Allen Luo and Zheng Gang: Let the Law Be the Law, and Let Emotions Be Emotions

By Zhuxi Huang, Yunxiao Guo

Edited by Jing Liu, Lili Yu

By now, everyone knows what happened: Zheng Gang, founder of Zihui Ventures, published a scathing post accusing Luo Yonghao of trying to get investors to "trade their hundreds of millions in buyback rights for Smartisan for shares in his new company, Thin Red Line." He said he would join dozens of other investors in firmly demanding that Smartisan honor its buyback obligations and compensate them for their losses.

In his subsequent response, Luo acknowledged that Smartisan's core business had essentially collapsed by 2018. Although shareholder meetings were held annually, they focused mainly on debt matters, and "the atmosphere wasn't great." As for the share swap proposal, there was nothing procedurally improper about it, and he respected the original shareholders' voluntary choice to sign or not sign. "We didn't deceive anyone, nor could we have."

The backlash was immediate. In the court of public opinion, the episode seemed to confirm certain expectations about "the investor-founder relationship": the investors' buyback demands looked downright "vicious," while the entrepreneur appeared a lamb to the slaughter.

In an interview with Dark Waves, setting aside the specifics, Zheng admitted there was an element of "emotional venting" in his actions —

Dark Waves: Have you had any direct communication with Luo Yonghao since this happened? Zheng Gang: He won't communicate with me. Before, I was always the one reaching out to him — hot face pressed to cold ass. He'd reply if he felt like it. Dark Waves: It sounds like emotional venting accounts for quite a lot of this. Zheng Gang: Yes, he interpreted some of what I said as venting, but it's not entirely that either? I felt I should speak out.

Setting emotion aside, Dark Waves tries to offer some more measured analysis: In China's distinctive venture capital dynamic, what exactly is a buyback? Why did this relatively rare buyback dispute so peculiarly erupt between Luo Yonghao and Zheng Gang? And beyond the legal framework, might there be better ways to resolve such conflicts?

"Buybacks" Are Everywhere

Before explaining "buybacks," we first need to introduce a related concept: valuation adjustment mechanisms, or "duidui" (对赌, literally "betting against").

In legal terms, a valuation adjustment mechanism is an agreement designed by investors and founders when closing a financing round to address future uncertainty, information asymmetry, and agency costs. In the well-known "South Beauty" case, for instance, it's been widely reported that when CDH Investments took a stake in the restaurant chain, the two sides set an IPO by end of 2012 as the target. Failure to achieve this would trigger a series of protective and compensatory clauses.

Buybacks are the most common way to fulfill such valuation adjustment mechanisms. Typically, investors and founders agree on an approximate timeline for going public. If the company fails to list within the expected timeframe, or if other pre-agreed conditions are triggered, investors have the right to demand that the company (or founding shareholders) purchase their equity at a set buyback price.

These "other conditions" generally include major personal integrity issues on the part of shareholders, serious violations of transaction documents by the company and/or founder, changes in China's legal environment rendering the business illegal, invalidation of VIE agreements (common in offshore-structured deals), and so on.

Buyback clauses originated in the United States, but China is where they truly came into their own.

According to statistics from law firm Fenwick & West, covering Silicon Valley venture deals from Q4 2020 to Q3 2022 (spanning Series A through E), only 2% to 4% of deals included "mandatory buyback" or "optional buyback" provisions. By contrast, domestic data from Han Kun Law Offices in 2021 showed that nearly 90% of the VC/PE projects it participated in employed buyback clauses — 92.82% for onshore structures and 87.7% for offshore structures.

Lu Zaiguang, a partner at Han Kun who joined in 2010 and oversees venture capital and private equity financing, offshore listings and public offerings, foreign direct investment in high-tech sectors, and M&A, told Dark Waves: "Entrepreneurs returning from Silicon Valley — including scientists in biotech, semiconductors/chips, and earlier waves of young people returning from Airbnb, Facebook, and Google — tend to have lower acceptance of 'buyback clauses' in financing documents. But in China's VC/PE projects, buyback clauses are present in the vast majority of cases."

"Eighty to ninety percent of deals will definitely include a buyback clause — it's basically a standard form contract," one FA partner told us. Of course, specific terms vary somewhat depending on the founder's bargaining power.

The reason buybacks are more prevalent in China's investment world is something Dark Waves has explored many times before: the difference in funding sources between Chinese and American primary markets, and the divergent philosophies behind them. We won't rehash that here.

