Adjudication Divergence, Enforcement Dilemmas and Risk Mitigation Regarding Redemption Waterfall Clauses in Multi-Round VAM Agreements: Introduction

In private equity multi-round financing transactions, the “later-round priority” redemption waterfall clause (also referred to as the redemption procedure clause or insufficient funds clause, hereinafter collectively the “redemption waterfall clause”) has become a common arrangement in investment agreements. Its commercial intent is to prioritise the exit interests of later-round investors when the redemption obligor’s solvency is limited, thereby balancing risk and return among investors of different rounds. However, in judicial practice, the wording of such clauses often leads to varying interpretations, creating uncertainty as to whether later-round investors can truly achieve priority exit.

This article starts with real cases, compares and analyses different arbitral tribunals’ interpretations of redemption waterfall clauses, dissects divergences across arbitral awards and examines the associated risks in enforcement proceedings. Based on this, it proposes practical risk prevention and control suggestions for investors and financiers from the perspectives of agreement drafting, dispute response and enforcement remedies.

Is Redemption Priority a Precondition for Investors to Exercise Their Rights or Merely an Order of Satisfaction?

Case I: arbitration case between an investment institution and a well-known e-commerce company regarding equity redemption

The redemption waterfall clause in the investment agreement stipulated:

• “If the assets of the redemption obligor are insufficient to redeem all the shares requested for redemption by the investors at that time, the redemption price shall be paid first to the Series A-3 investors who have requested redemption; if there are remaining assets, it shall be paid first to the Series A-2 and A-1 investors who have requested redemption; if there are still remaining assets, it shall be paid to the Series A investors who have requested redemption...”

The Claimant in this case was a Series A investor of the target company. The redemption conditions for Series A were triggered and the Claimant initiated arbitration to exercise its redemption right, but the claim was ultimately dismissed. The arbitral tribunal held:

• “The redemption waterfall clause granted Series A-3, A-2 and A-1 investors priority over Series A investors in requiring the obligor to redeem shares. Without evidence proving whether the obligor’s assets can fully satisfy the payment requirements of Series A-3, A-2 and A-1 investors once they request share redemption, the arbitral tribunal cannot override the order of exercising redemption rights agreed upon in the investment agreement to support the Claimant’s requests...”

In this case, the arbitral tribunal interpreted the redemption waterfall clause as making the exercise of redemption rights by later-round investors a precondition for earlier-round investors. Regardless of whether the later-round redemption conditions were met or whether later-round investors chose to exercise their rights, earlier-round investors had to wait until the later-round investors exercised their rights before they could demand redemption.

Case II: series of arbitration cases between multiple well-known investment institutions and a founder regarding equity redemption

The redemption waterfall clause in the investment agreement stipulated:

• “When the investors exercise their redemption rights simultaneously and the redemption obligor does not have sufficient funds to redeem all the shares requested for redemption, the funds available for redemption shall be distributed as follows: (i) first, fully pay the redemption price to the Series C investors for their shares; (ii) after fully paying the Series C investors the redemption price for their shares, fully pay the redemption price to the Series B investors for their shares; (iii) after fully paying the Series B investors the redemption price for their shares, fully pay the redemption price to the Series A investors for their shares. Before fully fulfilling all the aforementioned rights and interests of the Series C investors, the redemption obligor shall not assume any redemption obligations for anyone else’s rights and interests.”

After the redemption conditions were triggered, Series A, B and C investors, respectively, initiated arbitration against the founder, seeking to exercise their redemption rights. Cases for each round of investors were heard by different arbitral tribunals.

The founder attempted to raise a defence, as explained below.

Apart from other disputed issues, regarding the redemption waterfall clause, the founder attempted to defend against the cases brought by Series A and B investors by arguing that Series C investors were the first-priority redemption right holders and had already initiated arbitration. The founder’s assets were insufficient to pay the Series C investors’ redemption price; under the redemption waterfall clause, the founder was not required to perform the redemption obligation to Series A and B investors.

In the case brought by Series B investors, the arbitral tribunal interpreted the redemption waterfall clause as:

• “The redemption waterfall clause stipulated in the investment agreement targets the order and proportion of the distribution of the respondent’s executable funds after the investor’s rights are confirmed by an effective award and does not affect the adjudication of the scope of equity redemption in this case. Similarly, the respondent’s financial situation relates only to enforcement issues after the award takes effect. Therefore, the arbitral tribunal held that the respondent’s financial situation does not affect the scope of equity for which the claimant can exercise the redemption right.”

