Interpretation of Core Clauses in Investment Agreement (V) - Protective Clauses and Right to Information
01 Introduction
In PE/VC projects, investors, as minority shareholders, usually do not directly participate in the daily management of the target company. To balance the rights and obligations between the investors, the target company, and the founding shareholders, and to safeguard the core interests of the investors as shareholders, protective clauses and the right to know are widely stipulated in the transaction documents of PE/VC projects.
02 Protective Clauses
1. Basic Concepts
The protective clause, also known as the major matter veto right, refers to the clause where specific shareholders (mainly investors) or their appointed directors have the veto power over specific matters of the target company. Its core lies in restricting the decision-making power of the founding shareholders to prevent the damage to the investor's rights and interests caused by information asymmetry or abuse of control rights.
2. Legal Foundation
Take a limited liability company as an example. The "Company Law" of our country provides both basic regulations and gives the company autonomy in terms of the voting rules at the shareholders' meeting and the board of directors level. According to Article 66 of the "Company Law", except for the resolutions to amend the company's articles of association, increase or reduce the company's registered capital, as well as the resolutions for the company's merger, division, dissolution or change of company form, which must be passed by more than two-thirds of the voting rights of the shareholders, the procedures for deliberation and voting for other matters can be separately stipulated in the company's articles of association.
At the board level, in accordance with Article 73 of the Company Law, based on one vote per person, and in light of the basic division of duties between the shareholders' meeting and the board of directors as stipulated by the law, the company can independently design the voting mechanism of the board of directors. That is, investors can include certain matters within the scope of decisions that require unanimous approval by the board of directors.
3. Design Objective
The main purposes of formulating protective clauses are as follows:
(1) To balance the voting rights differences between investors and founding shareholders, investors not only hold a lower shareholding ratio but also usually do not participate in the daily management of the company. Protective clauses help investors supervise and restrain major matters, preventing founding shareholders from abusing their control rights.
(2) Ensure the investment returns of investors by including protective clauses. This not only enables investors to control the operational risks of the company to a certain extent, but also prevents uncertainties in investment caused by significant changes in the target company, thereby indirectly affecting the investment returns.
4. Core Content
(1) Items to be rejected
The items subject to veto fall into two categories. The first category consists of core matters related to the rights and status of investors, such as increasing or reducing the registered capital, amending the company's articles of association, modifying the board of directors' seats, employee equity incentives, etc.; the second category is related to the company's daily operations and is also the focus of negotiations and consultations between the company and investors in practice. It generally includes formulating the annual budget, large expenditures outside the budget, asset disposals, guarantees, loans, and related party transactions exceeding a certain amount.
(2) Director seats
The veto power at the board level is closely related to the allocation of board seats. Generally speaking, the boards appointed by the founding shareholders in the board of directors usually have a majority, while the seats of the minority investors are usually given to those investors whose shareholding ratio meets certain conditions. At this time, for investors whose shareholding ratio does not meet the conditions for appointing a director, it can be considered to strive for a seat as a board observer. Apart from not being able to exercise the voting rights, they can also attend the board meetings and timely grasp and understand the business trends of the target company.
(3) Voting mechanism
At the shareholder meeting level, it is usually stipulated that for certain matters, not only must they be approved by a certain proportion of shareholders with voting rights, but also must be agreed upon by specific investors before they can be voted through. In addition, there are also cases where, based on the relative shareholding ratios among investors, a certain proportion of voting rights must be reached before certain major matters can be passed.
At the board level, it can also be agreed that the relevant proposals can only be passed with the consent of the designated directors by specific investors, or with the approval of a certain proportion of the investor directors.
5. Restrictions proposed from the perspective of the founding shareholders
Set the threshold for the proportion of equity shares
The founding shareholders can stipulate that only when the shareholding ratio of an investor reaches a certain level, will that investor and the directors appointed by him/her have the right to cast a veto vote. If the investor's shareholding ratio is diluted due to subsequent financing or reduced due to partial exit and falls below the agreed threshold, they will automatically lose the right to cast a veto vote.
