In early 2024, an AI company in Shenzhen that had secured RMB 50 million in Series B funding from a leading institution triggered quite a stir. The founder repeatedly emphasized during the roadshow that its “independently developed underlying AI engine” had been running stably for over 18 months and served dozens of paying customers. Riding on an impressive technical narrative and strong business metrics, the company successfully completed its Series B closing.
However, the investor was shocked to discover during a post-investment technical audit that the core code of the so-called “self-developed underlying engine” had in fact been cobbled together by patching up an open-source project that had ceased maintenance back in 2018; the system architecture contained a large number of third-party dependencies flagged as “CVE high-risk”; the database design was seriously non-compliant, with some form field names still using the founder’s university course-project templates; and, most critically, only two engineers could truly understand the entire system, one of whom had already left in the second month after the Series B closing.
The investor demanded an explanation from the founder. The founder’s response was: “Don’t all startups work this way? Just get it running first.” This attitude caused the investor to lose all trust. The investor ultimately activated the redemption clause and required the company to revalue its technical assets. This crisis of trust became the direct trigger for the company’s subsequent failed financing.
This case reveals a common but long-overlooked issue: technical debt — it is not merely an engineering problem, but a core element affecting the legal relationship of equity investment.
I. The Legal Definition of Technical Debt — From an Engineering Term to a Legal Concept
1. What Is Technical Debt?
The term “Technical Debt” was first coined by software engineering expert Ward Cunningham in 1992 to describe the long-term maintenance costs caused by adopting short-term, expedient technical solutions. In a legal context, technical debt should be understood as: the aggregate of technical defects and technical liabilities existing within a company’s information system that may affect the system’s security, stability, maintainability, or compliance.
A distinction must be emphasized here: not all “less-than-perfect code” constitutes technical debt in the legal sense. What the law focuses on are those technical defects that materially affect the company’s asset value and business continuity. For example:
- Security defects use of dependency libraries with known vulnerabilities, unencrypted transmission of sensitive data, insecure API interface designs, etc.;
- Stability defects lack of exception-handling mechanisms, single point of failure risks, and absence of data backup and disaster recovery plans;
- License compliance defects use of third-party code that violates open-source license terms, or incorporation of GPL-licensed code into closed-source commercial products;
- Data compliance defects data processing methods in the database that violate the Personal Information Protection Law, or failure to implement a user data deletion function;
- Architectural defects system architecture design that fails to meet the performance metrics agreed in contracts or prevents necessary functional expansion.
2. The Legal Basis for the Duty to Disclose Technical Debt
In an equity investment transaction, the founder owes a duty of information disclosure to the investor. The legal basis for this duty mainly arises from the following two dimensions:
The First Layer: Liability for Fault in Contracting. Article 500 of the PRC Civil Code provides: “If a party falls under any of the following circumstances in the course of concluding a contract and causes loss to the other party, it shall bear liability for compensation: (1) feigning the conclusion of a contract to engage in malicious negotiation; (2) intentionally concealing material facts relating to the conclusion of the contract or providing false information; (3) engaging in other conduct that violates the principle of good faith.”
The liability for fault in contracting established by this article requires both parties to the transaction to uphold the principle of good faith during the negotiation stage and truthfully disclose material information relating to the transaction. If the founder deliberately conceals technical debt during the financing roadshow and due diligence, such conduct constitutes “intentionally concealing material facts relating to the conclusion of the contract” and the founder shall bear liability for fault in contracting. The investor is entitled to claim compensation for losses suffered from reliance on the false representations, including due diligence expenses, opportunity costs, and the diminution in value of the investment arising from the exposure of the technical debt.
The Second Layer: Liability for Defects (Warranty). Article 617 of the PRC Civil Code provides: “Where the subject matter delivered by the seller fails to satisfy the quality requirements, the buyer may request the seller to bear liability for breach of contract in accordance with the provisions of Articles 582 to 584 of this Code.” In a share transfer transaction, the company’s equity is the subject matter of the transaction, while the company’s core technical asset—the software system—is a key component of the company’s value. If the company claims to own a “self-developed, high-quality software system,” but what is actually delivered is a substandard product laden with technical debt, this may constitute a failure of the subject matter to meet the agreed quality.
