Keeping risks in check in equity investment and financing

Amid ongoing transformation of the domestic economy and reshuffling of industries, equity investment and financing activities are thriving, with particularly vibrant acquisitions in real estate, culture and tourism, and innovation and technology.

Equity investment and financing both take the form of equity transfer by shareholders of the target company, aiming to raise capital for development, restructuring property rights and optimising resource allocation.

The key difference lies in whether the acquisition directly involves operation and management of the target company.

In an equity investment, the investor generally leads or directly participates in the management after completing the equity transfer; while equity financing focuses more on tackling financing problems for the target company to ensure the safe withdrawal of capital.

Exposed to many legal risks in acquisition, enterprises should take early precautions and be mindful of risk control.

In this article, the author analyses legal risks that acquiring companies need to fend off in the general acquisition process or planning equity investment and financing.

Legal due diligence

Apart from detailed routine investigation of the target company, legal due diligence should also tackle the following risks:

Debts and restrictions on equity or significant asset rights of key related parties. This refers to situations where the target company has outstanding bank borrowings; the company and its related parties have made equity pledge guarantees; the company has borrowed funds from or lent them to related parties; or the company’s equity is frozen by court order.

In such cases, companies deciding to go through with the acquisition may negotiate with pledge holders – such as banks and other financial institutions – to make equity changes without altering the pledge, and negotiate repayment to lift the pledge or replace pledge holders.

Companies may also include the above-mentioned borrowings in transaction capital costs, or require original shareholders of the target company to commit that no material debts are undisclosed.

Accounts receivable. The percentage and account period of bad debt provision of accounts receivable and other receivables are the main issues requiring clarification, as well as the possibility of an increase in the bad debt rate and its impact on the target company’s valuation. For this, making adequate preparations for bad debts is advised; requiring actual controllers of the target company to provide guarantees for debts, establishing an early warning and assessment system for debt recovery risks; and readjusting the target company’s valuation.

Core technology development and IP rights. For target companies capable of independent development or co-development of technology, or those entrusting IP development to third parties, due diligence should focus on development and protection of core technologies, as well as the attribution and transfer of IP rights.

In this regard, companies are advised to refine and improve relevant agreements to optimise provisions on the attribution of IP rights, declaration of patents, and transformation of results, scientific achievements and infringement liability – establishing a sound pre-acquisition risk barrier

Core team and non-competition. Due diligence should also cover labour contracts and confidentiality agreements signed by core team members, along with their social security payments and non-compete agreements.

If no non-compete agreements have been signed, require the target company to promptly rectify the situation before the acquisition. The target company should also commit to bear liability risks for failing to pay the required social security and non-compliance of provident fund before the transaction, with its actual controllers required to sign a letter of commitment to ensure stability of the original core management team and no personnel attrition afterwards. The target company may also consider launching a share incentive scheme after the acquisition.

Involvement in litigation. This area mainly involves litigation-related claims and debts. Analysis should be conducted on the cost and period of disputed claims, the legal categorisation of disputed debts and the possibility of debt reduction or stripping, as well as the impact on valuation of the target company. The acquiror may insist that controlling shareholders and actual controllers of the target company assume joint and several guarantee liabilities for the debts.

Equity transfer agreements

When a company decides to make an acquisition after completion of legal and financial due diligence, drawing up an equity transfer agreement becomes the critical next step.

As a legal instrument for capital operation, equity transfer should be conducted via a secure and feasible agreement containing reasonably and prudently prepared clauses, accompanied by relevant subsidiary agreements – such as trade secret confidentiality agreements and technology authorisation agreements – catering for the interests of all parties.

Major clauses of equity transfer agreement are:

Subject of agreement. The subjects of the equity transfer agreement are the acquiring company and shareholders of the target company. Any legal risks concerning ineligible transfer subjects, ambiguity of equity and improper selection of transfer subjects should be avoided. The legality of the transferring shareholders’ identity should be verified, as well as the transferee’s eligibility and whether all parties are eligible to be either transferor or transferee under the law or the company’s articles of association.

Representations and warranty. Completely truthful information may be unobtainable through due diligence before acquisition. Therefore, commitments should be made in the equity transfer agreement on relevant matters to ensure the legality of the transaction and facilitate the acquisition, aiming to reduce legal risks of untruthful information disclosure.

For specific design and arrangement, refer to the above-mentioned “legal due diligence” section.

Asset valuation. To prevent the legal risk of inaccurate asset valuation, all types of tangible and intangible assets of the target company should be thoroughly assessed. In particular, the valuation of intangible assets must include the target company’s business reputation, management model, supply and sales channels, and market potential, in addition to IP rights.

Price and payment. Reasonable arrangements should be made for consideration of equity transfers, specific payment methods and the establishment of regulatory accounts.

Debt settlement. The clause should focus on how to assume the target company’s pre-existing, contingent or hidden debts, agreeing on the scope, manner or proportion to be shared by parties according to the purchase price.

Jin Wei is a senior partner at DOCVIT Law Firm