Core Clauses of the Investment Agreement - Repurchase Right

I. Preface

In the practice of investment and financing, the repurchase right is a core right that investors have to control project risks and lock in the exit path. It is also a common institutional design in transaction documents. This article will, based on the recent investment and financing practices in the primary market, gradually dissect the key rules and practical points of the repurchase right.

II. Repurchase Right

1. Basic Concept

The repurchase right refers to the right that when a specific event occurs, investors can require the company and/or founding shareholders to repurchase the company's equity held by investors at a specific price. In simple terms, the essence of the company's repurchase is to reduce the registered capital, and the essence of the founding shareholders' repurchase is to transfer the equity.

In recent years, there has been a trend in early investment and financing projects that the proportion of projects with repurchase rights has gradually decreased. This is partly because the founding shareholders have enhanced their awareness of the risks of personal repurchase obligations in investment terms, and partly because some investors, based on the relatively low investment cost and inherent uncertainty of early projects, have made temporary concessions.

2. Institutional Background

Firstly, institutional investors usually have a fixed term of existence and need to achieve project exit within a certain period. The repurchase right helps ensure that the fund has a liquidation channel when it is liquidated. Secondly, when the company's development is not as expected, achieving qualified listing or being acquired at a premium is impossible. Investors need to find an exit path. In addition, if the company develops smoothly and has abundant cash flow, but due to objective factors such as policies and the market, it cannot achieve qualified listing within a short period, then the founding shareholders, from the perspective of optimizing the shareholder structure and improving internal governance, may also have the motivation to actively repurchase.

3. Repurchase Circumstances

Common repurchase triggering circumstances include failure to achieve qualified listing, serious breach of contract, and serious personal problems of the founding shareholders. The specific circumstances are as follows:

If the company fails to complete the agreed qualified listing within a certain period, usually this period is 3-5 years, which depends on the stage of development of the company at the time the transaction documents were signed;

If the company or the founding shareholders seriously violate the provisions of the transaction documents, generally, "serious breach of contract" will be defined by all parties, and the company will also strive for a grace period for the initial breach;

If the founding shareholders have serious personal problems, usually including the company generating off-balance-sheet income, financial fraud, the founding shareholders being held criminally responsible or losing control of the company;

Other common repurchase triggering circumstances also include the company failing to obtain or maintain the necessary key licenses or permits for production and operation within a certain period, the request for repurchase by other investors, the company's unilateral disposal of core assets, and significant changes in the company's main business.

4. Repurchase Forms

According to the definition of the repurchase right in the previous text, the repurchase forms can be arranged and combined around the obligations of the company and the founding shareholders, including only the company bearing the repurchase obligation, the company and the founding shareholders jointly bearing the repurchase obligation, only the founding shareholders bearing the repurchase obligation, and the company bearing the first priority repurchase obligation followed by the founding shareholders making up the repurchase obligation.

From the current investment and financing practices, in the domestic structure, the most common situation is that the company assumes the first priority repurchase obligation, and the founding shareholders bear the supplementary repurchase obligation for the part that the company cannot fulfill. Many projects also stipulate that in certain circumstances, the founding shareholders should bear the joint repurchase obligation with the company; while in the foreign structure, the situation where only the company bears the repurchase obligation is more common. The main reason for this is that under the capital maintenance principle of the Company Law in China, the procedure for reduction of capital is relatively complex, and whether it can be actually implemented depends on the company's financial situation. Therefore, investors will seek the repurchase obligation of the founding shareholders to achieve the smooth exit of investors through the acquisition of equity.

It is worth noting that according to the "Selected Questions and Answers from LawAnswer Network (the Ninth Batch) - Special Topic on Company-related Selected Questions" published by the People's Court Daily on August 29, 2024, Question 2 involves the nature of the equity repurchase right in the "contingent payment agreement" and how to determine the exercise period. From the reply content, the answering experts tend to consider the repurchase option as a formation right, thereby determining the exercise period as the prescription period, and in cases where there is no clear agreement on the exercise period among all parties, the reasonable period is generally no more than 6 months. Although the aforementioned questions and answers do not have legal effect, they may have significant reference value and guiding significance in practice. Therefore, it is recommended that both the investment and financing parties make clear agreements on the exercise period of the repurchase right in the transaction documents to avoid future disputes.

5. Repurchase Price

Regarding the calculation method of the repurchase price, the most common one is to take the sum of the original investment amount and the annualized return calculated by simple interest or compound interest (the annualized yield is usually between 8% and 12%), and there are also situations where, for major issues of the founding shareholders or serious faults such as financial fraud, it is directly agreed to be a certain multiple of the original investment amount (usually 1.5-2 times, the higher the degree of fault, the higher the multiple agreement). In addition, in some projects, it is also agreed to compare the amount calculated by the aforementioned formula with the specific financial indicators of the company at that time (commonly the audited net assets), and calculate based on the higher value.

