In the past,the development of the domestic film and television industry was far behind that of Europe, America, Japan, and South Korea, even Hong Kong and Taiwan. One of the reasons was the lack of funding and production. There is high-quality content in Chinese film and television works, but due to various reasons, it fails to be presented perfectly to the audience. With the rise of major domestic film and television companies and the imitation of foreign operating models, capital has been injected into the creation of film and television, driving the prosperity of the industry. In this process, we often see the use of various financial instruments, among which the use of VAM agreement is quite frequent, and has become a common capital operation mode in the film and television industry. Industry insiders compare it to the "marriage" of culture and capital.

The Marriage of Culture and Capital: A VAM Agreement in the Film and Television Industry (Part 1)

Author | Joanna Wang Ai Tiantian

In the past,the development of the domestic film and television industry was far behind that of Europe, America, Japan, and South Korea, even Hong Kong and Taiwan. One of the reasons was the lack of funding and production. There is high-quality content in Chinese film and television works, but due to various reasons, it fails to be presented perfectly to the audience. With the rise of major domestic film and television companies and the imitation of foreign operating models, capital has been injected into the creation of film and television, driving the prosperity of the industry. In this process, we often see the use of various financial instruments, among which the use of VAM agreement is quite frequent, and has become a common capital operation mode in the film and television industry. Industry insiders compare it to the "marriage" of culture and capital.

In this article, we analyze the legal risks and countermeasures related to VAM agreements in the film and television industry from the perspectives of the definition of VAM agreements and the effectiveness of VAM agreements in the film and television industry. The article is divided into two parts, and this part is the first part.

What is a VAM agreement

The VAM , of which English full name is "Valuation Adjustment Mechanism" , originates from private equity investments in the United States. It is an investment agreement reached between the investor and the investee when future business performance is uncertain. Its function is to temporarily put aside uncertain events that cannot be agreed upon by both parties in the transaction, and allow both parties to settle again after the uncertainty disappears. If any agreed matter occur, investors can exercise the VAM agreement to compensate for investment losses; If the agreed matter does not occur, the investee may exercise certain rights to obtain economic benefits as rewards or compensation. From this, it can be seen that the essence of the VAM  agreement is an option, which is a value evaluation method with attached conditions, and promotes the smooth conclusion of the transaction by effectively solving the valuation differences between the investor and the investee..

In terms of legal norms, the "Administrative Measures on Material Asset Restructuring of Listed Companies" promulgated by the China Securities Regulatory Commission stipulates that where the assets to be purchased are evaluated  by using the  method that are based on the expectation of future earnings and such evaluation results are used as the reference and basis for pricing, the listed company shall sign an explicit and feasible compensation agreement with the transaction counterparty regarding the insufficiency of the actual amount of profit in comparison with the predicted amount of profit..

The "Minutes of the National Court Work Conference for Civil and Commercial Trials" (Law [2019] No. 254, hereinafter referred to as the "Ninth Minutes"), combined with past judicial practice experience, provides a relatively standardized definition of "VAM agreement": commonly known as "gambling agreement" in practice, also known as valuation adjustment mechanism agreement, refers to the agreement designed by the investor and the financing party at the time of entering into the equity financing agreement to adjust the valuation of the target company in order to solve the uncertainty, information asymmetry and agency costs related to the future development of the target company by the share repurchase or monetary compensation etc.

Industry Status

（1） Industrial chain

The upstream of the film industry chain is the production link, mainly including script development, project approval, and film production. At present, the entry threshold for the film production is relatively low. According to the "Regulations on the Administration of Movies" and other relevant regulations, the regulatory access measures involved in the film industry's production field mainly include three aspects: film production qualification access permit, film production administrative permit, and film content censorship permit. The film producers mainly include original author side such as Marvel and Disney from abroad, Huace Film and Television, Tencent Literature from China, etc, whose work involves domestic and foreign literary and script .

The midstream of the film industry chain is the distribution link. According to the situation of obtaining a release license and release schedule, the main work involves organizing film promotion and distribution, completing film public screenings and derivative sales.

