EXCERPT:
Classification of VAM Clauses,Commonly‑used VAM clauses fall into the following categories:,Equity adjustment,Monetary compensation,Equity dilution,Transfer of controlling power,Equity repurchase,Equity incentive,Equity preference rights
Common Clauses and Risk‑Control for Valuation Adjustment Mechanism (VAM) Agreements
The Valuation Adjustment Mechanism (VAM, commonly known as “bet‑on agreement”) widely adopted in China’s venture‑capital sector traces its origin back to the Performance Ratchet Clause used in Western PE/VC investment transactions. Originally, ratchet clauses were protective provisions crafted for early‑stage investors to guard against equity dilution when a company brings in new subsequent investors.
Following China’s accession to the WTO, large‑scale inflows of overseas venture capital coincided with China’s rapid economic expansion. Many enterprises were in urgent need of capital for market expansion. Ratchet provisions evolved in China into VAM agreements, which may appear highly unfair to founding shareholders. This phenomenon is largely market‑driven: amid high‑speed economic growth and untapped market niches, entrepreneurs were generally optimistic about corporate prospects and thus willing to accept seemingly one‑sided VAM terms. Morgan Stanley incorporated VAM clauses into its investment contracts for Mengniu Dairy (2002) and Shanghai Yongle Electrical Appliances (2005), as did Carlyle in its 2005 investment in Xugong Group.
Classification of VAM Clauses
Commonly‑used VAM clauses fall into the following categories:
- Equity adjustment
- Monetary compensation
- Equity dilution
- Transfer of controlling power
- Equity repurchase
- Equity incentive
- Equity preference rights
Typical Clauses under VAM Agreements
IPO Timeline Clause
High P/E ratios in China’s secondary market normally deliver favorable valuations, so many investment funds regard IPO as their ultimate exit channel. Some small‑and‑mid‑size private‑equity funds set NEEQ (National Equities Exchange and Quotations) listing milestones as VAM triggering events, referred to as NEEQ‑listing VAM.
Once a company initiates IPO procedures, VAM provisions deemed by regulators to jeopardize shareholding stability or operating performance must be terminated. Termination of VAM creates uncertainty for PE/VC investors: the company may have filed IPO materials yet fail to pass CSRC review. To address this risk, PE/VC investors often formally submit documents confirming VAM termination to regulators while executing separate private “conditional reinstatement” agreements. Under such side agreements, original VAM obligations revive if the IPO ultimately fails.
Anti‑Dilution Clause
This provision is the original ratchet clause. It ensures that equity interests obtained by new investors making equal‑value investments subsequent to the initial investor shall not exceed those held by the initial investor, insulating the initial investor’s equity percentage from dilution triggered by new‑investor entry. Depending on the negotiating leverage of original shareholders, anti‑dilution protection takes two forms: full‑ratchet clause and weighted‑average ratchet clause.
Preferred Dividend Right Clause
Where agreed among the company, controlling shareholders and original shareholders, annual net profits shall first distribute dividends to PE/VC investors at a specified multiple of their invested capital ahead of other shareholders.
Pre‑emptive Right for New Issuances
Prior to IPO, if the company intends to issue additional shares, PE/VC investors enjoy priority over other shareholders to subscribe for such new shares.
Liquidation Preference Clause
This clause entitles investors to priority distribution of residual corporate assets over other shareholders upon corporate liquidation. Some variants treat loss of controlling status by controlling (original) shareholders or transfer of a specified percentage of net assets to third parties as a deemed liquidation or dissolution event. Such clauses frequently trigger legal disputes, particularly where they conflict with provisions in the company’s articles of association.
Tag‑Along Right (Co‑Sale Right)
Where founding majority shareholders sell target‑company equity to a third party, investors may participate in the same transaction and sell all or part of their equity on identical price and terms.
Drag‑Along Right (Co‑Sale Obligation)
When an investor sells its equity holdings in the company, it may compel original shareholders to sell their equity concurrently. Investment funds may readily strip original controlling shareholders of control by exercising drag‑along rights.
Veto Right Clause
Investors demand veto power over specified resolutions at shareholders’ meetings or board meetings.
