Germany: Minority participation

Author: | Published: 1 Apr 2012
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As a result of the European debt crisis, banks are often unwilling to enter into risk-carrying engagements. As a consequence, companies are looking for alternative financing. One alternative financing method is minority participation by private equity investors.

A minority participation is an equity interest of less than 50% in a company. There are mainly four different scenarios in which a need for a minority participation by a private equity investor may exist: growth, replacement, refinancing and turnaround scenarios.

In a growth scenario the target company is looking for funding to be able to make strategic investments and to generate further growth. A replacement scenario includes the acquisition of shares from individual shareholders who intend to leave the target company. Refinancing scenarios occur when the maturity of debt, such as standard mezzanine programmes or acquisition finance taken out by the target company, requires new capital. Turnaround scenarios are those where the target company is in operative or financial difficulties and needs funding in order to move out of the doldrums. In all such scenarios, mezzanine financing, even if structured as equity for balance sheet purposes, is often not sufficient from the point of view of relevant third parties such as important customers, who may require that the gearing of the company is shifted toward real equity. In these instances, owners need to resort to minority participations rather than convertible bonds or other mezzanine instruments for financing.

According to the German Private Equity and Venture Capital Association (Bundesverband Deutscher Kapitalbeteiligungsgesellschaften, or BVK) the value of minority participations by private equity investors in Germany reached €929 million ($1.23 billion) in the first three quarters of 2010. During the same period in 2011, the value came only to €359 million. The reason for this remarkable decrease in value is, according to the BVK, based on a few very large transactions in 2010 rather than on a decreasing number of minority participations in 2011.

The challenge with minority participations is to devise and implement a bespoke structure which seeks to align the interests of the private equity investor to be an active investor and the owner and the management to be in charge.


The classic investment method of private equity investors in Germany is a buy-out strategy, where the private equity investor takes over control of the target company. This is because the private equity investors themselves depend on investors and are measured by the return they succeed to generate for their investors, and therefore have an interest in being able to decide independently on all matters crucial for the development and performance of their portfolio companies, for example. restructuring measures, investment strategy, and exit. Hence, control of the exit from their investment and influence during their engagement are of great importance for private equity funds.

When it comes to minority participations, the owner of the company naturally has little interest in granting control or influence exceeding normal shareholders' rights in exchange for financing. After the investor has identified a potential target company, the key terms of the investment are discussed with the owner and agreed in a letter of intent. If the owner is represented by advisers, the investor will often be requested already at this early stage of the transaction to indicate, among other things, which governance rights it expects in return for the investment.

However, as with the valuation of the company and the corresponding investment amount, it is even more necessary for the investor to maintain its flexibility at this stage, since the investor will not have sufficient insight into the company to propose a bespoke governance solution. Thus the investor should resist being coerced into any premature proposal and should instead seek to start a process with the owner and the management to jointly develop a proper governance structure.

Bridging the information gap

The due diligence process in preparation of a minority participation is comparable to one in a buy-out scenario. The private equity investor needs an equally sound information basis in order to take its investment decision. But against the background that the private equity investor will not gain control over the target company ,the assessment of due diligence findings may differ from the buy-out process because the decision on how to remedy any findings does not lie with the private equity investor alone.

The legal documentation concerning the acquisition of a minority participation in a German business consists mainly of a share purchase agreement or, alternatively, a declaration of assumption in cases of investment by means of a capital increase, the amended articles of association and a shareholders' agreement both relating to the company or a joint holding company.

The documentation covering the acquisition of shares in the target company should grant the investor the usual comfort one would expect when acquiring a share in a business. Compared to a buy-out, the investor has a certain structural cover given that the owner does not sell out, but remains aligned with the company's, and therefore the investor's, interest. This is in particular true if the investor injects new equity in the company exclusively, and does not make any direct or indirect payments to the owner.

