Austria: Participation rights as alternative investment and equity financing instruments

However, there are formalities with respect to LLCs – the most popular legal form in Austria – that sometimes make investing in LLCs unattractive or burdensome (eg, the requirement to draw up an Austrian (or equivalent foreign) notarial deed for the subscription or acquisition of shares). Increased transaction costs and logistical requirements (notarial deeds are read out loud in person to the signatories, who must be present or represented by a power of attorney during the reading) may be unattractive to some investors.

Further, shares in an LLC convey partly mandatory rights on minority investors (eg, the right to vote in the general assembly and attend general assembly meetings), which some founders and co-investors want to avoid.

To eliminate the above concerns, Austrian law provides a suitable, but widely unknown, alternative investment instrument: participation rights.

Participation rights as alternative investment and equity financing instruments

In principle, a participation right is a civil law (contractual) relationship between the issuer and a subscriber or holder, which confers to the holder a monetary property right with respect to the issuer. These rights are typically equivalent to a shareholder's monetary property rights and include, most notably, the right to receive dividends and liquidation proceeds.

Austrian law does not provide greater detail regarding the specifics of participation rights.(2) Participation rights are thus generally subject to the principle of freedom of contract and the consequential boundaries under Austrian law (eg, mandatory consumer protection laws and Article 879 of the Civil Code (violation of moral principles)). Participation rights are subject to no formalities. However, written agreements are recommended.

Participation rights can qualify as equity or debt instruments, depending on the actual rights conferred. A participation right that confers a right to receive profits and liquidation proceeds depending on the actual profits or proceeds (ie, no fixed income) typically qualifies as an equity participation right. A participation right that confers a right to receive a fixed income will likely qualify as a debt instrument. Obviously, equity and debt instruments have different effects on the issuer and the holders – especially from a tax (eg, tax deductibility versus no-tax deductibility of payments by the issuer and different types of income at the level of the holders) and corporate finance perspective. This update focuses on equity participation rights.

Issuing participation rights

Participation rights are issued when the issuer and holder conclude an agreement on the issuance of thereof. Alternatively, participation rights can be documented in a certificate (similar to a share certificate).

Registering participation rights

Neither participation rights nor their holders need be registered with the Commercial Register. However, the issuer may be required to publish certain information on the issuance of participation rights via its (publicly available) financial statements.

Transferring participation rights

Participation rights can be assigned or transferred by way of transfer of the contractual position. Participation rights issued as certificates can also be transferred by endorsement. The mere assignment of receivables may trigger Austrian stamp duties of 0.8% of the consideration for the assignment, whereas any transfer of the contractual position and endorsements should not trigger such stamp duties.

Transfers of participation rights can be restricted, similar to the restrictions that apply to share transfers. In many cases, participation rights are subject to transfer restrictions pursuant to shareholders agreements and articles of association (ie, pre-emptive rights and tag and-drag-along rights). In that respect, it is advisable that holders of participation rights accede to the shareholders' agreement.

Do participation rights confer any minority rights?

Participation rights generally do not confer the minority rights typically conferred by shares, unless otherwise agreed. In particular, participation rights confer no voting rights or rights to attend the issuer's general assembly.

Typically, investors in participation rights request certain minority rights, such as:

• information and access rights; and
• rights to have a say in certain extraordinary measures of the issuer (eg, sale of the whole business, obtaining debt financing in excess of a certain value, sale of material assets and material changes to the business).

Can participation rights be converted into shares?

Yes, participation rights can generally be converted into shares. Such conversion can be structured as option or subject to the mutual agreement with the shareholders. Any agreement on a conversion (option) should consider the applicable formalities, in particular with respect to shares in an LLC (see above).

Can participation rights be terminated?

Theoretically yes (eg, for cause), but in order to qualify as equity participation rights, any termination rights of the parties must be excluded to the greatest extent possible.

Benefits and downsides of participation rights

The biggest advantage to participation rights compared to other financing instruments is the parties' flexibility to agree on the terms and conditions of the underlying agreement. Such flexibility is usually seen only in debt financing instruments (eg, loan agreements), provided that participation rights still allow equity financing. They are also subject to only minimal formal requirements (written agreement) and few publicity requirements. These benefits make participation rights attractive for smaller investments (eg, pre-seed and seed rounds and employee incentive programmes).

Another benefit may be that holders of participation rights need not be registered with the Commercial Register. This may be attractive if the investment is only for short term or should be kept private.

The discussions between investors, issuers and shareholders clearly focus on the minority rights to be conferred by the participation rights. While investors may prefer shares over participation rights in order to have more of a say with respect to their investment, issuers and their shareholders may choose participation rights to limit minority rights to fundamental ones, such as the right to:

• receive annual financial statements (and interim financial statements, if available);
• attend the annual general assembly as an observer; and
• veto any extraordinary transactions that would typically be subject to the consent of minority shareholders.

Finding a fair arrangement and balance between the various (and sometimes opposing) interests of the parties involved will be key for closing a successful financing round.

Endnotes

(1) In some situations, it is easier to implement an acquisition by way of the post-money capitalisation table, rather than a capital increase. For LLCs applying the foundation privilege – which is an option to establish an LLC with only €5,000 paid-in capital – a capital increase is not possible until at least the minimum share capital (50% of €35,000) is fully paid in.

(2) Participation rights are, for example, provided for in the Joint Stock Companies Act, but not the Limited Liability Companies Act. However, the prevailing opinion allows the issuance of participation rights by LLCs and other forms of entities.

This article was first edited and first published on www.internationallawoffice.com