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: VC PRACTICE IN CHINA : : I. Introduction : China has started developing its venture capital investment business since 1998. The number of the existing venture capital enterprises is booming from zero to eighty-eight during the ped five years time. We have also seen large number of foreign venture capitalists participating in various Chinese project.. : According to the unofficial statistics, so far there are 23 formerly opened Venture Capital Enterpriese (the “VCE”) active in Chinese market. Their investment amount in various Chinese projects during the first half year of 2003 amounts to 170 million US dollars. : However, according to the previous regulations, only very large foreign VCs could be qualified to invest in China. Further, the various tax barriers have also increase their cost of practice. Therefore, foreign VCs are only interested in the large projects with high investment returns. It is very unlikely for them to invest in the small and medium size private companies. They are either not interested in the state own enterprises because such project need large amount of investment but very long period to get any return. : China government started its policies to encourage the development of private own enterprises. Also China government has focused on restructuring its state own ets, trying to turn some of them into private own ets by transferring and selling. All these need large amount of financial support. VCs could be a good option for Chinese government, because VC can not only bring funds required, but also the advanced management technologies. China government is now in the process to loosen the restrictions for foreign VCs to entering China market. : II. Setting up VCE in China : In 2003, China government has modified its previous regulation on introducing foreign VCs to China market and promulgated a new regulation (the “Regulation”) in which various barriers and thresholds have been lowered or loosen. Basically speaking, the procedures for setting up VCEs is almost the same as that of setting up other kind of FIEs in China, including obtaining approval from MOFTEC and registration with SAIC. The requirements of investors, required doents and approving procedures are stricter comparing to those required for setting up normal FIEs. Moreover, there introduces some new stipulations regarding the foreign investment, for example the clification of investors, which is not commonly seen in other foreign investment related laws and regulations. Such new stipulations could impact on the manner and process of business operations of foreign invested VCEs. : 1. Qualified investor : According to the Regulation, there clifies the investors of VCE into two categories: necessary investor and normal investor. Every foreign VCE intending to invest in China shall have at least one necessary investor. According to the Regulation, the necessary investor shall meet all the requirements listed as follows: : i) The investor has managed the capital for more than One Hundred Million US Dollars during the ped three years’ time, among which Fifty Million US Dollars shall be used to invest in VC industry. : ii) The investor shall have at least three specialists who have no less than three year’s experience in VCE management. : iii) The investor has not be punished for any break of laws or financial regulations during the ped three year’s time. : If one of the investor’s affiliate companies meets all requirements listed above, the investor could be qualified as necessary investor. : Apparently comparing with the previous regulations, the required managed capital is much less. However, many VC entrepreneurs still argue that the threshold is still very high for most of them, especially considering the depressive economic situation in most western countries these years. Most international VCs have somehow decrease their investment activities during the ped few years, especially during the collapse of the stock exchange market and high-tech industries. : Further, VCE has its unique way to proceed business. Unlike other business where the international group companies are keen to set up large enterprise network all over the world by merger and acquisition, VCEs are normally highly restricted within its active business and region. There are very few VCEs having the worldwide business scale, as high investment amount abroad would mean huge risks for the VCEs. VCEs are very careful to consider any investment into an industry or a region where it is not familiar with. : Therefore, the requirements set forth in Regulations have still prevented most of foreign VCEs who are of small or medium size from being qualified as necessary investors, unless they could seek cooperation with and support from large VCEs. : However, it will be interesting to discuss the actual position of necessary investors in the Foreign Invested VCEs (the “FIVCE”). It is provided in the Regulation that the necessary investors shall contribute no less than 1% of the total amount of investment. Therefore, it is not compulsory for the necessary investor to be the majority shareholder in the FIVCE. Further, in most successfully approved FIVCEs, the necessary investor does not involve the daily management of the company. Instead, it is only nominated and listed as one of minority shareholders of the company. : 2. Relationship among the investors of FIVCE : The clification of the investors has cause new issues inside FIVCE, especially concerning how to manage the mutual relationship and balance the benefits among the different investors. : The relationship among the investors shall depend largely on the form of FIVCE. According to the Regulation, the investors may choose to adopt either legal personality form or non-legal personality form for their FIVCE. : It is possible for the FIVCE be established in the form of organization with non-legal personalities. This kind of organization includes partnership, or otherwise some loose organization formed by various