Is OpenAI worried about triggering a buyback?

Author: Jessica, Sillicon Star Pro

"Repurchase protocol" has recently stirred the nerves of everyone in the Chinese venture capital circle.

From the dramatic farce between Luo Yonghao and Zheng Gang, to the overwhelming buyback trend reflected in various data, and then to the voices of practitioners represented by Kuang Ziping, the founding partner of Qiming Venture Partners, who believe that the buyback clause has been abused, the discussion about "stampede-style" buybacks has spread.

According to the latest VC/PE Fund Repurchase and Exit Analysis Report released by Lifen Law Firm, about 130,000 projects in the Primary Market are facing exit pressures, and 'tens of thousands of entrepreneurs may face hundreds of millions of yuan repurchase risks'.

In Kuang Ziping's influential articles, he mentioned the origin of the buyback clause, which is a 'foreign import': 'In the early days, the investments of USD funds in China were mainly invested in Cayman main body structures, and there would generally be 'redemption' or 'buyback' clauses, occasionally there would be performance ratchet clauses.'

But these imported goods have been "abused by some peers" over the past decade.

Behind the current buyback discussion is the concern about whether the prosperity of the entire scientific and technological innovation investment can continue, while at the same time, a striking contrast is that startups, represented by AI companies in Silicon Valley, continue to raise large amounts of funding.

OpenAI is the most prominent representative, and the latest rumor is that it is trying to raise tens of billions of dollars. In addition to the previous investor Thrive Capital planning to invest $1 billion, Apple and NVIDIA will also join the ranks of investors.

As the origin of Silicon Valley, what is the situation of buybacks here today? After Sam Altman took so much money from various gods, will he also lose sleep over "buybacks"? We talked to local first-line investors.

1 "Willing to gamble and accept the loss" guaranteed by precision mechanism

The concept of betting and repurchase clauses originated from the risk control requirements in the capital market of the US dollar and aims to help investors lock in exit channels in high-risk environments. Starting in the mid-20th century, these clauses gradually became popular on Wall Street and were standardized, and then spread to global financial markets, becoming common practice in the modern investment industry.

Specifically, the redemption clause specifies that under certain specific conditions, the company needs to redeem the shares held by investors at the agreed price. These conditions may include the company's failure to go public within the promised time, significant misconduct by the founder, or the overall acquisition of the company, etc.

For example, suppose you are an ambitious founder who has received a 10 million yuan investment from a certain institution. The agreement signed by both parties stipulates that if the company fails to go public within five years, the investor has the right to require you to buy back the shares at 1.5 times the investment amount. After five years, due to various reasons, the company indeed did not have an IPO, so according to the protocol, you must come up with 15 million yuan to buy back the shares held by the investor.

The concept of performance ratchet is similar. You and the investor make a bet on a future performance target or milestone event, such as reaching a revenue of 100 million within five years. If this is achieved, both parties are fine, but if not, the agreed-upon personal equity or cash payment must be made to compensate the other party. Essentially, it is like providing investors with insurance, giving them an extra way out if the invested company fails to rise as expected.

An investor who has been deeply involved in a top VC firm in the United States for many years told us that although buyback clauses are industry regulations and will be written into protocols, they are hardly triggered in Silicon Valley, and even if they are triggered, investors will not sue. If it is a company they believe in, they will focus on a willingness to bet and lose.

"In Silicon Valley, the culture, atmosphere, and mindset are very encouraging for entrepreneurship. For example, the Stanford VC alumni would support entrepreneurship. Moreover, many investors were entrepreneurs before they became investors, so they are more willing to support and give back. For example, the first achievement of a16z founder Marc Andreessen was actually founding Netscape," he said.

"There is also YouTube's co-founder Steve Chen, who joined PayPal before graduating from his senior year and worked as a software engineer for five years. Later, when he was working on YouTube, a large amount of money was needed for copyright, and financing was urgently needed. He was invested by Roelof Botha, the former CFO of PayPal, one of the PayPal Mafia, and a partner at Sequoia."

