How to effect a value adjustment for investors under Company Law

In private equity investment, a valuation adjustment mechanism (VAM) with equity or shares as subject matter is in essence about how to adjust the proportions of equity or shares (we shall refer to as equity) of investors and of founders after the investors have made investment in the target company. Free transfer of equity among the investors and founders is certainly one solution, which, however, is usually subject to some restrictions. For example, in a case where equity is state-owned, equity transfer for a VAM is hard to operate given restrictions on transfer of the state-owned assets in terms of prices and methods. Therefore, how to make use of other provisions under the Company Law to effect a VAM is of significance in a realistic sense.

Under the framework of the Company Law, there exist other legal vehicles that can help effect a VAM, including decrease of registered capital, conversion of reserve funds to capital stock, debt-for-equity swaps, as well as imitating classified equity.

Q: How is it possible to effect a VAM by decrease of registered capital? What are the limits?

A: Decrease of registered capital through the particular procedures is permissible under the Company Law. This not only lowers stockholders’ equity proportions, but also refunds investment to them legally. Thus decrease of capital helps refund investment to particular shareholders and lowers their equity proportions based upon the proportions of the refunded amount in the registered capital, and a VAM is made this way. However, such approach has limits as follows:

First, it is affected by the size of the registered capital. Since decrease of registered capital is to refund investment to particular shareholders and reduce their equity in proportion of the refunded amount in the registered capital, in the case of a relatively small registered capital the refundable amount is not sufficient to effect a VAM as expected;

Zhang Xianzhong is a partner at AnJie Law Firm