Fundraising rounds in Germany: Understanding term sheets, convertible loans and share purchase agreements

Understanding the Term Sheet

The term sheet summarises the key financial and legal terms of the planned funding round. It usually forms the basis for negotiations on the investment agreement, shareholders’ agreement, articles of association and other closing documents, without itself constituting a complete contract.

Typical contents include the investment amount with a payment schedule, the pre-money and post-money valuations, and the investor’s equity stake. It also sets out the size and treatment of the ESOP or VSOP pool, liquidation preferences and anti-dilution provisions.

In addition, it covers information, control and approval rights; the appointment of managing directors, an advisory board or supervisory body; and vesting and leaver rules for the founders. Subscription rights and participation in subsequent funding rounds, exit, drag-along and tag-along provisions, as well as exclusivity, confidentiality and the allocation of costs, are also included in the term sheet.

The terms sheet concludes with the conditions for signing and closing.

Is a term sheet binding?

Term sheets are often expressly described as largely non-binding. However, this does not mean that they have no legal effect.

Confidentiality, exclusivity or ‘no-shop’ obligations, and the allocation of costs are regularly made binding. The same applies to the applicable law and place of jurisdiction, procedural rules for due diligence, and occasionally individual obligations relating to completion.

Even non-binding provisions have a significant de facto binding effect. If, for example, a 1x participating liquidation preference is accepted in the term sheet, it will be virtually impossible later on to revert to the question of whether any preference should apply at all. The detailed contract then usually serves only to set out the economic framework that has already been established.

The term sheet should therefore not be treated as a non-binding letter of intent. It is the stage at which the key economic decisions can still be negotiated with relatively little administrative effort.

Valuation and Equity Stake

The pre-money valuation refers to the company’s value immediately prior to the investment. The post-money valuation is generally calculated as the pre-money valuation plus the new capital. With a pre-money valuation of €8 million and an investment of €2 million, the post-money valuation is €10 million. The investor holds a 20 per cent stake on paper. This simple calculation is only correct if no other factors need to be taken into account.

In practice, three factors in particular affect the actual dilution experienced by existing shareholders: an equity pool newly created or increased prior to closing; existing convertible loans or other convertible instruments; and outstanding options. Other factors that have an impact include multiple closings or tranches, different share classes, as well as transaction costs and other amounts borne by the company. Of particular relevance is the question of whether an equity pool is treated on a pre-money or post-money basis. If the pool is created prior to the investment, the existing shareholders bear the dilution economically almost entirely on their own. A seemingly minor difference in the term sheet can therefore significantly alter the founders’ stake.

Before signing, a fully diluted cap table should be drawn up for illustrative purposes. This should at least reflect the shareholdings immediately prior to the round, the shareholdings following a top-up of the pool, and the conversion of existing instruments. It should also include the ownership structure following closing and the distribution of proceeds at various exit valuations.

Liquidation preference

Liquidation preference determines how exit proceeds are distributed between investors and other shareholders. It can be of greater economic importance than the nominal ownership stake. In the case of a non-participating 1x preference, the investor generally receives the higher of their original investment and the proceeds to which they would be entitled based on their ownership stake.

In the case of a participating preference, the investor first receives the preference amount and then also participates in the distribution of the remaining proceeds. This structure can significantly reduce the founders’ proceeds, particularly for medium-sized exit values.

Among other things, the multiple, the question of whether the preference is participating or non-participating, and whether there is simple or cumulative priority across multiple rounds must be clarified. The treatment of dividends, the definition of a liquidity event and the ranking of share classes must also be regulated. The conversion of preference rights into ordinary shares and the treatment of earn-outs, escrow and rollovers should also be included on the list. A sample calculation for several exit scenarios should therefore form part of the financial review of the term sheet.

Anti-dilution protection

Anti-dilution clauses protect investors if a subsequent funding round takes place at a lower valuation. The main distinctions to be made here are: Full Ratchet. The original issue price is treated as if the entire previous investment had been made at the lower price of the new round. This can lead to significant dilution for the founders. And Weighted Average. The adjustment price takes into account not only the lower price but also the size of the new round. This variant is generally more balanced.

The agreement should provide for exceptions, such as employee share schemes within the agreed pool, strategic investments and the conversion of instruments already disclosed. These also include acquisition-related share issues, corporate restructuring and issues approved by a qualified majority. Anti-dilution protection should not be confused with statutory or contractual subscription rights. A subscription right enables participation in a new round. Anti-dilution, on the other hand, compensates for the lower issue price under certain conditions.

Governance and investor rights

Investors regularly demand rights that go beyond their mere shareholding percentage. These include approval requirements for budgets, financing and major investments, approval of acquisitions and disposals, and a say in the appointment of the managing director. It is also common to include advisory board or observer rights, regular financial and KPI reporting, as well as rights of inspection and access to information. The package is supplemented by the requirement for approval of new share issues and protection against transactions with shareholders or related parties.

