Interpretation of the core terms of the investment Agreement (II) - Pre-emptive rights and anti-dilution rights

Introduction

In the first article in this series, we looked at a pair of pre-emptive rights and co-selling rights that often co-exist to limit the founding shareholder's transfer of equity, and discussed in detail two other pre-emptive rights and anti-dilution rights designed to protect the investor's shareholding and equity value.

Preemption right

1. Basic concepts

The pre-emptive right refers to the right of specific shareholders (usually investor shareholders) to subscribe for new equity shares before other shareholders or third parties when the target company increases its registered capital.

2. Jurisprudential basis

As one of the priority rights frequently appearing in PE/VC project transaction documents, the priority right, like the priority right, has a corresponding legal basis in Chinese law. Article 227 of the Company Law of the People's Republic of China stipulates that when a limited liability company increases its registered capital, the shareholders have the right to subscribe to the capital contribution in proportion to the paid-up capital contribution under the same conditions. However, all shareholders agree that they do not have priority in subscribing to the capital contribution in proportion to the capital contribution.

Therefore, even if the individual domestic structure of the PE/VC project does not explicitly agree on the priority right, because the Chinese Company law has clear provisions on the new registered capital of limited liability companies, shareholders can still enjoy the statutory priority right in accordance with the provisions of the company law.

3. Design purpose

There are two main purposes for designing the preemption right in PE/VC projects. First, it is to protect the shareholding ratio of investors to avoid dilution due to subsequent rounds of financing of the target company, and may lose the right to appoint directors due to too low shareholding ratio. Secondly, the investor can improve the financing efficiency of the target company by exercising the preemption right, reduce the workload of negotiating the transaction documents, and avoid unnecessary or undesirable new shareholders from entering the target company, just like the preemption right.

4. Exercise ratio

In the first article, we mentioned that from the perspective of preventing the founding shareholders from transferring equity to other countries to the maximum extent, the majority of projects in which the pre-emption right adopts a relative proportion in practice, but under the pre-emption right system, the absolute proportion is more common. It is worth mentioning that from the perspective of founding shareholders, it may be proposed to specify the shareholding ratio as the paid-in contribution ratio:

(1) Absolute proportion

Absolute proportion refers to the new share of equity that each investor has the right to subscribe preferentially according to the proportion of shares in the target company. In this case, the investor cannot subscribe preferentially for all the new share of the company. As mentioned earlier, it is more common in practice for PE/VC projects to use absolute percentages, because the primary purpose of setting pre-emptive rights is to ensure that the investor's shareholding is not diluted, rather than to increase the investor's shareholding.

(2) Relative proportion

Relative ratio refers to the new shares that each investor has the right to subscribe preferentially according to the relative shareholding ratio among investors. At this time, the investor can subscribe preferentially for all the new shares of the company. Although this calculation method is not common, if the investor is strong enough and optimistic about the future development of the target company, such agreement can be considered in the transaction documents.

5. Absolute pre-emptive right

Absolute preemption right means that the investor has the preemption right on all the new registered capital in the subsequent round of financing, which is very rare in practice, and only a few strong investors will advocate it in the transaction documents of individual projects.

6. Over-subscription priority

Similar to the over-subscribed pre-emptive right, the over-subscribed pre-emptive right is also an agreement made by most projects, that is, if some investors who have the pre-emptive right do not exercise or do not fully subscribe for the new registered capital of the target company they have the pre-emptive right to subscribe, then the investors who have fully exercised their pre-emptive right in accordance with the corresponding exercise ratio, The right to further subscribe for the remaining new registered capital of the target company.

7. Limitations from the perspective of founding shareholders

From the perspective of benefiting the founding shareholders, we first propose to avoid special pre-emptive rights clauses in the transaction documents, such as absolute pre-emptive rights and excess pre-emptive rights, and weaken the concept of exercising the rights among investors in different rounds. Secondly, it is suggested to make a clear agreement on how to exercise the rights of the investor in the transaction documents, including written notice, exercise period, default waiver of exercise if the right is not exercised, etc. At the same time, the upper limit of the shareholding ratio of the investor can be considered to avoid the situation that the shareholding ratio of a single investor is too high, and then affect the controlling status of the founding shareholder. In addition, it is proposed to specify exceptions, such as when implementing share incentive or issuing new shares for the purpose of acquisition or merger of other entities, investors will not have the right of first refusal.

8. Model Clauses

Without prejudice to the other rights of the parties under this Agreement, upon completion of this Transaction and prior to the completion of the qualifying initial public Offering, if the Company increases its registered capital or issues new shares or raises new financing and is approved by the shareholders (general) Meeting and/or the Board of Directors in accordance with the provisions of this Agreement, The investor (hereinafter referred to as the “preemption right”) shall have the right to subscribe for the new registered capital or newly issued shares of the Company [in accordance with his/her shareholding ratio in the Company at that time], or enjoy the right to invest in the target company in new financing (hereinafter referred to as the “preemption right”). The price, terms and conditions for the subscription of new registered capital or newly issued shares or investments of the Company by the pre-emptive right holder shall be substantially the same as the price, terms and conditions for the subscription or investment of other potential investors and subscribers.

