In the practice of equity investment, equity investment and equity financing are two sides of the operation of equity capital. Investors and investees are conflicting parties of interest, and also partners of capital interest. The valuation adjustment mechanism (VAM) is a common investment arrangement in equity investment and financing practice.
The VAM refers to the agreement designed by investors and investees when reaching an equity financing agreement to adjust the valuation of future target companies, including equity repurchase, monetary compensation, etc., for the purpose of solving the uncertainty, information asymmetry and agency cost of future development of target companies.
The concept of a VAM is actually closely related to enterprises. As long as the enterprise involves financing, it will involve a VAM. Enterprises need funds, and they also need to provide investors with confidence, which is also a protection or guarantee. The parties are actually in a community of interests.
In the practice of a VAM, there have been many failures that have had a great impact, which make enterprises realise the bloodiness of capital in a VAM. But there are also many successful cases, and the VAM has always been highly praised in the investment field. Therefore, enterprises should correctly and rationally understand the problems in a VAM, while establishing a conceptual awareness of the mechanism.
Types and subjects of VAM
In practice, a VAM is mainly manifested in: (1) equity transfer; (2) cash compensation; (3) equity dilution; (4) equity repurchase; and (5) equity incentive.
From the perspective of the subject, there are three forms of VAM: (1) between investors and shareholders or actual controllers of target companies; (2) between investors and target companies; and (3) between investors, on the one hand, and shareholders of target companies and target companies, on the other.
VAM validity judicial precedent
There is no regulation on VAMs in China, and there have been controversies about the VAM clauses in investment agreements. The legal status of a VAM in the field of equity investment was not established until November 2012, when the dispute case of Haifu Investment Co Ltd v Gansu Shiheng Nonferrous Resources Recycle Co Ltd, Wisdom Asia Limited and Lubo for capital increase, [(2012) Min Ti Zi No.11], was reviewed by the Supreme People’s Court (SPC) and the final judgment determined that the VAM clauses were partially valid.
Based on this case, two judicial trial rules were basically determined: (1) recognising the validity of VAM between investors and shareholders; and (2) denying the validity of VAM between investors and target companies.
However, in the arbitration award of China International Economic and Trade Arbitration Commission (CIETAC), [(2014) China Mao Zhong Jing Cai Zi No. 0056], the VAM clauses between the investor and the target company were determined to be valid. The arbitration case caused big repercussions in the field of legal theory and practice.
Descriptions on VAM in Minutes of the National Working Conference on the Trial of Civil and Commercial Cases by Courts
On 8 November 2019, the SPC issued the above-mentioned minutes, which basically established the judicial applicable rules of VAMs. The minutes are instructive, and judicial practice generally follows the rules of the minutes.
The minutes clarify the validity of a VAM between the investor and the shareholders or actual controllers of the target company. Regarding whether a VAM between the investor and the target company is valid, and whether it can be actually performed, the minutes discuss the following handling rules.
(1) If no situation of legal invalidity exists in a VAM between the investor and the target company, and the target company claims that the VAM is invalid only on the grounds of equity repurchase or monetary compensation agreement, the people’s court will not support the claim. However, if the investor claims for actual performance, the people’s court shall examine whether it complies with the mandatory provisions of the Company Law on “shareholders shall not withdraw their capital contribution” and share repurchase, and decide whether to support its claim.
(2) If the investor requests the target company to repurchase its shares, the people’s court shall examine it according to the mandatory provisions of article 35 of the Company Law, on “shareholders shall not withdraw their capital contribution”, or article 142, on share repurchase. After examination, if the target company fails to complete the capital reduction procedure, the people’s court shall reject its claim.
(3) If the investor requests the target company to undertake the obligation of monetary compensation, the people’s court shall examine it according to the mandatory provisions of article 35 of the Company Law, on “shareholders shall not withdraw their capital contribution”, and article 166, on profit distribution. After examination, if the target company has no profit, or if the profit is not enough to compensate the investor, the people’s court shall reject or partially support its claim. In future, when the target company has profit, the investor can file another lawsuit for the profit according to the fact.
In summary, although the legal validity of VAMs between the investor and the target company is endorsed by the minutes, in the practice of equity investment, in order to avoid the risk of uncertainty caused by the application of the rules of the minutes in different situations, the investor is likely to choose a VAM with the original shareholders or actual controllers of the target company, unless a VAM with the target company is more profitable than a VAM with the original shareholders or actual controllers of the target company.
However, if a VAM with the target company is required in practice, the investors should follow rules of the minutes, avoid problems involved in the rules of the minutes, and not violate the mandatory provisions of laws and regulations to ensure that the VAM is legal, valid and enforceable.
Wang Yongjing is a partner at DOCVIT Law Firm