Hello, I am Attorney Kim Kwang-sik of Law Firm Cheongchul.

In large investment agreements for startups, unlisted companies, and game/platform companies, "listing" is often included as an important condition related to the investor's exit strategy. In particular, in mezzanine investments such as convertible bonds, redeemable convertible preferred shares, and bonds with warrants, it is not uncommon for the agreement to include a clause that the company will pursue an IPO if certain performance requirements are met.

Recently, in connection with the failed IPO of Smilegate RPG, a first-instance court issued a ruling fully recognizing the investor-side damages claim of KRW 100 billion, and the question of how to draft the IPO-pursuit obligation clause in investment agreements has once again emerged as a major issue. In that case, a KRW 20 billion convertible bond investment was made in December 2017, and the clause requiring the company to pursue an IPO if the net income threshold under the contract was met became the issue. The company later argued that the obligation to pursue an IPO had been extinguished because large valuation losses arose from the accounting treatment of conversion rights, resulting in a net loss, but the first-instance court did not accept that argument.

However, this ruling is currently only a first-instance decision, and it has been reported that the company has appealed, so the legal principle has not yet been finalized. Even so, it offers significant practical implications for drafting investment agreements. Today, using this case as a starting point, I will organize the points that must be checked when setting an IPO-pursuit obligation in future investment agreements.

[Question]

When setting the company's IPO-pursuit obligation in investment agreements such as convertible bonds, redeemable convertible preferred shares, and bonds with warrants, what should be kept in mind to prevent future disputes?

[Answer]

1. The IPO-pursuit obligation should be defined first in terms of "which procedures must be followed," not merely "completion of listing."

In investment agreements, the phrase "the company shall pursue listing if certain conditions are met" is often used, but in actual disputes this wording alone is often insufficient. A listing itself is not a result that a company can complete on its own. Various external factors are involved, such as exchange review, market conditions, the lead underwriter's judgment, accounting audits, internal control levels, and controlling shareholder issues.

Therefore, rather than result-oriented wording such as "the company must be listed," it is important to specify in detail what concrete procedures the company must carry out and by when. For example, the agreement should set out, step by step, the selection of the lead underwriter, preparation for designated or accounting audits, establishment of internal accounting control systems, adjustment of the articles of incorporation and governance structure, submission of the preliminary listing review application, and progress reports to investors.

In this case as well, the key issue was not simply whether "the listing actually took place," but whether the company acted in a way that avoided or hollowed out its contractual obligation to pursue listing. The court found that the company's failure to pursue listing constituted a breach of contract, and also held that it violated the principle of good faith and fair dealing.

Ultimately, the IPO-pursuit obligation clause should be written not as an abstract declaration, but as a list of actions whose performance can actually be assessed. From the investor's perspective, this makes it possible to prove the company's delay or evasion; from the company's perspective, it allows prediction of the scope of effort required to satisfy the obligation.

2. Financial conditions such as "net income above a certain amount" must be accompanied by adjustment criteria.

One of the most important issues in this case was how to interpret the contractual financial condition of "net income." The convertible bond subscription agreement at issue contained a clause to the effect that the company would pursue listing if net income for the business year immediately before maturity was at least KRW 12 billion, and the company argued that the IPO-pursuit obligation had disappeared because net income in 2022 turned into a net loss due to accounting treatment of conversion rights, even though it recorded approximately KRW 228.9 billion in net income in 2021.

The problem is that in financial instruments such as convertible bonds and redeemable convertible preferred shares, net income can vary significantly depending on accounting treatment. In particular, if a conversion right with a reset condition is classified as a liability, valuation losses may arise as the company's enterprise value rises and the value of the conversion right increases, which can in turn reduce net income on the financial statements or even turn it into a net loss.

Accordingly, when using financial indicators such as "net income," "EBITDA," "operating profit," "net assets," or "debt ratio" in an investment agreement, it is not enough to simply state the accounting figures. It is desirable to include adjustment criteria such as the following.

For example, you may consider language such as: "When determining whether the IPO-pursuit obligation arises, net income shall be based on the company's audited separate financial statements, but shall exclude fair value gains and losses related to this agreement or to convertible bonds, redeemable convertible preferred shares, bonds with warrants, stock purchase rights, or other derivatives held by the investor."

It should also be decided in advance whether to include or exclude one-time special bonuses, transactions with related parties, gains or losses from large asset disposals, effects of accounting policy changes, and tax adjustment effects. If this point is unclear, even if the company's actual operating performance has improved, it may be possible to argue that the IPO-pursuit obligation did not arise because of accounting costs or valuation losses.

3. The accounting treatment standard should be designed so that it does not end with the auditor's judgment alone.

In this case, K-IFRS No. 1032 and FSS private Q&A Jehoi-00094 were both at issue. K-IFRS No. 1032 requires the so-called fixed-for-fixed condition—that is, exchanging a fixed number of equity instruments for a fixed amount—to classify conversion rights as equity. On the other hand, Jehoi-00094 has been interpreted as meaning that the stock purchase rights in bonds with warrants containing a reset condition can be treated as equity, and the issue was that many listed companies have relied on that interpretation to classify conversion rights with reset clauses as equity.

