Contractual Innovation in China’s Venture Capital Market

Abstract

There is little empirical work examining contractual innovation in the context of China, which is the second largest venture capital market in the world, after the United States. Drawing upon extensive interviews, a hand-collected dataset of investment agreements and judgments made by Chinese courts on venture capital disputes, this article examines a unique contractual design that is common in the Chinese venture capital sector—the valuation adjustment mechanism (“VAM”). A VAM provides investors with a right to adjust a portfolio company’s original valuation and to get compensation by cash or equity upon the occurrence of certain future events (such as failing to meet financial or non-financial performance indicators). The prevalence of VAMs in China is potentially attributable to:

(1) severe information asymmetry in the less informed market,

(2) the lack of convertible preferred stock under Chinese law and excessive legal restrictions over investment tools and contractual mechanisms in venture capital financing, and

(3) insufficient legal protection for investors under Chinese law.

This article argues that, unlike American venture capital contracts, which are designed to encourage long-term, sustainable investor-entrepreneur relationships, VAMs are predominantly investors’ self-help mechanisms to address specific and serious investor protection issues in the transitional and less informed Chinese market. Thus, it suggests that the problems regarding investor protection motivating the use of VAMs can be better solved by law reforms such as allowing limited liability companies to issue convertible preferred stock, introducing more legal remedies for minority investors, as well as an improved regulatory environment governing venture financing.

Keywords: Venture Capital, Valuation Adjustment Mechanism, Investment Contract, China, the US