財經觀察 2350: 協議控股結構

Definition on VIE (Variable Interest Entity):

　　協議控股結構，也稱 VIE 結構，又稱新浪結構。源自新浪在納斯達克上市時所創造，後被普遍運用於互聯網、出版等 “ 外資禁入 ” 行業的企業境外紅籌上市。之所以稱 “ 協議控製 ” ，因為其具體方式為，當事人以其控製的境外公司名義，返程設立外商獨資企業 (WFOE) ，並以 WFOE 名義，通過排他性管理谘詢或技術服務協議等合同，控製境內企業的全部經營活動，進而取得境內企業的主要收入和利潤。通過上麵的一係列安排，雖然從表麵上看，境內企業仍然為獨立的內資企業，但實際上該企業的一切經營及其相應的資產、收入和利潤均歸屬境外公司，被境外公司實際控製。

Investors that hold the equity on the VIE do not have the privilege or responsibility of controlling the company. However, investors will receive the economic benefits through contractual agreements.

Regulations on online payment services

According to the announcement made by PBoC in June 2010, all non-financial institutions will require a license from the central bank to provide payment services by September 1, 2011. However, such announcement does not cover companies with foreign ownership. Some industry insiders interpret that the government would approve companies only with domestic ownership status.

Rumor on Tenpay, the online payment service business for Tencent

Similar to other Chinese Internet companies who are listed overseas (HK, US), Tencent listco is a Cayman Islands registered entity, which has no direct ownership on the operating entities in China but enjoys economic benefits through contractual agreements. Tenpay is a domestic company, 100% owned by Tencent Computer (also a domestic company), which has contractual relationship with Tencent listco (see below). Over the past few days, there has been rumor saying that the government is revoking Tenpay's online payment license because of its VIE structure. The rumor was initiated from a blog, so far there has been no confirmation from neither the government nor Tencent. In addition, we believe such rumor is about online payment business only, listco VIE structures will likely remain intact.

Restructuring on Alipay

Alipay has been fully transferred out from Alibaba Group to a domestic company majority owned by Jack Ma in order to eliminate the uncertainties for the online payment service license application due to its foreign ownership. Before the restructuring, Yahoo! and Softbank indirectly own Alipay via its ownership on Alibaba Group.

Explaining VIE structures

« Are VIEs a going concern?

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PCAOB reports on reverse mergers »

This posting will explain the use of variable interest entities (VIEs) by U.S. listed Chinese companies. I have selected E-Commerce Dangdang, Inc. (NYSE: DANG), which listed on the NYSE late in 2010, as an example of how the VIE structure is used. I have selected Dangdang because it follows the archetypal model for VIE structures, not because it has any higher or lower risks than other companies using VIEs.

Offshore holding companies. Like most U.S. listed Chinese companies, the actual listed company of DangDang is a Cayman Islands corporation. After the IPO, founders Peggy Yu and Guoqing Li controlled 44.1% of the voting power of the company.

Chinese companies that list in the U.S. mostly use a foreign incorporated company as the listed company. The exceptions are large former state-owned enterprises like PetroChina or China Life, which list the Chinese incorporated parent company. The foreign parent companies are usually incorporated in the Cayman Islands because it is a favored location for offshore companies due to its tax-free status and established legal system that is built on English law. Some companies have used corporations formed in the British Virgin Islands or the U.S. U.S. holding companies are usually a poor choice, since this brings the corporate group into the U.S. tax net. Such arrangements are usually an accident of history – the founders having started the company in the U.S. or used a reverse merger with a U.S. shell company.