This mechanism applies only to limited‑liability companies. Article 43 of the Company Law stipulates that voting rights at shareholders’ meetings of limited‑liability companies are exercised in proportion to capital contributions, save for contrary stipulations in the articles of association. For joint‑stock limited companies, the one‑share‑one‑vote principle applies mandatorily.
Equity Repurchase Clause
If the company breaches agreed covenants within a specified period, investors may demand repurchase of their shares by the company or original shareholders.
Key practical considerations for this clause:
- A repurchase obligation imposed directly on the company may be adjudged void, as it risks impairing the company’s independent property status, violating the capital‑maintenance principle and prejudicing interests of other shareholders and creditors.
- Where an investment contract in substance grants risk‑free returns to investment institutions, it constitutes “equity in form, debt in substance” (debt disguised as equity).
Answers of the Supreme People’s Court on Several Issues Concerning the Trial of Joint‑Operation Contract Disputes, Item 2 of Article 4: Where an enterprise‑legal‑person or institutional‑legal‑person contributes capital to a joint‑venture entity without participating in joint operation or bearing joint‑venture risks, but recovers principal and interest or collects fixed profits regardless of profit or loss, such arrangement shall be deemed a loan disguised as joint operation in violation of financial regulations, and the contract shall be held void. The contributing party may recover principal, but interest already received or agreed shall be confiscated; the counterparty shall be fined an amount equivalent to bank interest.
Restrictions on Introduction of New Investors
Per‑share subscription prices for future new investors shall not fall below the price paid by existing investors. If new investors subscribe at a lower price, the existing investor’s subscription price shall automatically adjust downward to match the new price, with the premium difference converted into additional corporate shares for the existing investor. This clause originated as a subset of ratchet‑clause arrangements.
Equity Transfer Restriction Clause
Conditions are imposed on equity transfers by contracting parties; transfers may proceed only upon satisfaction of such conditions.
Restrictions stipulated solely within investment contracts constitute purely contractual obligations for the restricted party. Breach triggers contractual‑liability damages but cannot prevent factual changes in the company’s shareholder register. Accordingly, equity‑transfer restrictions are typically incorporated into the articles of association to gain third‑party‑binding effect. In practice, pledges over original shareholders’ equity in favor of investors are also deployed to constrain unauthorized transfers.
Non‑Compete (Non‑Circumvention) Clause
Prior to IPO or M&A exit, majority shareholders and management shall not engage in businesses competing with the company through other entities, affiliates or any other means.
Non‑circumvention provisions are nearly universal in equity‑investment agreements and serve principally to mitigate moral hazard risks posed by original shareholders and management.
Debt‑Disclosure Clause
If the company fails to disclose external guarantees, indebtedness or similar liabilities to investors, investors may claim compensation against the company or relevant shareholders once actual payouts occur.
Corporate external guarantees and indebtedness are highly latent risks. Even thorough pre‑investment due diligence often fails to detect intentional concealment by the investee company.
Performance‑Metric Clause
Binding benchmarks commonly include net profit, operating revenue, market share, store count, output or compound‑annual‑growth‑rate targets. Failure to hit promised metrics triggers remedies including share compensation, cash compensation or equity‑repurchase demands against original shareholders.
Decision‑Right Clause
Where agreed VAM performance targets are unmet, investors obtain majority board seats in the investee company, enhancing their operational‑management control.
Supplementary Provisions
Corporate operating conditions are dynamic. Investment funds should implement full‑process risk management. Many disputes arise where triggering conditions under VAM clauses are satisfied amid changed market circumstances yet both parties take no affirmative action. When conditions further deteriorate, parties litigate or arbitrate. A substantial body of judicial precedents holds that investors are deemed to have waived rights or exceeded exercise periods if they fail to assert contractual remedies after triggering events materialize. Courts also frequently reject damage claims stemming purely from the investor’s own poor business judgment, notwithstanding prior theoretical feasibility of investment objectives.
Therefore, upon occurrence of VAM triggering events, parties should execute supplementary agreements confirming VAM effectiveness and setting revised conditions. Absent such documentation, investment funds must exercise their contractual rights in a timely and rational manner.
|Catogary：Chinese law |Trading and investment
