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Preface

As a kind of agreement frequently used by pe/vc circles in China, gambling has developed for nearly 20 years in the practice of investment and financing; However, there are still many disputes about gambling in all sectors of society, including both doubts on business ethics and different opinions on its legal nature. In any case, as a widely accepted means of financing in practice, there is no doubt about it. This paper attempts to clarify the various "crimes" and "achievements" of the bet agreement, and discusses how to prevent the risk of bet from the design of the bet clause.

Legal status of one-on-one gambling as a means of financing in China

Gambling agreement, also known as valuation adjustment mechanism (VAM), is the product of the combination of foreign capital operation and China's investment practice. It is usually reflected in an arrangement in which investors take shares in the target enterprise at a high premium, and the shareholders or actual controllers of the target enterprise make performance commitments, and exercise corresponding rights according to whether the performance goals are actually achieved. In essence, it is a game of interests between investors and financiers to solve the contradiction between the two needs of financiers to obtain funds and investors to avoid risks.

The legal subjects of VAM include investors and financiers, and whether the financiers as the subjects include both shareholders and target companies has not been unified in judicial practice. The objects of the bet agreement include equity, option subscription right, investment amount and other rights and interests. As for the legal nature of the bet agreement, there are many theories, such as lucky contract, conditional contract, option contract and guarantee. Because the bet has the characteristics of the above contract, but it does not meet all the requirements, it is still an anonymous contract according to the current civil code of China.

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In terms of the legal effect of the bet agreement, the "Haifu case" (the dispute over capital increase between Suzhou Industrial Park Haifu Investment Co., Ltd. and Gansu Shiheng nonferrous resources reuse Co., Ltd. [2012] min Ti Zi No. 11]) once established the principle of "gambling with the company is invalid, and gambling with shareholders is effective", which has been regarded as a standard for a long time. However, in recent years after the release of the minutes of the nine people's Congress, the attitude of the Supreme People's court and the local Supreme People's court has gradually changed subtly, from the "Hanlin case" (equity transfer dispute between Qiang Jingyan and Cao wubo [[2016] Supreme faminzai No. 128]) to the "Huagong case" (dispute between Jiangsu Huagong Chuangye Investment Co., Ltd. and Yangzhou Forging Machine Tool Co., Ltd. requesting companies to acquire shares [[2019] suminzai No. 62]), Judicial referees have increasingly abandoned the previous idea of "one size fits all" categorically denying the effectiveness of the contract, and are increasingly considering the substantive enforceability of the contract, reflecting the judicial wisdom of keeping pace with the times.

2. Business owners need to clarify the "good" and "evil" of gambling

The main purpose of gambling is to solve the problem of asymmetric information of investors and form an incentive effect on financiers to achieve "win-win". However, there are a large number of "lose lose lose" gambling cases in practice, which also makes many people in the industry have reservations about it. So, where is the boundary between "good" and "evil" of gambling?

The "goodness" of gambling is obvious: by signing the gambling agreement, the financing party can obtain a lot of funds urgently needed for the early growth of the enterprise, and the agreement on performance goals in the agreement also gives the investor a dose of "reassurance". If the performance goals are set appropriately based on reality, a win-win situation can be achieved. In fact, VAM has played an important role in the success of many enterprises. For example, at the beginning of this century, investment institutions such as Mengniu and Dama bet. The former became an industry giant from a start-up, and the latter also received rich returns. All parties are happy.

At the same time, the "evil" of gambling is also difficult to ignore: in practice, there are a large number of examples of gambling failure, so the financiers lost their money and fell to the bottom of the negative teaching materials are not a few. For example, in the "pony galloping" bet case (Jinyan and CCB cultural industry equity investment fund contract dispute case [[2018] jingminzhong No. 18]), the enterprise bet failed, and the founder also had a heart attack and castration. According to the arrangement of share repurchase in the bet agreement, the widow of the founder should be liable for 200million yuan of debt. This is a nightmare for financiers and their families.

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In fact, the "good" and "evil" of gambling largely depend on the design of the terms of the gambling agreement. We cannot deduce the reason based on the result of the event, so as to fall into the logical trap of hero based on success or failure, but we can judge the general trend from whether the design of the terms of gambling is in line with the objective situation of the enterprise and the market. Summing up the experience and lessons of a large number of gambling cases in practice, the author believes that the standard to judge the good and evil of gambling agreements is whether to take "risk prevention" as the real purpose.

The good faith gambling agreement is to follow the principle of good faith and prevent the risks caused by information asymmetry. Investors do not expect to "win the bet", but to achieve a win-win situation by achieving the expected goal; The malicious gambling agreement is to maliciously set traps in the terms, and even interfere with the operation and management of the target company. Or although there is no obvious malice, the expected goal is far higher than the actual and can not be achieved. As a result, the investor expects the target company to default, so as to achieve the real purpose of obtaining the equity of the target company at a low price or controlling the target company. Of course, there is another situation, that is, the shareholders of the target company unrealistically overestimate the profitability of the company and boast rashly in front of investors. As a result, they can only swallow the bitter fruit and pay for their recklessness.

What points should be paid attention to in the design of three pairs of gambling clauses?

The setting of the core terms of the bet agreement mainly includes two aspects: (1) agree on the criteria for judging the business performance of the enterprise in a certain period of time in the future, such as profit performance, whether to be listed, etc; (2) When the agreed standard fails to be achieved, the management shall compensate the investor for the loss.

When gambling on financial performance, we should pay attention to setting a reasonable performance growth rate; It is better to set the gambling agreement as a repeated game structure to reduce the uncertainty of the parties in the game. The cause of many disputes between PE, VC and the target company is that the major shareholders are too optimistic about the future situation and misjudge it, resulting in too high commitment value.

