The private equity industry in China has been developing rapidly in recent years. It is interesting to note that most private equity investors would distance themselves from the target firms' daily operations, and watch firms with ″gambling agreement″ instead. When the firm performs better, they would invest more|when it fails to meet its financial target, they usually exercise the right to mandatory conversion to control the target firm, or exercise the right to redemption and quit the investment. In such cases, the related contract clause is considered a ″valuation adjustment mechanism.″ In practice,information asymmetry and valuation gap make it difficult to assess the real value of the target firm, and contribute to the emergence of clauses relating to valuation adjustment. Moreover, China's underdeveloped legal infrastructure and inefficient capital market combine to force the investors to adopt valuation adjustment mechanism as a protective measure for their investment in the country. The valuation adjustment mechanism has been running for a long time without explicit consent of the legislature. Most valuation adjustment clauses in general are based on preferred shares. However, the Chinese Company Law does not clearly state the legitimacy of preferred shares in limited liability companies. As a result, a number of private equity investors choose the offshore investment model to avoid Chinese regulations. In addition, in order to reduce moral hazard of shareholders and managers, private equity investors are more willing to impose contractual liability on shareholders, managers and the firm at the same time. The Supreme People's Court of P.R.China has ruled on Haifu v.Diya, that the target firm is prohibited from signing a contract including provisions of valuation compensation. For the sake of better protection and interests equilibrium, we suggest that a better institutionalized environment should be built for the valuation adjustment mechanism in China. As to the Company Law, theoretical and practical obstacles of preferred shares in limited liability companies have already been removed, therefore it is time to revise the Company Law to legalize the adoption of preferred shares in limited liability companies. As to the judicial enforcement of the valuation adjustment contract, judges should familiarize themselves with the complicated business world, balance the interests of different stakeholders and minimize the moral hazard through proper allocation of rights and responsibilities. Furthermore, the State could instruct the private equity industry associations to draft model documents, to clarify the relevant legal issues and to allow customized provisions in the valuation adjustment mechanism contract as well.