Silicon Valley Legal Bible（12）Valuation Adjustment Mechanism Agreement
Silicon Valley's treasure trove of forty-two sutras, a legal encyclopedia customized for founders. I am American lawyer Liu Xiaoxiao.
When it comes to betting agreements, I'm sure you're no stranger to them. "Betting is very common in China's venture capital circles, and can even be said to be standard. Baidu encyclopedia says that the betting agreement originated in the United States, and to the betting agreement took a foreign name, Valuation Adjustment Mechanism Agreement, abbreviated as VAM Agreement.
There is a foreign name is necessarily foreign goods? You can try to put the betting agreement (Valuation Adjustment Mechanism Agreement/VAM Agreement) into the Google search, you will find that, indeed, there will be a few decent articles, but when you click in a look, actually are written by Chinese.
In all my time as a venture capital investor in startups, I've never seen anyone sign a VAM Agreement in a local US financing. I even asked a few partners from major US law firms and investment bankers about this, and the answer I got was "Never heard of it".
As a matter of fact, the concept of betting agreement does not exist in the United States at all!
In "Rules of Capital" written by Prof. Zhang Wei of Fudan University, there is an article called "No Betting in Silicon Valley", which is dedicated to "Valuation Adjustment Mechanism", and he found that in Silicon Valley, the most developed place for venture capital investment, the so-called pari-mutuel agreement does not exist.
So, what is a pari-mutuel agreement? Why is the betting agreement so prevalent in China, but completely ineffective in the United States?
In this issue, we will introduce this mysterious concept - betting agreement.
1.Mengniu bets on Morgan Stanley
When it comes to "betting agreements", we have to mention the successful case of Morgan Stanley's investment in Mengniu, which made the betting agreement a hit.
We often say Mengniu and Yili, in fact, these two companies are not a generation, Mengniu was founded in 1999, while others Yili it, listed in 1996 (SSE: 600887).
This reminds me of a consulting once, came up and said "Liu lawyer, our company (HKEx code xxxxxxxxxx)", hey!
OK, back to Mengniu.
At the end of 2001, the establishment of about 3 years Mengniu began to contact Morgan Stanley, at this time Mengniu is still a 3-year-old cow, the most suitable for killing to do beef sashimi to eat, not, that what, the most suitable to do the betting agreement, because betting on it is the future of the bet. If the enterprise has been very mature, very stable, that can bet on the space is very small, just like the roots of the firm, the plate of the giant tree, that corresponds to the imagination is very limited, but for the start-up company, betting on the possibility of ten times a hundred times to return to the capital.
So let's remember here the first key point about betting agreements, which is that they only apply to startups.
After sharpening their knives for more than a year, in 2003, Morgan Stanley and other investment organizations signed two sets of documents with Mengniu:
1.1 Convertible Instruments
The first was a "convertible instrument" under Hong Kong law, in which Morgan Stanley injected 35.23 million dollars, or 290 million yuan, into Mengniu through the convertible instrument. This convertible note is actually a call option on the stock, and its value ultimately depends on the future performance of Mengniu. If Mengniu's future performance is good, the high option value of the convertible note can be realized; otherwise, it will become a piece of paper.
1.2 Betting Agreement
The second set is the betting agreement. Mengniu and Morgan Stanley signed a betting agreement based on performance growth, remember the concept of "growth-based", we will break down the three types of betting agreements in detail.
According to the betting agreement, Mengniu's compound annual growth rate should not be less than 50% between 2003 and 2006. If it fails to do so, Mengniu's management will lose about 60 to 70 million shares of the listed company to Morgan Stanley; if it meets the standard, Morgan Stanley and other organizations will have to come up with their own corresponding share awards to Mengniu's management.
Note what we are talking about here, is the Mengniu management and Morgan Stanley signed a betting agreement, which is the second key point to remember today, that is, the betting agreement is often not signed with startups, but rather tied to the founders of startups, executives, personal "contract of sale".
