9/17/2015

When Private Equity Meets China:

China Myth and Chinese Company Law
Shen Wei
Shanghai Jiao Tong University Law School

Singapore Management University

Faculty of Law
September 2015

Topics
1.
2.
3.
4.
5.
6.

Private equity and China Myth

Private Equity Financing
Private Equity and Chinese Company Law
Preparation and Strategy
The On-the-Ground Reality
Hot-button Issues

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Topics

1. Private Equity and China Myth

Private Equity and China Myth

Chinas second largest PE market by deal value, after the US

China is recognized as the most attractive destination for
investments
China represents 40% of Asian market

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Private Equity and China Myth

Chinas success in the PE sector contradicts the
conventional wisdom in two respects:
PE flourishes in the jurisdiction which has a strong capital
market
Legal system of a country is considered as a decisive factor
in shaping the size and attractiveness of the PE market

Private Equity and China Myth:

World Banks Worldwide Governance Indicators

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Topics

2. Private Equity Financing

Types of Investors
Financial investors
Government-linked
Pure VC
Hedge Funds
Strategic Investors
NASDAQ technology companies
Venture Capital division
Angel/Seed Investors
The 3 Fs
Family, friends and fools
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Who are the Parties in the Transactions?

The Portfolio Company
The VCs (or Private Equity Funds)
The Existing Shareholders
Others (lawyers, i-banks, accounting firms, etc.)

Investment Philosophy
Strategic investor investments must fit corporate strategy
and must be financially justifiable
There are usually side business agreements + ongoing
post-closing technical arrangements with the investee
company
Investment capital is risk capital, but risk must be limited
to loss of investment - do not risk investor liability or
injury to Corporate name or reputation
Financial investor investment return or exit must be
realized within the life span of the Fund
Risk capital
Exit strategy
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Investment Philosophy
Targets: start-ups with limited operating history
Form of investment: equity financing; preferred stock with
higher rates of return and a variety of preferences and
privileges
Amount of investment: significant but not necessarily
controlling interest
Rationale for the Company: VCs will usually provide addedvalue such as management or technical expertise
11

What is the Relevance to the PRC?

Chinese companies increasingly seeking VC-type funding;
and using offshore structure with WFOE in PRC
Due diligence in M&A transactions: effect of existing
investor rights on your transactions

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Types of Investment
Early-stage Series A round: US$1-10 million investment
for 5-20% of company in the form of voting convertible
preferred stock w/standard rights (dividend &
liquidation preferences, participating preferred rights,
protective provisions, etc.)
Expansion-stage Series D round: US$20 - 40 million
Pre-IPO bridge financing: Convertibles
Co-investment back in vogue
Down rounds/Cramdown/Minority Blowouts/Pay-toPlay

13

Investment Process

Initial contact/evaluation of company

Deal Concept Meeting (DCM) (internal)
Company engaged & term sheet negotiated
Deal Kickoff Meeting (DKM): outside counsel engaged
Legal due diligence started, showstopper issues
identified
Investment Project/Committee Approval (internal)
Documentation/execution
Closing

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Deal Team
Team composition:
Financial Investor - Investment Managers/Partners:
Deal origination
Strategic Investors - Business Development Unit:
Locates/evaluates company and its strategic fit
Treasury evaluates financial aspects of deal, sets
valuation, negotiates/closes deal
Legal drafts or reviews documentation/legal issues
In-house legal
Outside counsel
Corporate business group attorney
15

Role of Outside Counsel

Scope of engagement:
Legal due diligence
Restructuring exercise (if required)
Documentation
Negotiation
Closing
Venture capital (or PE) team always on the road, busy,
stretched thin rely heavily on outside counsel
Independent decision-making encouraged, but keep
them informed
Raise showstoppers early
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Due Diligence
Technical and financial due diligence conducted
internally
Outside counsel conducts legal due diligence

