Navigating Contractual Pitfalls Before Your IPO: A Legal Editor's Guide

An upcoming IPO is a significant milestone for any company. However, amidst the intense preparation for financial, business, and fundraising strategies, many teams overlook potential contractual landmines lurking beneath the surface. Seemingly routine contract clauses can become critical factors that halt or even break the entire IPO process during due diligence. Many companies only realize before their IPO that past contract practices diverge from current regulations or the governance standards of publicly listed companies, making remediation difficult and often too late.

Drawing from practical experience, I will outline six major contractual red lines that legal departments should prioritize reviewing within 12 months before an IPO. These are not theoretical concerns but critical areas that will be scrutinized during due diligence and could lead to significant trouble for the company if mishandled.

I. Blurred Lines in Related-Party Transactions: Beware of Self-Dealing Allegations

During IPO preparations, regulatory authorities and underwriters significantly raise the bar for corporate governance, with "related-party transactions" being one of the most frequently examined items. As defined by regulations such as the "Rules Governing the Acquisition or Disposal of Assets by Public Companies," related parties typically include a company's responsible persons, directors, supervisors, managers, their spouses, minor children, and companies substantially controlled by or under the substantial control of the company. Improperly handled transactions can easily be questioned for benefiting specific related parties, thereby affecting the company's independence and the fairness of its financials.

Why They Fail: In the early stages of development, many SMEs frequently engage in financial dealings, leases, labor provisions, or sales of goods with affiliated enterprises or related parties for convenience or cost savings. If these transactions lack reasonable commercial justification, market-fair pricing, or proper resolution and disclosure by the independent board of directors or shareholders' meeting, they may violate the directors' duty of loyalty under the Company Act, as well as the disclosure and corporate governance requirements of securities regulators. For instance, purchasing equipment from a related party at a clearly unfair price or leasing significant assets to a related party could be deemed actions detrimental to the company's interests.

How to Fix: First, establish a clear list of related parties and comprehensively inventory all existing transactions between the company and its related parties. For all transactions, ensure they have a reasonable commercial purpose, and the terms (price, payment method, service content, etc.) comply with the Arm's Length Principle. If necessary, obtain independent third-party appraisal reports for substantiation. More importantly, all material related-party transactions must be authorized and resolved by the board of directors or even the shareholders' meeting in accordance with the Company Act, the "Rules Governing the Acquisition or Disposal of Assets by Public Companies," and other relevant regulations, and be fully disclosed in the financial statements. For future related-party transactions, establish stringent internal control procedures that clearly define authorization levels and review mechanisms.

Sample clause: When engaging in transactions with related parties, this Company shall adhere to the principles of good faith and conduct transactions at fair and reasonable prices. All contracts entered into with related parties shall be reviewed and approved by this Company's independent board of directors (or shareholders' meeting, depending on the transaction amount and nature) and disclosed in accordance with relevant laws and regulations. This Company shall establish internal regulations for the management of related-party transactions, clearly defining the procedures for review, execution, and supervision to ensure the independence and fairness of such transactions.

II. The Gray Area of Non-Compete Clauses: Protecting Key Talent and Trade Secrets

In the knowledge economy, talent and trade secrets are a company's core assets. On the eve of an IPO, ensuring these assets are not taken by internal employees or partners is a crucial task for legal departments. The purpose of non-compete clauses is to restrict former employees from engaging in activities directly competitive with the company's business within a specified scope and for a reasonable period after departure, thereby protecting the company's trade secrets and customer base.

Why They Fail: Many companies make the mistake of drafting overly broad, excessively long, or uncompensated non-compete clauses. According to the principle of good faith in the Civil Code and common judicial tendencies, overly stringent non-compete clauses lacking consideration may be deemed invalid. For example, a clause prohibiting an employee from engaging in any company-related business indefinitely and without geographical limitation clearly violates the principle of proportionality and is unlikely to be fully upheld by courts. Furthermore, without a clearly stipulated reasonable compensation, employees may still claim the clause is invalid after resignation.

How to Fix: The design of non-compete clauses must balance the protection of company interests with safeguarding employees' right to work. Clauses should clearly define: 1. Scope of Prohibition: Specifically list the business activities the employee is prohibited from engaging in, which should be highly relevant to the trade secrets, customer lists, or technical information they were exposed to during employment. 2. Time Limitation: Specify the post-termination prohibition period, typically between 6 months and 2 years; longer periods may be deemed unreasonable. 3. Geographical Restriction: The restricted geographical scope should align with the company's actual business operations. 4. Consideration and Compensation: Clearly stipulate reasonable post-termination compensation for the non-compete obligation, such as monthly payments or a lump sum, sufficient to offset the employee's restrictions.

