On the entrepreneurial journey, financing is a subject every founder must face. When you finally get the investor’s term sheet (TS, or term sheet) and look at that string of attractive numbers, do you feel your dream has come one step closer? But do not sign in haste—buried in that thick investment agreement is a clause that can ruin you, and it is the valuation adjustment mechanism (VAM).
Today, Lawyer Kevin Jun Lin will help you dismantle this “knife,” so that you can see its edge clearly before you sign.
I. Case Study: A VAM That Triggered RMB 230 Million in Damages
In 2012, the founder Zhang of a well-known restaurant chain brand signed a capital increase agreement with an investment institution and received RMB 50 million in investment. The agreement provided: if the company’s net profit for 2013 fell short of RMB 40 million, the founder would repurchase the investor’s equity at an annualized return rate of 12%.
In 2013, affected by the macro-economic environment and intensifying industry competition, the company’s net profit reached only RMB 28 million, failing to meet the VAM target. The investment institution immediately activated the repurchase clause, demanding that Zhang pay approximately RMB 120 million in repurchase consideration. Zhang was unable to pay, and the investment institution filed suit. After first, second, and retrial-instance proceedings, the court ultimately ordered Zhang to pay the investment institution repurchase consideration and liquidated damages totaling RMB 230 million. Zhang not only lost control of the company, but his personal real estate was also seized, plunging him into a debt crisis.
This case is no isolated incident. In recent years, disputes arising from VAMs have kept rising in number, with amounts in dispute frequently running into tens of millions or even hundreds of millions of yuan. Many founders, when signing a VAM, saw only the short-term benefit of “getting the money,” but lacked a clear understanding of the potential repurchase obligation, and ultimately paid a painful price.
So, what exactly is a VAM? Is it really “nine losses out of ten bets,” as the legend goes? And as a founder, how should you protect yourself in negotiations?
II. What Is a VAM
(1) Definition and Essence
A VAM, professionally termed a “valuation adjustment mechanism” (Valuation Adjustment Mechanism, VAM), is an agreement designed by the investor and the financier when concluding an equity financing agreement, to address the uncertainty of the target company’s future development, information asymmetry, and agency costs between the parties. It contains provisions such as equity repurchase and monetary compensation to adjust the valuation of the target company in the future.
In plain terms, a VAM is a “gamble” between the investor and the founder: the investor gives you money, but requires you to promise that the company will hit a certain target in the future (such as performance, an IPO, etc.); if the target is met, everyone is happy; if not, you must pay the price—typically by repurchasing the investor’s equity at a high price, or transferring a portion of equity to the investor for free.
(2) Background of the VAM
The VAM originated in U.S. private equity investment practice and rapidly gained popularity after being introduced to China in the 2000s. Its underlying logic is:
- Information asymmetry: the founder understands the company’s true situation better than the investor, and the investor needs a mechanism to restrain the founder from “telling stories.”
- Valuation divergence: founders always estimate the company’s value optimistically, while investors are relatively conservative; the VAM is the product of a compromise between the two sides.
- Incentive alignment: through the VAM, the founder’s interests are deeply tied to the company’s performance, preventing the founder from “lying flat after taking the money.”
In essence, a VAM is a risk-allocation tool. Through it, the investor transfers part of the investment risk onto the founder. The problem is that many founders did not fully appreciate the seriousness of this risk when signing.
III. Common Types of VAMs
In practice, VAMs can mainly be divided into the following types:
(1) Performance-Based VAM
The performance-based VAM is the most common form, using the target company’s operating performance over a future period as the VAM target. Net profit, operating revenue, and user numbers are typically used as assessment metrics.
For example: the agreement provides that the target company’s net profit for 2025 shall not be less than RMB 50 million; if the actual net profit is below 80% of that amount, the founder shall make a cash compensation to the investor according to the following formula:
Cash compensation amount = investment amount x (promised net profit – actual net profit) / promised net profit
The risk of a performance-based VAM lies in this: a startup’s operating performance is affected by many factors such as the macro-economy, industry cycles, and market competition; even if the founder does everything possible, they may still “lose the bet” due to force majeure.
