Venture Capital Financing

Venture Capital Financing

The concept of venture capital 

The term ‘venture capital’ (hereafter abbreviated as ‘VC’) refers to a temporary equity investment in a company that is usually still young, innovative and not yet listed on the stock exchange, but has high growth potential (referred to in the following as a ‘start-up’). The business model of venture capital is a subcategory of the private equity business, which involves trading equity interests in unlisted companies. 

 

As venture capitalists and financial investors, venture capital companies pursue the goal of investing in a young start-up during a specific development phase and providing their management expertise. In return, they receive a significant amount of decision-making power in the company. While a credit institution obtains collateral for a bank loan and the investor accepts company shares in the case of convertible loans, the investor does not receive any tangible collateral in the case of VC financing, but rather a say in the company. This allows the investor to work towards maximum corporate growth of the start-up during the investment period. Thus, the VC company’s involvement is usually limited to a specific phase of the company. VC companies often get involved with start-ups in the early or pre-seed stage and support the founders in setting up the company. 

 

Advantages and disadvantages of VC financing for the start-up 

For start-ups, equity participation by a VC company is particularly attractive because, as a venture capitalist, a VC company does not expect high collateral, as a bank would as a lender. The investor also supports the company not only financially, but usually also with entrepreneurial knowledge and substantive know-how. Start-ups benefit from this, particularly in the seed stage and also in their development phase, the so-called growth stage, in which the start-up is keen to increase sales, productivity and growth. 

 

Since the VC company, as a venture capitalist, is aware of the risk of its investment, liability to creditors and the potential risk of loss, the VC company usually demands extensive entrepreneurial rights to have a say in order to be able to influence the development of the start-up. If the start-up makes a profit during the investment period, the venture capitalist can also expect a high return. However, granting the venture capital firm such rights can lead to a partial loss of control and a ‘loss of power’ on the part of the start-up. To counteract a complete loss of control, a term sheet is negotiated between the start-up and the investor before the investment. This sets out the conditions and rights of the venture capital firm, thereby limiting its influence. 

 

Advantages and disadvantages of VC financing for the VC company 

As the capital provider, the venture capital company bears a significant risk. If the start-up proves to be unprofitable or does not generate the desired profit during the investment period, the venture capital company may lose its desired return or even the invested capital. At the same time, the investment also offers the venture capital company the opportunity to exert influence on the start-up and to control the company’s development. 

 

What should be considered when using venture capital? 

Start-ups that can imagine obtaining VC financing for their young company should consider several important aspects. Topics such as the investor’s potential influence, securities and the exit of the capital provider are of particular importance. It therefore makes sense for a start-up to consult an advisor as early as possible who can not only support the VC financing but can also help with the planning and preparation of the financing. Not only must the investment contract be legally secure and free of errors, but changes to the articles of association, for example, must also be taken into account. We would be happy to support you in this and provide you with legal advice. 

 

When is legal advice necessary and useful for a start-up? 

 VC is perhaps the most important form of financing for start-ups, but it also entails certain risk factors for them. In addition, a large number of legal and tax peculiarities must be taken into account in VC financing. Therefore, legal advice and support is required from the investor search, through the investment and up to the exit of the VC company. 

 

It makes sense to discuss potential VC financing as early as the start-up’s orientation and planning phase (pre-seed phase), to determine whether such financing is an option and to explain the pros and cons of this and, if necessary, discuss alternatives. 

 

Likewise, legal advice is advisable when looking for the right investor, because the investor must be a good fit for the start-up, bring the appropriate expertise and the interests of the VC and the start-up should be appropriately balanced. 

 

The creation and negotiation of the term sheet is also a key point, where we can provide legal advice, because the term sheet is at the beginning of every investment and forms the first framework of the investment conditions. Among other things, the amount of the investment, the duration of the investment and other important details are agreed here. It is important in this phase that the start-up and the investor are equally protected. Legal advice is particularly important during contract negotiations with a VC company, because the VC company will demand a say in the start-up, which can have fundamental effects on the corporate structure. Here, we can use our advice to identify risks and, if necessary, work out compromises so that the framework agreements set out in the term sheet can be implemented in a legally binding manner. In our advisory services, we pay particular attention to ensuring that the interests of the investor on the one hand and the interests of the start-up on the other are balanced fairly for both parties. Precisely because a VC investor usually only wants to participate for a certain period of time, we pay particular attention to the design of an exit clause. 

 

When is legal advice on the part of the investor necessary and useful? 

A venture capital company also has to consider a number of factors before investing. Before investing in a young company, it may be useful to carry out a ‘due diligence’ process. In doing so, it is important for the investor to get a precise overview of the economic, tax-related, financial and legal situation of the start-up. We are happy to advise and support you in this process in order to record and evaluate all of the company’s assets. 

