Introduction: Private equity fund investment originated in the United States and has become no stranger in China with the development of China’s economy and the Internet. Nowadays, private equity investment has become a booster for the development of enterprises, and the Angel round, A round, B round, and PreIPO round we often talk about have become common terms familiar to the public for investment and financing. Due to my work, I have been involved in dozens of equity investment projects as a lawyer for both the investor and the financier (enterprises) in legal due diligence, investment negotiations, agreement drafting and review, and witnessing the whole process of signing contracts. Here, I would like to share my personal views on some special clauses in investment agreements, which I hope can be of some help to enterprises with investment and financing needs.
1 | Part.1、Bet-on Clauses
The scientific name of the “bet-on” clauses is “valuation adjustment mechanism”, and it is figuratively called “bet-on” because of its function of adjusting the valuation in both investors and financiers due to their future uncertainties. Common “bet-on” matters include financial performance bets (such as betting on performance growth), IPO listing time bets, the next-round valuation bets, or non-financial performance bets such as KPI, user number, production, sales volume, production lines and technology research and development. Usually, investors and financiers will make comprehensive betting design agreements, including financial performance, IPO listing time, future valuation and other comprehensive non-financial performance betting agreements. The adjustment mechanism triggering the betting is generally divided into two types: one is that the investor gives up following up the development of the enterprise and exits the enterprise according to the agreed rate of return, and the founding shareholder or the actual controller takes over the investor’s equity; the other is that the investor receives equity or cash compensation according to the agreed calculation and continues to accompany the development of the enterprise.
Validity of bet-on clauses: The validity of bets is also evolving in judicial practice.
Firstly, before 2012, the determination on the validity of bets was ambiguous, but since 2012, the Supreme Court’s “Haitong-Fortis Investment Case” led to the judicial precedent of the invalidity of the bet between the investor and the company, and the rules of effective adjudication of the bet with shareholders, which caused an uproar in the private equity investment community, and investors began to pay attention to the effective determination of the subject of the bet.
Secondly, the “Huagong Case”, which caused a big controversy in the first half of 2019, seems to have changed to some extent the trial idea that has been confirmed since the “Haitong-Fortis Investment Case” (i.e., “the bets between investors and shareholders and actual controllers are valid and the bets with the target company are invalid”). The trial idea of the “Huagong Case” is as follows: firstly, the validity of the bet-on agreement depends on the determination of the contractual validity under the Contract Law. Generally speaking, the validity of the bet-on agreement can be recognized if it does not violate the mandatory provisions of the law (the mandatory provisions of the law mainly include those on share repurchase or profit distribution, etc.); secondly, the design of the bet-on clauses should be performable (e.g., refining the performance time and procedure of the repurchase, the different proportion of capital reduction involved in the repurchase, etc.). If the bet-on agreement is legally unenforceable, the investor’s request for continued performance can be rejected in accordance with the relevant provisions of the Contract Law; thirdly, in terms of value judgment, the performance of the bet-on agreement should be considered in the light of the target company’s operating conditions, solvency and other factors, which cannot infringe on the interests of the target company and its creditors; finally, the agreement on reasonable agreement on investment return rate is considered. That is, the corporate financing cost cannot be significantly higher than that for the same period, nor can there be departure from the normal business rules, i.e. the operating costs that the target company would incur and the operating performance that it would achieve under normal operations;
Thirdly, as for the determination of the validity of the bet-on agreement, the Minutes of the Ninth National Court Work Conference for Civil and Commercial Trials (the “Ninth Conference Minutes”) published in November 2019 gives the following principle directions: 1. The concept of the bet between the investor and the target company; 2. The validity of such bet-on agreements depends on “whether there are matters affecting the validity of the contract” (strictly based on the idea of determining the “validity of the contract” under the Contract Law); 3. According to the Contract Law, the way for the parties to assume the responsibility for breach of contract mainly includes “continuing performance, taking remedial measures or compensating damages, etc.”. Whether or not the bet-on agreement can be enforced depends on whether or not it complies with the mandatory provisions of the Company Law regarding share repurchase or profit distribution.
Lawyer Tips: At present, the validity of the bet between the investor shareholder and a company is not completely negative in judicial practice. If the company complies with the mandatory provisions of the Company Law regarding share repurchase or profit distribution, the performance of the bet-on agreement will not infringe on the interests of the target company and its creditors, and the investment return was agreed according to the trial idea of “Huagong Case” and the guidance of “Ninth Conference Minutes”, the bet-on agreement between the company and the investor will not be completely invalid. However, up to now, without more judicial practice decisions for further reference and analysis, we still suggest investors not to bet with the target company, but to choose a safe way to arrange betting with shareholders.
2 | Part.2、Preference Clauses
We commonly find a wide range of preference clauses in investment agreements, such as dividend preference clause, pre-emptive right clause, co-sale right and drag-along right clause, liquidation preference clause and repurchase preference clause.
