Managing the legal risks of investment and financing

By Zhou Chang, DOCVIT Law Firm

The growth of any enterprise relies heavily on investment, financing and fund management. This article considers economic activities that can be broadly classified into two categories: enterprise investment and enterprise financing.

Enterprise investment can be further divided into direct investment and indirect investment. Direct investment sees enterprises channelling funds into their own business development, such as for technology upgrades or equipment renewal. Indirect investment entails them investing in external projects like funds, bonds or equity to generate profits.

Enterprise financing refers to enterprises using their operating profits or external funds for further business operations and reproduction. Regardless of whether it is enterprise investment or enterprise financing, modern legal frameworks guide and facilitate these activities.

Because investment and financing enterprises are responsible for decision-making, execution and assuming accountability throughout these activities, they must prioritise legal compliance.

This article will analyse the management of various legal risks in investment and financing.

Due diligence

Zhou Chang, DOCVIT Law Firm
Zhou Chang
Senior Partner

For investment and financing enterprises, there is legal risk associated with information asymmetry. To mitigate risks, enterprises engage third-party intermediaries to investigate their target and its shareholders. This process is known as due diligence.

An investigation might encompass the target’s existing internal management systems, debts and liabilities, assets, primary business operations, customer base, employee and labour relations, and litigation and arbitration history.

Legal due diligence enables a comprehensive understanding of the target’s operational status, business feasibility, and any legal risks. However, due diligence investigations may have limitations placed on them.

In such cases, it is crucial to explicitly define the rights, obligations and responsibilities of all parties when signing investment and financing agreements, to avoid the information asymmetry arising from intentional information concealment or false information.

Enhancing the system

Investment and financing is restricted by the subjective factors of the enterprise’s decision-makers; their decision-making has a crucial impact on risk management and control.

Investment and financing enterprises must consider their own reality, the feasibility of their project plan and trends of industry development. They must analyse, investigate the characteristics of their target and its development prospects from a variety of perspectives, and they should establish scientifically sound investment plans to minimise the impact of subjective factors.

To ensure legality and compliance, investment and financing enterprises should conduct internal legal assessments of their management systems. This ensures the internal systems are in accordance with the law and feasible.

Ensuring rationality

During the investment and financing process, it is crucial for enterprises to only enter appropriate investment and financing agreements that clearly define the rights and obligations of all parties.

These agreements require careful attention. To minimise potential losses and safeguard their interests, investment and financing enterprises should strive to enhance the specificity and comprehensiveness of the agreement’s provisions.

For instance, the agreement should specify the responsible party for intentionally concealing crucial information and grant investors the right to supervise and raise concerns about the target’s internal management issues, with power to request corrections.

In some cases, provisions may even allow investors’ direct involvement in the target’s management processes.

Additionally, the agreement may include terms that address liquidation risks, such as the ability to demand priority compensation.

It is also advisable to include clauses outlining dispute resolution methods, thereby effectively preparing for potential investment and financing disputes, and ensuring the protection of the enterprise’s economic interests, ultimately facilitating long-term development.

Controlling diverse risks

In the investment and financing market, we encounter not only state-owned enterprises and large private enterprises, but also small and medium-sized enterprises (SMEs) and high-tech companies.

When it comes to investment and financing, investors tend to favour stable, large-scale enterprises. This places startups, SMEs and other companies at a clear disadvantage in attracting financing.

Different-sized enterprises or various investment and financing methods entail their own set of legal risks and management measures. For example, when small private enterprises engage in inter-company borrowing for financing, there is a risk of invalidity due to loan agreements violating mandatory legal provisions.

High-tech companies face risks related to the legitimacy of intellectual property rights, such as unclear ownership or difficulties in assessing the value of intellectual property rights.

Therefore, during investment and financing processes, it is crucial for enterprises to conduct thorough examinations of the legal attribution of core technological rights and ensure the legality of relevant intellectual property rights.

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Investment and financing enterprises are highly active in the market and hold a significant position, with their impact on social development gradually expanding.

However, they face numerous legal risks during their operational management. Understanding these risks is crucial to implementing appropriate management measures that ensure the effectiveness of enterprise development.

Zhou Chang is a senior partner at DOCVIT Law Firm

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