The result of the story, we should all know, Mengniu performance growth to meet the target, Morgan Stanley's convertible note option value can be realized, Mengniu's management also received share awards.
A win-win situation for both Morgan Stanley and Mengniu.
Note here why I emphasized that they signed two sets of documents when I talked about the Mengniu case, because I want you to realize that the bet between Mengniu and Morgan Stanley was actually the first bet in China's capital market, and it was also a very unusual bet. How can I put it? We haven't heard of a convertible call option in any of the bets we've seen since, and I don't think we've ever heard of an investor giving up his shares to the founder of the company if he loses a bet.
Why? Because at that time the betting agreement in China's capital market is still in the stage of trying, we do not have the number, so they are covering up. In this document, write a little this, in that document, write a little that, and do not dare to write too much. But then the bloodthirsty nature of capital, also let the betting agreement this original on the stage of the trick, still in the stage of barbaric growth in the Chinese capital market, and even more intense.
As to why the betting agreement is an "unseemly trick", we will reveal in the second half of the video.
2.South Beauty bets with CDH Capital
After several years of evolution, the betting agreement has torn off the disguise of the pipa and turned into the naked "Nanjing Treaty", which has made many entrepreneurial stars fall to the altar and lose.
One of the most famous cases is South Beauty betting against CDH.
On September 30, 2008, South Beauty signed a capital increase agreement with CDH Venture Capital, which injected about RMB 200 million and owned 10.526% of the shares of South Beauty. The terms of investment between South Beauty and CDH also have the so-called "betting agreement". Compared with the "performance-based bet" of Mengniu and JPMorgan, CDH is betting on the listing of South Beauty, and if South Beauty fails to be listed in 2012, South Beauty will have to buy back CDH's shares in cash and make up for the reasonable returns in these years.
But right after the contract was signed, the financial crisis hit, and South Beauty's business went from a bustling market to a bustling one.
In 2012, the New Year's Eve, the China Securities Regulatory Commission disclosed the IPO application termination review list, South Beauty is listed, also announced the South Beauty A-share listing road suspended.
South Beauty ran to the Hong Kong stock market in a hurry. But at this time it is also too late.
A shares and Hong Kong shares of the successive failure, South Beauty listing failure of the defeat can no longer be covered up, the betting agreement triggered, and store after store closure of South Beauty, where there is money to repurchase the shares of CDH capital? So there was no way, a European private equity fund CVC, which prefers to invest in the restaurant industry, took the opportunity to plunge in and bought 82.7% of South Beauty at a price of $300 million, in addition to the 10.526% sold by CDH, the rest of the more than 72% of the shares sold by the founder Zhang Lan.
The story ends with CDH Capital cashing out and tycoon Zhang Lan losing everything.
Now, Zhang Lan is still selling hot and sour noodles on air to pay off her debts.
3. Yang Mi's Jiaxing Media bets on Shangshi Pictures
Later, the fire out of the circle of the "betting agreement" also began to spread in the film and television entertainment industry. 2014, just married and gave birth to a child Yang Mi signed a betting agreement worth 300 million yuan of the Shangshi film industry, agreed that Yang Mi's Jiaxing Media must be in the three-year period from 2015 to 2017, to complete the target of 95% of the after-tax net profit index. Otherwise, Jiaxing Media would have to buy back the previous 300 million yuan of Sunseeker Pictures stock, plus a 15% annualized rate.
This signed the betting agreement Yang Mi, also disregarded the post-partum maintenance, crazy business, has taken over the film "He Yisheng xiaojiao", "I am a witness", the TV series "Guchen Qitan", "Dear Translator", and the variety show "Real Men Season 2", "Tomorrow's Children". One's own capacity is not enough, then pull on the newcomer Dili Jeba, the two co-starred in the "Three Lives, Three Worlds, Ten Peach Blossoms" also rely on more than 30 billion airplay for Jiaxing Media to bring a steady stream of wealth. In the end, Jiaxing Media's three-year net profit was as high as 400 million yuan, which exceeded the betting performance and also helped it get a new round of investment.
