Liability limitation and protection of founders in venture capital financing

In venture capital (VC) financing for startups, in addition to claiming certain protective ‘preferential’ rights, investors will usually require founders to bear more stringent personal liability for their (and company’s) breaches of contract or certain other matters. Subject to specific projects and bargaining positions, the manner and limits of founders’ liability are usually the focus of negotiations.

In this article, the author briefly analyses general approaches of liability limitation and protection available to founders.

Q: What are the general circumstances regarding personal liability of founders in investment agreements?

A: Core documents of VC financing transactions generally include the share purchase agreement and shareholder agreement, collectively known as “investment agreements”, which usually stipulate that investors have preferential rights – such as anti-dilution right, right of first refusal, pre-emption right, co-sale right and liquidation preference – and in a narrow sense do not require founders to directly bear personal liability.

Circumstances in which founders have to directly assume personal liability are mainly in relation to share repurchase obligations and liquidated damages; arising from breaches of founder representations and warranties under the investment agreements, breaches of contract under such agreements, or the company’s failure to achieve performance targets or qualified IPOs.

In addition, investment agreements generally stipulate that founders shall be jointly and severally liable with the company. Such liability may be assumed as the obligation of equity transfer or monetary payment.

Q: What are the general approaches to formulating provisions that limit liability and protect founders?

A: First, set an upper limit of liability. Common liability provisions for founders and companies may contain an overly broad scope of liability, resulting in unlimited liability for founders. The general approaches are: (1) limit the scope of subjects of liability and compensation items, narrowing the scope of minimum guarantee; and (2) limit the liability of founders to a fair and reasonable extent – and separate it from personal assets, including provisions stipulating that the founder is liable only to the extent of the fair market value of their equity in the company, or shall not be held liable with personal assets other than their equity in the company.

Second, limit the joint and several liability of founders. The general approaches are: (1) exempt founders from joint and several liability with the company, or limit it to specific circumstances such as malicious or intentional breach of contract; and (2) limit founder’s liability to supplementary liability only; so that in the event of a default by the company, investors shall first hold the company liable for damages, and then the founders for supplementary liability if the company is unable to make full compensation.

Q: How to limit liability in terms of common representations and warranties?

A: Representations and warranties are statements and guarantees made by founders and their companies on facts or status occurring in the past and existing at present – in which no time limit is usually set for investors to assert rights or claim compensation, and investors may even request a longer period for claims.

It is recommended to make an exceptional statement for matters that may be inconsistent with or conflict with the representations and warranties, so as to achieve the effect of prior exemption from investors.

It is also advisable to set a time limit for recourse, so that investors may seek recourse against founders or companies for possible false representations and warranties only within a specific period (generally within the statutory limitation of action), failing which they lose their right of recourse.

Q: What are the options on limiting liability in share repurchases or VAM?

A: The business logic of share repurchases or valuation adjustment mechanism (VAM) is to address asymmetric information. After investors have injected their capital into a company, the operation and management of the company is still in the hands of the original management and founders, while the investors do not have full access to the internal information of the company – hence VAM is used to control the investment risk.

In practice, when share repurchase or VAM is triggered, founders may no longer have control over or management right of their companies, or may even have left them. When a company is controlled by the investors, it would be very unfair for the founders to bear the obligation of share repurchase or VAM.

Some courts also hold that founders’ right to operate and manage their companies is the prerequisite for assuming liability for share repurchases or VAM, as seen in cases of Hengkang Medical Group et al v Lankao County Lanyi Business Consulting Centre et al (2019) and Kuangzhi (Tianjin) International Trade et al v Longzhou Group (2020).

The general approaches are: (1) to provide that founders’ ownership and right of control in the company is the prerequisite for undertaking the obligation of share repurchase or VAM, otherwise founders shall not bear any corresponding liability; and (2) to provide that in the event of major changes in the industry or objective environment in which a company is operating (for example, foreign governments impose sanctions on the company), resulting in the company’s failure to achieve its operating performance or intended target, the investors shall have no right to request share repurchase or VAM.

Q: What liability and risk reminders can be given in other areas?

A: In addition to the above-mentioned circumstances, two additional points are noteworthy.

First, when there is no buyer at the time of disposal of equity, founders may not be able to dispose of their held equity to assume liability. It is suggested to agree on an equity disposal period. If the equity cannot be disposed within such period, founders may transfer their equity to investors at no consideration or nominal consideration.

Second, the tax cost of disposal of equity should be considered. According to relevant provisions of China’s tax law, when selling his/her equity a natural person is a taxpayer, and the corresponding tax costs should not be underestimated.

It is therefore advised that upon disposal of equity to assume liability, founders should seek to hold investors liable for the corresponding taxes, or assume liability to investors with the proceeds from the disposal of equity after tax.

Cai Zongxiu is a partner and Zhu Honglei is an associate at AnJie & BB Law Firm

AnJie & BB Law Firm

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E-mail: caizongxiu@anjielaw.com
zhuhonglei@anjielaw.com

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