17

Due Diligence Philosophy

Due Diligence is expensive and no company is perfect
Focus on issues that affect value, investability, risk of
investor liability
Tailor effort to size of deal
Due Diligence report
Keep it concise
Focus on issues rather than what looked at
Categorize issues by red flag, yellow flag
Remediation is companys problem, not ours
Well tell them our concerns and will look over their fixes
but wont draft docs for them or tell them what to do
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Investment Documentation
Prefer to use Investors standard forms where feasible:
Subscription/Share Purchase Agreement
Investors Rights Agreement
Voting/Drag-along Agreement
ROFR/Co-Sale Agreement
Warrant
Convertible Note
Amended and Restated Articles of Incorporation (or
Amended and Restated Memorandum and Articles of
Association in BVI or Cayman) to be filed with the
Secretary of State of place of incorporation (or the
companies registry of the place of incorporation)
19

Related Agreements/Documents
Term sheets/MOUs/LOIs
Non-binding except for break-up fee, exclusivity,
confidentiality agreement, governing law and dispute
resolution
Put and Call Options redeemables
Employment Agreements
Non-competition
Non-solicitation
Confidentiality and Inventions Assignment Agreement
Side Letter (as needed)
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Execution/Wiring
Signature page to each agreement should carry footer
identifying the agreement
E.g., Signature Page to XXX Co. Share Purchase
Agreement
All agreements require internal legal sign-off before
Investors execution
Counsel should prepare & forward deal summary with
execution docs
Documents can be signed in Hong Kong for offshore
jurisdictions
For Hong Kong company, documents should be signed
offshore
Wire transfers must be sent from Treasury - need extra
couple of days plus allowance for intl wire delays

21

Closing
Company articles must be amended to authorize preferred
shares prior to closing
File-stamped copy at closing if possible (e.g. BVI
company), but well close on a director certificate and
legal opinion if recordal not a condition to effectiveness
(e.g. Cayman Islands company)
We must get share certificate + certified copy of updated
shareholder register at closing or within 3 days of closing
Formal escrow arrangement generally but not necessary
Must get clean legal opinions from company offshore and
onshore counsel
Closing sets: 1 loose set of fully-executed original closing
docs + 3 bound (velobound) sets of photocopies
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Deal terms 33 Act Registration Rights

Must get at least 1 demand right, 1 S-3/F-3 right,
unlimited piggyback rights
Rights must survive for at least 3 yrs after IPO
Underwriter cutbacks: directors/officers must be cut
back before preferred holders; preferred holders may
not be cut back below 25% of offering
Lockup/standoff agreements, shareholder
indemnification see infra
Registration rights must be transferable with preferred
shares
Company may not grant senior/equal registration rights
w/o preferred consent
Any founder/common registration rights must be
junior to preferred

23

Deal Terms Board Representation/Observer

Strategic Investors as a policy do not take board seats
Series seat OK if not a majority holder
Financial VCs will want board seats
seats to be included in quorum
Nonvoting board observer w/option to convert to board
seat
Waiver of fiduciary duty/investment opportunity
language
Right should terminate when company becomes subject
to 34 Act or upon an IPO

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Deal Terms Competition

Equity documents should not address competition
issues
E.g., covenants that forbid company to deal with
Strategic investors competitors
Never agree to limit/encumber investment
opportunities
E.g., agreements not to invest in companys
competitors

25

Deal Terms Confidentiality (Investment) (I)

Investments classified into 3 disclosure categories
High visibility fact and terms of investment
publicized in press release
Limited visibility company permitted to publicize
fact but not terms of investment
Confidential no disclosure permitted w/o prior
consent
Use Investors standard language where possible
Put directly into investment agreement where
feasible; otherwise put into side letter with company
If other parties want their own language in deal docs,
carve out Investor in favor of side letter w/company
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Deal Terms Confidentiality (Investment) (II)

Investor must reserve right to disclose investments at its
discretion
Portfolio companies seldom permitted to disclose
amount or terms of investment
Portfolio companies never permitted to use Investors
investment as an endorsement
Will want to do so in IPO filings we must have right
to advance copies of filings + right to require changes
to Investor references

