Venture capital, an important source of financing used to fund start-up and emerging growth companies which usually do not have access to the capital market, is a relatively new concept in China. Although some claim that venture capital funds have been active in China for more than 20 years, the more modern breed of high-tech venture capital only began to appear in 19931.
In recognition of the fact that the development of high-tech companies is critical for enhancing the country's position in the global economy, the Chinese Government has embarked on creating new sources of capital for Chinese enterprises. For some time, the Chinese Government has been developing domestic capital funds, but the need for capital has far outstripped the capacity of these domestic funds. China is therefore looking to foreign investors for additional capital. According to a report released by China's Ministry of Science and Technology (MST), by the end of 1999, the number of foreign-funded venture capital companies accounted for 8 per cent of the total venture capital organisations in China2.
Generally, foreign companies are not permitted to own or carry out business directly in China. Thus, typically international foreign venture capitalists will invest in China either through the establishment of a new venture capital company (VCC) in China or by investing directly in an existing Chinese company. In either case, it is not uncommon for foreign venture capitalists to use an offshore special purpose vehicle (SPV) as a conduit to invest in China.
Against this background, we examine below the current PRC laws and regulations applicable to international venture capital investments, with discussions on the legal and regulatory framework for regulating the initial public offering (IPO) in the domestic and the international markets.
Establishment of VCCs In China
Though foreign capital is always welcomed, China has yet to introduce a comprehensive legal and regulatory regime, at national level, to specifically to regulate the venture capital sector. In a bid to boost the high-tech industry, the MST, the State Development and Planning Commission, the State Economic and Trade Commission, the Ministry of Finance, the People's Bank of China, the General Bureau of Taxation and the China Securities Regulatory Commission (CSRC), upon prior approval of the State Council, jointly released the Several Opinions on Establishing a Venture Investment Mechanism (the "Opinions") on 16th November 1999. Although they are without any any binding legal effect, the Opinions do reveal a clear intention of the Chinese Government to encourage the development of the venture capital sector in China. By virtue of this policy, the Chinese Government has reportedly accelerated the drafting of regulations to govern venture capital investment. It is reported that a major focus of the drafting is to establish a "growth enterprise market" and to promote small and medium-sized high-tech enterprises not eligible for listing in the current "main boards" of the Shanghai Stock Exchange and the Shenzhen Stock Exchange3.
At local level, in response to the central government's call for venture capital, the Shenzhen Municipal People's Government has recently released a set of rules known as the Tentative Regulations on Venture Capital Investments in High and New Technology Industries (Shenzhen Regulations). For the first time, the Shenzhen Regulations specifically provide for venture capital investment in the Shenzhen Special Economic Zone. Some provisions of the Shenzhen Regulations are highlighted below:
Form Of VCCs
A VCC may take the legal form of a limited liability company or a company limited by shares. "Limited liability company" and "company limited by shares" are the two forms of companies regulated by PRC Company Law. In the case of a limited liability company, shareholders must assume liability towards the company to the extent of their respective capital contribution, and the company is liable for its debts to the extent of all its assets. In the case of a company limited by shares, the company's total capital is divided into equal shares, and its shareholders must assume liability towards the company to the extent of their respective shareholdings, and the company is liable for its debts to the extent of all its assets.
Minimum Registered Capital
The registered capital of a VCC must be no less than RMB30 million if it takes the form of a limited liability company, and no less than RMB50 million if it takes the form of a company limited by shares.
Injection Of The Registered Capital
The registered capital of a VCC can be contributed by instalments, but the last instalment must, in any event, be made within 3 years from the date of the issue of the Business Licence of the VCC. The first instalment of the registered capital of a wholly foreign-owned VCC must be no less than 20 per cent and, for an equity joint venture VCC no less than 15 per cent, of the total registered capital of the VCC.
