In investment and M&A deals, valuation adjustment mechanism (VAM) agreements, also known as bet-on agreements, are increasingly used to bind the parties’ interests and drive the target’s performance. However, disputes arising from missed targets are frequent.
Founders and original shareholders who sign personal guarantees with unlimited joint and several liability can fall into deep debt crises, with enforcement even reaching family assets.
The traditional risk control model of “equity pledge plus cash compensation” is no longer well suited to liability ringfencing in more complex deal structures.
How to protect the investor’s legitimate rights while still building an effective risk firewall for founders has become a core legal pain point in investment and M&A. Systematically using an SPV (special purpose vehicle) structure in VAM design offers a new approach to ringfence founder liability and balance interests on both sides of the deal.
Cap liability
Senior Partner
W&H Law Firm
Tel: +86 159 2032 2529
E-mail:
pengguopeng@weihenglaw.com
Looking back at classic capital markets cases, the South Beauty VAM dispute remains a cautionary tale. In 2008, to push restaurant chain South Beauty toward an IPO, founder Zhang Lan brought in CDH Venture Capital and signed a VAM agreement. It provided that if, for reasons not attributable to CDH, the company failed to list by the end of 2012, Zhang Lan would repurchase CDH’s shares.
After the IPO attempt did indeed fail in 2012 for multiple reasons, Zhang personally shouldered a repurchase of RMB200 million (USD29 million) in principal plus substantial interest. The fallout later led to CVC’s leveraged buyout.
The case highlighted the risk arising from tying the founder to the company, and is regarded as a typical scenario of a VAM going wrong.
Similar disputes, such as those involving Galloping Horse Media and Smartisan also show how the traditional VAM model can expose founders to massive risks through personal guarantees with unlimited joint and several liability. They have also alerted the market to the need to redesign VAM structures and draw clearer liability boundaries.
An SPV structure is not new in capital markets, but using it systematically in a VAM to ringfence liability requires careful, technical design. The idea is to reshape the deal structure and align it with the contract terms so the founder’s compensation liability is capped within a defined asset pool, enabling more precise risk isolation.
Instead of the traditional model, where the founder personally holds the target’s equity and bears full liability if the VAM fails, the optimised approach sees the founder set up and control an SPV, a limited liability company.
The SPV holds the target’s equity and, if the VAM fails, the compensation obligation sits with the SPV. This creates an initial legal separation between the founder and the VAM liability.
For the restructured setup to work in practice, it must be matched with properly aligned key terms. This is the core step that allows an SPV structure to actually deliver risk isolation.
Define the VAM obligor. The agreement should expressly provide that the compensation obligor is the SPV, not the founder personally. It can further state that the founder bears a supplementary obligation to the extent of his or her capital contribution to the SPV only if the SPV fails to perform, thus imposing a liability cap for the founder.
Limit guarantee provisions. Instead of having the founder issue a personal guarantee with unlimited joint and several liability, structure the security as a pledge of the founder’s equity in the SPV in favour of the investor, so the exposure is anchored to the value of the SPV equity.
Add an asset segregation statement. The agreement should state that, other than holding equity in the target, the SPV conducts no other business and has no material liabilities, so the VAM exposure is contained at the source.
Payment by instalment and performance linkage. Tie the payment schedule to the target’s achievement of performance milestones, reducing investor risk while providing a trade-off to secure investor acceptance of the SPV-based liability ringfencing.
Include a “priority of repayment” clause. Provide that, upon a compensation trigger, repayment will first be made from funds within the SPV perimeter, such as dividends received by the SPV from the target or proceeds from transferring the target equity, keeping the repayment assets concentrated in the SPV structure.
Greater purposes
Naturally, using an SPV structure in a VAM is not bulletproof, and potential disputes in judicial practice should be managed up front. Some courts may disregard the ringfencing effect on the ground of “debt evasion”, relying on article 5 of the Minutes of the National Courts’ Civil and Commercial Trial Work Conference.
To mitigate this, the parties should preserve a complete documentary record throughout structuring and execution, including legal opinions, negotiation records and performance measurement reports. These materials help evidence that the SPV was adopted as a commercially rational risk allocation tool, rather than a bad-faith attempt to evade liabilities, which strengthens the structure’s legality and reasonableness from an evidentiary standpoint.
In essence, the core value of a VAM is to incentivise the target to meet performance goals and achieve a long-term alignment of interests between investors and the founder, rather than simply to pursue breach damages.
Introducing an SPV “corporatises” the founder’s VAM liability. It caps the founder’s exposure within a controllable scope, reducing the risk that a single failed VAM pushes the founder into an irreversible debt crisis and preserving entrepreneurial vitality. Furthermore, it directs the investor’s recovery rights toward the SPV, a controllable and verifiable asset pool, reducing uncertainty in debt enforcement.
As investment and M&A transactions become more complex, the shift from personal liability to SPV-based liability management is not only a structural optimisation, but also a change in VAM drafting mindset.
When designing VAMs, it is important for senior executives and in-house counsel to fully consider the ringfencing value of an SPV, tailor the structure to the specifics of the target and transaction, and put in place contingency plans to mitigate potential disputes.
Both parties should move away from a zero-sum mindset and use the SPV structure as a bridge for joint risk management and shared upside, so that the VAM becomes an effective tool to drive business growth and align the parties’ long-term interests, rather than a risk trap in the capital markets.
Peng Guopeng is a senior partner at W&H Law Firm. He can be contacted by phone at +86 159 2032 2529 and by email at pengguopeng@weihenglaw.com
