To achieve IPO, Chinese companies have 2 options either
onshore (A share) listing or offshore (red chip) listing. Most companies use red chip listing because conditions lower and faster. For red chip listing, two options straightforward offshore listing structure or VIE structure. First used by SINA in 2000. In china, FDI is not totally open to foreign investors. Industries are classified into 4 categories encouraged, permitted, restricted and prohibited. Vie structure created to circumvent legal restrictions More than 100 Chinese companies have adopted VIE structure Alibaba, Tencent, Baidu, Sina, Tudou etc.
As indicated in the diagram above, foreign investors and PRC
individuals establish SPV1 in Cayman; then SPV1 sets up a whollyowned SPV2 in Hong Kong; and then SPV2 establishes the wholly foreign-owned enterprise ("WFOE") in the PRC. The domestic company usually is the one which owns licenses or approvals for the business. However, due to restrictions on foreign investment, the WFOE cannot obtain licenses or approvals from the PRC authorities to operate in the desired industry. Through a set of contractual arrangements among the WFOE, PRC individuals (usually PRC individuals are the companies founders) and the domestic
company, the WFOE may be able to actually control the domestic
company as if it directly owned the equity interests in such domestic company. Thus SPV1 may consolidate the financials of the domestic company into the groups overall financial statements, which is permitted and accepted by the US General Accepted Accounting Principles. In practice, the contractual arrangements include: (i) the Consulting and Service Agreement entered into by and between the WFOE and the domestic company, which provides that the WFOE shall provide certain services (for example, the consulting or strategic services and technical services) to the domestic company for a fee, typically determined by the WFOE with the intended result of shifting the domestic companys profits to the WFOE; (ii) the Asset License Agreement entered into by and between the WFOE and the domestic company, under which the WFOE licenses certain assets including intellectual properties to the WFOE for royalty fees; (iii) the Voting Rights Agreement or Proxy entered into by and among the WFOE, PRC individuals and the domestic company, in which the domestic companys shareholderPRC individuals authorize the WFOE to exercise their shareholders rights in the domestic company, including voting rights, inspection/information rights, signing rights and election rights, etc.; (iv) the Call Option Agreement entered into by and among the WFOE, PRC individuals and the domestic company, in which PRC individuals grant the WFOE an option to purchase all or a portion of their equity interests in the domestic company at a lowest possible price permitted by PRC law; (v) the Equity Pledge Agreement entered into by and among the WFOE, PRC individuals and the domestic company, through which the PRC individuals pledge their equity interests in the domestic company to the WFOE as a guarantee of the performance of their and the domestic companys obligations under other agreements among the three (3) parties in the VIE structure; and (vi) the Loan Agreement entered into by and between the WFOE and PRC individuals, in which the WFOE extends a loan to PRC individuals to use for capitalization of the domestic company. The cash flow goes like this: SPV1 will fund the SPV2. SPV2 will make a capital contribution to the WFOE. The WFOE will extend a loan to the PRC individuals, who will in turn establish and finance the PRC domestic company. When the PRC domestic company makes a profit, it will distribute a dividend to the PRC individuals. The PRC individuals will make a repayment of the loan to the WFOE. The WFOE will use the proceeds of the loan together with other funds to be discussed below to make a dividend distribution offshore to SPV2, which will in turn make a dividend distribution to SPV1. In addition, through the contractual arrangements between the WFOE and the PRC domestic company, the domestic company will also
make certain payments to the WFOE for provision of services. This
payment will be part of the dividend to be distributed by the WFOE offshore, thus completing the chain of cash flow. At the beginning, the VIE structure was used primarily for asset-light companies, such as internet companies, advertising companies, software companies, education companies and media companies, etc. However, after several years development, the asset-heavy companies also began to choose VIE structures for their financing or offshore listing and the typical example was China Qinfa Group Limited. Recently, the VIE structure has been increasingly used by asset-heavy companies. Alibaba files for US IPO! Licenses to operate websites in China are held by VIEs 100% owned by Chinese citizens. Basically licenses owned by Jack Ma and not owned by main Alibaba company filing for IPO.