A New Model of Direct Venture Capital Investment in China

Traditional Model of Venture Capital Investment

Prior to the promulgation of the New M&A Rules and CSRC Guidelines, overseas venture capital investment in a Chinese company (Target Company) was usually carried out through venture capitalists' indirect investment in an overseas special purpose vehicle (SPV) controlled by the founders/shareholders of the Target Company for the purpose of listing on an overseas stock exchange. Under this traditional investment model, the SPV shall acquire the entire equity interest of the Target Company as part of the restructuring exercise, prior to its listing on an overseas stock exchange (the Restructuring).

Under the New M&A Rules and CSRC Guidelines, the Restructuring and listing of overseas SPVs which are controlled by PRC entities or individuals are now subject to the prior approvals from the PRC's Ministry of Commerce (MOFCOM) and China Securities Regulatory Commission (CSRC) respectively. The New M&A Rules and CSRC Guidelines however seem not applicable to Foreign Invested Enterprises (FIEs) which are formed prior to 8 September 2006.

Due to the red tape involved in getting the requisite approvals from MOFCOM and CSRC, venture capitalists have found that the traditional investment model is no longer feasible and venture capitalists have been forced to look for an alternate investment model. As a result thereof, a new model of direct venture capital investment has emerged.

New Model of Direct Venture Capital Investment

Under the new model of direct venture capital investment, overseas venture capitalists will invest directly in the Target Company through a joint venture arrangement and thereafter, seek listing of the Target Company on the Chinese A-Share Stock Exchange or overseas stock exchange through its investing vehicle.

To effectuate the new model, overseas venture capitalists will first incorporate an overseas company as its investing vehicle (VC's Sub). The VC's Sub is usually incorporated in BVI or Cayman Islands, Hong Kong or Singapore. After the incorporation of the VC's Sub, venture capitalists will then negotiate and enter into definitive binding transaction documents with the PRC shareholders of the Target Company, with a view to convert the Target Company into a Sino-Foreign Equity Joint Venture company (EJV).

The relevant transaction documents are subject to the approval from the local authorised agency of MOFCOM and once obtained, the Target Company will be converted into an EJV and thereafter, the EJV is required to obtain from the local Administration of Industry and Commerce (AIC) a new business license before the EJV can apply to open a foreign currency capital account with the local State Administration of Foreign Exchange (SAFE). After the opening of such an account and the satisfaction of the closing conditions, venture capitalists will then inject their investment into the EJV through such an account.

Listing on Chinese A-share Stock Exchange

Subject to compliance with the relevant laws, regulations and listing rules of the PRC, the EJV may seek its listing on the Chinese A-share Stock Exchange by converting into a stock company. Pursuant to Article 15 of the Provisional Regulations on the Establishment of Foreign-Funded Joint Stock Companies Limited (关于设立外商投资股份有限公司若干问题的暂行规定), the JV Company is required to submit its profit records for the past three consecutive years in applying for such conversion. The approving authority is MOFCOM.

Overseas Listing

The new model of direct venture capital investment also reserves the possibility of the EJV seeking a listing on an overseas stock exchange in the future through the VC's Sub. In such cases, subject to the approvals from the relevant authorities, corresponding restructuring exercises will be undertaken to transfer the assets of the EJV to the VC's Sub for listing purpose.

Conclusion

With the promulgation of the New M&A Rules and the CSRC Guidelines, overseas venture capitalists who are interested in investing in PRC companies will now have to restrict their options to FIEs which were formed prior to 8 September 2006 or turn their attention to domestic listing on the Chinese A-share Stock Exchange, as opposed to any overseas listing. Since the promulgation of the New M&A Rules, we are currently not aware of any overseas listing applications of the VC's Sub. As such, pre-consultation with the relevant PRC authorities is strongly suggested should venture capitalists intend to use this new investment model and exit from the overseas listing of the VC's Sub.