 

After the investor is satisfied with the valuation of the start-up, the participation agreement is usually negotiated, a shareholder agreement is concluded and, if necessary, additional contracts are negotiated. These should also be legally secured. 

 

Overview of advisory services 

                Start-up 

                VC Company 

·      Supporting in deciding whether VC financing is an option 
 

·      If necessary, conducting  due diligence and evaluating the start-up 

 

·      Selecting the right investor 
 

·      Support in negotiating the term sheet  

 

·      Creating the term sheet 
 

·      Support in contract negotiations 
 

·      Support in contract negotiations 
 

·      Negotiation and drafting of the participation agreement  

·      Execution of the investment 

·      Payment of the investment amount  


Conclusion: Is venture capital recommended for start-ups? 

Whether VC financing makes sense for your start-up depends largely on the phase your company is in, what your start-up's finances would look like without an investor and whether it is even worth considering giving the VC company a say in the matter. 

 

As a founder, you should always be aware that during VC financing you no longer manage the company alone and that, on the one hand, a strong and experienced shareholder is involved who, however, also pursues his own interests. On the other hand, your company receives capital that favours the development of the start-up. 

 

It is therefore important to weigh up which factors play a role in the specific case and whether VC financing is an option for you and your company. 

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The convertible loan as an alternative to VC financing

The convertible loan as an alternative to VC financing

Is a convertible loan the right choice?

What are convertible loans?

A convertible loan is initially an ordinary loan (loan agreement), which, however, comes with the option or the obligation for the lender to convert his loan into a stake in the company in which he is investing under certain circumstances.  Thus, the loan debt can or must be converted into a company participation at a later date, so that the investor participates in the start-up. Therefore, the lender does not acquire an ordinary claim for repayment through the loan agreement concluded, but shares in the company. If the loan is converted into shares for the investor, a capital increase must take place at the start-up in order to create new shares. These are then taken over by the investor. 

The lender may be a third party outside the start-up, but it may also be a shareholder in the company. In the loan agreement, the lender and the borrower usually agree on the principal amount of the investment, the interest, the duration of the investment and the terms of a conversion into company shares.

When should a convertible loan be considered?

Convertible loans are particularly relevant for start-ups in the context of start-up and bridge financing. Often, start-ups have a product idea in the early stages of their development but no financial resources. In such cases, a convertible loan can be considered as start-up financing to enable the company to, for example, start developing its products. 

Another possible scenario is that the start-up has already completed an initial financing round (Series A) and a second financing round (Series B) is in prospect, but the current financing is not sufficient to bridge the time until the subsequent financing round is completed. In this case, a convertible loan can provide useful interim financing.

What do you need to watch out for with a convertible loan?

First of all, it is important that, in the event of the loan being converted into a company participation of the investor, an effective capital increase takes place in the start-up. To this end, all shareholders should be obliged with regard to the conversion right, so that an effective decision can be made to increase the capital. This can be implemented if all shareholders become parties to the participation contract. 

The creation of new shares (capital increase) usually means that the start-up’s articles of association have to be amended. However, this can be done without observing any particular form. If the participation agreement stipulates that the investor is obliged to acquire shares in the company, the participation agreement must be notarised in this case, as the obligation to acquire shares in the company must be notarised. 

Advantages and disadvantages of the convertible loan for the start-up

For a start-up as borrower, a convertible loan has the particular advantage that no company valuation is necessary for this type of financing. Especially in the case of VC financing, a detailed company valuation is usually necessary, which in turn often requires an annual forecast of 3-4 years and a comprehensive business plan. This is not necessary with a convertible loan, which makes it possible for a younger or smaller start-up to realise a convertible loan.

Thus, convertible loans are also a faster form of financing, since there is no need for founders, old and new investors to negotiate and agree on the valuation of the start-up. Although a convertible loan does not come entirely without some kind of valuation of the company, it is sufficient to simply refer to the upcoming financing round and use this value as a still-open reference point for the question of how many shares the investor will receive when the loan is converted. By eliminating the need to answer the specific question of valuation, the investment process can be accelerated, enabling start-ups to receive their financing more quickly. 

In addition, the convertible loan is often based on a straightforward loan agreement with limited provisions due to the simplicity of a loan. While complicated and extensive contracts have to be negotiated for VC financing, the convertible loan requires a loan agreement that is not too extensive.

Likewise, convertible loans can easily align the interests of the start-up and the lender, because the typical subjects of a loan agreement are not subject to any special legal regulations. Therefore, a convertible loan agreement is open to a variety of individual arrangements and thus particularly flexible for the contracting parties. 

