With M&A transactions typically involving equity investments, investors are increasingly entering into valuation adjustment mechanisms (VAMs) to reduce their risks and recover returns. The Supreme People’s Court (SPC) on 8 November 2019 released its Minutes of the National Work Conference on Civil and Commercial Adjudication by Courts, which defines a VAM as an agreement designed between an investor and a financier when they are reaching an equity-financing agreement, the objective of which is to adjust future valuation of the target company by addressing uncertainty in its development, information asymmetry and agency costs, which includes equity buybacks, monetary compensation, etc.
Before the minutes were issued, there was no consensus on the recognition of the validity of VAMs in judicial precedent or arbitration cases. In the minutes, the SPC formulates handling rules to guide adjudication of the validity of VAMs, particularly those entered into between investors and target companies. But what do these rules tell us about how to ensure VAMs comply with the current judicial guiding opinions?
Validity and performance
With respect to the validity of a VAM, regardless of whether the investor is dealing with the target company, its shareholders, or its actual controller, or any combination of these, there are no statutory grounds that automatically make its provisions invalid. That is to say, if the VAM does not harm the national interest, collective interests, the interests of third parties or the public interest, and does not violate the mandatory provisions of laws or administrative regulations, it should be found to be valid.
If a party to a dispute claims that a VAM is invalid solely on the grounds that it provides for an equity buyback or monetary compensation, the court should dismiss such a claim.
With respect to the performance of a VAM, if the investor, as a shareholder of the target company, aims to require the original shareholders and/or the actual controller of the target company to buy back equity equivalent to its investment percentage, and/or make up the shortfall in its investment returns, this is, in essence, a relative claim, and there is no legal impediment to its performance.
If the investor aims to require the target company to make up the shortfall in its investment returns, the court will reject or partially uphold the claim pursuant to the mandatory provision of article 35, that “shareholders may not illegally withdraw their capital contributions”, and the profit distribution provision of article 166 of the Company Law and depending on whether the target company has any profits.
If the investor aims to require the target company to buy back equity equivalent to its investment percentage, the court is required to conduct a review in light of the mandatory provision of article 35, that “shareholders may not illegally withdraw their capital contributions”, and the restrictions on the acquisition of equity/shares by companies in article 142 of the Company Law, and if the target company has not completed the procedure for reducing its registered capital, it is required to reject the investor’s claim.
It is incumbent upon an investor to enter into a VAM with a qualified counterparty. The minutes set the rules for handling the entry into a VAM by an investor and a target company and strictly distinguish between the “validity” and “performability” of a VAM, that is, even if the agreement is valid, the performance of the VAM commitment is required to comply with the mandatory provision of the Company Law on the buyback of equity/shares or profit distribution.
Accordingly, in order to better realise a VAM clause, when entering into an investment agreement with VAM provisions, the investor should preferentially select the target company’s shareholders, actual controller or connected parties as the party to perform the buyback/compensation obligation of the VAM clause.
If selection of the target company as the party to perform the buyback/compensation obligation of the VAM clause is necessary, consideration needs to be given to the probability of performance of the VAM clause in light of the relevant mandatory provisions of the Company Law.
For example, the investor and financier could further provide for a procedure for reducing the target company’s capital in the VAM and simultaneously amend the company’s articles of association to that effect. To avoid a capital reduction before proceeding with the buyback procedure, the investor could also set a VAM clause that substitutes “equity compensation” by the target company instead of an “equity buyback”.
It is reasonable to set milestones. Due to such issues and obstacles as information asymmetry, uncertain future development, etc., that exist in the course of establishing a VAM investment relationship with a financier, the investor necessarily finds itself in the position of being unable to fully confirm the risks of the investment and its chance of success.
Accordingly, referring to the Model Legal Documents for Venture Capital Investment compiled by the US National Venture Capital Association, domestic investors may draw upon the staged finance mechanism and provide in the VAM for achievement of its goals in stages.
For example, the initial goal is set in the first stage, the second stage interim goal is set based on the completion of the first stage initial goal and, finally, the third stage ultimate goal is set based on the completion of the second stage interim goal.
The advantage of setting the milestones is that if the VAM proves successful, the investor can gradually increase its investment and the financier can continuously obtain financial support; and if the VAM fails, the investor can promptly stop its losses, thus preventing a continuing increase in the risk of the investment failing.
Tang Sulan is an associate at East & Concord Partners
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