Interpretation of Core Clauses in Investment Agreements (Part III) - Liquidation Preference and Drag-Along Rights

01 Introduction
In the practice of investment and financing of start-up enterprises, the majority of investors do not aim to accompany the company from its establishment to its dissolution, nor do they hope to obtain dividends through long-term equity holding. Instead, they seek to exit at an appropriate time and achieve high investment returns. In practice, the ways for investors to exit usually include initial public offering (IPO), mergers and acquisitions, equity transfer, dissolution and liquidation, etc. Liquidation preference and drag-along right are two important priority rights that can ensure investors exit before the founding shareholders and obtain investment returns.
02 Liquidation Preference Rights
1. Basic Concepts
Liquidation preference refers to the right of specific shareholders (typically investor shareholders) to obtain liquidation proceeds in priority over other shareholders in accordance with the agreed method when a liquidation event occurs in the target company. Commonly seen preferred distribution amounts include a certain multiple of the investment principal, the investment principal plus annualized returns and undistributed dividends and bonuses, etc.
2. Legal Basis
Liquidation preference, as a common priority right in PE/VC project transaction documents, actually represents the inconsistency in exit interests between investors and founding shareholders. It is not a statutory right. Article 236, Paragraph 2 of the Company Law of the People's Republic of China stipulates that after the company's assets have been used to pay off liquidation expenses, employees' wages, social insurance fees, and statutory compensation, and to settle the company's debts and pay off taxes owed, the remaining assets shall be distributed among the shareholders of a limited liability company in proportion to their capital contributions. Based on this, the theoretical circle and judicial practice generally hold that the order of repayment is a mandatory provision, but all shareholders may make separate agreements on their respective distribution ratios of the remaining assets.
3. Design Purpose
The most important purpose of designing the liquidation preference clause in PE/VC projects is to ensure the investment returns of investors, whether it is to minimize losses as much as possible during legal liquidation or to obtain the maximum investment return during deemed liquidation. In addition, considering the inequality of the capital contribution obligations of the founding shareholders and the investors in the early stage of the development of start-up enterprises, the liquidation preference can also prevent the founding shareholders from taking advantage of their absolute controlling position to dissolve the company at will after the investment funds are in place, thereby obtaining improper benefits in a disguised manner and damaging the interests of the investors.
4. Liquidation Event
The liquidation event in a PE/VC project is not limited to the statutory liquidation scenarios stipulated in the company law, such as the expiration of the business term, resolution for dissolution, or revocation of the business license. It can be understood as any event that leads to a change in the control of the target company. Therefore, in addition to the aforementioned statutory liquidation scenarios, the acquisition of the company, the sale of controlling equity, or the sale of major assets may also be agreed upon as "deemed liquidation events". For investors, these are events that offer more exit value. The deemed liquidation scenarios are also a key point for the founding shareholders when negotiating the transaction documents with the investors. In practice, there are even cases where an IPO is agreed upon as a liquidation event.
5. Classification
After the investors receive their preferential allocation portion, whether they can continue to participate in the subsequent proportional allocation among all shareholders, liquidation preference rights are mainly divided into the following three categories:
Participatory distribution
Participating distribution refers to the situation where, in addition to being entitled to a preferred distribution ahead of other shareholders, investors can also participate in the distribution of the remaining assets together with all other shareholders in proportion to their respective shareholdings. This type of liquidation preference is the most favorable for investors. After recovering the principal through the priority right, they can still participate in the distribution and share the gains brought by the increase in the valuation of the target company. In terms of the nature of the rights, it is actually a combination of debt and equity.
(2) Participatory distribution with a cap
The capped participating distribution means that although investors can continue to participate in the distribution of the remaining assets in proportion to their shareholdings after receiving the preferred distribution, they cannot participate in subsequent distributions once the cumulative investment returns reach a certain upper limit. This is a compromise adjustment to the participating distribution, which controls the returns that investors can obtain from this project within a predictable range.
(3) Non-participatory Distribution
Non-participating distribution means that the investor can only receive the amount of the preferred distribution and cannot participate in subsequent distributions. In terms of the nature of rights, it is equivalent to the investor realizing a creditor's right. Just like the capped participating distribution, if the investor finds that the return obtained by participating in the distribution according to the shareholding ratio when the liquidation event occurs exceeds the amount of the preferred distribution obtained by exercising the liquidation preference right, then the investor can give up exercising the right and directly choose to participate in the distribution according to the shareholding ratio.
6. Implementation Method
Due to the mandatory provisions of the Company Law of our country regarding the liquidation process, in practice, the realization methods of the liquidation preference mainly include pre-liquidation dividends and secondary distribution after liquidation.
Dividend before liquidation
According to Article 210, Paragraph 4 of the Company Law, all shareholders of a limited liability company may agree not to distribute profits in proportion to their capital contributions. Therefore, after a liquidation event occurs, the target company can pay the amount that the investor is entitled to under the relevant liquidation preference terms through targeted dividends. However, this method can only be applied when the target company sells its main assets and has distributable profits. It is not applicable in the case of equity acquisition.