However, the disadvantage of a convertible loan for a start-up is that the loan weighs on the company as a liability. Furthermore, the company does not have the option of triggering the conversion of the loan itself, which can affect the financial flexibility of the start-up..

Advantages and disadvantages of the convertible loan for the investor

For the investor, the convertible loan offers low transaction costs, since it is basically an ordinary loan. The loan agreement can also be flexibly structured for the lender and is therefore considered uncomplicated.

However, especially in comparison to VC financing, the convertible loan has a crucial difference for the lender: convertible loans do not give the investor any rights to participate in the start-up. Convertible loans are also generally unsecured and are treated as subordinate. This means that in the event of the start-up’s insolvency, the investor, as the lender, has no security to fall back on. Furthermore, the investor is subordinate to all the start-up’s other creditors, which means that the other creditors take precedence over the investor in the event of insolvency. This means that the lender runs the risk of the loan amount possibly not being offset by any valuable assets in the company.

For the investor, the convertible loan offers low transaction costs, since it is basically an ordinary loan. The loan agreement can also be flexibly structured for the lender and is therefore considered uncomplicated.

However, especially in comparison to VC financing, the convertible loan has a crucial difference for the lender: convertible loans do not give the investor any rights to participate in the start-up. Convertible loans are also generally unsecured and are treated as subordinate. This means that in the event of the start-up’s insolvency, the investor, as the lender, has no security to fall back on. Furthermore, the investor is subordinate to all the start-up’s other creditors, which means that the other creditors take precedence over the investor in the event of insolvency. This means that the lender runs the risk of the loan amount possibly not being covered by the company’s valuable assets.

Conclusion: Is a convertible loan a sensible alternative to VC financing?

Whether a convertible loan is a viable alternative to VC financing must be decided on a case-by-case basis. 

If the start-up is still in the early stages of its entrepreneurial activity, convertible loans for smaller financing amounts generally make sense for both the start-up and the investor. With smaller amounts, the investor’s risk of loss is limited and the convertible loan is easy to implement.

However, it is particularly important for convertible loans to be unambiguous and complete so that the conversion mechanism works and no additional risks arise for the investor and the start-up. 

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The Term-Sheet

The Term Sheet

WHY A TERM SHEET IS IMPORTANT WHEN INVESTING IN A START-UP

Investing in a start-up can be a complex process during which it is important to weigh up all the risk factors and make the investment secure. The interests of the investor and those of the start-up should be taken into account in an appropriate balance, thus it makes sense to formulate and agree on the framework conditions of the investment before starting negotiations on the investment agreement.

A term sheet can be used as such a framework agreement. This article explains what a term sheet is, what exactly it is used for and what a meaningful term sheet should contain.

What is a term sheet and what is it needed for?

The term sheet is a central component of the process of investing in a start-up and a framework agreement between the start-up and the investor that is used as the basis for the investment and the preceding negotiations.

The term sheet is thus a basic document that contains the most important key points of a planned investment, important conditions, future terms and the ideas of the parties and serves as a binding basis for the design of the future participation agreement. The term sheet therefore serves to provide the parties with planning security and ensures that the parties’ contract negotiations and discussions are conducted in accordance with the conditions and principles described herein. Although the term sheet does not legally oblige the parties to conclude an investment contract, the clauses and principles formulated in the term sheet are binding.

The term sheet provides the parties to the planned investment with a structured overview of the desired course of the investment and any possible scheduling. It serves as an initial basis for clauses, rules and conditions and is intended to accelerate lengthy contract negotiations.

What can and should be regulated in a term sheet?

A term sheet has no substantive limits, so that the parties are initially free in terms of content. It can therefore cover everything from ideas and wishes regarding the investment, to the course of the investment, to the investor’s exit. All the key points for the parties can thus be included in the term sheet.

However, a term sheet should always include the time frame for the planned investment negotiations, the amount of financing and the investor’s stake, the use of funds, guarantees for the investor, the start-up’s valuation method, an exit clause and a confidentiality agreement.

A good term sheet is characterised by a specific and concise regulation of the most important cornerstones of the planned investment. While it should cover all the necessary points, the document should not be ‘overloaded’.

The valuation of the start-up as the central question

The valuation of the start-up is one of the main points to be negotiated in a term sheet. This is due to the valuation being the basis for determining the amount in which the investor will participate. The higher a company is valued, the less the founders’ participation rate decreases for a certain investment amount.

Since a start-up usually does not yet have a lot of reliable financial data, the valuation of a start-up is mainly based on future, forecast developments and on the potential demand for the start-up’s product on the market. For such a forecast, it is crucial, for example, whether there are many competing companies developing similar products, whether the product is likely to appeal to a wide range of customers and how the general future economic situation is generally assessed. 