Many successful giants have emerged from garages. If they had no money to save themselves during difficult times, they would have died many times over. These investors have all suffered in the past and have been through the rain, and now they want to help others hold up umbrellas.

Apart from the 'inherited' entrepreneurial culture in Silicon Valley not being supportive, objectively speaking, the buyback terms here are much more lenient compared to those in China.

Since the early investments of USD funds are mainly in technology companies with Cayman structures. According to Cayman law, repurchase needs to ensure that it does not affect the normal operation of the invested companies, and the responsible party is the company rather than the founder personally.

However, when this structure was localized by the RMB fund, two changes gradually appeared: the first was that the premise of "not harming the normal operation of the company" was ignored, and the implementation of the repurchase clause no longer considered the impact on the company's operation. Secondly, the "personal unlimited joint and several liability" is added, so that the repurchase obligation is transferred from the company to the individual founder. And it's "unlimited", no matter how much money you have in your account, what you promise must be repaid in full. Taken together, these two aspects puncture the layers of protection that were carefully laid out in the original buyback clause for the company and the founders.

So that's why entrepreneurs sigh, "The repurchase clauses signed before were more like gentlemen's agreements, and they were rarely triggered. Now, the repurchase clauses signed are like the sword of Damocles hanging over their heads, and investors are serious about it."

Hua Ying Capital's overseas partner Qiu Zun explained that in addition to extremely loose repurchase terms, Silicon Valley also has a whole system to provide support and security for entrepreneurs.

First, not enforcing the non-compete protocol, this is a typical California product. (For example, many technical backbones leave DeepMind to start a business with large models without being pursued, but in other states, it may be possible to be sued.)

The second point is the greatly simplified investment protocol (Term Sheet). The goal is to accelerate investment decision-making and execution by avoiding the overly complex legal details in the final signed investment protocol (SPA) through a concise and clear terms framework. ZhenFund has previously launched a very popular 'One-Page' investment letter of intent, which is actually derived from the Silicon Valley Term Sheet, which has always been 1-2 pages long.

Thirdly, early projects completely adopted the YC proposed standard convertible bond SAFE protocol, which allows start-ups to obtain funds without immediately determining the company's valuation, and investors can convert it into equity in subsequent rounds.

The fourth is to change the risk management mechanism of Wall Street and embrace venture capital instead.

This is also the fundamental difference between the two investment systems of Silicon Valley and Wall Street trap:

Wall Street's risk control mechanisms are more conservative, relying on building models, financial forecasting, and strict terms to mitigate risks, ensuring investment safety and stable returns, especially in the private sale equity (PE) field.

As a technology hub, Silicon Valley emphasizes venture capital. VCs in Silicon Valley generally believe that once a start-up's rise can be modeled and calculated, it loses its value for innovation. They are willing to take higher risks to support innovative companies, especially early-stage technology companies, that have the potential to transform industries and deliver huge returns. The philosophy in Silicon Valley is that while most projects may fail, once a project succeeds, the rewards will more than compensate for all the risks. Therefore, Silicon Valley is more willing to "bet" on the future of technological disruption and reflect long-term trust in technological innovation with a higher risk tolerance.

"But this mechanism is not invented out of thin air, nor is it really an angel coming down from the sky," Qiu Zun said, "VC also requires financial returns. From the perspective of TradFi mode, VC may seem somewhat 'alternative', but its true root can be traced back to the development of the Silicon Valley computer industry. The exponential rise and reinvestment characteristics of the computer industry have driven the rise and value realization of VC."

So it seems that to some extent, the investment style in China in recent years is more similar to the Wall Street approach, or it can be said that it has internalized the high-risk role borne by Silicon Valley. Investors are more following risk control and exit mechanisms, prioritizing return guarantees, pursuing steady profits, rather than seeking victory in danger.

2 Even used by entrepreneurs to counter investors

But no matter what, clauses such as earn-back buyback are also used to protect investors in the general Consensus. But in Silicon Valley, it can also be a tool for start-ups to counter investors.

