Balancing interests behind key PE/VC clauses

Private equity and venture capital (PE/VC) agreements play a crucial role in corporate financing transactions. The terms and conditions contained in these agreements not only set out the rights and obligations of both parties to the deal; they also provide protections for investors and companies, and help to manage risks.

A set of reasonable and rigorous PE/VC agreements will greatly reduce post-investment management costs and promote the mutual benefit of both investors and the startup.

This article aims to provide guidance for understanding and setting PE/VC clauses by analysing common clauses, the underlying demands, and the game of interests between investors and companies.

Analysis of common clauses

When we speak of PE/VC agreements, we mean not a singular agreement but a set of many agreements. This set includes both the master and supporting transaction documents. Master documents generally include a share purchase agreement, shareholders’ agreement and articles of association.

There are many important clauses in PE/VC agreements, forming a complex system. This article analyses four most typical and representative types of clauses.

Conditions precedent. The conditions precedent clauses to an investment, contained in the share purchase agreement, set out the conditions that must be satisfied before a transaction may be closed.

Customarily, conditions precedent include the execution of all transaction documents, internal approval, no material adverse effect, and submission of complete business plans and financial models. They also cover certain issues identified by investors in due diligence and deemed necessary to be addressed before the closing of the transaction, which may involve the financial performance and compliance of the target company.

For investors, the expectation is to reduce the post-transaction commercial risks, such as the risk of penalty for any prior non-compliance of the target company. For the target company, the information tends to reduce uncertainty in transaction completion, bringing a close to the financing as soon as possible.

To effectively resolve disputes and propose constructive solutions, it is necessary to:

• Understand the commercial concerns behind the specific conditions precedent raised by investors, on one hand; and
• Consider the extent to which fulfilling such conditions will affect the company’s financing schedule, on the other.

By way of example, an investor proposes that a company should rectify certain non-compliance issue before closing, but the rectification will take a long time and slow down the progress of financing.

If the legal risk of the non-compliance is under control at the time, it may be worth allowing the company to rectify it within a reasonable period after the closing of the transaction, with a clear breach of contract mechanism put in place. This approach eases the investor’s concerns without affecting the company’s financing schedule.

Corporate governance clauses. The nature of PE/VC dictates that investors, in spite of their significant capital input, hold only a small number of shares and do not take part in the day-to-day management of their target company. Therefore, they hope to set up certain mechanisms at key nodes of corporate governance to protect minority shareholders’ rights and interests.

An investor may, when it reaches a certain proportion of equity interest, require seats on the company’s board of directors and have veto rights over certain significant matters such as changing the business nature of the company, seeking new financing, or liquidation.

These clauses can influence the target company’s strategic decision-making and operational direction, and represent an important safeguard for investors. From the perspective of the target company, however, it will hope to keep the management’s decision-making flexible and maintain business autonomy.

In the negotiation of PE/VC agreements, the key to successful clause design is finding a governance model that allows investors to take part in major decision-making, while allowing the target company to retain its operational autonomy.

There is also a considerable difference between giving veto rights to a single investor and granting collective veto rights to a majority of investors.

For example, if a company has gone through many rounds of financing and, as a result, investors have appointed many directors to the board, the majority voting mechanism is recommended for investor-appointed directors.

To an extent, this satisfies the investors’ demand for exerting influence over corporate governance, while also reducing the probability of deadlock in corporate decision-making, thus improving efficiency.

Share repurchase clauses. A share repurchase clause requires the company or the founder to buy back shares from investors at an agreed price, and in an agreed proportion, when a repurchase trigger event occurs.

The trigger might be the departure of the founder, failure of the company to complete a qualified public offering within a certain timeframe, or an acquisition of the company as a whole. The repurchase price is generally based on investment principal plus a certain annualised return.

For investors, this clause directly influences their exit strategy and investment return, being an important measure to protect their exit mechanism. The target company and its founder, on the other hand, hope to minimise the number of repurchase trigger events, lower the repurchase price, and limit the repurchase obligation to the company while exempting its founder.

Therefore, such clauses need to represent a trade-off between the investors’ exit benefits and the company’s long-term development. For example, if investors insist on the founder performing the repurchase obligation, it is advisable to set a cap on the founder’s repurchase obligations to ensure that entrepreneurship does not become overwhelmed by concerns over disproportionate repurchase obligations.

Bet-on/VAM clauses. Unlike clauses on conditions precedent, corporate governance and share repurchase, VAM (valuation adjustment mechanism) clauses are generally divided into upward valuation adjustment and downward valuation adjustment. This is intended to address any significant gap between the company’s post-transactional valuation and that determined by both parties beforehand, thus safeguarding the interests of both parties.

In some investment agreements, the parties set the actual performance as a trigger mechanism for valuation adjustments, where the valuation of the investment is adjusted upwards if the company performs well, or downwards if the performance is very poor. This mechanism can motivate companies to pursue better performance while ensuring investors’ returns are proportionate to the company’s strength.

Vincent Shen is a partner at Commerce & Finance Law Offices. He can be contacted by phone at +86 21 6019 2659 and by email at shenjun@tongshang.com
Sun Jingqiu is an associate at Commerce & Finance Law Offices. She can be contacted by phone at +86 21 6019 2682 and by email at sunjingqiu@tongshang.com