Why Do Chinese Internet companies go IPO with the VIE Equity Structure?

By Kent Lin

When talking about the miracle of the Chinese Internet, your Chinese coworkers and classmates may share the idea that the three conglomerates Baidu, Tencent, and Alibaba (BAT), along with other Nasdaq-listed Chinese Internet companies, avail themselves of the opportunities to go big because of mass population and domestic market need. However, if you happen to check their equity structure, you’ll find that they’re not really “Chinese” companies at all.

In China, because of sovereignty, censorship and ideology concern, the government holds a tight grip on regulations, even prohibiting foreign investment in technology, media, telecom (TMT) and other business sectors. The policies from the Ministry of Industry and Information Technology (MIIT) and General Administration of Press and Publication (GAPP) state that only domestic enterprises can possess licenses of specific businesses. For example, MIIT specifies that only domestic enterprises can hold the license of Internet Content Provider (ICP).

However, once these domestic Internet companies grow to a certain level, they need to include foreign capital (get private equity or go public), technology and management experience. As a result, the equity structure Variable Interest Entities(VIE) was created. Under this new structure, Chinese Internet companies could acquire investments from overseas investors (mostly American) and go public. At the same time, they could also work in areas the Chinese government forbade foreign capital to go, including TMT, Internet information service, education, entertainment and so forth.

Back to 2000, Sina, a well-known Chinese web portal, planned to go IPO in the American stock market. However, their revenue the year prior (1999) was only 2.83 million USD, with $9.39 million in losses and $7.7 million in net assets. Their revenue in 2000 (their planned IPO year) was only 14.17 million USD. With a revenue threshold of $51.07 million, Sina couldn’t meet the listing standards. If they had followed the old way of going IPO, the IPO timetable would had been postponed until 2005.

For Internet companies, timing is not just important — it’s imperative. Once a company misses the bus to acquire capital and update their products, their market share drops, giving their competitors the chance to catch up. Therefore, Sina hired Liu Gong, a lawyer well-versed in government affairs. After a series of case studies and consultations, Liu Gong and his team designed the new VIE equity structure, helping Sina go public in the Nasdaq market. Here’s how they did it, step by step:

Step 1. Restructure the company

Sina was restructured into several different entities. To simplify things, let’s call them entities A-E. Utilize Chinese citizens as shareholders to found entity A, a Chinese domestic capital enterprise, in order to work in the industries that only domestic companies can operate in (Internet service, media, entertainment, etc.) with licenses that only domestic companies can hold (ICP, Internet service provider [ISP], Internet data center [IDC], etc.).

Step 2. Register BVI/Cayman companies and Hongkong shell company

At the same time, company founders and other financial investors register a BVI (British Virgin Islands) company, entity B, as equity ownership identity. Utilize entity B to set up an exempt limited company, entity C, in the Cayman Islands, and use it to set up a shell company, entity D, in Hongkong for tax-deduction purposes. Founders and investors register BVI companies because 1) they’re easily registered 2) highly confidential and 3) when equity transfer occurs in the future, the structure can help lower taxes.

Step 3. Hold WFOE inside China

Utilize entity D to set up a foreign capital company, entity E, inside China. Entity E is a Wholly Foreign-Owned Enterprise (WFOE), holding all the technology and patents of the original company.

Step 4. Make agreements

WFOE entity E makes a series of contractual agreements with entity A, such as equity pledge agreements, business operation agreements, exclusive consulting service agreements, technology service agreements, etc. Through these agreements, entity C can now exercise de facto control over domestic company entity A, transferring interest and auditing financial statements. For all intents and purposes, entity A is now controlled by the Cayman company entity C.

Step 5. Use entity C to go IPO

Now, it’s time to submit the prospectus to SEC. In this case, entity C is used to negotiate with SEC and go IPO.

In 2000, Sina became the first company using VIE to go IPO. After that, many Chinese companies, including but not limited to the Internet industry, such as Baidu, Tencent and New Oriental, also followed this path to go public overseas. Of the more than 200 NYSE and Nasdaq-listed Chinese companies, 95 of them use the VIE structure. Generally Accepted Accounting Principles (GAAP) also redesigned accounting standards to accommodate this new equity structure, allowing the companies listed on the U.S. stock market to consolidate the financial statements of the domestic companies.

In sum, VIE equity structure accelerates the development of the Chinese Internet industry by letting foreign capital, technology and management experience integrate with Chinese domestic companies.

Regarding the Chinese government, the attitude is ambiguous. On one hand, developing Internet requires huge sums of capital which, in that era, the government and Chinese VCs couldn’t afford. With its acquiescence, Chinese Internet companies could go IPO abroad and gain access to overseas investors. In return, the government could enjoy the many advantages that came with the resulting prosperity: society becomes more efficient, employment rates are bolstered and tax revenue increases. On the other hand, the government knows that industries like media, culture and Internet belong to the national ideology. By loosening its grip on regulations, it risks losing its grip on public opinion.

The grey area probably won’t last long. Since 2015, the government has been discussing putting into practice the Foreign Investment Industrial Guidance Catalogue. However, overturning the VIE structure could cause financial chaos and significantly weaken many large GDP-generating companies. For this reason, some believe the Chinese government will improve supporting measures in the near future.

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