Legal Analysis Of Valuation Adjustment Mechanism In Pe Investment And Equity Transfer

Valuation Adjustment Mechanism (hereinafter referred to as "VAM"), also namedas “Gambling agreement”, is commonly used as an arrangement method by adjustingthe share percentages between investor and investee, for the purpose of lowering thecost of valuation estimation and investment. Its legal applicability has aroused heatdiscussion in China as the gambling agreement allows in some circumstancesshareholders to obtain investment compensation from company`s profit without legallyrequired procedures, which contradicts with the current China`s company law. Pursuantto the latest decision from the Supreme Court, the effectiveness of the agreementbetween company and investor was denied on the basis of potential abuse ofshareholder`s rights. Note that according to the free will principle the agreementbetween shareholders shall be certainly supported. However, the gambling agreementitself will not necessarily result in infringement of interests of company and company`screditors and this problem shall be resolved on case-by-case basis.Chapter One defines the concept of VAM and its brief development in China, thendiscusses the operation scope and operation mechanism of VAM. Chapter Twodiscusses four legal characteristics of gambling agreement (Value AdjustmentMechanism) as follows, i.e., independence, causation, aleatority and legality. Chapter Three discusses the legal effects and foundation reasons of VAM in order for the veryessence of valuation adjustment. Chapter Four focuses on the applicable scope of VAMin China. First part discusses the feasibility and legality of VAM signed betweenshareholders by illustrating three methods allowed by current company law, second partdiscusses legal obstacles of the VAM signed between investor and the companyincluding the legality of company`s signing contract, whether it infringes the interestsof company and company`s creditors and breaches the equal risk principle. Furthermore,the chapter emphasize that VAM will not necessarily result in the uncertainty ofcompany`s equity structure.Practically VAM has been pervasively applied in PE investment, for example,Mengniu Diary Case, Yongle Electrics Case and the latest Haifu case. The capitalentrance clause, capital adjustment clause and capital exit clause of VAM have positiveeffects on protecting investment interests and encouraging further profit of the company.In order to assimilate VAM (gambling agreement) into domestic legal system, it is hightime to connect to mature overseas markets and draw up similar rules and regulationslike Preferred Shares. The permission and assimilation of VAM will bridge the gapbetween different legal systems, affect the direction of research of company law,facilitate most of domestic private enterprises to seek outside investment and contributeto build the prosperous domestic capital market.