investors in which the investors all act independently. If FIVCE adopts the form of organization with non-legal personalities, although the minimum total investment amount requirement is comparatively higher than that of a VC company, the investors will have more freedom and independence in conducting its own business. Moreover, with the approval and registration with the tax bureau, the investors are allowed to pay their respective taxes for their own part of business. Therefore, under this situation, unless otherwise stipulated in the mutual agreement, the investors will have less rights and obligations to each other. : Alternatively, if the FIVCE is established in the form of limited liability company, the relationship among the different investors will be very interesting, especially the relationship between necessary investor and normal investor. : Under most cirstances when the necessary investors are minority shareholders, the decision of FIVCE will be mainly conducted by normal investors who are majority shareholders. So far, despite few cases happened, the necessary investors do not take part in the operation or decision making of FIVCE. The FIVCE are normally dominated by its majority shareholders, i.e. the normal investors. : There is another concerning issue about the disclosure of confidential information According to China Company Law, the directors and other management tier appointed by the shareholders have non-disclosure obligations for the confidential information they have accessed. Any breach of such obligations will cause civil or sometimes even criminal liabilities. : However, as a shareholder, the investors are entitled to be informed the confidential information regarding the developing plan of company, project information, client list, etc. Further, the law does not prevent the directors p such information to their respective representing shareholders. There comes a problem when the investors, especially the necessary investors, do have their own other subsidiary in China. The confidential information may be easily ped to the competitors and will cause damage to the FIVCEs. : The practical way to prevent such damage is that the investors shall also sign a non-disclosure agreement or non-competition agreement in which the investors shall define carefully about the range of confidential information, the power and authorization of the respectively appointed directors and other management staffs, the use and access of confidential information by shareholders, the non-competition promises made by shareholders to the FIVCE. : 3. Tax Issues : Considering the high risk of its business operations, the VCs are always concerning the tax incentive policies offered by host government before they enter the foreign local market. In western countries, the government often offers comparatively low tax rate for VC’s profit from their investment in local market to encourage their investing activities. : Before the coming-out of this Regulation, the most concerned pending issue is whether China government will offer further tax incentive treatments upon FIVCEs comparing to other normal FIEs. However, the Regulation only provides a few clauses concerning the tax treatment of FIVCE. Apparently, according to the Regulations, the tax treatment for FIVCE with legal personality is almost the same as that for other FIEs in China. : It is provided that the tax treatments for FIVCEs with non legal personalities will be separately stipulated in some new regulations which will come out soon. It is understood that regarding their extraordinary risks during their business activities, FIVCEs with non legal personalities will enjoy lower tax rates and other tax incentive policies. : The FIVCEs will still be treated as other FIEs in China until there comes new tax regulations specifically for them. : : III. FIVCE’s investment activity in China : The Regulation has somehow lowered the legal barriers which were established by previous company laws and regulations. For example, in Company Law, it is provided that the total amount of investment of a company shall not exceed 50% of its total registered capital. In the Regulation, it is however provided that the FIVCE is allowed to use all of its self-owned capital to invest in other companies. Further, previously it is not allowed for the Chinese citizen to become the Chinese investor of Sino-foreign joint ventures. The Regulation has changed that Chinese citizen can remain to be the shareholder of the Sino-foreign joint venture if they were the shareholders of the company before acquired by FIVCE. : However, there are still some restrictions and limitation upon the FIVCE’s practice in China. For instance, FIVCE is not allowed to invest in the industries which are forbidden for foreigners to invest. : Further there are some issues that FIVCE shall be careful during their practice in China. : 1. Due Diligence issues : FIVCE’s investment activities depend largely on the accurate information obtained concerning the target company. Unfortunately, unlike the situations in western countries, where the information of companies are very open and easy to access, it will be comparatively difficult and complicated to obtain accurate information of target company in China. : For the basic information of target company, FIVCE could easily obtain from the local State Administration of Industry and Commerce (“SAIC”) where the target company has registered with. From SAIC, the FIVCE could obtain the information such as registered capital, time of incorporation, article of ociation, list of shareholders, etc. However, it is possible that some of the information is out-of-dated and could not show the actual current situation of the target company. Moreover, in some region of China FIVCE will have to employ Chinese lawyer to access the information while in other regions such registered information is opened to anyone. : The credit information is not so well organized in China, especially for the small companies. The banks will not issue