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In order to reduce risks, multiple stages can be designed in the VAM; The game in the previous stage is to provide research data for the game in the later stage. If the data in the previous stage is not ideal, both parties in the later stage should reduce their expectations or terminate the game to reduce losses. For example, the gambling between Mengniu and Yinglian is divided into two stages. In the first stage, we initially understand the situation, and in the second stage, we adjust the gambling terms based on the first stage, and finally achieve a win-win situation.

For the sake of fairness, the design of the gambling clause should reflect the characteristics of the bilateral contract as much as possible, that is, both parties bear obligations to each other in the gambling agreement, rather than the unilateral performance of one party to the other party. For example, it can be agreed that if the actual profit level of the target company is higher than the valuation, the investor should give the corresponding equity as a reward to the original shareholders. At the same time, if the investor is involved in the operation and management of the target company, it should clarify its responsibilities when the performance goals are not achieved. In addition, it is suggested that both parties make an agreement on the situation where market fluctuations, force majeure and other unforeseen factors affect performance standards, so as to reduce relevant responsibilities.

Finally, as the founder of the company, shareholders should also pay special attention to building a "firewall" between family property and company property, so as to avoid similar situations in the "pony Pentium case" and embarrass their families. For example, it can be clearly agreed in the gambling agreement that if relevant debts occur due to the performance of the gambling agreement, they belong to the shareholders' own personal debts rather than their husband and wife's joint debts; The remaining provisions of the agreement should also be carefully reviewed by professionals to ensure that the shareholders' personal property and the company's property are reasonably and effectively distinguished.

IV. what are the remedies for disputes arising from gambling?

When signing the bet agreement, all parties undoubtedly hope to achieve a win-win situation. However, the market changes rapidly, and it is often the case that the expected performance cannot be achieved, especially when the current epidemic haze has not dissipated and the economy is still in a downward cycle. Once the performance target is not achieved, both parties will go to court. How will the court decide? According to the statistics of the author, the vast majority (more than 80%) of the more than 1000 judicial precedents on gambling that have been published so far are won by the investors, and how the shareholders or actual controllers of the target company protect their rights in accordance with the law is still a difficulty in practice. Therefore, what the author wants to discuss in this section is: what are the legal defenses as a shareholder of the company in the dispute over the bet agreement?

1. If the investor excessively interferes with the company's operation and results in the performance not reaching the standard, it shall bear corresponding responsibilities

Capital operation is different from enterprise operation. In most cases, investors should refrain from impulse and avoid excessive intervention in the operation of the target company, so as to prevent the adverse situation of "laymen leading experts". Therefore, in judicial practice, if the court believes that the failure to achieve the performance of the target company is the result of excessive intervention by the investor, it will not support the investor's request for performance compensation. For example, in the case of contract dispute between Xinhua medical and Chengdu Yingde ([2018] luminchu No. 103), Shandong high court held that as an investor, Xinhua medical's participation in the operation and management of the invested company was not in line with the general practice of the gambling agreement and the general principles of the contract law. Nine defendants should be liable for compensation for the decline in performance caused by market risks; Both parties shall be responsible for the decline of performance caused by internal operation and management, and shall bear their losses in accordance with the principle of fairness.

2. If the investor maliciously contributes to the achievement of the compensation condition, it shall be deemed that the condition has not been achieved

The essence of a gambling agreement is a conditional contract. According to Article 159 of the civil code, a conditional civil juristic act is regarded as a conditional failure if the parties improperly promote the achievement of the conditions for their own interests. For example, in the case of the contract dispute between Jiangsu Ruihua Investment Holding Group Co., Ltd. and Cao KUANPING ([2020] Su 01 min Zhong No. 7618), the Jiangsu high court found that Ruihua company maliciously withdrew 25.79 million yuan of capital contribution, resulting in the target company unable to operate normally, let alone achieve its business objectives. Because Ruihua company defaulted first, the defendant Cao KUANPING has the right to refuse to perform his obligations based on the right of first performance defense.

3. It can be claimed that the exemption can be realized by change of circumstances or force majeure

In recent years, due to the outbreak of COVID-19 and the strict epidemic prevention and control measures in China, the performance of many start-ups has been significantly affected, so they face the risk of gambling failure. In this case, if the company considers defending on the ground that the epidemic constitutes force majeure, it should actively collect corresponding evidence and comprehensively evaluate the impact of the epidemic on performance. If the financing party can prove that the failure of the company's performance to meet the expectations is directly caused by the above force majeure, and it would have been able to achieve the performance goals if it had not been affected by the COVID-19, the court can support the financing party to exempt from gambling liability.

4. Special attention should be paid to the prescription of the right to exercise the gambling agreement

The prescription here includes not only the statutory limitation of action, but also the limitation of exercise of rights agreed by both parties in the contract. The former is three years according to China's civil code, but it can be interrupted after the parties' reminder. Therefore, a more effective way is to set terms in the bet agreement. For example, it is agreed that the investor must make a request for equity repurchase within a specific time after the agreed situation occurs, otherwise it is deemed to have voluntarily given up, So as to achieve the constraint effect on investors. If the investor fails to exercise the right of claim within the time limit, the financing party may invoke the above limitation clause as an effective defense.

Epilogue

There is no doubt about the important role of VAM in the field of pe/vc, but its legal risks are also self-evident. Entrepreneurs should face the above risks when using VAM financing, and carefully design the terms of the agreement from the actual profitability and expected market conditions of the enterprise, in order to achieve a win-win situation. In case of legal disputes due to failure to meet expectations, it is recommended to consult professionals in time to safeguard their legitimate rights and interests.