A Introduction

The German venture capital market is undergoing considerable changes due to the continuing effects of the financial crisis. While the statistics on the recorded break in investment volumes since 2009 have shown virtually no signs of a revitalization of the market, paradoxically there is currently a certain spirit of optimism in the Internet sector. A number of trends and structural changes are responsible for this optimism; these are reviving the market and will be discussed in more detail in the following. We will focus on how these developments will affect economically significant contractual terms and conditions in venture capital participation agreements.

B Implications of the Financial Crisis

The international financial crisis led to a significant break in buyout transactions in the private equity market in 2009. The venture capital market was also impacted by the financial crisis in the form of lower fundraising, as well as significant decreases in investments. The total VC investments in Germany in 2009 were reduced by almost half in comparison with the previous year, according to the statistics of the German Private Equity and Venture Capital Association (BVK e.V.)

In 2010, a stabilization of the market at approximately the 2009 level was observed, whereas primarily the last quarter was unusually strong for investments. This upturn initially seemed to continue in 2011 since with regard to investment volume, the first quarter significantly exceeded the last quarter of 2010. As of the third quarter 2011, however, another reduction in investments followed; the net volume of venture capital investments in Germany in 2011 was slightly less than the already low results of the previous year. Even in the course of 2012 up until now, no trend reversal can be statistically determined. In the first quarter of 2012, the figures of the positive previous quarter with regard to investment volume obviously fell short and the number of VC-financed companies again decreased. After there appeared to be an upswing at the turn of the year 2010/2011, the current figures reflect a returning instability in the market.

C Trends and Developments in the Venture Capital Market

In obvious contradiction of these figures, there are numerous announcements and reports on the developing entrepreneurial scene in Germany that is emancipating itself from the American market, particularly in Berlin. A look at the statistics could indeed mislead one to overlook the trends and developments in the German venture capital market that are currently engendering a significant market upturn and positively affecting the situation of capital-seeking startup companies.

Thereby, one should consider that the decrease in investments by institutional venture capital funds could be at least partially compensated by the participation of public or half-public investors (e.g. KfW (German development banking group), IBB Beteiligungsgesellschaft, High-Tech Gründerfonds, BayernKapital); these companies have participated as co-investors on almost every second new investment by a classic venture capital company. Concurrently, increased activities by the so-called corporate VCs have been ascertained for some time now, i.e. from venture capital companies of major enterprises that primarily execute strategic investments for the parent enterprise.

Investment companies from the media (e.g. Burda, Holtzbrinck Ventures, Bertelsmann, Axel Springer), telecommunications (e.g. T-Venture), commerce / e-commerce (e.g. Otto Group, Tengelmann Ventures, Vorwerk Ventures) and technology (e.g. Robert Bosch Venture Capital) sectors have been particularly active. An additional trend is so-called media-for-equity deals, in which advertising time is exchanged for shares in the company. In particular the broadcasting family ProSiebenSat.1 has in this way entered into many participations in German startups through the subsidiary company SevenVentures.

However, the revival of the venture capital markets has chiefly occurred due to the continually progressing professionalization and networking of the German entrepreneurial scene; thereby Berlin is currently on the point of – particularly in the Internet sector – developing into something of a European startup stronghold. The expressions of this professionalization are not only many startup events and competitions, but especially also structural changes such as the emergence of business angel networks and incubators (e.g. Rocket Internet, Project A Ventures, Team Europe Ventures, Venture Stars), which provide capital, technical infrastructure and know-how and demonstrate how quickly startups can develop and exhibit astonishing growth in such an incubator. The online distributor Zalando, founded in 2008 (and amply financed), may be named as the example of an excellent model.

D Implications for contractual terms and conditions

The previously mentioned market developments are not least also reflected in the market conditions for venture capital investments, which from the viewpoint of the entrepreneurs have not deteriorated but have rather tended to improve, defying all the statistics. This particularly applies to the economically significant contractual terms such as e.g. proceeds distribution and liquidation preferences (hereinafter I.) and clauses protecting against dilution (hereinafter II.)

I. Proceeds Distribution and Liquidation Preferences

1. Economic Context

By providing venture capital, the venture capital investor as equity capital provider assumes a significant financial risk, up to a total loss of the invested capital. At the same time, the valuation of young companies that have not yet broken even is associated with significant uncertainty. Dependent upon the agreed upon pre-money valuation, the non-monetary shareholder contributions of the entrepreneurs, who normally participate in their" company with a majority shareholding, are preferentially weighted more or less strongly vis-à-vis the financial contribution of the investor.

In case of a later exit, without a special agreement the investor would only participate in the exit proceeds in accordance with his (minority) shareholding in the company. Thereby, he runs the risk that his share of the proceeds, despite the assumption of significant financing risks, may fall short of his expectations of returns or even of his actual investment. Venture capital investors attempt to rectify this disproportionality between financing contribution on one side and participation in the economic company valuation and company success on the other side by way of proceeds distribution and liquidation preferences.

