Legal hiccups in start-up financing

2019 | roadmap

From pre-seed to exit, start-ups are chronically in need of money to ensure their steady growth. Due to lack of access to bank financing, start-ups are typically financed by their shareholders via equity finance or debt. But there are also hybrid instruments that can be used to bridge the gaps between financing rounds or to overcome valuation issues.

Convertible loans
Shareholder loans may be constructed as convertible instruments that provide the investor the right to convert its investment into equity in the respective start-up. The conversion is usually linked to an upcoming investment round, such as when the start-up receives its next valuation, or expiry of time, whatever occurs earlier. The investment itself is typically structured as a subordinated loan or as a "forward equity investment" (i.e. non-recourse investment). Upon conversion, the company issues a new share to the investor calculated according to specific commercial parameters, such as the valuation of the new financing round minus a discount, subject to caps and floors. In the case of convertible loans, the investor would waive the loan receivable in exchange for the new share. The overall concept of convertible loans is not foreseen under Austrian law. It thus has to be implemented synthetically in the underlying convertible loan agreement by obligating the start-up and its shareholders to effect a capital increase upon the occurrence of a conversion event and to allow the lender to subscribe for newly issued shares.1 However, the fact that no Austrian court has so far ruled on the enforceability of such synthetic constructions leaves behind an unsavoury aftertaste of legal uncertainty.

Participation rights
Participation rights are contractual relationships between the issuer (start-up) and the holder (investor). The holder of participation rights is typically entitled to receive dividends and liquidation proceeds. Further participation rights can be sold and transferred, just like shares. Participation rights are subject to minimal formal requirements and few publicity requirements (i.e. no notarial deed needed; holders are not registered in the commercial register). Participation rights can be structured as an equity instrument (similar to shares without voting rights) or as a debt instrument or hybrid. The structure is important for its qualification under accounting and tax rules.

Silent partnerships
The silent partner initially grants funds (the so-called "contribution") to the start-up and in return receives a participation in the company's profit and loss and sometimes also in its assets, including goodwill. The silent partner is not registered with the commercial register. Similar to participation rights, depending on the actual structure of the silent partnership (in particular regarding repayment terms), the contribution may be set out either as liability, equity or hybrid capital between equity and liabilities in the start-up's balance sheet.

Tax deductibility
Shareholder loans must be thoroughly structured to gain tax benefits from their repayment. If a shareholder loan is granted to a start-up that is founded or continued in the legal form of a limited liability company, the loan must be concluded at arms-length to be set out as liability in the balance sheet and to subsequently deduct the repayment instalments (including accrued interest) from tax. Shareholder loans that are not granted at arms-length are qualified as equity and thus their repayment has no tax benefits.

Banking licence
Lenders (shareholders or third parties) of convertible loans may qualify as "commercial lenders" according to the Austrian Banking Act and thus require a banking licence. Conducting banking activities without a corresponding licence exposes the parties to a risk of administrative fines (up to EUR 5 million or 200 % of the benefits of the loan). Thankfully, the Austrian Financial Market Authority (FMA) has shown a way to mitigate that risk. According to their website 2, the granting of sub-ordinated 3 loans does not require a banking licence. However, the subordination may lead to a total loss of the lender's investment if the start-up becomes insolvent.

Capital maintenance rules
Austrian law provides for mandatory capital maintenance rules, meaning that all transactions between a start-up and its shareholders must be concluded and executed at armslength. With respect to shareholder loans, capital maintenance rules apply to the interest rate, which must be at armslength. If it is not, the lending shareholder must prove that it would have granted the loan to a third party with the same interest rate anyway or it was justified by operational reasons (betriebliche Rechtfertigung). Legal consequences for breaching capital maintenance rules include the invalidation of the transaction, the affected shareholder's obligation to repay the unlawfully received payments to the start-up and the managing director's liability for any damage caused.

Financing start-ups in a financial crisis
Loans granted by shareholders with a participation in the share capital of at least 25 % or a controlling influence (e.g. through voting rights) to start-ups that are in financial crisis may fall within the scope of the Austrian Equity Compensation Law (EKEG). The applicability of the EKEG would prohibit any repayments of the loan during such a crisis. The lending shareholder must repay the payments unlawfully received during the crisis in full to the start-up. In addition, shareholder loans granted during the crisis are treated like equity in case of insolvency, meaning the affected shareholder may suffer a total loss.

Compliance with grant conditions
Start-ups are sometimes provided with grants from public institutions, such as the Austrian federal promotional bank (aws) and the Austrian Research Promotion Agency. Grant schemes commonly impose strict conditions throughout the funding period and sometimes afterwards. These can include minimum requirements for subsequent financings, such as prohibited repayment (e.g. loans may only be repaid if the company has gained profit) or maximum interest (e.g. the company may only take out financing for a maximum interest rate of 5 %). In such cases, subsequent financings must be coordinated with the respective grant institution to align the financing terms with the applicable conditions of the grant.

Unclear qualification
Depending on the structure, it may be difficult to clearly qualify the participation right or silent partnership for tax and accounting purposes. This uncertainty may lead to tax risks and accounting errors.

May the Law be with you
In a nutshell, start-ups, their shareholders and third-party investors should choose and structure the preferred financing instrument very carefully. Wrong turns and false decisions can be easily avoided through proper tax and legal advice during the decision-making process and afterwards.


1 C.f. [Kulnigg, Convertible Loans for Austrian Start-Ups]. 
2 www.fma.gv.at/faqs/ was-ist-ein-nachrangdarlehen/.
3 The subordination of a loan means that, in case of a start-up's insolvency, the lender's receivable regarding the repayment of the loan will only be satisfied after all other creditors of the start-up have been satisfied.

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This article was up to date as at the date of going to publishing on 10 December 2018.

Thomas Kulnigg

Thomas Kulnigg

Partner

T: +43 1 534 37 50757
t.kulnigg@schoenherr.eu

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Sascha Smets

Sascha Smets

Associate

T: +43 1 534 37 50781
s.smets@schoenherr.eu

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