The downstream of the film industry chain is the cinema link, which is an independent operating unit in the film industry that connects film distributors and film screeners, and implements unified film scheduling, unified operation, and unified management of cinemas. Due to the barrier of license entry for cinemas, the number of domestic cinemas has remained stable in recent years, and the competition pattern has been basically clear. The top ten cinemas represented by Wanda Film, Dadi Cinema, Shanghai United Cinema, China Film Southern, etc. have become the leading force in the commercial operation of China's cinemas market.

（2） Market size and investment and financing situation

According to the Research Report on the Development Status and Consuming Behavior of China's Film and Television Industry From 2021 to 2022 by iiMedia Consulting, the market size of China's film and television industry in 2021 was 234.9 billion yuan, a year-on-year increase of 23.2%, and a compound growth rate of 7.9% from 2019 to 2021. Due to the outbreak of the epidemic, the offline film and television industry in China has been greatly impacted in the past two years. However, with the controllability of the epidemic and the increase in per capita cultural and entertainment expenditure in China, it is expected that the market size of the Chinese film and television industry will further expand.

The report shows that the amount of investment and financing in China's film and television industry reached its peak in 2017, at 27.01 billion yuan. Subsequently, the financing amount and quantity showed an overall downward trend. At present, the   investment and financing situation of China's film and television industry is at a low point, and the income of the film and television manufacturing industry has relatively large uncertainty factors. Its liquidity has been controversial in recent years. However, with the improvement of Chinese residents' consumption ability, the future demand for film and television entertainment will lead to the rise of more film and television enterprises.

In summary, the film and television industry still has potential and there is room for further expansion and accelerated development.

（3） Policy driven industry recovery in the post pandemic era

In terms of policies, due to the impact of the epidemic in recent years, industry policies have been relatively loose, with guiding and relief policies as the main focus. The Ministry of Finance issued three relief policies in 2021 and 2022, which not only exempted value-added tax, but also provided 270 million yuan and 355 million yuan to each province and city in batches to support the development of the film industry. In the "14th Five Year Plan for the Development of Film", the country has put forward new requirements for the proportion of domestic film box office and the construction of cinema infrastructure. Overall, due to the impact of the epidemic, the Chinese film industry is almost in a state of suspension. In order to quickly revive the film industry, the overall policy of the industry has shown a relaxed state, which is conducive to stimulating industry vitality and promoting industry restoration.

VAM Agreements in the Film and Television Industry

（1） Overview

In the film and television industry, VAM agreements signed by the film and television industry are often referred to as "film guaranteed release agreements", mainly to play a role in adjusting the valuation of VAM agreements. Common betting agreements include box office betting, ratings betting, performance betting, and so on.

（2） Type

▶ 1. Box office betting

Taking the movie "Hello Li Huanying" as an example, according to the "Announcement on the Box Office of the Film" Hi Mom "released by Beijing Culture, Beijing Culture commissioned a third-party company for guaranteed distribution, with a guaranteed box office revenue of 1.5 billion yuan; As of February 17, 2021, Beijing Culture has generated approximately 60-65 million yuan in box office revenue from this film. According to relevant reports, the main body of Li Huanying's box office gambling parties is the Beijing culture as the producer and distributor, while the other side is the joint guarantee party Ruyi Film and Maoyan Film , which is a typical box office gambling subject.

▶ 2. Rating Bet

The "ratings betting agreement" generally refers to an agreement with the film producer regarding the ratings of a certain film and television work. If the agreed number is not reached, the production company will not be able to receive the sales money. Due to the frequent issue of ratings betting and data fraud, the State Administration of Radio, Film and Television held a special meeting in 2015, and organized relevant leaders of major provincial-level frontline satellite TV stations to sign self-discipline conventions and relevant documents related to rejecting ratings betting agreements, clearly opposing viewership only theory. [1]

▶ 3. Performance Bet

Performance betting generally means that the equity investor puts forward a requirement for the growth of a company's performance, and the commitment made by major shareholders to meet the growth. When the promised performance does not meet expectations, the major shareholders will cauculate the difference between the performance goals and actual performance according to the agreed calculation method, and compensated to the investors in cash or equivalent equity. Due to the fact that film and television culture is a light asset industry, the traditional valuation methods related to net assets are not applicable. Valuation is often based on committed net profit combined with a certain P/E ratio multiple, and performance betting has become the most important risk control tool for investors.

