Preferred Stock Structure: Theoretical and Practical Issues of Implementation in Chinese Foreign-invested Enterprises

In contrast, where either there is statutory flexibility in the setting of stockholders' equity percentages, or the flexibility for the stockholders to allocate among themselves certain economic interests, venture investment has been an attractive financing alternative. A similar situation exists with employee stock under option grants. Where the capital contribution obligations of employees also track registered capital and pose financial burdens to employees, the option plan would lack the expected incentivising effects.³ In view of the foregoing, the incentives for the founders to proceed with a private placement are based on the diminution of the effects of the registered capital system and/or the equity percentage requirement, so that the founders can benefit from the upside in the value of the company resulting from the new investment.⁴

Depending on the way certain fundamental stockholders' rights are structured, the founders' controlling position is possible as the example in Table 1 indicates.

The founders' controlling position is the basis and context for our discussions. Investors must bear in mind that the dichotomy of statutory equity percentage and negotiated equity percentage may still be a disincentive for some founders to proceed with private placements.

As we will expand upon below, in an incorporated venture capital fund (VC fund), the managing stockholders (the equivalent of the general partner in a partnership VC fund or, the “indispensable investors” under the relevant Chinese regulations) also enjoy certain privileges. The incentives for non-managing stockholders (the equivalent of limited partners in a partnership VC fund) to sign off on such privileges are different from those in a non-investment company. In addition, in a VC fund, the majority-minority stockholding status for the non-managing and managing stockholders is the norm.

Legal Basis for “Preferred Stock” in China

Certain provisions under the Company Law 《公司法》have the commonality of allowing certain economic rights of stockholders to be addressed by the company's corporate charter or stockholders' agreement. Examples of such provisions of the Company Law are found in sections 35, 43 and 72.

Similarly, the FIE laws do not contemplate different classes of stock. The FIE laws were enacted in a special historic context. Thus, certain assumptions underlying the FIE laws are obsolete for newer types of FIEs, such as foreign-invested VC funds.

For an EJV, equity percentages of stockholders are the basis for their share of profits and losses. For a CJV, in contrast, contract autonomy is allowed to determine such economic rights. In addition, with a CJV, the additional types of assets that each investor may contribute, i.e. cooperative conditions, versus the limited types of assets seen in the EJV Law, provide flexibility for what founders may contribute to the company. For these reasons, a CJV is generally considered to be better suited for multi-class stock structures.

In both an EJV and a CJV, the highest corporate authority is the Board. The number of directors each stockholder may appoint can be contractually set with reference to such stockholder's respective equity percentage. Thus, JVs would seem to have some flexibility to adapt to the preferred stock structure in corporate governance.

For WFOEs, the stockholders seem to have more leeway to address their respective economic interests in the WFOE agreement because such agreement is not required to be governed by PRC law. For this reason, the WFOE law leaves most of such rights to be addressed by the WFOE agreement. Where the agreement is silent on such rights, the Company Law (and presumably, its contract autonomy provisions) will likely be applied.

We note that there is a newer type of FIE which has the distinction of a two-class stock structure – incorporated foreign-invested venture capital funds (known as an FIEVC). This type of entity is subject to a special set of FIE regulations issued by several different authorities on January 30 2003 (the FIEVC Regulation). The FIEVC Regulation explicitly provides the basis for some stockholders' different rights such as in profits distribution, votes, etc.⁶

Different Types of Preferred Stock Rights under Chinese Corporate and FIE Laws

When certain stock is entitled to the rights not generally available to other stock, such stock is considered to have privileges. Privileges overcome the requirement that stockholders' economic rights are a function of their respective investment amount.

Privileges can be categorised as economic privileges and semi-economic privileges. An example of the first type of privilege is the participation rights in the distribution of liquidation proceeds, which enable the holders of the preferred stock to participate with the holders of the common stock in a pro rata distribution of the remaining proceeds after the holders of preferred stock have retrieved their investment.

Examples of the second type are rights of first refusal (ROFR) and tag-along rights.⁷

Preference is the ability of certain stockholders to receive certain economic rights in priority to other stockholders. Such preference implements the expectation of the investors related to certain rates of return. This becomes important when the distributable profits or proceeds might be insufficient were they distributed on a pro rata basis. Preference presumes that the distribution of economic interests is not required to be pro rata to the stockholders' relative equity percentages.