The key legal documentation concerning minority participations is the so-called equity documentation, which includes the articles of association and the shareholders' agreement. The equity documentation provides the structure for the shareholders' legal relationship and the bodies of the company during the engagement of the investor in the company. To create a solid structure, balancing and alignment of conflicting interests is pivotal. The investor's key objective is to generate an adequate return from its investment in the company. As a means to that end, it will require certain governance rights and the right to control its exit from the investment. On the other hand, the owner and the target company's management may fear the pressure of having to generate certain returns, and to lose their operative independence or the company altogether as a consequence of the investor's engagement or its exit.

Operative matters

The articles of association should allow the investor to participate in the decision-making process of the management for certain operative matters. This can be done, for example, by way of a catalogue of matters which require a prior shareholders' resolution with a qualified majority or for which the private equity fund has a veto right. Most commonly, however, a facultative advisory board is installed in the articles of association in this regard. In this case the catalogue of matters requiring prior consent of the advisory board is incorporated in rules of procedure for the management. Accordingly, the articles of association should provide for the right to enact these rules of procedure for the management and require the consent of the private equity investor for any later changes.

The advisory board typically consists of three members: a representative of the private equity investor and a representative of the majority shareholder as well as a neutral third party such as, for example, an industry expert. The articles of association should state the number of members to the board, who is entitled to appoint the members, the required qualifications of the members and a basic description of the board's responsibilities.

Matters requiring the prior consent of the advisory board should include, among others, the business, finance and investment strategy, important investments (such as add on acquisitions), investments of a certain value, taking on debt and employment or engagement of individuals being related to the majority shareholder in a certain way. The involvement in the determination of the finance and investment strategy is the most important instrument for the private equity investor to influence the future development of the target company.

Since the advisory board requires a sound information basis in order to take its decisions, the rules of procedure for the management should include certain obligations to keep the advisory board informed. The management should provide the advisory board with certain regular and special reports, and any material events outside the ordinary course of business should be brought to the attention of the advisory board without undue delay.

Moreover, the articles of association should contain a restriction on the transferability of shares in the target company and on the appointment of new managing directors in such way that the consent of all shareholders shall be required. This is to ensure that provisions in the shareholders' agreement regarding a sale of shares are being followed and that the private equity investor has a say in the selection process of new member to the management. Restrictions on the transferability of shares stated in the articles of association are according to German law effective even with regard to third parties. Therefore, shares cannot be validly transferred if the requirements for a transfer according to the articles of association of the respective company are not met.

Finally, rules on the appropriation of the net income of the target company should be included in the articles of association. The shareholders have to decide whether the target company should in general accumulate its profits or pay dividends to its shareholders. The investor may focus on the maximisation of the value of its share in the company and may therefore prefer that any income is used to increase the value of the company rather than being distributed to the shareholders, or may place more emphasis on a constant stream of payments from the company during its engagement. Private equity investors tend to have a value-oriented strategy which focuses on the exit, whereas family offices as investors often lean more towards payments of dividends, and are more indifferent as regards the exit. It has to be taken into account, though, that owners of family owned businesses often live from the proceeds of the target company and thus have a strong interest in a certain level of dividend payments.

The investor should seek to include certain special rights into the shareholder's agreement which will apply in case the performance of the company is unsatisfactory. The shareholders' agreement should, for this purpose, state certain performance milestones which, if not met, trigger special rights. Special rights could be, among others, the right to mandate advisers, to exchange members of the management board, put options and special liquidation rights of the private equity investor.

Special emphasis should be placed upon the exit of the investor. The parties should develop a joint understanding of when and how the investor is envisaged to terminate its engagement in the company, and ensure that the shareholders' agreement reflects such understanding properly. Typical provisions include control rights as regards triggering the exit and selecting the exit channel, and provisions on the sale of shares, in particular pre-emption rights, tag-along and drag-along rights, which can apply unilaterally or bilaterally.

