A Q&A guide to venture capital law in China.
The Q&A gives a high level overview of the venture capital market; tax incentives; fund structures; fund formation and regulation; investor protection; founder and employee incentivisation and exits.
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This Q&A is part of the PLC multi-jurisdictional guide to venture capital. For a full list of jurisdictional Q&As visit www.practicallaw.com/venturecapital-mjg.
Venture capital investors in China invest in companies with high growth potential, usually in the high-tech and high growth industries, such as medical, e-commerce, new media and telecommunications, with the hope of listing the investee company through an initial public offering (IPO) or trade sale. China's venture capital market is broadly comparable to other jurisdictions but investors must take into account a number of potentially problematic China-specific issues:
There is no statutory or legal recognition of the concept of preferred shares for limited liability companies. While companies can try to amend their corporate charters to emulate certain preferential shareholder rights customarily received by venture capital investors internationally, these may not be enforceable under applicable local Chinese laws and regulations. Therefore, local Chinese entities operating under Chinese law do not afford venture investors with the usual economic preferences or protections.
China is a particularly difficult jurisdiction for venture capital investors because the identity of a foreign investor and the nature of its investment activities in China largely dictate its options for an appropriate investment structure, the level of government scrutiny, and whether it is subject to preferential treatment. MOFCOM's Foreign Investments Industrial Guidance Catalogue (Foreign Investment Catalogue) published by the Ministry of Commerce (MOFCOM) and the National Development and Reform Commission (NDRC) categorises foreign investment in specific sectors as either encouraged, permitted, restricted or prohibited.
Foreign investments in encouraged sectors are normally eligible for various incentives and investors can use various investment structures. In general, sectors that involve advanced or new technologies are encouraged.
Foreign investment in restricted or prohibited sectors, however, are subject to strict examination by government authorities, and the investment structure options may be limited and a majority Chinese partner may be required. Restricted investment sectors commonly include banking, insurance, securities services, certain manufacturing sectors, and investments in areas that are technologically undeveloped. Restricted sectors also include new media, internet, e-commerce, telecommunications, education, logistics and healthcare, some of the most sought after sectors by venture capitalists.
Due to China's strict foreign exchange controls, venture capital investors must receive approvals from China's State Administration of Foreign Exchange (SAFE) to convert US$ into Renminbi (RMB) for investment purposes. US$ are of little use to an investee in China, as it must conduct its business in RMB. In addition to inbound currency exchange, Chinese company founders who wish to hold shares offshore must first register their holdings with SAFE in accordance with SAFE Circular 75 (SAFE 75 registration). SAFE 75 registration is a required registration application by which the Chinese government regulates the shareholding arrangements, foreign currency flows, and tax issues involved in offshore shareholding structures. Despite clarifying legislation the complexity of PRC foreign exchange rules and regulations can make investing in China difficult.
Although China is required to eventually open up nearly all of its sectors and markets to foreign direct investment (FDI) under its obligations arising from its entry into the World Trade Organisation, until China fully opens up to these types of investments, foreign investors must continue to adjust to the Chinese market and their foreign legal advisors must stay up to date with the changing rules and regulations governing foreign investment in China.
For structuring responses to these challenges see Question 7.
On 1 July 2011, SAFE issued new guidelines in its Circular 19 - Circular on Issuing the Operational Rules concerning Foreign Exchange Administration of Company Financings and Round Tripping Investments via Overseas Special Purpose Companies by Residents in China (Circular 19). Circular 19 introduced significant changes to the regulations that local Chinese companies must follow to establish offshore Special Purpose Vehicles (SPVs). Circular 19 addresses foreign exchange registration by SPVs established by Chinese residents, newly-established foreign-invested enterprises, and offshore direct investments by entities in China. With the exception of Shanghai, as of the end of October 2011, many of the SAFE offices in major Chinese cities now apply Circular 19. Some of the key Circular 19 provisions include that:
Registration can now be made after the SPV is established.
Non-SPVs are allowed for the first time to engage in foreign exchange registration.