The following are special types of rights: (1) stockholders' information rights; (2) the rights of stockholders to have their stock redeemed by the company if the company does not distribute any dividends for five consecutive years; and (3) unanimous approval of directors for certain fundamental corporate transactions in JVs. Thus, they seem to bar preference. However, we surmise that they do not seem to bar some stockholders from receiving such rights on a more extensive basis. For instance, to be given more extensive information rights than others.

Based upon table 2, a CJV seems to be the most appropriate structure for the two-class stock structure where the company expects substantial profits from its operation. Regardless of this, for a portfolio company for which a public offering on a Chinese stock exchange is anticipated, the company needs to be first restructured as a company limited by stock prior to the public offering, whereupon it will then be governed by the Company Law provisions applicable to companies limited by stock, and the flexibility peculiar to a CJV may be phased out in the restructuring.

With respect to FIEVCs, although FIEVCs encompass a broad range of flexibility permitting different corporate structures ranging from unincorporated to incorporated entities, the implementation of preferential rights or privileges is not clearly contemplated under the FIEVC Regulation. Thus, the FIE Laws would presumably apply. Because the managing stockholder's important economic interests arise partly from dividends, which usually are not based on the managing stockholder's capital contribution percentage, a CJV or a WFOE would seem to be a better structure than an EJV.

Implementation OF PREFERRED STRUCTURE IN Foreign-INvested Venture Capital FUNDS

FIEVCs present a special issue of implementation of transfer restrictions. Under the FIEVC Regulation, the foundation has been laid for a separate class of stock in an FIEVC. The question is whether the FIEVC Regulation should prevail over the FIE Laws in regards to particular rights. With respect to transfer restrictions in particular, to the extent that the JV Laws apply to issues not addressed in the FIEVC Regulation, the stockholders in an FIEVC will be subject to more rigid transfer restrictions than in a domestic VC fund, which is subject to the Company Law《公司法》. Under the FIEVC Regulation, the equity transfer by an indispensable investor is subject to majority approval of other stockholders and the requirement that the assignee must be a qualified indispensable investor. Whether the Company Law or the JV Law is applicable to address the ROFR of other stockholders (the equivalent of the non-managing stockholders) on the indispensable investor's transfer is unclear.

For other stockholders of an FIEVC, the FIEVC Regulation does not provide for any procedures for equity transfer. To the extent that the JV Laws are considered to supplement the FIEVC Regulation on this issue, veto rights and ROFR of other stockholders may be inferred. Application of JV Laws will bar the limited partnerships from achieving the limited transferability which would otherwise result from contract autonomy in other jurisdictions, such as intra-family transfers and intra-organisation transfers.

RECOMMENDATIONS to make the corporate law more friendly to venture capital investments in China

Creation and Formalisation of the Two-Class Stock Legal Basis

Since there is no clear classification of stock into different classes under China's corporate laws, preferred stock lacks a legal basis. Preference and privileges of stockholders may only be structured in reliance on an expanded interpretation by the authorities of “contract autonomy” in favour of the two-class stock structure. Therefore, in the implementation of the contract autonomy principle, there is a lack of certainty in how various privileges or preference of the investor will be received at different times and places. The law should be amended to incorporate a legal basis for and the designation of a separate class of stock, and the Company Law should be made to take precedence over the FIE laws for matters related to the two-class stock structure.

Creation of Stock System for Founders and Employees

The types of statutory capital that can be contributed to a company lack a sufficient scope to reward the founders for their early contribution to the company. A more flexible capital contribution mechanism needs to be created. For early stage high-tech companies, the registered capital as defined under the law lacks the flexibility in the capitalisation of some soft assets contributed by founders before the institutional financing of the company, such as services and business ideas. The likelihood of dilution under the registered capital system would disincentivise such founders from seeking private placements.

In a limited liability company, when the employee incentive stock pool is from new stock issuance, the employees must pay the same purchase price as other stockholders to be able to retain the specified equity percentage in the total registered capital. The Company Law should clarify the pricing criteria for option grants under the pool. A more flexible pricing method for stock to be issued under the pool should be permitted which is comparable to the discount for the price of common stock where a formal two-class stock structure exists.

