One Half of German Funds are Considering Leaving Germany

In an extraordinary and little-noticed announcement on May 11, 2007, the BVK, the German Private Equity and Venture Capital Association, released the results of a poll of its members showing that fully 50% of the membership are considering moving their funds out of Germany.

The cause of this discontent is of course the unsatisfactory and unworkable legal and tax framework within which German funds are forced to operate -- what we refer to in this blog as the Toxic German Legal Landscape for venture capital and private equity.

These views of the BVK membership are not merely theoretical. Some major German funds have already left Germany; for example, the current Chairman of the Board of the BVK, Rolf Dienst of Wellington Partners has recently moved his own fund out of Germany.

One should bear in mind that the BVK only has 185 members, a tiny number of venture capital and private equity funds in a country which has the world's fourth largest economy (after the U.S., Japan and China). That is to say, an already weak domestic German venture capital/private equity industry is about to become weaker.

The poll taken by the BVK was taken in part to demonstrate to the Bundesministerium der Finanzen (BMF) the seriousness of the German legal and tax situation for the industry. The poll was released on May 11.

On May 31, 2007, the BMF announced its decision to apply the VAT to the management fees of German venture capital and private equity funds. Clearly the BVK's poll did not have the intended effect. The BMF is either not listening or is unmoved.

It is difficult to escape the conclusion that, taken in the broader European context wherein other countries are moving positively to create favorable legal and tax regimes for investment funds, the BMF has take a policy decision that the venture capital/private equity industry is not an appropriate industry for Germany.

Another Shot in the Foot by the Bundesministerium der Finanzen

The response of the tax bar in Germany to the April 1, 2004, to the imposition of VAT on management fees was to create a work-around known as the "priority profit share." This work around, though artificial, worked and was tolerated by the BMF. On May 31, 2007, however, the BMF ended its tolerance and published an administrative pronouncement on its website declaring that as of June 1, 2008, the priority profit share will be subject to the 19% VAT.

It appears that the BMF has taken a policy decision that venture capital is not an appropriate form of financing for Germany.

The Toxic German Legal Landscape -- Introduction

I. The German Economic Landscape

The them of this blog is the German venture capital scene today. We need to begin with a view of the current German economic landscape from 30,000 feet above the ground. That aerial view shows the follow features:

• Germany is a high-tax jurisdiction, and its taxes are about to climb even higher -- the maximum income tax rate will move from 42% to 45%, and the VAT rate will climb from 16% to 19% -- this is the explicit policy of the new coalition government led by Angela Merkel.
• German has high unemployment -- at this writing the rate is 11.2%
• The Germany economy is in zero-growth mode and has been stuck there for several years.
• Consumer demand in Germany is low.
• The German population, including its representatives in the factions of the major political parties, have little appetite for reform of Germany's social welfare state, even though the costs have become unsustainable.
• The level of technological innovation is presently at a dangerously low ebb.
• The fires of entrepreneurial spirit in Germany burn dimly today, when they burn at all.
• Germany is now governed by a tenuous coalition of the CDU and the SDP, who are not good friends in the best of times, led by an untried, untested and inexperienced Chancellor, Dr. Angela Merkel. (I have to admit, however, that I have tremendous admiration and sympathy for Angela Merkel -- this 51 year old Ossie with a PhD in Physics who has defied political gravity by ascending to the top position in a political party dominated by a rather unpleasant group of Alpha males. Notwithstanding this extraordinary achievement she somehow gets almost no respect among the German population, including, amazingly enough, among German women! The standard comparison is to Margaret Thatcher, the implication being, apparently, that Angela Merkel is not bitchy enough to be taken seriously.)

Most of these observations are truisms and I need not dig deeper into them here. The critique of the current German economy has been done many times by numerous other writers, including Dr. Norbert Walter, Chief Economist of the Deutsche Bank, to name one of the best.

My purpose in re-capping these features of the current German economic landscape is to remind us all of the sad state of current affairs in Germany and of the self-evident need to create and foster a powerful, vibrant, well-financed, and cleverly-managed venture capital and private equity fund industry. It is precisely such an industry that can fan the entrepreneurial flame, stimulate technological innovation, finance the formation and growth of new German companies, create new employment and help get the Germany economy back on track.

Notwithstanding this obvious need, the German government, above all the Federal Ministry of Finance (the Bundesministerium der Finanzen), instead of making Germany a haven for venture capital and private equity investment funds is marching exactly in the opposite direction and appears to be hell-bent on making Germany a venture-capital-free zone. And that claim leads to my thesis, namely, that the German legal and tax landscape as it applies to such investment funds is toxic.

My critique has three main parts, which will be addressed in subsequent installments:

A. Taxation of Venture Capital and Private Equity Funds

The Federal Ministry of Finance (the BMF) promulgated a decree on November 20, 2003, pertaining to the taxation of venture capital and private equity funds which contains a set of rules which make impossible the competent and intelligent management of such funds when organized under German law. The decree is in fact having the effect of driving existing funds out of the country.

B. The Application of VAT to Management Fees

Effective April 1, 2004, the management fees received by general partners of German venture capital and private equity funds are subject to Germany's 16% VAT. As indicated above, that tax is about to go to 19%. This is an historic change and sets Germany apart from almost every other important venture capital/private equity jurisdiction. This tax charge undermines the economics of the fund business for German general partners, having in mind that German funds are on the whole much smaller than US funds and German management fees are accordingly much smaller. There is no room for 19% off the top.

C. The German Stock Corporation is a Dysfunctional Legal Form

The German Aktiengesellschaft is outdated, outmoded, complicated, expensive and dysfunctional as a corporate vehicle for growth companies. The German AG is not new, but its dysfunctionality as a vehicle for growth companies has only become painfully evident in the last several years. German corporate lawyers and German notaries, however, love the AG and have been very slow to take advantage of the new flexibility to adopt other EU country corporate vehicles flowing from the 2002 Ueberseering decision of the European Court of Justice.

[Coda: I do not want my critique of the German economic and legal landscape to be misunderstood as a critique of Germany per se. To the contrary, and apart from the sorry economic situation, I am prepared to argue that in terms of quality of life, standard of living, level of public safety, quality of infrastructure, transportation, health care, public education, cultural resources, cuisine, and adoption of new technology, including, in particular, broadband and mobile telephony, there is no better place to live on the planet -- including my native US, which is paradisiacal for the few but a hard row to hoe for the many.]