If any shareholder does not exercise or fully exercise its pre-emptive right, the Company shall issue another capital increase notice (the “Second Capital Increase Notice”) to the shareholder who has fully exercised its pre-emptive right in respect of the additional registered capital remaining after such shareholder has not exercised or fully exercised its pre-emptive right (the “remaining additional registered capital”). The shareholders who fully exercise the pre-emptive right shall have the right but not the obligation to confirm whether to continue to subscribe for the remaining new registered capital [in accordance with their respective relative shareholdings] within fifteen (15) working days after receiving the second capital increase notice from the Company, until all the remaining new registered capital has been fully subscribed by the shareholders of the Company.

Anti-dilution right

1. Basic concepts

The anti-dilution right refers to that when the target company has a discount financing (i.e. the valuation of the new round of financing is lower than the valuation of the previous investor's investment), the prior investor is entitled to anti-dilution protection, that is, the target company and/or the founding shareholder are required to adjust the valuation of the investment at that time in a manner agreed in advance, which is manifested by increasing the investor's shareholding ratio or giving the investor cash compensation.

2. Legal basis

Anti-dilution right is an imported product from American venture capital practice. In PE/VC projects under overseas structure, the purpose of anti-dilution is basically to adjust the price of conversion of preferred stock into common stock to ensure the equity value of investors, which is not a legal right under Chinese law. A special agreement on equity adjustment between shareholders of a limited liability company is usually made by the investment and financing parties in the investment agreement and/or the company's articles of association.

3. Design purpose

Most PE/VC projects under the domestic structure will agree on anti-dilution rights. Compared with the pre-emptive rights, which focus on protecting investors' shareholding ratio from dilution, the most direct purpose of anti-dilution rights is to protect investors' equity value of the target company from dilution. With the subsequent rounds of financing of the target company, the shareholding ratio of the prior investor itself will be diluted, and if the financing is still carried out at a lower valuation, the equity value corresponding to the equity held by the investor will be significantly reduced.

4. Implementation method

PE/VC projects under the domestic structure mainly achieve anti-dilution protection for prior investors in the following three ways:

(1) Allow investors to subscribe for a certain amount of newly added registered capital of the target company at a low price;

(2) The founding shareholder or the holding subject controlled by it transfers a certain amount of the equity of the target company to the investor at 0 yuan or a formal price;

(3) Cash compensation to the investor by the target company and/or the founding shareholder.

Since the first two methods are equity compensation, the potential tax burden should be considered in the case of equity transfer. In practice, it is generally agreed that the price of equity transfer is the lowest tax cost or the founder is required to bear all the taxes that may be generated. In the case of investors subscribing for new shares at a low price, it is necessary to consider the actual capital increase paid by investors. In practice, there is also a practice of agreeing that such capital increase is ultimately borne by the founder. In addition, if the investor obtains the equity at 0 yuan or at a low price, and then realizes the withdrawal by transferring the equity abroad, it will face the problem of being unable to subtract or fully subtract the original investment cost, resulting in tax base loss.

5. Calculation formula

In the specific calculation of the loss of equity value caused by the discount financing of the target company to the investors, intuitively speaking, that is, the calculation of how many shares the company should transfer or issue to the investors or how much cash compensation to pay to them, PE/VC practice mainly has three calculation formulas: full ratchet, broad weighted average and narrow weighted average. First of all, the complete ratchet calculation method is the most beneficial to investors, and the generalized weighted average is the most beneficial to the financing party. In order to facilitate understanding, we give examples here.

Assuming that the original registered capital of the target company is 2 million yuan, investor A adds 5 million yuan to the target company based on the valuation of 15 million yuan after investment (1 million yuan is included in the registered capital, 4 million yuan is included in the capital reserve), and the price of investor A's investment is 5 yuan for every 1 yuan of registered capital. After the completion of the previous round of financing, investor B adds 3 million yuan to the target company at the valuation of 12 million yuan after investment (1 million yuan is included in the registered capital, 2 million yuan is included in the capital reserve). At this time, the price of investor B when buying shares is 3 yuan for every 1 yuan of registered capital, that is, the target company has a discount financing:

(1) According to the full ratchet calculation, directly apply the new investor's share price (3 yuan per 1 yuan of registered capital) for equity ratio adjustment or other forms of compensation;