In the case brought by Series A investors, the arbitral tribunal interpreted the redemption waterfall clause as:

• “Regarding the redemption waterfall clause stipulated in the investment agreement, its essence is an agreement on the order of satisfaction for the redemption claims enjoyed by each investor. This agreement is merely an arrangement made by the parties to the investment agreement regarding the order of property distribution when the redemption obligor performs the redemption obligation and cannot be used to oppose or deny the later-priority investors’ exercise of redemption rights. Therefore, because the redemption conditions have been fulfilled, the arbitral tribunal supported the claimant’s request to exercise the redemption right in this case. The issue of the order of satisfaction of the redemption obligor to the redemption right holders or how the redemption obligor’s property is distributed, can be resolved in future stages such as the performance of the arbitral award and enforcement procedure.”

In both cases, the arbitral tribunals held that the redemption waterfall clause addresses how the redemption obligor’s property should be distributed during enforcement and does not prevent investors from exercising their redemption rights.

Divergence in arbitral tribunal opinions and legal analysis

From the aforementioned cases, it is clear that different arbitral tribunals have interpreted similarly worded redemption waterfall clauses in fundamentally different ways. The core divergence lies in whether the “later-round priority” redemption waterfall clause constitutes a precondition for exercising the redemption right or merely an order of payment distribution among multi-round investors. This interpretation directly affects whether an earlier-round investor can obtain a winning award.

• Case I – the arbitral tribunal interprets redemption priority as a precondition to exercising rights. Under this view, even if the earlier-round investor’s own redemption conditions have been fully met, as long as the later-round investor has not completed the exercise of rights or has not received full redemption payment (regardless of whether the later-round redemption conditions are triggered or whether the later-round investor chooses to exercise its rights), the earlier-round investor cannot make a redemption claim. This interpretation raises the threshold for earlier-round investors to exercise their rights and may leave their exit rights suspended indefinitely. That is, if later-round investors choose to delay or waive redemption for commercial reasons or if the later-round redemption conditions are never triggered, earlier-round investors – even if they have met all redemption requirements – will lose their ability to exit through redemption.
• Case II – the arbitral tribunal limits redemption priority to the order of satisfaction distribution, which does not impede the exercise of rights. Once the redemption conditions are met, the investor has the right to exercise the redemption right. The redemption waterfall clause only resolves the sequence of payment distribution during the enforcement stage when multiple investors make redemption requests and the redemption obligor’s property is insufficient to cover all debts. It cannot be used to deny the qualification of a single investor to exercise rights independently. Under this logic, whether the redemption obligor’s property is sufficient or whether the later-round investors’ redemption payments have been fully paid is not an element in judging the validity of the redemption request during the trial stage; instead, it is addressed in the performance and enforcement stages after the award takes effect.

In this regard, from a legal interpretation perspective, Article 142 of the Civil Code of the People’s Republic of China requires interpreting disputed contract terms comprehensively, considering the text, related clauses, transaction purposes and commercial customs. The commercial intent of setting redemption priority in multi-round financing transactions is mainly to balance the exit interests of investors in different rounds and implement the private equity commercial practice of “last in, first out” in scenarios where resources are limited and multiple rounds of investors exercise their rights collectively. It is not a tool to unilaterally undermine the exit rights of earlier-round investors. If the agreement does not use clear and explicit wording stating that “earlier-round investors shall not exercise the redemption right before later-round investors exercise their rights / receive satisfaction,” directly interpreting the waterfall clause as a precondition for exercising rights constitutes an expansive interpretation of the clause, which does not conform to the purpose and customs of investment and financing commercial transactions.

Therefore – unless the parties agree otherwise – the redemption waterfall clause should not become an obstacle to the exercise of rights by earlier-round investors.

How is the Redemption Waterfall Clause Applied in Enforcement Proceedings?

If the arbitral tribunal adopts the opinion of Case II, determining that the redemption priority only belongs to the order of satisfaction and does not constitute an obstacle to exercising rights, the issue of the order of satisfaction among investors of different rounds will be left to be handled in the award performance stage or enforcement proceedings. After the award takes effect, if the founder voluntarily performs the redemption obligation and investors of all rounds agree on the order of payment, there will be no dispute and no need to enter enforcement proceedings.

