Direct investment in German companies

Minority or majority stake: the percentage alone is not the deciding factor

A direct investment can be structured in various ways. The investor may acquire existing shares from a shareholder, take up new shares as part of a capital increase, or combine both approaches. The economic impact varies. When shares are purchased, the purchase price is generally paid to the selling shareholder. In the case of a capital increase, the company receives new equity capital for growth, acquisitions or the financing of its operating activities.

In the case of a German GmbH, the formal requirements must also be taken into account at an early stage. The transfer of shares – and indeed the mere commitment to transfer them – generally requires notarisation. The acquisition of new shares as part of a capital increase also requires a notarised or certified declaration. Shareholding agreements, shareholders’ agreements and resolutions under company law must therefore be coordinated from the outset.

Whether the investor acquires a minority or a majority stake is economically significant, but does not in itself reveal everything about their actual influence. A majority stake generally provides the ability to determine shareholders' resolutions. However, it does not mean that every decision can be taken freely. Statutory or contractual majorities, the rights of other shareholders, the duties of corporate bodies and specially protected measures may limit control. If the existing management or a family of entrepreneurs is to retain a stake, clear rules are needed regarding which decisions the majority investor can take alone and on which matters joint consent is required. However, even a minority stake can confer considerable influence.

Of particular importance are approval requirements for significant measures, a seat or observer status on an advisory or supervisory body, and regular financial, budgetary and compliance reports. In addition, rights to information and access beyond the statutory minimum standard are agreed, along with subscription and anti-dilution protection in the event of future capital measures, as well as participation rights in the appointment or dismissal of the managing director.

The package is rounded off by approval requirements for transactions with shareholders or affiliated companies, as well as rights in the event of a sale, change of control or initial public offering. The appropriate structure depends on the objective of the investment. A financial investor will primarily wish to safeguard performance, reporting and exit strategies. A strategic investor may additionally require influence over business divisions, technology, supplier relationships, sales or joint projects. An entrepreneurial family or a co-investor will often place particular emphasis on preserving operational autonomy and corporate identity.

The shareholding percentage is therefore merely the starting point. The actual influence stems from the rights attached to it.

Investment Agreement, Shareholders’ Agreement and Governance

The investment agreement governs the investor’s entry into the company. This includes, in particular, the purchase price or capital contribution, conditions precedent, warranties, indemnities and the question of when ownership of the shareholding is transferred, both economically and legally. In the case of a capital increase, the use of funds, the valuation of the company and the issue of new shares are also covered.

For the period following the closing, however, governance is crucial. It determines how shareholders, the managing director and, where applicable, an advisory or supervisory board work together and how decisions are made. In practice, these provisions are regularly set out across several documents.

The articles of association or the company’s statutes set out the basic framework under company law and are also binding on shareholders who join at a later date. The shareholders’ agreement governs the contractual relationships between the investors and shareholders involved. It may contain confidential, commercially sensitive or particularly detailed provisions. Rules of procedure set out responsibilities, approval requirements and processes for the managing director or advisory board. The participation or investment agreement governs the actual entry into the company and the completion of the investment.

These documents must not be drafted in isolation. If the articles of association, the shareholders’ agreement and the rules of procedure contradict one another, this gives rise to uncertainty and unnecessary potential for conflict. It is therefore particularly important to determine which provisions must be enshrined in company law and which are to apply purely under the law of obligations between the parties.

The key governance issues can be clearly outlined.

Composition of the governing bodies

Who appoints the management? Does the investor have the right to nominate a managing director, a member of the advisory board or an observer? What professional requirements apply, and under what conditions can a person be removed or replaced?

Reservations of consent

Certain measures should not be decided upon solely by the managing director or a majority shareholder. Typical reserved matters relate to the annual budget and the business plan, major investments or acquisitions, as well as the raising of significant financing or the provision of security. These typically also include changes to the business model, the acquisition or disposal of material assets, and the establishment, acquisition or sale of subsidiaries. Transactions with shareholders and related parties, the appointment and remuneration of the managing director, as well as capital measures, conversions and distributions, are also frequently subject to approval. Significant legal disputes or settlements complete the list.