Last month, a Silicon Valley unicorn called Bolt staged such a drama: the company planned to complete a new round of financing with a valuation of $14 billion. The CEO announced that if existing investors do not accept the price increase of 30% compared to the previous valuation to continue to follow the investment, Bolt will activate the "Pay to play" clause to repurchase their shares at a very low price of 1 cent per share.

Pay to play is a special system in the Capital Market of the United States, which requires existing investors to continue to contribute funds in subsequent financing rounds to maintain their equity stakes. Otherwise, they will lose anti-dilution rights, future financing participation rights, board seats, and preferred stock status.

Bolt's announcement has left almost all old investors in distress: on the one hand, they do not want to continue to invest in Bolt at a high price of $14 billion, on the other hand, they are clear about the consequences if they do not. The share buyback, which has always protected investors, has become a bargaining chip in the hands of entrepreneurs under the cover of 'Pay to play'.

According to the data compiled by the well-known US law firm Cooley, the proportion of investment protocols containing 'Pay to play' clauses has been rising steadily since the second quarter of 2021, reaching 8% in the first quarter of 2024, 'a previously rare clause that is becoming increasingly common'.

At first glance, Pay to play seems counterintuitive. Why should early investors who provided early funding for the company be 'washed out'? But when it comes back to the core of chasing risk in Silicon Valley, everything will become reasonable again.

Because Pay to play is not simply clearing certain investors out, but giving them a choice: to continue to invest and support the company, or to give up further participation. If investors are unwilling to continue to unite with the startup company and bear the risks together, they must accept the loss of share dilution. Conversely, from the perspective of some investors, they have already lost confidence in the company's prospects, and the financial aspect has already deemed this investment a failure. Being able to repurchase shares can also recover some funds, which is also a form of stop loss.

So, different soils will give birth to different tools to adapt to different rules, making everything run organically.

3 Under the worry of bubble, some cracks appear

Is Silicon Valley really so confident, self-sufficient, and even somewhat utopian? Or has someone already begun to sniff out the hidden worries beneath the shiny surface?

Behind OpenAI's $100 billion valuation and new round of financing, Silicon Valley is quietly undergoing changes.

Emerging star companies like OpenAI have always been valued and financed based not on traditional profitability or financial performance, but on expectations for the future AI progress, especially in general artificial intelligence. OpenAI has adopted a unique structure that combines a non-profit organization with for-profit subsidiaries to attract external capital to support high-cost AI research and development while limiting investor returns until the milestone of AGI is achieved.

However, this move by OpenAI has exposed some unsettling signals. 'The Information' recently pointed out in the article 'Why OpenAI Needs an IPO' that despite OpenAI's impressive valuation and revenue, the profit situation is not optimistic, with an expected loss of tens of billions of dollars this year. The costs of cloud services, GPUs, model training, and employee expenses are extremely high, and the company is unlikely to generate significant revenue in the short term, making an IPO their imminent choice.

In addition, Thrive Capital just led a round of employee stock repurchase at a valuation of 86 billion US dollars, and then led a new round of financing. In general, high-rise technology companies will attract longer-term investors, and the same investor leading consecutive rounds may indicate cautious attitudes from other investors towards the current valuation. Internal financing is often seen as a warning sign, indicating that the company may have difficulty attracting new investors. Despite OpenAI's technological leadership, the long-term viability of its business model and profitability remains unclear, and the market is beginning to reassess this high-valuation, high-risk investment model as a result.

The recent "Reverse acquisition" played out in Silicon Valley is also a product of this dilemma.

Several promising AI unicorn companies have been acquired by larger companies through reverse acquisitions. Character.AI, Inflection, Adept, and Covariant have recently been integrated through technology licensing and talent recruitment. Despite their high valuations, technological advancements, and product offerings, these companies have evidently been unable to find a stable path to profitability in the long run, prompting investors to take action.

Silicon Valley is also aware of the bubble problem, but it seems that they believe it is important to stop the music gracefully if it must stop.