Financing Rounds in Germany: Term Sheet, Convertible Loan and Investment Agreement

Understanding the term sheet

The term sheet summarises the principal commercial and legal terms of the proposed financing. It usually forms the basis for the investment agreement, shareholders' agreement, articles of association and closing documents without itself being the complete contract.

Typical terms include investment amount and funding schedule, pre-money and post-money valuation and investor ownership percentage. The term sheet also covers the size and treatment of the ESOP or VSOP pool, the liquidation preference and anti-dilution protection.

It further addresses information, control and consent rights, management or board representation and founder vesting and leaver provisions. Rights to participate in later rounds, exit, drag-along and tag-along provisions and exclusivity, confidentiality and costs belong there as well.

The signing and closing conditions complete the list.

Is a term sheet binding?

Term sheets are commonly stated to be largely non-binding. This does not mean they have no legal effect.

The following provisions are often binding: confidentiality, exclusivity or no-shop obligations and allocation of transaction costs. The same applies to governing law and jurisdiction, due diligence process provisions and occasionally specific implementation obligations.

Non-binding provisions also have strong practical effect. If a participating 1x liquidation preference has been accepted in the term sheet, it will be difficult to reopen the fundamental question of whether any preference should apply. The long-form agreements will normally develop the agreed commercial framework rather than replace it.

The term sheet should therefore not be treated as a casual expression of intent. It is the stage at which the important commercial points remain negotiable with relatively limited documentation.

Valuation and ownership

Pre-money valuation is the value immediately before the investment. Post-money valuation is generally the pre-money valuation plus the new capital.

By way of example: on a pre-money valuation of EUR 8 million and an investment of EUR 2 million, the post-money valuation is EUR 10 million. The investor's basic ownership is 20 per cent.

This calculation is correct only if no additional dilution applies.

The actual founder dilution is often affected by a new or increased employee pool created before closing, existing convertible loans and outstanding options. Multiple closings or tranches, different share classes and transaction costs economically borne by the company also have an effect.

Whether the employee pool is treated pre-money or post-money is particularly important. A pre-money top-up is economically borne mainly by the existing shareholders and may reduce the founders' percentage materially.

Before signing, the parties should prepare a fully diluted cap table. It should show at least ownership immediately before the round, ownership following the pool increase and conversion of existing instruments. It should also show ownership following closing and the distribution of proceeds at different exit values.

Liquidation preference

The liquidation preference determines the distribution of proceeds on a sale or liquidation. It may be more important economically than the investor's headline ownership percentage.

Under a non-participating 1x preference, the investor generally receives the higher of the original investment amount and the amount payable according to the ordinary ownership percentage.

Under a participating preference, the investor first receives the preference amount and then participates in the remaining proceeds. This can reduce founder proceeds materially at mid-range exit values.

The documents should address preference multiple, participating or non-participating structure and seniority between financing rounds. They should also address treatment of dividends, definition of a liquidity event and ranking of share classes.

Conversion into ordinary shares and the treatment of earn-outs, escrow and rollover consideration also belong on the list.

Waterfall calculations for several exit scenarios should therefore form part of the term sheet analysis.

Anti-dilution protection

Anti-dilution provisions protect investors where a later round takes place at a lower valuation.

Full ratchet. The original issue price is adjusted to the lower price of the new round. This may cause substantial founder dilution.

Weighted average. The adjustment reflects both the lower price and the size of the new issuance and is generally more balanced.

Customary exceptions may include employee equity within the agreed pool, strategic investments and conversion of previously disclosed instruments. They may also include acquisition consideration, corporate reorganisations and issuances approved by the relevant investor majority.

Anti-dilution is different from a participation or pre-emption right. A participation right permits the investor to invest in the next round. Anti-dilution adjusts the economic position following a down round.

Governance and investor rights

Investors commonly require rights beyond their percentage ownership, including consent rights over budgets, financing and major investments, approval of acquisitions and disposals and involvement in appointing management. They also commonly require board or observer rights, regular financial and KPI reporting and access and information rights.

