May The Agreement Not Be Protected By Chinese Law

2012-08-11   |   by CusiGO

The gambling agreement, with its popular Chinese translation, has been painted with a strong emotional color, and because it is in China, its application has gradually changed.

The lawsuit between Suzhou Haifu investment and Gansu Shiheng, a company to be listed, over the past month has been a hot topic in the PE industry. For this reason, in addition to the rare abandonment of the agreement by both parties, going to court and publicizing the gambling agreement, and because the court found that the gambling agreement between both parties was invalid, it became the first clear judicial case against this in China, which may have a profound impact on VC / PE Investment behavior in the future.

Although Suzhou Haifu’s claim was supported in the second instance, the decision of Gansu Provincial High Court was not based on the violation of gambling agreement by Gansu Shiheng, but on the qualitative analysis of Suzhou Haifu’s “investment is actually loan” and the basic principle of “debt repayment” – gambling agreement, a VC at home and abroad /In the process of the first and second instance, the commonly used interest protection measures of PE industry are all regarded as invalid by the judge because they do not conform to the company law, contract law and other laws and regulations of our country, so Suzhou Haifu is unable to obtain higher compensation according to the gambling agreement.

To a large extent, this indicates that the current domestic VC / PE performance gambling agreements signed with enterprises in investment may not be recognized and protected by Chinese laws in case of disputes. If so, we need to seriously think about why the gambling agreement will have such an impact? Can it really guarantee that the investment package will not make a loss? If it doesn’t work, what should we do when we invest?

The scientific name of the gambling agreement is valuation adjustment mechanism (valuation adjustment mechanism), which originally has a variety of subject matters and operation modes. The purpose of this agreement is to encourage enterprises to create better business performance on the one hand; on the other hand, it is to control risks in the case of information asymmetry, so as to adjust the valuation according to the actual situation of enterprises. The gambling agreement, with its popular Chinese translation, has been painted with strong emotional color. In China, its application has gradually taken shape.

Most of the funds held by VC / PE are provided by LP (limited partnership, the main organizational form of PE), which bears a greater pressure of exit return; while unlisted enterprises are faced with uncertain factors such as industry and policy in the growth process, which makes the possibility of investment loss great. In the past few years, the pursuit of PE by the whole people has made many enterprises hot headed, trying to get more funds through investors’ bidding and high performance commitment; Many investors who lack professional experience get the project as soon as possible, but also give up the careful due diligence in the early stage, choose to obtain the equity of the enterprise through the high amount of shares and gambling terms, and take it for granted that the compensation of the enterprise after the gambling failure is the last straw for stop loss or even profit.

If an enterprise can achieve rapid growth and listing on time, everyone can naturally cash in happily. However, if the environment of the industry and capital market changes, subsequent troubles will follow – the enterprise loses money, the operation will face greater difficulties, and the investors will lose the opportunity of high return; When a company loses its equity, investors may be forced to become major shareholders, but they may not be able to come up with a better way to reverse the situation. What’s more, investors are cheated of their funds by unrealized goals. In the future, not only will they not fulfill their promises, but they also take the initiative to leave a mess for compensation. Even if they write down the gambling agreement with great faith, the investors will have no way back.

Therefore, VC / PE should still return to the origin of value investment, and make more investment in the early project due diligence, and do not blindly follow the optimistic prediction of the enterprise, resulting in the fund being covered. No matter how complete the gambling agreement is or how attractive the payment terms are, they are only incentives and compensation measures, which can’t ensure the smooth growth of the enterprise and the large profits of the investors. Real excellent investors should not be addicted to the paper wealth outlined in the gambling agreement, but should focus on more industry research, more rational judgment and more help enterprises solve practical difficulties.