In performance betting, the original company of the target company needs to make a performance commitment to net profit, usually using net profit attributable to the parent company and/or net profit attributable to the parent company after deducting non-recurring gains and losses as indicators. Common forms include achieving both as fulfilling performance commitments, or assessing whether performance commitments are fulfilled based on the lower of net profit attributable to the parent company or net profit attributable to the parent company after deducting non-recurring gains and losses.

In addition, there are also cases where cumulative committed net profit is used as an assessment indicator. Taking the acquisition of Di Nv Media by Omnijoi Media Corporation as an example, its performance commitment method is based on the cumulative committed net profit for each year from 2017 to 2021, and is not based on independent net profit data for each year. This performance commitment method is easier than committing to achieving independent net profit for each year. It essentially allows the target company to have a situation where the net profit for a certain year does not meet the standard, but the cumulative net profit meets the standard.

（3） Features

The VAM agreements in the film and television industry mainly have the following three characteristics:

Firstly, unlike traditional industries, most film and television companies are light asset companies, and the valuation methods linked to assets are not accurate. They rely more on predicting future profits. To ensure the accuracy of valuation, target companies often have to make mandatory performance commitments.

Secondly, the true target of film and television investment is often a certain film and television work, or practitioners who already have a certain level of popularity and traffic in the film and television cultural industry, such as directors, screenwriters, actors, and so on.

Finally, the film and television industry belongs to a high-risk and high-yield industry. Popular IP film and television projects often generate huge commercial profits, which can also attract a huge amount of investment. The huge investment demand and the incomplete financial environment for intellectual property rights in film and television works are currently not matched. At the same time, this year's epidemic has been repeated, and these factors all mean that the market risk of investment in the film and television industry is huge, and investors often hope to "preserve value". On the other hand, the products of the film and television industry rely on the creation of film and television culture, and the creation itself has uncertainty, which directly leads to the uncertainty of related investment returns.

Therefore, whether from the nature of the film and television industry itself as a light asset industry or the investment risk return ratio of the film and television industry, the applicability of VAM agreements in the film and television industry is quite high.

Analysis of the Effectiveness of VAM Agreements

As far as the film and television industry is concerned, there are no special provisions in law. Therefore, it is still necessary to start from the overall civil and commercial legal system, conduct a systematic interpretation, while considering legal principles, in order to properly analyze the effectiveness of VAM agreements.

The Civil Code stipulates the grounds for invalidity of contracts, namely (1) invalidity of civil legal acts carried out by persons without civil capacity; (2) invalidity of civil legal acts based on conspiracy and false expression of intent; (3) invalidity of any act that violates the mandatory provisions on the effectiveness of laws and administrative regulations; (4) invalidity of civil legal acts that violate public order and good morals; (5) invalidity of the act of malicious collusion that harm the interests of others. If the VAM agreement violates the above provisions, it is considered absolutely invalid. These grounds for invalidity are listed in the following clauses respectively:

Civil Code of the People's Republic of China

Article 144: A civil juristic act performed by a person who has no capacity for performing civil juristic acts is void.

Article 146：A civil juristic act performed by a person and another person based on a false expression of intent is void.

Where an expression of intent deliberately conceals a civil juristic act, the validity of the concealed act shall be determined in accordance with the relevant laws.

Article 153: A civil juristic act in violation of the mandatory provisions of laws or administrative regulations is void, unless such mandatory provisions do not lead to invalidity of such a civil juristic act.

A civil juristic act that offends the public order and good morals is void.

Article 154: A civil juristic act is void if it is conducted through malicious collusion between the actor and a counterparty and thus harms the lawful rights and interests of another person.

Lawyer's advice

1. We should be cautious in choosing VAM agreements. VAM agreements are a double-edged sword. If it is used well,it can effectively prevent risks and stimulate the investment enthusiasm of investors in corporate mergers and acquisitions to a greater extent. Otherwise, both investors and financiers will face various risks simultaneously. Based on different perspectives, investors may require stricter standards for VAM agreements in order to reduce risks and achieve higher investment returns. Due to the lack of negotiating capital, financiers may be overly optimistic in predicting and evaluating industry development trends, future profitability, and development capabilities in order to obtain more funds from investors. Even if the content of the VAM agreement is unfair, they may accept it, which will bring great risks to both investment parties.

