When a PE/VC acquires a company, they would like to have the drag-along clause in place to ensure them to have a good exit mechanism. In practice, the typical description on drag-along rights should be as follows:
Drag-Along Right: Prior to a Qualified Public Offering, if a majority of the holders of Series A Preferred Shares agree to sale or liquidation of the Company, the holders of the remaining Series A Preferred Share and Common Share shall, if applicable, be required to approve such transactions and, if applicable, to sell their shares at the same price and upon the same terms and conditions.
A PE/VC would think such description could allow them to exit from the target company; however, if a foreign PE/VC does not become aware of the stipulation of PRC laws on foreign invested enterprise (“FIE”), such description would put them in a vulnerable spot.
After a foreign PE/VC acquire a purely domestic company in China, the target company will subsequently converted into a FIE. According to PRC laws regarding equity transfer of a foreign invested enterprise, the transfer of a shareholder’s equity in a FIE should obtain the approval from all of directors of board, and examination and approval authority require the board of directors to submit the resolution of approving equity transfer.
Drag along clause will trigger the aforesaid laws regarding equity transfer because the original target company has converted into a FIE. Thus, if one of directors, who was appointed by other shareholder of common share, refuse to vote for resolution in a board meeting of selling the company or their shares, the PE/VC is unable to submit to the authority the document which shows the board’s resolution in favor of equity transfer. Without such document, the examination and approval authority will not grant approval on equity transfer.
In light of the foregoing, if a PE/VC expects drag along clause to work under PRC legal scheme, they should prepare such resolution in favor of equity transfer and request other shareholders to sign such resolution in advance.
By Adam Li