The structure of the Chinese venture capital market is very different to its western counterparts. Jonathan Zhou of Fangda Partners examines how the region’s market is structured and how this has contributed to its current state.

China’s private equity investors
The Chinese government, unlike its counterparts in most countries, has played an active role in the private equity sector, not only by forming policies encouraging its development, but also by contributing money from public sources. Usually government money is pooled in an investment company and managed by the company’s management team, rather than a professional fund manager.

The bill of an investment fund law is still being discussed by the National People’s Congress, the legislative body of the Chinese government. There is no existing legal framework to accommodate a conventional fund management structure, as commonly used in other jurisdictions. For instance, the use of vehicles such as limited liability partnerships is simply impossible under current Chinese law.

Foreign private equity funds can directly invest inward from overseas without having a presence in China. Under such a model, the fund itself can be formed and managed in a foreign jurisdiction where the conventional structure can be applied without legal hurdles. So far, most foreign private equity investments have come from funds formed and managed overseas.

On August 28 2001, a new regulation was issued by the Ministry of Foreign Trade and Economy Cooperation (Moftec) concerning the establishment of Sino-foreign joint-venture venture capital companies. Under the Moftec Regulation, venture capital companies can be established in China in the form of a Sino-foreign joint venture (or a VC joint venture). The VC joint venture is in fact a corporate fund in which foreign investors can have a stake of at least 25 per cent.

In the past, foreign investors were only allowed to invest in specific project companies in China. Although they were allowed to form holding companies to consolidate their existing investments, these holding companies would not be approved before the investments in certain specific projects had already been made. The VC joint venture is obviously a step forward, but there are still restrictions to making investments:

According to Article 12 of the PRC Company Law, effective on July 1 1994, companies cannot make equity investments that exceed 50 per cent of their net worth. Except for the foreign holding companies mentioned above, all Sino-foreign joint ventures are subject to this rule under the Company Law. However, it is uncertain whether this restriction is meant to apply to VC joint ventures. Although some local regulations do exempt VC joint ventures from the restriction, the Moftec Regulation does not touch upon the issue. Under China’s legal framework, in the event of any inconsistency between local and national regulations, the national legislation prevails, ie the Company Law.

The VC joint ventures are restricted in investing in the industries that are classified as ‘restricted’ or ‘prohibited’ for foreign investment under the Industry Catalogue for Foreign Investment, which was jointly issued by the State Development and Planning Commission, State Economic and Trade Commission and Moftec, and updated from time to time.

Offshore investment structures
It is so far the prevailing market practice for foreign private equity and venture capital investors to use an offshore vehicle to invest in a China venture. Investors may invest in an offshore company, usually incorporated in tax havens such as Cayman, Bermuda or BVI, in which the founders and the investors can hold stakes subject to their agreement. The offshore company may then set up a subsidiary in China to operate the founders’ business, or to purchase the existing business operated by the founders.
From a legal point of view, the essence of the offshore structure is to use a foreign legal system to create certain investors’ rights, such as the conventional privileges attached to preferred shares, tag-along rights, registration rights, etc, which are not available under Chinese law. An offshore vehicle may also adopt a stock option scheme, which is also not provided for under Chinese law. The investors also look forward to the liquidity of their equities in their portfolio companies when they are listed.

However, domestic money, including funds from VC joint ventures, is not allowed to invest in an offshore company, unless approved by Moftec. This is mainly because of the Chinese government’s strict control over the outflow of capital. In other words, if foreign investors put money into a VC joint venture, they may only invest in a domestic entity.

Onshore investment structures
Alternatively, foreign private equity investors may invest in a domestic entity directly. Meanwhile, domestic investors, including the VC joint ventures, may have to put money in a domestic entity.

Under the onshore structure, if the money comes from overseas, the investee company will become a Sino-foreign joint venture. Under Chinese law, the premise for a joint venture is shareholder equality and mutual benefit, hence preferred shares cannot be issued. The investors can only seek very limited protections under a joint venture scheme. And stock option plans cannot be adopted. The domestic investors, together with the VC joint ventures, are facing the same situation when they put money in a domestic company formed according to the Company Law.

Exit strategies - trade sale
Exiting by trade sale is probably the easiest alternative for investors. Using the offshore structure, investors may sell their shares in the tax haven-incorporated investee companies without any Chinese approval procedure and without incurring any capital gains tax.

Using the onshore structure, if the investment is made from overseas, the company having received the investment is qualified as a Sino-foreign joint venture and the sale of the equity interest therein is subject to the approval of the original approval authority, namely Moftec, or the corresponding approval authorities at local level. If the investment is made by a domestic entity, no approval is required and the sale of the investment will become effective after it has been registered with the State Administration of Industry and Commerce.