Depending on the stage of the project, the intensity of buyback provisions varies. For early-stage companies, buyback deadlines typically extend beyond five years, with looser specific terms. For mid-to-late-stage projects where investment costs are higher, deadlines usually fall between three to five years, with more explicit and aggressive terms.

If the essence of investing is making money from risk and uncertainty, then buybacks represent a search for "certainty within uncertainty" — at least for investors. But for founders, the existence of a buyback is like a sword of Damocles perpetually suspended overhead.

Yet when a buyback is actually triggered, the investor-founder relationship has typically already reached a freezing point — a "last resort" scenario.

Typically, the agreed buyback price is calculated based on the original investment amount (or a multiple thereof) plus an annual interest rate (simple or compound, roughly 6% to 9%). Occasionally, it may reference fair market value, audited net assets, or other metrics, taking the higher of two or three such figures.

But for primary market institutions chasing investment upside, returns approximating wealth management products are essentially viewed as "capital preservation" at best.

Startups Die Nine Times Out of Ten — So Why Do So Few Buybacks Actually Happen?

Nine out of ten startups fail. By that logic, the past decade should have seen massive triggering of valuation adjustment and buyback clauses. Yet episodes like Zheng Gang's public showdown with Luo Yonghao are genuinely rare. Not just in terms of media spectacle — they actually happen infrequently. Dark Waves searched for notable domestic cases of valuation adjustments triggering buybacks and found very few, concentrated in the PE stage.

Why? We can break this down by scenario.

When a company is performing well but happens to trigger a clause (say, failing to IPO on schedule), investors generally won't demand a buyback. Even without the expected liquidity, holding a quality asset still has value. And selling on the secondary market, pushing for a new funding round and transferring partial equity, or having a newer fund take over the position to continue riding the company's growth — all of these offer far better return prospects than the "principal plus interest" from a buyback.

When a company is teetering on bankruptcy, the investment has essentially failed, and legal costs make pursuing a buyback "unnecessary." In fact, the vast majority of valuation adjustment and buyback clauses end up in this limbo.

And for the remaining companies stuck somewhere between going public and going under, it's not easy for investors to actually trigger a buyback either.

"With buyback provisions that have cross-trigger arrangements, if early-stage investors demand a buyback, later-round investors' confidence may be shaken, triggering their own buybacks — creating a domino effect," Lu Zaiguang described a scenario for us. "The result is that company liquidity dries up, and early investors may struggle to recover their principal, with their book value going to zero as well."

This is clearly a lose-lose-lose situation. In this hypothetical, due to the existence of creditor claims, buyback rights may not even fully protect investors' principal. Reality is far more complex.

In 2008, CDH invested 200 million yuan in South Beauty. A widely circulated version of events goes:

When South Beauty's IPO attempt failed by end of 2012, it first triggered the buyback clause in its valuation adjustment agreement with CDH. The struggling restaurant chain couldn't pay the buyback amount. So CDH activated its drag-along rights, with founder Zhang Lan participating in the sale. Since the shares sold exceeded 50%, this triggered the preferred liquidation clause — meaning the transaction had to prioritize CDH's return requirements. In the end, CDH recovered roughly 400 million yuan, while Zhang Lan lost 70% of her stake in South Beauty, cashing out 1.2 billion yuan and exiting.

The matter went through several subsequent reversals before ending in a handshake. Both sides maintained there was "no valuation adjustment agreement," implying the founder's departure wasn't caused by investors. But when discussing this deal, one FA told Dark Waves that the greater impact was still that "more entrepreneurs began to realize the consequences of valuation adjustment agreements."

This touches on another topic: reputation. This is actually a key reason why buybacks so rarely happen in practice.

Once a major investor triggers a buyback, the company's operating cash flow or the founder's control may be compromised — and a company that could have survived may well decline because of it.

This is especially true for early-stage investment institutions. Compared to their relatively low investment cost, merely recovering principal while potentially destroying a carefully cultivated brand image of "standing with entrepreneurs" simply isn't worth it.

A Special Case

Of course, this episode also has its own peculiarities.

As Zheng Gang has repeatedly told media: he didn't demand buybacks on 80% of his failed investments, yet chose to go the opposite direction this time.

Many attribute this to Luo Yonghao not being an ordinary entrepreneur. With his "True Debt Repayment Saga" persona and his track record as a serial entrepreneur, Luo not only made a splash in livestreaming commerce after Smartisan's collapse, but also successfully raised funding for his new VR company in 2022 — a brutally difficult year for fundraising. In other words, he's scarce, a rare entrepreneur with genuine repayment capacity. Zheng himself described Luo as a "major entrepreneur" and his subsequent situation as "successfully reaching shore."

