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Korea - Venture Business, Venture Capital and KOSDAQ

Since 1997, Korea has witnessed significant legislative changes to the venture business framework. This article from Woo, Yun, Kang, Jeong & Han provides a summary of the regulatory framework.

In 1997, the Korean government implemented a series of new laws to promote venture businesses (VB). The most important statute under this new legislative scheme was the Special Law for the Promotion of Venture Businesses (SLPVB). This law went into effect on October 1, 1997 and will remain in force until December 31, 2007. The main purpose of the special law was to provide the basic tools that were necessary for the development of venture businesses such as financial assistance, tax benefits, exceptions to general corporate laws, assistance to research and development and establishment of ‘venture valleys'. In addition, the Korean government adopted the Law for the Assistance of Small and Medium-sized Enterprises Start-up (LASMES), the Law for the Financial Assistance to New Technology Enterprises (LFANTE), the Finance Business Specialised in Lending Law (FBSLL) and the Law on Limitation of Special Tax Treatment (LLSTT) to address various other aspects of VB.

Based on this policy drive and other socio-economic factors, the KOSDAQ, which was incorporated into the regulatory framework of securities through the 1997 amendment of the Securities Transaction Law, exploded during 1998, 1999 and early 2000. For instance, while the number of IPOs at the Korea Securities Exchange stood at only 16 in 1999, 114 companies - comprising of VB as well as non-venture businesses - went public through the KOSDAQ during the same year. Further fueling the explosion was the significant addition to the KOSDAQ of mutual funds under the newly enacted Mutual Funds Company Law.

During 1999, KOSDAQ registered companies financed KRW6.4bn through issuing new shares and selling corporate bonds over 306 times. These figures are more than double the same figures for 1998. Thus, as of December 1999, the daily trading over the KOSDAQ was more than KRW2,000bn. Despite the fact that the KOSDAQ market has experienced a downturn during the latter half of 2000, the number of newly registered companies for the year 2000 stands at a more than modest figure of 140.

This note summaries the regulatory framework of venture businesses in general and also capsulates financing sources and investment vehicles related to venture businesses in Korea.

I. Definition of venture businesses
Under the SLPVB, there are four categories of VB. One overriding element among the four categories is that they must fall within the definition of small and medium-sized enterprises (SME) under the Small and Medium-sized Enterprises Basic Law. This provides specific limitations on the maximum number of permanent employees and the size of assets on a per industrial sector basis. The four categories of VB as defined in the SLPVB are as follows:

Venture capital

If the amount of investment by certain qualifying venture capital accounts for 20 per cent or more of the paid-in capital of the company or stock subscription price is ten per cent or more of the paid-in capital, such a company is considered to be a venture capital VB. The investment can be made in stock, convertible bonds or warrants. The qualifying venture capital investments are those made through: (i) SME investment company and investment fund under the LASMES; (ii) new technology financier and new technology investment fund under the LFANTE and FBSLL;(iii) Korea Venture Investment Fund; and (iv) Dasan Venture Company.

Research and development

If the value of R&D accounts for five per cent or more of the annual gross sales revenue, such a company is considered to be an R&D venture business.

New technology commercialisation

If the company is engaged in the business of commercialising patents, utility models, high technology licensed abroad, all of which are qualified for the tax exemption, or other knowledge or technology supported by various statutes such as the Industry Development Law, Energy Use Rationalisation Law, Telecommunications Basic Law, Technology Development Promotion Law, etc., the VB Vitalisation Committee, pursuant to the SPLVB, has the authority to designate such a company as a new technology commercialisation VB.

Miscellaneous

If the company is engaged in the business of commercialising less advanced technologies such as design and other less advanced knowledge or technology, the Agency for Technology and Standards, the SM Industry Promotion Corporation (SMIPC) under the Law for SME Development and Preferred Purchase Promotion or Korea Technology Credit Guarantee Fund (KTCGF) under the LFANTE can evaluate the relevant technology and declare such technology as excellent technology. Once such an evaluation is rendered, the company is considered to be a miscellaneous VB.   