(2) Secondary Distribution after Liquidation
If the target company has no distributable profits or the legal liquidation process has been initiated, in practice, the distributable assets are usually first distributed to all shareholders in proportion to their respective capital contributions. After the aforementioned distribution is completed, adjustments are made through free transfers among shareholders to achieve the purpose of the investor obtaining the corresponding distribution income in accordance with the relevant terms of the liquidation preference rights. It is worth noting that when the founding shareholders sell their control rights through equity transfer, the investor can also exercise the co-sale right we mentioned in the previous series of articles to obtain part of the income in advance. However, whether a different price can be agreed upon with the founding shareholders' external equity transfer at this time is controversial in practice.
7. Restrictions proposed from the perspective of founding shareholders
From the perspective of the founding shareholders, we first recommend clearly defining the scope of liquidation events in the transaction documents, especially the circumstances regarded as liquidation, to avoid overly broad or uncertain expressions. Secondly, since there are three different types of liquidation preferences, if you have a certain advantage in business negotiations, you can strive for not allowing the investors to participate in subsequent distributions or giving them capped participating distributions. Additionally, it is advisable to minimize the amount of preferred distribution given to the investors. If it is a certain multiple of the investment principal, it is generally between 1 and 1.5 times. If it is the investment principal plus annualized returns, the annualized return rate is typically between 5% and 12%.
8. Model Clauses
After the company has lawfully paid the liquidation expenses, employee wages, social insurance premiums and statutory compensation, and settled the outstanding taxes and company debts, the remaining assets of the company ("remaining assets") shall be distributed in accordance with the following principles and sequence:
The investors of this round shall be entitled to receive the preferred liquidation proceeds (hereinafter referred to as "Preferred Liquidation Amount of this round of investors") prior to all other shareholders: the actual investment amount paid by the investors of this round, the interest calculated at an annual rate of X% (simple interest), and the dividends that should be distributed to the investors of this round but have not been paid as approved by the shareholders' meeting. Specifically, if the remaining assets of the company at that time are insufficient to cover all the Preferred Liquidation Amounts of the investors of this round, all the remaining assets shall be distributed to the investors of this round, and among different investors of this round, the distribution shall be made in proportion to the Preferred Liquidation Amounts they are entitled to.
(2) After the full payment of the preferred liquidation amount of the investors of this round, if the company still has remaining assets, then the other investors shall be entitled to receive the preferred liquidation amount before all other shareholders except the investors of this round (hereinafter referred to as "preferred liquidation amount for other investors"): the investment amount of other investors and the interest calculated at an annual interest rate of X% (simple interest), as well as the dividends that should be distributed to other investors but have not been paid and approved by the shareholders' meeting resolution; particularly, if the remaining assets of the company at that time are insufficient to pay the preferred liquidation amount for all other investors, then all the remaining assets shall be distributed to other investors, and among different other investors, the distribution shall be made in proportion to the preferred liquidation amount for other investors that each is entitled to.
(3) After fully paying out the preferred liquidation amounts of the investors of this round and the preferred liquidation amounts of other investors, if the company still has remaining assets, such assets shall be distributed among all shareholders at that time in proportion to their respective shareholdings in the company at that time.
In the event of any of the following circumstances: (1) all or substantially all of the assets of the Group Company are sold, transferred or otherwise disposed of in a transaction or a series of related transactions, all or substantially all of the Group Company's intellectual property rights are exclusively licensed to a third party, or (2) the Company undergoes a merger, reorganization, acquisition or other similar transaction with another entity, as a result of which the shareholders of the Company prior to such transaction lose more than fifty percent (50%) of their voting rights in the surviving entity (or hold no more than fifty percent (50%) of the voting rights in the surviving entity after the merger, reorganization or acquisition), each of the above events shall be deemed a liquidation event of the Company, and the income obtained by the Company or its shareholders from the aforementioned events shall be distributed in accordance with the provisions of Article X.
03 Right of First Refusal to Sell
1. Basic Concepts
The drag-along right, also known as the tag-along right, refers to the situation where, upon the occurrence of a drag-along event, the investor holding the drag-along right has the right to force the target company, including the founding shareholders, and other shareholders to jointly complete the sale to a third party. On the surface, the realization of the drag-along right is one of the forms for investors to exit the target company, but it also means a change in the controlling shareholder and actual controller of the target company. Moreover, since the drag-along event usually triggers the liquidation preference mentioned earlier, it is of great significance to the target company and the founding shareholders and should be treated with caution.
2. Legal Basis
The right of first refusal is not a statutory right under Chinese law. It is a special agreement made by shareholders of a limited liability company regarding the disposal of equity, which is often clearly stipulated in the investment agreement and/or the company's articles of association. It is worth noting that since the right of first refusal usually implies a change of ownership of the company, and amending the articles of association requires the approval of shareholders representing more than two-thirds of the voting rights, which is a mandatory provision of the Company Law, we usually recommend that investors include this clause in the articles of association and explicitly exclude the preemptive rights of other shareholders at this time to ensure the smooth realization of the right of first refusal and subsequent acquisition.
