A valuation-adjustment mechanism (VAM), also known as a bet-on agreement (Chinese: 对赌协议), is a common clause in many Chinese private equity merger and acquisition deals.
In this article, we explain how a valuation-adjustment mechanism works, along with a widely-used example that applies to public share offerings.
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What is a VAM?
The VAM refers to a one-way or two-way contractual agreement between an investor and a target company where the target company agrees to compensate the investor if the target company’s performance falls short of certain, pre-specified indicators, and/or the investor promises to compensate the company if the target company’s performance significantly exceeds certain, pre-specified indicators.
What is the Form of Compensation?
Compensation is typically made in cash or equity (i.e. share purchases or repurchases).
What Kinds of Performance Indicators are Used in VAMs?
The performance indicators used in VAMs can be financial (e.g. net income or CAGR) and/or non-financial (e.g. a specified technological achievement) in nature.
In the case of a VAM where the investor is compensated for lower-than-expected target company performance, the VAM is essentially a hedging strategy that can mitigate some of the risks of investment, including those arising from information asymmetry. Target companies that are the counterparty of such a VAM agreement may be willing to contract in order to encourage more upfront funding from investors.
In the case of a VAM where the investor compensates the target company for above-expected performance, the VAM is essentially a speculative strategy for target companies that are relatively confident about their future prospects. Naturally, investors that are counterparties to such a VAM agreement are betting on the target company being overly optimistic about their future prospects.
Example: Share Offering VAM
As an example, we look at VAMs on share offerings, which consider whether or not a target company can go public within a specified period of time.
Simple Case
If the target company goes public within the time period under consideration, the VAM simply expires. Alternatively, if the target company fails to go public within the given time period, the target company may be required to compensate the investor, such as by repurchasing the company’s shares that were sold to the investor or by means of monetary compensation.
More Complex Case
If a clause specifying a certain IPO price is included in a share offering VAM, several scenarios can arise depending on the specific terms of the contract:
Scenario 1: Target Company Goes Public at the Specified IPO Price
The VAM simply expires.
Scenario 2: Target Company Goes Public at a Lower-Than-Specified IPO Price
The target company may be required to compensate the investor, such as through share repurchases or cash compensation.
Scenario 3: Target Company Goes Public at a Higher-Than-Specified IPO Price
The investor may be required to compensate the target company, such as by purchasing more of the company’s shares or by monetary compensation.
Scenario 4: Target Company Fails to Go Public
The target company may be required to compensate the investor, such as through share repurchases or cash compensation.
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