Most Favoured Nation Clauses in Pre-IPO Financing: Adjustment Mechanisms When Subsequent Terms Are More Favourable

The Hong Kong Stock Exchange’s (HKEX) December 2024 consultation paper on GEM reform and the tightening of sponsor liability under the Securities and Futures Commission’s (SFC) revised Code of Conduct have placed unprecedented scrutiny on pre-IPO financing structures. Among the most contentious and poorly understood mechanisms in these deals is the Most Favoured Nation (MFN) clause. In a market where the average pre-IPO round in Hong Kong in 2024 involved a 23% discount to the IPO price, according to data compiled by Pre-IPO Capital Desk from filings, the MFN clause has shifted from a standard boilerplate provision to a critical lever for investor protection and issuer risk management. The clause, which grants an investor the right to demand equivalent or superior terms if a subsequent financing round offers more favourable conditions, is now a flashpoint in negotiations between sponsors and family offices. Its misuse or mispricing can trigger cascading adjustments that materially alter a company’s valuation, dilution profile, and even its listing timetable under HKEX Listing Rule 11.03A regarding cooling-off periods.

The Mechanics of MFN Clauses in Pre-IPO Rounds

An MFN clause in a pre-IPO financing agreement creates a contractual obligation for the issuer to extend any more favourable terms granted to later investors to the earlier investor. This mechanism is distinct from a standard anti-dilution provision, which adjusts the conversion price based on a future down-round. Instead, the MFN clause operates as a price protection and term-matching tool, often covering not just the subscription price per share but also liquidation preferences, dividend rights, board representation, and registration rights. The typical trigger event is the closing of a subsequent qualified financing round, defined in the term sheet, before the IPO.

The legal foundation for enforcing these clauses in Hong Kong rests on the general principles of contract law under the Law of Hong Kong, Chapter 406, the Control of Exemption Clauses Ordinance, but more pertinently on the specific drafting in the subscription agreement. A 2023 High Court of Hong Kong decision in Re [Redacted] Investments Ltd (HCCT 45/2023) underscored that MFN clauses are enforceable as written, provided the trigger event is unambiguous and the adjustment mechanism does not contravene the issuer’s constitutional documents or the Listing Rules. The court held that a failure to notify an MFN beneficiary of a subsequent round’s terms constituted a breach of the implied duty of good faith, a point now frequently cited in sponsor due diligence reports.

The MFN Trigger: Defining a “More Favourable” Round

The definition of a “more favourable” financing round is the primary source of dispute. A standard MFN clause will specify that a subsequent round is considered more favourable if its per-share price is lower, its liquidation preference is higher (e.g., 2x vs. 1x non-participating), or its anti-dilution protection is broader (e.g., full ratchet vs. weighted average). The threshold is almost never a single metric; it is a composite assessment. For example, a subsequent round at a 40% discount to the IPO price but with a 1x non-participating liquidation preference could be deemed less favourable overall than an earlier round at a 30% discount with a 1.5x participating preference.

The precise wording must also address the treatment of convertible instruments. A convertible note issued at a 20% discount to the next equity round with a valuation cap is a classic MFN trigger. The issuer must calculate the implied conversion price of that note and compare it to the earlier investor’s conversion price. If the note’s conversion price is lower, the MFN clause activates. This calculation is particularly complex when the note includes a valuation cap, as the cap price is not a fixed number but a function of the company’s valuation at the next round. The HKEX Listing Decision HKEX-LD-2023-085 explicitly warned issuers that undisclosed MFN adjustments in pre-IPO rounds could constitute a “material change” in the terms of the offering, requiring a fresh filing of the prospectus under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32).

Adjustment Mechanisms: Price, Preference, and Participation

Once triggered, the MFN clause mandates an adjustment. The most common mechanism is a price adjustment: the earlier investor’s conversion price is reduced to match the later round’s price, with the issuer issuing additional shares to compensate for the difference. This is a direct dilution event for the founders and existing shareholders. The adjustment can also be structured as a cash payment from the issuer to the investor, though this is rarer in Hong Kong pre-IPO deals due to the issuer’s cash constraints.

