Germany Revenue Based Finance Debt - Impact Terms Platform

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Table of Contents

Executive Summary¹

In the German (debt/equity) market there is no classical “revenue-based finance” in the sense of a (customary) shareholders’/finance arrangement under which the investor has a priority right to receive repayment/distributions up to an agreed portion of “gross revenues” or “free cash flow”, until an agreed return on the investment is reached. However, the following three options come closest thereto: (1) preferred shares in a German Limited Liability Company (“GmbH”), (2) a silent partnership in a German corporation (GmbH or a stock corporation (“AG”)) or (3) a loan to a GmbH, AG or a limited partnership by shares (Kommanditgesellschaft auf Aktien (“KG aA”)) in combination with a warrant against the company’s/borrower’s shareholder(s) to call for shares (or, alternatively, to opt for a cash settlement) upon a specific trigger event.

Preferred Shares in a GmbH entitle the holder of such shares to a preferred treatment in regards of the priority of distribution of profits among the shareholders, i.e., the other (ordinary) shareholders accept that the investor has a right to repayment by way of distributions of profit (based on the revenue of the GmbH) and that such right needs to be discharged prior to other (ordinary) shareholders receiving their portion of the (remaining) amount to be distributed. Distributions and redemptions are limited by capital maintenance provisions applicable under German law to ensure that the GmbH’s funds in the amount of its registered share capital (Stammkapital) are not diminished by any profit distributions.

A silent partnership in a German corporation is an undisclosed civil law partnership. It can be designed with or without membership rights. In both scenarios, the investor participates in the corporation’s profit. In the typical case of a silent partnership, membership rights are excluded, and the investor solely participates in the corporation’s profit, for which reason the silent partnership is considered a debt instrument. The atypical silent partnership includes membership rights and/or entitles to participate in hidden reserves. Therefore, for tax and insolvency purposes, it is categorized as an equity instrument.

The combination of a loan to a GmbH, AG or KG aA combined with a warrant against its shareholder(s) combines a debt and an equity instrument. The warrant to call for shares or, alternatively, to opt for a cash settlement is mostly designed in the form of a right to demand release of proceeds. Usually, the warrant is designed without any membership rights or equivalent influence in order to avoid subordination in an insolvency scenario.

In any of the three options contestations by an insolvency administrator of repayments/distributions made to the investor needs to be considered on a case-by-case basis in the light of German insolvency law. For the instruments qualifying as equity or the investor qualifying as a shareholder or as shareholder like – which can only be assessed on a case-by-case basis -, investor’s claims are subordinated pursuant to German insolvency law.

Withholding tax on payments received by the investor is triggered in case of preferred shares. In case of the other instruments, it needs to be assessed on a case-by-case basis (details below).

Investment Structure Summary

As in the German (debt/equity) market there is no classical “revenue-based finance” in the sense of a funding/finance arrangement under which the investor has a priority right to receive repayment/distributions up to an agreed portion of “gross revenues” or “free cash flow”, until an agreed return on the investment is reached (whether or not the investor continues to participate in the equity upside after that), the following proposal mirrors what comes closest thereto in the German debt market. This would be achieved through a loan in combination with a warrant (together, the “Transaction“):

(A) the investor as lender granting a loan (with specifics as set out below, the “Loan“) to a German law governed limited liability company (be it in the form of a GmbH, an AG or a GmbH & Co.KG or a KG aA)(the “Company“) as borrower (the “Borrower“) in combination with (B) a warrant against the Company’s shareholder(s) / partner(s) (the “Issuer“) to be acquired for an arm’s length consideration (as an option premium) which provides for a contractual right of the investor as warrant holder against the Issuer to call for shares in the Company , provided that both parties (the warrant holder as well as the Issuer) are entitled to opt for a cash settlement instead (the “Warrant“). I.E., in a nutshell, the Warrant (at least) needs to provide for a contractual right of the investor as warrant holder against the Issuer to demand a certain amount of payment upon a specific trigger event. Such trigger event can be an exit event at, a change of control in, a sale, an IPO, a refinancing or an expert opinion on the valuation (Wertgutachten) of or any equivalent with respect to the Company. The payment amount is fixed to the equivalent of a certain percentage of, depending on the type of trigger event, the net sale proceeds or the value of the Company etc. respectively (each a “Reference Value“). I.e., in principle, the Warrant usually grants a contractual right (only) to demand the redemption amount (Gegenwert) of x-percentage of shares in / the Reference Value of the Company (mostly in the form of a release of proceeds (Erlösauskehr)). (NB: A warrant does not grant an in rem position like shareholdership, partnership or equivalent. The Warrant holder is a normal stakeholder, no shareholder.) [SBA: Sehen wir auch so – war nur eine verkürzte Darstellung.]