Provisions on sale of shares

Should the owner offer its shares in the company for sale to a third party, a pre-emption right would grant the investor the right to buy the owner's shares, usually at the same conditions as offered by the third party. Thus, the investor may avoid its premature exit and may instead gain control of the company – take the second step of what then becomes a two-step-buyout. In reverse, an owner's pre-emption right may severely burden the investor's exit, since potential buyers might shy away from investing into an offer to the investor which may be frustrated at an advanced stage of the transaction by the owner making use of the pre-emption right. At any rate, any owner's pre-emption right should be drafted carefully to set out clearly under and at which conditions it may be exercised and should provide for a very limited exercise period.

The investor should ensure that he has the right to sell its shares in the company pro rata to his total interest in the company in case the owner, and preferably any other shareholder, sells any of its respective shares to a third party. If applied bilaterally, the tag-along right will severely restrict the investor's ability to exit, given that other minority investors are excluded as potential buyers should the owner intend to exercise its tag-along right. The investor should therefore seek to avoid an owner's tag-along right, and should argue that the tag-along right is a minority protection right.

Under an investor's drag-along right the owner is obliged to sell his shares along with the investor. A drag-along right is normally subject to certain prerequisites such as an overly-long holding period of the investor, underperformance of the target company or failed exit efforts. If the owner refuses to comply with the drag-along right, the investor needs to engage in legal proceedings, which the investor will often want to avoid. Thus, the investor's drag-along right may be seen as more of a tool to strengthen the investor's bargaining position, than a clear-cut route to full exit. In addition the investor could suffer reputational damage if it actually enforces a drag-along right and forces the owner out of its (family) business. Again, the investor should generally resist a corresponding owner's right. If combined with a pre-emption right and a preference which seeks to set a floor to the return generated by the investment, an owner's drag-along right may be acceptable.


The exit channels for minority participations are more or less the same as in a buy-out scenario. Depending on the market environment the following exit scenarios might be of relevance: trade sale, secondary (only the minority participation or the target company as a whole is sold to a strategic or financial investor), listing or owner's buy-back. In addition, partial exits by way of recapitalisations may also be an option, again strongly depending upon the market environment, and the debt capacity of the company.

To set out a clear legal framework for an owner's buy-back as an exit route, the equity documentation should provide for corresponding call and put options. Usually call and put options are used in such a way that after a certain lock-up period in which none of the shareholders is allowed to sell its shares, the owner may during a certain period require the investor to sell its shares back to the owner for a purchase price equalling the initial investment amount plus a certain fixed return (call option).

After said period has elapsed, the investor, again during a certain period, may request the owner to buy back the investor's shares for its initial investment amount plus a certain fixed return (put option). After the call and put options have expired, the standard restrictions on the sale of shares set out in the equity documentation apply. Whether the parties make use of the call or put option as described above will depend on the development of the value of the company and its relation to the predetermined purchase price: whether the options are in the money or out of the money. Therefore, the parties should agree in detail upon the valuation of the company.

Jan Wildberger
  Dr Jan Wildberger is a partner at P+P Pöllath + Partners in Frankfurt. He specialises in M&A and private equity with a special focus on cross-border transactions. He has practised law since 1998 and was a partner at large domestic and international law firms in Frankfurt am Main and London. He was admitted to the German Bar in 1998 and admitted as a Solicitor of the Supreme Court of England & Wales in 2001. Wildberger is regularly listed in international rankings as a leading expert in his area of expertise.

P+P Pöllath + Partners
Zeil 127
60313 Frankfurt/Main

T: +49  69 247047 0
F: +49  69 247047 30

Katharina Reuther
  Katharina Reuther joined the Frankfurt office of P+P Pöllath + Partners in 2011. She focuses on M&A, private equity and joint ventures. She was an associate at large international law firms between 2008 and 2011, and was admitted to the bar in 2008. Reuther studied law in Augsburg and Kiel.

P+P Pöllath + Partners
Zeil 127
60313 Frankfurt/Main

T: +49  69 247047 0
F: +49  69 247047 30