Legal Problems Associated with Establishing Foreign Venture Capital Companies
-------Gary Gao

According to the "Opinions Associated with Establishing Venture Capital Systems" (the "Opinions"), the term "venture capital" is characterized as equity capital that an investor provides to a technological and high-growth enterprise and also the management or consultation service provided, as well. Once an enterprise matures, the investor can transfer his equity and profit from increment of mid or long-term assets investment proceeds. The Opinions contain information related to a variety of investment methods and also provides and describes internal foreign invested enterprises, foreign institutions registered in China, whose purpose is to raise capital primarily for investment in PRC domestic businesses. These are typically broken down into two types: Foreign venture capital investment company, and foreign venture capital fund.

1. Foreign Venture Capital Investment Company

The "Provisional Regulations Concerning Foreign Investment Companies" (the "Provisional Regulations") were issued by the Ministry of Foreign Trade Economic Cooperation in 1995. These address the basic regulations concerning foreign investment companies making their investments. When a foreign investment company engages in investment, it needs also to abide by the "Company Law of China", and other regulations applicable to foreign invested enterprises, such as the "PRC Law on Chinese-Foreign Equity Joint Ventures."

According to the "Provisional Regulations," a foreign investment company should be organized as a limited company. Only when the foreign assets are no less than 25%, can the enterprise benefit as a foreign investment enterprise. Otherwise it is considered a domestic enterprise. Also, according to the "Provisional Regulations", foreign investor's total assets should be no less than 400 million USD one year before he applies to establish an investment company. This is quite a steep requirement, however, one that most foreign venture capital institutions are unable to meet, even though their capability to raise capital may be strong. This requirement is currently the subject of debate as to whether it should be decreased.

The Provisional Regulations also set forth the registered capital remittance requirements for foreign investment companies. It allows the shareholders to pay in their capital in two years, commencing from the date the business license is issued. Foreign investors are to remit their capital in convertible currencies, and the Chinese investor can do so in RMB. Further, the investor is to issue a guaranty letter to the authorities, guaranteeing the fulfillment of the capital of the company that is invested by the investment company.

The clause 12 of the "Company Law of China" also stipulates that when a company invests into another limited company or company limited by shares, the accumulated investment capital amount shall never be more than 50% of its net assets, with the exception of investment companies or holding companies, as approved by the State Council. We are of the opinion that the aforesaid "investment company" should include the foreign investment company referred to under the Provisional Regulations, because it is not limited to only 50% of its assets as under the Company Law, and can even make investment through a loan.

The investments by foreign investment enterprises is also regulated under the "Catalogue for the Guidance of Foreign Investment Industries." This highlights the fact that making investment in China is not limited by the investment company's place of registration. It can invest in different areas if it so desires.

High tech venture capital investment enterprises do not always want to hold a majority share of venture enterprise because it can be limiting - investment capital usually will not be more than 20% of the venture enterprise's total equity. The tradeoff however, is that the venture enterprise cannot benefit as a foreign-invested enterprise. One way to achieve the best of both worlds is to joint venture with other investor, but this must be weighed carefully as there are risks and other factors that may outweigh the ability to keep one's holdings diversified while still qualifying for benefits as a foreign enterprise. After China enters the WTO, this dilemma may be resolved as national treatment of companies will be gradually implemented.

2. Foreign Venture Capital Fund

Since there are presently no laws governing the management of hi-tech venture capital funds, new ones are being formulated. The "Investment Fund Law", the "Regulations on Industry Investment Funds" and the "Regulations on Venture Capital Funds" will soon be issued. Once these guidelines are issued, it is expected that hi-tech venture capital funds will know how to operate within the parameters of Chinese law and thus develop much more in the future.

Many investment consulting companies and management companies have slowly begun conducting venture capital business, as either a de facto venture capital company or a venture capital fund. The introduction of these new laws will help these businesses better decide whether and how to more fully explore their options to make investments in other companies within the context of PRC law and regulation.

Another interesting option for venture capital funds in China is the fact that the government has recently declared ten favorable policies for development of China's western region. For these areas, venture capital funds are a promising source of investment because they are entitled to favorable tax benefits from the government. For venture capital funds themselves, they are also permitted incentives to make investments in companies that are participating in development of the west.