Explanation of the term and legal definition of Hurdle
The term Hurdle is used especially in a business law context and refers to a threshold that must be exceeded to trigger certain rights, remunerations, or conditions. In German, Hurdle is often translated as “Schwellenwert” (threshold value), “Hürde” (hurdle), or “Mindestschwelle” (minimum threshold). Hurdle clauses are primarily found in corporate law, particularly in private equity and venture capital agreements, as well as in fund compensation arrangements and bonus agreements.
Legal significance and areas of application
Hurdle in corporate law
In corporate law, the term Hurdle frequently appears in participation agreements, for example in the structuring of profit distribution systems and in the arrangement of “liquidation preferences.” Here, the Hurdle describes a threshold value that, for example, secures the investors’ capital input before proportional profit sharing for other beneficiaries begins.
Hurdle in fund and asset management
In fund practice, particularly with private equity and hedge funds, the Hurdle Rate is an essential component of the compensation arrangement for fund managers. Here, it denotes a minimum return or minimum yield that the fund must achieve for the benefit of the capital providers before further profit shares (usually in the form of a performance fee or carried interest) are distributed to the management. The legal basis here arises from the respective articles of association or the fund agreement. The goal is the fair distribution of generated gains and the creation of a balanced incentive system between investors and management.
Hurdle in employment and compensation law
Hurdle conditions are also applied in bonus agreements and stock-based compensation models. Employers may, for example, set sales targets or other corporate key figures as prerequisites before variable salary components or allocations of options are granted. The corresponding contractual arrangement must meet the legal requirements for transparency and determinability of compensation regulations.
Legal structuring of the Hurdle
Contract structuring and formal requirements
Hurdle clauses are fundamentally defined by contract. The precise structuring arises from the individual agreement between the parties. Particularly important here are the clear definition of the threshold value, the reference basis (e.g., return on equity, IRR – internal rate of return, EBIT), and the consequences of reaching or not reaching the hurdle. In cases of doubt, interpretation should be carried out according to objective standards (§§ 133, 157 BGB). In standardized participation or fund agreements, hurdle clauses are regularly regulated in detail within the respective contract.
Transparency and disclosure obligations
To ensure legal certainty and the enforceability of claims, a transparent and comprehensible structuring of the hurdle clause is required. Investors and beneficiaries must be able to recognize when a hurdle has been exceeded and what rights or obligations arise from this. Breaches of transparency obligations can result in the invalidity of the relevant clauses or claims for damages.
Control mechanisms and legal consequences
In the event of disagreements about the crossing of a hurdle, the parties are entitled to rights of audit and inspection, provided this is regulated in the contract or arises from the principle of good faith (§ 242 BGB). In particular, the proper calculation and documentation of the relevant key figures is of central importance to avoid disputes. In contested hurdle cases, the ordinary courts regularly decide. What is decisive is always the specific content of the contract in conjunction with the applicable law.
Tax and regulatory aspects
Tax treatment
The tax classification of income associated with exceeding a hurdle depends on the individual case. If hurdle overruns are paid, for example, as “carried interest” in investment funds, these are regularly taxable as investment income or — depending on the structure — as income from non-self-employed work. The separation principle applies; the tax treatment is carried out independently of civil law agreements according to the tax provisions of the Income Tax Act (EStG).
Regulatory requirements
In the context of funds, the structuring of the hurdle clause must not violate regulatory requirements, particularly the provisions of the German Capital Investment Code (KAGB) and the AIFM Directive (Alternative Investment Fund Managers Directive). Supervisory authorities such as the Federal Financial Supervisory Authority (BaFin) review the implementation of such mechanisms as part of fund supervision. The objective is to safeguard investors’ interests through fair compensation structures and to avoid conflicts of interest.
International perspective
Hurdle clauses are common practice internationally. The specific legal assessment may differ in detail depending on national law, for example with regard to the admissibility of certain minimum returns or the structuring of profit shares. Especially in Anglo-Saxon jurisdictions such as the United Kingdom or the USA, hurdle rates are a central element of participation agreements and fund structures.
Significance in litigation and case law
In the event of a dispute, the decisive factor is the interpretation and application of the relevant contractual clause. Courts examine the transparency, comprehensibility, as well as the effectiveness and appropriateness of the agreed hurdle based on the contract content and legal requirements. Case law on hurdle-related issues exists in particular in connection with profit distribution arrangements between fund initiators and investors, as well as with bonus claims in employment relationships.
Summary
The hurdle is a legal mechanism widely used in business that, as a threshold value, governs the occurrence and amount of contractual claims. It is of particular relevance in corporate, labor, and capital markets law, where it aids in the equitable management of profit and compensation claims. Legal structuring requires a precise definition and transparent regulation to prevent legal disputes and safeguard the interests of all parties involved. Tax and regulatory conditions must also be observed in accordance with the applicable laws. International differences in structuring must be taken into account. Hurdle clauses are a central element of modern contractual compensation models and make a significant contribution to balanced risk distribution and incentivization in commercial transactions.
Frequently asked questions
What are the legal consequences if a hurdle condition in articles of association is not clearly defined?