Of course, it should be specifically noted that Article 617 of the PRC Civil Code applies directly to sales contracts. The subject matter of an equity investment transaction is, in form, equity rather than a concrete software product; therefore, the application of liability for defects requires methods of contractual interpretation and purposive interpretation. In practice, however, the “representations and warranties” clause in investment agreements has already created a clear contractual obligation for the disclosure of technical debt, and its legal effect is highly analogous to liability for defects.
Key Provisions at a Glance
Article 500 of the PRC Civil Code (liability for fault in contracting)
Article 617 of the PRC Civil Code (warranty against defects in sales contracts, applied by reference)
Articles 582–584 of the PRC Civil Code (liability for breach of contract and damages)
3. The “Materiality” Standard for Disclosure of Technical Debt
Not every non-compliant piece of code needs to be disclosed. The disclosure obligation required by law is limited by “materiality.” So, what is “material” technical debt? We suggest a comprehensive assessment along the following dimensions:
- Quantitative impact Does the cost of remediating the technical debt exceed 10% of the company’s most recent annual R&D budget? Will it delay the product roadmap by more than one quarter?
- Compliance impact Does the technical debt cause the company to violate existing laws and regulations (such as the Cybersecurity Law, the Data Security Law, and the Personal Information Protection Law)?
- Security impact Does the technical debt constitute an exploitable security vulnerability that could lead to data leakage, service interruption, or system attack?
- Business impact Does the technical debt affect the company’s ability to perform its contractual obligations to customers, or prevent the company from achieving the product milestones promised in its financing plan?
- Intellectual property impact Does the technical debt involve infringement of third-party intellectual property rights or violation of open-source license terms?
In an investment agreement, the “materiality” standard should be quantified and specified as concretely as possible, rather than relying on subjective judgment. For example, it may be agreed that technical debt whose “remediation cost exceeds RMB 1 million” or that “may cause service interruption of more than 4 hours” constitutes material technical debt.
II. The Duty to Disclose Technical Debt — How to Draft the “Representations and Warranties” Clause?
1. The Shortcomings of Standard Representations and Warranties Clauses
Most “representations and warranties” clauses in investment agreements adopt generic templates, and their technology-related statements typically read: “The company owns full ownership or license rights to all intellectual property necessary for its business operations, and such intellectual property is free of any material defects.” Such wording is far from sufficient for the disclosure of technical debt.
The problem is: first, what is a “material defect”? Does a codebase that includes third-party dependency libraries already flagged as high-risk vulnerabilities constitute a “material defect”? Second, founders may subjectively not believe their system has any “defects” — the “just get it running first” mentality leads them to view technical debt as “the norm of entrepreneurship.” This cognitive bias renders generic clauses almost ineffective in actual implementation.
2. Designing a Dedicated Technical Debt Disclosure Clause
In light of the particularities of the software industry, we recommend adding a dedicated technical debt disclosure clause to the investment agreement, containing at least the following elements:
- Disclosure of a technical debt schedule The company and the founder shall disclose in writing, prior to closing, all known material technical debt, including but not limited to: known security vulnerabilities, license compliance issues, technical architecture defects, core modules pending refactoring, and third-party dependency libraries and versions requiring upgrades.
- Attachment of a technical audit report The company shall, before closing, engage a neutral third-party technical audit institution agreed by both parties to issue an audit report, which shall be attached as an exhibit to the agreement.
- Continuous disclosure obligation From the date of signing the agreement to the date of closing, if the company discovers new material technical debt, it shall notify the investor in writing within a reasonable period after discovery (typically agreed at 10 business days).
- “Known/unknown” classification of technical debt Technical debt shall be distinguished into “disclosed technical debt” and “undisclosed technical debt,” to which different legal consequences apply respectively.
