Current Issues in Early Stage Investments from China

Current Issues in Early Stage Investments from China

We have observed two recent trends relating to Chinese investment in early stage U.S. high tech companies which have caused entrepreneurs to consider restructuring their ventures to have a presence in China. We generally encourage our clients to consider every alternative for investment and these trends impact investment from China.  The first observation is that China’s continuing efforts to restrict capital from leaving the country have increased the concern about Chinese investors completing investment deals in the U.S.  Many Chinese investors are unable to close deals as a practical matter because they cannot secure official permission to convert renminbi (“RMB”) into foreign exchange.  When Chinese investors are interested, entrepreneurs in the U.S. are asking whether such investors already have the money in the U.S. since the difficulty of getting money out of China is currently so great. This situation is a result of a series of measures by China authorities since late last year to tighten restrictions on capital outflows, both on the net outflow of capital as well as the composition of the outflow in terms of sectors and countries.[1]

Because of the foreign exchange controls on RMB, many private investors in China may ask entrepreneurs in the U.S. to consider taking their technology to China to complete development and build a business there.  Investors in China appear willing to take more early stage risk in funding innovation and valuations for high tech companies are generally higher than in the U.S., especially in highlighted industries like artificial intelligence, big data, health technology and agricultural technology.[2]  This approach could also help obtain better access to the China market in addition to being a source of funding.

The second observation is that we continue to hear reports that local and provincial governments in China are providing non-dilutive funding to high tech companies to encourage them to set up locally for job creation and other economic development purposes.  These incentives and conditions for funding vary so an entrepreneur should shop multiple locations to look for the best deal. The foreign party will almost always be asked to set up an equity joint venture (“JV”) in China as a condition of such funding[3].  A local or provincial government will not fund a foreign company or its China subsidiary.[4]  In some instances, only a nominally wholly Chinese-owned company will qualify – non-Chinese investors are limited in such case to participation by indirect investment through the variable interest entity structure (“VIE”)[5].

This article will address some of the most common issues encountered when dealing with these trends.   The issues are caused by the China Catalogue for the Guidance of Foreign Investment Industries (“Catalogue”), the China Sino-Foreign Equity Joint Venture Law (the “JV Law”), the China Company Law (“Company Law”) and local government funding conditions.  The Catalogue prohibits any foreign ownership in certain business sectors and requires Chinese majority ownership in JVs in other restricted business sectors. The JV Law and Company Law have certain requirements for JV formation in China. The registered capital requirements were relaxed beginning in 2014 but approval by the local Administration for Industry and Commerce (“AIC”) for investment in restricted industries can still be an issue. Entrepreneurs who seek local or provincial governmental funding may also be subject to additional requirements as a condition of funding.

Entrepreneurs need to negotiate with the potential JV party and relevant authorities to determine the terms and conditions of a potential JV before taking any action to proceed with a move from the U.S. to China. The terms of the JV will be documented in the articles of association of the JV (“Articles”) and in the JV contract between the parties (“Contract”). Control of the JV, ownership percentage and protection of intellectual property (“IP”) are key concerns and should be the first negotiations before any action is taken for such a material change from current U.S. status.  U.S. and China legal counsel should be involved in the process as early as possible.

The Catalogue

China is not an open market for foreign ownership of businesses operating there.  The starting point for determining whether a particular type of business may be established and operate in China with any foreign ownership is the 2017 version of the Catalogue which became effective on July 28, 2017. The Catalogue applies to a business with ownership by a foreign founder(s) as well as foreign “investor” ownership. The Catalogue applies to a JV with both domestic and foreign founders so status under the Catalogue is a pacing item for a possible financing in China from either a local government or private investor.

The Catalogue has two basic categories of industries, encouraged and negative. The “encouraged category” is divided into two parts: encouraged and encouraged with special requirements.[6]  The “negative category” contains prohibited and restricted industries. Businesses operating in a prohibited industry may not have any foreign ownership whatsoever. The VIE structure is still the only way a business in a prohibited industry with any foreign ownership may operate in China.[7]

Businesses that want to operate in most restricted industries in China must form a JV. The JV will have limits on ownership percentages, control over operations, executive team composition, special approval requirements and other limitations. The China party generally must have majority ownership of the JV.