So Diligent should also thank the betting agreement.
4.Types of betting agreements
From the two cases of Mengniu and Morgan, and South Beauty and CDH, we will find that the contents of the two betting terms are quite different, so in fact, the betting agreement it is in fact a general concept, not a betting agreement is necessarily how to how, the specific bet what, how to bet or a lot of room for change.
4.1 What's in a Gamble
Let's start by looking at what the average bet is about. It's either a bet on listing or a bet on performance.
What does it mean to bet on listing? For example, South Beauty must be listed in 2012, which is a typical bet on listing.
4.2 Ways of betting
Betting on performance, such as the case of Mengniu, Morgan Stanley requires Mengniu compound annual growth rate of not less than 50%, Yang Mi's case, three years after-tax net profit target of 95% is also a kind of betting on performance.
The next step is how to bet on the law, there are three common types.
The first is the equity bet type. If the target company can not fulfill a certain condition, then the investor can get more shares without compensation, Mengniu's case inside the equity bet part.
The second is the cash compensation type. If the target company can't fulfill a certain condition, then the target company will compensate the investor with as much cash as possible, South Beauty and Yang Mi's case both have the cash compensation part.
The third type is the equity buyback type. If the target company fails to fulfill certain conditions, then the investor can ask the target company to redeem the investor's shares, and both South Beauty and Yang Mi's cases contain an equity repurchase component.
5. Legal Recognition of Betting Agreements
This seemingly magical betting agreement is really that good, the person who wins the bet is naturally satisfied, but there is no shortage of cases where the bet is lost and the case goes to court. Let's take a look at how the courts around the world have ruled.
In 2012, the Supreme Court ruled that the bet between the investor and the company was invalid, but the bet between the investor and the original shareholders was valid.
The Blue Bridge Fisheries case decided by the Supreme Court in 2014 similarly ruled that the bet between the investor and the original shareholders was valid.
In 2013, the First Intermediate Court of Beijing found that the bet between the investor and the original shareholders was valid.
In 2013, the Jiangsu Provincial High Court held that the bet between the investors and the original shareholders was invalid.
In 2014, the Jiangsu Provincial High Court found that the bet between the investor and the company was invalid, but the bet with the original shareholders was valid.
In 2019, the "Huagong case" clearly recognized the validity of the betting agreement between the investor and the target company.
After a decade of various judgments, how effective is the betting agreement?In 2019, the supreme court of a "nine people's record", completely to the betting agreement to cover the coffin of the conclusion.
On November 14, 2019, the Supreme People's Court (SPC) issued the Minutes of the Working Conference on Civil and Commercial Trials of the National Courts (Law [2019] No. 254), which took immediate effect. This is the ninth conference minutes issued by the SPC and it focuses on civil and commercial trial work, so it is called the Nine Minutes. Among the conclusions:
There is full support for the betting between investors and founders. That is basically nothing to say, who let you sign a contract of sale, own up to it.
For the betting between investors and start-ups, it is also supported in principle.
But the Nine Minutes also mentions at the same time that the validity of the betting agreement and the execution of the betting agreement are two different things. Valid is not necessarily enforceable. This is basically if you have been in a lawsuit, you know that the case should not only win the trial, but also win the execution, otherwise the win will be in vain.
For example, for the equity buyback type of bet, the Nine People's Chronicle says that this kind of bet is lost on the company to buy back the shares, and the premise of the execution is that the company has to go through the capital reduction procedure. Capital reduction procedures need to be passed by more than 2/3 of the company's shareholders, then the majority of shareholders are certainly unlikely to agree to pass the capital reduction procedures.
As for the cash compensation type, it is even more needless to say that the company has lost the bet and has no money, then how can it have money to compensate investors.
What this means is that it's basically impossible to enforce the company's bets.