2. We should fully conduct preliminary market research. The risk of VAM agreements runs through various stages of enterprise mergers and acquisitions, such as before, during, and after. If both investment and financing parties do not conduct good market research in the early stages of enterprise mergers and acquisitions, it will be detrimental to the application of VAM agreements. As is well known, VAM agreements are only a kind of financial tool, which can effectively promote investors to obtain high investment returns and the invested party to smoothly obtain a large amount of capital when used in mergers and acquisitions of enterprises. However, the key to corporate mergers and acquisitions is not to choose financial instruments nor the content of VAM agreements, but to choose suitable acquisition targets. When the acquisition target is mistakenly selected, in the event of investment failure, full compensation may not necessarily be obtained. The initial huge investment may eventually be paid by the investor alone. Therefore, for the sake of their own interests, investors need to fully understand the market and its development status, deeply understand the investment target enterprise, carefully review the financial information of the investment target enterprise, and strictly prevent financial fraud from causing the value of the target enterprise to deviate from the true situation.

3. Reasonable VAM targets should be set. Due to the close connection between the interests of the management of the enterprise and the performance commitments in the VAM agreement, formulating the VAM agreement is not only a unilateral responsibility of the acquiring enterprise, but also the responsibility of the management of the acquiring enterprise, the acquired enterprise, and their management. When VAM agreements are used to constrain management, it will be beneficial for management to continuously strive to achieve performance commitment goals. When setting VAM targets, it is necessary to conduct in-depth analysis of the purpose of the merger and acquisition parties entering into VAM agreements. If the performance target indicator value is set too low, although the acquired party is more likely to achieve financing goals, it will be difficult for the acquiring party to obtain ideal merger returns. On the contrary, if the performance target indicator value is set too high, the acquired party will not be able to complete it, and will have to compensate the acquiring party for huge losses. Therefore, setting reasonable VAM targets can effectively motivate the management of the enterprise, benefit both investment and financing parties, and promote complementary advantages between the acquiring party and the acquired party, achieving win-win cooperation.

4. Appropriate compensation methods should be chosen. As mentioned earlier, if the performance target set in the VAM agreement is set too high, the acquired party will not be able to achieve it and will need to compensate the acquiring party for huge losses. The VAM agreement can involve various compensation methods, including monetary compensation, equity compensation, and so on. The monetary compensation method refers to the payment of cash to the acquiring enterprise after the failed bet by the acquired enterprise. The equity compensation method refers to compensating the acquiring enterprise with equity compensation after the bet fails. Due to information asymmetry and other reasons, we should choose a more appropriate compensation method to avoid bankruptcy of the enterprise due to improper compensation methods. Therefore, in order to achieve more enterprise value, the acquired party should try to adopt a partial compensation plan and avoid choosing to pay all the compensation in one go.

In the next article, we will elaborate on typical VAM cases in the film and television industry.

reference material

[1] Notice of the National Radio and Television Administration on Further Strengthening the Administration of Radio, Television and Online Audiovisual Entertainment Programs (Radio and Television Administration [2018] No. 60)

Article 6: Strengthen the management of the use of survey data on ratings (click through rates), and resolutely crack down on fraudulent behavior in ratings (click through rates). All radio and television broadcasting institutions, as well as online audio-visual program service institutions, should establish a comprehensive evaluation system for programs, carry out comprehensive evaluation of programs correctly, view and reasonably use ratings (click through rates) data, and firmly oppose the tendency of relying solely on ratings (click through rates). Broadcasting agencies are strictly prohibited from requiring ratings commitments from production agencies, and signing ratings betting agreements is strictly prohibited. It is strictly prohibited for any organization or individual to interfere with or falsify viewership (click through rate) data. The relevant industry associations and social organizations should effectively play the role of self-discipline in industry associations, and urge all members to consciously resist the falsification of ratings (click through rates). Establish and improve a mechanism for deepening publicity, radio and television, and public security departments to jointly coordinate and crack down on fake ratings (click through rates), and resolutely punish institutions and personnel engaged in or involved in illegal and irregular activities such as fake ratings (click through rates). Timely expose typical cases to society and maintain good industry order.