Anti-dilution Provisions Under Venture Capital

In the middle of1980s, the mechanism of venture capital investment wasintroduced and launched into the market in China, providing a brand-new financingapproach for start-up enterprises in China. During the investment by the ventureinvestors, they usually face the dilution risk of the shares purchased by them. Thereare many factors leading to the dilution. It might be caused by the issuance of newshares or capital increase by the start-up enterprises for the purposes of acquiring thefunds needed for the operation expansion. It could also be caused by thedepreciation of corporate assets due to the information asymmetry between theventure investors and the start-up enterprises. Set forth below are the two (2) factorscausing information asymmetry: the difference of the professional knowledgebetween the venture investors and the start-up enterprises and the moral hazard of thestart-up enterprises (e.g., the entrepreneurs may cover up crucial information). Itwould be quite reasonable for the venture investors to burden the first kind of risk,while it would be unfair to make the venture investors to suffer the second one.Therefore, in general practice, the venture investors and the start-up enterprises wouldnegotiate and arrange for the “anti-dilution provisions” to balance their interests.Currently, the venture investors investing in the start-up enterprises in Chinainclude the venture capital funds established offshore and the venture capital fundsestablished in China. The anti-dilution provisions in the offshore structure andonshore structure differ widely from each other due to the difference of the applicable law. In the offshore venture capital structure, the anti-dilution provisions areimplemented through the conversion mechanism of the convertible preference shares,while in the onshore venture capital structure, the anti-dilution provisions are merelycontractual arrangements under which the start-up enterprises shall have certainobligations. This Article will discuss the implementation of the anti-dilutionprovisions in both offshore and onshore venture capital structure and examine theinterest game thereunder. Meanwhile, this Article will analyze the legal issues underthe anti-dilution provisions in the onshore structure, and based on the consideration oflegal costs, this Article will propose the suggestions of implanting the anti-dilutionprovisions in offshore structure.This Article is divided into three chapters. The first Chapter discusses thereasons why venture investors utilize the anti-dilution provisions to protect the sharesfrom dilution caused by the moral hazard, and briefly clarifies some basic conceptsfor the understanding of the following chapters. The first Section gives a briefintroduction of venture capital investment, and explains why it is necessary to studythe dilution issue based on the characteristics of venture capital. The second Sectiondiscusses the protection methods for the venture investors’ interest under the currentlegal regulations and points out the legal difficulties to avoid the dilution of sharesunder the legal regulations. The third Section makes an introduction of anti-dilutionprovisions and analyzes the legal costs associated with various mechanisms with“anti-dilution” function, and concludes that best approach to protect the right ofventure investors is to include the anti-dilution provisions in the charter documents ofthe start-up enterprises.The second Chapter and the third Chapter are the crucial parts of this Article,where the anti-dilution provisions in both offshore and onshore structure are analyzed.The second Chapter discusses the implementation of the anti-dilution provisions inthe offshore structure. The first Section of this Chapter discusses the commonoffshore investment structure and the conversion mechanism. The second Sectionanalyzes the implementation of different anti-dilution provisions based on differentcorporate events and the impacts thereof on the interests of each party. The third Section discusses the game theory of the anti-dilution provisions in the offshorestructure.The third Chapter focuses on the anti-dilution provisions in the onshore structure.The first Section clarifies the implementation mechanism of the anti-dilutionprovisions in the onshore structure. The second Section provides a detailed analysisof the legal issues of the anti-dilution provisions in the onshore structure, whichincludes high legal costs, high uncertainty and complexity of interests involved. Thethird Section proposes the methods of implanting the anti-dilution provisions inoffshore structure and provides suggestions on the improvement of China legalregime in connection with anti-dilution provisions, in order to perfect the Chineselegal system.