º¬Ðß²ÝÉçÇø

The valuation adjustment mechanism (VAM) refers to an agreement designed to address uncertainties, information asymmetry and agency costs between investors and investees in equity financing deals. It includes provisions for equity buyback and monetary compensation to adjust the future valuation of a target company.

Focus and types

The VAM primarily focuses on a target company¡¯s future performance and its timeline for going public.

Typically there are six types of VAM:

1. 1. Equity transfer, which alters equity proportions of the parties involved to compensate certain parties;
   2. Monetary compensation, which provides a cash payment instead of adjusting the equity proportions;
   3. Equity buyback, which allows investors to request a repurchase of all or part of their shares at a price that covers the original investment plus a fixed return;
   4. Corporate governance roles, which involves adjustments to the company’s board of directors, board of supervisors and senior management;
   5. Equity preference, which prioritises investors in profit distribution and in the allocation of remaining assets in the case of company liquidation; and
   6. Other tools, whether direct or indirect, designed by the parties involved targeting the company control and shareholders¡¯ rights.

Legal application

The Minutes of the National Courts¡¯ Civil and Commercial Trial Work Conference specify the legal application for equity buyback and cash compensation, while other types of VAM are to be reviewed on a case-by-case basis, pursuant to the Company Law, the Civil Code and other regulations.

Equity buyback. Even before implementation of the minutes in 2019, judicial practice has seen critical changes in relevant adjudication rules, manifested in a series of cases, from Haifu Investment Co Ltd v Gansu Shiheng Nonferrous Resources Recycle Co Ltd, Wisdom Asia Limited and Lubo in 2012 (the Haifu case), to Jiangsu Huagong Venture Capital Co Ltd v Yangzhou Metalforming Machine Tool Co Ltd in 2019 (the Huagong case).

The Haifu case first anchored the basic rule that VAM agreements with shareholders should be deemed valid, while those with companies should not. The Huagong case discarded the view that VAM agreements with companies should be deemed invalid, generally recognising their validity.

The minutes subsequently reaffirmed the validity of VAM agreements with companies, and distinguished between the validity and performance of such agreements, stipulating that companies must first reduce capital before repurchasing shares.

For investors seeking to recover their investment through capital reduction, the first major obstacle is initiating the capital reduction process. Capital reduction falls under the company¡¯s scope of self-governance. If the company does not convene a shareholders¡¯ meeting to resolve the reduction and conduct subsequent procedures, there are no other effective remedies for investors.

Additionally, obtaining investment returns through capital reduction constitutes a targeted reduction. The Company Law stipulates that a resolution to reduce registered capital is subject to the approval of shareholders representing more than two-thirds of the voting rights.

However, judicial practice generally interprets ¡°reducing registered capital¡± as a proportional reduction based on the original equity structure agreed on by the founders, rather than any disproportionate reduction.

A majority decision on disproportionate reduction is supposed to alter the initial equity distribution, imposing greater risks on certain shareholders and harming their interests. But such disproportionate reduction will risk the resolution being invalidated by the court, in violation of article 21 of the Company Law, which prohibits shareholders from abusing their rights to the detriment of the company or other shareholders.

Therefore, disproportionate reduction requires unanimous consent from all shareholders, or explicit provisions in the company¡¯s articles of association.

The second major obstacle lies in the priority of creditor rights over the disbursement of capital reduction. When the company announces its resolution on capital reduction, its creditors would typically demand debt repayment or collateral. In most cases, this could not be satisfied by the company, eventually making it even harder for investors to recover their investment.

Monetary compensation. The above-mentioned minutes stipulate that when investors request monetary compensation from a target company, the court should review the case according to mandatory provisions prohibiting shareholders from capital withdrawal and profit distribution.

If the review finds that the target company has no profits or insufficient profits to compensate the investors, the court should dismiss or partially support the claim. Investors may file a separate lawsuit when the target company generates sufficient profits in the future.

Pursuant to the Company Law, distributing profits to investors requires unanimous consent from all shareholders or explicit provisions in the company¡¯s articles of association. Any profits distributed to shareholders in violation of these regulations must be returned to the company.

Takeaways

In light of judicial practice, to better achieve the VAM goal, it is recommended that investors designate founding shareholders or actual controllers of the target company as VAM subjects, with the target company serving as the guarantor. Liabilities for breach of contract should also be prescribed to mitigate the risk of non-performance.

In addition, the new Company Law has opened up avenues for constructing VAM terms by introducing mechanisms of dissenting shareholders¡¯ share buyback, targeted capital reduction and classified shares.

Notably, regarding VAM agreements between investors and target companies, the judicial authorities maintain that finance should serve the real economy, investors should bear certain risks, and that the overall interests should be balanced. In practical operations, these principles should be observed by VAM parties in the allocation of rights and risks to achieve win-win co-operation.

Liang Qiang is a director and chief partner at Zhong Ce Law Firm. He can be contacted by phone at +86 185 0132 3758 and by email at liangqiang@zhongcelaw.com
Gong Youchao is a senior consultant at law at Zhong Ce Law Firm. He can be contacted by phone at +86 188 0012 7155 and by email at gongyouchaolawyer@zhongcelaw.com