Start-ups in Crisis Mode – Opportunities and Risks of Reorganising the Liabilities and Equity Section of the Balance Sheet

I. Challenging Financial Landscape

The German venture capital market has undergone an extremely dynamic development since 2019. Steady growth through 2020 led to a record boom in start-up investments in 2021, followed by a significant slowdown from 2022 onwards. As the financing volume stabilised by the first half of 2025, the industry focus of investments has narrowed at the same time. While investments by VC funds were "scattered" without a clear industry focus in the years up to 2021, there has been a clear trend since 2022 towards technology investments that promise long-term growth, develop relevant industrial property rights and have strategic relevance, such as artificial intelligence or defence technology. For companies outside of these technology industries, it could prove even more difficult to obtain follow-up financing.

This shift in the financing environment for start-ups is also having an impact on financing conditions. Round financings leading to a massive reorganisation of the liabilities and equity side of the balance sheet, and a fundamental restructuring of the cap table of the companies concerned are on the rise. In some cases, an imminent financing offers a welcome opportunity to clean up the shareholder list by heavily diluting or completely excluding (former) employees, business angels, early-stage financiers and other early shareholders. In many cases, however, these measures are necessary in order to reorganise the company in the long term.

Another aspect for consideration is the position of the founders and employees in the context of such capital measures. Their shares in the company are also diluted or eliminated by the restructuring measures, raising questions of employee incentivisation. A sustainable reorganisation can only succeed with the team, especially given that in order to overcome the crisis far-reaching operational changes are often necessary, too. Although the topic of employee ownership is not discussed below, it is usually a key component of reorganisation measures.

II. Capital Reduction and Comparable Measures

In practice, the following instruments can be found, among others, which have a considerable influence on the shareholders:

1. conversion instrument (SAFE, convertible loan), which converts at a substantial discount,
2. financing round with substantial liquidations preferences and
3. capital reduction

For the purposes of differentiation, proceedings under the German Act on the Stabilisation and Restructuring Framework for Companies (StaRUG) should also be mentioned. However, these are governed by a distinct statutory regime and are therefore excluded here.

1. Convertible Loans and SAFE

Convertible loans and the financing instrument of a SAFE (Simple Agreements for Future Equity) "imported" from US law have one thing in common: an investor makes a certain amount of money available to the company without directly receiving shares in the company in return. The investor initially only acquires a loan receivable or the right to subscribe for shares in connection with a future event. In the case of a convertible loan, these shares replace the repayment of the loan. The future event is usually an equity financing round at the company, the sale of the company or the maturity of the loan.

The number of shares that the investor can demand as part of the future event depends on the valuation of the company at the relevant time or is agreed in the loan agreement. The investor is treated as if they had made the investment directly as part of the future event. In order to take account of the fact that the money invested was already tied up and at risk at an earlier point in time, a discount of usually 20% or more and/or a valuation cap is usually agreed upon.

More recently, however, arrangements have been discussed in which the amount invested is taken into account with a multiplier for the purposes of conversion. For example, it could be agreed that ten times the loan amount is taken into account for the purpose of calculating the number of shares that the investor receives as part of the conversion. The consequences can be serious as noted in the below example:

A GmbH (German Limited Liability Company) has share capital of EUR 50,000. Investor A gives the company a non-interest-bearing convertible loan of EUR 1,000,000, which is converted into shares as part of the next financing round. The conversion is to take place at the share price of the financing round, whereby the loan amount is to be multiplied by a factor of 10 in the calculation. The next financing round will take place at a pre-money valuation of EUR 10,000,000. External investors provide EUR 2,000,000 in equity capital and will at best agree to the following simple calculation: Anyone investing EUR 2,000,000 out of a total of EUR 3,000,000 ("fresh money" plus loan amount) on a pre-money valuation of EUR 10,000,000 must end up holding 15.38% (=2,000,000/13,000,000) of the company. The lender would be treated as if it had invested EUR 10,000,000 (=10x EUR 1,000,000) at the same share price as the external investors. In order to do justice to both the lender and the external investors, the share capital would have to be increased by EUR 549,970 from EUR 50,000 to EUR 599,970. An existing shareholder holding 10% of the company before the financing round would be diluted to 0.77% by the financing round. Without the multiplier as part of the loan conversion, however, the minority shareholder's stake would still amount to 7.69% (10,000,000/13,000,000 x 10%).