3. Design Purpose
Because the right of first refusal can lead to significant changes in the equity or assets of the target company, it is not a commonly agreed-upon priority right in PE/VC projects in practice. Its design purpose is not only to provide investors with an exit path to obtain investment returns, but more importantly, to enable specific investor shareholders to have the right to decide on the sale of the target company to the outside, especially when the exit path through IPO is not ideal due to policy and market conditions.
4. Triggering Conditions
The trigger conditions for the drag-along right are a key focus for founding shareholders during negotiations with investors. In practice, they can usually be agreed upon by combining time limits, the drag-along subject, and the drag-along price.
(1) Time Requirements
In early-stage financing projects, it is generally agreed that the possibility of triggering the drag-along right exists only after a certain period following the closing of this round of financing. This is to ensure that the target company has a stable period of operation after receiving the investment funds.
(2) Right of First Refusal Holder
In practice, there are generally two major categories: one where only a specific investor decides on the drag-along right, and the other where both a specific investor and the founding shareholders jointly decide on it. Of course, there are also cases where the decision on the drag-along right is made based on the proportion of voting rights held. However, in general, if the drag-along right can be initiated solely by a specific investor, it is unfair to the founding shareholders. The founding shareholders should, as far as possible, have partial decision-making power over the overall sale of the target company.
(3) Tag-along Price
When it comes to the external sale of the target company, the most realistic and the most concerned issue by all parties is the drag-along price. For the founding shareholders, if the drag-along price is too low, after first ensuring the priority exit of the investors, the founding shareholders will ultimately find it difficult to effectively participate in the distribution of the proceeds from the overall sale of the target company. Therefore, the drag-along price should be as high as possible to ensure that both the investors and the founding shareholders who are forced to sell together can actually enjoy the exit benefits.
5. Restrictions proposed from the perspective of founding shareholders
As mentioned earlier, the realization of the drag-along right is of little significance to the founding shareholders. This is because they can only receive cash returns when the sale price far exceeds the amount that the investors can obtain through the exercise of the liquidation preference right. Therefore, from the perspective of benefiting the founding shareholders, first, the exercise threshold, that is, the trigger condition of the drag-along right, should be appropriately raised based on the actual negotiation situation. Secondly, no entrepreneur is willing to hand over their entrepreneurial "fruits" to a competitor. Therefore, it is possible to strive to include in the transaction documents a form of regularly updating the list of competitors to select potential acquirers. Additionally, if the acquirer is willing to purchase only the equity of the target company held by the specific investors who enjoy the drag-along right, without completing a control acquisition, it can be clearly stipulated in the transaction documents that the drag-along right will not be triggered in this case.
6. Model Clauses
(a) XX months after the completion of this transaction, if any third party makes a genuine offer to acquire all or more than 50% of the company's equity, or all or substantially all of its assets and business ("Drag-Along Event"), and (i) the Drag-Along Event is agreed by all Drag-Along Right Holders, and (ii) the overall valuation of the company reflected in such sale transaction is not less than RMB X billion, then the Drag-Along Right Holders shall have the right to issue a written notice to the company and all shareholders at that time (hereinafter referred to as the "Drag-Along Notice"), requiring all shareholders to sell all of their equity in the company (or the company's equity corresponding to the Drag-Along Event), or support the company in selling all or substantially all of its assets and business (as the case may be) (hereinafter referred to as the "Drag-Along Right"). The Drag-Along Notice shall specify (i) the identity and basic information of the third party, (ii) the third party's acquisition intention and the quantity or amount of equity, assets or business it intends to acquire, and the acquisition price, and (iii) the terms and conditions of the acquisition transaction. All shareholders undertake that they are obligated to sell all of their equity in the company (or the company's equity corresponding to the Drag-Along Event) to such third party within thirty (30) days after receiving the Drag-Along Notice in accordance with the terms and conditions specified in the Drag-Along Notice, or approve the company's sale of all or substantially all of its assets and business at the Drag-Along Price (as the case may be), including but not limited to signing all legal documents necessary for the equity or asset transfer, voting in favor of the resolution to sell the company's equity or assets at the company's shareholders' meeting and/or board of directors, and completing all registration, filing, approval and other legal procedures necessary for the equity or asset transfer.
(b) Upon the occurrence of a drag-along event, the pre-emption right under Article XX of this Agreement shall no longer apply (and all shareholders hereby agree to waive such pre-emption right), and all shareholders shall provide necessary cooperation to ensure the completion of the drag-along event.
04 Conclusion
From the perspective of investors, both liquidation preference and drag-along rights are priority rights for achieving exit and safeguarding investment returns. However, due to the inherent conflict of interests between founding shareholders and investors, how to successfully complete financing while protecting their own interests and avoiding falling into "word traps" is a huge challenge for founders.