Among increasingly vibrant outbound investment activities, Chinese venture capital funds (VCs) have begun to tap into international markets – the US in particular. Venture capital had a relatively late start in China, and its key terms were also largely borrowed from the US. However, in the course of localization, differences have emerged in several aspects where the Chinese VC practice differs from that of the US.
In China, provisions in VC agreements tend to place stricter requirements on founders and their companies. When negotiating with American startups, VCs often discover that the American party may resist certain investment provisions, particularly those requiring that founders bear personal liability or placing special restrictions on their rights. Keeping such differences in mind will help Chinese investors finesse their negotiations and communication with US companies and founders.
Participation right in liquidation preference. Liquidation preference is an utterly important right for holders of preferred stock, meaning that in case of liquidation events (including sale of the entire company), the investors as the holders of preferred stock have the right to receive a return equal to their original purchase price or more in preference to the shareholders of common stock.
However, in VC projects in the US, the preferred stockholders tend to be limited in their right to participate in the distribution of remaining assets. For instance, either a cap will be placed on the amount using the original investment amount as a base, or the preferred stock will not have the right to participate in the distribution together with the common stock (i.e. non-participating preferred stock).
The end result is that if it makes more economic sense to the investors for the assets of a company to be distributed in proportion to their shareholding percentages than for them to exercise their liquidation preference, the investors will have to waive the liquidation preference and convert their preferred stock into common stock, so as to participate in pro rata distribution along with the holders of common stock. In contrast, Chinese investors generally consider the participation right as an essential right, and only in rare cases will they accept limitations on participation right.
Personal liabilities of founders. In the US, representations and warranties given in respect of the investee company are made by the company, and founders generally do not give representations and warranties in their personal capacity nor will they bear personal liabilities concerning the matters related to the representations and warranties.
The common practice in China, however, is for the company and founders to jointly give representations and warranties, and the founders may be held personally liable.
Right of redemption. The right of redemption is a common VC provision in both China and the US. However, the main difference is that in the US, the redemption obligation is placed on the investee company, whereas the founders bear the redemption obligation in most cases in China if the investee company is a domestic Chinese company. One key reason is that in China, redemption by the company triggers a decrease in the registered capital of the company, which involves complex procedures. Moreover, since the Supreme Court of the PRC handed down its final ruling on the Haifu v Shiheng and Diya case in 2012, the Chinese courts no longer recognize the redemption obligation placed on a company, thus the founders will shoulder the redemption obligation in reality.
Veto rights. It is acknowledged in both China and the US that the investor has veto rights over certain matters. In the US, the veto rights generally focus on matters that have direct impact on the rights and interests of the investor, such as revisions to the investor’s rights and interests, offerings of preferred stock of a higher class, and liquidation.
In contrast, the scope of the investor’s veto rights is markedly broader in China than in the US. In addition to matters directly related to investors rights and interests, it also often covers matters relating to the operation of the company, such as budgets, disposal of intellectual property, appointment of senior officers and their remuneration, and stock option plan formulation and administration. In particular, Chinese VCs and their US counterparts take different views on a company’s future financing activities. Whereas in the US, VCs generally require veto on cheap finance and issuance of senior stock, Chinese investors often require veto on any future financing.
Binding the founders. Founders usually play crucial roles in startups. Investors will generally seek to attach the founders to certain strings to ensure that they will continue to serve the company for a considerable period of time after the company has obtained the venture capital. For instance, the founders’ stock will be categorized as restricted shares subject to certain repurchase right. However, Chinese VCs often also require the founders to make a commitment to providing service to the company for a certain period of time, ranging from three to five years or until the IPO. In the US, however, more respect is given to founders’ personal choices, and few founders will agree to make such commitment of service.
Understanding the differences
Some of the above differences result from disparate legal regimes in China and the US. For example, Chinese law provides that the company cannot bear the obligation in respect of the redemption right, thus it can only be borne by the founders. Another example is that non-competition commitments are unenforceable in many US states such as California, where non-competition clauses are hardly enforceable.
Many of the differences may also be attributed to the overarching differences in the VC environments in these two countries. First, it is not uncommon for disputes to erupt between founders and investors in China, including the high-profile disputes involving New Oriental and Alibaba. Being wary of founders, investors often desire to bind the founders with more restrictive provisions. Second, VC is a relatively recent import to China. Consequently, investors tend to hold a relatively stronger position, and founders are less sensitive to certain provisions and therefore more tolerant of stringent terms compared with their American counterparts.
Chinese and US investors and enterprises share many interests and motivations for cooperation. However, due to differences in the two countries’ economic and legal arenas, cross-border investors inevitably encounter legal provisions that are different from what they are used to back in their home country. By getting a more comprehensive understanding of differences in the VC environments and investment provisions, Chinese investors will be better equipped to achieve balance and act more efficiently in their negotiations and investments.
Zhou Min is an associate of PacGate Law Group
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