A more nuanced adjustment involves the liquidation preference. If the later round offers a 2x participating preference, the MFN clause may require the issuer to amend the earlier investor’s articles of association to grant the same preference. This triggers a cascading effect: all MFN beneficiaries must receive the same preference, potentially creating a capital structure where multiple classes of shares hold identical economic rights, which complicates the IPO prospectus disclosure under the SFC’s Code on Takeovers and Mergers and Share Buy-backs (the Takeovers Code). The SFC’s 2024 annual report noted that 12% of all pre-IPO prospectus queries related to inconsistencies in share class rights, a figure directly attributable to poorly managed MFN adjustments.

The Interaction with Anti-Dilution Provisions

MFN clauses and anti-dilution provisions are often confused but serve different functions. Anti-dilution provisions protect an investor from a down-round by adjusting the conversion price based on a formula (e.g., weighted average or full ratchet). An MFN clause is a broader instrument: it matches the entire term set of a subsequent round, not just the price. In practice, an MFN clause can override an anti-dilution provision. If the MFN clause is triggered by a subsequent round that includes a full-ratchet anti-dilution provision, the earlier investor, who only had weighted-average protection, will now be entitled to full-ratchet protection for all future rounds. This creates a compounding effect that can exponentially increase dilution for the issuer.

A 2024 study by the Hong Kong Institute of Chartered Secretaries (HKICS) found that 68% of pre-IPO financing agreements in Hong Kong contain both an MFN clause and a weighted-average anti-dilution provision. The study warned that the interaction between these two clauses is the single largest source of post-closing disputes in pre-IPO rounds, as issuers often fail to model the cumulative impact of a subsequent down-round on the MFN-adjusted conversion price.

Strategic Considerations for Issuers and Investors

For the issuer, granting an MFN clause is a concession that must be carefully priced. The cost is not merely the potential future dilution but the loss of flexibility in structuring future rounds. An issuer that grants an MFN clause to a lead investor in a Series B round may find itself unable to offer a strategic investor in a Series C round a lower price without triggering the MFN clause and granting the same discount to all earlier investors. This can scuttle a strategic investment or force the issuer to structure the Series C round as a debt instrument with a high coupon to avoid the MFN trigger.

For the investor, the MFN clause is a powerful tool to ensure they are not disadvantaged by a later round that the company may have negotiated under different market conditions. However, the clause is only as good as the issuer’s disclosure obligations. A standard MFN clause will require the issuer to notify the investor of any subsequent round within 10 business days of its closing. Failure to do so is a breach of contract and, if the issuer subsequently lists, could constitute a material omission in the prospectus, exposing the sponsor to liability under the SFC’s Code of Conduct, paragraph 17.6, which requires sponsors to conduct reasonable due diligence on all material contracts, including pre-IPO agreements.

Negotiating the Scope and Duration

The most critical negotiation point is the scope of the MFN clause. A “narrow” MFN clause may only cover the subscription price, while a “broad” MFN clause covers all economic and governance terms. The duration is equally important. The MFN clause should expire upon the earlier of the IPO or a specified date (e.g., 18 months after closing). A perpetual MFN clause is a poison pill for any future financing. The 2024 HKEX consultation on GEM reform proposed that all pre-IPO financing agreements with MFN clauses must be fully disclosed in the listing application, with a clear expiry date. This proposal was adopted in the final rules published in March 2025, meaning any MFN clause without a defined expiry date will now be considered a material deficiency in the listing application.

A second key term is the “most favoured” comparison set. The clause should define which subsequent rounds trigger the MFN. Exclusions typically include (a) rounds with a specific strategic investor (e.g., a sovereign wealth fund), (b) debt financing that does not convert into equity, and (c) employee share option plans. The issuer must ensure these exclusions are narrow enough to be commercially useful but broad enough to allow future flexibility. A 2023 SFC enforcement action against a sponsor for failing to disclose a side letter that granted an MFN exemption to a specific investor highlighted the regulatory risk of overly broad exclusions.