Additionally, pay attention to the relevant provisions of the Trade Secrets Act to ensure trade secrets are adequately protected while non-compete clauses are stipulated. If an employee had access to and knowledge of the company's trade secrets before leaving, they have a duty of confidentiality under the Trade Secrets Act, even without a non-compete agreement.

Sample clause: Upon termination of employment (including but not limited to dismissal for cause, resignation, or mutual termination), the employee shall not, directly or indirectly, engage in business activities competitive with this Company's business scope (e.g., [specifically list the company's core business, such as: developing and selling specific software, providing cloud computing services, etc.]) within the territory of the Republic of China, nor serve as a director, supervisor, manager, senior officer, or provide technical or business consulting services to a competing enterprise, for a period of twelve (12) months from the effective date of termination. In consideration thereof, this Company shall pay the employee, upon termination, a non-compete compensation equivalent to fifty percent (50%) of their average monthly salary in the month preceding termination, payable monthly until the expiration of the aforementioned prohibition period. Should the employee violate this clause, they shall immediately cease the infringing activities and compensate this Company for all damages incurred, and this Company reserves the right to reclaim any compensation paid.

III. Unclear Definition of Confidentiality Obligations: The Last Line of Defense for Trade Secrets

Trade secrets are a company's lifeline, especially crucial for the technology sector. Before an IPO, companies must ensure that all individuals with potential access to trade secrets have signed robust Non-Disclosure Agreements (NDAs), and that these agreements are valid and enforceable.

Why They Fail: Many NDAs are too brief, vaguely mentioning "confidentiality" without specifically defining what constitutes a "trade secret," nor clearly stipulating the duration, scope of confidentiality, or legal consequences of breaches. For example, a mere clause in an employee's labor contract stating they "shall maintain company secrets" might be insufficient for effective trade secret protection in practice. According to the Trade Secrets Act, trade secrets must possess "secrecy," "economic value," and require "reasonable measures to maintain secrecy." If the company itself has not taken adequate protective measures, such as failing to sign clear NDAs with key personnel or failing to properly classify and control confidential information, it will be difficult to claim such information as protected trade secrets even if a leak occurs.

How to Fix: An effective NDA should include, at a minimum: 1. Clear Definition of Trade Secrets: Explicitly list what information constitutes trade secrets, such as technical data, customer lists, financial information, marketing strategies, product blueprints, etc. 2. Scope and Obligations of Confidentiality: Detail the recipient's confidentiality obligations, including not disclosing, not using for purposes other than those agreed upon, and not duplicating or distributing. 3. Confidentiality Period: Stipulate the duration of the confidentiality obligation. For trade secrets, this obligation should persist as long as the information remains secret, often requiring a lengthy period, or even perpetual. 4. Consequences of Breach: Clearly outline the legal liabilities for breaching confidentiality obligations, including civil damages (liquidated damages may be stipulated, subject to the court's right to reduce them under Article 252 of the Civil Code), criminal liability (prosecution under the Trade Secrets Act), and injunctive relief.

For employees, in addition to signing NDAs, labor contracts should also clearly stipulate confidentiality obligations, and information security management measures should be implemented, such as access controls, regular training, and marking of confidential documents.

Sample clause: The parties agree that "Confidential Information" as used in this Agreement refers to all information disclosed by one party (Disclosing Party) to the other party (Receiving Party) in writing, orally, electronically, or in any other form, including but not limited to technical information, processes, formulas, designs, drawings, specifications, software code, customer lists, supplier information, market analyses, financial information, business plans, pricing strategies, etc., provided that such information is marked as confidential by the Disclosing Party or is inherently confidential by its nature. The Receiving Party shall exercise a high degree of care to safeguard the Confidential Information and shall not disclose it to any third party or use it for any purpose other than the purposes of this Agreement without the Disclosing Party's prior written consent. This confidentiality obligation shall remain in effect for five (5) years from the date of disclosure (or until such information becomes publicly known).

IV. Unclear Intellectual Property Ownership: Ensuring Ownership of Technology and Creativity

Before an IPO, the ownership of a company's core technologies, software, designs, and other intellectual property (IP) is a focal point for underwriters and investors. Any IP disputes can significantly impact the company's valuation.