The usual way to prepare for an IPO would be to contribute the shares of the Chinese operating company to the Cayman Islands company so that the Chinese company becomes a wholly owned subsidiary of the Cayman Islands company. The big problem with that was that foreign investment is not permitted in the internet sector where Dangdang operates. There are other problems related to foreign exchange and taxes that I will cover in another posting. In order to list in the U.S. (or anywhere for that matter), it was necessary for the Cayman Islands corporation to be able to consolidate in its financial statements the Chinese operations of Dangdang that were held by the founders. The Cayman company also needed a way to get access to the profits of the Chinese operations for the benefit of the shareholders. Since they could not simply transfer the Chinese company to the Cayman Island holding company, they used the VIE rules to consolidate the Chinese operations by putting in place the archetypal VIE structure, as illustrated in this chart from their registration statement:

VIE entities. Beijing Dangdang Kewen E-Commerce Co. Ltd. (Dangdang Kewen) is a Chinese company that is owned by Dangdang’s founders, Peggy Yu Yu and Guoqing Li, who are husband and wife. Because both shareholders are Chinese citizens, Dangdang Kewen is permitted to hold the licenses that are essential to the operation of Dangdang. Dangdang Kewen has a 100% owned subsidiary in Wuxi.

WFOE entities. The Cayman Islands corporation established a Chinese subsidiary, Beijing Dangdang Information Technology Co. Ltd. (Dangdang Information). Because this entity is 100% owned by a foreign corporation, it is known in China as a wholly foreign owned enterprise (WFOE). Dangdang Information is not permitted to hold the necessary licenses to operate the business, and is not permitted to sell audio and video products in China. It does, however, conduct a significant portion of Dangdang’s business in China, including , for example, handling product procurement and fulfillment operations and operating warehouses. Ideally, Dangdang Kewen would also be a WFOE, but this is not permitted in the internet sector. Dangdang Information has a 99% owned subsidiary in Wuxi.

Agreements. The concept that underpins a VIE structure is that control is obtained through legal agreements rather than through share ownership. Taken together, the agreements are intended to provide Dangdang Information with substantially all of the economic benefits from Dangdang Kewen and the obligation to absorb all of its losses. Dangdang uses five agreements to achieve this. These agreements are typical of most VIE structures:

Loan agreement. The founders borrowed funds from Dangdang Information in order to capitalize Dangdang Kewen. By using Dangdang Information instead of the Cayman Island parent to make the loan, the agreement is between two Chinese companies, avoiding the need to deal with the State Administration of Foreign Exchange.

Equity pledge agreement. The founders executed an equity pledge agreement with Dangdang Information which pledges their shares in Dangdang Kewen as collateral under the loan agreement and the other agreements.

Call option agreement. The founders agree to sell Dangdang Kewen to Dangdang Information at any time for the original capital contribution. The payment price can be offset against the loan. From a practical viewpoint, the option cannot be exercised unless at some point in the future China allows foreign investment in companies like Dangdang Kewen.

Technical support agreement. Dangdang Kewen agrees to use Dangdang Information as its exclusive technical service provider including platform and technical support, maintenance and other services. It is through this agreement that Dangdang extracts the profits of Dangdang Kewen. The transfer price that determines the amount of the charge for technical services creates tax risk, which I will discuss further in a later post.

Power of attorney. The founders give a power of attorney to Dangdang Information that gives it all the normal shareholder rights, including voting, attending shareholder meetings and fulfilling the call option agreement.

Operations. The registration statement of Dangdang does not provide details on how it will operate, but there are some clues. The objective in any VIE structure will be to minimize the profits in the VIE. Residual profits in the VIE cause problems because the ultimate transfer of these profits to the public shareholders is difficult and expensive. While VIE agreements typically require the VIE shareholders to turn any dividends over to the public company, any distributions to the VIE shareholders would be subject to individual income tax in China, layered on top of corporate taxes already paid.

Companies with VIE operations in China typically try to conduct as much of the business as they can justify in the WFOE. In Dangdang’s case, it appears that they intend to conduct procurement, fulfillment and warehousing activities in the WFOE (except for audio and video products that the WFOE is prohibited by law from handling). On top of that, the WFOE will charge the VIE for a technical service charge to compensate for developing and maintaining the internet trading platform. The ideal situation will zero out the profit of the VIE, resulting in all of the profits residing in the WFOE.

This posting has outlined the basic structure of VIEs using a typical example. There are some variations on this structure that I will explain in future postings. In these postings I intend to present some of my research on how VIEs are actually being used in China, and outline some of the more significant risks.