The list of reserved matters should include thresholds and be tailored to the company’s stage of development. Thresholds that are too low can slow down day-to-day operations. Overly broad wording can effectively give the investor a right of veto over day-to-day management.

Convertible loan or genuine equity round?

A convertible loan initially provides debt capital which is to be converted into shares at a later date under contractually defined conditions. It is frequently used as bridge financing ahead of a larger equity round or to quickly extend the financial runway. A genuine equity round, by contrast, leads directly to a capital increase or transfer of shares. Valuation, stake and shareholder rights are bindingly agreed upon at closing.

With a convertible loan, the valuation is often deferred until the subsequent round. Where the structure is simple, it is usually implemented more quickly; however, until conversion takes place, investors have only limited rights and, initially, no direct stake in the cap table. Legally, it remains a loan as long as it has not been converted. Whether notarisation is required depends on the specific conversion mechanism. The main risk lies in the uncertainty surrounding future dilution and the maturity date.

The investment round determines the valuation upon completion. It requires a more extensive contractual and notarial process; in return, investors’ rights apply immediately, and dilution takes effect straight away. From an economic perspective, this constitutes equity capital without a right to repayment. Capital increases and the issue of shares must generally be notarised. The greater administrative burden is offset by a clear ownership structure.

Typical provisions of a convertible loan

A robust agreement should, in particular, govern the loan amount and disbursement, the term and maturity, as well as the interest rate. In addition, it should cover the qualifying funding round as a conversion event, the discount on the share price of the next round, and the valuation cap.

The contract must also cover automatic or optional conversion, the treatment in the event of an exit prior to the next round, and the treatment in the event of insolvency or liquidation. The contract should likewise include subordination or junior status, information rights and a most-favoured-nation clause.

The agreement is rounded off by approval requirements, costs and taxes, as well as the notarisation of the subsequent conversion.

Discount and Valuation Cap

The discount grants the lender a reduction on the share price of the next funding round upon conversion. A discount of, for example, 20 per cent means that the lender enters at a lower price than the new investor.

The valuation cap limits the valuation at which conversion takes place. If the valuation in the next round rises sharply, the lender receives more shares as a result of the cap than would result from the discount alone.

The agreement must clearly specify which of the two mechanisms takes precedence and how pool top-ups, further convertible loans and transaction costs are to be taken into account. Without a fully diluted calculation, the founders’ subsequent shareholding may deviate significantly from expectations.

When might notarisation be required?

A convertible loan is not automatically exempt from the requirement for notarial form simply because a loan is initially granted. If the agreement already contains a binding obligation to acquire, transfer or take over GmbH shares as part of a capital increase, Section 15(4) of the German Limited Liability Companies Act (GmbHG) may require notarial form.

The question of form depends on the specific mechanics involved.

Of particular relevance are automatic conversion, binding obligations to acquire shares, and obligations on existing shareholders to transfer their shares. Finally, capital measures that have already been determined, as well as powers of attorney for subsequent execution, must be taken into account.

A mere intention to negotiate at a later date must be assessed differently from an acquisition or transfer obligation that has already been bindingly established. The structure of the contract should therefore be reviewed for any formal requirements prior to signing. An invalid conversion obligation jeopardises the very central purpose of the financing.

When is a convertible loan appropriate?

It is particularly suitable when short-term liquidity is required, a larger funding round is already on the horizon, or it is currently difficult to arrive at a reliable valuation. This also applies where existing investors are providing bridge finance or where transaction costs are to be kept to a minimum initially.

It is less suitable if the timing of the next round of funding is uncertain, if the company would be unable to repay the loan when it falls due, or if multiple instruments would lead to a complex conversion process. This also applies if key governance issues need to be resolved immediately anyway, or if the cap or discount makes it virtually impossible to calculate the subsequent dilution.

Alternative instruments

In the German market, various equity-like or SAFE-oriented models are also used. However, their designation does not determine their legal effect. The right to repayment, ranking and treatment in the event of insolvency, as well as the conversion mechanism, must always be examined. In addition, there is the corporate form, the accounting and tax classification, and the treatment in the event of an exit or liquidation. A SAFE document adopted from the US market should not be used without adaptation to German company law, insolvency law and tax law.

Investment and Shareholders’ Agreement

In a genuine financing round, the contractual framework typically consists of several coordinated documents: a term sheet, an investment or shareholding agreement, and a shareholders’ agreement. These are supplemented by the amended articles of association, the shareholders' resolutions on the capital increase, and the undertakings.

Depending on the round, these may be supplemented by rules of procedure, the employee share scheme, a catalogue of guarantees and a disclosure letter. The process is concluded with the completion and commercial register documents.

