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28 February 2023
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to the point: technology & digitalisation l February 2023

Welcome to the February edition of Schoenherr's to the point: technology & digitalisation newsletter!

We are excited to present a selection of legal developments in the area of technology & digitalisation in the wider CEE region.

Insights waiting for you in this edition: 

Welcome to our monthly newsletter! We understand that navigating the world of venture capital can be challenging, especially for young or inexperienced start-up founders who may not be familiar with all the industry jargon. That's why we've decided to introduce a glossary of the top 20 common venture capital terms and concepts with some specifics of the Austrian start-up ecosystem. In every edition of our technology newsletter, we will provide you with some new terms and insights. Our goal is to help you become more familiar with the language and concepts of venture capital so that you can feel more confident and prepared when seeking financing for your company. Our glossary will provide clear, easy-to-understand definitions of key terms that will help you understand the VC landscape. So be sure to check out our glossary section in every edition of the newsletter, and as always, feel free to reach out to us with any questions.

Term sheet

There is hardly any way around signing a term sheet when seeking financing for a start-up. A term sheet outlines the basic terms and conditions of a financing round (such as the amount of investment, valuation mechanics, share classes, anti-dilution protection, liquidation preferences, board composition, etc.).

Although a term sheet is typically not legally binding (with only a few exemptions, such as clauses on confidentiality and exclusivity), it is perhaps the most important document in the financing process. A signed term sheet serves as a blueprint for negotiating and finalising the definitive long-form legal documents and it demonstrates the commitment of the parties to closing the deal on such terms. Requests for substantial deviations from the term sheet are mostly not accepted (or traded against other requests) when negotiating binding long-form documents and a requesting party risks losing credibility vis-à-vis the other party and ultimately the contemplated investment. Thus, be careful when signing a term sheet, even if it is legally not binding.

A term sheet typically refers to a broad variety of venture capital concepts without defining them in detail. Considering the importance of the term sheet, it is crucial to be familiar with such terms and concepts before signing one. For example, it may have a huge economic impact on the founder whether the term sheet refers to "full ratchet" or to "broad-based weighted average" anti-dilution protection.

Of course, not every clause in a term sheet needs to be negotiated and fought for. Engaging an experienced VC lawyer at an early stage of a financing round can help founders focus on the important aspects of the term sheet and avoid common pitfalls.

Note: the principal difference between a term sheet, a letter of intent (LoI) and a memorandum of understanding (MoU) is only the document style. While a term sheet is the most widely used document type in the venture capital world, key terms of a financing round can also be agreed in a non-binding way in an LoI or MoU.

Anti-dilution protection

Anti-dilution protection is a mechanism designed to protect an investor's ownership percentage in a company from being diluted in a future share issuance. Typically, the protection applies only in case of a so called "down round", i.e. a share issuance below the valuation that was agreed with the protected party.

When an investor invests in a company, they typically receive a certain number of shares or ownership percentage in exchange for their investment. However, if the company issues more shares in the future to raise additional capital or as part of an acquisition, the investor's relative ownership decreases, even though they haven't sold any of their shares. Commonly, each shareholder has a right to participate in each share issuance (subscription right or pre-emptive right). However, for down-rounds, investors often seek protection beyond subscription rights.

Anti-dilution protection can help prevent down-round dilution by adjusting the investor's ownership percentage to account for any new shares issued in the future. This can be done in a few different ways, but common methods are called "weighted average anti-dilution" and "full ratchet anti-dilution".

These anti-dilution protection methods have in common that investors only pay the nominal amount of the anti-dilution shares (rather than the full subscription price).

Weighted average anti-dilution

The basic concept of weighted average anti-dilution is calculating a weighted average share price that ends up somewhere in between the share price that was paid by the investor (usually the share price in the last financing round) and the share price that will be paid in the down round. Essentially, the investor's initial purchase price is adjusted downwards to reflect the fact that the company is now worth less per share due to the new shares being issued. This means that the investor will receive additional shares to compensate for the dilution. The actual number of shares issued to the investor in the anti-dilution financing round depends on the application of the agreed formula. Commonly, one of the two formulae is applied: "broad-based" or "narrow-based" weighted average. The difference between these formulae essentially lies in the number of shares to be weighed against the shares to be issued. "Broad-based" is typically more founder-friendly.