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Deal Terms Dividends & Distributions

Preferred should have distribution preference + right to
participate in distributions on common
Particularly where liquidation/redemption premium
Dividend payments order of payment of dividends
Redemption Rights
Liquidation/Liquidity Preference
Order of distribution of proceeds upon a liquidation
event
Definition of liquidation event
Merger, acquisition, sale of assets/licensing of IP should
be constructive liquidation triggering liquidity
preference
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Deal Terms Company ESOPs

Companies generally should have ESOP
Shares reserved for employees generally should be 1015% of diluted co.
> 15% should require preferred OK
Employee options should vest over 4+ yrs.
25% after one year, evenly over remainder
Ensure that ESOP is factored in at time of Closing
Percentage shareholding should be based on fully
diluted capitalization table

29

Deal Terms Conversion Rights

Investment should be convertible at option of holder
Purpose of conversion rights
Rights for participating preferred stock
Automatic conversion on Qualified IPO
Automatic conversion or consent of specified % of
preferred try to retain discretion

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Deal Terms Financial Information Rights

For portfolio maintenance purposes Investor needs
periodic financial information delivered to it
Pre-IPO: at least audited annual & unaudited
quarterly financials, annual budget, annual
shareholder report
Post-IPO: limit to copies of all securities filings &
annual shareholder reports
Still need the company to deliver these to us even
after IPO too many portfolio companies for us to
keep checking for new filings

31

Topics

3. Private Equity and Chinese Company Law

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How Do PE Investors Invest?

Execution of PE investment
Private placement
Acquisition of preferred shares

33

PE Investment Model and Chinese Company Law

Lack of concept of share under Chinese company law

Minimum registered capital rule: a blocking concept

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PE Investment Model and Chinese Company Law

Same shares with differentiated rights
Dividends preference
Voting rights
Rights of first refusal
Stock options
Information rights
Redemption rights
Minority shareholder protection

35

Preferential Rights in Different Corporate Forms

LLC

EJV

CJV

FIEVC

Two-class stock structure

Dividends distribution
Conversion right
Redemption right
Anti-dilution
Right of first refusal
Board seats
Information rights
Veto of holders of preferred stock
Tag-along right
Drag-along right
Registration rights
Liquidation preference
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Mitigation Strategy
Contractarian approach maximizing corporate
default rules in transactional documents
Opt-out approach
Reliance on arbitration (Chinese courts?)

37

Mitigation Strategy
Investment forum shopping approach a great
escape to a more PE-friendly corporate law regime

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Box 1 Round-trip Investment Model

Founders
Investment Vehicle

Foreign
Investors

SPV

Operating Vehicle

Offshore
China

Unregulated
Business

39

Topics

4. Preparation and Strategy

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Preparation and Strategy

A. Overview of the M&A practice in China
-

China is definitely on the radar: internationally and domestically

Moving from greenfield projects to more M&A transactions

More industry sectors open to foreign investors

Hot industries include telecoms, financial, energy, mining, retail,

pharmaceuticals, machinery, automobile

Two-folded policy concerns

41

Preparation and Strategy

B. Some basic concepts in the M&A practice in China
-

Inbound M&A vs. outbound M&A

public company vs. private company

asset deal vs. equity deal

transaction modes: share purchase, share swap

various targets: SOEs, FIEs, pure domestic entities

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Preparation and Strategy

C. Recent Developments in the M&A practice in China
-

Increasing number of private equity led deals

Protection of key industries from foreign takeovers a case of deja ru?

Share reform of listed companies

C, G and legal person shares

Using stock for acquisitions

How do these changes affect the market?

What are the implications?

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Box 2 - Alphabet Soup

One share
class
denominated
in RMB

Domestic
Exchange

Foreign/Hong Non-tradable
Kong
Exchange

Domesticinvested

Traded in
RMB A Shares
G Shares

Not possible

C Shares

Foreigninvested

Traded in
foreign
currency B
Shares

Traded in
foreign
currency:
H Shares
Hong Kong
N Shares
New York
T, S, L etc.