The requirement to provide three years of the company's operating history before application is no longer in force.
Less documentation is required for foreign exchange registration.
Retroactive registration of SPVs established before 31March 2006 after the filing deadlines is again possible.
Due to national security concerns, the General Office of the State Council (State Council) issued the Notice on Establishing a Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (Circular 6), which took effect on March 2011. Circular 6 established an extensive national security review process for foreign investors seeking to acquire a local enterprise or an asset.
More recently, MOFCOM issued the Provisions on the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, Announcement No. 53, (No. 53 Provisions), which helps implement Circular 6 and expands the reach of Circular 6's security review process to transactions involving variable interest entity structures (VIE structures).
Circular 6 and the No. 53 Provisions collectively give the Chinese government broad powers to:
Define what transactions may affect national security interests.
Prevent transactions from taking place that are deemed to be detrimental to national security interests.
Change the terms of a transaction or even cancel it to mitigate any potential national security threats.
Foreign investors looking to acquire enterprises or assets in China should prepare for a more complex and prolonged transaction approval process.
On January 23, 2011, the Shanghai Municipal Finance Office issued the Details on Implementing the Pilot Programme of Foreign-invested Equity Investment Enterprises (pilot programme). Similar programmes have been adopted in other large Chinese cities such as Tianjin. The pilot programme encourages foreign investors to invest in RMB-denominated private equity/venture capital (PE/VC) funds (see Question 7) and PE/VC investment management enterprises in Shanghai.
The pilot programme sets out the policies and procedures for the establishment and operation of investment vehicles in Shanghai. The pilot programme stipulates clear establishment requirements for foreign-invested fund enterprises, including the qualification of investors, the documents required and the timetable of establishment. One of the highlights of the Shanghai pilot programme is that a fund sponsored by a general partner (GP) is treated as a domestic-funded enterprise if the GP's foreign exchange contributions to the fund do not exceed 5% of the committed capital and no contributions have been made by foreign limited partners. It has also loosened the restrictions on the scope of investment for foreign investors. Despite this opening up, there are still many unanswered questions regarding the application of the pilot programme.
China's tax law regime is one of the most complex in the world. US$-denominated venture capital funds (US$ funds) typically invest in a tax-free manner and exit in a tax-free manner, subject only to tax rules based on its domicile.
In contrast, RMB-denominated venture capital funds (RMB funds) are subject to a capital gain tax in China on all of their investment exits. Certain incentives exist for either the investor in venture capital funds or the venture fund itself but these are jurisdiction and industry specific and must be applied for on an individual basis. For example, clean-tech (green) energy may enjoy certain tax incentives, as may technology-focused funds, provided the investee is in a jurisdiction where job creation is a high priority.
Offshore US$ funds (see Question 7) are typically invested into by cash-rich institutional investors, such as pension plans, universities, insurance companies, foundations, endowments, and high-net worth individuals. Typically the GP provides only a small proportion (about 1% to 5%) of the capital raised by a given fund. Most venture capital firms are structured as management companies responsible for managing several pools of capital, each representing a legally separate limited partnership.
As with offshore funds, RMB funds (see Question 7) are typically structured in the form of a limited partnership with a lead investor as the GP to manage the operation of the fund and a series of other limited partners (LPs). Other LPs may be angel investors, pension funds, insurance companies and other venture capital firms.
The currency of a venture capital fund can have a direct and significant impact on how investments are made in China and venture capital funds are typically structured as limited partnerships, with the GPs serving as the managers of the firm and as investment advisors to the portfolio companies of the venture capital fund. The most common investment structure for a US$ fund is an offshore limited partnership, often established in the Cayman Islands or a similar offshore jurisdiction.
Investments made by US$ funds typically involve the VIE structure where the investee company lists outside China (see Question 7).
With the strong performance of the Chinese shares exchanges over the last few years, as well as increased competition from local RMB funds, US$ funds are increasingly considering alternative investment structures such as RMB funds, joint ventures and similar structures. When properly structured, such a fund may enjoy improved tax treatment. If the fund is structured as a joint venture, there is no enterprise income tax and distributions to foreign investors are only subject to a withholding tax.
