Since a private equity/venture capital (PE/VC) firm (the investor) usually does not have a direct hand in the management of an investee enterprise (the target company), in negotiations between it and the financed party it will usually demand various special rights that take priority over the founding shareholder in order to protect its interests. What kinds of pressure do these special rights provisions place on the financed party? To what degree can the financed party accept such provisions? The author proposes to provide a brief summary below and offer some advice from the perspective of the financed party.
Director seats. The investor may demand a seat on the board of directors and a veto to prevent the founding shareholder from harming the interests of small shareholders, i.e. the investor. The financed party can take these measures to prevent the investor from affecting the normal operations of the target company: (1) setting a minimum share requirement for such provisions to enter into effect; (2) flexibly arranging the matters to be resolved by the board of directors and the shareholders’ meeting; and (3) elimination of certain protective terms once business performance achieves certain targets.
Preemptive right and right of first refusal. The former refers to the investor’s preemptive right of subscription when the target company carries out a capital increase or new share offering. The latter refers to the investor’s preemptive right of acquisition, all things being equal, when the founding shareholder or other shareholders propose to transfer equity to an outside party. Preemptive subscription is divided into subscription for subsequently offered new shares based on the proportion of shares held, and subscription for all such new shares. The financed party should set a reasonable percentage in light of the company’s stage of development at the time in question and the resource strengths of the investor.
Anti-dilution provision. When the subscription price for a proposed registered capital increase by the target company is less than the investor’s previous subscription price, the investor can secure a certain quantity of equities without paying a consideration so as to counteract the dilution of its shares by the offering of new shares of lower value. When the investor exercises this provision, the founding shareholder’s shareholding will be reduced accordingly.
Therefore, during the negotiations, the financed party should: (1) do its utmost not to accept a full ratchet (meaning calculating all of the investor’s equities anew at the new lowest price, with the portion of the increasable equities transferred to the investor by the founding shareholder without, or at a nominal, consideration) and strive to secure a weighted average (giving consideration to both the price of the new capital contribution and the financing limit); (2) set limiting conditions, e.g. specifying that low cost financing within a certain period of time after the A round of financing be exempt, or setting a price floor, with the anti-dilution provision being triggered only if a subsequent financing price falls below such floor; and (3) specify the greatest possible number of anti-dilution exceptions: under certain circumstances, even if the company carries out a low price offering, anti-dilution is not triggered in accordance with commercial practice – an employee equity incentive plan being a typical example.
Liquidation preference. It means that, when a liquidation event occurs, such as in the case of bankruptcy, the investor usually has priority over the founding shareholder in the distribution of the company’s remaining assets. In the investment agreement, in addition to the company being liquidated following dissolution of the company for a statutory reason specified in the Company Law, the acquisition of the company, the transfer of its major assets, etc. may also be deemed liquidation events. During the negotiations, the financed party should endeavour to remove circumstances that could be deemed liquidation events. Furthermore, consideration needs to be given to the type of liquidation preference clause, the preference liquidation return multiple (usually between one and two times), whether the investor has the right to participate in the distribution when it triggers the clause, whether there is an upper limit on the right of distribution, etc.
Drag-along right. The investor has the right to mandatorily require the founding shareholder to transfer shares of the target company in concert with it to a third party. Counter strategies for the financed party include increasing the equity percentage required to trigger the drag-along right as well as setting restrictive conditions for triggering the drag-along transaction, e.g., a minimum guaranteed company valuation or minimum guaranteed acquisition price. Additionally, it should be demanded of the investor when it exercises its drag-along right that the purchaser of the shares not be another company in which it has invested or any of its affiliates.
Tag-along right. When the founding shareholder proposes to transfer shares, the investor has the right to demand, all things being equal, to transfer its shares to the buyer on a priority basis so as to prevent difficulty in transferring equity due to its small shareholding percentage. To counter, the financed party should: (1) expressly specify an equity percentage limit for any proposed tag-along by the investor; and (2) specify circumstances under which the tag-along right cannot be exercised.
Redemption right. The redemption right is a method whereby the investor can recover its investment and divest by requiring the founding shareholder or target company to effect a buyback. However, requiring a company to effect a buyback presents legal risks as the provisions of the Company Law on the buyback by a limited liability company of its own shares are unclear. Furthermore, when a company is in deficit, the investor requiring it to buyback equity at a certain premium rate would run counter to the principle under the Company Law that shareholders are required to jointly bear operating risks, and could be deemed to constitute an illegal loan relationship.
Valuation adjustment mechanism (VAM). When the target company fails to achieve the specified performance targets, fails to achieve a listing or other such circumstance that affects valuation arises, the investor adjusts the specified investment price or divests early. The financed party needs to consider the reasonableness of the valuation adjustment conditions and relatively accurately forecast the company’s performance growth so as to avoid triggering the mechanism.
The financed party must, on the one hand, fully respect the investor’s demands and, on the other hand, fully consider the risks they pose in light of the target company’s actual circumstances and not, for immediate financing, accept all of the investor’s terms at the cost of jeopardizing the enterprise’s future growth.
Wang Yuzhong is a partner at Boss & Young
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