The existing shareholder will question under what conditions the company is authorised to conclude convertible loan agreements. The same question will also be asked by the lender who is concerned about the enforceability of his claim to the shares. As the issue of convertible loans is aimed at increasing the company's share capital and therefore at amending the articles of association, the issue of convertible loans is generally the responsibility of the shareholders. However, the shareholders can authorise the managing directors to issue convertible loans, either by creating authorised capital in accordance with Section 55a of the German Act on Limited Liability Companies (GmbHG) or by shareholder resolution. Both require a majority of 75% of the votes cast. Convertible loans are therefore not possible without the involvement of a broad majority of shareholders.

2. Liquidation Preference

Liquidation preferences can be regarded as the market standard in the German VC market. The typical arrangement stipulates that the investors receive an amount equal to their investment from the proceeds of a sale of the company before all other shareholders.

A liquidation preference reduces the default risk for the investors and thus serves to secure the invested capital. The arrangement can also be structured in such a way that it secures a minimum return in addition to the capital invested. Depending on the structure, the proceeds of the sale are redistributed so that the favoured investors receive an amount that exceeds their pro rata share of the sale proceeds, while all other shareholders lose out on a pro rata basis. Such arrangements can therefore also lead to considerable (economic) dilution, as the following example shows:

Investor A invests an amount of EUR 1,000,000 in return for a 10% stake in a GmbH. They agree to a liquidation preference which, in the event of a sale, allocates their proceeds amounting to ten times the invested capital before all shareholders, which is to be offset against their pro rata proceeds. The company is sold for EUR 12,000,000. Of this amount, EUR 10,000,000 is allocated to investor A and EUR 2,000,000 to the other shareholders. An existing shareholder who holds 10% of the GmbH would still receive an amount of approximately EUR 222,222 (= EUR (2,000,000/90) x 10). Without the investor's liquidation preference, their proceeds would have totalled EUR 1,200,000.

In practice, liquidation preferences are usually found in the shareholders' agreement, possibly with a supplementary provision (e.g. for dividends) in the articles of association. The shareholders' agreement is a contract between the shareholders that is only effective between the parties thereto. As a rule, liquidation preferences cannot therefore bind the shareholders without their consent. If, by way of exception, the liquidation preference is (also) regulated in the articles of association, its subsequent amendment nevertheless requires the consent of all affected shareholders due to the associated interference with the shareholders' right to draw profits and can therefore not be implemented by majority resolution.

3. Capital Reduction

The term "capital reduction" refers to a simplified capital reduction combined with capital increase for cash. Sections 55 et seq. and 58 et seq. of the German Act on Limited Liability Companies (GmbHG) contain the relevant provisions for such procedure. A capital reduction is usually realised in the first step through a simplified capital reduction in accordance with § 58a of the German Act on Limited Liability Companies (GmbHG). The capital is then increased by issuing new shares. The following example illustrates how this works:

The share capital of a GmbH amounts to EUR 31,250, of which shareholder A holds a share with a nominal value of EUR 25,000 and shareholder B holds a share with a nominal value of EUR 6,250. Shareholder A founded the company in year 01 and invested EUR 50,000. Shareholder B acquired their share in year 02 as part of a capital increase for cash and made a contribution of EUR 250,000. The shareholders' meeting resolves, with the votes of shareholder A and against the votes of shareholder B, to cancel the capital reserve to cover the accumulated loss, to reduce the share capital to zero, and to carry out a capital increase for cash to EUR 31,250, whereby 31,250 new shares with a nominal value of EUR 1.00 and a premium of EUR 99.00 are issued. The new shares will be offered to the shareholders pro rata to their shareholding in the company. Shareholder B does not wish to participate in the cash capital increase. Shareholder A acquires all of the new shares and pays the company an amount of EUR 3,125,000. With the entry of the capital reduction and simultaneous capital increase, the share capital is once again EUR 31,250, but is now held 100% by shareholder A. Shareholder B has left the company.