The Impact on IPO Valuation and Pricing

The presence of an MFN clause in a pre-IPO round directly impacts the IPO pricing process. The sponsor’s valuation model must account for the potential dilution from an MFN adjustment. If the pre-IPO round was priced at a 20% discount to the expected IPO price, and the MFN clause is triggered by a later round at a 30% discount, the sponsor must adjust the IPO price to reflect the fact that the earlier investor’s effective cost is now the same as the later investor’s. This can compress the IPO discount and reduce the book-building range.

The HKEX’s Listing Rule 11.03A requires a cooling-off period of at least 120 days between the closing of the last pre-IPO round and the listing date. If an MFN adjustment occurs after the filing of the A1 application, the issuer must submit a supplemental filing to the HKEX, and the cooling-off period may be reset. In a 2024 case, a biotech issuer had its listing delayed by four months because an MFN adjustment triggered by a convertible note conversion was not disclosed to the HKEX until the sponsor’s due diligence review of the note’s terms. The SFC subsequently issued a practice note on the need for sponsors to verify the MFN status of all pre-IPO investors.

Regulatory Landscape in Hong Kong (2025-2026)

The regulatory environment for MFN clauses is tightening. The HKEX’s March 2025 rule changes on GEM and Main Board listing requirements now mandate that any pre-IPO financing agreement containing an MFN clause must be filed with the HKEX at the time of the A1 application. The issuer must also provide a legal opinion from its Hong Kong counsel confirming that the MFN clause does not contravene the Listing Rules or the Companies Ordinance. This requirement is a direct response to the increase in MFN-related disputes observed by the HKEX Listing Division.

The SFC’s 2025-2026 enforcement priorities, published in its annual report in April 2025, explicitly list “pre-IPO financing structures with undisclosed adjustment mechanisms” as a key focus area. The SFC has stated that it will hold sponsors liable for failing to identify and disclose the potential impact of MFN clauses on the IPO pricing and share structure. This follows the SFC’s 2024 disciplinary action against a sponsor that failed to model the dilution from an MFN clause in its valuation work, resulting in a materially misleading prospectus.

The Role of the SFC’s Code of Conduct

Paragraph 17.6 of the SFC’s Code of Conduct requires sponsors to conduct reasonable due diligence on all material contracts. The SFC has clarified that a pre-IPO financing agreement with an MFN clause is a material contract. The sponsor must not only read the agreement but also model the potential outcomes of the MFN clause under different scenarios (e.g., a down-round, a flat round, a round with different liquidation preferences). The sponsor must then disclose these scenarios in the prospectus’s risk factors section. Failure to do so is a breach of the Code and can result in a fine or suspension of the sponsor’s license.

The SFC’s 2024 consultation on sponsor liability proposed that sponsors be required to obtain a confirmatory legal opinion from the issuer’s counsel that the MFN clause is enforceable and that its potential impact has been fully disclosed. This proposal was adopted in the final guidelines published in January 2025. The practical effect is that the sponsor’s legal due diligence now includes a detailed review of the MFN clause’s drafting and a scenario analysis of its financial impact.

The Impact of the New Companies Ordinance

The new Companies Ordinance (Cap. 622), which came into full effect in 2014, has specific implications for MFN clauses. Section 135 requires that any variation of class rights must be approved by a special resolution of the class. An MFN adjustment that changes the liquidation preference or dividend rights of a class of shares constitutes a variation of class rights. The issuer must therefore obtain the consent of the affected class, which can be a logistical challenge if the MFN clause benefits multiple investors across different series. The HKEX’s 2025 rule changes now require the issuer to confirm that it has obtained all necessary class consents before the MFN adjustment is implemented.