We would be happy to advise and support you with our expertise in planning and creating a term sheet of this kind.

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Employee data protection in the digital age: challenges and solutions​

Employee data protection in the digital age: challenges and solutions

THE EMPLOYEE DATA ACT

In the modern world of work, which is increasingly characterised by digitalisation and data-driven processes, the protection of employee data is becoming more and more important. Despite its importance, there is still no separate law in Germany that comprehensively regulates this complex area. The Act to Strengthen Fair Handling of Employee Data and for More Legal Certainty for Employers and Employees in the Digital World (RefE-BeschDG) is intended to regulate data processing in the context of employment relationships in the future.

What do employers need to be aware of in the near future?

Background to the law

Employee data protection is essentially based on the general requirements of the General Data Protection Regulation (GDPR) and the specific provisions of the Federal Data Protection Act (Bundesdatenschutzgesetz – BDSG). In particular, Section 26 of the BDSG plays a central role as it regulates the processing of personal data of employees. The Employee Data Protection Act is currently still available as a draft bill. The European Court of Justice (ECJ C-34/21) has ruled that Section 26 of the Federal Data Protection Act (BDSG), which previously regulated data processing in employment relationships, does not comply with the principles of the GDPR because it only repeats the legal basis from the GDPR, in particular for the performance of a contract, and is therefore inapplicable.

Regulations issued by national legislators must take into account special measures to safeguard human dignity, legitimate interests and fundamental rights of the persons concerned, which is why a mere repetition of the wording of the GDPR is not sufficient. After this decision, it was clear that there had to be a more differentiated regulation to ensure transparency and legal certainty for both employers and employees.

Key points of employee data protection

The draft bill for the Data Protection Act is a comprehensive law that is supposed to regulate the protection of employees’ personal data. It applies to both private and public employers and covers a wide range of applications.

Central aims and content

The draft bill aims to strike a balance between the interests of the company and those of its employees. This is reflected in the fact that a balance of interests must be carried out in individual cases if consent has not been granted. On the employer’s side, there are then (legitimate) operational reasons and on the employee’s side, there is their right of privacy. When weighing up the interests, the employee’s relationship of dependency must always be taken into account.

If consent is given, it must be given voluntarily and in an informed manner. To this end, the employee must be informed at an early stage.

If the data processing is based on legitimate business interests, these interests must be adequately explained to the data subject.

In addition, the law also contains regulations regarding artificial intelligence in the employment relationship.

Furthermore, attention is paid to the monitoring of employees. Surveillance measures are subject to strict regulations. For example, audio recordings are prohibited, and video recordings are only permitted to fulfil the employer’s obligations under legislation or collective agreements or to protect important business interests. Even in such cases, a balance of interests must be carried out. Recordings may be made for a short period of time and for a specific purpose, or on a random basis, with a maximum storage period of 72 hours.

Special aspects

A special feature is the exclusion of evidence of data processed in violation of data protection law in legal proceedings concerning personnel measures. An exception should only be made if there is a disproportion between the infringement of the employee’s right of privacy and the employer’s constitutionally protected interests in the judicial utilisation. In its rulings, the Federal Labour Court has so far tended to favour a practice that is more conducive to utilisation. Now, even intentional conduct in breach of contract does not yet appear to speak in favour of exploitation, because this does not automatically justify an obvious imbalance.

The data processing by group companies is also covered. These may process employee data exclusively for a specific purpose necessary for the performance of the employment relationship, for the fulfilment of an obligation established by law or collective agreement, or for the protection of the legitimate interests of the employer or the group company. Furthermore, it is necessary that the interests of the employer prevail.

The processing of employee data relating to the core area of private life is not permitted.

Relationship to the GDPR

The two regulations complement each other. The GDPR provides the general framework, while the draft of the new law specifies and supplements the specific area of employee data protection. It will therefore not replace the GDPR, but build on it.

Outlook

It is not yet clear when the law is expected to come into force. Summer 2025 is being predicted. The bill still has to go through the parliamentary process. It remains to be seen what changes will arise in the course of the deliberations.

One thing is certain: a separate Employee Data Protection Act would significantly change the legal situation in Germany and could serve as a model for other European countries.

Need for action by companies

It already makes sense to critically review the processing of employee data in your company and to adapt it if necessary. Due to the existing case law of the ECJ, it is important not to wait until the new law comes into force, but to act proactively in order to already act in accordance with the law.

We will be happy to support you in taking stock, conducting a necessity check for the scope of data processing and advising you on the extent to which you need to inform your employees about the type and scope of data processing in your company.

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