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Validity of Valuation Adjustment Mechanism ( ”VAM”) Agreement

Q: What is Valuation Adjustment Mechanism ( ”VAM”) agreement?

A: A Valuation Adjustment Mechanism ( ”VAM”) agreement, also known as “Bet-on Agreement”, is concluded between the Private Equity (“PE”) investor and the invested company, agreeing upon some conditions (mostly the future financial performance indicator of the invested companies) by which the investors may exercise the right to adjust the valuation when the conditions are satisfied. The VAM Agreement is widely employed in the PE investment activities in China.

 Q: What terms are set in the VAM Agreement?

  A: Financial performances and non-financial performances (e.g. management destination, technology achievement) could both be taken as the conditions. When the conditions are met, the Investor shall transfer some equity to the target company or its shareholder free or at low price, and in contrast, the investor is entitled to cash compensation or require the invested company or its shareholder to purchase back the equity when the invested fails to meet the conditions.

Q: Why VAM Agreement commonly is adopted?

A: VAM Agreement is usually in favor of the Investor and can mitigate the risk of investment incurred due to the uncertainty of future evaluation of the invested company. In the meanwhile it can inspire the invested company or the management team to strive for IPO.

Q: Is VAM Agreement legally effective and protected by law?     

A: Though VAW Agreement is very common in practice, there is no specific law or regulation that provides guidance on the terms of VAM Agreement. A recent judgment delivered by the Supreme Court brought public attention to the validity of the VAM Agreement.

 Q:  What the case is about?

 A: This judgment is on re-trial of the case of Haifu Investment Co., Ltd. vs. Gansu Shiheng Non-Ferrous Recycling Co., Ltd. and Hong Kong Diya Limited.

In accordance with the judgment, the VAM Agreement is valid if it is concluded between the Investor and the controlling shareholder of the target company, the Investor and the target company on the ground that the compensation commitment made by the shareholder of the invested company for the benefit of the Investor will not impair the interest of the invested company or its creditors, nor is it against any mandatory laws or regulations. However, if the VAM Agreement is made between the Investor and the invested company, it shall be invalid as such agreement enables the Investor to obtain fixed profits of not connecting to the performance of the invested company, which damages the interest of the invested company and its creditors.

 Q:  What is the implication of the judgment?

A:  The judgment of the Supreme Court, to great extent, removed the concerns of investors as it does not overall deny the validity of VAM Agreement. Instead it provides some guidance for the PE investor in concluding the VAM Agreement going forward. The VAM Agreements already existing between the investor and the shareholder of the invested company in other specific cases will not automatically invalidated either.

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