Foreign investor private equity firms generally prefer investing into funds under the Foreign-Invested Venture Investment Enterprise Administrative Regulations (FIVCIE regulations) (see Question 7).
Venture capital investments can be made either individually or by a syndicate of venture capital funds, in either RMB or US$. It is common for venture capital and private equity investments to involve co-investors or syndicate investors.
Most funds invest in China through offshore holding companies. These funds are typically set up in tax-favourable jurisdictions and invest in Chinese companies through the VIE structure (see below). Offshore funds are set up in accordance with the laws of their respective offshore jurisdictions. Most offshore funds are structured as standard LP-GP structures and are governed by the terms of the limited partnership agreements.
As a result of the specific characteristics of the Chinese market (see Question 1), in order to facilitate lawful transactions while taking into consideration the restrictions on foreign investment and still give venture capitalists the same type of investment rights and protections as they would find in other jurisdictions, most foreign venture capital is invested through an unique offshore structure called the VIE structure. The VIE structure has been the investment structure of choice for foreign investors to navigate the grey areas of Chinese law on FDI for over a decade. The VIE structure is designed to allow foreign investors to hold a controlling interest in a business that operates in one or more of China's many restricted or prohibited sectors. The VIE structure is also used to allow Chinese domestic entities to gain access to international capital markets through offshore listings.
The key concept that underpins the VIE structure is the foreign investors' control over a domestically licensed company, typically a domestic Chinese company, that operates in an industry requiring the existence of a restricted business licence. The foreign investors establish a controlling interest in the domestic company through various control agreements (VIE contracts), rather than through direct share ownership, which in many cases is not permitted by Chinese laws and regulations.
Although the VIE structure has been the accepted structure for investors for over a decade, due to recent negative publicity foreign investors have become increasingly apprehensive over the possible underlying defects in VIE structures. To address this some investors are starting to use alternative structures. One such structure is the multi-jurisdiction captive company structure (MJCC structure), which gives additional rights and protection to foreign investors investments in China. However, many of the alternative structures are less established than the commonly used VIE structure and further refinement of VIE contracts by practitioners is expected.
China recently reformed its rules and regulations to further liberalise its financial system and now permits the formation of RMB funds. Foreign venture capitalists can also raise and manage RMB funds. As with offshore funds, RMB funds are typically structured in the form of a limited partnership.
Although foreign investors have been able to form RMB Funds since 2003, it is only recently that these funds have become popular. This popularity (with both domestic and foreign investors) can be attributed to China's economic growth as against the backdrop of an uncertain global economy. At present, many US professional investors are aggressively seeking to tap into China's vast investment prospects through the use of RMB funds. Although investment through the VIE structure is still the preferred investment vehicle, the development and potential benefits of RMB funds have led to greater competition between overseas funds and domestically formed funds.
As foreign-invested RMB funds are regarded as domestic entities, they can make investments into other domestic entities without obtaining the often elaborate approvals required by the Chinese government (except where such investments fall within either a restricted or prohibited industry under the Foreign Investment Catalogue (see Question 1). Therefore, a foreign investor into a RMB fund can access both domestic and offshore deal flow.
RMB funds incorporated in China are typically licensed to invest in either industrial or high tech assets. In this context "industrial" generally means private equity and "high tech" means venture capital. Therefore, the types are often translated as private equity investment enterprise (PEIE) or as a venture capital investment enterprise (VCIE). (Both VCIE and the PEIE are EIFs. Other types of EIFs exit but we do not discuss them.) Both the PEIE and VCIE legal regimes permit foreign investment participation (creating a FIPEIE and a FIVCIE respectively), and can also be structured in a corporate form (an incorporated FIVCIE), or in the form of a Chinese-foreign co-operative joint venture (CJV FIVCIE). The legal structure of a CJV FIVCIE is similar to that of a limited partnership. Recently the new PRC Partnership Law created yet a new class of FIVICIEs permitted limited partnerships (LPs) and general partnerships (GPs) to exist.
