There is little empirical work examining contractual innovation in the context of China, which is the second largest venture capital market in the world after the United States. Drawing upon extensive interviews, a hand-collected dataset of investment agreements and judgements of Chinese courts on venture capital disputes, my recently published article ‘Contractual Innovation in China’s Venture Capital Market’ in the European Business Organization Law Review examines a unique contractual design that is common in the Chinese venture capital sector—the valuation adjustment mechanism (‘VAM’).
A VAM (also termed as a ‘bet-on agreement’, pinyin: duidu xieyi) is a contractual arrangement concluded between an investor (typically a venture capital fund) and a portfolio company’s shareholders (typically the largest shareholder, founder or actual controller). In some cases, the company is also included as a party to the contract. The parties agree upon some conditions (future financial or non-financial performance indicators of the portfolio company), following which the investor may exercise a contractual right to adjust the valuation of the company at little or no cost to investors. The specific terms of the VAM agreements vary widely across different companies and industries. If the specified conditions are met, the main mechanisms through which investors may then adjust the company’s valuation or obtain compensation include, for example, compensation in cash or by transfer of equity to the investors at little or no cost.
In essence, VAMs envisage future adjustments to the portfolio company’s valuation by instituting forward-looking mechanisms to alter the relative shareholding or financial positions of entrepreneurs vis-à-vis investors upon the fulfilment of certain conditions or targets. The performance or ‘bet-on’ targets generally fall within three common categories:
- financial key performance indicators (KPI) such as revenue, EBITDA, profits, sales growth rate, CAGR, NAV, turnover volume or market share;
- non-financial KPI such as the quality of products, the acquisition of new patents, the successful industrialisation of new technologies or skills/processes, forming a new strategic alliance or the retention rate of technical staff; and
- the occurrence or non-occurrence of specified events which can correlate with the portfolio company’s performance to different extents, such as mergers & acquisitions (‘M&As’) and initial public offerings (‘IPOs’).
Although VAMs are prevalent in the Chinese market, my empirical studies showed that they are not commonly found in their American, British, Singaporean and Indian counterparts. My article thus seeks to answer three fundamental questions: first, what is the economic function of VAMs? Second, why are VAMs only prevalent in the Chinese market? Third, are VAMs a desirable contractual innovation and under what conditions might VAMs be usefully transplanted into other jurisdictions?
Tapping on the empirical data, this paper concludes that VAMs function as contractual protection to investors. A VAM is adopted to bridge the valuation gap by reducing overvaluation risks for investors and providing incentives for entrepreneurs to perform. An alternative and popular mechanism used in the US is convertible preferred stock. However, Chinese companies, including both limited liability companies and joint stock companies, are not allowed to issue convertible preferred stock under the Company Law of the People’s Republic of China (‘PRC Company Law’). My article suggests that the prevalence of VAMs in China is potentially attributable to: (1) severe information asymmetry in the less informed Chinese market, (2) the absence of convertible preferred stock as an investment mechanism and other excessive legal restrictions over investment tools and contractual mechanisms in venture financing, and (3) insufficient legal protection for investors under Chinese law.
In sum, the article develops a narrative of market participants creating self-help mechanisms through private ordering amidst a chaotic market with inadequate legal protection. Unlike the American venture capital contracts, which are designed for universal and long-term applicability, VAMs specifically address the investor protection issues in the transitional and less informed Chinese market. However, such contractual innovation is unhealthy for the long-term development of party dynamics in the Chinese venture capital and private equity market. It is not a desirable contractual innovation that can be transplanted to other jurisdictions either. Moreover, there are severe problems in using VAMs, such as unrealistic performance goals that reduce mutual trust between the parties, the lack of continuity and further motivation for entrepreneurs post-VAM, the complexity and high transaction cost of structuring a VAM, as well as legal uncertainties relating to the validity of VAMs.
My article also contributes to the literature on the evolution of contracts. It argues that, unlike in the US, where lawyers play an outsized role in driving the process of contractual innovation, contractual protections such as VAMs can also be highly influenced by investors who are seeking to protect themselves. More specifically, it is suggested that Chinese investors are actively seeking out protective measures and promulgating such norms instead of relying on the expertise of lawyers to do so on their behalf.
Lin Lin is an Assistant Professor at the Faculty of Law of the National University of Singapore.