(2) IPO-Based VAM
The IPO-based VAM, also known as a listing VAM, requires the target company to complete a listing within an agreed period (typically on the A-share, Hong Kong, or U.S. market), failing which the founder must repurchase the investor’s equity.
The IPO-based VAM clause is typically phrased as follows: “If the target company fails to complete a qualified listing before December 31, 2026, the investor shall have the right to require the founder to repurchase all or part of the company’s equity held by the investor at the investment principal plus simple/compound interest at an annualized rate of 8%-15%.”
The IPO-based VAM carries even greater risk. Because whether a company can list depends not only on its own performance, but is also severely affected by uncontrollable factors such as the capital market environment, regulatory policy, and review pace. In recent years, as A-share IPO review has tightened, many companies that signed VAMs have been forced to clean up their VAM clauses before an IPO, or the founders have had to bear huge repurchase obligations.
(3) Other Types of VAMs
In addition to the two main types above, the following VAM forms also exist in practice:
- Milestone VAM: uses product R&D progress, technological breakthroughs, or signing of major customers as the VAM target.
- Anti-dilution VAM: provides that the valuation of subsequent financing shall not be lower than that of the current round, otherwise the founder must compensate the investor with equity.
- Founder full-time service VAM: provides that the founder shall not leave the company within a certain period, otherwise a repurchase is triggered.
IV. Legal Validity of VAMs: From the “Hairun Case” to the “Nine Minors Minutes”
The legal validity of VAMs is one of the most controversial topics in China’s equity investment legal practice. Its evolution has gone through three stages:
(1) Stage One: The “Hairun Case” Era—Valid Against Shareholders, Invalid Against the Company
In 2012, the Supreme People’s Court established the adjudication rule in the “Hairun Case” (Hai Fu case): a VAM between the investor and the company is invalid because it harms the interests of the company’s creditors; a VAM between the investor and the shareholders is valid.
The core logic of this rule is: if the company bears the VAM obligation (such as repurchasing equity or making cash compensation), in substance it amounts to the company distributing profits to, or reducing capital for, the investor, which may harm the interests of the company’s creditors, and is therefore invalid. By contrast, where a shareholder personally bears the VAM obligation, it is a matter of autonomy of will among shareholders and does not harm the interests of third parties, and is therefore valid.
(2) Stage Two: From the “Huagong Case” to Judicial Loosening
In 2019, the High People’s Court of Jiangsu Province rendered a breakthrough judgment in the “Huagong Case,” holding that a VAM between the investor and the company may be valid where it complies with the capital maintenance principle under the Company Law. Thereafter, some local courts began to attempt to recognize the validity of VAMs between companies and investors, but the adjudication standards varied.
(3) Stage Three: The “Nine Minors Minutes”—the Current Adjudication Rule
Article 5 of the “Minutes of the National Courts’ Civil and Commercial Trial Work Conference” (the Nine Minors Minutes) [on “VAM” with the target company] provides: where an investment agreement concluded between the investor and the target company contains a “VAM,” and no statutory ground for invalidity exists, the people’s court shall not uphold the target company’s claim that the “VAM” is invalid merely on the ground that it contains an equity repurchase or monetary compensation provision. However, where the investor claims actual performance, the people’s court shall review whether it complies with the mandatory provisions of the Company Law on “shareholders’ prohibition against withdrawing capital” and on share repurchase, and decide whether to uphold the investor’s claim.
Where the investor requests the target company to repurchase equity, the people’s court shall review it in accordance with Article 35 of the Company Law on “shareholders’ prohibition against withdrawing capital” or Article 142 on share repurchase. Upon review, if the target company has not completed the capital reduction procedure, the people’s court shall dismiss the investor’s claim.
Where the investor requests the target company to bear a monetary compensation obligation, the people’s court shall review it in accordance with Article 35 of the Company Law on “shareholders’ prohibition against withdrawing capital” and Article 166 on profit distribution. Upon review, if the target company has no profit or its profit is insufficient to compensate the investor, the people’s court shall dismiss or partially uphold the investor’s claim.
