By Kuang Zhiping, Founding Managing Partner of Qiming Venture Partners
AsianFin--I began working in China’s venture capital industry in 1999, initially managing U.S. dollar investments for multinational corporations, and later founded Qiming Venture Partners in 2006.
From managing U.S. dollar funds to overseeing RMB funds since 2009, I have experienced firsthand the evolution of investment terms over the years. In this article, I want to trace the origins of some commonly misunderstood or misused terms, such as redemption clauses and performance-based clauses, particularly those related to IPOs, to contribute to the healthy development of the industry. The terms discussed here pertain to the venture capital (VC) industry, and there may be differences for private equity (PE) terms in mature projects.
In the early days, U.S. dollar funds in China primarily invested in Cayman Islands-based entities, often including “redemption” or “buyback” clauses and occasionally performance ratchet clauses. I will analyze the intent, boundaries, and misunderstandings of these two clauses.
A redemption clause allows investors to request the company to redeem their investment after a certain number of years, typically five or more. The redemption price usually includes the principal plus interest. This clause is automatically canceled if the company goes public or is acquired. However, a legal provision often overlooked is that under Cayman law, shareholder redemption can only be implemented without harming the company's normal operations. This explains why, despite being imported from U.S. dollar funds, redemption clauses are rarely used in Silicon Valley.
I recall attending a training session over 20 years ago where I asked, “Since this clause can only be exercised when the company has surplus cash without affecting normal operations, on what conditions can it be used?” The lecturer responded, “Indeed, it’s not very useful. The only scenario where it might apply is if a company has been stagnant for years, with profits but no growth or IPO plans. In such cases, the clause could be used. Additionally, a startup’s trajectory changes significantly over five years; market opportunities envisioned at the time of investment might no longer exist, making the funds on the balance sheet not needed for operations. At that time, negotiations can occur to partially redeem shares without harming the company.”
It’s important to note that in the original U.S. dollar fund investment terms, this clause was unrelated to individual founders and was about the company using its own funds to buy back investor shares.
When this clause was introduced in RMB funds, two changes occurred. First, early attempts to include redemption clauses in RMB funds faced legal uncertainty about companies using their own funds to repurchase shares. As a workaround, investors required founders to make buyback commitments. Although founders often lacked the capability to repurchase, this clause was thought to encourage diligence. With this obligation falling on individuals, the precondition of not harming company operations was naturally ignored.
Second, as buyback clauses became more common in recent years, lawyers have noted that courts seem to be accepting company buybacks. Consequently, more investment institutions have shifted buyback obligations from individuals to companies, with some requiring joint liability of companies and founders. However, when buyback obligations are borne by the company, a critical issue arises: the precondition of not harming the company's normal operations is not reflected in RMB fund redemption clauses or in the framework of China’s company law.
In summary, while redemption clauses offer some protection for investors, they should not push companies or founders to the brink.
Now let’s delve into the performance-based clause. Like the redemption clause, it was also imported to China and designed to adjust valuations based on actual outcomes if there is a significant gap between investors’ and entrepreneurs’ expectations for the company's future growth. Investors, after due diligence, develop a forecast for the company’s growth, while entrepreneurs provide their predictions, which may include revenue/profit performance, new drugs’ clinical timelines, or customer acquisition numbers. If investors believe these forecasts are unrealistic, they may negotiate for a lower valuation. If negotiations fail, investors may withdraw. However, during bullish market conditions, entrepreneurs with much confidence and investors willing to agree to performance-based clauses might have the company "return" shares if performance falls short of expectations. These "returned" shares typically have a cap, preventing the company from being entirely "lost" to investors.
Despite being a concept originated in Silicon Valley, performance-based clauses are rarely used in Silicon Valley. Historically, investors with independent judgment tend to frown upon performance-based clauses, as they think they can rely on their due diligence and experience. If founders’ projections are not accepted, they simply do not invest. Performance-based clauses can lead to conflicts between founders and investors, with management sometimes sacrificing other important goals to meet performance targets. Responsible investors prefer to reach a consensus on valuation, work collaboratively once they become shareholders, and support each other.
In the past decade, performance-based clauses have been misused. Some investors, attracted by promising projects without thorough due diligence, engage in valuations akin to market haggling, and some omit minimum thresholds, leading to significant issues. Even more concerning is that, for some time, certain investors believed that as long as a company went public, profits were guaranteed. "Isn't delivering good performance just a means to go public?" they thought. So, they skipped performance-based earnouts altogether and jumped straight to IPO-based earnouts. As a result, they combined two different concepts: buyback clauses triggered by failure to go public years later, and valuation earnouts based on one or two years of business performance. This merging of different mechanisms led to IPO earnouts being triggered in a much shorter timeframe.
Performance-based clauses are not inherently problematic but should be used sparingly, particularly for relatively mature companies with stable business models and development paths. It should not be a fixture for all projects.
With over 20 years of experience in the venture capital industry, I have witnessed the emergence of many great enterprises, experienced their growing pains, and observed some failures. Our industry has gradually matured through trial and error. Today, among the thousands of well-performing companies we have invested in, many face redemption or performance pressure although they have created substantial job and entrepreneurial opportunities.
Addressing these issues requires the collective wisdom of the entire ecosystem. We cannot rely on a single policy or one-size-fits-all approach. For example, if an investor requests redemption after 10 years, it is reasonable for a capable company to comply. However, demanding IPO performance after only three years, triggering redemption and causing chain reactions among other shareholders, is problematic.
In conclusion, we should foster patience in the primary market, moderate openness in the secondary market, encourage mergers and acquisitions, especially for unprofitable companies, and support overseas listings. LPs should pragmatically assess GPs’ fulfilling their buyback obligations. This collective effort will give companies and entrepreneurs a chance to continue growing and benefiting society. Of course, when a company is developing well, investors ultimately need a healthy, predictable, and dynamic secondary market as the most important and promising exit channel. Many of my colleagues have already spoken on this topic recently, so I won't elaborate further here.
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