Whether Chinese companies invest through greenfield or brownfield, in overseas investments and with counterparties, they ultimately need to confirm the commercial arrangements for their investments in relevant transaction agreements, such as equity acquisition agreements and shareholder agreements. An important part that partners should consider when determining the underlying legal documents is the relevant exit arrangements. In the business world, the life cycle of a joint venture company can vary, but on average, the median life of a joint venture company is 10 years, which means that it is important to draft fully considered exit clauses in the relevant legal documents of the joint venture company. At the same time, a complete negotiation exit arrangement is also a legal protection against the failure of an investment project. However, at the initial stage of the project, the mood of the partners is passionate and they are confident about the cooperation prospects. In the project model, the focus is on the cash flow forecast above the breakeven point. Stress testing is more to prove the feasibility of the project than to consider and respond to the extreme black swan situation. In addition to matching the investment strategy and development strategy of the enterprise, the final exit mechanism is also relatively complex: unlike other mechanisms, exit mechanisms are scattered across different parts of the contract, including default clauses, compensation clauses, and dilution clauses. Therefore, we believe it is necessary to conduct a centralized review of the exit mechanism to assist Chinese enterprises in their overseas investment work.

 

To facilitate discussion, we will sort out the exit mechanisms according to different genealogies, from fully autonomous exit without any additional conditions, to exit mechanisms with different restrictions, to exit mechanisms mutually agreed by both parties. We will examine and elaborate on the relevant mechanisms one by one.

 

1、 Different exit scenarios

 

（1） Autonomous exit

 

When there is no breach of contract or drastic market changes or events that have significant negative impacts on the operation of the joint venture company, the partners choose to withdraw at their own discretion, which is a quite rare arrangement in the business world. In a joint venture, partners choose to use their intellectual property, knowledge, and assets to expand their territory in certain new fields and projects, with a view to generating 1+1>2 chemical reactions. The partners of a JV are different from financial investors in financial institutions such as funds. They often have demands in the industry. Therefore, the withdrawal of one party usually has a negative impact on the JV, or even causes the joint venture to become unsustainable because it cannot be replaced. Therefore, at a minimum, arrangements for a lock-up period are usually placed for cooperation, or the scope of the transferee at the time of exit is limited. For example, in an overseas oil and gas acquisition for which the author is responsible, the seller restricted the buyer from selling its equity to a listed company that has been engaged in oil and gas exploration and development business for more than 10 years.

 

（2） Event driven or triggered exit

 

The most common exit mechanism is the right of one party to exit when a specific event occurs. Common events include bankruptcy, change of control, company deadlock, dilution of the equity ratio below a certain threshold, and significant adverse changes.

 

（3） Mutually agreed withdrawal

 

In the absence of adverse circumstances, both parties can achieve exit by reaching consensus.

 

In the business world, partners can maximize their rights and interests by designing different exit mechanisms in different situations. At the same time, we would like to emphasize that considering the different roles and positions of partners in a JV, as well as the different equity distribution ratios in the JV, the terms of the exit mechanism are usually asymmetric, that is, often one party enjoys the right to exit independently, while the other party does not enjoy similar rights; Or when one party exercises the exit right, the other party has a tag along right, while when the other party exercises the exit right, the counterparty can only exercise the first right of offer.

 

2、 Withdrawal of relevant rights arrangements

 

（1） Relevant rights enjoyed by the party initiating the withdrawal

 

When a party withdraws through the transfer of equity, its rights include the following:

 

Right of exit

 

The simplest and direct right of exit is that one party can transfer to a third party without any restrictions under any circumstances to achieve exit. As mentioned earlier, such arrangements are extremely rare, and often have restrictive terms attached, such as a lock period, transferee restrictions, or only full transfer.

 

2. Drag long right

 

For major shareholders or shareholders who are operators, they usually occupy a dominant position in joint ventures and enjoy more rights. They will want to enjoy the right to drag and sell, making them force other shareholders to exit together when initiating an exit, thereby enjoying more initiative in the exit transaction, as third parties often prefer to buy 100% of the assets.