3. Designing the Legal Consequences of Breaching the Disclosure Obligation
The legal consequences of breaching the technical debt disclosure obligation should be expressly agreed in the investment agreement. A typical arrangement consists of four tiers:
- Tier 1: Indemnification mechanism The founder shall be liable to compensate the company or the investor for losses caused by undisclosed technical debt. Such losses include, but are not limited to: the direct cost of remediating the technical debt, business interruption losses caused by the technical debt, third-party claims triggered by the technical debt, and the diminution in investment value resulting from valuation adjustment.
- Tier 2: Valuation adjustment If the aggregate remediation cost of one or more undisclosed items of technical debt exceeds the agreed threshold (e.g., 5% of the investment amount), the current round of investment shall automatically be recalculated based on the adjusted valuation to determine the shareholding ratio.
- Tier 3: Triggering of redemption rights If undisclosed technical debt causes material harm to the company’s core business (e.g., the product cannot be launched, or key customers are lost), the investor shall have the right to require the company or the founder to repurchase all or part of its equity.
- Tier 4: Director replacement and governance intervention The investor shall have the right to require replacement of the company’s technical head, or to station a technical governance specialist with veto rights at the company.
III. “Setting Aside” a Portion of the Investment — A Special Budget for Technical Refactoring
1. Why Is a Dedicated Refactoring Budget Needed?
Repaying technical debt requires real money. The compensation cost of a senior software engineer, the expense of setting up a testing environment, the outlay for code review tools, and the opportunity cost of business stagnation during refactoring — these are all tangible capital investments. If the investment agreement does not reserve a dedicated budget for technical debt remediation, the funds paid by the investor may all be diverted to market expansion and headcount growth, while the technical debt continues to deteriorate and ultimately erupts in a concentrated manner at the next financing round or IPO audit.
In practice, we are seeing a growing number of professional investment institutions beginning to stipulate a “dedicated technical refactoring budget” in investment agreements, requiring the company to earmark a certain percentage of this round’s investment (typically 10%–25%) exclusively for the repayment of technical debt, including system refactoring, technology upgrades, security vulnerability remediation, and compliance remediation.
2. Key Points in Drafting the Dedicated Budget Clause
- Budget ratio and total amount Agree on a specific percentage of the investment allocated to technical refactoring (e.g., 15%) or a specific amount (e.g., RMB 7.5 million).
- Scope of use and priorities Specify the scope of the dedicated budget (security vulnerability remediation takes priority over architectural refactoring; personal information protection compliance takes priority over performance optimization), to prevent funds from being diverted to “pseudo-refactoring” — using the refactoring budget to develop new features.
- Approval mechanism for use The use of the dedicated budget must be approved by the investor or a director designated by the investor, ensuring the funds are genuinely applied to the agreed technical debt remediation.
- Disposition of unused funds If the dedicated budget is not fully used within the agreed period, the treatment of the remaining funds (extension of the use period, return to the investor, or use for other agreed purposes).
- Milestones and acceptance criteria Break down the technical refactoring into several milestones (e.g., complete security vulnerability remediation in Q1, complete core module refactoring in Q2), with each milestone corresponding to specific acceptance criteria and fund-release conditions.
3. The Founder’s Perspective: A Dedicated Budget Is Not a Straitjacket
Many founders are resistant to the “dedicated budget” clause, believing it restricts their free discretion over funds. But in the long run, a dedicated refactoring budget is actually a form of protection for the founders themselves: it not only provides institutionalized funding security for the repayment of technical debt, but also sends a positive signal to the next-round investors and potential acquirers — that this company takes the quality of its technical assets seriously and possesses sustainable engineering capability.
In terms of negotiation strategy, we recommend that founders proactively propose the dedicated technical refactoring budget plan and frame it as a “quality commitment” rather than a “constraint.” This not only demonstrates the founder’s emphasis on technical quality, but also helps secure reciprocal concessions from the investor on commercial terms.
IV. The Hidden Cause of “Failed VAM” — Technical Debt and Product Delays
1. How Does Technical Debt Trigger a VAM?
In investment agreements in the software industry, performance-based VAM clauses typically center on product milestones — for example, “release Version 3.0 and achieve no fewer than 100 paying customers within 12 months after investment closing.” However, the true cause of many apparent “product delay” failures is not a flawed market strategy or insufficient team execution, but rather being dragged down by the technical debt incurred early on.