Equity investment funds (EIFs) provide an alternate RMB fund structure to FIVCIEs Recently, the concept of a pure RMB fund (meaning a RMB fund that is entirely domestically funded and therefore not subject to foreign investment restrictions or any deal-level approvals) has been viewed as a possible substitute. Such pure RMB funds usually adopt the EIFs' business scope and structure, and permit greater flexibility for its fund sponsors and investors to dictate their internal governance. Since there is no foreign funding, EIFs are not:
Subject to the Foreign Investment Catalogue.
Limited to investing in the high-technology sector.
Required to convert currency.
EIFs generally do not need special government approval for various deals, and generally offer simpler structures and tax pass-through treatment.
Given the many variations, and as the needs of each foreign investor is different, investors should consult legal advisors to strategically devise the most suitable structure for their needs.
Funds typically seek a high return for their high-risk taking activities, regardless of the type of currency. The average life of a US$ fund investing in China ranges from eight to ten years. In contrast, a RMB fund may have a fund life as short as three years, and this is not uncommon.
In general, US$ funds are domiciled in offshore tax havens and therefore are subject to their local rules. Therefore, no special licence is required, unless the fund receives capital onshore or engages in business activities which require a special licence. However, a fund can become subject to regulation and taxation in China if it directly engages in investment management or consulting business in China (instead of through a separate Chinese fund management company) under the permanent establishment rules. Once a fund has created a permanent establishment in China, the fund is arguably subject to Chinese taxation.
In contrast, local RMB funds must have a fund management and/or fund investing licence to lawfully operate.
Offshore US$ funds are mostly regulated by the law of their home jurisdiction where the fund is domiciled and/or formed. However, a fund can become subject to regulation and taxation in China if it directly engages in investment management or consulting business in China (see Question 9).
RMB funds are regulated by the Chinese authorities. On formation, an RMB fund must select what form it will take, and that selection will determine its tax treatment, as well as differences in its management and operations. While it is logical that all fund managers should select a tax efficient structure, given China's developing tax, fund and partnership laws, it is difficult for fund managers to gauge which particular fund structure will provide the best tax savings. In addition, the analysis will be affected by the investee companies' industries and the listing location. While the LP-GP RMB fund set-up should receive a better tax treatment because they are pass-through legal entities, Chinese tax regulations in this regard are unclear and subject to interpretation.
For both offshore and onshore venture capital funds, a limited liability partnership is the most common form of organisation. The relationship between investor and fund is governed by the partnership agreement, which normally provides for two types of partnership, general partnership and limited partnership.
Investors seek protections covering all aspects of the investee company, including, but not limited to, formation, organisation, business operations, employment and exit.
The partnership agreement between the GP and the LPs of a fund sets out the protections afforded to the partners and covers all aspects of the fund, such as formation, operation and exit, as well as including key commercial and administrative issues.
The agreement between the investors and the fund sets out the protections afforded to the investors and covers all aspects of the fund such as formation, operation and exit, including key commercial issues (for example, investment policies, profit sharing, fees and expenses), as well as administrative issues (for example, information and reporting requirements).
The interest taken may take the form of equity, option rights, debt, short term bridge financing or any combination of the above.
Venture capital funds use different methods to evaluate investee companies such as the status of a company in the relevant Chinese market, the intellectual property of a company, and the price-to-earnings ratio (P/E Ratio) which is often benchmarked against a similarly situated publicly traded company. In addition, funds look at a company's potential value, growth potential and management team.
Venture capital funds carry out a thorough due diligence investigation on each company in which they invest. The due diligence on a company usually includes reviewing the company's:
Corporate organisation and history.
Management and employee relations.
Financial and accounting matters.
Legal and tax matters.
In particular, legal professionals often focus on regulatory compliance and local permit and licensing requirements, which must be investigated in detail to confirm the viability of a proposed investment.
