Tapping China's venture capital market - a legal perspective

Venture capital is an important source of financing used to fund start-up and emerging growth companies that usually do not have access to the capital market. This is a relatively new concept in China.

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.

Generally, foreign companies are not permitted to own or carry out business directly in China. Typically, international foreign venture capitalists will invest in China either through the establishment of a new venture capital company 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 means of investing in China.

Establishing venture capital companies in China
Foreign capital is always welcomed, but China has yet to introduce a comprehensive legal and regulatory framework at national level to regulate the venture capital sector specifically. In a bid to boost the high-tech industry, a number of government agencies jointly released the Several Opinions on Establishing a Venture Investment Mechanism in 1999. Although they are without any binding legal effect, the opinions do reveal the intention of the Chinese government to encourage the development of the venture capital sector in China. The government has reportedly accelerated the drafting of regulations to govern venture capital investment.

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. These rules are known as the Tentative Regulations on Venture Capital Investments in High and New Technology Industries. For the first time, the Shenzhen Regulations specifically provide for venture capital investment in the Shenzhen Special Economic Zone.

Highlights of the Shenzhen Regulations

What form a VCC may take - a VCC may take the legal form of a limited liability company or a company limited by shares - these 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 RMB30m if it takes the form of a limited liability company. If it takes the form of a company limited by shares the registered capital must be no less than RMB50m.

Injection of the registered capital - The registered capital of a VCC can be contributed by instalments, but the last instalment must be made within three years from the date of the issue of the business licence of the VCC.

Requirements imposed on investors of a VCC - The Shenzhen Regulations require investors setting up a VCC to satisfy the following conditions:

(a) they must be of good standing their key employees
(b) must have relevant expertise in venture capital investment
(c) to set up a wholly foreign-owned VCC, the foreign investors must have total assets of no less than US$50m 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$30m at the end of the year immediately preceding the application

Scope of business - Subject to approval, a VCC may conduct the following business.

(a) direct investment in hi-tech enterprises or other new industries
(b) managing and running the venture capital of other VCCs
(c) providing investment consultancy services
(d) investing directly or participating in an enterprise incubator
(e) other business allowed under PRC laws and regulations

According to the Shenzhen Regulations, VCCs are explicitly banned from investing in the financial sector.
 
Foreign direct investment

Corporate structure
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.

Using a special purpose vehicle
It is not uncommon for foreign venture capitalists to invest in Chinese operating companies through an offshore SPV, usually taking the form of a holding company. A holding company would typically be formed in a tax haven, such as Bermuda, the Cayman Islands or the British Virgin Islands.

Briefly, use of an offshore holding company could bring the following benefits:

(a) 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 foreign investment enterprise (FIE) normally requires government approval. Approval is subject to a statutory right of first refusal for other investors in the FIE. Under current PRC law it is a company in which foreign investment holds 25 per cent or more of the stakes.

(b) The transfer of an interest in an FIE may attract tax implications. By adopting an SPV, international venture capitalists are able to avoid such tax obligations.

(c) All PRC enterprises, including FIEs that seek to go public and list overseas, need to go through lengthy approval procedures. An offshore holding company seeking to list on foreign stock exchanges is subject to less stringent requirements.

Restrictions on foreign investment
While China is eager to receive foreign investments, the rules governing foreign direct investment can appear discouraging to investors. The Chinese government has divided foreign investments into four broad categories - encouraged, permitted, restricted and prohibited.

Initial public offerings 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 specifically tailored to accommodate high-tech companies in China. The ‘main boards' of the Shanghai Stock Exchange and Shenzhen Stock Exchange are known as the Domestic Exchanges.

Under the existing PRC law, the conditions 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 China Securities Regulatory Commission (CSRC), a Chinese company seeking to list on the domestic exchanges must also satisfy the following requirements:

• the shares must be 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 RMB50m
• 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, no FIE has been granted approval to list so far.

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 NASDAQ or the Growth Enterprise Market of the Stock Exchange of Hong Kong Limited (GEM). International venture capitalists may follow either of these strategies:

• list the shares of the Chinese company directly on a foreign stock exchange (direct overseas listing); or
• if an SPV is employed, list the holding company on a foreign stock exchange (indirect overseas listing).

Separate regulations on Chinese companies seeking GEM Listing
Under the direct overseas listing mode, a Chinese company that 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), issued in 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:

(a)  the company must be a company limited by shares. The company must have obtained approval from the provincial government or the state economic and trade commission and must be incorporated legally
(b)  the company and its principal promoter must conform to national laws and regulations
(c)  the company must satisfy the requirements imposed by the GEM Listing Rules and
(d) other requirements that may be imposed by the state council

Notably, advanced and high-tech enterprises certified by the Ministry of Science and Technology (MST), will enjoy priority in obtaining approval.

Conclusion

Driven by the need for foreign capital, the Chinese government has reportedly put the legislation of venture capital investment on its agenda.

With China's accession to the World Trade Organisation, international venture capitalists can be expected to become increasingly interested in the Chinese venture capital market. On one hand, this is a consequence of the globalisation of the Chinese market; on the other, 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. Janine advises clients on private equity, mergers and acquisitions, disposals and joint ventures. She is described in the Asian Legal 500, the Chambers Legal Directory and Asia Law's lawyers survey, as a leading business lawyer in the field of M&A, e-commerce communications.

Chris Southorn is a partner in CMS Cameron McKenna's corporate and commercial group in Hong Kong. Chris specialises in corporate finance, M&A and private equity transactions. He has advised on numerous start-up and development capital deals and buy-outs, and has extensive experience of cross-border mergers and acquisitions, public company takeovers, listings, public equity capital raisings, share buy-backs and stock exchange matters.

CMS Cameron McKenna is a leading international firm with more than 180 partners worldwide. It has offices or associated offices in 35 cities in 23 countries. The Hong Kong office opened in 1980 and has ten partners and approximately 40 lawyers. The firm has been heavily involved in the private equity markets for many years, acting for institutional and strategic investors. The firm has extensive experience in the establishment, management of and investment in, funds and limited partnerships in various jurisdictions for private equity, and advise on the regulatory and compliance issues affecting investment funds. 

For more information on the firm's private equity capability in Asia please contact Janine Canham on +852 2846 9175 This e-mail address is being protected from spambots. You need JavaScript enabled to view it or Chris Southorn on +852 2846 9137 This e-mail address is being protected from spambots. You need JavaScript enabled to view it or visit the firm's website www.cmck.com

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