The Structural Constraints of the GmbH

The GmbH is the most common form of Corporation for startups but it is limited by structural constraints. While offering limited liability, the GmbH is quite inflexible when it comes to taking in new members. Pursuant Sec. 15 para 3 GmbHG the transfer of shares requires a notarized deed. Furthermore, the information and control rights of shareholders can be limited only to a certain extent. For example, pursuant Sec. 51a GmbHG, every shareholder has the right to demand information on company affairs at any time.

This makes direct employee share participation in the GmbH less attractive and leads in practice to legal constructs bypassing immediate shareholding. For established startups, mediated shareholding through EIPs (Equity Incentive Program) has been established as the governance and tax optimal market standard. For early-stage startups, virtual equity (VSOPs) is the most common form of share participation, albeit with strong tax disadvantages. In contrast, direct employee shareholding in the GmbH is rare.

Furthermore, raising the capital necessary for growth in startups tends to come at the cost of equity. Diluting equity in the GmbH is inextricably linked to diluting control in the company. For founders, every financing round carries the risk of not only diluting their economic stake but also losing their entrepreneurial autonomy. Highly successful companies such as Alphabet and Meta show the benefits of a visionary founder able to retain control in order to implement his vision.

While we have previously discussed how multiple voting rights can mitigate this, there is another, more radical legal construction that could be the perfect setup for founders yet remains untapped in the startup world: the GmbH & Co. KGaA.

The Hybrid Structure of the GmbH & Co. KGaA

The Partnership Limited by Shares (KGaA) is a hybrid legal form that combines the scalability and fungibility of equity in a stock corporation with the governance flexibility of a limited partnership. Legally, it is a juridical person where at least one partner has unlimited liability (the General Partner), while the rest of the capital is provided by others whose contributions are divided into shares (the Limited Shareholders). The shares of the limited shareholders can be transferred without notarization. Pursuant Sec. 278 para 2 AktG the corporate governance of the KGaA is subject to the provisions on the Limited partnership in the German Commercial Code (HGB). Apart from this, the KGaA is governed by the AktG.

The General Partner may have a stake in the equity of the company, but that is not obligatory for him to exert control over the company.

For a startup, the capitalistic "GmbH & Co. KGaA" variant is especially attractive: a management GmbH, controlled 100% by the founders, acts as the General Partner, while Investors and employees are limited shareholders. This setup ensures the founders manage the company without facing personal liability. The GmbH & Co. KGaA was expressly declared possible by the Federal Court of Justice in 1997 (BGH, resolution dated 24.2.1997 - II ZB 11/9) and has enjoyed increasing popularity since.

Raising Capital without giving up control

The biggest advantage of the KGaA for founders lies in its management structure and the ease with which (limited) shares can be transferred. In a standard AG, the management is appointed by the supervisory board, which in turn is appointed by the stockholders’ meeting. In a GmbH, the managing director is appointed by the shareholders' meeting. As a founder, diluting equity in these types of companies therefore always carries the long-term risk of being removed from management.

The KGaA works differently: According to Sec. 164 HGB, the general partner is the “born” management. His authority to manage the company derives directly from the status as general partner.

Depending on the articles of association, it may therefore be impossible to remove the general partner from management. In contrast to the executive board of an AG, a general partner of a KGaA cannot be dismissed by the supervisory board, and even the shareholders cannot easily withdraw his management authority. Regardless of any deviating provisions in the articles of association, the general partner can only be removed from management by completely leaving the company. This requires a compelling reason in pursuant Sec. 134 of the German Commercial Code (HGB). This allows founders to retain strategic control even if their economic share falls to a minimum.

From a capital perspective, the KGaA behaves exactly like a stock corporation, which theoretically makes it perfect for scaling. Investors join as limited shareholders and, as in a stock corporation, benefit from limited liability. Their shares are highly fungible and can ultimately be listed on a stock exchange without having to change the form of the company. In addition, employees can be involved through shares or stock options (ESOP) without the risk of them compromising the strategic control of the founders, as they have only limited control and information rights as limited shareholders. The transfer and allocation of limited shares does not require the involvement of a notary - unlike in a GmbH and a normal limited partnership.

The balance of power in a KGaA usually shifts decisively in favor of the founders, as the supervisory board is restricted by law. While the supervisory board of an AG has the power to appoint and dismiss the management, its counterpart in a KGaA does not usually have these powers. This means that the role of the supervisory board is primarily limited to monitoring legality of management.

Practical Constraints

If the GmbH & Co. KGaA is such an ideal construct for founders, why is it not yet standard for startups? The answer lies in the practicalities of the international venture capital market. The structure is legally complex, involving a parallel application of partnership and stock corporation law that requires significant legal "translation" for foreign parties. Limited partnerships are uncommon in international VC practice and the GmbH & Co. KGaA is an entirely German construct, unknown in most legal systems.

Administration cost is another issue. For the GmbH & Co. KGaA at least two legal entities must be administrated, leading to additional legal and tax advisory costs. Especially for early-stage startups this poses a problem.

International VCs, particularly from the US or UK, are accustomed to the standardized governance of the GmbH and might not be open to exotic legal constructs. Furthermore, raising capital without giving up control requires a very strong bargaining position. VCs generally dislike the lack of "checks and balances" inherent in a structure where they cannot fire the management.

Conclusion

The first KGaA has been founded 1851 in Germany, making it one of the oldest legal forms of company in Germany. Yet it may be exceptionally well suited for modern startups. In the form of the GmbH & Co. KGaA it offers founders a level of long-term strategic security that no other (German) legal form can provide. It allows for massive and flexible capital influx while keeping the steering wheel firmly in the founders' hands. However, for a startup, the choice of legal form is not just a legal decision; it is a marketing decision for future investors. Very few startups have enough leverage to implement their preferred form of company. Founders who have this kind of leverage and a vision that spans decades should consider the KGaA.