II. Special assistance and exceptions to VB

Direct and indirect supply of public funds and guarantee

Most of the public funds can invest up to ten per cent of their funds directly to VB or indirectly through SME investment funds, new technology investment funds or Korea venture investment funds. Korea venture investment funds are those established by the SMIPC. In addition to these funds, the Korean government incorporated Dasan Venture Company to further facilitate investments in VB. With respect to providing sufficient guarantee, the KTCGF, which provides a guarantee to SMEs for financing from other financial institutions, is required to guarantee the debts of VB prior to guaranteeing those from non-venture businesses.

Special Treatment of Foreign Investment

Under the Foreign Investment Promotion Law (FIPL), foreign equity investment for a continuous economic relationship with a Korean entity, unlike foreign portfolio investment, may satisfy notification requirements by simply filing a notification to a foreign exchange bank. An investment in SME investment funds or Korea venture investment funds is deemed to qualify as foreign investment for continuous economic relationship as set out under the FIPL and, therefore, a simple notification would be sufficient to meet the notification requirements. Furthermore, investment in listed VB is exempt from the restrictions on acquisition of securities listed on the Korean Securities Exchange under Article 203 of the Securities Transaction Law. Thus, a foreigner can invest in listed VB without being subject to any caps.

Variation from basic corporate law

The minimum paid-in capital of a VB is KRW20m. As the minimum paid-in capital of a joint stock company is KRW50m, one can incorporate a VB more easily with fewer financial resources. The SMPVB provides for stock options. This used to be possible only for listed companies. However, as the revised Korean Commercial Code (CC) allows any joint stock company to adopt the stock option plan, this is also not a special favour any more. Nonetheless, the stock option for VB is slightly different from that of a joint stock company in general. While joint stock companies may grant stock options only to its officers and employees, VB may also grant stock option plans to outside researchers, legal counsel and even accountants. The cap on such stock options is 50 per cent of the outstanding shares. It should also be noted here that any stock option plan must be reported to the Korea Securities Dealers Association and the SME Administration. The methodology of stock option plans, the procedure and the way to decide the option price, and the market value are the same as stock option plans in general.

Tax benefits

The LLSTT provides for a number of tax benefits such as exemption of acquisition tax and registration tax or stamp duty, special deductibility of certain reserves and investment tax credits relating to SME and R&D in general. These tax benefits have been further expanded for VB. Thus, as regards certain VBs, the corporate income tax is reduced by one half for the next five years. They are also free from acquisition tax and registration tax for the two years after incorporation and one half of property tax and composite land tax are waived for the first five years of incorporation.
    
III. Pre-IPO financing

Angel investors

The SLPVB provides for the possibility of special tax benefits on an individual's direct investment to VB or indirect investment made through other venture capitalist funds, angel investment partnership, etc. Thus, under the LLSTT, such investment, if made by the end of 2000 to VB of seven years or less, shall be credited up to 30 per cent to its taxable income for the taxable year during which the investment is made or for one of two following taxable years. If, however, such investment is recovered by way of transferring the stock or redemption within five years, the tax credit is recouped. As for angel investment partnership, it must be reported to the SME Administration for such tax benefits. Any capital gains from the transfer of stock are also not taxable if such investment was made to VB of three years or less.

Venture capitalists

The LASMES provides for special support for SME investment companies. These investment companies are venture capital companies that are recognised by the SME Administration as such. For such recognition, they must be a joint stock company with the paid-in capital of KRW10bn with the business purpose of investment in new SMEs of seven years or less. Once an SME investment company is duly registered with the SME Administration, it can borrow public funds and issue bonds up to ten times the paid-in capital and retained earnings. As to the investment activities, it cannot make an investment in another SME investment companies or own more than 50 per cent of shares of another SME. Investment in companies identified as big conglomerates under the Anti-Monopoly and Fair Trade Law and/or investment in financial institutions are also not allowed. Each year, SME investment companies' financial statements must be reported to the SME Administration.

An SME investment company can also organise an SME investment fund as a partnership with other investors. Under these partnership agreements, an SME investment fund must have a general partner who bears unlimited liability, and limited partners. Under these partnership arrangements, SME investment companies are the general partner while other investors are the limited partners. Investment by a SME investment fund also qualifies for certain tax benefits.

