In private equity investment, a valuation adjustment mechanism (VAM) with equity or shares as subject matter is in essence about how to adjust the proportions of equity or shares (we shall refer to as equity) of investors and of founders after the investors have made investment in the target company. Free transfer of equity among the investors and founders is certainly one solution, which, however, is usually subject to some restrictions. For example, in a case where equity is state-owned, equity transfer for a VAM is hard to operate given restrictions on transfer of the state-owned assets in terms of prices and methods. Therefore, how to make use of other provisions under the Company Law to effect a VAM is of significance in a realistic sense.
Under the framework of the Company Law, there exist other legal vehicles that can help effect a VAM, including decrease of registered capital, conversion of reserve funds to capital stock, debt-for-equity swaps, as well as imitating classified equity.
Q: How is it possible to effect a VAM by decrease of registered capital? What are the limits?
A: Decrease of registered capital through the particular procedures is permissible under the Company Law. This not only lowers stockholders’ equity proportions, but also refunds investment to them legally. Thus decrease of capital helps refund investment to particular shareholders and lowers their equity proportions based upon the proportions of the refunded amount in the registered capital, and a VAM is made this way. However, such approach has limits as follows:
First, it is affected by the size of the registered capital. Since decrease of registered capital is to refund investment to particular shareholders and reduce their equity in proportion of the refunded amount in the registered capital, in the case of a relatively small registered capital the refundable amount is not sufficient to effect a VAM as expected;
Second, it could trigger repayment of debts in advance and further worsen the financial difficulty of a target company with bad performance. Pursuant to the Company Law, in the case of decrease of capital, security should be extended to the creditors or debts should be repaid in advance. When the VAM is triggered by the target company’s bad performance, if creditors of the target company require repayment in advance for decrease of capital, the VAM will worsen the target company’s financial difficulty.
Q: How is it possible to effect a VAM by conversion of reserve funds into capital stock? What are the limits?
A: In accordance with the Company Law, reserve funds can be converted into increased capital of the company. Generally, when reserve funds are converted into increased capital, shareholders increase their equity accordingly, in the same proportions as that of their shares. Such conversion for equity increase with distinct proportions can have the effect of a VAM, which means that only one shareholder’s proportion of equity is increased when reserve funds are converted into increased capital of the company. And there have been such legal practices in China. However, limits of this approach lie in:
First, the extent to which the VAM is effected relates to the size of the reserve fund. When the size is relatively small, the expected effect can hardly be achieved;
Second, the individual shareholders should bear their tax burden. In accordance with China’s tax policy, an individual should pay income tax for procured equity in a case where statutory reserve fund and discretionary reserve fund set aside from the taxed profits is converted into registered capital. Thus the founders should pay income tax when the reserve fund is converted to the registered capital, to increase their equity proportions.
Q: How is it possible to effect a VAM by a debt-for-equity swap? What are the limits?
A: According to the Administrative Provisions on the Registration of Companies’ Registered Capital, issued by the State Administration of Industry and Commerce, debts can be converted into equity of the company. Investors can make an investment in the target company in the form of debt in the first place, and convert the debt into equity once the conditions are met. Limits of this approach are as follows:
First, there is uncertainty as to the legitimacy of loans extended by the private equity investors directly to the target company. In China, loan agreements among non-financial enterprises are generally deemed invalid and the stipulated interests could have no legal protection;
Second, the proportions of equity converted from debt should be based upon the appraisal of convertible debt. The debt to be converted to equity must be appraised and its contribution amount should not exceed the appraisal.
Therefore, however much the target company’s evaluated value is at the point of time when a VAM is invoked, the proportion of equity from convertible debt should be based upon the appraisal of the debt.
Q: How is it possible to imitate classified equity? What are the limits?
A: Increase and decrease of equity proportions will result in change in the right to dividends, the right to residual assets and the voting power. In a case where the equity proportion is not changed, while the right to dividends, the right to residual assets and the voting power are not related to the equity proportions, the same effect as that of the change of equity proportions will be achieved.
In terms of right to dividends, the Company Law permits the articles of association to stipulate, or all shareholders to agree, that profits can be distributed not based on the equity proportions. Regarding the voting power, shareholders of a limited liability company are permitted under the Company Law to exercise the voting power not based upon their proportions of capital contribution, however there should be one vote for one share in a joint stock limited company.
In terms of right to distribution of residual assets, the Company Law stipulates that distribution of residual assets must be based upon the proportion of equity in a limited liability company, and allows no arrangement otherwise stipulated in the articles of association, or by all shareholders.
The Company Law will not allow arrangements distinct from what it stipulates. The shareholders can still transfer their distributed residual assets among themselves, however such arrangements will bring a tax burden.
The limits of this approach: in a case where the private investor exits by initial public offering, when the same shares with the same rights should be resumed, a VAM effect will not be fully achieved.
Zhang Xianzhong is a partner at AnJie Law Firm
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