Equity Finance 2024 Comparisons

The financing arrangements are typically based on convertible loans (also known as “SAFE notes” in foreign jurisdictions), combined with capital increases where these loans are exchanged into equity when larger amounts are being raised. While these convertible loans are intrinsically debt instruments, investors already have a strong focus on the corporate governance and valuation of the underlying company when negotiating them, and hence, they are basically a hybrid between equity and debt.

Typical debt financing from lenders is only available in very limited circumstances at such initial stage of a company, as venture debt has not successfully conquered the German market. If it is available, it often comes from state-owned institutions with the particular aim of strengthening the regional start-up ecosystem and/or it is often combined with an equity component (a so-called “equity kicker”).

What not many investors (and their lawyers know) is that every loan instrument which provides for a mechanism to convert it (or a portion of it) into equity might need to be notarised, depending on the legal form of the underlying company. Without notarisation there is a serious risk that the respective loan agreement will be found invalid, which will then affect the later share issuance.

In this segment of the market, an investment via a capital increase, sometimes combined with an acquisition of shares from existing shareholders, is fairly standard. The reason for this is that the investment ticket per investor is typically larger and hence there is a greater need to have adequate corporate governance rules, including provisions on future capital raises and exits, than in an early-stage scenario.

For an equity listing, there are basically two different segments available, and the decision which one to choose (or whether an issuer fulfils the conditions to be listed there) determines the process behind it and who is listed there. These two segments are: the regulated market (organisierter Markt) and the so-called unregulated, open market (Freiverkehr). There are literally thousands of typically smaller companies listed in the open market, as the requirements for being listed and the cost involved are significantly lower than those encountered on the regulated market (where, in turn, the total number of issuers is smaller, but the market cap is much higher). It is not possible to go into further detail here, but it is crucial to consider the relevant factors when evaluating whether the intended goal, that is, to raise capital, can in fact be achieved.

Smaller companies often decide – because of the requirements to achieve a listing, and the ongoing duties thereafter – that an equity raise from selected investors via a directly negotiated process is preferable to a listing, as it is faster, more flexible and grants them more transaction certainty.

Debt-to-equity swaps, down rounds, capital increases with dilution of existing shareholders, etc, can all be encountered on the German market, and which one to choose often depends on whether existing shareholders and creditors (and how many of them) support the measure. But even if there is no unanimous support for a measure, German insolvency laws set the basis to achieve, for example, debt-to-equity swaps, whereas a down round can typically only be achieved if at least such number of shareholders who need to decide on a capital increase, approve it. 

The positive thing about German corporate law is that the law provides these details if the shareholders do not determine otherwise in the respective corporate documents. What the law provides for depends on the legal form the underlying company has (eg, partnership v limited liability) and the parties are hence advised to take on good corporate counsel who can explain to them the legal regime a certain company has, and whether this is suitable for the particular situation at hand. Almost all of these rules can be adjusted based on what the parties want to achieve, which is the reason why the corporate documentation for an investment of an investor typically consists of a so-called “investment and shareholder agreement” (ISHA) in which the parties determine in detail the corporate governance rules they want to have applied, plus the core corporate documents such as the articles of association or partnership agreement.

The ISHA typically grants larger investors the right to demand an exit at a certain period in time, right of consent when it comes to important business decisions, and detailed information rights. Board seats are sometimes also granted.

Leaving aside equity kickers in debt financings or situations where existing shareholders might bridge an immediate financing need with a (convertible) loan, investors typically choose to be either an equity or a debt investor. Debt has the advantage (for the investor) that it ranks ahead of equity in an insolvency scenario, but in turn, it typically provides for a limited return (upside) – although a return mechanism that mirrors equity returns can be agreed. On the other hand, while being riskier, equity typically grants more rights when it comes to influence on the business (although covenants in a debt instrument can be structured so that a debt investor also has significant influence).

Despite the fact that smart drafting might almost manage to make the differences in returns and influence between debt and equity investors almost disappear, the mindset of the respective investor, and the reaction and expectation of the management of the respective company when it comes to the different sources of capital, cannot be ignored.