2. Definition and Functionality

Differing from the pro rata distribution according to the participation quota, liquidation preferences preferentially allocate profits in a specific amount to the venture capital investor. Modeled on the Anglo-Saxon provenance of the term liquidation preferences, one also often speaks in German of Liquidationspräferenzen". However, contrary to the suggested meaning of the term, not only the distribution of surpluses from the liquidation of the company is regulated, but also and primarily the profit distribution in case of an exit or economically similar measures. A typical example of this is the distribution of material proceeds (shares) upon contribution or conversion processes. Also the assessment of profit or dividend distributions to the shareholders is more rare but not unusual.

To secure the investment, the investor should normally receive a sum in the amount of his capital contribution, plus a certain yield if applicable, before the other shareholders participate in the distribution of the assessed proceeds. How much the proceeds preference exceeds the amount of the original investment may be negotiated and is, in particular, dependent upon the individual negotiating position of the parties, the situation and prospects of the company, as well as the economic environment. In the cases covered by the liquidation preference (sale, conversion processes, liquidation, dividend distribution if applicable), the investor is in a better position than the other shareholders, since initially only he profits from the proceeds and possibly profits in greater proportion to his participation quota. Only if the proceeds exceed his preferred claims, do the other shareholders participate in the surplus proceeds.

If multiple financing rounds with different investors take place, normally the principle last in, first out" applies to the different liquidation preferences. The investor who has most recently participated shall take precedence with the respective liquidation preference before the other preferred investors and receives his investment first, including yield. Thereby, the older investors move down a step with their" liquidation preferences with each financing round.

The result is that proceeds distribution preferences ensure that the preferential weighting of non-monetary shareholder contributions is shifted in the distribution of proceeds in favor of the monetary shareholder contributions of the investors.

3. Organization, Trends and Market Conditions

The organizational latitude for proceeds distribution preferences is conceivably broad and is primarily a negotiating point between the older shareholders and the new investors.

A significant economic question is always whether the investor, after receipt of his preferred sum in the first stage, should also be considered in the second stage in the pro rata distribution of the remaining proceeds. If this is the case, one commonly speaks of a so-called participating liquidation preference", in another case of a non-participating liquidation preference". A true non-participating liquidation preference, in which no participation by the investor occurs in the distribution of the remaining proceeds after receipt of the preference(s), is very seldom seen in VC practice in Germany, if not completely unusual.

If in practice, however, one speaks of a non-participating liquidation preference, this usually means provisions that in principle provide for participation of the investor in the pro rata proceeds distribution in the second stage, but should avoid the resulting unjustified favoritism of the investor from the viewpoint of the entrepreneurs. As of a certain amount of exit proceeds, the participation of the investor in the proceeds according to his participation quota would already cover the investment, including returns, to be secured by the proceeds distribution preference. In these cases whether and to what extent double-dipping by the investor shall be excluded contractually can be negotiated by providing that the proceeds distribution preference e.g. crediting proceeds received in a preferential stage to the proceeds amount of the investor, which is due to him based on the pro rata distribution of the proceeds remaining after distribution of the preferential amounts.

In the current market environment which, contrary to all statistics, is not at all bad from the viewpoint of the entrepreneurs, severe" participating liquidation preferences without crediting provisions are not unusual but are, however, found in the minority of participation agreements. In most cases, a form of crediting is provided for; this is often done by using clauses that provide for cancellation of proceeds distribution preferences when exit proceeds in a certain amount are achieved. This threshold value shall thereby equal the amount as of which the investor would already get back his investment (plus a certain yield or multiplied by a certain factor, if applicable) in the course of a pro rata distribution of the total proceeds.

However, severe" non-participating liquidation preferences are not observed. Even in an optimal market environment from the entrepreneurs' viewpoint, these could hardly be enforced vis-à-vis an investor, because they would contradict the intent of a liquidation preference that should only protect the investor from a bad" exit, without at the same time taking away the chances of a successful company development.

It can further be observed that multiple" liquidation preferences, according to which the investor should receive a multiple of his investment at his respective preferential stage (e.g. two or three times), have become less common. Within the scope of the common simple" liquidation preferences, however, minimum yield expectations are often secured by providing for a certain interest return – often between 5% and 20% - on the preferential amount. In conclusion, it can be said that securing the investment itself (return of investment) is currently of primary importance in stipulating liquidation preferences and the investor is less concerned with maximizing yields (return on investment).

II. Dilution Protection Clauses

1. Economic Context

Financing requirements and the valuation of young companies, until they break even or an exit takes place, often encounter significant uncertainties and prognosis difficulties. New companies often need further financial resources after the first seed financing in order to finance further growth or also to bridge liquidity shortages. Without effective access to borrowed capital, these resources are often provided in the form of additional equity capital in subsequent financing rounds. Within an investment term of five to seven years, venture capital investors often therefore take part in multiple financing rounds after assuming the initial investment.