Key features:

(A) Loan: In principle, it is a market standard loan that in such Transactions typically may contain one or any of the following features: (i) an accordion / additional uncommitted /incremental facility/ies to address growth issues of the Borrower, and (ii) an interest (base rate, i.e. EURIBOR (or any equivalent), plus margin or at times also a fixed interest) with specials like “pay if you can” or “payment in kind” (“PIK“). “Pay if you can” provisions stipulate that, in principle, no interest is to be paid in cash but only optionally, so to say, if the Borrower can. PIK provisions stipulate that, in principal, interest is to be paid in cash at designated intervals but the Borrower may, after the end of the current interest period, opt to add the total amount of interest due and payable for the last interest period to the total amount of principal outstanding under the Loan (so called “to PIK interest”).

(B) Warrant: Typically, the Warrant holder’s right to demand payment equals and is limited to a certain percentage of the Reference Value and the Warrant is exercisable only at pre-agreed trigger events.

Typical context: Startups, growth financings

Pros and cons (not captured below):

The upside of such Transactions is that the burden of interest (Zinslast) of the Borrower can be preserved (i) by using the pay if you can/PIK option as well as (ii) by reducing the regular interest by the upside sharing of the Warrant where payment happens at a later point in time and payment does not eat into Borrower’s cash flow.

Category for tax purposes

If properly structured, the Loan and the Warrant are considered separate instruments with the Loan being a (straight forward) debt instrument and the Warrant an option like instrument. For more details see below.

Governance Rights

For the Loan this is not applicable.

Warrant: Usually, the Warrant is drafted to only provide for a contractual right in the redemption amount (Gegenwert) of x-percentage of shares in / the Reference Value of the Company (mostly in the form of a release of proceeds (Erlösauskehr)), thus, only provides for a monetary contractual participation, hence, governance rights are not applicable as a matter of law. The usual Warrant holder qualifies as normal stakeholder (not as shareholder).

If so agreed, the Warrant may provide for observation or consultation rights, (very rarely) voting rights or veto/approval rights in respect of particular matters). But, regularly, granting voting or veto/approval rights are not granted as not only (A) under German insolvency law any shareholder (i.e. any person having in rem rights in the Company, i.e.) (i) holding directly or indirectly more than ten (10) percent of the shares or interests in or (ii) (it or any of its affiliates) being a managing shareholder (geschäftsführender Gesellschafter) of a German Company, is subordinated with any of its claims against the Company vis-à-vis any other (secured or unsecured) creditors, but moreover (B) it has been determined on a case-by-case basis by German case law that the same applies mutatis mutandis to any person having an equivalent influence/position (so called “shareholder like position” (gesellschafterähnliche Stellung)) in the Company, even solely out of contractual (in personam) rights. Thus, in such exceptional cases the legal or factual position of the Warrant holder pursuant to the Warrant may lead to a subordination of the investor’s rights as Lender under the related Loan.

Investor Qualification Requirements

No particular qualifications or requirements in excess of what would be required under a common, market standard loan (as debt instrument) under German law: e.g. such as a banking licence of the investor (subject to certain exceptions (other than in case of a revolving loan) such as reverse solicitation) etc.

Currency Considerations

(A) Loan: no specifics

(B) Warrant: Usually the currency denominating the Warrant and any payment obligations related thereto follow the local currency of the jurisdiction of the share capital of the Company. But that’s a pure commercial decision. If the investor wants to deviate therefrom and the Warrant shall be denominated in another currency than the share capital of the Company, usually, an exchange rate is contractually fixed.