A typical scenario is: the company plans to complete a major upgrade to Product V3.0 within six months. During implementation, engineers discover that, due to design flaws in the system’s underlying architecture dating back to the beginning, the new features require rewriting nearly 40% of the existing code. This means the actual workload is 2–3 times the original plan. Product delay becomes almost inevitable. And only when the product delay triggers the performance compensation obligation under the VAM clause does the founder realize: the performance promised when signing the VAM agreement was built upon a technical foundation full of “hidden pitfalls” that the founder had never fully understood.
2. A Linked Design Between Technical Debt Disclosure and VAM Safety
Based on the risks above, we recommend a linked design in the investment agreement between the disclosure of technical debt and the VAM clause:
- VAM exemption clause If the product delay is caused by the remediation of disclosed technical debt, the investor waives the founder’s VAM breach liability. The key to this clause is that it forces the founder to candidly disclose technical debt during due diligence, because “candor today” is the “golden amulet of immunity tomorrow.”
- Flexible adjustment of the VAM period If the technical audit report shows that the company has a large amount of technical debt to address, the VAM period shall be extended accordingly. For example, if an additional six months of refactoring is technically required, the VAM period is automatically extended by six months.
- Accelerated application for VAM failure caused by undisclosed technical debt Conversely, if the VAM failure is caused by undisclosed technical debt, the relevant legal consequences apply with greater severity — e.g., the repurchase price drops to a lower ratio, and the founder’s equity lapses at an accelerated pace.
3. Managing the Evidence Chain for Product Delays
When a VAM dispute enters litigation or arbitration proceedings, the causal link between technical debt and product delay becomes the core contested issue. The founder will argue that “the delay was due to technical debt,” while the investor may argue that “the delay was due to poor management.” Therefore, day-to-day evidence chain management is crucial:
- Retain minutes of technical review meetings, recording the discovery and handling of technical debt in each version;
- Establish a technical debt ledger to track the identification time, impact assessment, remediation plan, and actual remediation progress of each item of technical debt;
- Code review records and commit logs in the version control system are the strongest evidence to prove that “a lot of time was spent fixing bugs”;
- Third-party technical audit reports carry greater probative weight; it is advisable to engage a third party to conduct a technical audit and issue a written report at key milestones (e.g., after financing closing, before launching a new product).
V. Summary of Practical Takeaways
1. Acknowledge the ubiquity of technical debt and adopt a legal perspective
Technical debt is not the “original sin” — concealment is. Elevate technical debt from an engineering issue to a legal one, and squarely face the contractual liability it may bring.
2. Technical audit in due diligence is indispensable
Financial and legal due diligence can no longer meet the needs of the software industry; technical due diligence should become a standard component of investment decisions.
3. Dedicated disclosure clauses are essential
Separate the disclosure of technical debt from the generic “representations and warranties” clause, and establish quantified disclosure standards and tiered legal consequences.
4. Link the budget with the VAM to close the protection chain
The three mechanisms — the dedicated technical refactoring budget, the VAM exemption for technical debt, and evidence chain management — should operate in coordination to form a complete technical debt management loop.
5. Candor by the founder is the greatest self-protection
At the legal level, candid disclosure of technical debt is not merely passive; on the contrary, it can obtain substantive protection through the “disclosed-means-exempt” mechanism.
Risk Warnings
- Difficulty of proving fault in contracting Although Article 500 of the PRC Civil Code provides the legal basis for liability for fault in contracting, the investor must prove that the founder “intentionally concealed” material facts. In practice, the latter often defends by claiming “I wasn’t quite clear either” or “the technical choices in the early startup phase were not made by me.”
- Limitations on the application of warranty liability The liability for defects under Article 617 of the PRC Civil Code primarily applies to sales contracts; its application in equity investment transactions requires more judicial practice to support it.