But in his interview with Dark Waves, Zheng denied having direct financial motives.

Dark Waves: Some say your dissatisfaction with the agreement is that the price didn't meet your expectations — many entrepreneurs lack repayment capacity, but Luo is different. Zheng Gang: "Wouldn't taking the money be nice? Do I need traffic? Am I selling goods? Am I raising a fund?"

Yet as a relatively small VC, he clearly faces considerable pressure from his LPs. After the incident, he said several LPs who had been unhappy that he "never spoke up to Luo or initiated a buyback" told him, "You're finally doing the right thing." This pressure was even concrete enough that he had to try connecting several LPs — in gold jewelry and socks respectively — to Luo's livestream studio. "None of those talks succeeded."

A partner at a dual-currency fund told Dark Waves, "Their RMB fund LPs also constantly want them to get CEOs to sign unlimited joint and several liability." "In a sense, this is one of the things many RMB funds get criticized for," while Zheng feels LPs are similarly vulnerable after putting up money. "There are very few institutions or high-net-worth individuals willing to commit capital now."

Of course, this episode isn't just a manifestation of mutual pressure between LPs, GPs, and entrepreneurs amid increasingly difficult fundraising conditions. It's also a subtle adjustment of many venture capital norms as we enter the RMB fund era.

The dual-currency fund partner noted that many RMB funds are state-backed, and to prevent loss of state assets, they care deeply about individual projects.

Multiple interviewees pointed out to us that as the internet tide shifts toward manufacturing and real industries, and as dollar funds migrate to RMB funds, both trends could make Zheng Gang-style incidents increasingly common. "On one hand, buybacks and valuation adjustments become more enforceable; on the other, capital providers are more risk-averse overall."

Referencing how Zheng didn't initiate buybacks in many past investment cases, the fund partner speculated that as an early investor, Zheng likely originally signed agreements limited to company-level buybacks. But subsequent rounds bringing in more RMB funds may have demanded unlimited joint and several liability from the founder — at which point "all investors would have their rights leveled (as most-favored-nation clauses in agreements require, to ensure fairness)." He surmised Zheng thus acquired the right to demand unlimited joint and several liability from the founder.

When Dark Waves pressed him on where this was heading, Zheng himself expressed uncertainty: "Let the lawyers decide, many of these terms were discussed by later-round investors, not drafted by me — we just signed."

As of press time, regarding whether he would initiate a buyback, Zheng told us: "I can only say, we'll follow the agreement, lawyers are handling it." "So far, no one has formally demanded a buyback from Luo, and no one has asked for money."

Reason and Emotion

Beyond Luo Yonghao's natural traffic magnetism, the Zheng Gang episode caused such an uproar because "buybacks" appear to be such a founder-unfriendly constraint. Once personal buyback liability is triggered, founders face demands ranging into the hundreds of millions.

Compared to investors, entrepreneurs seem to occupy the moral high ground. From a universal perspective, this should be so: for an investor, one project is merely one of many possibilities; for a founder, it's everything.

But Dark Waves wants to say: let law be law, and let emotion be emotion.

If "buybacks" are a constraint on founders, then the price investors pay is: purchasing company equity at a premium, and not participating in daily operations. Safeguards against extreme scenarios are entirely justified.

In this sense, stepping back from the Zheng Gang episode — if a company genuinely fails to achieve what it promised investors, then an investor choosing not to trigger a buyback may be a favor, not an obligation.

Lu Zaiguang also pointed out that in some earlier projects, buyback clauses even had founders sign "unlimited joint and several liability." This meant that once problems arose, founders stood to lose far more. But as investor-founder relationships have evolved, such situations have become less common. In any case, the spirit of contract is always valuable.

Whether there might be a better resolution to this situation — in some sense, perhaps.

Zheng Gang believes his most direct grievance, contrary to what people might imagine, isn't "inappropriate equity ratios" but rather that his right to information wasn't respected, and the "poor communication" on many matters. He repeatedly and insistently raised his dissatisfaction with Luo's manner in meetings and agreement discussions, believing "the core issue is communication." "Entrepreneurship needs to travel light — you can't be weighed down by baggage. But we at least saw preliminary success with Jiaoge Pengyou. Couldn't you give us some explanation?"

And what needs communicating apparently extends beyond just this matter, even bleeding into a larger, intangible emotional realm beyond what law can define.

Image source | Visual China

Layout | Yunxiao Guo