A standard venture investment by a foreign fund in China includes the following documentation:
Share purchase agreement.
Revisions to the company's memorandum and articles of association are almost always necessary.
In addition, the investor may also require:
Resolutions approving the transactions.
A management rights letter.
A compliance certificate certifying that the company documents are correct.
Letters of commitment.
Copies of the company's standard employment contract, to ensure the company's intellectual property and other rights are adequately protected.
Venture capital funds almost always require the issuance of a formal legal opinion by local Chinese counsel concerning the structure of the investment, as well as an opinion from offshore counsel on the legality of the securities being issued.
Investors in a company using an offshore structure usually have contractual protections in the form of extensive representations and warranties by the founders of the company and each of its subsidiaries.
A typical shareholders' agreement contains information rights that require a company to provide financial information to the investor, and inspection rights that allow the investor to inspect the company's books and records.
As a preferred shareholder, investors usually also have rights of first refusal, rights of co-sale (or tag-along), pre-emption rights and shareholder and/or board protective provisions (see Question 21).
A venture capital fund often purchases an equity interest in the form of preferred shares in the offshore company (not a company in China because Chinese laws do not recognise preferred equity) (see Question 1). This equity interest is similar to the preferred shares mechanism commonly accepted around the world.
Offshore funds commonly enjoy preferred share rights including but not limited to dividend preferences, liquidation preferences, anti-dilution protection, redemption rights, and protective voting rights.
The following rights, preferences and privileges are common in most venture capital investments by foreign funds in China:
Protective voting provisions.
Drag-along and tag-along rights.
Right of first offer.
Right of first refusal.
Provisions regarding the voting procedures in the memorandum and articles of association, as well as certain provisions in the shareholders' agreement commonly provide the fund with control over the investee company. The protective provisions usually require either shareholder or board approval for company actions such as:
Sale or issuance of any equity security.
Declaration or remittance of any dividend or distribution.
Mergers and acquisitions (M&A).
Dissolution or liquidation.
Approval or amendment to budget, business plan and operating plan.
Engagement of any material agreement.
Appointment and removal of directors.
Amendment to memorandum and articles of association.
Award or amendment of any employee share ownership plan.
A company's shareholders agreement typically includes restrictions on share transfers.
It is common for an investor to require the founder(s) and other key management of a company to covenant not to transfer their shares (other than back to the company) for a specified period of time. To supplement this restriction, the founder and key management must also enter into a share restriction agreement where the founder agrees to sell a portion of his shares back to the company at a nominal value if he leaves the company before a certain date.
In addition, there are usually a number of provisions that affect a founder's ability to transfer shares. A right of first refusal is usually included, which gives the company and its preferred shareholders the right to purchase any shares which are proposed to be transferred. Preferred shareholders also typically have a right of co-sale (tag-along right), which is a contractual obligation imposed on the founders and/or key shareholders allowing the preferred shareholders to sell their shares along with the founder or key holder.
Co-sale or tag-along rights can protect minority shareholders in a sale exit as they allow the minority shareholder to insist that a potential purchaser must agree to purchase an equivalent percentage of their shares, at the same price and under the same terms and conditions, which effectively obliges the majority shareholder to include the minority shareholder in negotiations with the purchaser.
A drag-along provision may also be included in the investment documentation, which may require shareholders' approval for transactions over a certain threshold.
Pre-emption rights are typically included in venture capital investment in China. A venture capital investor typically requires the right to purchase the number of shares necessary to maintain its percentage ownership in the company where the investee company makes a future share offering.
A venture investment cannot be finalised until all of the required consents and approvals from third parties and governmental bodies have been received, as follows:
MOFCOM's approval is required for an SPV to set up a wholly foreign invested enterprise in China.
Registration with SAFE is required for a Chinese resident to obtain shares of an offshore SPV. Without this, funds invested offshore may not be legally transferable into China and profits may not be transferable out of China.
Under the articles of associations of the investee company, changes such as issuing shares, granting rights, changing board seats and other material changes to the investee company typically must also obtain the approval of the existing board and the shareholders.
