Valuation Adjustment Mechanisms (VAMs) exist because the acquirer of an asset wishes to reduce risk and seeks to proactively manage the purchase agreement to do so.
Perhaps the financial statements are unreliable, the company itself has questionable revenue streams over the long term but great potential, or maybe the management team is in the middle of a shake up. Especially in China, where disclosure of financials without a display of ‘high likelihood’ to invest is a tall order from the business owner, often an initial investment with a VAM attached is used to gain access to additional information and trust of the management team. So let’s explore the different types of VAMs and their uses…
There are 4 major flavors of VAMs:
1) Financial Measures – these relate directly to the financial performance of the company. If management fails to meet a certain revenue target, for instance, the investor’s equity stake could rise in percentage terms, or the investor could gain extra board seats. If the company meets revenue targets, perhaps the investor will lead another round of investment/funding.
2) Product-related Measures (or Non-Financial Measures) – these might relate to patents around the product(s) in question, for instance. If a patent is granted, then the management receives stock options, if not, no new capital is invested. Could also revolve around output, quality, or product improvement over time.
3) Compensation Measures – if a performance target is not met, management does not receive or cannot pay out dividends, and must first pay investors. When the target is met, the VAM dissolves or management receives a bonus.
4) Stocks/IPO-related Measures – when a target share price (or P/E) is reached, the VAM agreement expires. But if the magic number is not breached by the set date, or the IPO does not come to fruition, then the management might promise to buy back the investor’s equity stake.
VAMs represent ways for the investor to mitigate risk while adding incentive-aligning clauses to the purchase contract. At the end of the day, neither party wants to see the VAM take effect in a negative way and they should be structured with a win-win endgame in mind. This is where it gets tricky…
VAMs are really what separates the ‘art’ from the ‘science’ of valuation in PE, especially in developing economies when financial statements are not as transparent or reliable. A shrewd dealmaker can find the present value of an opportunity at X, but with careful VAM structuring, the deal can take on a completely new scope of possibility and to that investor, with a proper VAM in place, could now be worth Y.
Which of the following above do you think most closely aligns investor and management incentives? Or what combination would you like to see, as an investor, placed upon a management team to inspire top-notch performance?
lol, most these structures mean the CEO takes it even deeper from behind.
This is how P.E truly functions screwing over other shareholders - Anti dilution clauses for start-ups are a classic tool. I've seen founders who have sweated and fought for their business only to find out they worked for absolutely nothing
- Equity ratchets which fail to take into account external factors or natural business cycles. Seen PE firms flip on the ratchet exercise mechanism when a company is having a blip, take a larger slice of the cake and then flip in sunnier times..
You must must have experienced bankers and experienced lawyers when dealing with the sharks
Fairly ignorant to make such a broad statement regarding PE when this really only applies to early stage start-ups and distressed opportunities because the business concepts are either unproven or desperate for capital. Any prudent investor would want to have mechanisms in place to ensure that key milestones were met along with contingencies to protect themselves in a downside scenario. Founders should expect to give up almost half of their business in an initial round as capital is a precious commodity for them as they seek to grow. Nothing wrong with a VC using earnouts in their purchase price negotiations as it should align interests and more fairly value companies with difficult to predict performance.
Fucking VAM.
-Sell-side M&A banker.
The use of VAMs have been very popular among PEs in China. However, in light of this recent ruling, what do you think the future holds for VAMs in China? http://xbma.org/forum/chinese-update-chinese-court-ruled-valuation-adju…
In a nutshell, the supreme court ruled that an VAM is only legal if it is arranged between the investor (PE) and the controlling shareholder of the company as opposed to the company itself. It looks like this nullifies most of the benefits laid out in your post.
So if VAMs are systematically nullified by courts as they are here, what other mechanism can the P.E firms employ to obtain similar outcomes and downside protections?
In the few deals that I have worked on till now, I've seen 1, 3 and 4 being implemented simultaneously in each deal. All of these deals were either start-ups or restructurings and the fund's board and PM have close relationships with the promoters, so it was comparatively less difficult to sell the management on such structures.
Alignment of interests fell into place like a charm once we had these clauses documented. Without exception, every promoter wanted their equity dilution to be minimal, which is rather obvious. Since the projected terminal valuation, and consequently our equity stake was linked to their performance, they had quite concrete incentives to perform well. Indeed, we would tell them in the beginning that for this level of performance, the dilution would be so much. This would give them sort of a benchmark that they would have to beat in order to retain maximum possible stake.
Ut nam rerum sequi error voluptatem cumque. Qui ut recusandae iste culpa soluta soluta. Voluptas nisi saepe laborum odit in. Perferendis magnam modi doloremque est.
Quo quis omnis et delectus expedita quia culpa. Voluptatem voluptatem et esse. Numquam ea accusantium explicabo nihil commodi.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...