Navigating legal risks for tech startups

Fast growing tech innovators typically navigate complex funding deals, equity incentives and collaboration agreements. Focusing on equity frameworks and contract management, and drawing on court rulings and regulatory updates, this article dissects the fundamental legal risks faced by these companies and provides concrete guidance for safeguarding their operations.

Equity structure

A company’s equity structure determines its control, internal stability and capacity for financing. Structural flaws at this level risk breeding continuous internal strife.

The fight for control. The seemingly balanced 50:50 ownership split is a high-risk setup. Without a clear tiebreaker, it readily descends into decision-making deadlock, crippling corporate governance. A real-world example involves an electronics group owned by five shareholders. Although one held a 51% stake, de facto control remained with the founding team, fuelling tensions that erupted into a legal battle for company dissolution. This highlights the dangerous rift that can emerge between capital providers and founder-managers.

Another prominent dispute saw an AI chip company’s former chief technology officer sue for RMB4.29 billion (USD633 million) in equity incentive compensation, a record sum. The case hinged on a single question: did he leave voluntarily or was he pushed out?

The answer legally dictated whether he could monetise his founder shares. This highlights a crucial lesson for fast growing businesses: Well considered “lock up” and exit clauses in equity plans are not just legal formalities, but vital tools for securing long-term stability.

Hidden dangers of valuation adjustment mechanisms (VAMs). While essential for funding innovative tech firms, VAMs carry rising risks in today’s stringent IPO environment. One biotech company faced penalties after its controlling shareholder agreed to a share buyback worth several billions in renminbi once the IPO was blocked – a liability massively exceeding the company’s net asset value of under RMB500 million. The danger lies in “side deals” that publicly void VAM provisions while privately reviving them if listing plans collapse, creating a covert guarantee.

Article 78(2) of the Securities Law requires disclosed information to be truthful, accurate, complete, concise, intelligible and devoid of false records, misleading statements or material omissions.

Under the Guidelines on the Application of Regulatory Rules – Issuance No.4, VAM arrangements should generally be cleaned up before filing, with only four exemptions permitted. Companies must therefore master the limits within which VAM terms may operate.

Risk prevention advice. Key measures include:

1. 1. Establishing clear control, steering clear of 50:50 splits and bolstering governance stability via share class structures or voting agreements;
   2. Formalising equity incentive plans with defined lock-ins, clear exit classification rules, and transparent buyback pricing formulae;
   3. Cautiously handling VAM clauses, ensuring any hidden “side deals” are properly cleared in line with the Securities Law and supervisory directives, so that special rights clauses are substantively and properly addressed.

Contract management

For tech-driven companies, contracts are the bedrock of daily business. How well they are drafted dictates not just legal compliance, but a company’s very ability to navigate and survive unforeseen challenges.

Technical contracts and IP ownership hazards. The Civil Code defaults patent rights for commissioned inventions to the developer unless stated otherwise. An AI co-operation project illustrates the hidden hazard: the commissioning party agreed only on the work and payment, failing to specify who would own the IP.

When the developer later asserted exclusive ownership of all outputs, the client was left having paid for research without securing rights to the results. This underscores the necessity for clear terms on ownership of the resulting IP, licensed use and benefit sharing in any collaborative or outsourced R&D contract.

Performance and disclosure risks for material contracts. A listed company was heavily sanctioned for disclosure violations concerning a RMB3.69 billion computing services agreement, resulting in an RMB8 million corporate fine and RMB9.2 million in penalties for its management.

The central failing was the non-disclosure of a critical contractual provision allowing the client to unilaterally cancel orders without penalty if its end customer withdrew. Therefore, robust compliance for material contracts cannot be confined to execution; it must actively govern the fulfilment process to clearly establish and mitigate legal exposure.

Legal pitfalls of penalty clauses. In China, liquidated damages serve mainly to compensate, not punish. Article 585(2) of the Civil Code, together with the Interpretation of Several Issues Concerning the Application of the Contract Provisions of the Civil Code, establishes the principle of compensating that damages should generally not exceed 30% of the actual harm.

For late payment in business contracts, a cap of four times the one-year loan prime rate is sometimes applied. Courts are typically reluctant to reduce penalties for deliberate breaches, only doing so in limited circumstances based on loss and fault. Therefore, an inflated contractual penalty is counterproductive – courts tend to slash disproportionate sums. A reasonable and enforceable clause offers better protection for recovering genuine losses.

Takeaways

In legal risk, an ounce of prevention is worth a pound of cure. For tech startups, this translates to early action: set up a clear, stable equity foundation, draft investment terms with care and manage contracts rigorously, from securing IP to disclosing key performance updates. Making compliance part of the company’s DNA is not just a box-ticking exercise; it is the bedrock for thriving in a fast paced, competitive market.

Huang Jun is a partner at Ronly & Tenwen Partners