A New Welcome for Venture Capital

China’s emphasis on indigenous innovation and several other developments have created a more welcoming environment for venture capital

by Calvin Ding and Tony Zhang

Structural defects in China’s economy, including overreliance on low value-added manufacturing and export-led growth, have led the PRC leadership to emphasize the importance of indigenous innovation as a national development strategy to sustain China’s competitiveness and economic growth. In turn, the government has also begun to view venture capital (VC) as an important means of fostering indigenous innovation.

VC has played an important role in the economic development of many countries, especially in fostering the stunning growth of the Internet and high-tech sectors. Venture capitalists can assume this vital role because they focus on entrepreneurs, who are the driving force behind indigenous innovation. Through advisory, selection, and investment capacities, venture capitalists provide valuable commentary on the feasibility of entrepreneurial endeavors and absorb much of the risk involved in entrepreneurial experimentation.

Venture capital pours into China

Against the backdrop of the global economic downturn and the concomitant decline in investment, VC investment in China remains a relative bright spot. According to Dow Jones VentureSource, venture capitalists invested a record $4.2 billion in 245 deals in China in 2008, up from $2.8 billion in 290 deals in 2007. Information technology (IT) related investments led the way as investors injected $1.6 billion in 86 IT deals in 2008, up 60 percent from the $1 billion invested in 117 deals in 2007. At $10 million, China’s 2008 median VC deal size was the largest in the world.

China’s domestic VC market

China has relatively limited domestic sources of VC funding—it comes mostly from government investment, enterprises, and wealthy citizens. PRC law limits the scope of financial services and securities companies. For example, it prevents financial institutions, such as banks and insurance companies, from engaging in VC investment. This contrasts with developed Western economies, where large institutional investors, such as pension and mutual funds and financial institutions, constitute significant sources of VC investment in nonfinancial sectors. The result is that large institutional investors and high-net-worth individuals are the primary sources of venture-capital funding in the United States and Great Britain, but the PRC government, enterprises, and foreign funds account for the vast majority of venture-capital funding in China.

Though government investment can play a vital role in the development of a healthy VC market, the issue of governments acting as venture capitalists has stoked heated debate. Much of the concern stems from questions about whether the government is capable of selecting investments that will lead to the most profitable returns. Critics of governmental VC investment have argued that bureaucratic funding decisions are sometimes removed from market concerns and may result in the subsidization of unviable enterprises, impede development of private sector VC, and, in the long term, dampen entrepreneurship. In addition, because many Chinese enterprises that make VC investments are partially or wholly state-owned, whether corporate investors can make independent investment decisions is a significant concern.

The relative absence of domestic sources of VC funding has led many Chinese companies to seek foreign VC. For example, successful Chinese companies such as Baidu.com, Inc.; Suntech Power Holdings Co., Ltd.; and Focus Media Holding Ltd. all received funding from foreign VC sources in their early developmental stages. Though government restrictions on pension-fund investment in the VC market were recently lifted for two companies, and though there have been reports of greater relaxation of VC regulations, substantive changes have been gradual and their long-term effects remain unclear.

Hurdles for VC funds in China

Despite growing VC investment in China, venture capitalists still face many challenges, including the lack of an efficient exit route by which they can recoup their initial investments. In the United States, one of the most frequently used exit mechanisms is to sell shares through an initial public offering. In China, this option is limited because listing requirements for China’s stock exchanges are high and regulatory approval is difficult to obtain. Domestic companies also require approval from the China Securities Regulatory Commission (CSRC)—China’s regulator of stocks, bonds, futures, and mutual funds—before they may list overseas, and the criteria for CSRC approval in these cases are even more stringent than those for listing on the domestic stock exchanges.

To circumvent CSRC restrictions, Chinese enterprises have historically taken what is known as the “red-chip” route to obtain an overseas listing. The red-chip route refers to the listing of an offshore special purpose vehicle (SPV) through which the shares of the Chinese enterprise are owned. When making the VC investment, foreign VC funds and Chinese companies and individuals jointly invest in an SPV, which then acquires the shares or assets of the Chinese business concern, effectively transferring ownership overseas. The SPV subsequently applies for listing on an overseas stock exchange, such as the New York or Hong Kong stock exchanges, effectively evading PRC approval of the overseas listing. Yet the viability of the red-chip route has diminished significantly since 2006, when China passed regulations on mergers and acquisitions and foreign exchange filing rules that aim to promote the listing of promising Chinese companies on domestic exchanges.

Strategies for foreign investment in China

Since foreign VC funds first entered China in the early 1990s, companies have adopted various investment strategies to conform to changing PRC regulations with an eye toward maximizing investment returns. Currently, the “offshore” and “onshore” structures are the two most popular investment strategies, and foreign VC funds sometimes pursue both strategies concurrently by adopting offshore and onshore structures to obtain greater investment and exit flexibility.

Offshore VC funds

Many offshore VC funds have invested in Chinese high-tech companies through SPVs under the red-chip structure and exited with handsome profits following the listing of the portfolio company. The primary benefits of the offshore structure are that its establishment and fundraising are free from PRC regulatory oversight, investors can invest in SPVs and China-based companies, and offshore funds generally enjoy a lower income-tax rate than onshore funds. As PRC regulations on mergers and acquisitions and foreign exchange filing rules have restricted the listing of SPVs overseas, however, offshore funds have invested directly in China-based portfolio companies by converting them to foreign-funded equity joint ventures with a plan to exit through initial public offerings in the Chinese stock market.