Consent to new share issues and controls over related-party transactions complete the package.

Reserved matters should contain appropriate thresholds and reflect the company's stage. Thresholds that are too low may slow ordinary business. Broad drafting may give the investor an effective veto over day-to-day management.

Convertible loan or equity round?

A convertible loan initially provides debt funding that is intended to convert into shares on defined terms. It is commonly used as bridge financing before a larger equity round or to extend runway quickly.

A full equity round immediately results in a capital increase or share transfer. Valuation, ownership and shareholder rights are fixed at closing.

With a convertible loan, the valuation is usually deferred to a later round. If simply structured, it is generally faster to implement, but investor rights remain limited before conversion and there is no immediate direct ownership in the cap table. Legally it remains a loan until conversion. Whether notarisation is required depends on the conversion mechanics. The main risk lies in uncertain future dilution and maturity.

An equity round fixes the valuation at signing or closing. It involves broader documentation and a notarial process, but investor rights apply immediately and dilution occurs at once. Economically the investment is equity without an ordinary repayment claim. The capital increase and share issue generally require notarisation. The additional work buys a clearer ownership structure.

Typical convertible loan terms

A robust agreement should address principal and funding, term and maturity and interest. Added to these are the qualified financing trigger, the discount and the valuation cap.

The agreement further needs to cover mandatory or optional conversion, treatment of an exit before conversion and insolvency and liquidation. Subordination, information rights and most-favoured-nation protection belong there as well.

Consent matters, costs and taxes and the notarial implementation of conversion complete the list.

Discount and valuation cap

The discount allows the lender to convert at a lower price than the new investor. A 20 per cent discount means that the conversion price is reduced accordingly.

The valuation cap limits the valuation used for conversion. If the next round valuation increases substantially, the cap may give the lender more shares than the discount alone.

The documents must define whether the more favourable mechanism applies and how employee pool increases, other convertible instruments and transaction costs are treated. Without a fully diluted calculation, the founders' eventual percentage may differ significantly from expectations.

When may notarisation be required?

A convertible loan is not necessarily free of form merely because it starts as debt. Where it already creates a binding obligation to acquire, transfer or subscribe for GmbH shares, section 15 (4) GmbHG may require notarisation.

The analysis depends on the drafting, in particular automatic conversion, binding subscription obligations and obligations of existing shareholders to transfer shares. Predefined capital measures and powers of attorney for implementation matter as well.

A future intention to negotiate is different from an existing binding transfer or acquisition obligation. The form requirements should therefore be reviewed before signing. An invalid conversion obligation undermines the central purpose of the instrument.

When is a convertible loan suitable?

It is often suitable where funding is required quickly, a larger round is realistically expected or valuation is currently difficult. The same applies where existing investors are providing bridge funding or initial transaction costs should be limited.

It may be less suitable where the timing of the next round is uncertain, the company could not repay at maturity or several instruments create an unmanageable conversion. The same applies where governance needs to be settled immediately or the cap and discount make dilution difficult to predict.

Alternative instruments

SAFE-inspired and other equity-like instruments are also used in Germany. Their title does not determine their legal effect.

The following require analysis: repayment rights, ranking and insolvency treatment and conversion mechanics. Corporate form requirements, accounting and tax classification and exit and liquidation treatment need the same scrutiny.

A US SAFE form should not be used without adaptation to German corporate, insolvency and tax law.

Investment and shareholders' agreements

A German equity financing typically consists of coordinated documents including term sheet, investment agreement and shareholders' agreement. The amended articles of association, the capital increase resolutions and the subscription declarations come with them.

Depending on the round, management or board rules, the employee participation plan and the warranties and disclosure letter are added. The closing and commercial register documents complete the set.

Investment agreement

The investment agreement governs the investor's entry.

Typical provisions include investment amount and capital measure, closing conditions and company and, where applicable, founder warranties. The agreement also governs disclosure, indemnities and use of proceeds.

