In start-up financing, termination clauses may be effective which stipulate that founders will lose their shares in the company if they have to leave the company through no fault of their own within the first year.
Once investors have invested in a company, it is common for founders to agree on what is known as vesting clauses. A vesting clause is a contractual provision stating that a founder only acquires the right to certain shares over a fixed period of time, which usually lasts three to four years. Vesting arrangements aim to bind the founders to the company and motivate them to continue to contribute their full expertise. If a founder leaves the company before the end of the vesting period, such founder will only retain the shares earned up to that point during the vesting period. The first shares are, however, often only released after the first year (known as cliff). The Berlin Higher Regional Court (Kammergericht Berlin, KG) recently ruled that a termination clause in the form of a vesting provision for a start-up may be valid. The clause in question stipulated that a shareholder must transfer such shareholder's shares to the co-shareholders at their request if the shareholder's employment relationship with the company is terminated within the first year of the vesting period.
In the appeal proceedings, the parties disagreed on the shareholder status of the claimant, who was a co-founder of C-GmbH. This company, originally founded as an entrepreneurial undertaking with limited liability, known as Unternehmergesellschaft or UG, signed an investment agreement with investors investing EUR 1.373 million in return for the issue of shares. As part of the deal, the founders agreed to vesting and had to define a corresponding exit provision for their holding company, which stipulated that the founders would lose all shares if their employment contracts were terminated within the first year of the three-year vesting period. The claimant was released from his duties and negotiated his resignation for six months, which was finally confirmed by regular termination. The claimant felt that the purchase option for his shares was contra bonos mores and therefore invalid. The Berlin Regional Court (Landgericht Berlin) dismissed his claim in the lower instance. The claimant's appeal to the Berlin Higher Regional Court was unsuccessful.
The Berlin Higher Reginal Court in its notice to the parties found, among other things, that a termination clause in the form of a vesting schedule is valid if the intention is to link a founder's shareholder status in a start-up company with his continued commitment to the company.
The Berlin Higher Regional Court (Kammergericht Berlin, KG) initially refers to rulings of the German Federal Court of Justice (Bundesgerichtshof, BGH). The BGH considers termination clauses in which the other shareholders of a GmbH (i.e. a private limited liability company under German law) are granted the right to exclude a co-shareholder from the company without objective reason to be null and void. The affected co-shareholder is no longer in a position to exercise his membership rights in the company and meet his membership obligations. This is because the possibility of free termination can actually be interpreted by him as a disciplinary tool ('Damoclean sword') and prevent him from exercising his membership rights. Termination clauses are only justified in exceptional cases if there is an objective reason. If the behaviour of a shareholder is reproachable, it is much easier to objectively justify a termination (bad leaver event). If, however, the termination is not based on reproachable behaviour - as is the case here with the regular termination (good leaver event) - the requirements for the objective justification of a termination clause are higher. However, it is always necessary to analyse all the relevant circumstances of the individual case.
The Berlin Higher Regional Court makes it clear that it could be justified to completely force a founder out of his shareholder position during the first year of the three-year vesting period by means of a cancellation clause. It is true that the founder may lose the rewards of his previous contribution to the (future) success of the company. However, a certain period of time, in this case the first year, may be used to resolve any differences between the shareholders and find workable compromises.
According to the Court, such arrangements were in the interests of both the investors and the founding shareholders: investments in start-ups involve uncertainty for investors, particularly as to whether the company will successfully survive the start-up phase. Investors needed to rely on the founders to continue to contribute their expertise and hard work to the company, particularly because the founders could not offer them any traditional collateral. At the same time, there might be an interest in subjecting the founders to a probation period to avoid having to be more restrictive with regard to placing trust or calculating with an increased failure risk as part of the investment decision.
The KG not only considers the perspective of the investors and their financial risk, but also emphasises that the vesting rule is in the ex-ante interest of the founders. The crucial factor was that the (urgently needed) financial resources could be raised and (future) disagreements among the shareholders could be resolved as easily as possible without the need for the successive retransfer of shares. In this important phase for the company, it was therefore justified to link the continuation of the founder's shareholder status with his continued commitment to the company.
This decision makes it clear that a termination clause may be effective even when there is no reproachable behaviour, provided there are objective justifications. The notice by the Berlin Higher Regional Court to the parties is fully consistent with the past BGH decisions on termination clauses. The BGH had already previously assumed objective legitimate grounds in several individual cases, such as the temporary 'probation period' of a new partner in a joint practice.
A vesting provision also usually includes arrangements for the amount of severance pay. However, the KG leaves it open whether a severance payment at the nominal price is appropriate in the case of a good leaver clause, as an appropriate severance payment could replace the agreed one. According to established case law, the market value settlement is the standard case. There are limits to the restrictions that may be imposed. In practice, deductions are often made as a percentage of the market value depending on the leaver event. It seems reasonable to assume that bad leavers would lose 40% and good leavers 20%. A distinction is also made as to whether shares that have already been vested are lost or whether only unvested shares are to be transferred back. For bad leavers, a settlement at nominal value is common, as this corresponds to the acquisition costs. In the case of a good leaver, usually only unvested shares are retransferred at nominal value.
Severance pay at the nominal price or with a small premium may also be justified for good leavers. The KG emphasises that the start-up gains considerably in value through investor capital, while the founders have to earn this value over time.
In practice, it is advisable to use fall-back clauses for retransfers. These stipulate that the lowest permissible severance payment applies if a court declares the original severance payment provision invalid.
Berlin Higher Regional Court, notice of 12 August 2024 – 2 U 94/21
Christian Burmeister
Damien Heinrich
This blog post also appears in the Haufe Wirtschaftsrechtsnewsletter.
