Valuation Adjustment Mechanism (VAM for short): It is domestically called a "betting agreement", which has nothing to do with gambling. Literally translated as a valuation adjustment mechanism, it is actually a form of option. Through the design of clauses, investors and financiers agree on the rights and obligations of both parties under uncertain future circumstances. A VAM can effectively protect the interests of investors.

Founders may take advantage of funds to carry out ambitious plans and make the enterprise soar, or they may lose all their wealth due to the failure of the "VAM". High returns are always accompanied by high risks.

Typical Successful Case — Mengniu Dairy

In 2003, Morgan Stanley and other investment institutions signed a "convertible instrument" similar to convertible bonds in the domestic securities market with Mengniu Dairy, with a future conversion price of only HK$0.74 per share. They injected US$35.23 million (equivalent to RMB 290 million) into Mengniu Dairy through the "convertible instrument". The "convertible instrument" is actually a call option on stocks. However, the value of this option ultimately depends on Mengniu Dairy's future performance. If Mengniu Dairy's future performance is good, the high option value of the "convertible instrument" can be cashed out; otherwise, it will become a worthless piece of paper. To ensure the realization of the expected appreciation target, Morgan Stanley and other investors signed a VAM based on performance growth with Mengniu's management. Both parties agreed that from 2003 to 2006, Mengniu Dairy's compound annual growth rate (CAGR) should not be less than 50%. If the target is not met, the company's management will lose about 60 to 70 million listed company shares to Morgan Stanley; if the performance growth meets the target, Morgan Stanley and other institutions will reward Mengniu's management with their corresponding shares. In June 2004, Mengniu's performance growth reached the expected target. The option value of Morgan Stanley and other institutions' "convertible instruments" was cashed out, and the stock price of Mengniu Dairy reached more than HK$6 at the time of conversion; the share rewards given to Mengniu Dairy's management were also cashed out. The performance VAM between Morgan Stanley and other institutional investors in Mengniu Dairy made all parties winners.

Failed Case — Yongle Home Appliances

In January 2005, Morgan Stanley and CDH Investments invested US$50 million to acquire 20% of the equity of Yongle Home Appliances at that time, with an acquisition price equivalent to about HK$0.92 per share. According to media reports, after taking a stake in Yongle Home Appliances, Morgan Stanley also reached an agreement with the enterprise: it obtained a warrant right free of charge to exercise a warrant right of about US$17.65 million at a price of about HK$1.38 per share at a predetermined future time. This warrant right is also essentially a call option on stocks. To cash out the value of the call option, Morgan Stanley and other institutional investors signed a "VAM" with the enterprise's management. The prospectus shows that if Yongle's net profit in 2007 (which can be extended to 2008 or 2009) is higher than RMB 750 million, foreign shareholders will transfer 46.9738 million Yongle shares to Yongle's management; if the net profit is equal to the target, this is equivalent to about 4.1% of the total issued share capital of Yongle after its listing (excluding the exercise of the over-allotment option). The calculation of net profit shall not contain any water, excluding any profits from Shanghai Yongle's real estate investment and non-core businesses, and excluding any additional or non-recurring gains. Since the exercise time of the VAM for Morgan Stanley's investment in Yongle Electric Appliances was after 2007, the offering price per share of Yongle Electric Appliances was set at HK$2.25; by November 24, the closing price of Yongle Electric Appliances rose to HK$2.85. Compared with Morgan Stanley's original investment price and the subscription right of about HK$1.38 per share.

Types of Valuation Adjustment Mechanism

1. Equity Betting Type: When the target company fails to achieve the performance standards specified in the VAM, the actual controller of the target company will transfer a portion of the equity to the private equity investment institution free of charge or at a nominal price. Conversely, the private equity investment institution will transfer a portion of the equity to the actual controller of the target company free of charge or at a nominal price. This is the most common type of VAM.

2. Equity Dilution Type: When the target company fails to achieve the performance target specified in the VAM, the actual controller of the target company will agree to the target company issuing a portion of new equity to the private equity investment institution at an extremely low price, thereby diluting the equity ratio of the actual controller of the target company and increasing the equity ratio of the private equity institution within the company.

3. Equity Repurchase Type: When the target company fails to achieve the performance target specified in the VAM, the actual controller of the target company will repurchase all or part of the shares held by the private equity investment institution at a price of the investment amount plus a fixed return.

4. Equity Incentive Type: When the target company fails to achieve the performance target specified in the VAM, the actual controller of the target company will transfer a portion of the equity to the enterprise's management free of charge or at a nominal reserve price.

5. Equity Priority Type: When the target company fails to achieve the performance target specified in the VAM, the private equity institution will obtain specific rights. Such as priority equity distribution right, priority distribution right of residual assets, or certain voting rights, such as a veto right in the board of directors.

6. Cash Compensation Type: When the target company fails to achieve the performance target specified in the VAM, the actual controller of the target company will pay a certain amount of cash compensation to the private equity institution without adjusting the equity ratio of both parties. Conversely, the private equity investment institution will reward the actual controller of the target company with cash.