(2) Limit the number of seats held by investor directors
As mentioned earlier, the number of directors appointed by investors can be limited to ensure that the directors appointed by the founding shareholders hold the majority of the seats. For example, if the board consists of five directors, it can be agreed that only the top two investors in terms of shareholding ratio will have the right to appoint directors.
(3) Establish a dynamic adjustment mechanism
It is suggested that, in light of the changes in the company's operating conditions, such as after reaching certain milestone events, the protective clauses stipulated in the existing transaction documents should be adjusted to prevent excessive intervention by investors during the company's rapid development, thereby achieving a balance between the interests of investors and the autonomy of the management.
6. Model Clause
(1) At the shareholders' meeting level
The shareholders' meeting is conducted by the company's shareholders exercising their voting rights in proportion to their capital contributions. The shareholders' meeting shall exercise the following powers, among which the matters listed in item 【】 require the consent of shareholders representing 【2/3】 or more of the voting rights (among which at least 【】 of the consent is required) to be passed; for other matters, they can be passed with the consent of shareholders representing 【1/2】 or more of the voting rights:
i. Matters related to increasing or reducing the registered capital, issuing equity, shares or other company securities, conducting any equity financing, equity repurchase, or changes in the company's equity structure, including investment and financing activities.
ii. Company split, merger, acquisition or sale, other transactions that result in the disposition, transfer or any other action that may lead to a change in the company's control of more than 50% of its assets;
iii. Company dissolution, liquidation or change of company form;
iv. Any form of modification, alteration or deletion of the rights of investors or any provisions beneficial to investors;
v. Amend the company's articles of association;
vi. Increase or decrease the number, composition and appointment methods of the board of directors;
vii. Develop or revise any employee equity incentive plans or schemes;
viii. Make substantive changes to the main business of the group company;
ix. Review and approve the profit distribution plan;
x. Review and approve the purchase, sale (including disposal), or mortgage of individual assets with a single transaction amount exceeding RMB 【】 million or exceeding 【】% of the company's latest audited consolidated assets in the most recent financial period;
xi. Review and approve borrowing activities or external guarantees conducted by off-budget companies where the single transaction amount exceeds RMB 【】 million or exceeds 【】% of the company's latest audited consolidated assets.
xii. Review and approve any single transaction between the company's shareholders, directors, senior management personnel, or their close relatives or affiliated parties and the company, where the transaction amount exceeds RMB 【】 million or exceeds 【】% of the company's latest audited consolidated assets; or any other transaction that may result in the transfer or distribution of company benefits to the aforementioned parties.
13. Determine the company's business strategy and investment plan;
xiv. Elect and replace directors and supervisors, and determine matters related to the remuneration of supervisors;
xv. Review and approve the company's annual financial budget plan and final accounts plan;
xvi. Review other matters that are stipulated by laws, administrative regulations or the company's articles of association and that should be decided by the shareholders' meeting.
(2) Board level
The voting for the board resolution is conducted on a one-vote-per-person basis. Matters requiring a board resolution must be approved by a resolution passed by more than 1/2 of the directors present at the company's board meeting. However, for the following items (the "Board Special Matters"), item [ ] must receive the approval of more than 1/2 of the directors (including [ ] directors) for implementation:
i. Formulate the company's business plan, major capital usage plan and investment scheme;
ii. Develop the company's annual financial budget plan and final accounts plan;
iii. Formulate the company's profit distribution plan and loss compensation plan;
iv. Formulate plans for increasing or reducing the company's registered capital and issuing corporate bonds;
v. Formulate plans for the merger, division, dissolution or change of the company's form;
vi. Determine the establishment of the internal management structure of the company;
vii. Decide on the appointment or dismissal of the company's general manager, financial director, and related matters regarding their remuneration;
viii. Formulate the basic management systems of the company;
ix. Make significant changes to the accounting system and policies;
x. Determine any external investment by the company that exceeds an amount of 【】 million yuan but is no more than 【】 million yuan, or does not exceed 【】% of the company's latest audited total assets (whichever is higher). This includes single transactions that are outside the company's budget.
xi. Determine transactions involving the purchase, sale, or mortgage of major assets that exceed an amount of 【】 million yuan but do not exceed RMB 【】 million yuan, or do not exceed 【】% of the company's most recent audited total assets (whichever is higher); such transactions must be outside the company's budget.