So the betting agreement in China basically can only bully the founder of the individual, which is Luo Yonghao in the betting agreement after the loss of a few years of the scene, every time you open WeChat will find a bunch of people in the say "in it? In it?" "Lao Luo, are you there?"
6. No pari-mutuel bets in Silicon Valley.
You've been talking about Chinese law for half a day, but not about the U.S.?
OK, OK, this is the arrangement!
I have actually done a case in California, litigation attorney-led, in which I assisted the equity contract review part, and finally to the Northern California Superior Court, the results of the court did not consider the betting agreement.
So some people will ask, you just said the story of Mengniu and Morgan, Morgan Stanley is not a U.S. investment bank? How can you say that there is no betting agreement in the United States. Note that math has no borders, but the law has borders.
Morgan Stanley can engage in betting agreements in China, but it can't engage in betting agreements in the United States.
This is a result of the different legal systems in China and the United States.
In the U.S., betting agreements are not feasible for two main reasons:
6.1 Fair Market Value (FMV)
In China's equity transactions is not everyone just randomly set a transfer price, what 0 yuan transfer, 1 yuan transfer. Even if you let me consider some financial data, I will take the company's net assets to calculate on the end of the software company, signed a butt of debt, the office on a few tables and chairs, net assets properly negative. This is the common operation of equity transfer price in China. But not in the U.S., the company's valuation must be fair market value (Fair Market Value/FMV), so you want to ask me how to calculate the company's fair market value (Fair Market Value/FMV)? I don't know, and neither do accountants, so you'll have to go to an appraiser to figure it out. It's definitely not something you can figure out with a few numbers on your financial statements, but it's something that uses complex financial modeling and largely takes into account future expectations. So that's why a software company that loses money every day is valued at tens of millions of dollars, while a restaurant that makes millions of dollars in profit a year is only a couple million. For more details, you can go to my "Startup Law Speaks" lecture 8 on valuation.
So once the concept of Fair Market Value (FMV) is limited, the betting leads to the problem that even if the terms of the bet are in effect, the party who is able to obtain the transfer of the shares has to pay the corresponding Fair Market Value (FMV) to buy the shares, otherwise the transfer is illegal.
In other words, there will always be a price for the shares, and there is no such thing as a $0 transfer. This also takes away the incentive for the profiting party of the betting agreement.
6.2 Capital Gain Taxes
Another reason for Capital Gain is, how do I put it? When the company was first established, the price of equity is $0.0001/share, after 3 years, the betting conditions are realized, to transfer the equity, the company's stock has risen to $100/share, then there is a $99.9999/share premium in the middle, for these parts of the person who transferred the shares, they have to pay 20% of the capital gains tax. To put it bluntly, it's a contribution to the state.
This also makes the losing party in the betting agreement lose further.
6.3 The risky nature of equity
Then some people say, you just said these two reasons are the equity transfer of the bet, some bets do not need to transfer equity, just directly return the investor's money plus the reasonable interest in these years on the line. This is also untenable in the United States, why? Don't you think that paying back the money plus a few years of interest is a bit like borrowing? There are two ways to invest money in a company, one is equity investment and the other is debt investment. What are the elements of a debt investment? Guaranteed repayment of interest, but there is no imagination, although the company whether making money or losing money to pay you back these loans, but if the company really broke out, then you can only compared to the principal more than 6% or 8% interest, not followed by the company a step up the possibility of heaven. And what about equity investment? You get the possibility of taking off with the company, but you also take a huge risk that you may not get your money back. So the Chinese betting agreement is essentially contrary to the nature of the equity investment, in the U.S. law such a contract itself can not be established.
Said so much, is to say to you, betting agreement we listen to very wonderful, but in the relatively sound legal system of the United States, capital can play the tart operation, wild way in fact not so much. It's better to start a business and invest according to the rules.
Silicon Valley's 42 chapters, a customized legal encyclopedia for founders. I am Liu Xiaoxiao, a U.S. attorney.
