Performance Ratchet is Enforceable in China Based on Recent Supreme Court Decision
By SEAN TAI
A performance ratchet (also commonly referred to as “valuation adjustment mechanism” or “”in Chinese) is a contractual arrangement among an investor, the target company and typically the company’s largest shareholder or founder to lower the pre-money valuation of the target company if the target company fails to achieve certain performance targets upon which the pre-money valuation is based. Typical performance targets include minimum revenues or earnings in the financial years following the investment. When the target company fails to achieve a performance target, the performance ratchet would commonly:
increase the investor’s equity interest in the target company without a new capital injection (commonly referred to as “equity-based performance ratchet”); or
return a part of the investor’s investment through a cash compensation that is payable by the controlling shareholder and/or the target company without affecting the investor’s equity interest in the target company (commonly referred to as “cash-based performance ratchet”).
The performance ratchet may provide the investor with protection from aggressive projections of the future performance of the target company by its management or existing shareholders, especially where the pre-money valuation of the target company is largely based on such projections. The performance ratchet may also protect the investor in times of a business downturn during which the target company underperforms for an extended period of time.