Germany’s Act against Restraints of Competition (ARC) went largely unnoticed by VCs thus far. Deals are being negotiated day in day out ignoring the ARC. The larger the deal and the bigger the players involved, the greater the likelihood of deals being null and void. Done and dusted, at least for the time being.
Deal makers learning curve
German merger control is a funny old thing. It has – almost – always been around, but has been largely ignored for an equally long time by companies and their counsel alike. Then something snaps and industry after industry adheres to the rules set out in the ARC.
A couple of years ago (my recollection doesn’t go any further) deal makers in the real estate market “discovered” the ARC. I haven’t quite figured out what has actually happened, but somehow the deal documentation must have passed the desk of someone with some sort of merger control background. To anyone who is somewhat familiar with merger control it is blatantly obvious, that every odd big real estate deal is null and void from the time a shelf company is acquired or an investment vehicle is set up. To anyone who is familiar with real estate deal making this sounds absurd. Nevertheless, the ARC levels some hefty fines against violators. Off course, the merger control expert prevails. Hence, ever since that “discovery” real estate deals are thoroughly investigated for ARC compliance and the Bundeskartellamt, the German competition authority, is notified of the big deals in advance.
Done and dusted VC deals
So why are done deals – at least the big ones – dusted as we are at the beginning of the learning curve in the VC industry? Sec. 41 para. (1) ARC renders these deals to be “of no effect” until the Bundeskartellamt has been notified and has cleared such deals. As hardly any VC deal has been sent to the competition authorities for approval most of the big done deals are null and void. Hence, under German law the VC never became the owner of the shares. The shareholder agreement is just as null and void as the transfer or issuance of new shares to the VC. In return the VC can only require the target to re-transfer his investment. Good luck with that. Or to put it in other words: Violating the ARC can lead more often than not to a complete write-off of the investment.
Expect a rush of all big VCs to the Kartellamt in order to apply for approval of done deals in Germany (watch this space). Until then their portfolios look rather hollow from a legal perspective. Until then a VC would be foolish to give any good title guarantees with respect to a so called notified merger. This effectively brings any third party financing round, transfer of shares or an exit for that matter to a halt until the competition authorities have come up with a decision.
The scope – doing a “big deal” and exercising control
What’s a “big deal” or in other words the scope of ARC with respect to VCs? The size of the deal is not measured by the size of the investment, but instead by turnover of the parties involved (excluding VAT). The following thresholds apply cumulatively (sec. 35 para (1) ARC):
- – worldwide turnover of all parties of more than EUR 500 mm
- – the domestic turnover of at least one party of more than EUR 25 mm
- – the domestic turnover of another party of more than EUR 5 mm.
It is important to note, that the first two thresholds can be cracked by one company alone. I will not go into further detail how to figure out the numbers. But a good look at the investors and their portfolio and ownership structure is required. The same applies when doing deals with the High-Tech Gründerfonds (HTGF),Germany’s EUR 272 mm startup initiative backed by the federal government and German heavyweights like BASF or Siemens.
The second requirement which has to be fulfilled once the turnover thresholds are met is concentration (sec. 37 ARC). No matter how small the investor’s stake in the target company the issue of concentration arises if the investor exercises a competitively significant influence on the target. Whether an investor controls the target in such a way is open to legal argument, off course. Control is deemed to be exercised according to sec. 37 para (1) ARC if stake holdings exceed 25 or 50 percent. Below theses thresholds it is widely accepted, though, that the following veto rights which can often be found in deal documents lead to exercising control, too:
- – appointment and dismissal of managing directors
- – consent to the annual budget
- – approval of audited annual accounts and appropriation of net income
- – approval of the actions of the managing directors.
As a rule of thumb one VC heavyweight alone makes a deal look rather dicey if the concentration thresholds are cracked or veto rights can be found. Such a heavyweight can be for instance a big fund with a portfolio turning over more than EUR 500 mm (only the turnover of such portfolio companies is relevant in which the fund exercises control), a strategic investor, an investor controlled by a media company or the HTGF.
* Btw: There are a couple of exemptions regarding thresholds and control which I did not get into.
Outlook
Every VC doing a “big deal” and exercising control should go for an ex ante notification of the competition authorities. Done deals should be presented to the Bundeskartellamt asap in order to reduce the risk of the aforementioned hefty fines. These are the easy answers from the merger control perspective.
From a VC’s perspective the strict rules of the ARC seem totally out of touch in a world of big risks, small seed and early stage investments, spray and pray and so on and so forth. In most cases no negative effects on competition are even in sight, still the ARC applies and requires a notification to be sent to the Bundeskartellamt. At the end of the day though, most deals will be cleared on exactly these grounds. VCs and startups are left to share the tab of their counsel and lose more time during deals, financing rounds or leading up to exits.
It is somewhere between ambitious and wishful thinking to expect the regulators to act in order to create an exemption for the VC industry or to add further requirements reflecting the unique nature of VC investments compared to other M&A activities. Instead it is up to VCs to change their deal terms and loosen their grip on targets if they want to avoid the competition authorities. Let’s face it, how often are veto rights actually exercised? True, they are designed to give VCs downside protection but they hardly serve this purpose. There are even further determents to a tight grip coming in the form German taxation law. Basically, VC funds are ill advised to become too operative in their portfolio companies, as they may lose certain tax benefits in Germany (further details here). Thus veto rights may work against VCs in this respect, too. Better deal making does away with operative veto rights and establishes a good working relationship with the management.