- The blurred boundary of “known” technical debt With the proliferation of artificial intelligence and automated code-scanning tools, the scope of technical debt that founders are legally “deemed to know” is expanding — even if the founder subjectively does not know of a certain vulnerability’s existence, if appropriate tools should have been able to detect it, the founder may still be held to have a disclosure obligation.
- Cross-border legal risks of open-source compliance If the company’s software product involves export, the open-source license compliance issues within its technical debt may trigger legal risks under export control regulations.
VI. Lawyer Kevin Jun Lin’s Recommendations
Advice for Entrepreneurs:
- Before financing, proactively conduct a third-party technical audit and provide the audit report as part of the due diligence materials to the investor, demonstrating candor and professionalism;
- In the business plan, set aside a clear budget and time window for technical refactoring; do not plan to allocate all funds to business expansion;
- Establish a technical debt ledger system, update it regularly, and report to the board of directors — this is both a management necessity and future evidentiary protection;
- When signing the investment agreement, strive for a “risk exemption for consequences caused by disclosed technical debt” clause, converting candor into legal protection.
Advice for Investors:
- Incorporate technical due diligence into the standard due diligence process, and select a professional technical audit team with industry experience rather than relying on the subjective judgment of the in-house team;
- Design an “incentive-compatible” disclosure mechanism in the agreement — making the founder safer the more candid they are, rather than more passive;
- A dedicated technical refactoring budget is not a cost but an investment; it is as important as revenue growth in protecting the long-term value of the invested assets;
- In post-investment management, continuously monitor the progress of technical debt remediation and make it a regular agenda item for the board of directors.
Advice for In-House Counsel:
- Establish contract templates and negotiation checklists for technical debt disclosure, translating engineering language into legal language;
- Coordinate the technical team and external technical audit institutions to ensure that technical debt identification during due diligence covers all dimensions of legal risk;
- Specify quantified “materiality” standards for technical debt in the contract, to avoid future disputes in litigation over “what constitutes materiality”;
- Pay attention to insurance products related to technical debt, and explore the possibility of transferring part of the technical risk through insurance mechanisms.
Technical debt to a software company is like the foundation to a building. You can paint pretty wall paint over the cracks, and you can work hard on the leaning floors, but when a new investor stands before you with a survey report, all concealment will be laid bare. Face technical debt candidly, and use legal contracts to keep its impact within a predictable range — this not only protects the investor’s interests, but also protects the entrepreneur themselves, so that they will not lose the company’s future at a critical moment because of the “technical debt” owed in the past.
Disclaimer
This article is for general reference only and does not constitute legal opinion or advice. For specific legal issues, please consult a professional lawyer. The cases in this article are adapted from real events, and the company names and details involved have been anonymized.
Lawyer Kevin Jun Lin
Senior Corporate Lawyer · Industry Legal Practice Expert
💬 Feel free to share your views and reasons in the comments section
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About the Zhenpin Lawyer Team |
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Lawyer Kevin Jun Lin — Today’s Author Doctoral candidate in Civil and Commercial Law at China University of Political Science and Law (in-service). Combining theoretical depth in company law with extensive practical experience, focusing on company law, shareholder disputes, corporate compliance system building, data compliance, and product quality disputes. |
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Lawyer Yan Ge: Founding partner of the law firm, with decades of frontline legal experience, possessing practical expertise across the four dimensions of courts, supervision, justice, and enterprise. |
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Lawyer Lin Bing: 27 years in practice, with a dual background in law and finance, having handled over 2,000 litigation and non-litigation matters. |
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📞 Tel: 0755-82222148 📱 Mobile: 18938871445 (v) 18938871445 (v) 📧 Email: 1160727593@qq.com 🌐 Website: www.zhenpinlaw.com 📍 Address: 40F, Room 4004, Block B, Shenfang Plaza, Renmin South Road, Luohu District, Shenzhen |
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Further Reading
If you need professional support in shareholders’ agreements, review of investment terms, or shareholder disputes, please contact Lawyer Kevin Jun Lin (Shenzhen Corporate Lawyer) for a one-on-one consultation.
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