Requirements Imposed On Investors Of A VCC
The Shenzhen Regulations require investors setting up a VCC to satisfy the following prerequisites:
- they must be of good standing;
- their key employees must have relevant expertise in venture capital investment; and
- in order to set up a wholly foreign-owned VCC, the foreign investors must have total assets of no less than US$50 million at the end of the year immediately preceding the application. Foreign investors proposing to set up a Sino-foreign venture capital investment company must have total assets of no less than US$30 million at the end of the year immediately preceding the application.
Scope Of Business
Subject to approval, a VCC may conduct the following business:
- direct investment in hi-tech enterprises or other new industries;
- managing and running the venture capital of other VCCs;
- providing investment consultancy services;
- investing directly or participating in an enterprise incubator; and
- other business allowed under PRC laws and regulations.
According to the Shenzhen Regulations, VCCs are explicitly banned from investing in the financial sector.
A VCC which has over 70 per cent of its capital invested in high and advanced technology industries will be able to enjoy the incentives designated by the Shenzhen Municipal Government.
Although the promulgation of the Shenzhen Regulations leads the way in regulating venture capital in China, it appears to leave a number of legal issues unresolved. For instance, it is unclear whether Article 12 of the PRC Company Law still applies to VCCs in Shenzhen. Article 12 of the PRC Company Law provides that if a company (other than an investment company or holding company as specified by the State Council) invests in other limited liability companies or companies limited by shares, the aggregate amount of such investment may not exceed 50 per cent of the investing company's total net assets value. As it is very unlikely that VCCs established in accordance with the Shenzhen Regulations, being local legislation, fall within the definition of "investment company" or "holding company" as specified by the State Council, the investment act of VCCs would be caught by Article 12. It is apparent that the operation of this provision would introduce significant difficulties for VCCs.
Foreign Direct Investment
In order to increase long-term investment, China has encouraged various foreign investment models. Over time, these investment structures have evolved to meet domestic and international needs.
In July 1979, the National People's Congress of China (the "NPC") adopted the Law of the Sino-foreign Equity Joint Enterprises of the PRC, with the effect that equity joint ventures became commonplace in China. In April 1988, the NPC enacted the Laws of the Sino-foreign Co-operative Joint Venture Enterprises of the PRC, whereby co-operative joint venture enterprises became allowed. In 1990, the NPC adopted the PRC Laws of Wholly Foreign-Owned Enterprises". Wholly foreign enterprises became commonplace. The mid- to late- 90s then witnessed the advent of Sino-foreign joint stock companies, as thea result of the promulgation of the Tentative Provisions concerning Several Questions on the Establishment of Foreign-invested Companies limited by Shares by the Ministry of Foreign Trade and Economic Cooperation.
Under current PRC law, a company in which foreign investment holds 25 per cent or more of the stakes will be treated as a foreign investment enterprise (FIE) and may enjoy a variety of incentives granted by the central and local governments.
Use Of SPV
As mentioned, it is not uncommon for foreign venture capitalists to invest in Chinese operating companies through an offshore SPV which usually takes the form of a holding company. Such a holding company would typically be formed in a tax haven, such as Bermuda, the Cayman Islands or the British Virgin Islands. The holding company might be owned by a single fund or by all of the foreign investors in the operating company, and it might hold a single investment or a group of related investments.
Briefly, use of an offshore holding company may bring the following benefits:
- It is often easier for regulatory reasons to transfer the shares of an offshore entity than to transfer a direct interest in the Chinese operating company. In the PRC, for example, the transfer of an interest in a FIE normally requires government approval and is subject to a statutory right of first refusal for other investors in the FIE, whereas the transfer of shares in an offshore holding company may not require such approval.
- The transfer of an interest in a FIE may attract tax implications. By adopting a SPV, international venture capitalists are able to avoid such tax obligations.
- All PRC enterprises, including FIEs that seek to go public and list overseas, need to go through lengthy approval procedures, whereas an offshore holding company seeking to list on foreign stock exchanges is subject to less stringent requirements. More details on this part are discussed below.