IPO
The Chinese second board that has been eagerly expected is still not in place and may not be completed in the foreseeable future. Regulators are arguing about the need for a secondary board when the main boards in Shanghai and Shenzhen are still facing serious problems of price manipulation and false disclosure. Chinese companies that have received private equity money may make their initial public offerings and list their shares on the main board of the Shanghai Stock Exchange (The Shenzhen Stock Exchange is not accepting listing applications at present in preparation for the second board.), the Hong Kong stock exchange’s Growth Enterprise Market (Gem) or other foreign securities markets.

Chinese main board
The main board is not an ideal place for private equity investors to exit. Listing candidates must have a long track record of profitability - a criterion that most start-up companies find difficult to meet - and only the company’s publicly offered shares may be traded on the exchange. From the investors’ point of view, this is highly unattractive due to the absence of liquidity for their own shares.

Only the investee companies under the onshore structure may be able to issue and list their shares on a domestic stock exchange. So far, listing applications from foreign companies, including those of the offshore vehicles established under the offshore structure, are not accepted by the Chinese regulatory authorities.

Hong kong gem and other securities markets
Most of the investee companies established under the offshore structure have been looking for the possibility of an IPO in foreign securities markets; mainly Gem in Hong Kong and Nasdaq in New York.

However, any company with a Chinese interest is still subject to the regulation of the China Securities Regulatory Commission (CSRC), according to a notice issued by the CSRC on June 9 2000. Under that notice, the IPO of a foreign company with a Chinese interest must be filed with the CSRC and no IPO can go ahead before a no-action letter is issued by the CSRC. To closely monitor the capital outflow, the CSRC has become reluctant to issue the no-action letter to a foreign company with Chinese nationals holding its shares. In the past two years, only a couple of such applicants have obtained no-action letters from the CSRC.

A Chinese investee company under the onshore structure can apply to list on a foreign exchange. This application must also be submitted to the CSRC. It is clear that the Chinese regulators are much more in favour of this approach, and have granted dozens of such approvals. However, the liquidity of the shares held by an investor in a Chinese investee company remains an unresolved problem. If the shares were originally subscribed for in renminbi, they may not be sold in foreign currencies unless approved by the foreign exchange administration authority. This is primarily because sale of the renminbi-subscribed shares in foreign currencies will be deemed as a capital account item under the Chinese foreign exchange administration regime, and renminbi is still not freely convertible in capital accounts transactions. Were the shares originally subscribed for in a foreign currency, the foreign exchange issue does not exist. But unfortunately, the clearing system of the Hong Kong stock exchange only accepts the registration of shares that are publicly offered in Hong Kong, and it is still questionable whether such shares could be accepted for registration and become freely tradable.

Redemption
The redemption of share capital by a pure domestic company will result in the reduction of the registered capital, which may give rise to certain statutory obligations under the Company Law. Such statutory obligations include the public announcement of the redemption or, upon request, the provision of security by the company in favour of the creditors for all the outstanding debts. If the redemption is adopted by a foreign invested company, such redemption is subject to the approval of the company’s original approval authority.

Tax on sales proceeds
Depending on the different investment structures, the applicable tax on the sales proceeds may vary. Under the onshore structure, sales proceeds are deemed as taxable income and, together with other taxable income received in the same tax year, subject to enterprise income tax at a rate of 33 per cent, after the deduction of the deductable costs in that tax year.

Under the offshore structure, the gross sales proceeds are subject to withholding tax at a rate of ten per cent. In summary, the tax burden on capital gain under the offshore structure is, under usual circumstances, substantially lower than that under the onshore structure.

The government has realised the important role of private equity in boosting the technology industry. No matter how much less attractive it is, the Moftec Regulation is one of the efforts the government has made. However, it is still a difficult time for China’s private equity industry, not only because of the deteriorating global market sentiment, but also because of a legal system under which the exiting channels are limited, employee incentive schemes are not applicable and shareholders’ rights are not well protected. Notwithstanding all these factors, numerous deals have been made and are still going on, although at a sluggish pace at the moment.

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Jonathan Zhou is a partner at Fangda Partners.

Fangda Partners is one of the first truly private partnership law offices in Shanghai. The firm serves both PRC and international clients in various industries and are continuously involved in, advising on, and creating innovative legal structures for transactions in a whole spectrum of commercial areas such as corporate, capital markets, private equity, banking, structured finance, project finance, inward investment, commercial property, tax, intellectual property, insolvency, telecommunications, media and internet. For more information please visit www.fangdalaw.com