1. Dividend preference clause. In a quality target company, there are often multiple rounds of financing, such as A, B, C and D. Investors in each round want to be given priority in the distribution of dividends to the target company to ensure their own earnings. If the agreement is unclear or there is no agreement or concern, unnecessary disputes and conflicts will arise, so the agreement on the right to dividends for different rounds of investors is usually agreed in advance in the investment agreement. The usual principle of dividend payment is “last in, first payment”, i.e. the latest round of investors will be paid first and historical investors will be paid in order of entry. The reason for this is that the valuation of the target company is getting higher and higher, and subsequent investors will have to pay more capital costs to obtain the same amount of equity from previous investors, and later round of investors do not want their newly invested capital to soon become a source of profit distribution for previous investors and original shareholders or a source of funds to fill the hole of a failed bet. According to the relevant provisions of the Company Law, the setting of dividend preference in a limited liability company requires the unanimous consent of all shareholders, while in the case of a joint stock company, dividend preference clauses need to be included in the Articles of Association. Based on our previous practice, we recommend that the Articles of Association of a limited liability company also include an express dividend preference clause to protect the interests of investors.
Lawyer Tips: When setting up this dividend preference clause, firstly, it is necessary to consider the procedural integrity and legality; secondly, in view of the different negotiating positions of the investment and financing parties and the background of the project, the parties need to consider clarifying the subject matter and the order of dividends, setting a reasonable annual interest rate that can be quantified and calculated, as well as considering whether to calculate the dividend preference cumulatively and the design of the distribution of the remaining profits, etc.
2. Pre-emptive right clause: The so-called pre-emptive right means that when the target company increases its registered capital, the agreed shareholders (generally investors) of the specific agreement of the target company are entitled to subscribe for the capital in accordance with the priority over other shareholders and third parties. The pre-emptive right is designed to protect the investor’s equity from dilution in multiple rounds of financing and, if the pre-emptive right is granted to small and medium-sized shareholders, it can also improve the protection of the vulnerable position of small and medium-sized shareholders and restrain the major shareholders from strengthening their controlling position through unilateral capital increases. Under the relevant provisions of the Company Law, the setting of pre-emptive rights for limited liability companies requires the unanimous consent of all shareholders, while for joint stock companies, the pre-emptive right clauses require the approval of the general meeting of shareholders.
Lawyer Tips: When designing the pre-emptive right clauses, it is often necessary to consider the design of the following points: first of all, it is necessary to consider not only the procedural integrity and legality, but also some details, such as agreeing on the written notice of financing, setting the exercise period, the confirmation of the exercise or non-exercise of the pre-emptive right by the investor, etc.
3. (1) Co-sale right clause: Also known as tag-along right clause, it means that when the founding shareholder wishes to transfer or sell its shares, it must notify investors, who have the right to transfer or sell the shares to a third party together with the founding shareholder at the founding shareholder’s sale price in proportion to the capital contribution (or investors have the right to exercise the right of first refusal to sell). The promoter of a co-sale right share offer is the founding shareholder and the investor has a co-sale right and can decide whether to sell the shares together with the founding shareholder. In such cases, each investor shareholder is entitled to exercise this right and to participate proportionately in the proposed sale by the founding shareholder, provided that a valid written notice is sent to the founding shareholder selling the stake within the agreed period.
Lawyer Tips: In practice, in the case of investor shareholders, attention should be paid to the exercise conditions and the exercise period. From the perspective of the founding shareholders, if the founding shareholders are in a strong position or in the interest of fairness in investment and financing, the founding shareholders may set restrictions on the exercise of the co-sale right, such as setting additional conditions that the investor shareholders may not exercise the co-sale right or setting a reasonable time for the investor shareholders to exercise the right, and if they do not indicate this within a reasonable time, they are deemed to have waived the co-sale right.
(2) Drag-along right clause: Also known as come-along right clause, it refers to the investor’s right to compel a company’s founding shareholders to participate in an investor-initiated sale of the company. The investor has the right to compel a company’s founding shareholders (primarily the founders and management team) to join him or her in transferring equity to a third party. The promoter of the drag-along right is the investor. Once the investor has found a suitable M&A party, the founding shareholders or their management team may not agree with the M&A party, the M&A offer, the terms of the M&A, etc., making it difficult for the M&A transaction to proceed, at which point the investor can force the founders to accept the transaction through the drag-along right. For founding shareholders, the design of a drag-along right clause can easily result in a change of control and careful consideration needs to be given to the acceptability of such a clause. A drag-along right is not a statutory right, but rather a contractual right, which is usually agreed in the investment agreement or shareholders’ agreement.
