The use of performance-based escrow provisions has become a ubiquitous, yet contentious practice in reverse mergers.  The lack of disclosure from private companies necessitates specific incentives that ensure their financial projections are accurate.  Chinese companies in particular, which are an exploding portion of reverse merger deals, bring an added layer of risk due to concerns surrounding the validity of their financials.

Make-good provisions, as they’re informally known in the industry, don’t force disclosure, but put “a company’s feet to the fire in living up to the valuations agreed upon in a deal,” says Mitch Truelock, a managing director at Roth Capital.

To be sure, performance goals and incentives for reaching those goals have been a standard feature in a majority of M&A transactions for some time.  Regardless of cash, debt or equity considerations, these provisions are predominantly structured as additional earn-outs to be paid periodically to management based on the company reaching specified financial forecasts.

The metrics evaluating performance, the amount withheld, and the escrow account structures differ from deal to deal, but the underlying premise of make-goods is more or less the same.  Senior executives of the new public company will place a specified number of their personal shares into an escrow account, which amounts to a negotiated percentage of the number of shares issued to private placement investors.  They will then get a portion of the escrow back each year for two to three years if they successfully meet the agreed upon targets.

One prominent reverse merger investor said he doesn’t believe that he has ever done a deal in China without a make-good provision and doesn’t have any intention of starting now.

Providing make-good provisions is often the only way to attract investors to such newly public companies, says the investor.  The provisions offer a “wonderful purpose of clarity to incremental investors.”

While make-goods provide downside protection and entice management to ensure the accuracy of their financials, they are not designed as a bonus for investors.  Investors never want to take back the escrowed shares, according to John Micklitsch, portfolio manager with the Ancora Greater China Fund.  The prominent investor agreed.  “We don’t want the make-good shares,” he said.

Joe Smith, a partner at the law firm Feldman Weinstein & Smith, says a make-good is the investor’s first line of defense against possibly inaccurate financial claims.  He is deeply cynical about transparency in China.

Bob Stevenson, a managing director at Roth Capital, is also unaware of a reverse merger financing in China without a make-good.  The risks in China are very real and may even be greater now that a growing number of investors are clamoring to enter the market.  “The high returns have brought in bankers, investors and lawyers that no one has ever heard of before,” he said.

Chinese companies often have multiple sets of books, according to one investor familiar with the region.  What they show the government is in all likelihood different from the financials they will provide to foreign investors.

Due diligence must be done on the ground, the investor said, adding that the process can take months and still end without dispelling all uncertainty. The make-goods are, in essence, a must.

Each deal is negotiated and structured in a manner befitting its specific circumstances.  There are a number of structures that can be used, varying with the preferences and concerns of the bankers, lawyers and auditors putting together the deal.

Problems arise from a “whatever-it-takes mentality” on the part of Chinese companies, can to a certain degree, be mitigated by how the escrow accounts are structured, Michlitsch said.

Until recently, investors have taken an all-or-nothing approach with respect to executives at the company earning back their shares.  If the targeted financials were not hit, regardless of how close management came, the shares were forfeited.  It was not unusual for management to lose the whole lump in escrow after falling short by only a few thousand dollars, according to Micklitsch.

An increasing number of deals have been migrating to escrows with shares released back to the management on a pro-rata basis.  If they hit 90% of the target, they earn back 90% of the shares.

This alleviates a major concern surrounding the performance targets, says Micklitsch.  With so much on the line, there is always the possibility that executives will sacrifice prudence to meet their numbers.

A company can ramp up production of inventory to the point where quality begins to slide, for example.  Management can take a four-year growth plan and cram it into two years, or even less, jeopardizing long-term performance.  There is also the concern of accounting fraud in attempting to meet targets.

It’s very difficult for a small- or micro-cap company to project out two years, Stevenson said, adding that negotiations can become rather heated.  Chief executives in China have often built their companies from the ground up, devoting an extraordinary portion of their lives to the endeavors.  “Chinese executives have a fair understanding that this needs to happen, but it can be understandably difficult to negotiate the provisions.”

Richard Anslow, a partner with the law firm Anslow & Jaclin, agrees that negotiating make-goods into reverse mergers can be a difficult process.  However he says that the situation is improving, though there is still a high degree of risk.

“Make-goods are a major, major item, but investors in China are much better now with their on-the-ground due diligence.  The negotiations may be difficult at times, but investors won’t set goals in which there Is not full confidence that the company will meet them,” Anslow said.

Phillip Zhang, the CFO of Shengtai Pharmaceutical, has a different opinion.  Last May, Shengtai reverse merged with shell company West Coast Car Co. and raised $17 million in a concurrent PIPE with investors including Jayhawk Capital and Pope Investments.

The deal included a make-good provision requiring management to sock away 5 million shares.  Management earned back 2.5 million of those shares after exceeding a fiscal 2007 goal of $7 million in after-tax net income.  Management will receive the remaining shares if it racks up $9 million in after-tax net income in fiscal 2008, which it is on track to do.

However, Zhang who joined the company nine months ago, after the deal was completed, did not come aboard with confidence that the targets would be met.  “If I were the CFO at the time, I would have not voted in favor of the make-good.  I was not very confident that we would hit the targets,” he said.  Zhang said that the company’s president was severely worried and could not sleep due to his concern income levels might not be met.

The Chinese economy is subject to deep fluctuations that make it very difficult to project income one or two years away, Zhange said.  “Fortunately, the Chinese economy has been very strong,” he added.

Bottled water distributor China Water & Drinks has so far exceeded the targets from the make-good in its $30 million reverse merger last year.  The company received an additional $50 million round of funding led by Goldman Sachs. 

China Clean Energy, which closed a reverse merger in 2006 lacking a make-good, completed a second financing for $15million recently, which included such a provision.

The company’s banker, Jung Min Choi with Westminster Securities, said each side entered into the negotiations for the recent financing with rather different expectations, but were able to find a suitable middle ground.

In the case of China Clean Energy, the investors’ perceived risk was more a bargaining tool than an actual element of their investment, said CFO Gary Zhao.  The company never filed late and its operations are not affected by seasonal fluctuations.  As a testament to the perceived low risk, Choi said the company was able to register all 16.2 million shares in the PIPE, including those underlying the warrants.

Choi said negotiations with investors included a $3 billion hedge fund that wanted 10 million shares delivered to the escrow account.  Choi and management absolutely refused to go that high and the fund balked.  The final terms stipulated 1.5 million.  JLF Asset Management, which ended up as the lead investor with a $7 million stake, first “though 1.5 million shares was ridiculously low,” but in the end, agreed.

In addition to the escrowed shares, investors wanted a 24-month lockup on 85% of management’s shares, which was negotiated to 18 months.

Choi and Zhao still maintain that China Clean Energy had an amicable negotiation process despite the wide discrepancies in each side’s desired terms.