xii. Determine any borrowing activities or external guarantee matters that exceed an amount of 【】 million yuan but are no more than 【】 million yuan, or do not exceed 【】% of the company's latest audited total assets (whichever is higher);
xiii. Determine any single transaction between the company's shareholders, directors, senior management personnel, or the close relatives or affiliated parties of the above-mentioned individuals and the company, where the transaction amount does not exceed RMB 【】 million or does not exceed 【】% of the company's latest audited total assets (whichever is higher).
xiv. Develop plans for the acquisition, merger or bankruptcy of the company;
xv. Develop plans for external financing (including loans, borrowings, etc.) beyond the company's budget.
03 Right to Know
1. Basic Concepts
The broad concept of the right to know encompasses the rights of information access and inspection. It refers to the right of investors to understand and obtain the company's financial information and operating conditions, as well as the right to conduct financial and business inspections of the company.
2. Legal Foundation
Article 57 of the Company Law provides a legal basis for shareholders to exercise their right to know. In investment and financing practices, investors usually, on the basis of the legally stipulated right to know, will further request the target company to provide more detailed information such as financial data and business conditions, and clearly specify the types of materials, the time of provision, and the frequency.
3. Design Purpose
Similar to the protective clauses, the existence of the right-to-know clauses serves the following two main purposes:
(1) Effectively balancing the information asymmetry between the investors and the founding shareholders, investors can promptly obtain the company's true and accurate operating conditions and financial information by exercising their right to know, so as to regularly assess investment risks and make reasonable decisions.
(2) Investors can review the company's financial records to supervise its standardized operations, urge the founding shareholders to abide by the terms of the transaction documents, and, depending on the circumstances, decide whether to further exercise their inspection rights to prevent any actions that may harm the investors' interests.
4. Restrictions proposed from the perspective of the founding shareholders
Given that the right to know information is itself a legally recognized right, in practice it is rarely linked to the shareholding ratio of investors. From the perspective of the founding shareholders, the following two points can be considered for restrictions:
(1) Confidentiality Obligation
In the transaction documents, it is required that investors assume the obligation of confidentiality for the company information obtained through exercising their right to know. Moreover, for highly confidential information, an additional confidentiality agreement should be signed to clearly stipulate the confidentiality obligations, confidentiality period, and liability for breach of contract, etc.
(2) Non-compete Clause
If the investors (mostly industrial investors) are engaged in a business that competes with the target company, the scope of confidential information they can obtain can be restricted. If the investors have invested in multiple companies in the same industry, the target company can also impose such restrictions and make further agreements.
5. Model Clause
(1) The company shall submit the following information and materials to the investors as per the following agreement:
i. Within 30 days after the end of each quarter, provide unaudited quarterly financial statements and quarterly reports on business operations prepared in accordance with Chinese accounting standards;
ii. Within 180 days after the end of each fiscal year, provide the annual consolidated audit report and annual consolidated operation report prepared in accordance with Chinese accounting standards, which have been approved by the board of directors.
iii. Within thirty days prior to the end of each fiscal year, submit to the board of directors the draft of the company group's operating plan, financial forecast and investment plan for the following year.
iv. Other materials provided by the company to government departments and securities regulatory authorities that have a significant impact on the company's operations (including but not limited to applications for initial public offering or listing on the New Third Board, as well as materials related to major administrative penalties, investigations, and lawsuits);
v. Other documents and information reasonably requested by the investor.
The above-mentioned financial statements should at least include the balance sheet, the cash flow statement and the income statement.
(2) Shareholders have the right to review the company's financial ledgers and other business records without affecting the normal operation of the company. They also have the right to consult the company's advisors, employees, hired accountants and lawyers.
04 Conclusion
The protective clauses and the right to know complement each other and are both core mechanisms for safeguarding the interests of investors. They not only grant investors the right to veto major matters but also provide them with the necessary information basis for decision-making. In specific transactions, all parties should, with the assistance of professional lawyers, combine the characteristics of the target company's industry, its scale of operation, and its governance structure, etc., to reasonably design the relevant clauses, laying a solid legal foundation for subsequent cooperation