Material restrictions or conditions for the remittance of investment proceeds outside of the German jurisdiction:

No specifics – usual restrictions and remittances and anti-money-laundering restrictions (pursuant to the Money Laundering Act (Geldwäschegesetz (GwG)) apply. As to tax implications see below

Collateral

(A) Loan: no specifics – Loans are seen secured (or unsecured) depending on the credit worthiness and/or rating of the Borrower; Collateral by all types of asset classes (shares, accounts, receivables, immaterial rights, property etc.), granted by the Borrower and its direct and/or indirect subsidiaries or third party security providers.

(B) Warrant: Usually, even if the Loan is secured, the Warrant is unsecured as it typically matures beyond the Loan. If the Warrant is secured (i) the Loan may either not be re-financeable or (ii) any security granted under the Warrant will need to be released for the purpose of the refinancing of the Loan and the Warrant would need to persist unsecured from then on

Priority Payment Rights

In principle, the Lender receives periodical interest payments. Thus, in principle, the Lender receives payments prior to any shareholder who, typically, only receives distributions annually and on the basis of the (equivalently) reduced profit. But besides that there are no further priority payment rights to receive distributions based on an agreed portion of gross revenues, free cash flow and/or net income

Distribution and Redemption Limitations

(A) Loan: For the Loan this is not applicable.

(B) Warrant: For the Warrant this is not applicable either as, usually, it does not grant shareholder rights (due to reasons described above) and grants a contractual right in the redemption amount (Gegenwert) of x-percentage of shares /the Reference Value in the Company (mostly in the form of a release of proceeds (Erlösauskehr)) only, thus, no distribution rights, such as dividend rights etc., and no redemption rights exist.

Legal limitations to pricing or total return

Customary limitations (such as violation of public policy, bonos mores (Treu und Glauben) apply and are subject to the specific circumstances of each individual case. With this regards, for example, it has been determined by German case law that a loan agreement by which a lender causes himself or a third party to be promised or granted pecuniary advantages which are clearly disproportionate (auffälliges Mißverhältnis) to the performance (i) by wilfully exploiting the weaker position (bewusstes Ausnutzen der schwächeren Position) of the borrower or (ii) by gross negligently (leichtfertig) denying (sich der Erkenntnis verschließen) that the borrower only engages in the pressuring conditions due to its weak position, will be null and void (due to breach of German public policy (pursuant to sections 138, 826 of the German Civil Code (Bürgerliches Gesetzbuch (BGB)(Wucher (usury), Sittenwidrige, vorsätzliche Schädigung)). German courts assumed such conditions in case the interest agreed increases the interest to be agreed at arm’s length by (relatively) 100 % or (absolutely) 12 %.

NB: However, these are just indicative values (Richtwerte) and it cannot be excluded that a German court will decide otherwise on a case-by-case basis.

Status in Insolvency Proceedings

It has to be taken into account that the Loan repayment claim is directed against the Company as Borrower, whereas the payment claim under the Warrant is directed against the Company’s shareholder(s) / partner(s) as Issuer. Thus, with regard to an insolvency event the following applies:

(A) Loan: In case of an insolvency event in the Company: Usually, the payment obligations of the Borrower under the Loan rank at least pari passu with all other unsecured and unsubordinated payment obligations of the Borrower, except for obligations which are accorded priority by bankruptcy, insolvency, liquidation, reorganisation or other laws of general application (e.g. secured obligations which are treated with preferred satisfaction (Aussonderungsrecht)).

Only, (as described above) in exceptional cases, where the Warrant grants a shareholder like position (gesellschafterähnliche Stellung) in the Company to the investor, the investor as Lender may pursuant to German case law be subordinated with its repayment claims under the related Loan in case of an insolvency event in the Company. Further, as such shareholder like investor is / may (on a case-by-case basis pursuant to German case law) be treated equal to a shareholder, (1) repayments on such shareholder like loans effected within the last year (365 days) prior to insolvency filing of the Borrower, or (2) granting of security to any shareholder like person within the last 10 years prior to insolvency filing, may be challenged by the insolvency administrator. Therefore, the Warrant is usually drafted as a contractual (in personam) right (schuldrechtlicher Anspruch) only without shareholder like rights.