 

3. Put option or call option

 

As an option to repurchase or sell, put or call gives one party the right to sell equity to or buy back equity from the other party. We have noticed that with the recent escalation of tensions in the international political and economic situation, some Chinese companies hope to increase geopolitical terms, which can enable them to exit through the exercise of put options in the event of escalation of conflicts.

 

（2） The rights that the opposing party can enjoy include the following:

 

Right of first refusal (ROFR)

 

This right gives other partners the priority to purchase their selling equity under the same conditions. However, this right is essentially passive, and other shareholders can only act under purchase conditions that have been determined by a third party. ROFR is not useful for companies that do not have sufficient funds or do not meet their development strategies. For third parties, ROFR is also an obstacle to their successful acquisition. No buyer is willing to discover that the transaction has been taken down by existing shareholders through the exercise of ROFR after lengthy negotiations and payment of significant transaction execution costs. Due to the same logic, few ROFR and Tag Along rights appear simultaneously, and they may make the transaction unimaginably complex, thereby scaring away any interested potential buyers. Therefore, ROFR usually empowers the leading party of the transaction, such as the operator of oil and gas assets, who have the willingness, strategy, and the ability to make subsequent capital contributions to fully hold the assets of a JV.

 

Right of first offer (ROFO)

 

When one party attempts to withdraw, it is obligated to send a notice to the other shareholders inviting the other party to enter into negotiations to purchase its shareholding. In terms of rights arrangement, ROFR is stronger than ROFO because the former gives non exiting shareholders the right to purchase equity, while the latter only provides an opportunity to bid. However, from the perspective of non withdrawing parties, ROFO allows them to negotiate specific withdrawal conditions with the withdrawing party, rather than passively accept the conditions already proposed by a third party. From the perspective of the withdrawing party, ROFO also provides more certainty. Other shareholders often do not need to undergo in-depth due diligence as a third party to quote, and are more certain about the transaction process.

 

In business negotiations, ROFOs often appear together with the right to tow, allowing partners who are unable to purchase equity from shareholders to abandon their ships and escape by selling their equity together.

 

3. Tag Along Right

 

As mentioned earlier, the Drag Along Right is usually a defensive right granted to minority shareholders or non operating shareholders. The rationale is simple: to prevent them from being trapped in a joint venture arrangement that is not their own initiative, or to give them the right to secure the investment they have made.

 

3、 Withdrawal of relevant restrictive provisions

 

（1） Restrictions on the party initiating the exit

 

As mentioned earlier, there may be restrictions on the lock in period, qualification of the transfer subject, and transfer share of the party initiating the exit.

 

1. Lock up period

 

For example, oil and gas assets or new energy power plant assets often restrict the right of cooperative shareholders to withdraw before entering the commercialization stage, to ensure that the JV's work in the exploration phase is not interrupted.

 

2. Limitations on the subject qualification of third parties

 

As mentioned earlier, restrictions are imposed on third parties who purchase equity held by exiting shareholders to protect other partners from being caught in joint venture arrangements that are detrimental to them. The most common restriction is not to be a competitor of a non withdrawing party, or to impose relative requirements on its qualifications and operational capabilities.

 

3. Sale ratio

 

For example, in order to avoid the business arrangement of a JV becoming too complex, restrictions may be imposed on the proportion of equity sold by exiting shareholders, such as only selling 100% of their equity holdings, to ensure that the number of cooperative shareholders does not increase.

 

4、 Withdrawal of relevant punitive provisions

 

In the case of partial exit (especially in the case of default), in the case of diluting the equity of exiting shareholders, they can be subject to certain index penalties, thereby greatly diluting their equity ratio. Or directly require them to undertake certain punitive obligations.

 

epilogue

 

For each specific transaction, how to obtain the most appropriate exit right in the negotiation based on the development strategy and market position of the enterprise is an important lesson for every Chinese enterprise in going global. We hope to maintain communication with Chinese enterprises and deepen relevant practical experience in this regard.