[Venture, Litigation Alert]② "Take Responsibility If IPO Fails"... Founders Suffer Under Toxic Clauses

Many Reasons for IPO Failure, Including Economic Downturn and Stricter Reviews
Contracts Demand "20% Annual Damages for IPO Failure"
Startups Facing Civil Lawsuits One After Another
"Focus on Partnership and Balance, Not Just LP Protection"

Editor's NoteIn advanced venture markets such as the United States and Israel, failure in starting a business is often recognized as valuable experience and serves as a stepping stone for another attempt. However, in Korea, failure still acts as a stigma for entrepreneurs and even blocks the path to a comeback. In particular, lawsuits that require founders to take personal responsibility for company debts, based on investment contracts, pose a critical risk. This three-part series analyzes recent lawsuits between startups and investors in Korea, strategies for avoiding toxic clauses in contracts, and more.

There has been a growing number of cases where startups, after failing to go public through an initial public offering (IPO), become embroiled in legal disputes with investors. Among founders, there is a growing sense of crisis that "the promises made during fundraising can ultimately come back as lawsuits." This is because, amid an economic downturn, high interest rates, and stricter IPO screening, investors facing increased pressure to recover their investments now have more opportunities to use unfavorable contract terms against startups through legal disputes.

Investors Demand Contracts: "IPO Within 2 Years" and "Compensation for Failure"

This year, the courts have seen a series of lawsuits in which investors demanded compensation from startups after a failed IPO. A representative case is Hyundai Asset Management's damages claim against the robotics startup Alpi (formerly Roboprint) and its founder. According to Asia Economy's findings on September 16, the appellate court ruled in favor of Alpi last month, finalizing the decision.

The dispute arose over the IPO obligation clause in the investment contract. At the end of 2018, Hyundai Asset Management invested 500 million won in Alpi, attaching the condition that the company must complete its listing on KONEX within two years. However, due to the impact of COVID-19, Alpi failed to secure sufficient results as local government projects were scaled back, and it did not meet the listing requirements. In 2022, Hyundai Asset Management filed for damages, citing breach of contract.

The first trial sided with Alpi. The court ruled that "the obligation to go public is an obligation of means, not of result," and stated, "If the company made a sincere effort but failed to list due to external factors, it cannot be considered a breach of obligation." An obligation of result requires a specific outcome to be achieved, and failure to do so is regarded as a breach. In contrast, an obligation of means requires sincere effort toward the outcome, and if best efforts are made but the result is not achieved, the obligation is considered fulfilled. The appellate court upheld this judgment, dismissed Hyundai Asset Management's appeal, and the ruling became final when Hyundai Asset Management withdrew its appeal.

Earlier this year, the lawsuit between craft beer company Korea Craft Beer and HB Investment also ended in a loss for the investor. HB Investment invested 5 billion won in 2016, attaching the condition that if the IPO was not completed by the end of 2022, the company would pay the principal plus 20% annual compound interest as damages. When the listing failed within the deadline, HB Investment filed a damages claim against Korea Craft Beer and its management in early 2023.

The first trial stated, "An IPO is not a goal that can be achieved solely through the company's efforts. Holding the company responsible based only on the outcome, without considering external factors such as the slump in the craft beer market, is unreasonable," and pointed out, "Imposing a 20% annual interest burden is an unfair contract that unilaterally favors the investor." HB Investment appealed but later withdrew, finalizing Korea Craft Beer's victory in February.

In summary, both courts interpreted the IPO obligation as an "obligation of means" rather than an "obligation of result." In other words, even if the company ultimately failed to go public due to external circumstances, as long as sincere efforts were demonstrated, it could not be considered a breach of contract.

In particular, the court in the Korea Craft Beer case emphasized that "granting an unconditional right to claim damages for breach of IPO obligation and forcing the company to pay high interest is an unfair contract that unilaterally benefits the investor," and stated, "This runs counter to the intent of the contract, which was to pursue mutual benefit for both the fund and the startup through a successful IPO, to the nature of venture investment as risk capital, and to the policy goal of fostering startups."

Investors: "For LP Protection" vs. Founders: "Effectively Shackles"

Following this series of lawsuits, concerns about the risks of toxic clauses have grown in the venture industry. Redemption convertible preferred share (RCPS) redemption conditions, put options, repricing (conversion price adjustment), and penalty clauses are commonly found in startup investment contracts, but in Korea's investment environment, they are often drafted in favor of investors. For startups in urgent need of funding, it is difficult to refuse investor demands made under the pretext of "protecting fund limited partners (LPs)."

The structural limitations of Korea's venture investment ecosystem have also played a role. Compared to advanced countries, Korea has a smaller mergers and acquisitions (M&A) market and a high dependence on IPOs. In this environment, years of high interest rates have made it difficult for the venture industry to raise funds. On top of this, IPO screening has become even more stringent, further narrowing exit opportunities. As investors have fewer means to recover losses, startups and founders are left to shoulder the risks of toxic clauses and lawsuits.

Experts say that a balance must be found between investors' fiduciary duty to LPs and the policy goal of fostering startups.

Attorney A, a specialist in startup investment contracts, said, "In Korea, it's common for contracts to be packed with toxic clauses, and startups desperate for funding are forced to sign them. However, since investors are also subject to a fiduciary duty to manage LP funds with even greater care than their own, they try to include various clauses. Ultimately, it is an issue that both sides need to balance from the perspective of 'partnership.'"

Kim Sunghoon, managing attorney at Mission Law Firm, stated, "Ultimately, what is needed now is policy leadership." He added, "Many LPs are often institutions connected to government policy. It is necessary to provide guidance to investors to prevent unnecessary and excessive legal actions that trigger disputes," and emphasized, "The government should review the overall situation and consider ways to strengthen trust and transparency in the startup investment market."