Second Closing for Financing Rounds
An Instrument for optimising the Timing of a Venture Capital Investment Process in the Search for Investors for a German GmbH
Irrespective of the current Covid-19 pandemic situation, the most essential factor in the search for new investors and/or business angels is the time: only the time determines when and if money flows at all. Time-related uncertainties can prevent the required investment, or at least (seriously) delay it. This delay will inevitably worsen the negotiating position of the Venture, as potential investors will know the required financial requirements.
Despite numerous advantages, the inflow of funds through the creation of so-called authorized capital (cf. section 55 German Limited Liability Companies Act (GmbHG)), should the required financing volume of the "first" financing round not yet be reached, is still rarely seen in the German venture capital sector.
In the context of a venture capital participation of investors already involved as well as in the search for new investors up to a certain deadline, it is advisable to reserve the right for additional investors to join the participation agreement and thus the company. In the case of the GmbH, this is done by a so-called Second Closing which is implemented through authorized capital. Here the GmbH is provided with the necessary liquidity and in return a simplified form of share issue is made to the (new) investor.
Although this results in a simplification of the time frame for all parties involved, the first step requires a careful and accurate contract drafting excercise.
Authorized Capital in a Nutshell
Basically, the shareholders of the first financing round (Closing) agree that further investors or those from the existing shareholder base can subscribe new shares without the need for further shareholder resolutions at a later date. As a result, the management of the GmbH is (usually) authorised to increase the share capital of the company by a maximum of 50% of the previous share capital within the next - maximum - five years, subject to the conditions initially set by the shareholders. Said shareholders' resolution amending the articles of association (notarisation and majority required to amend the articles of association, cf. section 53 para. GmbHG) is filed with the commercial register and consequently becomes a new component of the then applicable articles of association.
The creation of authorised capital in venture capital financing is being flanked by the placement of further provisions in the entire investment documentation, including the Investor Agreement and/or the Shareholders Agreement. The entire content sought by the shareholders should finally be included in the investment documentation. This requires a careful approach to contract drafting in order to avoid later changes (in the articles of association).
What should thus be definitely arranged and stipulated - in advance - without fail?
- Maximum increase amount (maximum 50% of the share capital already subscribed);
- Number and nominal amount of the maximum number of shares to be issued (if necessary, by mentioning the ranking (keyword: Preferred Shares));
- Clarification of the issue of gradual authorisation, i.e. repeated exercise until the maximum amount of the increase is exhausted;
- Collateral duties of the investor, including joining the Investor Agreement/Shareholder's Agreement in the case of a (new) investor;
- Provisions regarding the obligation to make contributions (Einlageverpflichtung), such as payment or overpayment (free capital reserve in accordance with section 272 para. 2 no. 4 German Commercial Code (HGB));
- Exclusion of subscription rights of existing shareholders;
- Catalogue of approval (Zustimmungskatalog) of individual existing shareholders, if applicable.
Closing of the Second Closing
Second Closing is then executed by the management or nominated investors. The takeover of the new shares is based on the notarised takeover declaration (Übernahmeerklärung) of the (new) investor and a declaration of acceptance (Annahmeerklärung) of the company (informal). Subsequently, the management registers the capital increase with the commercial register and submits a list of the transferees and a new list of shareholders to the commercial register. At the same time, this registration also leads to an amendment in the articles of association, as the share capital is increased as a result.
Advantages and Disadvantages
The creation of the possibility of a Second Closing at economically identical or already determined conditions leaves founders and their investors the necessary time to select and negotiate with (new) investors. Since the decisive parameters are already carved in stone, there is planning security and the founders have the opportunity to make their selection of the new investor without the participation of the entire shareholder group. The (new) investor would have to renegotiate or refrain from participation if it did not agree with the conditions of the authorized capital. The chances of saving (notary) costs compared to the venture capital investment process of a normal investment round are enormous.
On the other hand, there is the concern that the conditions in the first round were not correctly assessed or simply poorly, if not wrongly drafted. The authorized capital and the wording of its terms and conditions require extreme care in contract drafting and also estimation of the valuation, as the economic parameters cannot be changed later or only with greater effort.
Recommendation for Action
Although the factual requirements for authorized capital seem to be clear by law, the exact intentions of the shareholders must be reflected in the creation of such capital. This requires sound advice in advance and, as a consequence, proper and thorough contractual implementation. Furthermore, the formal requirements associated with a possible amendment of the articles of association must be observed even before the authorized capital is created. Only if all this is observed can the Second Closing be a chance to save time, money and nerves.
Dr Sebastian Weller