Interpretation of the core terms of the investment Agreement (I) - the right of first refusal and the right of joint sale

Introduction

In the transaction documents of PE/VC projects, investors are often limited by low shareholding ratio, and there is an objective situation of information asymmetry between the management of the target company. In order to protect the rights and interests of investors, relevant priority clauses and rights restriction clauses for founding shareholders are widely used. This series of articles intends to interpret common core clauses in private equity investment one by one.

This article, the first in a series, will explain how pre-emption rights and co-selling rights, which often go hand in hand, are designed to limit the priority arrangements for founding shareholders to transfer equity abroad.

Right of preemption

Part 1. Basic Concepts

The pre-emption right refers to the right of other specific shareholders (usually referred to as the founding shareholders) to purchase all or part of the equity to be sold under the same conditions, before other shareholders or third party transferees.

Part 2. Legal basis

As one of the most common priority rights in PE/VC project transaction documents, the preemption right itself has a corresponding legal basis under Chinese law. Article 84 of the Company Law of the People's Republic of China stipulates that shareholders of a limited liability company may transfer all or part of their equity to each other. Where a shareholder transfers the equity to a person other than a shareholder, it shall notify the other shareholders in writing of such matters as the quantity, price, payment method and time limit of the equity transfer, and other shareholders shall have the right of preemption under the same conditions. If the shareholder fails to reply within 30 days from the date of receipt of the written notice, it shall be deemed to have waived the preemptive right. If two or more shareholders exercise the preemptive right, the respective purchase ratio shall be determined through consultation; If no agreement can be reached through negotiation, the pre-emptive right shall be exercised according to the respective proportion of investment at the time of transfer. Where the articles of association provide otherwise for the transfer of equity, such provisions shall prevail.

Therefore, even if the individual domestic structure of the PE/VC project does not explicitly agree on the right of preemption, because the Chinese Company law has clear provisions on the transfer of limited liability companies, shareholders are still entitled to enjoy the statutory right of preemption in accordance with the provisions of the company law. In addition, due to the principle of “agreed priority”, even though the Company Law has revised the procedural rules for the transfer of equity by shareholders to foreign countries after the amendment, such amendments will not have a material impact on the investment practice of PE/VC projects.

Part 3. Design purpose

There are three main purposes to design the preemption right in PE/VC projects. First, it is to restrict the equity transfer and exit of the founding shareholders. The second is to guarantee the shareholding ratio of investors, by participating in the external transfer of founding shareholders at a relatively reasonable price under the same conditions, to increase the shareholding ratio in the target company; In addition, based on the “personal fitness” of a limited liability company, investors can also effectively prevent unnecessary or undesirable new shareholders from entering the target company by exercising the right of preemption.

Part 4. Exercise ratio

Without considering the sequence of investors in different rounds, when multiple investors in the same sequence intend to exercise the right of first purchase jointly, the exercise ratio can be calculated in the following two ways:

(1) Relative proportion

Relative proportion refers to the share of shares that each investor has the right to purchase according to the relative shareholding ratio among investors. In practice, the projects that adopt relative proportions account for the vast majority, because in this case, investors can have the priority to purchase the amount that exceeds their shareholding proportion in the target company. Ideally, each investor can even purchase all the equity to be transferred by the founding shareholder by exercising the preemption right, so as to prevent the founding shareholder's foreign transfer behavior to the maximum extent.

(2) Absolute proportion

Absolute proportion refers to the share of shares that each investor has the right to purchase according to the proportion of shares in the target company. In practice, the absolute proportion of projects is a minority, because investors usually have a low proportion of shares in the target company, if calculated according to this, investors can only preferentially subscribe a small part of the founding shareholders to transfer the equity. It is worth noting that under the system arrangement of pre-emptive rights, there are more cases of absolute proportion calculation, which will be discussed in the next series of articles.

Part 5. Excess preemption right

Overpurchase is also a common arrangement in the design of pre-emption rights in practice, which is also intended to limit the transfer of equity by the founding shareholder and increase the share of equity that the investor has the right to purchase. Since the preemption right itself is a preemption right enjoyed by the investor, rather than an obligation, because there will often be cases where some preemption rights have been abandoned or have not fully exercised the preemption right, at this time, the investor who has fully exercised its preemption right in accordance with the corresponding exercise ratio has the right to further purchase the remaining shares of the founding shareholder to be transferred to the outside world.

Part 6. Sample terms and conditions

Subject to the other terms of this Agreement, if each Restricted Transferor (the “Transferor”) intends to sell, transfer or otherwise dispose of all or a portion of its equity interest in the Company, directly or indirectly, to any third party (the “prospective Purchaser”) or accepts an offer from the prospective Purchaser to purchase the Transferred Equity Interest, It shall give notice to the remaining Shareholders of the sale of its shares (hereinafter referred to as the “Sale Notice”). The notice of sale shall include all the terms of the transfer of the shares, including the selling price, terms of payment and the identity of the transferee (hereinafter referred to as the “prospective Buyer”).