In relation to this, the court held that the conversion rights in question could be classified not only as liabilities but also as equity, and in particular determined that in the context of deciding whether the contractual IPO-pursuit obligation arose or was extinguished, it would be difficult to allow treatment that classifies conversion rights only as liabilities and thereby reduces net income.

Practically speaking, it is important to note that it may not be sufficient to simply include language such as "the auditor's accounting treatment shall apply" in the contract. The auditor's accounting treatment is important for financial statement preparation purposes, but it does not necessarily have to be identical to the standard used to determine whether contractual rights and obligations arise.

Therefore, the contract should consider how to handle situations where changes in accounting treatment or differences in the interpretation of accounting standards affect the IPO-pursuit obligation, put options, early redemption rights, conversion price adjustments, or damage calculations. For example, if a dispute arises regarding accounting treatment, the contract may provide that the judgment of an independent accounting firm agreed upon by the company and the investor will control, or it may establish a separate formula for the purpose of determining financial conditions under the investment agreement.

4. Be careful with any structure that allows the company to avoid the occurrence of the obligation through "prevention of condition fulfillment."

It is natural for an investment agreement to link the IPO-pursuit obligation to certain conditions. This is because a company cannot be forced to list when it has not achieved a certain level of performance or has not objectively satisfied the listing requirements.

However, the issue changes if whether those conditions are met can be influenced by the company's choices, accounting treatment, related-party transactions, or one-time expense recognition. If the company can pay large special bonuses at the time the IPO-pursuit obligation would arise, recognize expenses through transactions with related parties, or reduce net income through accounting choices and thereby create the appearance that the listing requirements have not been met, then from the investor's perspective the contractual protection may effectively become meaningless.

In this case as well, the court found that if valuation losses and special bonuses were excluded, the company's net income was of a substantial size, and concluded that the appearance had been created that the conditions for extinguishing the IPO-pursuit obligation had been met because of those expenses.

Accordingly, the investment agreement may consider a clause to the effect that "the company shall not change accounting policies, recognize expenses beyond the scope of ordinary management, engage in transactions with related parties, or take actions that materially alter its capital structure or financial position for the purpose of avoiding or obstructing the occurrence or performance of the IPO-pursuit obligation."

5. Drafting direction needed for both investors and companies

From the investor's perspective, the IPO-pursuit obligation should not be left as a mere declaration. The agreement should reflect the financial indicators used to determine whether listing requirements are met, accounting methods, adjustment items, the listing schedule, prohibited acts by the company, reporting obligations, and the method of calculating damages in the event of a breach. In particular, for investment instruments such as convertible bonds, redeemable convertible preferred shares, and bonds with warrants, where profits and losses can vary greatly depending on accounting treatment, a separate accounting clause for the purpose of determining financial conditions is essential.

Conversely, from the company's perspective, care must be taken so that the IPO-pursuit obligation is not interpreted too much like an obligation to achieve a specific result. If there are reasons beyond the company's control, such as failure in exchange review, sudden market changes, a negative opinion from the lead underwriter, legal restrictions, or major litigation or regulatory issues, it is necessary to include certain exceptions or deferral procedures. However, if these exceptions are drafted too broadly so that the company can assert them at will, they may become a source of disputes, so it is also necessary to define objective documentation and investor-notification procedures.

In the end, a good investment agreement should be a document that balances protecting the investor's exit opportunity while ensuring that the company does not bear unlimited liability for listing failures beyond its control. This ruling can be seen as a case showing the need to design that balance not through abstract wording, but through concrete standards and procedures.

This first-instance ruling concerning Smilegate RPG has not yet become final, but it clearly shows that the IPO-pursuit obligation clause in an investment agreement is not a mere ancillary clause, but a key provision that can lead to damages liability in the hundreds of billions of won.

In particular, wording such as "pursue listing if net income is at least KRW 12 billion" may seem clear at first glance, but once conversion-right accounting treatment, valuation gains and losses, special expenses, or accounting policy changes are involved, it can lead to entirely different interpretive disputes. Going forward, investment agreements are expected to require much more sophisticated drafting of the trigger conditions for the IPO-pursuit obligation, accounting standards, adjusted financial indicators, the company's duty to cooperate and prohibited acts, and the method of calculating damages in the event of a breach.

From the investor's side, the clause should be made specific so that the IPO-pursuit obligation can function as a real exit mechanism; from the company's side, exceptions and procedures should be made clear so that it does not become a structure that imposes liability even for uncontrollable causes.

Law Firm Cheongchul provides specific legal advice to ensure that IPO-pursuit obligations, put options, and damages clauses actually function in the process of drafting and disputing investment agreements such as convertible bonds, redeemable convertible preferred shares, and bonds with warrants. If you need to conclude a future investment agreement or review an existing one, we recommend checking accounting, commercial law, and contract law issues together from the initial stage.