If the pre-money valuation based on an additional financing round is below the post-money valuation of the previous financing round (so-called down round"), for the older investors this means that the new investor shall receive a relatively greater participation in the company for the same investment sum than he would have received in the previous financing round. The reason for a lower valuation could be, for example, unsatisfactory development of the company since the last financing round. It is also possible – and not rare considering the uncertainty in the valuation of young companies – that the valuation of the previous round was estimated too high due to unrealistic planning. The following financing round at a lower (but realistic) issue price does not thereby lead to an economic loss in value of the participation of the older investors. However, they would have received a greater number of shares for their investment. In order to protect the participation of the investors against this form of dilution, participation agreements often provide for dilution protection clauses.

2. Definition and Functionality

The term "dilution protection" can have a number of meanings and should therefore be defined. If within the scope of a financing round shares are issued to a new investor, the value of the participation of the older shareholders in the assets of the company are not necessarily hereby reduced (only in case of unreasonably low valuation), however in any case it lowers the percentage of participation in the original capital. The shareholders are already sufficiently protected against a reduction of their participation quota by their statutory subscription right, which bestows on them a claim to participation in a capital increase in relation to their previous participation. Preservation of the participation quota can only be legitimately requested, if a respective percentage of the new investment is also assumed. The dilution protection clauses implemented in a participation agreement pursue in principle a different goal than the statutory subscription right. They do not serve the preservation of the participation quota, but the protection of the older investors from a lower company valuation in a later financing round. The older investor takes a risk that other investors may participate in the target company in subsequent financing rounds on more economically favorable terms and thereby economically dilute their existing participation.

In order to counteract this form of capital loss, dilution protection clauses are tied in with the issue of new shares in a down round at a lower price as in the previous financing round. If the clause takes effect, the older investor has a unilateral subscription right to newly issued shares at the nominal value, without paying further premiums and, respectively, another additional payment in the capital reserves of the company. By assuming these so-called anti-dilution shares at the nominal value, the valuation difference from the previous financing round is moderated or, depending on the number of the assumed anti-dilution shares, possibly completely eliminated. How many anti-dilution shares the investor may assume depends on which respective calculation method has been agreed upon (see hereinafter 3.)

Often, dilution protection clauses are misunderstood, with the effect that, at the expense of the entrepreneurs, investors receive a general safeguard against negative value developments of the target company in the future. However, poor market acceptance falls under the original scope of risk of the venture capital investors; compensation by the entrepreneurs would contradict the participation model of "risk capital". The clauses should only protect against the uncertainties in the valuation of the company at the point in time of the investment.

3. Organization, Trends and Market Conditions

The number of anti-dilution shares to which the older investor is entitled is based on the respective calculation method agreed upon. The full ratchet method (complete compensation) represents the most desirable form of dilution protection for the investor. In this case, the investor is entitled to assume as many new anti-dilution shares at nominal value, until he has the same result as if he had acquired his existing shares at the same lower valuation as the down round. The weighted average (weighted average price) and the average methods are not so far-reaching. The price of the shares of the (initial) investor is effectively only reduced to the average price of both financing rounds. The weighted average method, contrary to the average method, also considers the volume of both financing rounds and thereby determines a weighted average price. The calculation method that is most friendly to entrepreneurs is the broad-based weighted average method (weighted average price on a wider calculation basis). In simple terms, here the calculation basis for the calculation of the average price is "broadened" by taking into account the shares of the entrepreneurs or e.g. virtual shares that were issued as part of an employee participation program. Hereby the number of anti-dilution shares is even further reduced and thereby also the protection of the investors.

Traditionally, investors protect themselves either through full ratchet or weighted average clauses. None of these methods would allow the assertion that they represent the exclusive market standard. Recently, however, a clear trend of weighted average clauses has been observed. Full ratchet clauses remain quite common, but these are increasingly replaced with provisions that apply to the weighted average price. This is also a sign that the initial position of entrepreneurs seeking capital in Germany has not fundamentally deteriorated.

The broad-based weighted average method, the most advantageous from the viewpoint of the entrepreneurs, was almost non-existent until recently but seems to be on the rise. Whether this is due to a market environment that is more advantageous for entrepreneurs is difficult to determine. If one looks more closely, the impression is imposed that this calculation method is primarily acceptable to US investors, because it was much more widespread in their territory in the past.

An additional trend that has been observed is the use of so-called pay-to-play clauses. These provide that the investor may only exercise his dilution protection right, if he participates himself to a certain extent within the scope of the new financing round (usually the amount of his existing participation quota). Through such pay-to-play clauses, the entrepreneurs' acceptance of dilution protection clauses can usually be significantly increased.

E Conclusions

Despite the statistically documented decrease in the investments by institutional venture capital funds, the German venture capital market has again proved itself to be vigorous. The increasing networking and professionalization of the entrepreneurial scene, the creation of incubators and business angel networks, the participation of public and half-public investors, as well as the increasing activities of corporate VCs have prevented a breakdown in the financing of young companies.

Even if the investment volumes since 2008 have significantly decreased, due to the mentioned structural changes the initial position for entrepreneurs seeking capital has not fundamentally deteriorated. Signs of this can also be seen in the developments in contractual terms and conditions in venture capital participation agreements. Therefore, in particular, we are able to observe in the economically important contractual terms, such as liquidation preferences and dilution protection clauses, a tendency toward more advantageous provisions for entrepreneurs.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.