The Investor has the right to purchase all or a portion of the transferred equity from the transfer Shareholder on the same material terms and conditions in accordance with its relative shareholding, with priority over the prospective purchaser or any other shareholder of the Company. Within fifteen (15) days after the Investor receives the transfer notice from the Transferring Shareholder, the Investor may send a written notice to the transferring Shareholder indicating its intention to exercise the preemption right on all or part of the transferred equity and the amount of the equity to be purchased in accordance with the terms and conditions set forth in the Transfer Notice.

Right of joint sale

Part 1. Basic concepts

The co-selling right means that when a specific shareholder (usually the founding shareholder) intends to transfer the equity of the target company held by it externally, the investor shareholder who has not exercised the pre-emptive right has the right to participate in such equity transfer under the same conditions, and jointly sell the equity of the target company held by the founding shareholder to the proposed transferee.

Part 2. Legal basis

Joint selling right is not a legal right under Chinese law, but a special agreement made between shareholders of a limited liability company on equity transfer. Due to the principle of “contractual priority” in paragraph 3 of Article 84 of the Company Law, the investment and financing parties can specify the institutional arrangement of joint selling right in the investment agreement and/or the articles of association of the company on the premise of not violating the prohibited laws and regulations.

Part 3. Design purpose

In PE/VC projects, the provision of co-selling rights is designed for two purposes. On the one hand, it is to ensure that investors have the right to participate in the transaction in the case of partial withdrawal of the founding shareholders, so as to realize joint withdrawal, and to protect the investment income of investors to a certain extent. On the other hand, in the early PE/VC projects, investors' investment in the target company is more based on the recognition of the founding shareholders. Through the system design of joint selling rights, it can further restrict the freedom of the founding shareholders to transfer the equity, ensure the stability of the equity and operation of the target company, and also facilitate the subsequent round of financing negotiations.

Part 4. Exercise ratio

In the system design of co-selling rights, a point of concern is the proportion of shares that investors can participate in the sale. In practice, there are mainly the following calculation methods, among which the first one is the most common, because it can ensure that investors can participate in the founding shareholders' transfer of shares to the outside world to the greatest extent:

(1) The numerator is the equity held by the investor, and the denominator is the sum of the equity held by all the investors who actually exercise the joint selling right and the equity held by the founding shareholder who intends to transfer the equity

(2) The numerator is the equity held by the investor, and the denominator is the sum of the equity held by all the investors who have the right to exercise the joint selling right and the equity held by the founding shareholder who intends to transfer the equity

(3) The numerator is the equity held by the investor, and the denominator is the sum of the equity held by all investors and the equity held by the founding shareholder who intends to transfer the equity

(4) The numerator is the equity held by the investor, and the denominator is all the issued equity of the target company

Part 5. Special Co-Sale Terms under Change of Control

In domestic PE/VC projects, there will occasionally be special co-sale arrangements under change of control. This system design refers to that if the founding shareholder's transfer of equity to the outside world will lead to a change in the control of the target company, the investors have the right to jointly sell all the equity of the target company they hold at that time, without being restricted by the above-mentioned exercise ratio.

Part 6. Sample terms and conditions

If any of the Investors (hereinafter referred to as the “Co-offerors”) decide not to exercise or waive their pre-emption rights under section XX above, The co-offeror who has not exercised the pre-emptive right shall have the right, but not the obligation, to sell a certain percentage of its shares in the Company to a third party purchaser on the terms and conditions agreed between the Seller and the prospective Purchaser in connection with the proposed transfer of Shares (the “Co-offeror”). The maximum value of the number of shares that can be sold by any joint offering holder exercising the joint offering right is the product of: (i) the number of shares to be sold as set out in the seller's notice of sale less the balance of the pre-emption right exercised by the pre-emption right, and (ii) a score expressed as [the number of shares of the Company held by the co-offeror at that time, The denominator is the sum of the number of shares of the Company held by the seller at that time and the number of shares of the Company held by all co-sellers who decide to exercise the right at that time]. If the co-seller exercises the co-selling right, the seller shall ensure the realization of the co-selling right by means such as reducing the number of shares sold by the seller accordingly. If the prospective buyer does not accept the purchase of the equity interest of the co-placer as agreed above, the Seller shall not transfer its equity interest to the prospective buyer unless the Seller simultaneously purchases from the Co-placer, on the same terms and conditions, all of the equity interest originally intended to be transferred by the Co-placer to the prospective buyer by the co-placer. The co-sellers shall, within [ten (10)] days of receipt of the notice of sale provided for in Article XX, reply in writing to the Seller whether they have exercised the co-selling right.

Conclusion

The pre-emption right and the co-selling right, as important terms to restrict the founding shareholders from transferring equity, usually appear together in the transaction documents of PE/VC projects. In addition to the founder, the definition of founding shareholders is generally extended to core employees who directly hold shares, employee shareholding platforms, and even prior investors.

From the perspective of the founding shareholder, it is also possible to advocate the corresponding exceptions to restrict the priority rights enjoyed by the investor, such as requiring the investor not to transfer the equity to the competitors of the target company, and stipulating that the founding shareholder has the right to freely transfer the equity not exceeding a certain proportion or has the right to freely transfer the equity when the shareholding proportion is not less than a certain proportion. The Investor shall be exempted from the transfer to a third party due to inheritance, court judgment and other reasons, and the investor shall be deemed to have given up if he does not reply in writing within a certain period of time.