5 minute read | October.10.2024
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Following a ruling earlier this year by the Regional Labor Court of Munich on the validity of negative vesting clauses (more on this in one of our last Legal Ninja Snapshot), another ruling by a higher German court just came down the pike that provides further clarity. The Court of Appeal in Berlin (see KG - 2 U 94/21) decided on the general permissibility of founder vesting, a cliff period and the consequences of a compensation clause that might result in an unreasonably low compensation amount.
As a quick reminder, here is what we mean by founder vesting. Founder vesting means that the founders need to "earn" their shares in the start-up over a period of time known as the vesting period through their continued involvement in the company. This vesting prevents founders from leaving the company prematurely while keeping an unduly large portion of the company. A vesting period of three to four years is common in Germany. Founders earn their shares usually in monthly (occasionally quarterly) instalments over that period. The first 12 months are usually a so-called cliff period during which no vesting occurs. Only after the cliff period has expired, usually a quarter or a third of the founders' shares vest. Such vesting clauses usually provide for a call-option to be granted by the founders to the (lead) investors, the company, or a third-party nominated by the (lead) investors or the company to acquire all or a portion of the leaving founder's shares. In the case of a good leaver, the founder can often retain their vested portion or have to sell them for fair market value consideration while the unvested portion is acquired for nominal consideration only. If the founder leaves during the cliff period or is to be considered a bad leaver (e.g., the contract or appointment as managing director is terminated/cancelled by the company for good cause), they will usually have to sell all of such founder's shares (vested and unvested) against nominal consideration.
Please note that the aforesaid is a simplified summary and in reality, founder vesting provisions can be more nuanced (more on founder vesting and respective market standards can be found in our OLNS#9: Venture Capital Deals in Germany – Pitfalls, Key Terms and Success Factors Founders Need to Know).
Against this background, the Court of Appeal in Berlin ruled on the general permissibility of founder vesting clauses, cliff periods, and certain questions around the compensation that needs to be paid to a departing founder. Here are the key takeaways from the latest ruling:
Vesting clauses are a sub-group of the so-called break clauses ((Hinaus-) Kündigungsklauseln) for which a relevant body of case law exists. Break clauses allow shareholders to force a shareholder (for example a manager who holds ESOP shares or a founder who holds common shares) out of the company if certain conditions are met.
In general, such clauses are upheld by the courts if they can be justified given the specifics of the case at hand.
The Court of Appeal in Berlin clarifies that break clauses in the form of founder vesting can be permissible in early-stage start-ups since the founders play a key role in the success of the company. Here, vesting clauses are meant to incentivize the founders to remain in active service for the company. Without these clauses, the Court sees a risk that the founders could participate disproportionately in the company's success although the founder might have left the company shortly after the investors got on board.
After having established that founder vesting can generally be justified, the Court of Appeal in Berlin then ruled that in the case at hand, a cliff period of 12 months was justified. Cliff periods work as a testing ground for founders and investors. Especially in the early stages of a business, founders and investors need to get acquainted and develop a working relationship. The first 12 months are crucial to iron out differences and make sure everyone is pulling in the same direction. In addition, the cliff period allows the relevant stakeholders to test their hypothesis that the management team of the start-up has the right composition and does not require changes.
As mentioned above, founder vesting schemes often force the departing founder to sell (all or a portion) of their shares for less than their fair market value. Here, the Court of Appeal stated that although some consideration for the shares to be acquired is generally mandatory, a founder vesting scheme can be upheld even if the agreed consideration is unreasonably low. In the latter case, the agreed settlement payment will "only" be replaced by an appropriate settlement payment.
Vesting periods of three to four years with a 12-month cliff period are currently the norm. However, this practice may evolve as the path to exit or IPO often takes longer today. It is therefore conceivable that longer vesting periods will be discussed in future court decisions in order to bind founders to the company in the long term. This is all the more relevant as the Court of Appeal has repeatedly stated that the statements made on the permissibility of vesting and cliff refer to limited periods which are justified. It remains to be seen, however, whether these periods will be limited to a maximum of 4 years and 12 months cliff, or whether longer periods will be permissible in light of changed market conditions.
Since the Court of Appeal has not decided on which compensation is appropriate in case of founder leaver events, however, it is still recommended to provide fallback provisions in vesting clauses, where compensation amounts will be paid at the lowest value permissible by law, in case the agreed-upon compensation (e.g., nominal value per share) would otherwise be regarded as unreasonably low.