any letter for its client for the purpose of evidencing their bank credit. Further, there is no effective nationwide bank information exchange system in China. Therefore, FIVCE can only employ some special research authorities to conduct the credit research on the target company. : For the accounting information and legal information, which is deemed as confidential information for most companies, FIVCE and its employed lawyer or accountant can only access the information subject to target company’s consent and cooperation. : Legal due diligence involves an ysis of the legal framework within which the target company is operating. The investigation will normally extend to a review of the company's legal constitution, its key contracts with customers and suppliers, ownership of key intellectual property, employment arrangements with key senior employees and an ysis of any employee benefit schemes, its pension arrangements, any potential or ongoing litigation and any other areas identified as being particularly important within that company. Experience suggests that FIVCEs are anxious to identify any problem areas and common issues examples of which can include: : : • "Messy" group structures where as a result of historic inter-group transactions, the group structure is not suitable to accommodate the transaction envisaged by the FIVCE. In the case of an incoming FIVCE on a re- financing, complicated ratchets, share rights on sale and drag and tag along provisions can be a headache. However, this kind of situations happen to most of state owned enterprises in China. : • From the day-to-day business perspective, significant key contracts, without exclusivity or ignability, containing clauses allowing termination on change of control of which are with either the wrong company or commercially weak can be difficult to put right within most FIVCE's envisaged time frames for completion. : • For employees who have been identified by the FIVCE as key, inadequate contracts of employment containing short notice periods or unenforceable restrictive covenants particularly where the employee is not willing to agree to a new form of contract in the FIVCE's prescribed form. : 2. MBO (or MBI) issues : Besides direct trade in, FIVCEs may consider other manners of acquiring the equity of target company. Management Buy-out (“MBO”) or Management Buy-In (“MBI”) are two of the most popular manners to acquire the equity of target company. : Management Buy-Out is the term applied when a business is sold to the existing management team. Often this occurs when large companies seek to dispose of parts of the business or when the existing owner-manager is looking to retire. : The existing management are often the people in the best position to take the business forward as they have expert knowledge of the company and its work-force. Strategically, they also present a more favorable option to the existing owner than selling to a competitor or closing the business down. : Management Buy-In is the term applied when an outside management team buys a stake in an existing business. Typically this happens where the business is under-performing due to weak management or lack of suitable expertise or where the business growth demands a more knowledgeable and experienced management team. : The MBI enables the business to inject the depth of experience it requires and the new managers share in the future profits they generate. : Both MBO and MBI need large amount of financial resource to support. Comparatively, they will need more financial resource support than those needed by the starts-up. : However, in China, there are still no special laws and regulations concerning MBO and MBI. Moreover, foreign VCs should be extremely careful dealing with following issues during their MBO or MBI process: : a. MBO companies : An MBO is commonly achieved in the following way: : i) A new company (“Newco”) is established to acquire the transferring company or business (Target); : ii) Newco and Management agree terms with equity investors (the Investor) and with bankers to fund the acquisition of Target and to provide working capital. If there is a funding ""gap" between the equity and debt funds available and the funds required, this may be filled by mezzanine funding, which ranks behind ""senior" bank debt but in priority to equity (and may include a right to subscribe for equity); : : iii) Management and the Investor subscribe for shares in Newco and Newco's bankers (and, if relevant, the mezzanine funders) commit to provide debt facilities; : iv) Once funds are in place, Newco completes the acquisition of Target. : However, in China, the threshold for establishing investing company is extremely high and would be a large barrier for conducting MBO. Setting up a investing company with foreign funds will need large amount of registered capital and long period of examination and application procedures. All the above will increase the cost of FIVCE’s operations significantly. : : b. State-own ets (“SOA”) protection : China needs foreign funds to support its SOA, especially for its restructuring of SOA. However, China has established very strict controlling system upon all of its SOAs, including the evaluation, transfer, disposal, using SOA forming joint venture with foreigners. Such strict procedures and formalities might build up barriers for FIVCE to select the profitable ets out of the whole target company. : The procedure for transferring SOA to any non-government parties is under strict evaluation and approving procedures. Although a recently promulgated regulations in 2001 has simplified the procedures to some extent, the negotiating-evaluating-registering three step procedure is still required. According to the three step procedure, FIVCE shall first negotiate with the administrating authority of SOA regarding the involving SOA and its price. Then FIVCE and the administrating authority shall employ a evaluating authority jointly to conduct the appraisal upon the SOA. The final transferring price of SOA