Lawyer Tips: From the perspective of investor shareholders, the best option is to agree it in the Articles of Association, which is more conducive than doing so in the agreement. For the founding shareholders, since the target company was founded and developed by the founding shareholders, it is unlikely that the founding shareholders will fully agree to the drag-along right clauses as the exercise of the drag-along right will lead to the loss of control of the target company by the founding shareholders, therefore, the founding shareholders may impose certain restrictions on the drag-along right of the investor shareholders, such as setting the trigger conditions for the drag-along right, limiting the subjective bad faith of the investor shareholders by setting a fair price or a legal procedure, or setting the exercise timing or limiting the parties to whom the right may be exercised (such as competitors or other transferees unacceptable to the founding shareholders).
4. Liquidation preference clause: It refers to the right of investor shareholders to receive all or part of the liquidation value of the business at a pre-agreed price before ordinary shareholders in the event of the company being liquidated or deemed liquidated (e.g. if the company is acquired, the controlling interest is sold or the main assets are sold). The purpose of the clauses is to ensure that the investor shareholders minimise losses on exit of the investment or receives a relatively good return in the event that the company is deemed to be liquidated. Liquidation preference clauses are generally divided into non-participating preference clauses, participating preference clauses and preference participation clauses with a cap. Non-participating preference clauses mean that only the agreed distribution is received and no further participation in the distribution of the residual proceeds can be made; participating preference clauses mean that investor shareholders with preference can, after participating in the agreed distribution, also participate in the residual proceeds in proportion to their shareholding with ordinary shareholders; preference participation clauses with a cap means that the shareholder will not participate in the distribution of the remaining liquidation funds until the agreed maximum return has been reached. Liquidation preference clauses are usually realised by way of dividends or secondary distribution. The legal basis for the realisation by way of dividends is Article 34 of the Company Law, which states that “unless all shareholders agree not to distribute dividends in proportion to their capital contributions”. Therefore, it is possible for investors to exercise their liquidation preference before the legal liquidation is initiated. The liquidation preference realized by way of secondary distribution means that the distributable assets are firstly allocated to the shareholders of the company in proportion to their capital contribution (“initial distribution”); after the initial distribution is completed, the amount of assets obtained from the initial distribution should be adjusted again by way of gratuitous transfer between the founding shareholders of the company to the shareholders with liquidation preference, so that the amount of distributable assets finally obtained by the shareholders of the company achieves the same or similar effect under the distribution scheme stipulated in the liquidation preference, but the above realisation is easy to achieve in simple rounds of financing, and becomes particularly complicated to operate when there are multiple rounds of financing.
Lawyer Tips: From the investor’s point of view, when designing the liquidation preference in multiple rounds of financing, they usually take the following two agreed ways: one is that the investment shareholders who entered the target company afterwards have priority over the investor shareholders who entered before them in order; the other one is that regardless of the order in which the investor shareholders entered the target company, the liquidation preference of each investor shareholder are equal and each investor shareholder is allocated in proportion to its capital contribution, and such liquidation preference is only exercised in relation to the ordinary shareholders. For the founding shareholders, if the founding shareholders are in a stronger position or from the perspective of fairness in investment and financing, they may consider suggesting to avoid such a clause design, or adopt the second way above, or set certain restrictions when setting the liquidation event that triggers the liquidation preference. However, as the liquidation preference clause is a unique and individual clause, no single liquidation preference clause is suitable for all private equity cases, and it is the result of negotiations and games between the founding shareholders and the investor shareholders and the various rounds of investor shareholders.
5. Repurchase clause: It refers to the right of an investor shareholder to request the company or the founding shareholder to repurchase its shareholding at a specified price when certain specific circumstances are agreed. The specified price requested by the investor shareholder will generally be calculated by deducting the portion of dividends paid and adding a premium (in the form of compound interest or simple interest on the amount invested). In the investment agreement, the investor shareholder will generally take the timing of the IPO of the target company, a material breach of contract by the company or the founding shareholder or a material fraud by the target company or the founding shareholder or a material event of concern to the investor shareholder as the trigger for the repurchase. When a repurchase event is triggered, the investor shareholder will generally choose whether to apply it based on its own circumstances.
Lawyer Tips: The first risk of the repurchase clause is described in the first part of this article on the bet-on clauses, namely the choice of the repurchase subject. At present, in the absence of more cases to support the repurchase of the target company, we still advise investors not to bet against the target company and ask it to repurchase, but to choose a prudent way of betting against the shareholders to ask the major shareholder to exercise the repurchase right. The second risk of the repurchase clause lies in the difficulty of repurchase execution. If the company or the major shareholder does not have enough cash and cannot obtain cash through financing, the repurchase clause cannot be executed. In such a situation, there are two solutions: either the major shareholder is allowed to compensate for the equity interest or the company goes into liquidation and the investor shareholder activates the liquidation preference.
