Positives of target company equity buybacks

Despite frequent deadlocks where a target company is subject to buyback obligation, this clause is still widely used, reflecting a positive attitude to equity buybacks by target companies

Private equity investment involves four essential stages: fundraising, investment, management and exit. Among these stages, the exit phase is of particular concern to fund managers.

While IPOs are the most popular and often most profitable exit route, in reality only a minority of investments actually succeed in going public. Most investment targets ultimately exit through methods such as being acquired by listed companies, third-party acquisitions or equity buybacks.

Traditionally, using equity buybacks as an exit strategy may seem synonymous with investment failure, and it is generally seen as a last resort option.

However, the reality presents a different perspective. Annualised return of around 10%-15% (buyback rate) provides investors with a stable and risk-free profit.

For target companies, the associated costs of buybacks are relatively low compared to other financing methods like leasing or supply chain finance, not to mention private lending.

Additionally, the capital and interest are paid back in a lump sum at the end of the investment period, without pressure on the expenditure of funds during the investment phase, and potentially resulting in even lower actual financing costs.

Therefore, while equity buybacks may not yield high returns for fund managers, they do offer a satisfactory explanation to investors.

Buyback challenges

If equity buybacks are so advantageous, shouldn’t private equity investment enjoy a smooth ride, regardless of market conditions? Why does the reality differ?

(1) Not every startup company has a controlling shareholder or actual controller. Some startups have a relatively dispersed shareholding, or very complex shareholding structure, from their inception. In such cases, investors find it challenging to find willing transaction counterparts (the actual controllers) to sign buyback agreements.

(2) Not every actual controller is willing or capable of assuming the buyback responsibility. Even if a startup company has an actual controller with the capacity for buybacks, he or she might not be willing to take on such a responsibility. Alternatively, the company’s actual controller might lack the financial means to execute a buyback, especially if the founders started the company with limited resources and borrowed initial capital.

(3) Buybacks by target companies entail legal risks. The Supreme People’s Court (SPC) established the principle of invalidity for buyback clauses in the case of equity buybacks and the valuation adjustment mechanism (VAM) involving Suzhou Industrial Park Haifu Investment. Despite this, numerous similar cases have since been presented to the SPC.

Consequently, article 5 of the SPC Minutes of the National Courts’ Civil and Commercial Trial Work Conference made relevant provisions, admitting the validity of target company equity buyback clauses, but the court’s public authority is generally hesitant to directly intervene if the target company refuses to fulfil the agreement.

Faced with such judicial uncertainties, investors remain reluctant to sign buyback agreements with target companies, or simply abandon this buyback approach.

Buyback positives

In light of the above-mentioned challenges, are there any solutions to address these issues?

(1) Economically speaking, having the target company conduct equity buybacks is more practical and feasible. In many cases where there is no controlling shareholder in startup companies – or when the existing controller is unwilling or unable to take on the responsibility of equity buybacks – the target company has accepted the funds of investors as long as it continues its regular business activities.

As long as there are no systemic risks in the social and economic landscape, or within its industry, with no man-made or operational risks arising internally, the company’s overall business performance should not face major issues, thereby retaining the ability to conduct buybacks to some extent. Hence, buybacks initiated by the target company provide investors with a stronger sense of security.

As investors become shareholders in the target company, they also gain a certain level of control, giving them increased confidence in their investment.

(2) From a legal standpoint, equity buybacks initiated by the target company align more with the equivalence principle of rights and obligations. Equity investments involve complex legal interactions, encompassing various legal relationships under the Civil Code and the Company Law.

From the perspective of the Civil Code, equity buybacks by the target company adhere more closely to the equivalence principle of rights and obligations. In this context, if the target company accepts investments, and certain situations specified in the agreement occur, the company should be responsible for returning the investment (i.e., conducting equity buybacks) rather than the actual controller.

However, from the perspective of the Company Law, the target company is a legal entity, and its expression of intent needs to be made by the corresponding corporate authorities.

Therefore, while fulfilling the buyback obligation according to the Contract Law, the target company must also adhere to capital reduction procedures prescribed by the Company Law.

This capital reduction resolution needs to be made by the shareholders’ meeting. Convening of the shareholders’ meeting and decision making are generally considered internal company matters where judicial authority should not interfere. This constitutes the legal basis for relevant opinions in the above-mentioned SPC minutes.

(3) From the perspective of practical feasibility, the SPC’s guidance provides a potential resolution without a definitive solution. First, the agreement for the target company to undertake the buyback obligation is unquestionably valid.

Second, it is essential to avoid being deemed as an illegal withdrawal of the capital contribution.

Finally, incorporating capital reduction procedures directly into the buyback clause by explicitly listing and convening a shareholders’ meeting, and forming a capital reduction resolution, and adhering to article 177 of the Company Law, as integral parts of the buyback obligation, with all target company shareholders required to sign and seal the agreement.

This approach transforms internal corporate matters governed by the Company Law into contractual obligations under the Civil Code, granting future judicial enforceability and legal recourse in case of credit risks.

Guo Baosheng is a senior partner at Liang Gao Law Firm. He can be contacted at +86 138 0113 5830 or by e-mail at gbs2001@163.com.

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