CHINESE startups are increasingly facing demands from early-stage venture capitalists to return their investment or face legal action, after failing to provide an exit via a stock market listing within an agreed time frame, said leaders in the sector.

Startups around the world often agree to buyout rights, allowing private equity and venture capitalists to ask for their money back as well as a premium if goals such as an initial public offering (IPO) fail. are not reached.

In China, however, a virtual freeze in the IPO market this year and dwindling sources of capital in an economy hobbled by a real estate crisis and struggling for growth have given rise to redemption demands, threatening the existence of many startups, executives said.

The situation conflicts with the government’s determination to foster innovation and achieve technological autonomy in systemically important industries in order to protect the country from the impact of geopolitics.

In response, one initiative is to promote “patient capital” rather than the race for quick profit.

Yet buyout exits have almost tripled to 641 in 2023, according to data from consultancy Zero2IPO. This number jumped 68 percent between January and September compared to the same period last year.

During this period, regulators tightened their control over the IPO process, prompting companies to abandon their listing plans en masse.

Buyout litigation has also increased because startups and their founders have no money to return, lawyers said.

About 14,000 Chinese startups are currently at risk of investors exercising buyout rights, representing up to 8.6 trillion yuan ($1.2 trillion) in investment, law firm Lifeng Partners estimated.

“There has been a notable increase in takeover cases due to changes in the market environment and increased exit pressure,” said Huang Jiri, a partner at Hylands law firm in Shanghai. Most of these cases were triggered by startups not going public on a pre-agreed date, Huang said.

Responsibility

A declining economy has left venture capitalists under pressure to return money to their own investors, so they exercise buyout rights even at the cost of pushing startups and their founders to the brink, industry sources said.

In China, redemption is the responsibility of the founders, whereas elsewhere it is often the responsibility of the startup.

In one case, investor Luxin Capital sued the majority shareholder of startup Shandong Inlarin Technology, Peng Hongyue. Luxin Capital, in its disclosure, said Peng had failed to honor its commitment to buy back its stake.

The agreed buyout conditions included the inability to proceed with an IPO, Inlarin Technology said in a July statement in which it also revealed that a local court had frozen Peng’s assets.

“I understand that (the clause) was about this (particular) investment at the time. The company was doing really well at the time,” said Inlarin Technology board secretary Ma Xiaonan.

“If it weren’t for the three-year pandemic, we might already be on the Beijing Stock Exchange,” Ma said. The slowdown in the construction sector in which the company operates has also precipitated a sharp decline in business volume, he explained.

Neither Luxin Capital nor Peng could be reached for comment.

Disappearance

A booming economy and vibrant IPO market meant takeover rights were rarely exercised in China before the pandemic.

However, post-pandemic economic gloom has since combined with a withdrawal of US dollar funds due to geopolitical tensions as well as gloomy IPO prospects at home and abroad due to the increased market volatility.

In August last year, Zibo Tianheng New Nanomaterials Technology said failure to complete an IPO by the end of 2023 could trigger buyout requests from investors Luxin Capital and Zibo Hightech Venture Capital .

In March, he said he could not reach founder Wang Bo and that his bank accounts and major assets had been frozen.

Neither Zibo Tianheng nor Wang Bo could be reached for comment.

“As an entrepreneur, if you are confident enough, you can choose not to sign a buyout agreement,” said Andrew Qian, chairman and CEO of New Access Capital, an investment and financial advisory firm based in Shanghai.

“But if you don’t agree with buyouts, you’ll probably have trouble finding investors.”

Precautions

For venture capitalists, returning money to their own investors must take precedence over the survival of a startup from which they are entitled to full repayment with interest.

“Redemption rights are often agreed simply to comply with a procedure to avoid liability,” said a director of a state investment group, speaking on condition of anonymity due to the sensitivity of the matter. .

“Public funds are subject to all kinds of audits and inspections,” the director said. “We sympathize with the companies, but we cannot avoid the scrutiny we are under.”

To promote the growth of the sector, the government is considering introducing “fault tolerance” for state-backed venture capital firms.

Buyout rights are necessary to protect venture capitalists from immature, capricious and even corrupt entrepreneurs, said Tom Jing, partner at Greater Filter Venture.

“Some entrepreneurs change their minds quickly. A biotech boss may go into the chemical business; others may be involved in patent infringement; some may even waste investors’ money,” Jing said.

“As an investor, you have to take precautions.”