achieved the most significant amount of capital in one quarter (Q3 2018) coming in at €700 million, which was attributed to a new €350 million fund by Munich-based Digital+ Partners.
Earlier this year, the Financial Times came out with their third annual list of Europe’s fastest growing companies and Germany had 24 startups on the list, 20 more than 2018 coming in fourth behind London, Paris and Milan. In 2003, the mayor of Berlin described the city as ‘poor but sexy’, but today, 16 years later, the city has a robust employment market anchored by a healthy startup ecosystem that raised €4.4 billion in VC funding in last year alone.
So what makes the Germany startup ecosystem so strong? Soft factors, including an affordable cost of living attracting, an international workforce, as well as financial factors both play a role. Some experts attribute the strength to the decentralisation of the German start-up market which has active regional hubs in Munich, Hamburg and Frankfurt, which is unlike the UK and France. Then there is the power of Berlin-based tech investor Rocket Internet, which has built and backed many of the tech success stories in the German market. Ex-Rocket entrepreneurs founded 10 out of the largest 22 non-Rocket backed start-ups in Germany.
The biggest winners coming out of Germany in 2017 were Delivery Hero with €989 million; Auto1, a used car portal with €360 million; Rocket Internet spin out, HelloFresh with €268 million; and Soundcloud raising €143 million in emergency funds. Investments took safe bets in e-commerce and B2B over emerging technology like blockchain and artificial intelligence.
But when we get down to the business of financing rounds, while there are common elements across Europe that underpin a healthy market, there are several factors that are unique to each country. Here’s a look at some of the key differences I have observed between ventures deals in the UK and Germany, focusing on the transaction documents, the deal terms and the role of tax incentives.
In the UK we have well-established market standard precedent documents published by the British Venture Capital Association, which are used as a benchmark on most early-stage deals. In Germany, there is no equivalent set of documents, though they are emerging and some German law firms have published their template documents for use on the broader market.
For the most part, the standard documentation for a UK financing round is the same as in Germany. There is however quite a big difference in the form of these documents. Most of the critical provisions that are included in the articles of association in the UK, including pre-emption and transfer provisions, founder vesting, drag, tag, anti-dilution and liquidation preference, Germany would include in the shareholders’ agreement.
By having all of our operative provisions in the articles, such terms apply to all members of a UK company (and not just those that are a party to the shareholders’ agreement) by operation of law. Thus the company and all of its members can sue and be sued under them. One key advantage of this is in the context of remedies; whilst a breach of a shareholders' agreement gives rise to contractual remedies (usually damages which can be challenging to quantify), an act in breach of the articles is, as a general rule, viewed as invalid.
So the remedies for breach of articles may be more effective than those available for breach of the shareholders' agreement and arguably serve as better protection for minority shareholders.
In Germany, start-up companies must have a management board to run daily operations and to represent the company, and most start-ups also establish an advisory board to advise and supervise the management board. Leading investors will often have the right to be appointed to the advisory board. The financing documentation usually contains rules of procedure (concerning the establishment, composition and powers) for both and include veto rights over crucial company decisions, like in the UK.
In the UK private limited companies only have one board of directors responsible for the day to day management of the company, and it is to this board that major investors may be afforded the right of representation.
Arguably the UK's one tier approach is better for investors looking to play an active role in the investee company’s business, because in Germany if you are a member of the advisory board, you are likely to have fewer information rights than at management level. There is, therefore, a risk that you are not privy to all decision making.
On the other hand, membership of the advisory board is not governed by statutory regulation and so does not impose fiduciary duties on its members. This means membership is more flexible with less exposure to liability. From the company’s perspective, if the advisory board functions according to design, it should be to its benefit to have an independent body able to share their views on the decision making of the company in a neutral and unbiased way.
Pooling of minority investors
The concept of a voting trust or pooling arrangement for minority investors is relatively rare in the UK but a regular practice in Germany.
In Germany, it is standard for minority shareholders to enter into a pooling agreement with a designated investor acting as their pool leader. This means that minority investors are required to pool their voting and other shareholder rights and, if the power of attorney is sufficiently broad, ensures that all minority shareholders speak with one voice.
It serves a function both administratively and in terms of voting power and might also serve to stonewall potentially problematic minority shareholders. In the UK, when exercising votes in general meeting, the general principle is that shareholders are free to vote based on their interests and do not have to have regard to the interests of other shareholders or the company. Perhaps, therefore, the pooling arrangement is seen by shareholders of UK companies as a limitation on their rights to vote freely, especially if it requires them to enter into an irrevocable proxy in favour of the trustee or pool leader. What is more common in the UK is the use of a nominee company to ring-fence a particular group of shareholders, particularly in the context of crowdfunding rounds. In this scenario, you might see a nominee company holding shares on behalf of numerous individuals with the power to vote on their behalf.
VC investors in Germany expect representations and warranties from the founders and the company as well as certain limited representations and warranties from any existing shareholders.