Restrictions On Foreign Investment
While China is eager to receive foreign investments, the rules governing foreign direct investment can appear discouraging to investors. By the Foreign Investment Industrial Guidance Catalog (revised) issued by the State Planning Commission (now known as State Development and Planning Commission) on 31st December 1997, the Chinese Government has divided foreign investments into four broad categories - encouraged, permitted, restricted and prohibited. The Catalog lists the sectors in which foreign investment is encouraged, restricted or prohibited. Foreign investment is deemed to be permitted in sectors that are not listed in the Catalog, except where other PRC laws, regulations or industrial policies provide otherwise.
As a result, one of the considerations to be taken into account at the outset of the investment is to determine the category under which the proposed investment is classified. For instance, under existing PRC law, investments in the manufacturing sector are generally encouraged, investments in the financial services, domestic commerce, foreign trade, advertising and Internet sectors are restricted, and investments in broadcasting and telecommunications are strictly prohibited.
IPO – One Of The Exit Options
In practice, there exist a number of alternatives for international venture capitalists to exit their investments in China. These exit options may include IPOs, transfer of shares, redemption and winding up. It is beyond the scope of this article to discuss many of these areas. Instead, we focus on the legal and regulatory framework for regulating IPOs in the domestic and international markets.
IPOs In The Domestic Market
Both the public securities market and the private capital markets in China are still underdeveloped. There has not been a market, separate from the "main boards" of the Shanghai Stock Exchange and the Shenzhen Stock Exchange (together the "Domestic Exchanges"), specifically tailored to accommodate high-tech companies in China.
Under the existing PRC law, the prerequisites for a company to be qualified to list in the Domestic Exchanges are extremely stringent. Few of the high-tech start-up companies would be able to satisfy these requirements. In addition to obtaining prior approval from local government and CSRC, a Chinese company seeking to list on the Domestic Exchanges must also satisfy the following requirements:
- The shares must have already beenbe issued to the public with the approval of the relevant securities supervisory department under the State Council;
- The company must take the form of a company limited by shares;
- The registered share capital of a company proposing to list must be no less than RMB50 million;
- The company must have been in operation for three years and have made profits for the past three consecutive years; and
- Other conditions stipulated by the State Council must be met.
Although the existing PRC law does not explicitly prohibit or restrict FIEs from going public and listing on the Domestic Exchanges, in fact no FIE has been granted approval to list so far. On the other hand, even if a FIE is granted approval to list on the Domestic Exchanges, the following restrictions may pose a hurdle to the liquidity of shares:
- Only shares issued to the public can be traded on the Domestic Exchanges. Shares held by promoters cannot be openly traded (but can be sold by private agreement subject to the approval of the CSRC).
- Shares held by the promoters are prohibited from being transferred within a three year lock-up period after the listing.
IPOs In International Markets
As FIEs have extremely limited access to China's domestic capital markets, they often choose to list on international stock exchanges. As a matter of practice, Chinese high-tech start-up companies prefer to list their shares on the NASDAQ or the Growth Enterprise Market of the Stock Exchange of Hong Kong Limited (GEM). The following strategies may be taken by international venture capitalists to list their Chinese companies:
- Listing the shares of the Chinese company directly on a foreign stock exchange (Direct Overseas Listing);
- If a SPV is employed, listing the holding company on a foreign stock exchange (Indirect Overseas Listing).
By way of a table, a comparison of the legal and regulatory requirements for Direct Overseas Listing and Indirect Overseas Listing is depicted below:
Comparison of the Requirements for Direct Overseas Listing and Indirect Overseas Listing
Direct Overseas Listing
Indirect Overseas Listing
·Special Provisions on the Share Offering and Listing of Companies limited by Shares (promulgated by the State Council on 4th August 1994)
·Circular of Several Questions concerning Enterprises' Application for Overseas Listing (issued by the CSRC on 14th July 1999)
·Circular of the State Council on Further Strengthening the Administration of Issuing Stock and going public on Foreign Markets (Document No 21 , issued by the State Council) (State Council Circular)
·Circular of Questions concerning the Issue and Listing Overseas of Overseas Companies involving Domestic Interests (released by CSRC on 9th June 2000) (June 9 Circular)
A company (including FIEs) seeking to list overseas must fulfill the following conditions:
·The company must comply with the relevant laws, regulations and rules stipulated by the CSRC;
·The proceeds raised through overseas listing must be applied in compliance with China's industrial policies, its policies for the utilization of foreign capital and state regulations concerning fixed asset investment;
·The company must have a net asset of no less than RMB400 million, with no less than RMB60 million of after-tax profit for the past one year.