(2) Calculated according to the generalized weighted average, the adjusted price is 5 yuan * (3 million + 600,000 yuan /3 million +1 million) = 4.5 yuan per 1 yuan of registered capital, and the adjustment of equity ratio or other forms of compensation shall be made accordingly, in which 5 yuan is the price at the time of investor A's investment and 1 million is the registered capital of the company held by Investor A after the completion of the previous round of investment. 600,000 is the amount of share capital that investor B can obtain at the original price of 5 yuan for every 1 yuan of registered capital, and 1,000,000 is the amount of share capital actually obtained by Investor B;

(3) Calculated according to the narrow weighted average, the adjusted price is 5* (1 million + 600,000 /1 million +1 million) = 4 yuan for every 1 yuan of registered capital, and the adjustment of equity ratio or other forms of compensation shall be made accordingly. Among them, 5 yuan is the price when investor A shares, and 1 million is the registered capital of the company held by investor A after the completion of the previous round of investment. 600,000 is the amount of share capital that Investor B can get at the original price of 5 yuan for every 1 yuan of registered capital, and 1,000,000 is the amount of share capital actually obtained by Investor B.

6. Limitations from the perspective of founding shareholders

From the perspective of benefiting the founding shareholders, we first suggest to avoid the full ratchet calculation method as far as possible, and strive to apply the generalized weighted average, that is, the founding shareholders and investors jointly bear the impact of discount financing on the company's valuation. Secondly, it is suggested to agree on the exceptions in the transaction documents, mainly including the implementation of equity incentives or the issuance of new shares for the purpose of acquiring and merging other entities; Third, strive to agree in the transaction documents to trigger the anti-dilution clause of the floor price and the application period, that is, as long as the low price does not break or exceed the application period, even if the discount financing, do not trigger the anti-dilution clause.

In addition, it is worth mentioning the “Pay to Play” mechanism, that is, only if the original investor continues to participate in the company's subsequent financing, it can retain anti-dilution rights (which can be extended to other priority rights). Although this mechanism is rarely applied in PE/VC projects under the domestic structure, if it is a star project in which the company is in a negotiating position, founding shareholders can try to argue that this can help the founders find investors willing to invest in the long-term value of the company and share the risk, and encourage the first investors to participate in subsequent rounds of financing.

7. Model clauses (Take “full ratchet” as an example)

(a) The Company shall not, without the prior written consent of the current round of Investors, introduce any new investors in any way at a price lower than the unit price corresponding to this transaction. If the Company increases its registered capital or issues new shares and the unit price per dollar of registered capital or unit price per share (hereinafter referred to as the “Share/Share new unit Price“) for such capital increase or new share issue or equity or share transfer is lower than the subscription price per dollar of registered capital or per share of the Company subscribed by the investor (hereinafter referred to as the “anti-dilution rights holder”) (the “anti-dilution Reasons”), The anti-dilution right holder shall have the right to request an adjustment of the subscription price per 1 yuan of registered capital or per share of the subscribing company to make it [equal to the new unit price of equity/shares].

(b) For the avoidance of doubt, (i) newly issued shares or shares under the share incentive Plan approved by the general meeting and/or the Board of Directors of the Company in accordance with the provisions of this Agreement, (ii) shares issued at the time of the Company's qualifying initial public offering; Or (iii) Equity or shares in connection with a stock split, dividend payment or similar transaction.

(c) In order to realize the anti-dilutive rights of the anti-dilutive rights holder under paragraph (a) above, the anti-dilutive rights holder shall be entitled to require the Founder to transfer to the anti-dilutive rights holder a corresponding number of shares or shares of the Company held by him at no cost or at the aggregate price of the lowest price permitted by law such that the anti-dilutive rights holder shall, upon such capital increase or transfer of such shares/shares, The subscription price per 1 yuan of registered capital or per share of the company's equity/shares owned is equal to [equity/share new unit price].

(d) If the Founder transfers the equity or shares to the anti-dilutive right at the lowest price permitted by law as agreed in paragraph (c) above, the Founder shall return to the anti-dilutive right the consideration for the transfer of the equity actually paid by the anti-dilutive right to the anti-dilutive right without compensation.

(e) If the provisions of paragraph (d) above are not feasible for any reason, the Founder shall take all other means recognized by law to achieve the aforesaid anti-dilution effect.

(f) To avoid ambiguity, the Founder shall use his best efforts to seek the lowest tax costs and bear all taxes incurred by the anti-dilutive right holder as a result of the anti-dilutive adjustment.

Conclusion

According to the purpose of the design of the terms, the pre-emption right, the co-selling right, the pre-emption right and the anti-dilution right can be considered as a kind of pre-emption right that restricts the founding shareholders from transferring equity to other countries and guarantees the investor's shareholding ratio and equity value. However, how to apply it in specific projects ultimately depends on the negotiating position of the financing party and the investor in the overall project promotion process. And with the help of professional lawyers in the transaction documents to be clear, to lay the foundation for corporate governance and the protection of the rights and interests of all parties.