shall be subject to the report of evaluating authority and the transfer shall be registered with SOA administration authority. : c. Manager’s situations in MBO : Managers will acquire most benefit from MBO transactions. Normally, they are willing to cooperate with FIVCEs during the transaction, including providing information of target company, using their network and powers inside company to provide convenience for the transaction, offering advice to restructure the transferred SOA so that the non-profitable ets are filtered, etc. However, their situation in MBO is also pretty sensitive. On one hand, they shall take part in the transaction as one independent party and fight for their own interest. On the other hand, as they as the employees have their obligations to the target company, their fully involvement will do harm on the state interests and may be considered as criminal under some situations. : In China, top managers of state owned enterprise are deemed as governmental officers. They shall make sure not to break the criminal law of China and not to conduct a criminal of corruption. : It is provided in China criminal law that governmental officers will be found guilty if they ly occupy the state own ets. To avoid the prosecution of criminal, the managers shall manage to prove the following two points: : i) the managers involved are not governmental officers. Although according to the China Criminal Law, the mangers of state own enterprises are deemed as governmental officers, however it is not clear about the term “state owned enterprises”. In China, there are major three kind of state participated enterprises: 100% state owned enterprise in which state owns 100% of the shares of the company, state controlling enterprises in which the state owns majority shares of the company and state partially owned enterprises in which the state owns minority shares of the company. According to a notice issued by Supreme Court in 2001, only the managers of purely state owned enterprises are deemed as governmental officers. : ii) all required procedures and formalities regarding the transfer of SOA shall be strictly complied. Although in some regions, due to the good relationship of managers with governmental authorities, the transaction could be completed without having to strictly comply with the procedures and formalities as required, the transaction will be under the risk of declaring invalid by China government upon later examinations. The importance of complying with the procedures and formalities shall be again emphasized here. : Despite the corruption prosecution, the manager shall also be careful not to break other legal and contractual obligations to the company. For example, if the managers have revealed non-disclosure information during the transaction so that the benefits of current shareholders of target company are damaged, the managers will be found liable for their participation. Further, normally the managers have their non-competition obligations to the company, in which the managers have promised not to participate in any business operations which composes competition to the company. The duration of such obligations lasts normally longer than the duration of employment. Therefore, the managers shall first termination such obligations before they could fully participate in the three party involved MBO transaction. : A good option to avoid all above mentioned troublesome is that the managers resign from the current position and form a MBI team with FIVCE. As the member of MBI team outside target company, the managers have little obligations to the company and could be free to bargain with the current shareholder for their own benefit. : To further secure the transaction, FIVCE may also choose to make a little change on the process of transaction. Normally, during MBO or MBI transaction, there involves two equity transfer: the current shareholders transfer their owned equity to both managers and VCs simultaneously, i.e. there will be a three party involved agreement. However, under most situations, the bargaining period of forming such agreement will be very time consuming and the involvement of managers in such agreement will be further complicate the situation considering all above mentioned issues. It will be comparatively easier if the FIVCE reach an equity transfer agreement with current shareholders first and then transfer part of its owned shares to the current managers. The managers are required to enter into an agreement with FIVCE separately first, in which managers promise to manage the company after the equity transfer and as the return of such promise, FIVCE undertakes to transfer to the manager part of its shares of company with very little considerations. Such agreement is preferred to be confidential, whether during or after the transaction, so that the current shareholders will not be irritated to break up the transaction. : 3. Other manners of equity acquisition : In western countries, despite MBO and MBI, there are other manners of VC practise, such as Investor Led Buy Out (“IBO”) or Leverage Buy Out (“LBO”). : LBOs are simply buy-outs where the level of debt financing is unusually high. Typically, the term is used where in excess of 70 per cent of capitalisation is in the form of debt. LBOs often arise where there is an intention to sell a significant part of Target's business within a relatively short time after acquisition, enabling part of the debt to be repaid. : However, considering the stipulation in Regulation and other laws, LBO is not practicable in China. According to the Regulation, it is forbidden for the FIVCE to offer any loan to the target company. Further, according to the Loan Regulation, the loan between the enterprises are not allowed to be used for the equity investment. Moreover, even the banks are not allowed to practice LBO because according to Commercial Bank Law, the banks are not allowed to invest and hold equity of a non-bank related enterprise.

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