Nifty article at China Law & Practice on implementing FIEs with preferred stock structure by Greg Pickrell and Judy Deng, Preferred Stock Structure: Theoretical and Practical Issues of Implementation in Chinese Foreign-invested Enterprises (sorry, subscription only access [I don't pay, but my school does]) . The goal of the article is to pick out ways to play with and recommend ways to modify Chinese law to allow preferred stock so that VC and PE firms can retain veto rights despite the percentage of equity they hold in a company, or to allow PE and VC funds founded in China to have multiple stock classes. My biggest takeaway from the article is that the red-headed stepchild of the FIE world, the Cooperative Joint Venture (CJV), is getting some loving.
The reasoning is pretty simple. An Equity Joint Venture (EJV) does not allow for preferred stock because voting rights in the company are determined by equity investment in the company, and China's registered capital system does not allow for a preferred stock investment in an EJV. A Wholly Foreign Owned Enterprise (WFOE) could have preferred stock if it was acquired with private equity and organized under the laws of a different country, which the authors say is allowed, but venture capital investments into a Chinese company wouldn't work with a WFOE because it wouldn't be WFO. This just leaves the CJV.
The CJV is a nice option because at the time of formation the founders can create a legal fiction of multiple classes of stock. In legalese, a legal fiction means pretty close to the opposite of what it means in English. The articles of incorporation can be written in such a way as to give some investors all of the rights that a preferred stock holder wants while giving all the other investors rights that are more similar to a common stock. It might take a bit more work, but that is pretty cool.
Of course, if you want to form a PE or VC firm in China, rather than acquire targets or invest in businesses, then there are different options. If you want a WFOE, then the WFOE can be formed under the laws of a different nation with any sort of structure you want. If you want to form a VC or PE company with a Chinese partner, then a CJV might be clever for the reasons mentioned above to protect certain investors, but the authors point out that EJVs are done. The final option is to choose the little understood and vaguely legislated Foreign Invested Venture Capital Fund (FIEVC). The authors try to figure out what is going on this with this type of FIE, and make recommendations for future implementing regulations. But, the jury seems to be out.
Good article.
For more on why the FIEVC regulations don't make sense, check out the Venture Capital FAQ at Lehman, Lee & Xu.
3 comments:
I'm not sure I buy the notion that CJVs can work as a substitute for a lack of share classes under Chinese law.
The entire system of regulation around CJVs is, to be kind, in transition. For this reason, investors do not have a decent level of comfort with their ability to secure a remedy in the event that something goes wrong. It is no accident that companies continue to rely upon round trip investment structures rather than risk their capital to the vagaries of the Chinese court system, despite the fact that Chinese law now act to limit the ability of PRC citizens to set up such an arrangement.
For more on CJVs and when they actually DO work in China, check out "Understanding Contractual Joint Ventures in China" (in the Journal of Chinese Economic and Business Studies), an article by Yue Wang. In essence, she argues that CJVs work very well as more integrated form of subcontracting than a typical processing and assembling arrangement. The money quote is this one:
"When the subcontracting activities require even higher transaction-specific investments or the partners’ strategies require even closer coordination, the CJV intermediate form of contracting may have to be transformed into a fully integrated hierarchical structure, such as EJVs and WFOEs. Therefore, for CJVs to remain the optimal governance structure there must be significant contracting benefits that outweigh the internalization advantages of EJVs and WFOEs."
Micah,
Unfortunately, my school doesn't have a subscription to that journal. I don't see how the money quote differs from the conclusions of Mr. Pickrel and Ms. Deng. They say that they have used CJVs in PE and VC transactions because, to quote Ms. Yue, there are "significant contracting benefits that outweigh the internalization advantages of EJVs and WFOEs." These contracting benefits are the ability to structure shareholder rights in a way that is not solely based on equity in the enterprise. The shareholder rights can be different for each shareholder, and can be structured in such a way that some shareholders can have rights that mimic the veto rights of certain preferred stock without necessarily having a majority of equity in the company, and without fear of losing those veto rights when an equity share could otherwise be diluted. Veto rights, which are only possible with preferred stock or some business form in which multiple stock classes can be mimicked, are very important in the formation of a VC fund and in the demands that a VC is likely to make of an investment target.
Micah,
Also, I can't find your email address anywhere, and I'd be interested in contacting you. You can reach me at wd.lewis@gmail.com
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