Foreign Investors Targeting New Economy Businesses

Acquisition Vehicles

Acquisition vehicles used by foreign investors may be foreign enterprises (FE) incorporated overseas or a foreign-investment enterprise (FIE) in China. Establishing a new joint venture (JV) with the Chinese asset owner may also be an efficient method of asset acquisition. Cooperative joint ventures (CJV) are often chosen for this purpose because of their relative flexibility, especially in the recognition of intangible assets.

The impending Investment Fund Law will give foreign investors a new vehicle ¨C private investment funds with substantial foreign shareholding targeting new economy companies. Whether industrial restrictions will be relaxed for passive foreign investments through such funds remains to be seen.

Human Factor ¨C as Predator or Prey

Where foreign acquirers find the "gem" of their targeted companies are key personnel that hold core information, they tend to acquire individual talents, not the company. However, this technique may not be viable if the current employment contracts of these "techies" include draconian clauses regarding IP ownership, confidentiality and non-competition.

Management buy-outs (MBO) have been
no stranger in China. As foreign individuals may be investors to FIEs, a foreign manager of a FIE is also eligible to stage an MBO for his company.

In spite of the practice, the legal environment is unprepared for full-fledged MBOs. The Lending General Provisions prohibits financial institution loans from being used to purchase equity interests, largely limiting the current MBOs as unleveraged transactions. Neither regulations nor judicial precedents are adequate in elaborating on the exact nature of the corporate manager's duties to their companies and preventing the RJR Nabisco type of scandal, which stemmed from a conflict of interests in MBO scenarios.

Business Scope

The Foreign Investment Industrial Guidance Catalogue (外商投资产业指导目录) lists industrial areas where foreign investments are encouraged, restricted or prohibited. Foreign investments are encouraged in most hi-tech businesses. An existing FIE engaged in restricted businesses may be more attractive to foreign acquirers, especially when its business scope is clarified or favourably interpreted by the government.

Internet-related businesses are categorized as telecommunication services and prohibited from foreign investment. Hence foreign-funded ICP companies usually adopt the "Sina/Sohu model" structure accepted by the government. It is believed that the government will require such models to be restructured into a JV after China joins the World Trade Organization, when foreign JV investments will be formally allowed in telecom businesses.

Government Approval Process

The acquisition of new economy companies will presumably involve minimum government approval because the target companies typically have few State assets, a limited number of unemployable labourers and a short operating history. For the acquisition of State-owned enterprises (SOEs), approval from SAAB and the State as shareholder of the company may be easier to obtain due to relaxed State control over smaller SOEs.

Ministry of Foreign Trade and Economic Cooperation (MOFTEC) approval may be easier to obtain for smaller transactions. MOFTEC Shanghai has introduced its "Green Passage" procedures, an expedited approval process for equity interest transfer to foreign investors where the transfer price is less than US$10 million and where it is transacted through the Shanghai Technology and Property Ownership Exchange.

Venture Capital Funding Effect

Some new economy companies received foreign or domestic funding early on, including many internet-related companies with dim hopes of IPO and lining up for trade sales. Acquisition of all or part of these companies' shares may trigger restrictive clauses in their original shareholder agreements.

Intellectual Property

The acquisition of IP deserves to be independently planned and executed in an M&A transaction. The IP of the target company may be subject to encumbrances and variables, such as licensing contracts, IP registration by others, potential accusation of infringement, employees' non-competition commitment to their former employers, defection of key technology personnel and rapid changes in the landscape of technology.

Tax Considerations

Many hi-tech companies enjoy considerable tax incentives granted by the local governments. However, such tax incentives may bite back if the receiving entity has operated for less than 10 years by the time it is extinguished as the result of an M&A transaction. Other tax policies may also affect acquisition and restructuring decisions. Tax-free cash purchases of technology may be more desirable when compared with allocating equity interests to contributors of technology to a JV.

By Michael Qi
Fangda Partners, Shanghai