Welcome everyone to another edition of my China Tech Law Newsletter, where I try to have a little fun with the titles once and while with my "sense of humor."
After much anticipation, China has just amended its Company Law with real substantive changes that matter. There have been plenty of good articles written on the topic including from our own firm R&P, so I won’t go into a complete summary here. This short post is to add some color to the black letter law.
The "Oh No You Didn't" moment comes from people with a company in China that were led to believe they had all the time in the world to put in their capital and now, things have reverted back to the way they were before. The new law's requirement to contribute capital is now 5 years. It is expected there will be a grace period for existing companies to comply, but certainly no grandfathering in of current companies' "unlimited" schedules.
Let’s take a step back about the purpose of registered capital. In the US and other places, shareholders will also put in initial share capital as well. This amount is typically contributed upfront in full, and then additional shares can be subscribed for over time (in VC world, what we’d call a “round”) by other investors or the original founders. In the US, there is no pre-commitment to how much capital you will fund in and by what date.
Registered capital in China, by contrast, is an amount you commit to contribute to the company now and in the future. Well over a decade ago, the requirement was that a portion of your registered capital must be put in upfront and the balance within 2 years. That 2 year timeline disappeared subsequently but now, in this latest Company Law, we have a return to a 5 year timeline.
And to no one’s surprise, during that interim no-deadline period, there have been folks who have set up companies with large registered capital but with no expectation that they would contribute the full amount soon, if ever.
So you might ask, why would you put a high registered capital amount for a company? Why wouldn’t you just set an amount you planned to fund and then increase accordingly as needed?
Well its important to note that a company’s registered capital is generally public information which anyone can obtain. Traditionally, customers, suppliers, and other business partners would as part of their diligence look to the company’s registered capital amount as a sign of strength or weakness as to its stability and longevity as a partner.
But the trick is that while the registered capital amount is public information, the amount actually contributed generally is not. So you can see the implicit temptation to set up a company with a large registered capital to project outward strength knowing that you were not going to get called out for it when not actually contributing the bulk of the capital.
This is not necessarily a common case, but you can see at the margins, many honorable people setting up a company that would still put the registered capital amount a little higher than they might otherwise do, and that gap is what is now an issue as the timeline comes back into play. Particularly as investors are leveling off the amount of capital they put into their China-based ventures these days.
Yes, you can apply to have the registered capital reduced, but that is a process in itself and needs to fit into certain explainable circumstances for why you must do that. You would expect given the new law and a likely uptick in applications, authorities will start to be more forgiving on this issue. But we also forsee the new registered capital deadline as an issue that local authorities will raise if you have other applications pending for your company (for example to expand your business scope, apply for an industry-specific license, change the legal representative, etc.).
A quick final point under the new Company Law on one other issue dear to my heart. Over the many years of working with venture capital funds and startups, we constantly had the issue come up of offshore versus onshore structures. Offshore structures would be a Hong Kong, Singapore, Cayman, or BVI parent company sitting on top of the China subsidiary (WOFE) which allowed easy sale of shares (in foreign currency) and flexibility as to governing rights and returns (e.g. preferential shares).
For these reasons, we would shy away from recommending an onshore structure unless the prospective lead investor in the startup really only had RMB to make the investment. The caveat being that we would have to contractually try to recreate some of the rights that a Series A or B set of preference shares would have otherwise hardwired into the basic charter documents of the company in a Cayman/BVI/Singapore/HK context.
The latest Company Law now seems to be finally allowing more room for preferential-type shares. More details to be worked out and arguably a bit too little, too late for foreign funds... but local investors will certainly appreciate the changes.
Overall, I think the changes are made with a good faith intent to try to fix legitimate problems and not necessarily a reaction to any kind of macro circumstances. Many of the issues, for example, the preferential rights one and on fiduciary duties for controlling shareholders are just conforming to prevailing norms on governance in other countries. On balance, this is a good thing and good sign for future corporate law measures.
*This blog may be considered attorney advertising. It is for informational purposes only and does not constitute legal advice.