Using valuation adjustment mechanisms in M&A deals

Valuation adjustment mechanisms, or VAM agreements, have been employed in mergers and acquisition deals. VAM agreements were first used in private equity and venture capital, and have been most commonly used in M&A transactions with large premiums.

VAM agreements are principally used in these translations because of the asymmetrical state of information. Specifically, when making a proposal to a target company, the investor usually fail to fully understand the financier’s situation due to this asymmetry, even where the investor has engaged professional services to conduct due diligence into the company.

In their investment agreement, an investor will set out the value adjustment triggering conditions in order to protect their interests. Once these conditions are met, both the investor and the financier exercise their rights to adjust value based on mutual agreement to pay the damages, either to the investor due to high valuation or to financiers due to low valuation.

The meat of an agreement

Choosing a proper entity is key to securing the validity of an agreement. VAM agreements generally are between an investor and a target company, its shareholders or its actual controller(s). To ensure the agreement’s legality, the other party should not be the target company itself but its major shareholders or actual controller(s). Common practice in China is to employ a value adjustment mechanism on the financial performance or share offering of a target company.

In practice, VAM agreements that have been used most widely in equity investment are those on financial performance. In these, the financial performance of the target company (e.g. net profits, compound annual growth rate) is specified for a period in the future. If the financial performance falls short, the target company and its original shareholders or actual controllers should compensate, and vice versa. Compensation is fulfilled in cash or equity.

VAM on share offerings focuses on whether the target company can be listed in a specified period of time. If the target company fails to do so, investors are entitled to repurchase shares from the original shareholders. The formula for calculating the value of repurchased shares is set out below:

Investment value + (investment value × investment term × bank loan interest rate during that term)

The VAM agreement automatically becomes invalid when the target company goes public.

Judicial acknowledgement

The Supreme People’s Court heard a capital increase dispute between Suzhou Industrial Park Haifu Investment and Gansu Shiheng Nonferrous Metals Recycling and Hong Kong Diya. In the dispute, Haifu increased capital in Shiheng by RMB 20 million (US$3.2 million), giving Haifu a 3.85% stake. Per their agreement, if the net income of Shiheng failed to reach RMB 30 million in 2008, Haifu would be entitled to claim compensation. If Shiheng failed to compensate, Haifu would be entitled to demand that Diya fulfil Haifu’s obligated compensation.

The Supreme People’s Court determined that the VAM agreement between Haifu and Shiheng was invalid on the grounds that the agreement “enabled Haifu to obtain relatively fixed profit from its investment, which deviates from Shiheng’s operational efficiency and impairs the interests of the target company and its creditors”.

The court also determined that “Diya’s compensation commitment toward Haifu is valid and an authentic declaration of the wills of the parties; it neither damaged the interests of the target company and its creditors nor did it violate the prohibition stipulated in laws and regulations”. Thus the performance compensation commitment between investors and the target company’s shareholders is legally valid.

In the equity transfer dispute between Shanghai Ruifeng, Lianyungang Dingfa and Zhu Liqi heard by Shanghai Municipal No. 1 Intermediate People’s Court, the parties specified in their capital increase agreement and supplemental agreements that Ruifeng would invest RMB 30 million and hold a 5.64% stake; if the target company failed to be listed by 31 December 2013, then Ruifeng would be entitled to repurchase in cash all or part of the shares held by Zhu Liqi and Dingfa.

The court found that the repurchase agreement between Ruifeng, Dingfa and Zhu Liqi was valid. The court held that the law encourages transactions, respects party autonomy, maintains public interests and secures the procedural justice of commercial transactions.

These cases demonstrate that courts have acknowledged VAM agreements between investors and shareholders of target companies in either financial performance or share-offering. The courts’ view that the law respects shareholder autonomy and the role of markets in disputing resources is admirable. Their recognition of VAM agreements between investors, shareholders and actual controllers of a target company, based on the determination standards of general validity, should be lauded as well.

Some considerations

There is an opinion that the VAM agreement is an embodiment of the arrogance of capital, a Wall Street-esque plundering of start-up entrepreneurs by financial giants. The authors, however, would hold that, in contrast with traditional civil entities, commercial entities have stronger transactional ability, greater information access and more pertinent capacity for professional judgment.

Peking University professor Jiang Daxing has stated that the law should offer commercial parties equal opportunities for protection as well as equality in protection, rather than securing all parties to enjoy equal profits within a certain transaction. Therefore, he said, when evaluating VAMs, the law should pay closer attention to whether the parties’ transactions are just, rather than simply what results from gambles on VAM.

It is noted that what results from VAM is wholly dependent on both parties’ risk preferences and how they play the game of commerce. Per the principle that holds that parties should shoulder their own risks, VAM agreements between investors and target companies should be deemed as valid if they reflect the genuine will of the parties and do not violate any law or administrative regulation.