Not possible

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Preparation and Strategy

D. Recent Regulatory Developments in the M&A practice in China
-

New Company Law 2005

New Securities Law 2005

Rules for Mergers with and Acquisitions of Domestic Enterprises by Foreign

Investors 2006

Takeover Rules of Listed Companies 2006

Administrative Measures on Strategic Investment in Listed Companies by Foreign

Investors 2005

Others i.e., infamous SAFE Notices

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Preparation and Strategy

D. Recent Regulatory Developments in the M&A practice in China (cond)
-

China is evolving towards a more sophisticated legal regime for M&A

transactions

Good news:
Clearer approval requirements and procedures
More experienced local players and government authorities
Adoption of new transactional tools such as share swap

Bad news:
More new limitations and restrictions imposed
Approval authorities now have more discretionary powers

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Box 3 MOFCOM

MOFCOMs discretionary power

-

Any deal involving a key industry or well-known brand, or may affect

national economic security shall be filed with MOFCOM (Article 12 of the
M&A Rules 2006)

Possible key industries include

Nuclear power
Military
Machinery
Power generation/transmission
Shipbuilding
steel

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Box 3 MOFCOM

MOFCOMs discretionary power

-

MOFCOM may stop a deal if it has grounds to believe that it will affect
national economic security similar to US CFIUS Review

Vagueness in rules escalates uncertainty in deals

Coca-cola & Huiyuan

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Preparation & Strategy

E. Winning Strategies
-

Keep abreast of new developments

Cultivate local partners

Understand the counterparty

Cultural sensitivity not cultural blindness

Adjust time lines (forward or backward) and manage expectations with home
office

49

Box 4 Cultivate local partners

Watch out for Foreign Corrupt Practices Act issues

-

many commercial entitles have State-owned links

Companies may keep different sets of accounts

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Topics

5. On-the-Ground Reality

51

The On-the-Ground Reality

F. Navigating the Chinese Regulatory Regime and doing deals in heavily regulated
industries
-

Investing in heavily regulated industries

The Encouraged, Restricted, Permitted and Prohibited or The Good, Bad and
the Ugly

Foreign ownership caps

Good nominee structures, bad nominee structures

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Box 5 Foreign ownership caps

Strategic
Investor
Individual
cap?

Strategic
Investor

Financial
Investor

Foreign sub of
PRC company
Outside China

Foreign consortium cap ?

Public
shareholders

PRC anchor
investor

China

Impact ?

Domestic Bank

53

Box 6 I got your number

Foreign
Publishing
House

Copyright Cooperation

PRC
company

Magazine
Name

Brand Name

Cannibalisation

(publication
number)

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Box 7
Bad Nominee Structure telecom CCF arrangements
China
Unicom

Foreign telco

Provincial Subsidiary

local
network

Cooperation
Joint Venture

Operation Agreement

55

Box 8 Valueadded telecoms

Founders
Investment Vehicle

Public

Listco

Founders

Nominee
contract

License holder
Regulated
Business

Operating Vehicle
Security and
Cash
Extraction
Contracts

China

Unregulated
Business

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The On-the-Ground Reality

G.

Regulators

MOFCOM

SASAC

CBRC

SAIC

NDRC

CIRC

SAFE

CSRC

MII

Customs

SAPP

EPB

57

The On-the-Ground Reality

G. Regulators (cond)

Central
MOFCOM

Local
MOFCOM

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The On-the-Ground Reality

H. State-Owned Enterprises
-

Recent developments
- Xugong, Chenming

Deal drivers
- Which member of the group?
- Dealing with the Hong Kong listed member
- Parent guarantee?
- State-owned assets valuation (mandatory, licensed appraising firm, methodology, SASACs
confirmation)
- Payment terms (90% rule)