(B) Warrant: The payment claim under the Warrant is directed against the Company’s shareholder(s) / partner(s), thus, is from a pure legal perspective not affected in case of an insolvency event in the Company (but commercially due to the potential decrease of the Reference Value of the Company). In case of an insolvency event in the Company’s shareholder(s) / partner(s) as Issuer, the payment obligation of the Issuer under the Warrant ranks at least pari passu with all other unsecured and unsubordinated payment obligations of the Issuer, except for obligations which are accorded priority by bankruptcy, insolvency, liquidation, reorganization or other laws of general application (e.g. secured obligations which are treated with preferred satisfaction (Aussonderungsrecht) – but, as described above, collateral will be rarely seen in case of a Warrant due to the refinancing issues).

Limitation of Liability

The investor’s liability towards the Company and its creditors is limited to its funded or committed investment. There is no, nor will there be, any obligation to make additional contributions (Nachschusspflicht).

Transfer Restrictions

(A) Loan: Due to the combined nature of such Transactions, regularly, the Loan shall not be transferred without the Warrant and vice versa, meaning, in any case the lender needs to be the Warrant holder (so called “stapled investment”). Besides that, customary transfer restrictions apply.

(B) Warrant: stapled investment (see above).

Critical Tax Considerations

If properly structured, the Loan and the Warrant are considered separate assets also for German tax purposes. Note that this requires, among other things, that the Warrant is acquired for an arm’s length consideration (as an option premium) that will forfeit (and retained by the Issuer of the Warrant) if the Warrant is not exercised. The option premium is payable (incl. by way of set off) when the Warrant is granted i.e. at the outset of the transaction.

If Loan and Warrant are viewed as two separate assets, the tax consequences could be summarized as follows (on high-level basis and without regard to the individual case and assuming that the Warrant holder does not become a Company shareholder):

(A) Loan:

Any payments to the investor are tax deductible at the level of the Company subject to general limitations (such as the German interest barrier rule (Zinsschranke) and the add-back provisions under German trade tax).

In principle, there is no German withholding tax on such payments. However, exemptions apply if

the borrower is a bank / financial institution,
the Loan has hybrid features (such as profit participating loans, silent partnerships),
the Loan is secured through German real estate, in which case the German tax administration may request the Borrower to withhold taxes in the individual case (i.e., no automatism),
the lender resides in a so-called non-cooperative jurisdiction, or
the investor is to be considered a related party of the Company (e.g., because the investor holds an equity interest in the Company) and the Loan is not at arm’s length.

Note that the Warrant should generally not “taint” the Loan in a way that the Loan is to be considered “hybrid” if Warrant and Loan are viewed as separate assets. However, there is a risk that the German tax authorities might take a different view, which would need to be analyzed on a case by case basis.

The taxation of payments in the hands of the investor depends on a number of different factors, including the investor’s tax residence and the eligibility of the investor under an applicable double taxation treaty. However, generally speaking, the investor should not be subject to German limited tax liability if the Loan is not secured with German real estate (unless in cases where the Lender resides in a non-cooperative jurisdiction).

(B) Warrant:

The exercise of the Warrant and any payments thereunder should generally not affect the tax situation of the Company (as the Warrant is issued by the Company’s shareholder(s)).

Furthermore, payments under the Warrant should generally not attract German withholding tax.

The taxation of payments under the Warrant in the hands of the investor depends on a number of different factors, including the investor’s tax residence and the eligibility of the investor under an applicable double taxation treaty. Generally speaking, a Warrant holder would be subject to limited taxation in Germany if (i) the Warrant was to be considered an “expectancy right” (Anwartschaftsrecht) or a “participation right” (Genussrecht), and (ii) such right would entitle its holder to participate in 1% or more of the profits/liquidation proceeds of the Company. We believe that there are arguments that the Warrant should not give rise to limited taxation if the Warrant could be structured as a virtual instrument with a mandatory cash-settlement (i.e., not entitling its holder to receive shares). However, there is no explicit case law in this respect, so that there is a risk that the tax authorities take a different view.

Note that Warrant holders might be protected under an applicable double taxation treaty, in which case Germany should not have the right to tax payments under the Warrant. However, details would need to be reviewed on a case by case basis.

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Executive Summary1