There has been some relaxation in the investment categories since the 2015 version of the Catalogue but not in a very substantial way.  The new Catalogue has not yet been fully implemented everywhere in China.   Any Internet app that has artificial intelligence functionality would likely be in the prohibited or restricted category. The China government recently stated it intends to transform China into the world’s leading artificial intelligence technology power by 2030[8]. This sector is also very important to the U.S. government so that any transaction in which a U.S. company would lose control may have to be approved by the Committee on Foreign Investment in the U.S. (“CFIUS”).

Internet (excluding certain value-added Internet services, some of which fall in the restricted category), security, telecommunications, gaming, media and most private education businesses are still in the prohibited category. Although the new Catalogue opens some new industries to foreign investment such as agricultural technology, investment in several important industries such as banking and securities, healthcare, and telecommunications remain highly limited. Limitations on foreign investment in cultural related industries such as internet publishing and online media in the “prohibited” category actually may have been expanded. The following industries are included in the prohibited category:

  • Aerial photography mapping
  • Editing and publishing of books, newspapers, and periodicals
  • Editing, publishing, and production of audio-visual products and electronic publications
  • Radio, television video-on-demand businesses, and satellite television broadcasters receiving facility installation services
  • Internet public information services

Industries in which foreign investment restrictions were eased or removed include new energy vehicle batteries which could be a signal of possible future liberalization in the auto industry. A small number of high-tech industries, such as agricultural technology, virtual reality (VR) and augmented reality (AR) devices, have been given special incentives to encourage foreign investment. Encouraged industries can still be subject to certain restrictions on foreign investment such as permitted only in the form of a JV with a Chinese party.

General Planning

The time to establish any FIE entity[9] in China will take much longer than setting up an entity in the U.S.  Entrepreneurs used to completing a financing transaction in Delaware or California will have to be very patient.

Under the Catalogue, a JV is the only way for a foreign company to participate in certain restricted business sectors in China.  A registered capital amount will be required in the Articles that is sufficient to initially fund the JVs business cash flow needs based on the nature of the business, its scale of operations and its location.[10] The Company Law authorizes in-kind (non-cash) contributions to be used as consideration for a party’s contribution to registered capital.  In-kind contributions other than IP are permitted but usually an early stage company has only IP to contribute.  Both cash and in-kind contributions may have to be verified by a valuation and capital verification report by a public accountant licensed in China.

IP Transactions

The upfront consultation and negotiation with the regulatory authorities and China JV party needs to determine the scope of IP rights the U.S. party needs to contribute. IP is considered to be trademarks, patents, copyrights and know-how. This issue could be the deal killer if the China party or regulatory authorities push for a broad scope.  The U.S. party will want the transaction to be a license of some type while the China JV party will likely want an assignment of ownership rights of some type. The JV will qualify for certain incentives, such as high and new technology reduction of income tax, only if it receives an assignment of technology from the U.S. party – a license is not sufficient.  Again, an early stage company generally has only IP to contribute to the JV.  Regulatory authorities may require an appraisal process to support the value of an IP in-kind contribution to the JV registered capital – an appraisal is always required if the China party has state investment.  Such authorities will also review an IP transaction even when IP is not being used as an in-kind contribution to registered capital.    A license or technology transfer contract for the transfer of IP in the restricted category must be registered with relevant authorities before it can take effect in China and needs to address rights to ownership and use of modifications and improvements.

The negotiations over the scope of IP rights could begin with proposing a limited license such as to the extent necessary to operate the JV’s business in China (the “Territory”). Another approach is a license in a specific field of use in the Territory.  A “joint ownership” approach could be considered in some cases but the meaning of “joint ownership” needs to be carefully defined or could result in significant uncertainty.  For example, the China Patent Law states that unless otherwise agreed upon in writing, a joint owner may individually exploit or allow another to exploit a jointly owned patent by means of a general license.