Normally an investor requests that the investee company pays or reimburses the investor for all or at least a portion of financial and accounting fees and costs incurred in the course of investment. Sometimes this reimbursement is subject to a cap and may exclude certain extraordinary expenses, such as legal due diligence fees from the fund.
In general, founders and employee incentive plans used in China include option plans, restricted share plans and sometimes valuation adjustment mechanisms.
It is common practice for venture capital funds and investee companies to set aside up to 10% of all outstanding common shares to grant founders and employees employee share option plans.
SAFE requires Chinese residents to register any offshore share holdings. While options can be granted to Chinese employees, their right to exercise such options is limited. Before registration of an option plan with SAFE, Chinese employees may only hold a restricted right to purchase shares in the future. It is possible to register an option plan with SAFE, but in practice option plans can usually only be registered immediately before a company's public offering. Sometimes, however, they may also be registered afterwards.
Valuation adjustment mechanisms are often used to incentivise founders in China. Normally, valuation adjustment provision(s) adjust a company's valuation on the occurrence or non-occurrence of some event. The possibility of gaining (or losing) equity in the company is seen to motivate the founders and management.
Under Chinese tax laws, there are no particular tax benefits for employee share options unless the company issuing them is a public company. Generally speaking, an employee share option plan allows an employee to defer their capital gain taxes until the shares are vested and the option is exercised.
A share restriction agreement is often used to ensure that a founder or other key employee remains with the company. A typical share restriction agreement allows the company to repurchase a certain portion of unvested shares if the founder or key employee leaves the company before a specified time.
An investor will also ask that a founder sign a letter of commitment as a condition to the financing. In a letter of commitment, a founder or other key holder makes representations that he will devote all (or some) of his working time and attention exclusively to the business of the company and use his best efforts to promote the company.
Founders and members of management teams are often required to enter into non-competition agreements with the investee company, which prohibit them from engaging in the related business for certain period of time. Such non-competition agreements are enforceable, provided that they are in compliance with Chinese labour contract law, under which employers must pay reasonable compensation on a monthly basis to an employee during the term of a non-competition period.
The preferred exit is by way of an IPO. If an IPO does not take place, investors normally have a liquidation preference which allows them to receive their investment amount plus a premium in the event of the company's sale or on the liquidation of the company's assets. This allows funds to recoup their investment in the event that an investee company fails. However, unsuccessful companies are often sold at a low value or their assets may not be large enough on liquidation to pay each investor its full liquidation preference.
It is common for investors to ask for a right of redemption. A right of redemption allows an investor to redeem its shares for the initial purchase price plus an agreed rate of return.
As in many other jurisdictions, the most common exit strategies for venture funds investing in Chinese portfolio companies are IPOs and trade sales.
Venture capital funds favour exiting through offshore IPOs on the Hong Kong main board, the New York Stock Exchange or the NASDAQ.
Trade sales are also a common way for venture capital funds to exit successful companies. In trade sales, venture capital investors often sell some or all of their shares in the investee company to another investor or an acquiring company. In contrast to exiting through an IPO, the most significant benefit of a trade sale exit is that it is a complete and immediate exit. However, venture capital investors usually receive much less for their investment than in IPOs.
Venture capital investors usually require undertakings from the investee company and other shareholders that they will endeavour to achieve an appropriate share listing or trade sale within a limited period of time. If the company fails to meet this time frame, the redemption right is triggered, allowing the investor to recoup its investment and rate of return.
A trade sale would normally also trigger the liquidation preference (and the participation right, if it exists) of preferred shareholders.
Venture capital investors always also request that standard registration rights be included in the investment documentation so that the investors have a right to demand that their shares be registered.
In the event that investors wish to exit though an IPO, a drag-along provision (see Question 21) can force the founders and/or other investors to approve a public offering.
Qualified. California, US
Areas of practice. Private equity; venture capital; alternative investments; funds; corporate; M&A; foreign direct investment