Legal instruments

As legal instruments for investment in VB, there exist common stock, preferred stock and convertible bonds classified as such under the Korean CC. Due to a dearth of legal authorities regarding the relationship between common and preferred shareholders or convertible bondholders, however, a clear picture has yet to emerge of the precise classification of the various instruments that may be used. Nonetheless, the various features of convertible preferred stock or bonds such as preference in dividend payment, liquidation preference, adjustment of conversion price and redemption have been adopted. Although one cannot be totally free from doubt, it appears that a separate agreement on lock-up, drag-along, tag-along, or right of first refusal may also be made.     

IV. KOSDAQ registration

Requirements

The requirements for registration of a company with the KOSDAQ are generally no less stringent than those for the Korean stock exchange. With respect to VB, however, several significant financial and historical requirements are waived. These are: (i) three year operating history; (ii) minimum paid-in capital of KRW500m and debt-to-equity ratio of less than 1.5 times that of the average ratio of the applicable industrial sector in general; and (iii) existence of ordinary income and positive net equity for the immediately preceding fiscal year. The other requirements such as those pertaining to distribution to the public, restrictions on capital change by means of stock bonus and issuance of new shares during one year pre-application period, independent auditor's opinion, designation of a transfer agent, standard stock certificates, finalised financial statements for the previous fiscal year, no litigation, no restriction on transfer of shares and no change to the shareholding ratio of the largest shareholder during six months pre-application period are equally applicable to VB.

The distribution requirement has recently been changed and, under the revised rules, the total number of shares offered to the public from the date of the preliminary review for registration to the date of its application for registration must be (as of the date of its application for registration): (i) at least 30 per cent of the total issued and outstanding shares; or (ii) at least ten per cent of the total issued and outstanding shares and at least one million through five million, depending on the amount of equity. Additionally, the number of the minor shareholders must be 500 or more. (The Employee Stock Ownership Association shall be deemed as one shareholder for the purposes of meeting the number of minor shareholders requirement.) If a venture capitalist has made a capital injection one year prior to the preliminary review application, the ten per cent distribution requirements shall be deemed to be met.

As a procedural matter, a VB first has to register itself as a securities issuer with the financial supervisory commission. Upon such registration, the VB can file a preliminary review for an IPO with the KSDA. After the KSDA reviews the preliminary application positively, the VB can issue new shares to the public to meet the foregoing distribution requirement upon filing a registration statement with the financial supervisory commission. Once the distribution requirement is met, the VB is duly registered.

Regulations on KOSDAQ-registered VB (RVB)

Once a VB is registered with the KSDA, the largest shareholder cannot sell its shares for a year after IPO. For the second year after IPO, it can sell up to five per cent a month of its initial shares. After two years has passed since the IPO, no restrictions are imposed on share transfer by the largest shareholder. As for venture capitalists, if the capital injection was made one year prior to IPO, a three month lock-up is applicable. If the venture capitalists have made an investment for less than one year prior to IPO, a six month lock-up applies.
 
A lot of regulations and exceptions available to KSE-listed companies are generally available to VB as well. These are : (i) VB can acquire treasury stock through the market up to the amount of distributable retained earnings despite the prohibition under the CC; (ii) VB can issue new shares to the public according to the resolution at board of directors despite the preemptive rights under the CC; (iii) VB can issue non-voting shares up to one half of the total number of outstanding shares despite the one quarter under the CC; (iv) VB can make stock dividends up to the amount of distributable retained earnings despite one half cap under the CC; (v) VB can issue participating bonds or exchange bonds in addition to the convertible bonds and bond with warrants under the CC; (vi) the amount of bonds that VB can issue has no limits, unlike the restrictions of four times the net asset value under the CC; and (vii) as regards minor shareholders, two-week prior notice requirement for a shareholders meeting under the CC can be replaced by two public notices in a daily newspaper.

Young-Cheol Jeong is a partner with Woo, Yun, Kang, Jeong & Han in Korea. For more information on this topic he can be contacted by telephone (82-2-528-5200) by fax (82-2-528-5228) or by e-mail (ycjeong@wooyun.co.kr)

The law firm of Woo, Yun, Kang, Jeong & Han includes many of Korea's most eminent business attorneys and trial lawyers. Over the years, through extensive first-hand experience, the members, associates and staff of Woo,Yun have acquired a comprehensive knowledge of virtually every aspect of both the domestic and international practice of law as they relate to commerce. Today, Woo Yun vigorously exploits that experience and knowledge to serve the interests of its business clients, both foreign and Korean.

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