Market Access Report: Venture Capital

China did not have a national law on the establishment of foreign invested venture capital enterprises until September 1 2001 when the Establishment of Foreign-funded Venture Investment Enterprises Tentative Provisions (the Provisions) were issued. While the Provisions were by no means the panacea that the international VC industry had hoped for, they did contain several important breakthroughs.

One primary benefit of the Provisions is the simple fact that they provide an unequivocal legal basis for the establishment of foreign invested enterprises in China that can carry out VC business activities (such enterprises are referred to hereafter as VCEs). The Provisions also provide a legal basis to contractually allocate liabilities among the investors, thus helping to replicate fund management structures that one typically sees offshore. The varying requirements imposed on investors to VCEs also reflect an appreciation of the different roles that investors will play in a typical VC arrangement.

Persisting Issues For China VCs

Investment Restrictions - Direct foreign investments into China by offshore venture capitalists continue to be subject to the Investment Catalogue, which classifies all foreign investment projects by industry as permitted, encouraged, restricted or prohibited and, in some instances, imposes restrictions on the foreign investors' permitted equity holdings. The Provisions further provide that VCEs can invest in non-publicly listed enterprises mainly in high and new technology sectors (in which foreign investment is encouraged or permitted). While many existing equity restrictions will disappear over time in light of WTO requirements, the China market is, thus far, by no means fully open to venture capitalists.

Scheduled Capital Contribution - The Provisions make clear that VCEs will be subject to the same types of capital contribution obligations that are imposed on other foreign invested enterprises (e.g., capital must be paid in within a statutory period of time, equity stakes in portfolio companies may not be disposed of if the investor has not yet fully paid in all of its committed capital to the relevant company). Such funding requirements are contrary to international industry standard "just-in-time" funding practices and could significantly lower potential rates of return on committed capital.

Capital Structure - While it is a standard international practice that VC investments be made through the purchase of a target company's preferred stock or other derivative securities, China's company and foreign investment enterprises (FIE) laws do not generally allow complex capital structures beyond simple one tier common stock ownership. This results in a lack of structural flexibility crucial for delineating rights and obligations between foreign venture capitalists and domestic entrepreneurs, thus retarding the potentially beneficial union of the two.

Target Companies - The Provisions provide that "in general" VCE investments (together with other foreign investors, if any) shall not be less than 25% of the target company's registered capital. This same requirement is imposed on foreign investors seeking to establish foreign investment enterprises in China.

Exit Strategies

Public Offerings - Current Chinese laws permitting a Chinese portfolio company to go public on either domestic or overseas exchanges impose a substantive governmental review and approval procedure that is not necessarily market-driven.

Equity Dispositions - Transfer of equity investments in a portfolio company by a VCE or a foreign venture capitalist is subject to the consent of other equity holders and examination and approval by the relevant Chinese authorities. For VCEs, the additional consent of the Chinese Ministry of Science and Technology is effectively required.

"Put" Rights - The Provisions subject any privately negotiated equity buy-back arrangements between target companies and VCEs to substantive scrutiny based on yet-to-be-published standards.

Conclusion

While the entry and exit hurdles certainly complicate VC financing in China, they are not insurmountable. VC financing is gaining strength in China, albeit through somewhat hybrid models given the idiosyncrasies of the PRC foreign investment regulatory regime. With China's WTO accession and implementation of its various market liberalization commitments, the potential pool of target companies in which venture capitalists may legally invest will expand. But as with all changes in China, some things do indeed stay the same. In that vein, a key task for venture capitalists, both before and after China's WTO entry, is forming appropriate investment structures based on a body of foreign investment regulations that are not particularly suited for the purposes.

By Mitch Dudek & Wang Cheng

Jones Day Reavis & Pogue, Taipei