What makes a sale of securities a “private” offering as opposed to a “public” offering? The primary distinction is that firms who make public offerings seeking equity investors must register with the Securities and Exchange Commission (SEC). On the other hand, private securities offerings are defined as those that do not need to formally register…
Tag: Venture Capital
Not Just Another Face in the Crowd: OurCrowd’s Equity Crowdfunding Success
Crowdfunding is “the practice of funding a project or venture by raising many small amounts of money from a large number of people, typically via the Internet.”1 One of the most recognizable names in crowdfunding is Kickstarter. Kickstarter allows any person to create an account and donate any amount of money to a project they…
Venture Capital in Emerging Markets
With Silicon Valley dominating the venture capital arena,[1] it is easy to overlook the significance of investments occurring in smaller markets. In 2011, roughly $3.4 billion of venture capital investments were made in emerging markets such as Brazil and India[2] with many more made in more established, yet still relatively small, markets such as China and Israel.[3] In fact, despite remaining the world-wide leader in venture capital, the United States is no longer as controlling a market economy as it once was.[4] The move into emerging markets is attributable in part to troubles in traditional markets.[5] As pre-money valuations continue to rise due to increased competition,[6] fund managers are finding it increasingly difficult to realize returns that keep investors close to home.[7] Consequently, venture capital firms looking for the “next big thing” are making significant investments in emerging markets.[8]
Brazil
While Brazil’s private equity market has seen significant progress in the past decade, venture capital seems to be lagging behind.[9] Due to illiquidity and a relative lack of exit opportunities, global funds are apprehensive about investing in Brazil.[10] Consequently, the venture capital market’s primary investors are local pension funds, the Brazilian National Development Bank, and other domestic institutional investors.[11] Moreover, the relatively long maturation period for most investments leads to a depressed internal rate of return, making investment in Brazil less attractive.[12] Nevertheless, a strong private equity market spells exit options for Brazilian companies and has helped attract at least some venture capital investors.[13]
China
In 2011, China surpassed its previous record in both dollar amount raised and number of investments entered into.[14] A variety of factors contributed to the country’s all-time highs, including government support for venture capital, a soaring GDP growth rate,[15] ample exit opportunities,[16] high price-earnings multiples, demand for shares in newly listed companies, and the overall strength of late-stage private companies looking for equity in preparation for an initial public offering.[17] The increasingly positive outlook of venture capital in China has not gone unnoticed, drawing the attention of global investment funds such as the Carlyle group and Sequoia Capital.[18] Despite this attention, domestic funds continue to spring-up and grow at very fast rates.[19] Like many other global venture capital markets, China exhibits a strong focus on cleantech, internet technology and e-commerce.[20]
India
Despite a historical focus on the internet and telecom sectors, India’s venture capital market over the coming decade is predicted to revolve around innovations in both technology and business models in areas such as e-commerce, mobile applications, health care, medical devices, clean-tech and IT.[21] However, the expected paradigm shift is not without its challenges. With roughly 400 funds in operation, valuations in India are growing fast and creating apprehension among potential investors.[22] Nevertheless, India’s rapid GDP growth, its proliferating middle class,[23] and its increased attention to early-stage investments is likely to continue drawing investors in the near future.[24]
Israel
Unlike China and India, the Israeli venture capital market is currently struggling.[25] The continued success of domestic firms will depend largely on their ability to raise follow-on funds in the coming years.[26] In 2011, 75% of capital invested came from United State funds, particularly for investments exceeding $50 million.[27] Exacerbating the situation is Israel’s relatively weak IPO market,[28] making acquisition the most practical exit option.[29] Notwithstanding the seemingly grim outlook painted by market analysts, at least one Israeli venture capitalist is optimistic about the near future of Israel’s venture capital market.[30] Daniel Cohen[31] predicts that the optimal Israeli fund over the next decade will most likely be “dedicated [to] health care, tech or cleantech” and will control between “US$100 million–US$200 million . . . with a strong local presence complemented by excellent global access.”[32]
As globalization flattens the investment playing field, venture capital is seeing a shift from traditional markets to emerging markets around the globe. With innovations in countries like China and India growing at astonishing rates, it may not be too long before Silicon Valley becomes an equal player in a truly global marketplace.
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[1] See Ernst & Young, Globalizing venture capital: Global venture capital insights and trends report 6 (2011) [hereinafter Globalizing venture capital] available at http://www.ey.com/Publication/vwLUAssets/Globalizing_venture_capital_-_Global_venture_capital_insights_and_trends_report_2011/$FILE/Globalizing_venture_capital_Global_venture_capital_insights_and_trends_report_2011.pdf; see also, WilmerHale, 2012 Venture Capital Report 6 (2012) available at http://www.wilmerhale.com/files/upload/2012_VC_Report.pdf.
[2] VC Clone Home: Making money by bringing old ideas to new markets, The Economist (June 2, 2012), http://www.economist.com/node/21556269 $3.4 .billion is over double the amount invested in 2008.