59

The On-the-Ground Reality

H. State-Owned Enterprises (contd)
-

Special considerations
- Diligence
- Procedure (involvement of the asset exchange centre)
- Timing
- Documentation
- Social obligations
- Cross-provincial consolidation
- Sovereign immunity

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Box 9 The Hong Kong listed member

HK listco

Foreign
investors

SOE
Onshore
Operating Vehicle
- Hong Kong Stock Exchange issues

Connected
transactions

- Disclosure of interests
- Hong Kong Takeovers Code issues
- Insider dealing issues
- Pricing issues and the halo effect
61

The On-the-Ground Reality

I. The Public Company
-

Share reform
- The good news, the bad news
- Theme is convergence

Special considerations
- Investor qualification
- Public bid process
- Lock-up
- Diligence insider trading issues
- Timing pricing and approval process(es)

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The On-the-Ground Reality

I. The Public Company (contd)
- Trading restrictions
- Disclosure of interests
- Connected transactions

Listed Company Takeover Rules

- Mandatory Offers
- Partial offers
- Stock as acquisition currency

63

The On-the-Ground Reality

J. The Private Company
-

M&A Rules 2006

- Multi-agency effort
- Approval for acquisitions of key industries, famous Chinese brands
- Deals affecting state economic security
- Stock deals
- Merger Control
- May be inconsistently applied across China

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The On-the-Ground Reality

J. The Private Company (contd)
-

Special Considerations
- If privatized, was it privatized properly?
- Offshore control vs. onshore control using a holdco

65

The On-the-Ground Reality

K.

Investment Funds, Hedge Funds and other Alternative Investors

-

Meeting investor qualification criteria

Prejudice against financial investors?
Opportunities and risks

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Transactional Models
Round-tripping investment model
VIE model

67

Box 11 Nominee (or VIE) Structure for Valueadded

Telecoms Business
Founders
Investment Vehicle

Public Investors

Listco

Founders

Nominee
contracts

License holder
Regulated
Business

Operating Vehicle
Security and
Cash
Extraction
Contracts

Offshore
China

Unregulated
Business

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VIE Structure
Widely used by Chinese e-commerce portals,
internet search engines, and foreign investors:
Alibaba.com, Sohu.com, Sina.com, Baidu.com,
Youku.com, 51job.com, eLong.com
Recognised by Hong Kong and New York Stock
Exchanges
Commercially sensible
However, it has never been tested in Chinese courts
69

BUT, well-planned transactional structures are not

necessarily risk free
High-profile dispute among Alibaba, Yahoo and Softbank over Alipay
(equivalent to eBays PayPal)
Chinese regulators tightening up the regulatory space
Foreign exchanges rules in 2005
M&A Rules in 2006
MIIs Value-added Telecoms Business Rules in 2006
Tax Notice 82 in 2009
Circular 601 in 2009
Online Gaming Notice in 2009
PBOCs Measures on Online Payment Services in 2010
Rationale of regulatory moves

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Chinas Extraterritorial Attempt

General Administration of Taxations Circular on
Strengthening the Administration of the Enterprise
Income Tax on Non-resident Enterprises Equity
Transfer Income (Circular 698)

71

Chinas Extraterritorial Attempt

Key rules
Where a foreign investor transfers the equity in a Chinese
resident enterprise indirectly so as to avoid paying the
enterprise income tax on its income generated from China
through setting up the offshore holding company, the
Chinese tax authority may ignore the existence of the
offshore holding company and deem it as a direct transfer
of the equity in the Chinese resident enterprise by the
foreign investor.

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Chinas Extraterritorial Attempt

Key rules
Where a foreign investor (actual controlling party)
indirectly transfers the equity of a Chinese resident
enterprise by abusing the organizational form and other
arrangements without any reasonable business purpose so
as to avoid the enterprise income tax duty [the tax
authority can] deny the existence of the offshore holding
company used for tax arrangement.

