For U.S. venture capital, to invest in China is no longer so far away. Some early birds have already made investments with high returns, and many new investments are now underway. Although making venture capital investments in China is very similar to making them in the U.S., investors should learn as much as possible about China’s market and legal environment. Next they should carefully formulate an investment strategy, structure the transaction and make detailed contractual arrangements.
China’s Industry Policy is a key legal factor to consider first. It divides foreign investment into (1) Encouraged, (2) Permitted, (3) Limited, and (4) Prohibited. While investments in the categories “Encouraged” and “Permitted” industries are subject to fewer approval formalities, they are stricter for “Limited” industries. For some industries foreign investors cannot own 100% equity or hold majority equity. Therefore, before making the decision to invest, a foreign investor should research China’s legal requirements for a particular industry.
Once a foreign investor finds a good project and potential partner in China, a highly useful option now available is the Special Purpose Vehicle (SPV). Using this option the investor may form the overseas SPV joint venture with the partner and with it acquire and hold 100% equity of the existing Chinese company. As a result, the Chinese company will eventually become a wholly foreign owned enterprise, or WFOE.
Compared with directly setting up a joint venture (described below) in China, the SPV method has these advantages:
The SPV has 100% control of the WFOE, so the foreign investor may transfer interests in the project by selling its shares in the SPV without Chinese government approval (which is otherwise required if the transferring target is shares in a Chinese JV).
The investor is allowed to set up the SPV as a tax haven and avoid tax related to the transfer of SPV shares. By contrast, for China JVs, income tax is payable by the seller for such kind of deals.
China still has control on foreign exchange, especially in sophisticated deals with a share swap between a Chinese entity and an overseas company, so JVs are subject to strict government approval. With an overseas SPV this problem may be avoided.
If the SPV or its parent company goes public in an overseas market, e.g., NASDAQ, the case will not involve Chinese government approval. By contrast, if Chinese JV seeks listing in a foreign stock market, it must obtain approval from the China Securities Regulatory Commission (CSRC), China’s securities watchdog.
Note, however, with SPVs the Chinese partners should obtain approval from the government when they invest overseas to set up the SPV with the foreign investor. They are also required to report any substantial changes and developments related to such overseas investment.
When the SPV acquires the Chinese company, a public appraisal firm must perform a compulsory appraisal prior to the acquisition of the target shares. The Chinese partner cannot transfer the shares at a price “significantly lower than the appraisal result”. If the Chinese partner is State-owned, a competent government agency may also need to approve the case. In addition, like other acquisition deals, the foreign investor should conduct careful due diligence on the target company before entering into the final acquisition agreement.
Besides the SPV, foreign investors have the option of forming a joint venture (JV), a direct investment into China. Here the investor sets up a JV with a Chinese partner, choosing either partial acquisition of the existing Chinese company, turning it into a Sino-foreign JV, or founding an entirely new JV. The Sino-foreign JV has the advantage of retaining historical tracks of the existing company; this is especially important in projects where licenses held by the Chinese company are the crux of the entire business. By contrast, if a new JV is formed, the foreign investor must ensure that the Chinese partner puts into the JV its core technology, team, assets, licenses and so on, from its previous entity.
Setting up a Chinese WFOE or JV
Government approval is required for the set-up, transfer of shares, M&A, increase or decrease of capital, and winding-up of WFOE and JV. Today, the Chinese government tends to take an open gesture and in most cases government approval is merely a formality.
Legal documents to apply to set up a WFOE or JV include such details as a JV contract or agreement (only for JV projects), articles of association, application letter, feasibility study report, project proposal, documents certifying the legal status and financial standing of the foreign investor and list of the directors.
Normally, a WFOE or JV should be a limited liability company. The statutory minimum registered capital amount is RMB30,000 (about US$3,600 ), but in any event should match the company’s operation scale as described in the feasibility study report and project proposal. The first installment of capital contribution cannot be lower than 15% of the total amount subscribed by the shareholders, nor can it be less than the statutory minimum amount. Other installments should be finished within the timetable as specified in the approved JV contract or articles of association (usually 2 years). The capital contribution can be made in currency, equipment, intellectual property, land-use-right, or other transferable and valuable lawful properties, while the currency contribution cannot be lower than 30% of the total capital amount.
Dividends received by the foreign investor from a WFOE or JV are free of income tax and may be converted into foreign exchange and remitted out of China. On the other hand, foreign invested companies with 25% or higher proportion of foreign capital may enjoy some tax preference in China. A company engaged in production having an operation period of not less than 10 years is exempted from company income tax for the first two profit-making years and a 50% reduction in the company income tax payable for the next three years. Some special areas (e.g., economic and technology development districts, high-tech zones, special economic districts, foreign invested companies) enjoy more preference on tax.
Foreign Invested Venture Capital Enterprise
Foreign investors with a long term plan for the China market may consider setting up a venture capital investment enterprise in China. The enterprise may be a WFOE or a JV, and either a limited liability company or partnership. Statutory minimum capital for partnership VC is RMB10 million (about US$1.2 million), and RMB5 million (about US$600,000) for a limited liability VC company. The time frame to pay off the subscribed capital is 5 years. The main foreign sponsor of the VC or its affiliated entity should have experience of managing up to US$100 million assets in the previous three years.
Alternatively, a foreign investor may set up a venture capital management company to manage venture capital investment enterprises in China. The minimum capital requirement for this kind of companies is RMB1 million (about US$120,500).
Exits for foreign venture capital
Most foreign VCs prefer the overseas SPV-WFOE route through which they can use various tools to realize exits, e.g., transfer of shares, M&A, IPO in overseas market, re-purchase of shares. Chinese government control on transfer of shares, foreign exchange, securities will not have significant impact on the transactions. The deals’ result, time and costs therefore may be more predicable. However, if a JV applies for listing in an overseas stock market, approval from CSRC should be obtained.
Main foreign VC exits in China are transfer of shares, IPO, and M&A. But note that governmental approval is involved with transfer of shares in a Chinese JV, or with the acquisition of a Chinese company. Also note that the other JV partner has a preemptive right on the shares to be transferred.
Despite past poor market performance, the China stock market doorway has been opened wider to foreign capital in the past two years. WFOEs or JVs can apply for listing in the Chinese domestic market, and foreign strategic investors are allowed to buy A Shares. The entire stock market is undergoing a tremendous reform that will make shares of listed companies all tradable in the market. It is believed that the reform will greatly promote the development of China’s stock market. In this regard, foreign investors may now seriously think about the possibility of having a project go public in China.