Listings have drawbacks as well as rewards

The pros and cons for Chinese technology or high-growth companies choosing to go public

There is an increasing number of China-based technology startups competing globally in the software, Internet, clean technology, and technical sectors.

Many of them have been founded by grass-root entrepreneurs and inspired by high-growth success stories such as Tencent and Youku, both of which are already successfully trading publicly on international stock markets.

From just a handful of venture capitalists back in 2000, a few hundred active VCs have now emerged, and many of them are enjoying huge success.

Many of those investing in technology or high-growth Chinese companies are offshore funds, often based in the Cayman Islands but with ties in Silicon Valley.

Notably, an increasing number of angel funds have also been set up by former Chinese entrepreneurs - sometimes serial entrepreneurs - to offer not just money but also guidance from experienced hands to founders of new startups.

Typical "exits" for these investors would be by initial public offering, often in the US, or through a sale to a more mature company in the investor's portfolio.

In either event, it would generally take place under US or Hong Kong law, and many of the legal terms used in the due diligence and transaction are modeled after those found in the Valley.

But there are also several differences between startups financing in China and those in California or the rest of the US.

In the latter, other than share purchases, there is an active market for banks and private equity investors providing venture loans to startups, even though the startups have little or no assets to provide as collateral.

In contrast, the venture loan market in China is still in its infancy and unlike in the US, investment funds backed by the Chinese state - such as state-owned companies, public universities, and government agencies - often provide funding to startups.

China-based VC investors tend to manage risk more carefully by applying more controls on their investment.

For example, an investor often insists that in addition to the company itself, the company's founder(s) be personally liable for any lack of disclosure to the investor or breach of the financing agreement once the deal is signed.

Investors also tend to list more conditions which it, or the board director appointed by it, can veto.

The almost universal use of variable interest entities by US-listed Chinese technology startup companies consists of offshore plus onshore entities, including one or more local units that are not directly or indirectly owned by the ultimate parent company, which have heightened the risks related to China deals.

To mitigate those risks, VCs have often asked for co-signatory rights over the company's bank accounts, and the appointment of additional board directors on any subsidiaries of the company.

Meanwhile, whereas some exits may mark happy success stories for investors - with a public listing of the company, or an IPO marking a significant milestone in a company's story - this minefield of listing compliance can prove too much for some technology companies.

In many cases, the costs of maintaining a public company such as compliance with increasingly complex public market regulations, and the risks of securities litigation filed by minority shareholders which are commonplace in the US have caused companies to remove themselves from the market.

In going private, the company, an affiliate of the company, or one or more private equity firms acquire all of the outstanding shares and in effect "cash out" all or almost all of the publicly-traded shares.

As a result, the company is de-listed from the stock exchange and if it was previously listed in the US, de-registered with the Securities Exchange Commission.

Going private can be a good choice for some.

The company may realize a higher value in a depressed market, and with fewer shareholders to answer to, its management can then focus on long-term objectives rather than the short-sighted management of stock market expectations.

As well as avoiding the costs related to SEC compliance, a de-listing can also mean a company can avoid public scrutiny of its operations and the sometimes-sensitive disclosure of information to competitors, while increasing its knowledge and control of its own shareholder base.

However there are three main negatives in going private, or choosing not to go public at all.

First, shareholders face reduced liquidity, or put simpler, they have less opportunity to cash out.

The ability to access the capital markets for future funding needs is also reduced, because the company would not be able to use its stock as currency in acquisitions or other transactions.

And last but not the least, private stock can lack the attractiveness of stock-based incentives to key employees.

The author is senior attorney at Cooley LLP.

(China Daily Africa Weekly 07/18/2014 page9)