Formalising the Legislative Intent for the Two-Class Stock Structure in FIEVCs

For FIEVCs, the two-class stock structure would be used to address the business purposes of FIEVCs as distinct from portfolio FIEs. Further, the rigid restrictions on the transferability of an FIE stockholder's equity do not fit well with the business purposes of FIEVCs. The policy considerations underlying the transfer restrictions applicable to other FIEs do not have the same applicability and should cede to the contract autonomy in an FIEVC. This difference, or precedence of the FIEVC Regulation over FIE laws, should be clarified in an amendment to the FIE Laws. Of course, the solution may also lie in the successful creation of the two-class stock structure in the Company Law as discussed above.

Endnotes

1. A portfolio company whose venture capital investor is a non-Chinese venture capital fund will be treated as a foreign-invested enterprise (FIE). The interplay of the Company Law and the FIE laws and regulations may pose issues to the implementation of certain preferred stock rights.

2. Preferred stock is a senior security that either has certain privileges over other stock (i.e. the junior stock) or grants certain stockholders' rights in preference over those of junior stock. It is an important structure of venture capital financing since the seniority of such security provides an incentive for an investor to invest in early stage companies.

3. The "stem stock" or free stock approach is not a viable structure since it lacks legal basis. For other stockholders to transfer stock without charge to employees, there are enforcement uncertainties where stockholders are dispersed.

4. With regard to a Cooperative Joint Venture, since an investor is permitted to contribute what is called “cooperative conditions”, there is more likelihood for the founders to enhance their initial equity percentage.

5. This assumes contribution of cash and intellectual property by the founders.

6. An ordinance that governs non-FIEVCs effective on March 1 2006 (the Domestic VC Measures) was the first regulation to explicitly mention “preferred stock investments” in addressing the types of investments that a VC fund may engage in. However, since the Company Law does not expressly give precedence to the Domestic VC Measures in any respect, it may be premature to imply that this is a step of officially writing into the law the two-class stock structure.

7. There are two types of ROFRs for the holders of preferred stock: new issuance ROFR (also known as the “preemptive rights”) and transfer ROFR. The new issuance ROFR entitles the investors to subscribe for new stock of the company in priority to other stockholders. The transfer ROFR, which often is accompanied by a tag-along, entitles the holder of preferred stock to acquire the stock that a founder offers for sale to third parties on the same terms and conditions. The tag-along permits holders which do not exercise the ROFR to participate with the founders in the sale of stock to the third parties.

8. This right is sometimes structured as a contractual right for holders of the preferred stock to enjoy rights available to holder of common stock in addition to the preferred stock's privileges and preference.

9. This right is sometimes structured as a put option to achieve exits.

10. The prohibition against stock redemption is set forth in the Company Law chapter on stock limited companies, although the law is silent about limited liability companies. Such prohibition might be made applicable to limited liability companies by analogy in its implementation by government approval authorities.

11. Note also that a stock redemption usually would involve a reduction in the registered capital of an FIE, which, under the FIE Laws, is a very rigid process for which approval is generally difficult to obtain.

12. There are ambiguities regarding whether this can be contracted out.

13. There is no explicit bar under the Company Law against stockholders agreeing to higher thresholds than ? on either the fundamental or non-fundamental transactions.

14. There is no explicit bar under the EJV Laws against stockholders superimposing stockholders' approval on board approval for either the fundamental or non-fundamental transactions; however, such extra approval might be considered as a deviation from the “highest corporate authority” rule in practice.

15. Stockholders must be aware of the minority stockholder protection provisions in the Company Law in negotiating and implementing drag-along or other voting agreements.

16. Both an EJV and a CJV have been used in venture capital and private equity investments in Chinese companies in practice. Theoretically, a WFOE is comparably flexible using a CJV structure except for the flexibility with the types of contributable capital. Although for practical reasons, a WFOE is not a viable ultimate structure for private equity/VC's direct investments where Founders are Chinese citizens. (Again, this observation is not relevant for FIEVCs.)