Both the simplified capital reduction in accordance with § 58a of the German Act on Limited Liability Companies (GmbHG) and the subsequent capital increase require a shareholder resolution with a majority of 75% of the votes cast.

III. Duty to Cooperate and Defence Strategies of the Shareholders

All of the aforementioned measures therefore require the approval of a broad majority of shareholders or - like the liquidation preference - even unanimity. While shareholders are fundamentally free to reject shareholder resolutions for self-serving or irrelevant reasons, an obligation to consent may arise from the duty of loyalty under company law. For practical reasons, this obligation is unlikely to be enforced in court. However, a breach of the duty of loyalty under company law can give rise to claims for damages, therefore, a shareholder should carefully consider whether to object to capital measures.

If the company is objectively capable of and in need of reorganisation, shareholders may be obliged to approve capital measures on the basis of their duty of loyalty. Such an obligation to consent may also arise from the shareholders' agreement. This can have serious consequences for minority shareholders, in particular the dilution of their shares and the resulting de facto loss of shareholder status. Particular attention must be paid to the ability and need for reorganisation. Approval is not required if the proposed capital measure is insufficient to sustainably reorganise the company or if reorganisation can be achieved by other, less drastic means, such as the sale of non-essential assets or the collection of outstanding receivables.

In practice, various attempts are made to incorporate restructuring capital measures into the company law documentation, for example by establishing obligations to agree to new financing if a (qualified) majority demands this (so-called financing drag) or by agreeing to the right of individual or all shareholders to provide the company with additional equity or debt capital in a crisis situation under certain predetermined conditions. However, such provisions are often rather generic, and are not really helpful in the event of a crisis scenario that goes beyond the next "plain vanilla" financing round. A more detailed regulation, for example on valuation parameters, interest rates, multiples, etc., on the other hand, leads to potentially difficult negotiations being brought forward at a point in time when the extent of the crisis and the financing requirements, financing environment, distribution of roles of the parties involved (financing from the circle of existing shareholders or "white knight" from outside?) are not yet known and therefore tend to be avoided by the parties involved. In practice, approaches to balance sheet reorganisation therefore tend to emerge on an "ad hoc" basis rather than on the basis of detailed contractual specifications, which then only need to be implemented.

If a minority shareholder refuses to consent to one of the aforementioned financing measures and is the measure nevertheless implemented by majority resolution, the minority shareholder's defence options depend on the financing instrument chosen and require that the minority shareholder in question actively defends itself by challenging the shareholder resolutions adopted, at considerable cost risk. The following arguments are conceivable, for example:

A capital increase could be contested on the grounds that the valuation on which it is based is unreasonably low or high. If the issue price for the new shares is too low in relation to their intrinsic value, a de facto compulsion to participate in the capital increase is created, which is not compatible with the principles of German company law. For example, it could be argued that the conversion of a convertible loan at a considerable discount would lead to an inappropriately low valuation, for example if the discount does not appear to be commensurate with the risk in view of the short period of time between the granting of the loan and the conversion. If the issue price is too high, this could result in a de facto exclusion of subscription rights if the excessive amount has been set primarily in order to exclude certain shareholders from the capital measure.

A simplified capital reduction could be contested on the grounds that the losses to be covered are based on an arbitrary undervaluation of assets or overvaluation of liabilities. A challenge is also conceivable if the capital reduction violates the general prohibition of abuse, which is the case, among other things, if the capital reduction serves the predominant purpose of excluding shareholders from the company. However, the requirements for an abuse of rights are high, and the burden of presentation and proof lies with the plaintiff.

IV. Conclusion

The aforementioned measures are associated with considerable risks from the perspective of both the company and the affected shareholders. However, if these measures are carefully planned and harmonised with the existing majorities, they can often be implemented with legal certainty from the perspective of the company concerned if the ability and need for restructuring can be proven.