The release of the long awaited Provisional Measures on Administration of Initial Public Offering and Listing on the Growth Enterprise Market (“Provisional Measures”), which come into effect on May 1, 2009, pave the way for the launch of China’s Growth Enterprise Market (“GEM”). Similar to other overseas alternative or secondary markets, the GEM is intended to provide a new financing platform for emerging companies in China.
Chapter 2 (Conditions for Issuance) of the Provisional Measures sets out the main listing requirements. Like most other overseas capital markets, the thresholds for listing on the GEM are much lower than those for listing on the main boards of both the Shanghai and Shenzhen stock exchanges. According to the Provisional Measures, a listing candidate must be a company limited by shares with a continuing operating history of at least three years. In addition, a listing candidate must meet the following financial criteria:
- it either (i) has been profitable for the past two consecutive years and has accumulated net profits of at least RMB10 million, or (ii) has been profitable for the last fiscal year with revenues of at least RMB50 million and net profits of at least RMB5 million and a growth rate of the revenue for the last two years of at least 30%;
- the pre-IPO net assets shall be not less than RMB20 million and there shall be no losses that need to be made up; and
- the post-IPO share capital shall be not less than RMB30 million.
In addition to the operating history requirements and financial criteria set out above, the Provisional Measures require that listing candidates demonstrate an ability to continue to operate profitably. Accordingly, amongst other things, a candidate must demonstrate that it is not operating in an industry subject to a major change in the future, that its position in the industry in which it operates has not experienced, and will not in the future experience, a major change, that there is no risk of a major change with regards to the continued use or acquisition of its trademarks, patents, exclusive technology or special operating abilities and that its business income and net profits for the last year did not come from relying on an associated party or a major unproven customer.
Another significant provision requires that, in the past two years, there be no material change in the candidate’s major business, the board members and the management team and the actual controlling person of the candidate must not have changed.
Such financial entry ongoing feasibility requirements should help to maintain the quality of companies listed on the GEM; an issue that has plagued Hong Kong’s secondary market since its inception.
With more and more foreign venture capital and private equity in China turning to onshore structures to directly invest in Chinese emerging companies given the current “round tripping” restrictions on offshore restructuring, viable exit strategies in China have increasingly become a challenge for foreign investment funds. So will the GEM provide an attractive exit to foreign venture capital and private equity firms?
Perhaps it will but there are a number of hurdles for foreign venture and private equity firms that may make the GEM a less attractive option when compared with domestic funded enterprises. The major concerns for a foreign invested enterprise (“FIE”) are likely to be as follows:
Firstly, an FIE, which is usually incorporated as a limited liability company, must be converted into a foreign invested company limited by shares (“FICLS”) before it can apply for a listing on the GEM. Although the track record of profitability for a GEM listing has been reduced to 2 years or even 1 year under the Provisional Measures, an FIE is not allowed to be converted into an FICLS unless it has been profitable for the last three consecutive years according to the relevant FIE regulations.
Secondly, after conversion into an FICLS, an FIE is still subject to more restrictions than non-FIEs in order to go public. In accordance with the relevant FIE listing rules, the following requirements must be met before an FICLS can apply for a listing:
- its business scope must comply with relevant regulations concerning foreign investment;
- it must have passed various annual inspections by different authorities for the last three years;
- the proportion of shares held by foreign investors shall not be less than 10% of the total shares post-IPO; and
- FICLS which are controlled by the Chinese parties, or for which there is a requirement to maintain a certain shareholding percentage by the Chinese parties, must keep such controlling positions or shareholding percentage post-IPO.
Thirdly, the new listing rules of the main board on the Shanghai Stock Exchanges have reduced the post-listing lock-up period for non-controlling shareholders from three years to one year, regardless of the time of their investment in the company pre-IPO. Although the GEM listing rules have yet come out, it is anticipated that the relevant provisions concerning the lock-up period will mirror the new main board listing rules. Nonetheless, if the investors are controlling shareholders or promoters of an FICLS, their shares in the company will still be locked up for three years after the listing or the establishment of such FICLS.
Fourthly, the tax exposure for the foreign investors is also a factor to be taken into account when considering a listing on the GEM. According to the new Enterprise Income Tax Law of China, foreign firms making investment in China are treated as non-resident enterprises and the dividends and/or gains from the transfer of shares in Chinese companies by such firms shall be subject to an income tax at the rate of 10%, unless there are lower applicable rates provided in relevant tax treaties between China and the countries where the investment firms are registered.
There is little doubt that the release of the Provisional Measures represent a significant breakthrough in the development of China’s securities law regime. Chinese entrepreneurs are still lured by the appeal of the higher profile IPO over a trade sale so the introduction of an alternative market geared towards emerging growth companies should be welcomed by both the investment and entrepreneurial community in China. In one sense, the timing could not be better given the unattractiveness of Hong Kong’s growth enterprise market and the United Kingdom’s AIM market; let’s hope that the Chinese regulators will have learnt the lessons from the shortcomings of these two markets.