Setting up a limited liability company (UG)

UG or GmbH: The question of capital is not the only decision to be made

The UG is suitable for start-up founders who need a company with limited liability but do not yet wish to raise or tie up the share capital required for a GmbH. It can be a good fit for consultancy, software, retail and other lean business models. For capital-intensive projects, long-term leases, staff expansion or significant upfront expenditure, a GmbH may offer greater credibility and financial stability right from the start.

The share capital of a GmbH is 25,000 euros. In the case of a cash formation, it is not mandatory for the entire amount to be paid in before registration. However, certain minimum payments are required by law. With an UG, on the other hand, the chosen share capital must be paid in full in cash before registration. Contributions in kind are not permitted at the time of formation.

This decision also has external implications. Banks, landlords, suppliers and customers may require additional security, advance payments or personal guarantees from a very low-capitalised UG. The statutory limitation of liability remains in place, but is effectively undermined in economic terms if the founder has to personally guarantee important contracts.

An UG is not automatically cheaper to run on a day-to-day basis. Accounting, annual accounts, disclosure requirements, tax returns and registration obligations are essentially the same as for a GmbH. Anyone simply organising a small sideline without significant liability risks should therefore also consider whether the additional administrative burden of a limited company is justified.

How much should the share capital be?

Legally, the share capital can be set at a very low level. From a business perspective, however, it should cover the costs of the formation and start-up phases. Factors to take into account include notary and registration fees, bank charges, software, insurance, consultancy, marketing, rent, stock, staff costs and the time until the first secure payments are received. A company that is unable to pay its due invoices shortly after incorporation is in an existential crisis, despite having been formally established in accordance with the law.

The share capital is not a frozen balance that must remain untouched in the account indefinitely. Following registration, the company may use it for operational expenses. However, it belongs to the UG and must not be repaid to the shareholders without legal grounds. Payments to shareholders require, for example, a valid contract, a proper reimbursement of expenses or a subsequent resolution on the appropriation of profits, and must comply with capital maintenance requirements.

Capital planning should distinguish between share capital and additional financing. In addition to their capital contribution, shareholders may provide loans or inject further equity. Loans offer flexibility but are subject to special insolvency law provisions in the event of a crisis. Where there are several founders, it should be documented who is providing which funds and whether any additional financing obligations exist.

A nominal share capital can work for a virtually cost-free digital business model if further liquidity is immediately available. In many cases, however, it is clearer to reflect the actual start-up capital required as share capital or a structured financing package. The figure in the commercial register should not be considered more important than the company’s ability to meet its financial obligations in the first few months.

Model articles of association or bespoke articles of association?

Under Section 2 of the German Limited Liability Companies Act (GmbHG), the articles of association must be notarised. For straightforward incorporations, the statutory model protocol is available. It may be used if the company has no more than three shareholders and only one managing director. Deviations from these provisions are not permitted under the simplified procedure.

The model protocol combines the articles of association, the appointment of the managing director and the list of shareholders. It may be appropriate for a single-member company with a simple structure. However, its brevity is also its limitation. It does not cover differentiated majorities, pre-emption rights, vesting mechanisms, competition issues, deadlocks, lists of matters requiring approval or specific rules governing withdrawal.

Where there are several founders, it is generally advisable to draw up individual articles of association. These should set out how decisions are made, which transactions require the shareholders’ approval, and what happens in the event of a shareholder’s death, resignation, breach of duty or wish to sell their shares. A supplementary shareholders’ agreement may contain confidential commercial arrangements. It must not contradict the articles of association and does not replace any provision that, under company law, must be included in the articles of association.

Even in the case of a single-member UG, a bespoke set of articles of association can be advantageous if investors are to be brought in at a later stage, several managing directors are to be appointed, or shareholdings are to be transferred. The initial savings achieved by using the model protocol should not lead to higher costs once the structure grows.

The company formation process in practice

Before the appointment with the notary, the company name, registered office, corporate purpose, shareholders, shares, share capital and managing directors must be determined. The company name must be distinctive and must not be misleading. A preliminary check with the Chamber of Industry and Commerce and the commercial register can help minimise delays, but does not replace the decision of the registration court. The corporate purpose should describe the planned activities in sufficiently specific terms, without unnecessarily ruling out any future developments.

The articles of association are notarised and the managing director appointed. Subject to the statutory requirements, the incorporation can also be carried out via an online notarial procedure using video communication. The company being formed then opens an account into which the shareholders pay the full amount of the share capital. The managing director confirms the payment to the register.

The notary submits the application electronically to the commercial register. The UG only comes into existence as a legal entity with limited liability upon registration. Prior to this, there is a pre-formation or pre-company phase. Anyone who already enters into contracts on behalf of the future UG may be personally liable. Larger commitments should therefore, where possible, be subject to a condition precedent pending registration or be deliberately financed. 