The IP transaction may cause a tax liability for the U.S. party. Many U.S. entrepreneurs are surprised to learn that they may need to pay U.S. tax when licensing or assigning their IP but receive only equity in the JV. [11] The valuation of the IP for U.S. tax purposes may be subject to adjustment over time.[12]

Loss of Control

The U.S. party will very likely lose control of the JV if it is operating in a restricted industry under the Catalogue.  In other cases, the U.S. party may believe a China JV is controlled like a Delaware corporation. Having a 51% ownership in the China JV is not enough.  Control of a China JV means having majority ownership and control over the day-to-day management of the business.  The measures of control are appointment of a majority of the board of directors, the power to appoint and remove the JV’s legal representative and to direct the use of the company seal or “company chop”.  The China party will negotiate hard to have these powers. The U.S. party will have given up control if these powers are ceded to the China party.

Exit/Liquidity Strategy

The liquidity event for the China JV and its stockholders will likely be either a public listing on a China domestic stock exchange or an acquisition by a China entity.  Liquidation, merger or division of the JV requires unanimous board consent under the JV Law, which means either party to the JV may exercise a veto when their interests don’t align.  In addition, due to China’s foreign exchange controls, stockholders will only be able to get a limited amount of funds out of China after such an event.

Conclusion

The investment trends in China provide great opportunity as well as risk. Entrepreneurs need to negotiate with the potential China JV party and relevant authorities to determine the terms and conditions of a potential JV before taking any action on a sea change move from the U.S. to China. U.S. and China legal counsel should be involved in the process as early as possible. Control of the JV, ownership percentages and protection of IP are key concerns and need to be negotiated first. The Catalogue prohibits any foreign ownership in certain business sectors and requires Chinese majority ownership in JVs in other restricted business sectors. Thorough due diligence on the potential JV party and on incentives and restrictions under various local and provincial governments reduce the risk and increase the likelihood of success of the JV.

 


 

[1] See, for example, Dollar, China’s New Investment Rules, August 23, 2017: https://www.brookings.edu/blog/order-from-chaos/2017/08/23/chinas-new-investment-rules/

[2]  Allen, China’s Red-Hot Venture Capital Tech Scene, October 9, 2017: https://www.eastwestbank.com/ReachFurther/News/Article/China-s-Red-Hot-Venture-Capital-Tech-Scene

[3] The equity joint venture is a form of Foreign invested Enterprise (“FIE”).

[4] In the VIE structure, Chinese investors sometimes pay the investment funds to the China domestic company with the paperwork for the transaction reflecting an investment at the parent level (usually a Caymans company) and the money flowing downward through intercompany transactions.  This is only feasible if the funds can be used in China since the money will not be able to leave the country.  This approach could work for a WFOE structure as well with the same caveat about the money being used in China.

[5] Greguras and Xu, The China VIE Structure is Vulnerable – So Why is it Still Used?, November 18,2016: https://rroyselaw.com/international-law/ecommerce/the-china-vie-structure-is-vulnerable-so-why-is-it-still-used/

[6]Industries in the encouraged category supposedly do not require any pre-approvals by the government unless there are special requirements for the industry Special requirements could include pre-approvals, equity ownership ratios and composition of executive team

[7] Id. note 5.

[8] Chinas AI Awakening,  October 10, 2017:  https://www.technologyreview.com/s/609038/chinas-ai-awakening/

[9]  Foreign invested Enterprise

[10] The local government where the company is registered will have a recommendation for the amount of registered capital but there is no fixed rule after the 2014 and 2016 changes to the law.

[11] Internal Revenue Code Section 351 is not applicable because the transferee is a foreign company.

[12] Given the new flexibility on amounts and timing of capital contributions, the U.S. party might be able to contribute cash on an installment basis based on the financial results of the JV business and avoid having the IP transaction be for equity. The strategies for outbound IP transactions depend on the facts and circumstances of each specific case, and is beyond the scope of this article.

Fred Greguras and Fiona Xu
fxu1@rroyselaw.com
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