Equity merger and acquisition transactions are characterized by a high failure rate on account of a variety of reasons, including fraudulence on the part of the current shareholder who harbors evil intentions. Reflecting back on the pains, you will find that the counterparty had harbored the evil intentions from the very outset, and it was only that you were not aware of it. This paper intends to outline the signs of several commonplace cases of harbored evil intentions.
- The person with actual control over the target company is not the legal representative of the target company.
Legal representative is the most important position in a company with prominent authority and the power over the business operations of the company. Accordingly, if the company were to run into any problem, the legal representative shall assume legal liabilities commensurate with such authority. Ordinarily, the person with actual control over a company would personally serve as the legal representative of the company, to prevent power from falling into the hands of others. On the other hand, if a person with actual control over a company is not the legal representative, and he/she instead comfortably allows an unrelated person to serve as the legal representative without other reasonable justification, it is likely that the person with actual control treat the target company lightly, even treating it merely as a vehicle for mitigating risks and earning profit, and the life or death of the target company does not matter much to the person with actual control who may abandon the target company at any time without much concern regarding legal liabilities as he/she is not the legal representative. Needless to say, an investor investing in such a company where the person with actual control is poised to exit at any time is exposed to substantial risks.
- The target company has an affiliated company which works in closely related businesses, and the affiliated company is under the absolute control of the current shareholder and delivers good performance with seemingly no efforts.
Where a target company has an affiliated company that works in closely related businesses, connected transactions are likely to occur between the target company and the affiliated company, and furthermore, the affiliated company is under the absolute control of the current shareholder. Although the current shareholder focuses its attention primarily on the target company, the affiliated company performs well, which implies that the current shareholder is transferring the profit of the target company to the affiliated company via connected transactions. In this case, the target company may just be a vehicle for the current shareholder, and it is the affiliated company that represents the center of the current shareholder’s interests. An investor investing in such a vehicle may turn out to be making wedding dresses for others.
- The amount of the registered capital of the target company does not match the type or scale of its business, while the target company has few bank loans, and low capital turnover.
A company gets its working capital mainly from three sources. The first source is the registered capital subscribed by the shareholders; the second source is external borrowings, and the third source is operating revenue. If a company has a low capital base which is inadequate to support its normal operations, it could only rely on external borrowings or operating revenue. There are two main sources for external borrowing, namely bank loans and inter-company borrowings (i.e. illegal borrowing). If the company has a low capital turnover, it is impossible to generate enough operating revenue to make up for the funding shortfall. In fact, if the amount of registered capital is small, even with a high capital turnover, it is impossible to generate enough operating revenue, in absolute terms, to make up for the funding shortfall. It is all too obvious that if a going concern does not have a large amount of registered capital, operating revenue and bank loans, it could only rely on borrowings from affiliated companies to make up for its funding shortfall. If the target company is such a company, it shows that the target company is only a vehicle for the current shareholder, and it is the affiliated company that is the center of the current shareholder’ interests, and there might be abnormal connected transactions between the target company and the said affiliated company.
- Key assets or key employees are not owned by the target company.
If the key assets, such as patents, trade secrets, trademarks, buildings, major equipment, and vehicle, that the target company relies on in its business operations are not owned by the target company, and instead are owned by an affiliated company who only leases or licenses them for use by the target company, or if key employees, whether managerial or technical, pivotal to the operation of the target company are employed by an affiliated company and then seconded to the target company, it warrants suspicion the target company may be merely a vehicle for the current shareholder who might abandon it at any time.
- The investment plan reflects a strong desire by the current shareholder to cash out.
Generally, if the current shareholder intends to build up the target company by attracting new investors, it would not reduce its own control over the target company, nor will it reduce its investment in the target company. Hence, in such a case, the current shareholder is unlikely to voluntarily offer to transfer a part of its equity to the investor, let alone let go of its control to the investor. In such a light, if the current shareholder claims to want to build up the target company while voluntarily offers to transfer part or even a substantial part of its equity to the investor, let the investor beware.
- The current shareholder maintains its control over the target company while imposing many restrictions on dividend distribution.
Shareholders are all alike in their desire to realize returns on its investment, and there are two ways to realize returns: one is by dividend distribution; the other is by cashing out the target company. If the current shareholder maintains its control over the target company while imposing many restrictions over dividend distribution, it may imply that the current shareholder wishes to leverage its control over the target company to cash out by connected transactions, borrowings, reimbursements or other means.
- The target company or its current shareholder or the person with actual control was sued in many proceedings, and they even refuse enforcement of judgments/arbitral awards.
The litigation history of the target company or its current shareholder or the person with actual control is ample evidence of its good faith standing and its approach to cooperation. It is truly necessary to know about the litigation history of the counterparty before taking the key step, to see how the counterparty treats others which will reflect how the counterparty will treat yourself in the future.
As the saying goes, we are not afraid of bad things, but we are afraid of bad people. Investment risks more often than not originated from evil-willed partners. Evil intentions can be concealed, but the signs of it could not be concealed. So long as an investor remains highly alert all the time, there will not be any later regret that it has erred by negligence.