Article 5 of the Nine Minors Minutes establishes a “binary approach” to reviewing the validity of VAMs:
- Validity level: an agreement for a VAM between the investor and the target company is, in principle, valid and is no longer directly held invalid on the ground of “harming creditors’ interests.” This reflects respect for the parties’ autonomy of will and accords with Article 143 of the PRC Civil Code on the valid elements of civil juristic acts.
- Performance level: a valid agreement does not mean it is necessarily enforceable. Where the investor requires the company to repurchase equity, it must comply with the Company Law’s provisions on capital reduction; where it requires the company to make a cash compensation, the company must have distributable profits.
This means: a VAM between the investor and the founding shareholders is generally held valid and enforceable so long as there is no fraud, coercion, or manifest unfairness; a VAM between the investor and the company, although valid as an agreement, faces obstacles of capital reduction procedures or profit distribution in actual enforcement.
V. Impact of the Newly Revised Company Law on VAMs
The newly revised Company Law, effective July 1, 2024, has a significant impact on the performance of VAMs, mainly in the following respects:
(1) On the Capital Reduction Procedure
Articles 224 and 225 of the newly revised Company Law impose stricter requirements on the capital reduction procedure. A company’s repurchase of investor equity must first complete the capital reduction procedure, which requires a shareholders’ resolution, notice to creditors, public announcement, and other steps—time-consuming and uncertain.
In practice, many VAM clauses between investors and companies, though valid, are dismissed by the court because the company cannot complete the capital reduction procedure. This is also why many investors prefer to sign VAMs with the founders personally rather than with the company.
(2) On Accelerated Maturity of Shareholders’ Capital Contributions
Article 54 of the newly revised Company Law provides that where a company is unable to repay its due debts, the company or its creditors may require shareholders who have subscribed capital but whose contribution period has not yet expired to pay in their capital in advance. This provision may increase the founder’s debt-repayment pressure after a failed VAM.
(3) On Horizontal Piercing of the Corporate Veil
Paragraph 2 of Article 23 of the newly revised Company Law establishes the horizontal denial of corporate personality. If a founder evades VAM debts by transferring assets through related-party transactions, the court may deny the independent personality of the affiliated companies and impose joint and several liability.
VI. Practical Points: Analysis of Core VAM Clauses
When reviewing a VAM, founders should focus on the following clauses:
(1) VAM Target and Assessment Criteria
Whether the VAM target is reasonable directly determines the probability of “winning the bet.” Founders should note:
- Indicator type: prefer operating revenue over net profit as the assessment metric, because net profit is more affected by costs and expenses and is less controllable.
- Assessment caliber: clarify whether net profit is calculated before or after deducting non-recurring items, and whether it includes non-recurring gains such as government subsidies.
- Buffer zone: strive to set “low, medium, and high” tiered targets corresponding to different compensation ratios, avoiding the extreme result of “all or nothing.”
(2) Compensation and Repurchase Methods
The consequences of a failed VAM usually take two forms:
1. Equity compensation (equity dilution): the founder transfers a certain proportion of equity to the investor for free. The advantage of this method is that it involves no cash outflow; the disadvantage is that the founder’s equity ratio is diluted, possibly resulting in loss of control.
2. Cash compensation or equity repurchase: the founder pays cash compensation to the investor, or repurchases the investor’s equity at the agreed price. This method directly creates a cash payment obligation and exerts the greatest financial pressure on the founder.
Risk warning: founders should avoid, wherever possible, undertaking VAM obligations with personal joint and several liability. If they must, they should strive to set a liability cap, such as “limited to the value of the equity held by the founder in the company” or “limited to a certain multiple of the investment principal.”
(3) Repurchase Price and Interest Rate
The repurchase price clause directly determines the amount of damages upon a failed VAM. The common repurchase price formula is:
Repurchase price = investment principal x (1 + annualized return rate x investment term) + declared but unpaid dividends
The negotiation room for the annualized return rate is typically between 8% and 15%. Founders should note:
- strive for simple interest rather than compound interest;
- clarify the calculation method of “investment term” (actual days/365 or rounded up by year);
- require a cap on the repurchase price to avoid unlimited accumulation.
(4) Grace Period and Remedies After Trigger
In practice, strive to set the following protective clauses:
- Grace period: where the VAM target is not met, grant the founder a 6-12 month rectification grace period.