Why They Fail: The most common issues arise when there is no clear agreement on the ownership of IP generated during employment or collaboration between the company and its employees, external consultants, or partners. For instance, if software developed by an employee using company resources lacks a clear stipulation of company ownership in their employment or engagement contract, the employee might claim partial or full rights to the software after leaving. Similarly, unclear terms regarding IP ownership, usage rights, and modification rights in agreements with third parties for commissioned development, technical collaboration, or licensing can lead to subsequent legal disputes.

How to Fix: Develop appropriate IP ownership clauses tailored to different types of collaborations: 1. Employee Employment Contracts: Should clearly state that all inventions, creations, software, designs, etc., generated by employees during their employment, using company resources, and within the scope of their duties, belong to the company. 2. External Consultant and Contractor Agreements: When working with external individuals or companies, contracts should clearly stipulate that the IP of commissioned development, design, or creative work belongs to the company. If the other party requires reasonable usage rights or licenses, these should also be clearly defined. 3. Technology Collaboration and Licensing Agreements: For joint development or technology licensing, detailed agreements should cover IP ownership, patent application rights, ownership and usage rights of subsequent improvements, licensing scope, and royalty payments.

Furthermore, companies should actively pursue IP applications and registrations, such as patents, trademarks, and copyrights, and establish comprehensive IP management systems to regularly inventory and maintain the company's IP assets.

Sample clause: All inventions, creations, software programs, designs, technical documents, data, and other intellectual property (collectively referred to as "R&D Results") developed by employees during their tenure, whether independently or in collaboration with others, utilizing company resources, equipment, or information, or based on their job responsibilities, shall belong exclusively to this Company. This includes, but is not limited to, patent rights, copyrights, trademark rights, and trade secrets. Employees shall cooperate with the Company in handling applications, registrations, and maintenance procedures for relevant rights and shall not disclose or utilize them externally.

V. Risks of Fixed-Term Labor Contracts and Termination Certificates

Compliance with labor laws is an indispensable part of IPO due diligence. Improper handling of labor contract types and terminations can lead to labor disputes, affecting the company's reputation and operational stability.

Why They Fail: Article 9 of the Labor Standards Act stipulates that continuous work should be under an indefinite-term contract. To avoid costs associated with labor insurance, health insurance, and severance pay, many companies use repeated fixed-term contracts for work that should be indefinite. If deemed "deemed indefinite-term contracts," the company faces risks of back-paying related expenses, paying severance, and even penalties from regulatory authorities. Additionally, according to Article 19 of the Labor Standards Act, employers must issue a certificate of service upon request by a worker. Refusal to provide such a certificate can also lead to disputes.

How to Fix: 1. Review Labor Contract Types: Comprehensively review all labor contracts to distinguish between fixed-term and indefinite-term contracts. Fixed-term contracts are only applicable for "temporary, short-term, seasonal, and specific work." All other continuous work should be indefinite-term. If improper fixed-term practices are found, promptly convert them to indefinite-term contracts and ensure legal protection of labor rights. 2. Ensure Compliant Termination Procedures: Establish standardized termination procedures to ensure the issuance of certificates of service upon employee departure as required by law, and properly handle salary settlements, severance payments (if applicable), and labor/health insurance transfers. Avoid labor disputes arising from procedural defects. 3. Comply with Labor Regulations: Regularly review the company's human resource policies and practices to ensure compliance with the latest labor laws, including regulations on working hours, leave, wages, overtime pay, gender equality in employment, and occupational safety and health.

Sample clause: This labor contract is an indefinite-term contract. Upon termination of this contract, if the employee requests a certificate of service, the employer shall issue it free of charge in accordance with Article 19 of the Labor Standards Act, and shall not refuse.

VI. Hidden Clauses and Obligations in Major Contracts: Scrutinizing Potential Risks

In addition to the points mentioned above, major contracts signed with key customers, suppliers, and partners, such as distribution agreements, agency agreements, technology licensing agreements, loan agreements, and lease agreements, must also be comprehensively reviewed. These contracts may contain unfavorable clauses or obligations that are not easily discernible.

Why They Fail: Many major contracts, especially those with large corporations, may include "change of control" clauses, "termination rights," restrictions on "force majeure," high liquidated damages, or require unreasonable guarantees from the company. Article 16 of the Company Act stipulates that a company, unless otherwise provided by law or its articles of incorporation, shall not act as a guarantor for any party. If a contract requires the company to provide guarantees for related parties or third parties without proper authorization, the company's responsible persons may be personally liable as guarantors or even compensate the company for losses.