Disadvantages for an Investor in Providing Debt and Equity Financing

Providing both sorts of financing by the same investor might have significant disadvantages for such investor when it comes to an insolvency, as the debt provided by investors who own more than 10% in a company is usually subordinated behind any other third-party debt, and issued securities for such debt become unenforceable. In addition, having too much influence on the business might endanger the preferred position of a lender in an insolvency and even create liability vis-à-vis third parties beyond it, under the rules of a de facto manager.

Typically, the term “equity finance” includes straight equity investments (eg, via capital increases) as well as hybrids (eg, convertible loans) and differentiates between:

• the financing need or development stage of a company (eg, early stage, growth equity);
• the type of investor (business angel v private equity v corporate money);
• the amount of equity or purchase price to be paid (small cap v large cap investors); and
• whether the underlying company is publicly listed or whether a minority or majority stake is acquired.

All of these sub-sets can be found in the German market with an established, sophisticated investor and adviser base for each of them. Although not as common as investments into privately held companies, IPOs, takeovers or minority investments into listed companies can also be seen in the market and there is a well-established set of rules applicable to them.   

Typically, German law and the market do not differentiate between the type of investor or the jurisdiction such investor comes from, and the courts provide for equal treatment of both domestic and foreign investors. Only in certain limited, defined scenarios concerning industries of heightened importance to German society are foreign investments subject to particular review, and every investor should pre-check with its advisers when this is the case. Similarly, certain industries require a particular level of qualification from the owner or its acquisition structure, eg, certain types of healthcare investments.

It should be mentioned, however, that anti-money-laundering and KYC rules might require a heightened review process before transactions can be done with investors from particular regions or backgrounds, and this should be considered by any investor planning to do transactions in Germany.

As explained previously, the development stage of a company and the amount of capital it seeks has an impact on the financing process and the legal techniques employed (see 1.1 Early-Stage and Venture Capital Financing). In Germany, since the spring/summer of 2023, all segments of the market have faced headwinds due to the uncertainty in the market and the economic outlook, with venture capital investments, IPOs and large cap private equity deals suffering in particular. Signs of improvement have been seen across all segments in Germany since autumn 2024. 

The equity finance market in Germany is very well established and, both in terms of the number of deals and market participants, it is the largest in the EU. There are thousands of transactions in the various sub-sectors of the market, with only the public offering and large cap deal segment lacking a bit in terms of deal numbers in 2024. This was mainly due to the (large) size of investment tickets required in large cap PE transactions, which results in a smaller number of transactions and the heightened importance of leverage (and its costs) in these types of transactions. In addition, capital markets do not appreciate uncertainty, which is why public offerings suffered as well. At least large cap PE transactions are expected to return in 2025 with the outlook of decreasing interest rates. 

The amount of privately allocated capital is far greater than public-raised capital in Germany, both in terms of number of transactions and the aggregate combined size of it. This is not a new development. It can be explained by the fact that the typical exit path for a start-up or PE portfolio company is still a private sale to another PE house or strategic investor, and while a public offering might be considered in parallel, this is often only the second preferred alternative. In addition, German-based, tech-focused IPO candidates tend to prefer foreign stock markets, such as the US, as they hope to find more risk-tolerant investors there. Disregarding the boom (and bust) of the Neue Markt in 1999, the German stock market tends to favour more conservative investors and issuers than other international markets, which is why its relevancy as an attractive exit path for investors is lagging behind private markets. 

Sourcing of deals happens both by a direct approach between an issuer and a potential investor (or seller and buyer), but also (and more often) in the form of a structured process led by an investment bank or M&A boutique. In some cases, advisers such as lawyers and accountants also act as facilitators. As a large and established market, Germany has a well-developed and differentiated adviser scene consisting of basically all the international investment banks and advisory firms, as well as focused or niche advisers. 

As stated in 2.5 Privately Allocated Equity Versus Public-Raised Equity, the typical exit path is a negotiated private sale of (a minority or majority stake of) a company, often by means of an auction.

Although precise data is missing, the debt finance market is still believed to be, in total, far larger than the equity finance market. The main reason for this is not so much lack of equity capital, but rather the preference of a company (and its shareholders) seeking finance; debt finance is typically still far cheaper and involves less interference in the daily business by the provider in comparison to equity investment.