Tranches and milestones, costs and liability limitations follow. The closing mechanics complete the picture.

Founder warranties should distinguish between knowledge-qualified statements, objective warranties and operational undertakings. Personal founder liability should not arise incidentally from a standard warranty schedule. Caps, thresholds, limitation periods and exclusions require express negotiation.

Shareholders' agreement

The shareholders' agreement governs the relationship following closing, including governance and reserved matters, information and reporting and appointment of management and board members. It further covers founder vesting and leaver provisions, transfer restrictions and pre-emption and participation rights.

Further building blocks are the liquidation preference and share classes, anti-dilution protection and drag-along and tag-along. Exit and IPO provisions, confidentiality and non-compete covenants and deadlock and dispute resolution also have their place here.

Finally, the agreement governs its term and the accession of new shareholders.

Provisions creating an obligation to transfer or acquire GmbH shares may require notarisation. This frequently concerns vesting, call options, drag-along and tender obligations. The articles and shareholders' agreement must therefore be aligned both commercially and formally.

Founder vesting

Investors often require reverse vesting. The founders already hold their shares but may have to transfer the unvested portion if they leave early.

The documents should address vesting commencement, period and cliff and monthly, quarterly or annual vesting. They should also address good, bad and possibly grey leaver categories, repurchase price for vested and unvested shares and illness, death, permanent incapacity and parental leave.

Removal or termination by the company, acceleration on an exit and the notarial form of transfer obligations belong there as well.

Bad-leaver treatment should be limited to clearly defined serious misconduct. Treating every resignation as bad leaver without distinction may be disproportionate and undermine retention.

Rights in later rounds

Investors often receive pro-rata or super-pro-rata rights allowing them to maintain or increase their ownership.

Founders should consider whether the rights restrict the admission of new strategic investors, minimum ownership thresholds and whether unused rights are reallocated. They should also consider exclusions for employee or acquisition shares and duration of the rights.

Signing and closing for a German GmbH

A GmbH capital increase generally requires a notarised shareholder resolution. Subscription for new shares must be declared in the required form, followed by commercial register filings and an updated shareholder list.

Signing and funding may occur at different times.

Common conditions include completion of due diligence, notarial capital measures and payment of the investment. Customary further conditions are accession to the shareholders' agreement, assignment of IP to the company and execution or amendment of management and employment agreements.

Where relevant, the creation of the employee pool and regulatory or investment-control clearances are added.

The company should plan liquidity until the funds are actually available. Signed financing documents do not themselves provide cash.

Glossary of key financing terms

The pre-money valuation is the value of the company immediately before the investment.

The post-money valuation is the value after the new investment has been added.

The fully diluted cap table shows the ownership structure including all options, pools and convertible instruments.

A liquidation preference gives specified investors a preferential share of the proceeds on an exit or liquidation.

With a participating preference, the investor first receives the preference and then also participates in the distribution of the balance.

Vesting means the time- or performance-based earning of founder or employee rights.

The cliff is the initial period before any rights generally vest.

Good leaver describes a departure without serious misconduct, bad leaver a departure due to narrowly defined serious breaches.

Anti-dilution protection adjusts the investor's position where a later financing takes place at a lower valuation.

A pro-rata right allows an investor to take part in later rounds and maintain its percentage.

Reserved matters are actions requiring the approval of the investor or a qualified majority.

A drag-along obliges shareholders to sell in a qualifying company sale. A tag-along gives the right to sell on the same terms when another shareholder sells.

The valuation cap sets a maximum valuation for the conversion of a loan, while the discount grants a reduction from the price paid in the next round.

A qualified financing is a round that meets defined criteria and triggers conversion.

The runway is the period for which the available liquidity covers expected expenditure.

Before signing a term sheet, founders should have at least a fully diluted cap table, exit waterfall calculations at different values and a list of investor vetoes. They should also have a conversion calculation for existing instruments and a realistic signing and closing timetable.