6. Restrictions from the Perspective of Founding Shareholders

The upper limit of the repurchase liability of founding shareholders

For founding shareholders, if they need to bear the repurchase obligation, even a make-up obligation, the most important thing is to clearly stipulate their own upper limit of repurchase liability in the transaction documents to avoid affecting their personal or even family property due to a single entrepreneurial failure. Common expressions include limiting the repurchase liability to the company's equity held by the founding shareholder or the value of the equity, and there are other expressions based on this in practice, such as the fair value of the equity, the realized value of the equity, etc.

Other

From the perspective of the founding shareholders, first of all, they can strive to eliminate the qualified listing class repurchase in the early financing transaction documents and only retain the default class repurchase; secondly, they can strive to reduce the agreed annualized yield and stipulate a phased payment arrangement for the repurchase funds to reduce the financial pressure on the company and the founding shareholders; in addition, they can also consider stipulating various exemption circumstances, such as when the listing window is closed due to changes in regulatory policies or when the industry in which the company operates undergoes significant changes.

7. Model Clauses

a. If any of the following circumstances occur:

(1) The Company fails to complete a qualified initial public offering by [year] [month] [day];

(2) The Group Company or any founding shareholder seriously violates the terms of this agreement or other transaction documents, including but not limited to violating the statements and guarantees made in the transaction documents, making commitments, or the statements, guarantees, and commitments being untrue, incomplete, or inaccurate, or there being significant omissions or concealments of information;

(3) The founder has major personal integrity issues related to the operation of the Group Company, including but not limited to the Group Company having off-book cash receipts and payments that the investors are unaware of or the founder having criminal or illegal behaviors;

(4) Any shareholder of the Company at that time requests to exercise the repurchase right.

The investor has the right to require the Company and/or the founder (hereinafter referred to as the "repurchase obligor") to jointly repurchase all or part of the investor's equity held in the Company at the price stipulated in Article [number] (hereinafter referred to as the "repurchase price"). When exercising the repurchase right, the investor shall issue a written notice (hereinafter referred to as the "repurchase notice") to the repurchase obligor, listing the triggering events that occurred and the quantity of equity to be repurchased/purchased by the Company and/or the founder. The repurchase obligor is obligated to repurchase/purchase the equity listed in the repurchase notice from the investor within [number] months after receiving the repurchase notice, and complete all necessary change registration procedures required by law for reduction of capital or equity transfer.

b. Repurchase Price

(1) If the triggering events mentioned in items (1) and (2) above and due to such matters trigger item (4), resulting in the investor requesting to exercise the repurchase right, the repurchase price is: the investor's investment amount plus the interest calculated at an annual rate of [number]% (simple interest) (for the avoidance of doubt, the cash dividends already paid by the Company to the investor cumulatively should be deducted).

(2) If the triggering events mentioned in item (3) above and due to such matters trigger item (4), resulting in the investor requesting to exercise the repurchase right, the repurchase price is the higher of the following two:

The investor's investment amount plus the interest calculated at an annual rate of [number]% (compound interest);

200% of the investor's investment amount.

c. When the triggering events occur, in addition to exercising the repurchase right against the repurchase obligor, the investor also has the right to transfer or dispose of the equity held in the Company to any third party (including any strategic investor) in any form without any restrictions, but shall not transfer or dispose of the equity of the Company to the competitors of the Company. If there are two or more third parties who are interested in purchasing the equity held by the investor, the investor has the right to independently choose the transferee of such equity. Regarding the equity transferred or disposed of by the investor in accordance with this article, all shareholders of the Company hereby waive any preemptive purchase rights or other rights under this agreement and applicable laws and regulations, and the Company and all shareholders agree to provide necessary cooperation, including but not limited to signing all necessary documents and assisting in the completion of all necessary change registration procedures.

d. Before the Company and/or the founder pays the entire repurchase price to the investor, the investor still enjoys all complete shareholder rights under Chinese law and this agreement regarding the equity not yet repurchased.

III. Conclusion

The repurchase right is a post-event guarantee mechanism to ensure the exit of investors and is the top priority in negotiations between the investment and financing parties regarding the transaction documents. All parties should, in consultation with professional lawyers, reasonably design relevant clauses based on the enterprise development stage, the duration of the fund, the enforceability of the terms, the personal responsibility of the founding shareholders, etc., in order to better balance the interests of both parties and build a sustainable investment and financing partnership.