However, in practice, the founder often fails to perform the redemption obligation under the award and their assets are insufficient to cover the redemption prices owed to all investors. In such cases, investors of each round will separately apply to the court for enforcement against the founder. Once the founder’s property enters the judicial auction process, all investors can apply to the court of first seizure that disposes of the property to participate in the distribution. Disputes are prone to arise among the parties regarding the order of distribution of the enforcement proceeds.

Based on our case experience, courts generally conduct a formal review. They usually do not voluntarily obtain or review the redemption waterfall clause in the investment agreement, nor directly formulate a distribution plan according to the priority order agreed in the agreement. Instead, they are more likely to formulate a property distribution plan based on the effective legal documents held by each investor and the Civil Procedure Law of the People’s Republic of China, in proportion to each creditor’s claim amount relative to the total amount of claims participating in the distribution.

After the court formulates the distribution plan, it will serve it on all investors applying for enforcement and the founder. If later-round investors disagree with the distribution result of proportional satisfaction, they can file a written objection. If other investors do not accept this objection, the enforcement procedure cannot directly adjust the distribution plan. The relevant dispute must be resolved in a lawsuit challenging the distribution plan, initiated by the investors. This litigation will further extend the case period, causing investors to incur additional time costs and litigation expenses, thus significantly delaying repayment.

Nevertheless, should the investors obtain a favourable award, the redemption waterfall clause remains difficult to enforce in proceedings. In addition, if earlier-round investors apply for property preservation and seize the founder’s core property first, even if later-round investors enjoy priority satisfaction, this internal agreement cannot directly prevent the investor who seized it from disposing of the property in judicial proceedings. When the redemption obligor is a company and its assets are insufficient to repay the full redemption price, the case may be transferred to bankruptcy proceedings. It is also unclear whether the redemption waterfall clause applies in bankruptcy proceedings.

Risk Mitigation Suggestions

Investment agreement drafting

When drafting a redemption waterfall clause in an investment agreement, it is essential to explicitly differentiate between the prerequisites for exercising redemption rights and the order in which payments are to be distributed. If the true intention of the parties is merely to give priority to payment when property is insufficient, it is advisable to clearly state in the clause: “This redemption waterfall clause applies only to the enforcement and satisfaction distribution stages when the redemption obligor’s property is insufficient to repay all redemption price and does not affect the independent exercise of the redemption right by investors of each round when the redemption conditions are met.” This excludes the possibility of interpreting the priority as a precondition to exercising rights from the text, preventing the interpretation seen in Case I of this article.

Conversely, if the parties do have a special commercial arrangement agreeing that earlier-round investors shall not claim redemption rights at all before later-round investors receive full satisfaction, it can be stipulated as: “Before the later-round investors receive full satisfaction of their entire redemption price, earlier-round investors shall not make redemption requests, nor initiate judicial procedures to claim redemption rights,” to prevent subsequent disputes over clause interpretation.

Strategies for dealing with disputes

For earlier-round investors, when the redemption conditions are triggered and the investor initiates arbitration proceedings, if the founder raises a defence related to redemption priority, the earlier-round investor can combine the tribunal’s opinions in Case II of this article to fully explain to the arbitral tribunal that the redemption priority is only an order of satisfaction distribution and not a prerequisite threshold for exercising the redemption right.

In addition, regardless of whether they are earlier-round or later-round investors, they should apply for property preservation promptly to avoid having no property available for enforcement after winning the case and to prevent other creditors from taking control of the redemption obligor’s main property first.

Enforcement remedy

It is recommended that investors in each round continuously follow up on the enforcement and property disposal process and prepare response plans for different situations, such as participation in distribution and bankruptcy. If there is any objection to the distribution plan or the property distribution order in the corporate bankruptcy proceedings, it should be raised promptly and relevant supporting documents, such as the investment agreement, should be submitted to facilitate the effective implementation of the transacting parties’ commercial intent regarding the order of satisfaction.

In summary, the redemption waterfall clause in investment agreements reflects the commercial balance of private equity multi-round financing, but this clause may face certain risks in substantive adjudication and enforcement. Investors should carefully draft investment agreement clauses and prepare risk plans for arbitration and enforcement in advance to maximise the achievement of commercial purposes.