Welcome everyone to another edition of my China Tech Law Newsletter. In this post I’m going to address one of the most common questions I get from foreign clients with the opportunity to bring on local Chinese investors.
Sometimes the issue comes up with a more mature company setting up in China and a local partner wants to invest in them to better align interests and incentives between the two. They could create a local JV together, but that might be more than the parties want at such an early stage. Also, if the Chinese shareholder is a minority shareholder, that often leaves them exposed to intra-group transfer pricing and other ways funds can move around and leak value out of the local China venture.
Often the situation also arises when an early stage company whose founders are foreigners have a Chinese investor willing to invest as a purely financial investor in their business. And because foreigners typically setup the corporate structure with an offshore entity on top (such as a Hong Kong or Singapore company) owning say the local Shanghai subsidiary that actually operates the business, there are a few problems which typically come up.
(1) Alignment with other investors
As I was getting at above, its already hard enough to make a structure work where you have part of the business outside of China and part in China with a JV partner. Where the local JV partner is worried about value leakage. A similar problem occurs for financial investors if you were investing down at the local China company level and the other financial investors and founders were holding their shares at the parent holding company level offshore.
What if that parent company started keep some of the overseas customer payments out at the offshore level instead of feeding into the local company even when the work was done locally? Or it started setting up a business in say Southeast Asia and started bringing some of the best managerial talent, IP, or other resources out of China to get that new business off the ground. The China shareholder isn’t seeing any of that value with its ownership only in the Chinese entity, right?
So we generally want all investors, especially financial investors, sitting at the same (highest) corporate level in holding their shares.
(2) Renminbi trapped in China
Okay, so we just have the Chinese investor invest at the parent company level right? Problem solved? Well, the parent company needs to take the capital investment from the shareholder in a foreign currency. The bank won’t be able to accept RMB as it generally doesn’t circulate outside of China. And while there are some limited options to convert RMB to a foreign currency, making an overseas financial investment (especially not one by a large SOE in a strategic industry) is generally not going to cut it to get approval to convert the currency at the bank. So your investor can’t fund his investment where he needs to fund it.
(3) How about an equity swap?
Why can’t the investor give the Chinese company RMB and get shares at the offshore parent level? Well, first its an accounting problem because the money is a capital investment at the local company but the shares are being issued at the parent level. Accounting 101, the debits and credits won’t line up. Could you have the Shanghai company issue shares (technically registered capital interests) in exchange for the local RMB capital and then swap the equity for equity at the offshore parent level?
Well, let me introduce you to one of the most powerful regulators in China, the State Administration of Foreign Exchange (SAFE). You couldn’t get this transaction past the first step, the Administration of Market Regulation to update the shareholding records, and even if you could, SAFE would surely disapprove as well. Its a transaction which too obviously bypasses the SAFE’s currency exchange restrictions we just discussed.
As I mentioned in a previous post, SAFE and the fact that the RMB is not freely convertible tends to rear its head all over the place in trying to structure transactions. For example, let’s say even the Chinese investor did have foreign currency to make the investment in the offshore parent company. Technically that investment would still need to somehow be registered with SAFE even though often there is no real mechanism to do so in practice.
To be frank, a lot of this was easier in the past, say pre-2016 or so when policies were freely encouraging of outbound investment and RMB convertibility was less of an obstacle, or at least transactions less scrutinized. Sometimes foreign founders will hear cases of founders past who successfully raised money locally but I have to caution that was a different era. After a period of significant capital outflows at the macro level, these days review of converting RMB is much stricter.
So a JV is the only option?
Okay, so you just walk away and turn down the money? Usually if the investor is keen enough, they find a way to get the foreign currency to make the investment. Otherwise, this RMB-forex conversion unfortunately is often a deal killer. If the amount was huge and no other good and much needed funding sources were stepping up to help sustain the business, you might still consider going down the JV route.
But that is done at a cost to getting future investors. First, having a major local investor has essentially turned this into a local business for the foreseeable future. As big as the market in China is, that may make it hard for the company to go global and achieve vaunted unicorn status.
Second, future foreign investors will not want to typically come in at the local level where they are less familiar with rules on share ownership and preference stock rights, abilities to liquidate their investments, and other perceived exposure to local liability (even if totally based on misconceptions). Essentially you’ve boxed yourself in to raising locally from this point forward.
Of course, as many founders know especially in difficult fundraising times right now, a check in hand is worth an awful lot more than the promises of other would be investors who will join when the business “gets more traction” or who don’t want to be the first major money in.
Stay tuned to a future post on local investment and JVs, and in the meantime please subscribe if you have not already!
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