Results

73

Chinas Extraterritorial Attempt

Real cases of enforcement Circular 698

Chongqing tax authority
Xinjiang tax authority
Yangzhou Chengde Steel Tube Co. and Carlyle

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Box 12 Yangzhou Chengde Steel Tube Co.

Carlyle Group

HK Co.

Carlyle Marco

Offshore
China

Jiangsu Chengde

Yangzhou Chengde

75

China is at a crossroads
Rule of law
Regulatory techniques
Policy making
Ideology
Legal institutions
Governance quality
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Topics

6. Hot-button Issues

77

Hot Button Issues Governing Law & Venue

(Offshore Investments)
Investment docs should be governed by U.S. (Delaware or
N.Y.), Hong Kong, English law for offshore companies
Do not accept PRC, Cayman, BVI law
Singapore or HK law depends, check with Intel legal
Jurisdiction/venue should be California, N.Y., England,
Singapore or Hong Kong
Do not accept PRC, Cayman, BVI venue
Singapore or Hong Kong venue
Onshore investments: case-by-case
Governing law, venue generally should be jurisdiction
where company & assets located
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Hot Button Issues Investor Liability

OK to give customary 33 Act purchaser reps &
warranties
OK to agree to give customary shareholder registration
rights indemnification provided liability is limited to
proceeds from offering
Avoid other purchaser reps/warranties, indemnification,
liability
Do not agree to joint & several or vicarious liability

79

Hot Button Issues IP

Company patents, copyrights, TM/SMs should be
registered where registration is condition to
validity/enforcement
Company should show us employee
confidentiality/invention assignment agreements signed
by key employees prior to closing
Company should commit to have all new employees sign
confidentiality/assignment agreements

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Hot Button Issues Liquidity

Must preserve liquidity of investment w/minimum restrictions
Do not accept any of the following:
Undertaking to hold shares for minimum period
ROFR/co-sale rights/transfer restrictions on shares or
limitations on class of potential transferees
Prohibitions on assignment of contract rights w/transfer of
shares (OK to carve out board observer & financial info rights)
Other conditions/restrictions/encumbrances on transfer
See infra for issues relating to registration rights, IPO
lockup/standoff agreements

81

Hot Button Issues

Market Lockup/Standoff Agreements
OK to agree to sign lockup agreement subject to following
conditions
Applies to IPO only & < 180 days
Applies only if and to extent all directors, officers, & 1%
shareholders also locked up
We must be notified of any release and procure same
release to the same extent
Terminates automatically if no IPO within 90 days after
date of lockup agreement
Carve-out for transfers among affiliates
Dont write lockup directly into investment docs
Make the underwriters come to us
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Hot Button Issues Preemptive Rights and AntiDilution Adjustments

Articles or shareholder agreement should give existing
shareholders pro-rata preemptive rights to any new
issuances
Anti-dilution rights attaching to Preferred Shares
Full-ratchet basis
Weighted average basis
Narrow-base
Broad-base
Conversion Ratio Adjustments
Milestones
Revenue targets
83

Hot Button Issues Protective Provisions

Company articles should give preferred approval rights
over fundamental legal/financial decisions by company
reserved matters or protective provisions in the
SPA
Determination of how many votes each share of
preferred stock will be entitled to
Board seats
Super-majority approvals (75% or more)

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Hot Button Issues ROFR/Drag-Along/TagAlong/Co-Sale Rights

Purpose: provide for an exit strategy
Preferred should always have a ROFR/co-sale rights in
transfers by founders/mgmt
Wont give ROFR/CS on Investors own shares,
though
Same in transfers by other VCs if we can get it without
giving the same rights on clients shares
Controlling shareholders will want drag-along rights
Minority shareholders will want tag-along or co-sale
rights
Information rights
85

Hot Button Issues Value Adjustment Mechanism

Two recent cases in China
Supreme Peoples Court: Jiangsu Haifu v. Gansu
Shiheng
Beijing High Court: Beijing Investment Company v.
Cao

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Questions?
Thank you.

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