Onshore VC funds

The onshore structure—except in cases where only renminbi (RMB) funds from domestic sources are used—refers to a RMB-denominated equity joint venture fund (EJV fund) or contractual joint venture fund (CJV fund) with Chinese investors or a RMB-denominated wholly foreign-owned enterprise fund (WFOE fund). (All of these are known as foreign-invested venture capital investment enterprises [FIVCIEs] under PRC law.) The establishment and operation of FIVCIEs are subject to the approval of the PRC Ministry of Commerce (MOFCOM) or its provincial counterparts, and investments must be reported to PRC regulators for approval and filing purposes. PRC foreign-exchange controls limit FIVCIE investments to only China-based portfolio companies, so the primary exit strategies are an initial public offering on a Chinese stock exchange or a transfer to other entities or other funds through an acquisition.

Because foreign-invested limited partnerships are not recognized as a corporate form under Chinese law, establishing a CJV fund in a non-legal-person form has become the most preferred onshore strategy for foreign VC funds. A CJV fund’s major strengths are its similarities to a limited partnership fund—both have similar management, contractual profit allocation, and pass-through taxation structures. In contrast, WFOE or EJV funds can be incorporated only as limited liability companies, which face more restrictions under PRC law. Under current PRC practices and stock exchange rules, however, it is difficult for a CJV fund in a non-legal-person form to open a securities account (zhengquan zhanghu), meaning that a CJV fund in a non-legal-person form cannot exit from the portfolio company through an initial public offering on the Chinese stock market.

If a foreign VC fund expects China’s RMB appreciation to continue and is familiar with the Chinese stock market, a CJV fund formed with a sophisticated Chinese partner could be worthwhile. Several foreign VC funds have already established CJV funds or WFOE funds and invested in China-based companies in combination with parallel offshore funds, with the expectation that they will eventually exit through the Chinese stock market or future acquisitions.

Welcome developments

Two recent developments may facilitate VC investment in China: a new bourse and a relaxation of onshore fund rules.

China’s Growth Enterprise Market

In March, CSRC published its long-awaited Interim Measures for Initial Public Offerings and Listings on the Growth Enterprise Market. Pursuant to the measures, the Growth Enterprise Market (GEM) will be created on the Shenzhen Stock Exchange. The new board has lower listing requirements than Shenzhen’s main board and is expected to make it easier for smaller Chinese private enterprises to list. This will also benefit foreign VC funds by providing a new exit. To list on the GEM, a company must have:

• Operated in China for at least three years and be in the form of a company limited by shares;
• Been profitable in the past two years, with total net profit of at least ¥10 million ($1.5 million), or a net profit of ¥5 million ($732,000) and revenue of ¥50 million ($7.3 million) in the most recent year with at least a 30 percent annual growth rate in the most recent two years;
• At least ¥20 million ($2.9 million) in net assets and no non-recovered loss; and
• At least ¥30 million ($4.4 million) in equity after the offering.

Several questions remain unanswered, however. First, CSRC has not yet indicated what the implementing standards for verification will be. Given the low listing requirements, CSRC will likely implement detailed verification standards to determine which companies, among the possibly hundreds of qualified applicants, may list on the GEM. Shenzhen Stock Exchange officials have previously indicated that candidates engaged in high-growth, high-tech fields, as well as those in new economy, service, agriculture, materials, energy, and commercial modes, are most welcome to list on the GEM. CSRC may give leading high-tech companies that specialize in encouraged industries priority status for listing. The timeframe for listing also remains unclear, though CSRC Deputy Chair Yao Gang has noted that each listing verification could take roughly three months. Because listing decisions for initial public offerings are often a function of China’s macroeconomic policy, wait times may be industry-specific.

Relaxed rules for onshore funds

In addition to the creation of the GEM, the PRC government has adopted new incentive policies to encourage the establishment of onshore funds. In March, MOFCOM authorized its provincial-level counterparts to approve the establishment of onshore funds that involve less than $100 million and has allowed all onshore funds to report their investments to provincial authorities rather than to MOFCOM in Beijing. This move shortens the approval period from several months to several weeks. At the local level, municipal governments in Beijing; Shanghai; Shenzhen, Guangdong; and Tianjin have enacted local rules to support the establishment of onshore funds, including more relaxed formation procedures, tax holidays for onshore funds and high-level managers, cash bonuses on establishment, and lower capital requirements, compared to national rules published in 2003 by MOFCOM.

Given the current global recession and the resulting cash drought that many Chinese companies face, the PRC government will likely hasten reform by publishing the final revised onshore funds measures and new foreign-invested partnership enterprise measures that permit the establishment of onshore partnership-fund structures. Presumably, upcoming measures would encourage more foreign VC funds to establish onshore funds.

With the opening of the GEM and the implementation of central- and local-government support measures, foreign VC funds face fewer legal restrictions and gain many new investment opportunities in China. By initiating VC investments in China during the current global economic downturn, investors will likely reap handsome rewards when the economy recovers.

[author]Calvin Ding is associate, and Tony Zhang is legal consultant, at Greenberg Traurig, LLP.[/author]