This really depends on the level of due diligence requested by an investor, the readiness of the company to accommodate it, the quality of the financials of a company and whether it is experienced in dealing with investors, the attractiveness of the company and, of course, the documentation to be executed in connection with the finance. The time required can range anywhere from two weeks up to four to six months, and difficult market conditions may result in a delay beyond that. 

There are some restrictions on investors (see 2.2 Equity Finance Providers and Potential Restrictions on Them). In some cases, these might be overcome by means of smart structuring or good counselling, whereas in others they might be real deal-blockers. An experienced counsel is often able to give clear guidance upfront whether a certain type of transaction might involve regulatory challenges or not.

There no restrictions on paying investors dividends or on repatriating capital outside of Germany.

Germany has implemented detailed anti-money laundering and KYC rules based on EU regulation, and adherence to these rules by all the parties involved (banks, notaries, accountants, lawyers) is regularly monitored. Parties should expect a detailed, time-consuming process in order to comply with the regulations.

Typically, the underlying documentation of an equity financing transaction in Germany is governed by German law, and only in rare exceptions would you find a combination of US or UK law with German law. German courts provide fair treatment and do not discriminate against any particular party irrespective of its function, origin or other reasons. The only aspect of the legal process that has sometimes been criticised is the time required to receive a court decision, which depends on the region where the respective court is located, as the efficiency (and sophistication) of the court system differs from state to state and city to city. Arbitration, as well as a foreign jurisdiction or the applicability of foreign law can be agreed by the parties, and in approximately 50% of transactions, arbitration is in fact agreed for various reasons.

One important trend to watch is the development to restructure companies by employing the tools provided by the German insolvency laws. This allows  companies to be restructured by eliminating the subscription rights of shareholders in a capital increase, if this is required to achieve the restructuring (and certain other conditions are met too). This has resulted in large-ticket restructurings eliminating outside shareholders against their will (and even though they would have been interested in participating in a capital increase). Equity investors would be well advised to watch this trend carefully and seek advice against it.

No information supplied.

No information supplied.

Germany is party to a large number of tax treaties and understandings, providing investors and companies with certainty on the tax treatment of their dealings. In addition, prior tax guidance on complex scenarios can be sought from the tax authorities.

The main purpose of German insolvency laws is to satisfy the debt of a company, and as a second priority, to safeguard the future existence of a company and its employees by allowing a financial restructuring of the company. The protection of shareholders is not a key priority and hence the insolvency process is typically run by the creditors, the insolvency judge and a court-appointed administrator (with some variations). As a general rule, shareholders have no say in the process.

Typically, equity investors are the last to be paid in an insolvency scenario, and in almost all cases, they do not receive any payback, as the realised proceeds do not generally even result in the satisfaction of all creditors. Whether uncalled capital must be paid out by an investor in the case of insolvency depends on the drafting of the respective agreements and there is a risk that this may be the case. 

An insolvency process of a company can take, depending on the number of assets and the company set-up, anywhere between three months (if administration is not even opened due to lack of assets) or many years (until all the assets are liquidated and the proceeds distributed to the creditors). Shareholders typically receive no recovery due to insufficiency of assets/recovery.

While differences exist depending on the size of the company and the know-how of its management, investors and debt providers, it is typically the management or the equity holder who drives the rescue process of the company, closely monitored by the debt provider. Typically, some part of the debt is secured and hence the debt providers are less affected than the equity holders, who risk to lose their total investment. In addition, once insolvency administration has been ordered, the influence of the equity holders is significantly reduced, which is why they typically try to find a pre-insolvency solution.

Insolvency administrators aim to increase the asset base of the insolvent company to improve the recovery rate of creditors, and one typical way to do this is to review whether payments have been made to equity holders which might be contested by the administrator to seek repayment. Further, administrators occasionally seek to sue investors for outstanding funding commitments, or because such investors can be seen as de facto managers of a company. Every investor who may face an insolvency scenario should seek legal counsel to evaluate the risks attached to it, and ideally, these risks should have been mitigated when the investment documentation was negotiated.