Full ratchet anti-dilution

The basic concept of full ratchet anti-dilution offers investors the most protection. Essentially, the investor's initial purchase price is effectively "reset" to the new lower price for the purpose of calculating their ownership percentage in the company. In other words, the investors are put in a position as if they had invested at the lower share price.

Full ratchet anti-dilution protection is less common than weighted average anti-dilution protection. It is typically applied only in specific situations, e.g. if the valuation agreed with the investor is (from the investor's perspective) too high and is to be adjusted in certain circumstances (e.g. if an agreed minimum financing volume is not reached within a certain time).

According to several German newspapers (e.g. Handelsblatt), German Federal Minister of Finance Christian Lindner proposed new terms for employee participation. The proposal aims to decrease taxes payable on employee options or employee shares. Generally, giving equity to employees can trigger dry income for the employee, i.e. taxable income on assets, which cannot be (easily) exchanged into cash (to pay taxes). This issue applies in Germany, but also in other jurisdictions including Austria. Dry income is generally the major roadblock for "real" (equity-based) employee participation programmes. Lindner now wants to solve the situation in Germany by moving the due date for such taxes on dry income to 20 years after the grant (with potential for another extension). Also, the tax allowance on employee shares will be increased from EUR 1,440 to EUR 5,000. The new rules will further apply to a larger group of companies, i.e. companies with not more than 500 employees (instead of 250 employees), not more than EUR 100m in revenue (instead of EUR 50m) and a balance sheet sum of not more than EUR 86m (instead of EUR 43m). It remains to be seen whether the proposal will find a corresponding majority and whether the proposal is generally accepted. According to another Handelsblatt article, however, the reaction of the start-up scene in Germany was mixed. Major points of criticism include that EUR 5,000 is far too low and that there is still a tax risk (even if the tax is payable only after 20 years). Also, the thresholds for eligible companies are too low, as they would exclude German scale-ups.

From an Austrian point of view, we look forward to watching what our German neighbours do next and how the discussion will unfold. This is because the Austrian start-up scene is in a similar situation – dry income is a big problem when granting equity to employees. It would certainly help to at least answer specific questions in the Austrian tax system, such as how to properly (and easily) valuate start-up participations. The absence of clear (and ideally start-up-friendly) valuation rules is an additional risk when dealing with start-up participation programmes. Lawmakers, we look forward to an efficient solution for the Austrian market!

Austrian state funding bank AWS has launched the new funding scheme "AI Business and Growth" to support the use of artificial intelligence in Austrian companies. EUR 6m in funding are available under this new scheme which are also accessible to start-ups and SMEs. The scheme consists of three modules intended to finance AI projects in different stages:

  • The first-time implementation of a (pilot) project based on AI in an SME is supported with up to EUR 15,000 (capped at 50 % of the cost incurred). The project can involve the identification of suitable use cases of AI in a business and/or the planning, implementation and realisation of a pilot project.
  • Larger projects can be funded with up to EUR 150,000 (capped at up to 80 % of the cost incurred). Projects must qualify as "trustworthy AI"-projects to be eligible.
  • The third module subsidises consulting services on how to recognise intellectual property created by AI companies and how to best protect and exploit it commercially.

This new funding scheme is part of the larger "AI Mission Austria" funding initiative, which AWS announced together with other leading Austrian state funding institutions in October 2022. Find out more about the new funding scheme here (German only). 

A spectre is haunting Europe, the spectre of the Unitary Patent! With Germany having deposited its ratification document on 17 February 2023, this spectre is finally coming to life, as the European Patent with Unitary Effect and the Unified Patent Court system will enter their preparatory phase. The launch date (the date as of which Unitary Patents will be in effect and actions can be filed with the Unified Patent Court) is set for 1 June 2023. Read more about what is going to happen.

A ruling by the Austrian Supreme Court could change the common practice of companies only "taking into account" the data protection notice in their Terms and Conditions. The Austrian Consumers' Association filed a lawsuit against an insurance company because, according to consumer protection experts, several provisions of the insurance company's data protection notice violated the General Data Protection Regulation (GDPR). The lawsuit was initially dismissed because the data protection notice was not part of the contract. However, the Supreme Court ruled in accordance with a judgment of the Court of Justice of the European Union and in favour of the Austrian Consumers' Association, annulling several provisions of the data protection notice, as it was an integral part of the contract. Companies should therefore have their privacy statements reviewed by lawyers to avoid scrutiny.

