Venture Capital Financing in China:Processes and Issues

Presented by James Hsu

US-China Business Law Conference

UCLA School of Law

October 2007

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Criteria for Successful VC investment

Abundant source of capital VC, PE, government funding, capital markets

Intellectual capital Universities, research institutions, pillar companies

Legal and regulatory framework IP protection, tax incentives, stock options

Infrastructure Advisors, physical infrastructure

Market Domestic market, early adopters

Attractive Environment Nice place to live, political stability

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Greater China/Silicon Valley Technology Corridor

Synergy of “3 shores” US – capital, technology, imports Taiwan – management, production, marketing

expertise China – work force, growth, domestic market

Fast changing landscape – this conventional thinking may no longer hold true

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How does China measure up?

Abundant source of capital

Huge engineering talent pool

Growing domestic market

No longer viewed as a hardship post

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Challenges for China

Shortage of management talent

Underdeveloped systems for transferring technology from research institutions

Large degree of control exercised by the central government in the venture ecosystem (e.g. SAFE Circular 75)

Evolving IP regulation and protection

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Typical PRC Investment Structure

Offshore holding company – Typically in the Cayman Islands and British Virgin Islands

Establishment of an operating entity in China – WFOE or JV depending on the type of business (e.g. telecomm – restricted)

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Fund Management Co.

Fund Co./LLPFund Co./LLP

100% Foreign Co*.PRC – Foreign Co*.

WFOE*

WFOE

Restricted* Business

PRC

*Targeted for offshore listing or private sale

PRC

Overseas

Pledge

Typical PRC Investment Structure

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Impetus for Offshore Structure

Foreign exchange restriction

IP protection

More familiar venture financing structure

Exit Strategy – overseas listing or sale of company

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China – the new frontier for VCs

Notwithstanding the challenges, the VCs are moving to China

Many new VC and PE funds have been formed in the last 5 years specifically focusing on China

Gold rush/herd mentality

Too much money chasing too few deals

High valuation, short due diligence periods

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Typical deal terms

Very similar to US VC deals

Preferred stock

Liquidation preference

Board participation

Special shareholders rights

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Terms not typically seen in the US

Reg. S offering to non-US persons (concurrent offering under Reg. D permitted)

Indemnification provisions

Redemption rights

VC veto rights