Shareholding Agreement

The investment agreement primarily governs the investor’s entry into the company. Typical provisions include the investment amount and the capital measure, the conditions for completion, and guarantees provided by the company and, where applicable, the founders. It also governs the disclosure of risks, indemnities and the use of funds. In addition, it covers tranches and milestones, costs and limitations of liability, as well as the closing process. In the case of founder guarantees, a clear distinction should be made between knowledge-based guarantees, objective guarantees and operational commitments. The founders’ personal liability must not arise incidentally from a standard list of terms. Maximum liability amounts, thresholds, limitation periods and exclusions must be explicitly included in the negotiations.

Shareholders’ Agreement

The shareholders’ agreement governs cooperation following the closing. This includes, in particular, governance and reserved matters, information and reporting obligations, and the appointment of the managing director and advisory board. It also sets out founders’ vesting and leaver rules, restrictions on disposal, and subscription and participation rights. Further provisions include liquidation preferences and share classes, anti-dilution provisions, as well as drag-along and tag-along rights. Exit and IPO provisions, confidentiality and non-compete covenants, as well as deadlock and dispute resolution mechanisms, are also covered here. Finally, the term of the agreement and the admission of new shareholders are set out.

Provisions containing an obligation to transfer or acquire shares in a GmbH may require notarisation. This frequently applies to vesting, call options, drag-along rights and other mandatory tender offers. The articles of association and the shareholders’ agreement must therefore be consistent with one another in both substantive and procedural terms.

Founder vesting

Investors often require what is known as ‘reverse vesting’. The founders already hold their shares but, in the event of an early exit, must transfer or offer for sale any portion that has not yet vested. The start of the vesting period, its duration and the cliff period, as well as monthly, quarterly or annual vesting steps, must be set out. Good, bad and, where applicable, grey leaver categories must also be defined, along with the repurchase price for vested and unvested shares, and the treatment of illness, death, permanent incapacity to work and parental leave. In addition, provision must be made for dismissal or termination by the company, acceleration upon exit, and the notarised formulation of transfer obligations. ‘Bad leaver’ rules should be limited to clearly defined serious breaches of duty. Treating every voluntary resignation as a ‘Bad Leaver’ across the board may be inappropriate and could undermine the programme’s intended retention effect.

Rights in subsequent funding rounds

Investors frequently secure pro-rata or super-pro-rata rights. These enable them to maintain or increase their stake in subsequent rounds. In particular, it must be clarified whether these rights make it more difficult to bring in new strategic investors, and what minimum stake is required for their exercise. Furthermore, it must be clarified whether unexercised rights are transferred to other investors and whether certain employee or acquisition shares are excluded. Finally, it must be clarified how long the rights remain valid.

Signing and Closing for a German GmbH

A capital increase in a GmbH typically requires a shareholders' resolution certified by a notary. The acquisition of new shares must be formally declared. Subsequently, the capital increase and amendment to the articles of association are filed with the commercial register. The signing and the economic completion may take place at different times. Typical closing conditions include the completion of due diligence, the notarised capital measures and the payment of the investment. It is also common practice to sign the shareholders’ agreement, transfer intellectual property rights to the company, and conclude or amend managing director and employment contracts. Where relevant, this is supplemented by the establishment of the investment pool and approvals from regulatory authorities or under investment law. The company should take into account its liquidity requirements until the capital is actually available. Signed financing documentation does not yet constitute receipt of payment.

Glossary of key terms

Pre-money valuation refers to the company’s value immediately prior to the new investment.

Post-money valuation is the company’s value after the new capital has been added.

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

Liquidation preference guarantees certain investors priority in the distribution of proceeds in the event of an exit or liquidation.

In the case of a participating preference, the investor first receives the preference and then also participates in the residual distribution.

Vesting refers to the time- or performance-dependent vesting of founders’ or employees’ rights.

The ‘cliff’ is the minimum period, before the expiry of which nothing usually vests.

‘Good Leaver’ describes leaving the company without serious misconduct on the part of the individual, whilst ‘Bad Leaver’ describes leaving due to narrowly defined serious breaches of duty.

Anti-dilution provides protection against dilution if a subsequent funding round takes place at a lower valuation.

The pro-rata right allows a participant to take part in subsequent funding rounds and maintain their shareholding.

‘Reserved Matters’ are measures that require the consent of the investor or a qualified majority.

A ‘drag-along’ clause obliges the holder to sell their shares alongside others in the event of a qualifying sale of the company. Conversely, a ‘tag-along’ clause grants the right to sell one’s shares on the same terms as other shareholders in the event of a sale by them.

The valuation cap sets an upper limit on the valuation for the conversion of a loan, whilst the discount grants a reduction on the share price in the next financing round.

Qualified Financing is a funding round that triggers conversion on the basis of defined minimum criteria.

The runway quantifies the period for which the available liquidity will suffice at current expenditure levels.

Before signing a term sheet, founders should first have a fully diluted cap table, an exit waterfall calculation for several company valuations and a list of all investor veto rights. These should be supplemented by a calculation of the conversion of existing instruments and a realistic signing and closing timetable.