The list should be tailored to the specific company. Approval requirements that are too restrictive can paralyse day-to-day operations. Conversely, provisions that are too broad may leave the investor with less influence than the economic significance of their shareholding would suggest. Clear thresholds, responsibilities and decision-making deadlines are advisable.

Information and reporting obligations

An investor needs reliable information in order to exercise their rights and assess the company’s performance. This typically includes monthly or quarterly reports, annual financial statements, liquidity planning, budget variances, compliance reports and information on material contracts or legal disputes. As well as the scope, the format is important. Reports should be timely, comparable and structured in such a way that they can actually serve as a basis for decision-making.

Financing and Dilution

It should be clarified at the outset how future capital requirements will be met. Will shareholders need to provide further capital? Are there subscription rights? What happens if a shareholder does not participate in a funding round? Are there anti-dilution provisions, shareholder loans or alternative financing mechanisms? Unclear provisions can quickly lead to conflicts, particularly during periods of growth or crisis. The shareholders’ agreement should therefore set out not only the current investment but also realistic future financing scenarios.

Conflicts of interest and transactions with related parties

Strategic investors, founders and family offices may maintain business relationships with the company in addition to their role as shareholders. Supply, licence, consultancy or financing agreements should therefore be concluded transparently and on arm’s-length terms. Clear rules on disclosure, abstention and approval are required to address conflicts of interest.

Deadlock and decision-making capacity

In the case of equal shareholdings or far-reaching veto rights, a deadlock may arise. A deadlock mechanism should initially provide for escalation to a higher decision-making level and allow sufficient time for a commercially viable solution. Only then can mediation procedures, purchase or sale rights, or other separation mechanisms come into play. Automatic solutions that trigger a sale immediately upon any disagreement are rarely appropriate. Good governance protects individual shareholders and safeguards the company’s ability to act.

Exit arrangements: Negotiating your future exit at the point of entry

Every investment eventually comes to an end through sale, buy-back, an initial public offering, restructuring or a split between the shareholders. The exit should therefore not be agreed only once interests have already diverged.

The starting point is often transfer restrictions. These prevent shares from being sold to an undesirable third party without consent. They include consent requirements, pre-emption rights and rights to join a sale being negotiated with a third party.

In addition, tag-along and drag-along clauses play a central role.

A tag-along right typically protects the minority shareholder. If the majority shareholder sells their stake, the minority shareholder may demand to sell their shares on the same terms. This prevents them from being forced to remain in the company with a new controlling shareholder.

A drag-along right, on the other hand, makes it possible to oblige the remaining shareholders to sell their shares as well in the event of a sale of the company. For a buyer, it is usually crucial to be able to acquire all the shares. The drag-along right can therefore increase the marketability and thus the value of the shareholding.

Both mechanisms must be precisely formulated. In particular, it must be clarified at what shareholding threshold a tag-along or drag-along is triggered, and whether all shareholdings or only proportional shareholdings are covered. Furthermore, it must be clarified what minimum conditions apply to the purchase price and consideration, and how guarantees, liability and transaction costs are to be handled. Provisions should also be made regarding whether shareholders are obliged to cooperate with due diligence, and which safeguard mechanisms apply if a shareholder blocks the completion of the transaction.

Depending on the investment structure, other exit and separation mechanisms may be appropriate. These include put and call options, repurchase rights in the event of breaches of contract, and leaver provisions for managing directors. In addition, sale processes following the expiry of a minimum holding period, IPO and reorganisation clauses, and mechanisms in the event of a permanent deadlock may be considered. Provisions regarding changes of control at the level of a shareholder may also be considered.

Valuation is particularly prone to disputes. General terms such as ‘fair market value’ or ‘reasonable market value’ are often insufficient. The agreement should specify whether an agreed multiple, an expert valuation process, a specific valuation standard or the price of a third-party offer is to be used. Equally important are the valuation date, financial ratios, net financial debt, minority discounts and the treatment of extraordinary effects. A robust exit regime provides protection not only in the event of a dispute. It also provides clarity regarding the shareholders’ financial expectations whilst the investment is ongoing and improves the company’s ability to be sold at a later date.