If a hurdle condition in articles of association, especially in the areas of private equity or venture capital, is not sufficiently clearly defined, this can lead to significant legal uncertainties and disputes. The contracting parties, usually investors and founders, risk not being able to enforce their economic expectations. Unclear formulations may result in the timing and calculation basis for exceeding the hurdle remaining indeterminate. In the event of a dispute, courts may interpret the clause by way of supplementary interpretation, or, if interpretation is not possible, declare it invalid (§ 133, § 157 BGB). Such invalidity may call into question the entire compensation mechanism or profit distribution of the affected party, which can have considerable financial and corporate law consequences. Furthermore, any violations of the transparency requirement under § 307 (1) S. 2 BGB (when using general terms and conditions) can lead to invalidity.
When is a hurdle agreement legally permissible?
Hurdle agreements are generally legally permissible, provided they do not contravene mandatory statutory law, in particular corporate law principles, the prohibition of immorality (§ 138 BGB), or the transparency requirement (§ 307 BGB). Special care must be taken in contract drafting to avoid covert profit distributions within the meaning of § 8 (3) KStG when shareholders are affected. Furthermore, corporate loyalty duties and any disadvantages to individual shareholders must be taken into account to prevent possible challenges or actions for defects in resolutions. In addition, the provisions on the hurdle must be harmonized with the requirements of § 30 GmbHG to avoid unlawful payments to shareholders.
How does a hurdle affect profit distribution under corporate law?
The hurdle influences profit distribution by setting a specific return threshold that must be exceeded before certain parties — such as managers or founders (e.g., under carried interest models) — participate further. From a corporate law perspective, it should be noted that the hurdle rule must be part of the profit distribution arrangement in the articles of association (§ 29 GmbHG; § 120 AktG). If the hurdle is not reached, the favored parties do not share in further profits. Conversely, a contractually stipulated redistribution takes effect. It is important that the hurdle mechanism determined in the articles of association does not conflict with statutory provisions on minimum profit distributions or mandatory capital maintenance rules. In corporations, creditor protection interests must also be considered.
What role does the hurdle play in complying with tax regulations?
Tax recognition of a hurdle requires that the contractual provisions withstand the so-called arm’s length principle and are not classified as hidden profit distributions (see § 8 (3) KStG) or inappropriate compensation (§ 4 (4) EStG). What is crucial is that the conditions are clearly and comprehensibly documented, in particular the basis of calculation and the mode of payment. Tax treatment also depends on whether the distributions resulting from the hurdle arrange a redistribution to related parties. In such cases, the tax authorities especially examine whether there is an improper granting of benefits. Tax recognition is at risk if the hurdle is changed arbitrarily or retrospectively to the detriment of the tax authorities.
Can a hurdle be changed unilaterally at a later date?
A unilateral change to a hurdle clause is generally legally excluded, as changes to contracts in corporate law are subject to the approval of all, or the majority specified in the articles of association (§ 53 GmbHG, in the case of the GmbH for example a qualified majority). Unilateral amendments, for example by the advisory board or management, without the corresponding legal basis in corporate law, would be invalid and could lead to the nullity of the relevant resolution or to personal liability consequences for the acting bodies. Contract amendments relating to the hurdle regularly require written form and must be entered into the shareholder list or submitted to the general meeting to ensure transparency and legal certainty.
What legal disputes can arise in connection with hurdle agreements?
Typical disputes concern the calculation of threshold values, the interpretation of unclear contractual provisions, and the classification of hurdle payments as compensation or hidden profit distributions. There may also be questions as to whether a company or individual shareholders derive impermissible benefits from the application of the hurdle, which can be subject to legal proceedings. Furthermore, actions for annulment or declarations of nullity may be brought due to formal defects in resolutions or violations of statutory provisions (for example, contravention of the capital maintenance requirement; § 30 GmbHG). Judicial enforcement depends greatly on the previously selected wording and documentation; unclear or contradictory hurdle regulations are particularly likely to give rise to legal disputes.
Do hurdle clauses have to be disclosed or approved?
In principle, hurdle clauses are not subject to explicit disclosure or approval requirements vis-à-vis third parties. However, in certain types of companies, in particular public companies (e.g., publicly listed joint-stock companies, investment funds), a disclosure requirement may exist, for example under the German Commercial Code (§ 325 HGB), the KAGB, or as part of prospectus obligations. In GmbHs and partnerships, disclosure is often only required internally to the shareholders. Depending on the structuring of the articles of association, however, reservation of consent, reporting, or approval requirements may exist. For intra-group regulations or co-determination obligations of the supervisory board, additional body approval may be required.
What special significance does the hurdle have in insolvency?
In the insolvency of a company, payment claims based on a hurdle are subordinated, provided they are structured as profit participation and not as fixed remuneration claims. They then — to the extent that their ranking can be distinguished — participate in the general loss sharing and are regularly satisfied only after the claims of creditors (§ 199 InsO). After insolvency has commenced, a distribution pronounced in favor of certain parties that exceeds a hurdle may be contestable (§ 134, § 135 InsO). In practice, hurdle agreements therefore mean an increased risk for creditors, which must be taken into account when drafting contracts.