In the UK we avoid giving representations, and it is customary for warranties to be given by the founders and the company. Increasingly we also see company-only warranties (following a US approach) particularly in later rounds in which the founders bear less risk.
The primary reason why representations are not offered in the UK is the significant difference in the remedies available for misrepresentation. These are the rescission of the contract and/or damages calculated in accordance with a tortious claim. So whereas for breach of warranty the investor is only entitled to claim damages in respect of any proven loss in value of their shares, for breach of representation, the investor is entitled to compensation which puts it in the position it would have been in had it not entered into the contract in the first place. The measure of damages is, therefore, broader and far harder to quantify.
The primary remedy in UK and German VC transactions is damages for breach of contract in the form of cash payment. However, in Germany, there are various alternative forms of compensation that you do not find in the UK. These include a capital increase (where you reduce the pre-money valuation of the company by an amount equal to the loss suffered, and then issue new shares to put the investor who has suffered the loss in the position they would have been in had they invested on the basis of the pre-money reduced valuation), a transfer of shares by the existing shareholders or the founders in breach, or a redemption of shares.
Paying up the investment
Investments in a German start-up GmbH are implemented through a share capital increase where new shares are created and subscribed for against payment of their nominal value. The investors then undertake to pay the ‘bulk of the investment’, which we tend to refer to in the UK as the share premium, after the registration of the share capital increase at the German registrar, which can take up to 2 weeks. This is usually made by payment of additional cash into the company's capital reserves, but investors may also contribute an existing convertible loan or undertake to provide certain services, including media services (such as advertising at discounted rates).
We do not have the same filing requirements in the UK when it comes to increasing share capital, and so nominal value and share premium are paid up as one; rarely is any differentiation made between them in the documents.
The time lag in Germany, to account for registration of shares with the German registrar, explains why German investment agreements state that the obligations of the investors to pay up their investment is made vis-a-vis the investors and the existing shareholders, and expressly not vis-à-vis the company. We do not have wording of this kind in a UK investment agreement. This ring-fencing of liability protects investors from a situation where the company goes bust, and an insolvency administrator tries to request fulfilment of their additional payment contributions. As the company does not have any claim for payment in its own right, neither does the administrator.
There is a significant discrepancy between the UK and Germany in terms of the operation of VC and business angel tax incentive schemes. In 2017, the European Commission reported that the UK operates six distinct schemes to incentivise investment activity, which is the highest number of schemes operate by an EU member next to France. These six schemes are as follows, though rarely do we see the final three listed here on a deal:
- Seed Enterprise Investment Scheme (SEIS)
- Enterprise Investment Scheme (EIS)
- Venture Capital Trust (VCT)
- Social Investment Tax Relief
- Private Placement Withholding Tax Exemption
- Business Property Relief
Germany has one scheme which is known as INVEST – Venture Capital Grant. This is similar to VCT in the UK except that, while both offer relief on the amount invested and income received, VCT also offers relief on disposal.
The SEIS, EIS and VCT schemes are among the five highest ranking tax incentive schemes operated in the EU, Australia, the USA and Japan. This list also includes Germany’s INVEST. In each of these, there are extensive eligibility requirements that must be met by the company and investor under each scheme. For SEIS and EIS these include a prohibition on pre-arranged exit mechanisms (which would de-risk the investment), a minimum three year holding period (any disposal in that time would result in relief being clawed back) and maximum investment value.
In the UK, taxes are the most important macroeconomic variable in the investment decision of business angels. In Germany, taxes play only a relatively minor role in an investor's decision to invest.
This means that we, as VC lawyers in London, must have a good level of understanding of the EIS, SEIS and VCT schemes in our work, so that we are able to identify any areas of risk and/or where a client might fall foul of these rules and to advise our clients to seek appropriate tax advice.
In terms of the long-term impact of tax incentives on investee companies, for example, concerning their growth or profitability, there does not appear to be any clear evidence of this and views in the industry are mixed. So, for now, I think it is safe to say that these tax reliefs continue to play the most critical role at the start of a company’s life, helping to ‘de-risk’ an investment and thereby provide access to capital that the company might not otherwise have had.
The previous overview of nuances of VC backed financing rounds in the UK and Germany reveals that perhaps unsurprisingly, there are more similarities than differences between the two approaches. This explains the continued appeal of these jurisdictions to international investors who are looking for commonality in terms of the agreements and structures as well as the flexibility to accommodate their particular interests.
Looking ahead and to the UK's impending departure from the EU, London is still predicted to remain the VC capital of Europe. It may, however, provide an opportunity for Germany to capitalise on the loss of certain comparative advantages, including, for example, the UK's access to talent.
The end of freedom of movement will upset London's continued ability to recruit highly skilled tech talent from across Europe, which has played a vital role in the success of its tech sector to date. Germany might also consider adopting some of the more free-wheeling tax incentives that characterise the UK system to increase investor appetite. Whatever may happen, VC funding levels in Europe are only expected to grow, demonstrating that Europe is a place where ambitious international start-ups can thrive.