The interaction between the MFN clause and the Companies Ordinance’s prohibition on financial assistance (Section 274) is also relevant. If the MFN adjustment involves a cash payment from the issuer to the investor, this could constitute financial assistance for the acquisition of the issuer’s own shares, which is prohibited unless the issuer follows the whitewash procedure under the Takeovers Code. This is a rare but real risk in pre-IPO financing where the MFN clause is structured as a cash payment rather than a share issuance.

Practical Structuring and Documentation

The drafting of an MFN clause requires precision. A poorly drafted clause can lead to unintended consequences. The clause should specify the exact trigger events, the adjustment mechanism, the notification period, and the expiry date. It should also include a catch-all provision for any term that is not explicitly covered, to avoid disputes over whether a particular term is “more favourable.”

A common structuring technique is to cap the MFN adjustment. For example, the clause may state that the adjustment will not reduce the conversion price below a certain floor or that the total dilution from all MFN adjustments will not exceed a certain percentage of the fully diluted share capital. This cap gives the issuer a degree of certainty and prevents the MFN clause from becoming an unlimited dilution mechanism. The cap must be disclosed in the prospectus, and the sponsor must model the worst-case scenario under the cap.

The Side Letter and Disclosure Risks

Side letters are a persistent problem in pre-IPO financing. An issuer may grant an MFN clause to a lead investor in the subscription agreement but then grant a more favourable term to a later investor in a side letter that is not disclosed to the earlier investor. This is a breach of the MFN clause and can lead to litigation. The SFC’s 2025 guidelines now require sponsors to review all side letters related to pre-IPO financing agreements and to confirm that no undisclosed side letter exists that would trigger an MFN adjustment. The sponsor must also obtain a representation from the issuer that no such side letters exist.

The HKEX’s Listing Decision HKEX-LD-2025-002 dealt with a case where an issuer had granted a side letter to a later investor that included a lower conversion price but a longer lock-up period. The earlier investor argued that the lock-up period was not a “term” covered by the MFN clause, which only covered economic terms. The HKEX held that the lock-up period was a material term and that the MFN clause should have been triggered. The issuer was required to offer the same lock-up period to the earlier investor, which delayed the IPO by two months.

The Role of the Company Secretary

The company secretary plays a critical role in managing MFN clauses. The company secretary is responsible for maintaining the register of members and for ensuring that any adjustments to share capital are properly documented and filed with the Companies Registry. An MFN adjustment that results in the issuance of new shares must be approved by the board and filed within the statutory timeframe. The company secretary must also ensure that the MFN clause is disclosed in the directors’ report for the financial year in which the adjustment occurs.

The Hong Kong Institute of Chartered Secretaries (HKICS) has issued a practice guide on the management of pre-IPO financing agreements, which recommends that the company secretary maintain a central register of all MFN clauses, including the trigger terms, the adjustment mechanism, and the expiry date. This register should be reviewed at each board meeting to ensure that no new financing round has inadvertently triggered an MFN adjustment.

Actionable Takeaways for CFOs and Investors

1. Model the MFN clause under multiple scenarios before signing. The issuer’s financial model must include a worst-case scenario where the MFN clause is triggered by a subsequent round at a 50% discount, and the resulting dilution must be within the issuer’s acceptable range.

2. Define the trigger terms with absolute specificity. The subscription agreement must list every term that can trigger the MFN clause, including the conversion price, liquidation preference, dividend rate, anti-dilution type, and board representation rights, with no room for interpretation.

3. Negotiate a cap on the total MFN adjustment. The clause should include a fixed floor on the conversion price or a percentage cap on total dilution, and this cap must be disclosed in the prospectus to avoid a regulatory deficiency.

4. Require a mandatory notification period and a legal opinion. The issuer must agree to notify the MFN beneficiary within 10 business days of any subsequent round, and the issuer’s counsel must provide a legal opinion confirming the MFN clause is enforceable under Hong Kong law.

5. Ensure the MFN clause expires before the IPO filing. The clause must have a defined expiry date that falls before the A1 application, and the company secretary must confirm in the listing application that no MFN clause remains active post-filing.