·The company must have a regular corporate governance structure and solid internal management system.
·The company must have reliable foreign exchange sources for dividend and interest payment.
·Other conditions stipulated by the CSRC
·State Council Circular. The State Council Circular is viewed as concerning the circumstances where state-owned assets are involved. It requires that where an overseas Chinese-funded company seeks to issue shares overseas and to list their domestic assets which they actually owned for more than three years, the company's domestic equity holder shall obtain approvals from the local government and the CSRC. Domestic assets actually owned by the overseas Chinese-funded company for less than three years shall not be included for listing.
·June 9 Circular. The June 9 Circular concerns the circumstances where foreign companies which seek to list on international stock exchange have assets and operations in China but where the State Council Circular does not apply. It requires that a PRC legal opinion, detailing information including the legality of the stakes owned by Chinese institutions and citizens (if any), the domestic interests and assets owned directly or indirectly by the foreign companies and the legality of the formation of the China-based interests and assets, be submitted to the CSRC for review. A foreign company seeking to list on international stock exchanges will only fulfill the requirements after it receives a letter of "no comments" from the CSRC.
·Local Government (or the relevant department under the State Council)
·Authorities approving the establishment of the company
·Applications covered by the State Council Circular:
Local Government (or the relevant departments under the State Council
·Applications covered by the June 9 Circular
Separate Regulations On Chinese Companies Seeking GEM Listing
Under the Direct Overseas Listing mode, a Chinese company which is seeking to list on the GEM is also subject to the Guidelines for Approving and Regulating the Listing of Domestic Enterprises on the GEM of Hong Kong Stock Exchange (Guidelines) which was issued by the CSRC on 12th October 1999. The Guidelines apply to state-owned enterprises, collective enterprises as well as enterprises of all other forms of ownership. The Guidelines provide that a company seeking GEM listing must meet the following conditions:
- The company must be a company limited by shares having obtained approval from the provincial government or the state economic and trade commission and must be incorporated legally;
- The company and its principal promoter must conform to national laws and regulations;
- The company must satisfy the requirements imposed by the GEM Listing Rules; and
- Other requirements may be imposed by the State Council.
Notably, advanced and high-tech enterprises certified by the MST will enjoy priority in obtaining approval.
Driven by the need for foreign capital, the Chinese Government has reportedly put the legislation of venture capital investment on its agenda4.
With China's accession to the WTO, international venture capitalists can be expected to become increasingly interested in China venture capital market. On the one hand, this is a consequence of the globalization of the Chinese market. On the other hand, it is a natural extension of the development of Chinese law in the area of venture capital investment.
Janine Canham is a partner in CMS Cameron McKenna's corporate and commercial group based in Hong Kong. She has been in Hong Kong since 1991. Janine advises clients on all aspects of corporate and commercial law and is experienced in private equity, internet and e-commerce. Janine has written many articles and delivered numerous lectures on the subject of corporate acquisitions and compliance and e-commerce.
Chris Southorn has recently joined the Hong Kong office corporate group from London where he was a partner in the corporate department specialising in corporate finance, private equity, mergers and acquisitions and general company law.
1See "In search of Growth, China turns to High-Tech Venture Capital Funds", Francis Bassolino on www.chinaonline.com
2Reported 31st July 2000, on China Daily
3Reported on 8th August 2000, on www.chinaonline.com originally reported on 7th August 2000, on www.zaobao.com
4Reported on 13th October 2000, on Tou Zi Dao Bao
© CMS Cameron McKenna 2000
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