Theoretical Study On Vam From Contract Theory Perspective

Value Adjustment Mechanism is a special financial contract provision which iswidely adopted in venture capital industry in China. From the contract theoryperspective, this paper points out that VAM is not the proper covenant for venturecontracting. The venture capitalist persues the more companies-less effort kindinvestment strategy and VAM is really working in terms of VC’s interest. However,the use of VAM would cause inefficient investment and distortion of incentivestowards the entrepreneur and the venture capitalist. The distortion of incentive wouldinduce the entrepreneur to make asset substitution, window dressing to get anotherround of financing. This so-called Value Adjustment Mechanism just can’t make thecorrect adjustment due to bad timing and pricing. On the other hand, the combinationof convertible securities and ratchet provision is considered to be the most effectiveanti-dilution tool. At last, the effect of VAM on venture exit is considered. The VCchooses to exit by IPO more often because they could be compensated in case oflow-value IPO under VAM. This could partly explain different venture exit structuresbetween China and US. Better financing tools like convertible securities will boost theventure capital industry and should be widely adopted.