The Origin of Valuation Adjustment Mechanism (VAM)
Generally, a company's valuation should be tied to its profits: multiplying a fixed P/E ratio by the actual profits achieved yields the mutually agreed valuation.
Valuation adjustment mechanisms (VAMs) are essentially unique to China, for two core reasons:
First, founders tend to be overly optimistic about their company’s future prospects. When investors can’t convince them to adopt a more conservative outlook, VAMs are used to hold founders accountable for their predictions. Second, Chinese companies have a history of financial fraud, so VAM agreements sometimes even include clauses that reward founders if no such fraud occurs.
If a company is poorly managed and investors are unable to effectively constrain the founder or timely correct operational issues, an investment that appears promising at the time can still run into problems.