Profit participation rights - old but gold in mezzanine corporate financing?

Profit participation rights are a popular form of investment in companies, particularly in the area of venture capital/start-ups. They allow investors to participate in promising start-ups or companies and benefit from their success without directly influencing the management of the company. However, the seemingly relaxed concept of profit participation rights conceals a number of legal aspects that need to be considered.

Profit participation rights, what exactly are they?

Profit participation rights are a German construction and can already be found in the Imperial Stamp Act of 1894. From 1924, it was possible for shareholders of a stock corporation, partnership limited by shares or limited liability company to convert their company to so-called gold shares. If the shareholder acquired a corresponding payment claim, this could be converted into a claim to bearer participation certificates upon application. Why am I telling you this? Because the Gold Balance Ordinance issued for this purpose provided the first legal definition: "The profit participation certificates do not grant voting rights, but do grant a corresponding share in the net profit of the company and, in the event of the dissolution of the company, a claim to the company assets to be distributed." (§ 12 sentence 2 Goldbilanz-VO).

Profit participation rights are therefore a type of capital investment that companies can issue in order to receive money from investors. Unlike shares, however, profit participation rights do not securitise a share in the company, but grant the holder the right to a certain profit share or a fixed interest rate.

For example, imagine a company wants to raise money to expand or finance new projects. Instead of issuing new shares (e.g. shares or business shares), which represent shareholdings in the company and grant the holders participation and co-determination rights in the company, the company could issue profit participation rights. People who acquire profit participation rights invest their money in the company and in return receive regular payments in the form of interest or profit shares, depending on how the profit participation right is structured.

Prospectus requirement - what is it and what is it good for?

And that's just how it works? Not quite! The regulation of the so-called "grey capital market" has been significantly tightened. When the amendment to the Prospectus Act came into force on 1 July 2005, the issue of investments, for example, was placed under the control of the Federal Financial Supervisory Authority (BaFin). Today, investments in small and medium-sized companies (e.g. profit participation rights) are subject to a prospectus requirement. In recent years, the Prospectus Act has been modified several times and renamed the Capital Investment Act.

With the introduction of the Capital Investment Code in July 2013, the scope of application of the Capital Investment Act was also curtailed. If the planned investments constitute so-called investment assets, they are now subject to the Capital Investment Code. As if that were not enough, the catalogue of investments requiring a prospectus was then extended again by the Small Investor Protection Act. Since July 2015, BaFin's inspection powers now also extend to subordinated loans, profit-participating loans and comparable capital investments such as direct investments.

For every capital market product submitted to BaFin, the first step is therefore to check which of the existing capital market laws are applicable.

As you can see, it is a jungle of regulations and adjustments in which it is easy to lose track. For the sake of simplicity, I have therefore limited myself below to uncertificated profit participation rights, which are subject to the Asset Investment Act.

The Asset Investment Act stipulates that a sales prospectus must be prepared and published for certain capital investments, including (uncertificated) profit participation rights. This serves to protect investors and ensure transparency on the capital market. The obligation to publish a prospectus applies when profit participation rights are offered to the public, insofar as there is no exception in accordance with Section 2 VermAnlG. The exceptions in detail:

• Shares in a cooperative within the meaning of Section 1 of the Cooperatives Act
• Profit-participating loans, subordinated loans and other investments issued by cooperatives (see above)
• Investments issued by insurance companies or pension funds
• Offers of no more than 20 units of the same investment
• Offers whose sales price does not exceed a total of €100,000 within 12 months
• Offers with a minimum selling price of each unit of €200,000 per investor
• Investments that are offered exclusively to institutional investors
• Partial issues of investments for which a valid prospectus has already been published
• Investments offered to a limited group of persons or investments in the form of employer offers
• Investments offered by issuers with a high credit rating (public sector, credit or financial services institutions in the case of permanent or repeated issues, state monopolists in the EEA)
• Investments offered in the case of conversions under the German Reorganisation Act (UmwG) or takeovers under the German Securities Acquisition and Takeover Act (WpÜG)
• Investments offered as part of a secondary sale (secondary market), i.e. those that were first sold before 1 July 2005 and are offered to the public after 1 July 2005 on a regular market that has regulated operating and access conditions, is directly or indirectly accessible to the public and is under the responsibility of its operator

The definition of a public offer pursuant to section 2 no. 4 WpPG applies accordingly to section 1 (1) VermAnlG, which does not provide for a separate definition of an offer in this respect. This originates from
Art. 2 para. 1 lit. d Directive 2017/1129:

"offer to the public [...] a communication to the public in any form and by any means, containing sufficient information on the terms of the offer and the securities to be offered to enable an investor to decide to purchase or subscribe for those securities."

The prospectus - preparation and procedure

If there is a public offer and none of the aforementioned exceptions apply, it comes to the oath. A (sales) prospectus (and in many cases also an investment information sheet) is required. The content requirements for a sales prospectus have been constantly tightened in recent years. They are currently set out in the German Investment Act and its ordinance. The Small Investor Protection Act has standardised further mandatory information for sales prospectuses.

The Asset Investment Act itself regulates in particular the obligation to publish a prospectus, including the obligation to prepare the so-called asset investment information sheet, as well as the approval and publication procedure for sales prospectuses. The mandatory information to be included in the prospectus is primarily derived from the Asset Investment Sales Prospectus Ordinance by virtue of a reference.

Essential components of the prospectus are

• Presentation of the risks associated with the investment
• Information on the investments to be issued, such as subscription procedure, existing rights and obligations of investors, type, total quantity and nominal amount of the investments, tax implications for investors
• Description of the issuer and the members of the executive bodies
• Description of the business activities (including audited annual financial statements or opening balance sheet and budgeted figures) and description of the investment projects (so-called investment objects)

Before the investment can be advertised, BaFin checks the (sales) prospectus for completeness, consistency and comprehensibility in what is known as the approval procedure. The prospectus must be submitted in the form in which it will later be printed and published. BaFin must inform the issuer of its decision (approval or refusal) within 20 working days of receipt of the complete (sales) prospectus. The deadline is extended in the event of queries or additional requests for information/documents.

Once the prospectus has been approved, it must be publicised. As a rule, this is done by placing a so-called information notice in a national mandatory stock exchange journal and in the Federal Gazette. The placement of investments can begin one working day after the announcement.

Conclusion

To summarise, profit participation rights are a tried and tested method of corporate financing that is still relevant today, particularly in the context of mezzanine financing for companies. Although they offer investors the opportunity to participate in the success of a company without direct influence on its management, there are numerous legal aspects to consider.

The regulation of the grey capital market and the introduction of and amendments to the German Investment Act have tightened the prospectus requirement for profit participation rights, which promotes investor protection and transparency on the capital market. The preparation and approval of a prospectus as well as the publication and placement of profit participation rights are subject to strict regulations and procedures. Despite these hurdles, profit participation rights remain an attractive option for companies to raise capital (off the beaten track) and for investors to invest in promising companies.

THE AUTHOR AS WELL AS YOUR USUAL CONTACT PERSONS ARE HAPPY TO ANSWER ANY QUESTIONS YOU MAY HAVE!

Christian Schon
schon@tigges.legal
+49 211 8687 284