Valuation Adjustment Mechanism (VAM), also known as the valuation adjustment mechanism, refers to a mechanism designed by investors and financiers when entering into an equity financing agreement to adjust the future valuation of the target company, including equity repurchase, monetary compensation, etc., in order to resolve the uncertainty about the target company's future development, information asymmetry, and agency cost issues between the two parties to the transaction.

A VAM can be entered into between an investor and the founding shareholders or actual controllers of the target company; it can also be entered into between an investor and the target company itself.

I. Legal Provisions

Prior to the "Minutes of the National Court Civil and Commercial Trial Work Conference (the 2019 Nine Civil Minutes)", there was significant controversy over the validity of "VAMs between investors and target companies". Represented by the "Haifu Case", it was held that a VAM with the target company violated the shareholder capital contribution obligations stipulated in the Company Law, and thus the VAM was deemed invalid. However, after the issuance of the Nine Civil Minutes, the practical sector unified its judicial thinking, holding that a VAM between an investor and a target company is not necessarily invalid provided that it complies with relevant laws and regulations including the Company Law.

Articles 5 (2) and (3) of the Nine Civil Minutes stipulate:

Where an investor requests the target company to repurchase equity, the people's court shall conduct a review in accordance with the mandatory provisions of Article 35 of the Company Law on "shareholders shall not withdraw their capital contributions" or Article 142 on share repurchase. After review, if the target company has not completed the capital reduction procedure, the people's court shall dismiss its litigation claim.

Where an investor requests the target company to assume monetary compensation obligations, the people's court shall conduct a review in accordance with the mandatory provisions of Article 35 of the Company Law on "shareholders shall not withdraw their capital contributions" and Article 166 on profit distribution. After review, if the target company has no profits or has profits but insufficient to compensate the investor, the people's court shall dismiss or partially support its litigation claim. If the target company has profits in the future, the investor may file a separate lawsuit based on such fact.

II. Conditions for the Validity of a VAM with the Target Company

Based on the above provisions and combined with the analysis of specific judicial thinking, the following conditions must be met for a VAM with the target company to be valid:

1. True and Legally Effective Expression of Intent

The VAM signed between the investor and the target company shall be a true expression of the intentions of both parties, shall not violate mandatory provisions of laws and regulations, and shall not involve circumstances that may render the agreement invalid such as violating public order and good morals, or malicious collusion to damage the legitimate rights and interests of others.

2. The Articles of Association Do Not Impede the VAM

The provisions of the target company's articles of association and other documents shall not constitute an obstacle to the performance of the VAM, i.e., they shall ensure the effective approval of the future capital reduction procedure.

3. Practical Feasibility of Performance

Combined with factors such as the target company's actual operating performance and financial status, the amount of the repurchase price, and the impact of the payment of the repurchase price on the target company and its creditors, it shall be determined that the target company has practical feasibility to perform the repurchase obligation. The following points may be considered in detail:

• No Harm to Creditors' Interests: For the creditors of the target company, the company's repurchase of shareholders' equity means a reduction in the company's assets, and correspondingly, the company's ability to repay its creditors will decrease. Based on the principle that creditor protection takes precedence over equity protection, the company's repurchase of shareholders' equity shall not affect the rights and interests of creditors.

• No Impact on Normal and Sustainable Operations: After the company repurchases equity, it shall still have sufficient funds to ensure the normal operation of the company.

• Smooth Completion of Internal Procedures: In accordance with the requirements of the Nine Civil Minutes, when a company repurchases shareholders' equity, it must complete the internal capital reduction procedure, which means the company must effectively complete the following procedures:

  • The board of directors formulates a capital reduction plan
  • Approval by a resolution of the shareholders' meeting or general meeting of shareholders
  • Notification to creditors and public announcement (creditors may require the provision of guarantees or debt repayment)

  • Completion of industrial and commercial registration changes

  

III. Risk Tips and Practical Suggestions

In summary, although current judicial decisions recognize the validity of VAMs with target companies, in practice, there are still risks that VAM agreements with target companies cannot be effectively enforced due to cumbersome capital reduction procedures, uncertainty about the distributable profits of the target company, and other reasons.

In this regard, we recommend:

1. Prioritize VAMs with Founding Shareholders or Actual Controllers: When conducting equity investment, investors should still prioritize entering into VAMs with the founding shareholders or actual controllers of the target company.

2. Require Joint and Several Guarantee Liability: If it is necessary to enter into a VAM with the target company due to transaction arrangements, the founding shareholders or actual controllers of the target company should also be required to assume joint and several guarantee liability for the target company's repurchase obligations.

3. Clarify Obligations to Cooperate with Procedures: Clearly stipulate in the VAM agreement that the target company and its shareholders shall take all necessary procedures to cooperate with the target company in performing its VAM obligations, including but not limited to passing shareholders' resolutions on relevant capital reductions.