- Cure right: allow the founder to perform the repurchase obligation by alternative means (such as introducing a new investor in the next round to take over).
- Installment repurchase: if repurchase is triggered, allow the founder to pay the repurchase consideration in installments rather than in a lump sum.
VII. Core Risks Facing Founders
(1) Risk of Unlimited Joint and Several Liability
Many investment agreements require the founder to bear personal unlimited joint and several liability for the repurchase obligation. This means that even if the company goes bankrupt and is liquidated, the founder must still perform the repurchase obligation with all of their personal property, including personal real estate, savings, and future income. Zhang’s RMB 230 million damages case is a typical example.
(2) Risk of Debts Incurred by the Marital Community
Under the relevant provisions of the Marriage and Family Book of the PRC Civil Code, debts incurred from jointly engaging in production and business operations during the marriage are, in principle, debts of the marital community. If a VAM fails, the founder’s spouse may likewise bear the debt-repayment obligation.
(3) Risk of Loss of Control
If equity compensation is used to perform the VAM obligation, the founder’s shareholding ratio will be substantially diluted. In extreme cases, the founder may lose control of the company, or even be squeezed out by the investor.
(4) Risk of Chain Default
If the company has introduced multiple rounds of investors, and the investment agreements of each round contain cross-default clauses, one failed VAM may trigger simultaneous repurchase requests from all rounds of investors, creating a “run” effect that directly leads to the company’s capital chain breaking.
Major risk warning: founders must not take the repurchase obligation in a VAM lightly just because it is a “future obligation.” In judicial practice, courts generally uphold investors’ claims requiring founders to perform repurchase obligations, and the repurchase price is usually calculated as agreed, without discretionary reduction on account of the company’s operating difficulties. Once a VAM fails, the founder may face the legal consequence of ruin.
VIII. Action Recommendations: How Founders Can Protect Themselves
Five must-do items before signing:
1. Assess the achievability of the VAM target: do not be carried away by the joy of financing. Ask the finance team to run a stress test based on conservative assumptions, to ensure that the VAM target has a high probability of being met even under adverse scenarios. If the probability of achievement is below 70%, it is recommended to renegotiate.
2. Strive for the “VAM target” to be borne by the company: although, after the Nine Minors Minutes, there are obstacles to the performance of VAMs between investors and companies, having the company bear the VAM obligation can still isolate the founder’s personal risk from the company’s risk. At the very least, strive for the founder to bear only “supplementary liability” rather than “joint and several liability.”
3. Set a liability cap and isolate assets: expressly agree in the agreement that the founder’s repurchase liability is capped at some limit (such as the value of the shareholding, or twice the investment principal). At the same time, establish a proper legal separation between personal and family assets before financing.
4. Add force majeure and changed-circumstances clauses: expressly agree that where failure to meet performance is caused by force majeure such as the macro-economic environment, changes in industry regulatory policy, or natural disasters, the founder is exempt from the VAM obligation.
5. Engage a professional lawyer to participate in negotiations throughout: do not let only financial advisors or FAs review the legal clauses. VAMs involve complex legal relationships and risk allocation and must be reviewed clause by clause by a professional lawyer who proposes amendments. The legal fee is negligible compared to the cost of a failed VAM.
IX. Conclusion
A VAM is a double-edged sword. For the investor, it is an important tool to control investment risk; for the founder, it may be the last straw that breaks the camel’s back.
Lawyer Kevin Jun Lin has seen too many founders trapped by VAMs. Many of them were not insufficiently hardworking, but merely failed to fully appreciate the full picture of the risk when signing the VAM. Every clause in a financing negotiation may have a decisive impact one day in the future.
As a founder, while enjoying the development boost that capital brings, please stay clear-headed: the investor’s money is not given for free, and behind every investment there is consideration. See that “hidden knife” clearly, so that you can walk the entrepreneurial path more steadily and further.
Further Reading
If you need professional support in shareholder agreements, investment term review, or equity disputes, please contact Lawyer Kevin Jun Lin (Shenzhen Corporate Lawyer) for a one-on-one consultation.
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