UNIDROIT, one of the main global legal standard setters, is currently developing a common international approach with respect to certain private law aspects of digital assets. The Draft UNIDROIT Principles on Digital Assets and Private Law will introduce a legal taxonomy of digital assets and establish rules for the transfer and use of digital assets. This includes conflict of laws rules for determining the law applicable to proprietary issues in digital assets (in particular, the transfer of ownership as well as other rights in rem in digital assets). In addition, the draft principles lay down rules governing the enforcement of digital assets and the treatment of digital assets in the respective owner's insolvency. While this initiative is highly welcomed by the digital asset industry, it remains to be seen when the draft principles will finally be approved by UNIDROIT and if and how the international community will adopt and implement them.

On 13 February 2023 the European Parliamentary Research Service issued a study on the social approach to the transition to smart cities. The document explains what should be understood under the definition of a "smart city" and developed five main categories which need to be considered: (i) smart and safe living; (ii) smart governance and e-citizen; (iii) smart mobility; (iv) smart environment; and (v) smart economy. Additionally, the report disclosed a set of key challenges and elaborates on the main accelerating factors that may amplify or contain their impact on certain groups and territories. Based on the case studies, the EPRS proposed six policy options to be considered in the transition to smart cities in the EU. These include: (i) setting up a supervisory body for certification and quality assurance of the digital infrastructure in cities; (ii) strengthening the role of national contact points to further link EU and local realities and support capitalisation and upscaling; (iii) setting up helpdesks for less-digitalised cities; (iv) reinforcing capacity building of public administrations to strengthen digital skills and promote capitalisation through peer-to-peer learning; (v) researching and providing evidence on the benefits and costs of remote working and service provision in cities; and (vi) creating a knowledge platform for best practices to support the replicability and scale-up of inclusive smart city solutions. The full study can be found here.

The Omnibus Directive (Directive (EU) 2019/2161), also referred to as the "Enforcement and Modernisation Directive", is aimed at strengthening consumer protection and enhancing enforcement measures as the world gears up for the digital age. Recognising the increased use of online platforms and marketplaces, it encourages Member States to adopt specific measures to maintain a high level of consumer protection, including in these channels.

Read more

Dynamic Search Ads, as offered by Google, utilise an organic web crawling technology where instead of the advertiser specifying particular keywords, the entire website is opened for the technology to extract keywords from the entire content of the website (including synonyms of actually used content). The explicit manual exclusion of relevant terms as keywords is possible, but not realistically feasible.

Recently, the Austrian Supreme Court (OGH 22 November 2022, 4 Ob 134/22 t) ruled on the liability of advertisers who unknowingly commit a trademark infringement by using Dynamic Search Ads via Google. In the case, the plaintiff was the owner of the trademark AIRBUTLER (designating air purifiers), which was also used in the defendant's Dynamic Search Ads on Google.

The Austrian Supreme Court ruled that an advertiser using Google's Dynamic Search Ads is liable for unlawful acts committed in connection with the content and design of advertisements, even if it does not specify the content and form of the advertising in detail or expressly waives content specifications. This particularly applies to advertisement with Dynamic Search Ads, especially since the risk associated with these types of ads – that infringements can also be committed "automatically" – is inherent in this form of advertising and not unforeseeable.

The US Securities and Exchange Commission (SEC) has reached a settlement with Kraken over the crypto exchange's USD 30m staking-as-a-service offering, which violated US securities laws. The settlement requires Kraken to pay the fine and cease offering its staking service in the US. Kraken was not required to admit guilt. The development is the latest setback for the US crypto market, raising questions about the legal status of digital assets and whether they are subject to securities regulation. The SEC's action against Kraken could have implications for other US betting providers, such as Coinbase, which have also come under scrutiny from the agency over the issue of securities regulation.

In a separate development, the SEC is investigating Binance USD (BUSD), a stablecoin launched by Binance and Paxos. The SEC considers BUSD to be a security, which could have significant implications for the entire crypto sector. Paxos has suspended the issuance of new BUSD units, which could lead to a delisting. Tether (USDT) is of course benefiting from this turmoil around BUSD.

It will be exciting to see how the actions of the SEC in the US will affect the major players and thus the entire crypto market.