How to Fix: 1. Establish a Contract Management System: Centralize the management of all major contracts, creating a contract database that records contract type, parties, effective and expiration dates, renewal terms, key obligations and rights, potential risks, etc. 2. Review Key Clauses Item by Item: Pay special attention to guarantee clauses, default clauses (including methods for calculating liquidated damages), termination clauses, confidentiality clauses, limitation of liability clauses, insurance clauses, governing law, and dispute resolution clauses. Ensure these clauses align with the company's interests and that the company is capable of fulfilling them. 3. Identify Potential Risks: Assess whether contracts contain clauses that could impact the company's IPO, such as allowing key customers or suppliers to terminate contracts unconditionally, or requiring the company to provide guarantees beyond its capabilities. These issues need to be clarified or renegotiated with the other party before the IPO.

Sample clause: The parties agree that the governing law of this Agreement shall be the laws of the Republic of China. Any disputes arising from this Agreement shall be resolved through good faith negotiation between the parties. If negotiations fail, either party may submit the dispute to the jurisdiction of the Taiwan [Designated Location] District Court.

One-Sentence Checklist

• Do all related-party transactions have reasonable commercial purposes, fair prices, and undergo appropriate resolution and disclosure?
• Are non-compete clauses clear, reasonable, and accompanied by compensation?
• Do confidentiality agreements clearly define trade secrets and stipulate specific obligations and durations?
• Is IP ownership clearly defined in contracts, and have necessary registrations been completed?
• Are labor contract types compliant, and are termination procedures legally sound?
• Do clauses regarding guarantees, defaults, and terminations in major contracts pose unreasonable risks to the company?

A Common Myth

Myth: Any contract signed internally within a company is automatically valid and requires no special review.

Clarification: The validity of any contract must comply with relevant laws. Even internally signed contracts may be invalid or voidable if their content violates mandatory legal provisions (such as Article 16 of the Company Act prohibiting companies from acting as guarantors), public order, or good morals, or if there were significant defects during the signing process (e.g., fraud, duress). IPO due diligence aims precisely to identify these potential invalid or voidable contracts and prevent them from impacting the company.

FAQ

1. What is the most common oversight in contract review before an IPO?

The most common oversight is over-reliance on past "customary practices" while neglecting the significantly heightened requirements for corporate governance and legal compliance demanded by an IPO. Many SMEs have historically been flexible in their contract handling, but this flexibility can become a "risk point" under the standards for listed companies. Examples include insufficiently rigorous recognition of related-party transactions, overly lenient non-compete agreements with employees, or unclear stipulations on IP ownership – all of which can be magnified during due diligence.

2. Do related-party transactions always require board approval?

Not necessarily. According to the Company Act, the "Rules Governing the Acquisition or Disposal of Assets by Public Companies," and other regulations, material related-party transactions, such as asset sales, loans, or guarantees, typically require resolution by the board of directors or even the shareholders' meeting. However, whether it is required, and at what level of resolution, depends on the nature and amount of the transaction, the company's articles of incorporation, and relevant legal requirements. The key focus is on the "fairness" and "independence" of the transaction, and whether it has undergone appropriate "procedures."

3. Can a departing employee freely engage in competitive industries?

Not entirely freely. If a departing employee had access to the company's trade secrets during their employment, they still have a duty of confidentiality under the Trade Secrets Act, even without a non-compete agreement. If a legally valid non-compete agreement exists, the employee is restricted within the agreed scope, time, and geographical area. However, as mentioned, non-compete clauses must be reasonable and include consideration; otherwise, they may be deemed invalid.

4. Our contracts are all standard templates; do we still need to review them individually?

Absolutely. Even standard templates must be customized based on the company's actual business, industry characteristics, partners, and the latest regulatory requirements. Many templates may not cover specific risks or may contain overly broad clauses. IPO due diligence is precisely for identifying these hidden risks and ensuring that contract clauses truly protect the company and meet the standards for listed companies.

5. What if we discover contractual problems and don't have time to revise them?

If time is short and comprehensive revisions are impossible, at the very least, communicate fully with the underwriters and legal counsel, explaining the nature of the problems, potential risks, and the remedial measures the company intends to take. Sometimes, fully disclosing relevant risks in the IPO prospectus and committing to immediate contract revisions after listing can gain understanding from regulators and investors. However, this is merely a temporary solution; the best strategy is always early identification and prompt resolution.

6. Which types of contracts are most likely to be questioned during due diligence?

The most frequently questioned contracts typically include: material transactions with related parties, collaboration agreements involving unclear IP ownership, non-compete clauses without clearly defined compensation, and major customer/supplier agreements with overly stringent terms or unclear company obligations. Additionally, past labor contracts with improper fixed-term arrangements or procedural defects are also common areas of scrutiny.