German Start-ups in Troubled Waters?
by Volker Beissenhirtz, Legal Partner at Schultze & Braun GmbH Rechtsanwaltsgesellschaft
While the public hype about start-ups is globally still unbroken, the recently cancelled IPO of WeWork indicates that there might be troubled waters ahead for start-ups. In Germany, a recent study shows that numerous fintechs have already run out of steam in recent years. However, particularly in Germany, the awakening after bankruptcy can sometimes be very bitter for the former founders especially when it comes to personal liability. In this context, it is worthwhile noting that the German Federal Supreme Court (“Bundesgerichshof,” “BGH”) in a 2007 decision, explicitly raised the duties for managing directors of start-ups. Knowing this, the following brief might help to avoid a rude awakening.
The difference between setting up a normal business and a start-up usually lies in the fact that start-ups aim to capture large market shares as quickly as possible. To this end, the founders usually try to scale-up their respective business models and win as many customers as possible in a short time frame. In order to achieve this goal, profitability is initially put on the back burner in favor of growth, with the result that start-ups incur losses over the years. In order to compensate for the losses, it is essential that they are continuously compensated by money injected by third parties through so-called “financing rounds”.
In the so-called “New Economy” at the beginning of the 2000s, such financing rounds usually covered the necessary liquidity for two to three years. The liquidity acquired today often only suffices for one year. These customary practices, however, have the potential to conflict with the German Insolvency Law. Because of the financing requirements and structure of start-ups, it is almost inherent in the system that they are chronically in debt on their balance sheet and any extended liquidity planning depends on the goodwill of third parties rather than on hard currency. However, the short-term nature of the planning almost inevitably collides with the requirements of the so-called “continuity prognosis” (“Fortbestehensprognose”) according to statute 19. InsO, i.e. the (obligatory) examination of the management as to whether there is a reason for insolvency. In 2007, the BGH, after again clarifying the general requirements for managing directors of companies in a crisis said:
“A managing director has to always ascertain the economic situation of the company. This includes, in particular, an examination of over-indebtedness and insolvency. He, therefore, acts negligently if he does not obtain the necessary information and knowledge in good time to meet the obligation to file for insolvency.” (para. 16),
They tighten these requirements for startups even further:
“In a start-up company like the debtor, which generally only produces debt in the start-up phase and – as here – is dependent on promotional loans, a constant, intensive examination of the economic situation of the company is particularly necessary.” (para. 17)
In other words, in order to avoid their own liability, it is important for the managers of start-ups to keep a constant eye on liquidity planning and to document the course of financing negotiations in such a way that it can also be proven afterward that the success of the financing-round was “predominantly probable”. It is also advisable not to rely on the proverbial handshakes to secure financing, which are also customary in the industry. This led to a later lawsuit in one of my own cases. In that case, the management of the start-up had concluded a financing round with a fund between Christmas and New Year by handshake only, but the documentation of the transaction was only made at the beginning of the following year. In spite of the fact that the money agreed upon in this financing round was actually paid-out and the start-up only failed later and independently of this financing round, the insolvency administrator tried to hold the managing directors liable for an undue delay in filing for insolvency on the grounds that the company’s liquidity was not formally properly secured in the time-frame between Christmas and beginning of next year.
In order to avoid such an even worse awakening after the failure of one’s own start-up, the above remarks of the BGH should thus be followed accordingly in Germany.
Please note: This article contains the sole views and opinions of Volker Beissenhirtz and does not reflect the views or opinions of Guidepoint Global, LLC (“Guidepoint”). Guidepoint is not a registered investment adviser and cannot transact business as an investment adviser or give investment advice. The information provided in this article is not intended to constitute investment advice, nor is it intended as an offer or solicitation of an offer or a recommendation to buy, hold or sell any security. Any use of this article without the express written consent of Guidepoint and Volker Beissenhirtz is prohibited.