Following registration, depending on the nature of the business, the next steps include business registration, tax registration, registration with the transparency register, professional or licensing procedures and, where applicable, employer notifications. The business bank account, accounting and tax advice should be set up in such a way that private and company payments remain separate from the outset.

Managing Directors, Liability and Contracts Prior to Registration

The limitation of liability generally protects the shareholders’ private assets from ordinary company debts. However, it only applies in the intended form once the company has been registered and the company’s capital has been duly raised. During the formation phase, directors’ liability and other personal risks may arise.

Managing directors are not personally liable simply because the UG has little capital. However, they must closely monitor the company’s financial position. If insolvency is imminent, financing options and the company’s continued operation must be assessed at an early stage. In the event of insolvency or excessive debt, there may be an obligation to file for insolvency. A share capital of just a few euros leaves little room to absorb errors, delayed customer payments or unexpected costs.

Personal liability may also arise from sureties, guarantees or breaches of duty on the part of the directors themselves. Banks and landlords often require security from the founders in the case of newly established UGs. Anyone providing such security should negotiate the amount, term and conditions for release. The UG structure does not prevent the founder from entering into contractual obligations on their own behalf.

Contracts with shareholders and managing directors should be in writing, clear and in line with arm’s-length terms. This applies to managing directors’ salaries, expenses, loans, tenancy agreements, IP transfers and services provided by a start-up company. Unclear withdrawals from the business account jeopardise accounting, tax compliance and capital maintenance.

The statutory reserve and the path to becoming a GmbH

Under Section 5a(3) of the German Limited Liability Companies Act (GmbHG), a UG must establish a statutory reserve. A quarter of the net profit for the year, reduced by any loss carried forward, is allocated to this reserve. The reserve may only be used for the purposes specified by law, in particular for a capital increase from the company’s own funds or to offset certain losses. The common assertion that the UG must ‘set aside’ 25 per cent of its profit every year ‘until it automatically becomes a GmbH’ is an oversimplification. Without a net profit for the year, no such allocation can be made. The reserve grows only from profits actually generated. It must not be treated as freely available distributable assets.

If the share capital reaches at least 25,000 euros through a valid capital increase, the special restrictions applicable to the UG cease to apply. This does not mean that the company is automatically operated under a new name without further action. A capital increase, amendment to the articles of association, notarised resolution and entry in the commercial register must all be planned together. The company may then use the suffix ‘GmbH’. The capital increase may be carried out through new contributions or, subject to the statutory requirements, from the company’s own funds. Which option is appropriate depends on liquidity, reserves and the balance sheet. The change should not be made solely for image reasons. It may be advisable if investors are coming on board, major financing is pending or the capital base is to be strengthened on a long-term basis.

Investors, employee share ownership and growth

The UG can work well for a simple start-up structure. However, as soon as investors, employee share ownership or multiple classes of shares are planned, the model articles of association quickly reach their limits. Investors typically expect rights to information, approval rights, protection against dilution, liquidation preferences and rules governing a future sale. These points should form part of a coordinated structure comprising the articles of association and the shareholding arrangements.

The issue of new shares requires a notarial capital increase. The transfer of existing GmbH or UG shares must also be notarised. Vesting or leaver rules agreed at an early stage must take these formal requirements into account. A mere private written undertaking to return shares at a later date may be legally insufficient.

Virtual share programmes avoid the immediate admission of further shareholders but create contractual claims for payment. They should be consistent with the financing and exit waterfall. When deciding between genuine and virtual shares, company law, tax law and employment law must be considered together.

If the UG grows rapidly, its governance structure should grow with it. Authorisation of bank accounts, shareholders' resolutions, managing directors’ responsibilities and reporting procedures must not be formalised only after a conflict has arisen. The low barrier to entry for a UG is an advantage, but must not lead to a permanently improvised organisational structure.

Common start-up mistakes

A common mistake is setting the share capital at a level that does not even cover the basic start-up costs. Equally problematic is commencing business operations with substantial obligations before the company has been registered. Anyone required to sign contracts at an early stage should inform their contractual partners about the start-up phase and explicitly clarify liability and the validity of the agreements.

Where there are several founders, the standard memorandum of association is often chosen for cost reasons, even though key issues that could lead to conflict remain unresolved. Disagreements over work contributions, financing, voting rights and withdrawal only become apparent once the company is already operationally committed. A custom-negotiated memorandum and articles of association costs more initially, but can safeguard the company’s ability to act effectively later on.

Other common mistakes include a company name that is too broad or inappropriate, an unclear corporate purpose, a failure to transfer intellectual property rights, and the commingling of private and business payments. In the case of software- or brand-based start-ups, it should be clarified before incorporation who owns existing code, domains, trademarks and content, and how these are to be transferred to or licensed by the UG.

Finally, the requirement to maintain statutory reserves is often overlooked. A resolution on the appropriation of profits must not distribute the entire net profit for the year if a quarter of the relevant net profit is to be allocated to the statutory reserve. The accounts and the shareholders' resolution must reflect this correctly.