If a manager holds shares in the equity of a company, he/she is normally entitled to participate in a share capital increase by subscribing for new shares according to his/her individual participation quota. However, subscription requires that the manager has sufficient financial means to make the contribution on the new shares. Further, there are situations in which the manager’s subscription rights are excluded, e.g., in connection with the participation of further managers, add-on acquisitions which are carried out by way of share-to-share transactions or events of default such as upcoming insolvency or breach of covenants under financing agreements.
If the manager does not participate in a share capital increase, his/her participation quota decreases (nominal dilution). This may in principle be acceptable since the manager normally only holds a minority participation without any veto rights. However, the manager needs protection from an economic dilution, i.e., an impairment of the inner (economic) value of a manager’s equity participation.
Such economic dilution occurs, if the subscription price for the newly issued shares is inappropriately low, i.e., below the fair market value without justifying cause. In that case, the increase of the fair market value of the company is proportionally lower than the share capital increase, so that the participation in the fair market value per share diminishes accordingly. The managers have normally no possibility to contest any resolution on such share capital increase, if they are under an obligation to exercise their voting rights in connection with capital measures along with the investor. Therefore, the managers may wish to oblige the investor to carry out share capital increases at fair market value only (subject to certain exceptions, as the case may be). To avoid legal disputes, the shareholders’ agreement should stipulate how the fair market value is to be calculated and which proceedings apply in the event of disagreement on the valuation.
If new preference instruments (such as preference shares or shareholder loans) are issued with a non-market interest, or preference dividends, respectively, attached to it, the investor gains an unjustified profit leading to an economic dilution of the managers. Therefore, the parties agree in the shareholders’ agreement that preference instruments shall only be issued at “market terms”.
Further, an economic dilution occurs, if the common shares and preference instruments are allocated disproportionally between the investor and the managers, and the investor reduces the amount of common shares of the managers by way of share capital increase. Thus, upon a successful exit, there will be less proceeds remaining after repayment of the preference instruments. Investor and management should therefore agree from the start whether the initial split between common shares and preference instruments is to be maintained upon a share capital increase.
In the event of capital increases from the company’s funds, mandatory law requires that the newly issued shares are allocated to each shareholder according to the individual participation quota (§ 212 German Stock Corporation Act (Aktiengesetz) or § 57j German Limited Liability Company Act (GmbH-Gesetz)). Thus, the economic position of each shareholder remains unaffected, and there is no need for anti-dilution protection provisions in the shareholders’ agreement.
In lieu of or in addition to an equity participation, managers may have a virtual participation (such as exit bonuses, virtual shares or profit participation rights). Also in that case, an increase of the (real) share capital results in an economic dilution of the managers if the bonus entitlement depends on the company’s share capital amount, e.g., according to the following formula:
(Gross) Bonus Amount = (P / (SC + VS)) * MS
P = gross proceeds from an exit minus transaction costs,
SC = share capital of the company,
VS = all virtual shares granted to all participating managers (nominal amount or number),
MS = virtual shares granted to the relevant manager (nominal amount or number).
If the investor increases the share capital at a subscription price below fair market value, the exit proceeds allocated to the virtual shares diminish (analogue to a real share capital increase). As a consequence, the bonus entitlement of a manager is reduced accordingly, unless a compensation has been agreed.
Upon a share capital increase from funds of the company, the virtually participating managers are protected by an automatic adjustment under statutory German law (§ 216(3) German Stock Corporation Act (Aktiengesetz) or § 57 (3) German Limited Liability Company Act (GmbH-Gesetz)). The question has been raised whether such legal adjustment applies analogously in the event of a share capital increase at a subscription price below fair market value to mitigate the dilution effect described above.
The German Federal Labor Court (Bundesarbeitsgericht) rejected such approach in its decision dated June 27, 2018 (10 AZR 295/17) in connection with a bonus depending on dividend payments. This is convincing since the legal and economic effects of share capital increases against contributions on the one hand and share capital increases from the company’s funds on the other hand cannot be compared. Inappropriate results in the individual case can be corrected by supplementary interpretation of the underlying contract (ergänzende Vertragsauslegung) or adjustment based on frustration of contract (Störung der Geschäftsgrundlage, § 313 German Civil Code (BGB)). To avoid any doubt, an explicit exclusion in the virtual participation agreement is recommendable.
A comprehensive analysis of the aforementioned decision by the German Federal Court, a calculation example and further notes regarding contractual arrangements has been published here: 2019 / Anti-Dilution Protection in Management Participations in: DStR / Deutsches Steuerrecht, 6/ 2019, 287-292.