[3] Globalizing venture capital, supra note 1, at 6.
[4] Jennifer Kho, Following the Money: Venture Capital Flocks to Emerging Markets, Daily Finance (Mar. 28, 2011, 10:00AM), http://www.dailyfinance.com/2011/03/28/following-the-money-venture-capital-flocks-to-emerging-markets/
[5] VC Clone Home: Making money by bringing old ideas to new markets, supra note 2.
[6] There are currently over 350 venture capital firms trying to raise $50 billion dollars in North America. Id.
[7] Id. See also, Vijay Govindarajan, What Venture Capital Can Learn from Emerging Markets, Harvard Business Review (Feb. 17, 2011, 3:10PM), http://blogs.hbr.org/govindarajan/2011/02/what-venture-capital-can-learn.html
[8] Kho, supra note 4.
[9] See Globalizing venture capital, supra note 1, at 21 (interview with Clovis Meurer, Partner and Senior Executive at CRP Companhia de Participações). On the one hand, when asked to describe the history of venture capital in Brazil, Clovis Meurer paints a picture of a flourishing market starting in 2005, where “the Brazilian stock market was booming, with a lot of new IPOs and a very good exit environment.” However, when asked about the biggest obstacles in the path to a larger Brazilian venture capital market, Meurer notes that for global funds to “invest in Brazil they need to see more liquidity than there is currently” and that “exit opportunities, especially by way of the local stock exchange, are still maturing.” Id.
[10] Id. The stock exchange in Brazil is still developing leaving relatively little opportunity for domestic IPOs.
[11] Id.
[12] The average maturation period of venture capital investments in Brazil is between five and seven years. Id.
[13] Id.
[14] Id. at 22.
[15] China’s GDP growth rate surpassed that of the United States and Europe by over 400%. Id.
[16] Domestic IPOs comprise over 90% of venture capital backed exits in China. Id. at 24. Additionally, China has seen a rapid increase in the number of private acquisitions; up nearly 400% from 2008 to 2010. Id. Moreover, the median turnaround for a VC-backed company was just slightly over 4 years. Id.
[17] Id. at 22.
[18] Id. at 23.
[19] Id.
[20] Id. at 25.
[21] Id. at 26
[22] Id.
[23] India’s rapid growth in domestic consumption is leading venture capital firms to invest in “companies that are capitalizing on the proliferation of wealth.” Id. at 27.
[24] Id. at 26.
[25] Id. at 34.
[26] Id.
[27] Id.
[28] See id. at 35. A major contributing factor is low valuations for Israeli companies in foreign markets. Id.
[29] Id.
[30] Id. at 36
[31] General Partner of Gemini Israel Funds. Id.
[32] Id.
London Bank Scandals Open Doors for Financial Start-Ups
Throughout the United Kingdom, consumers’ trust in banks has deteriorated due to a series of recent scandals.[1] The tidal wave started in June, 2012, when Barclays Bank agreed to pay $450 million to settle claims that it manipulated interest rates to lift profits and mask concerns about its declining health.[2] Next, the United States Senate issued a report that HSBC bank failed to stop laundering Mexican drug money; HSBC faces up to $1 billion in fines.[3] Furthermore, JPMorgan & Chase Co. recently disclosed a $5.8 billion trading loss caused by its London office in a portfolio designed to circumvent risks that the bank takes with its own money.[4] As a result to these financial disasters, London bankers now worry that regulators will increase their efforts to clean up the image of the financial sector and quell public outrage.[5]
As a result of these scandals, newcomer financial firms seek to capitalize on United Kingdom banks’ misfortunes. Financial startups are using new technology and are innovating in ways that banks cannot in order to improve customer service, and venture capital firms are jumping at the chance to get a piece of the action.[6] For instance, Wonga, an online lending firm that offers high interest lending services to small businesses and consumers, has secured about $150 million in venture investment[7] from Balderton Capital, TAG, and Kreos Capital.[8] To cut own on costs, Wonga gathers publically available online data to determine a potential lendee’s creditworthiness.[9] Consumers are attracted to the fact that they can obtain loans within 15 minutes that they would not be able to receive from banks due to their risky credit.[10] Last year, Wonga reported revenues amounting to $73 million,[11] and is contemplating a $1.5 billion IPO on Nasdaq.[12]
Other venture capital success stories include GoCardless, a new financial firm based in London, which provides services to small businesses and consumers, allowing them to set up monthly payments directly to suppliers, at a cost dwarfing that of what banks charge.[13] The company is able to provide such favorable rates by cutting out the cost and complexity of credit card networks.[14] GoCardless has secured approximately $1.5 million from the venture capital firm Y Combinator.[15]
Finally, as banks have pulled back on lending, deeming small businesses to be too much of a financial risk, MarketInvoice helps small businesses obtain capital fast.[16] MarketInvoice is an online marketplace where small businesses are able to auction their long-term supply contracts to money managers for the highest price.[17] The company has received $1.4 million from venture capital investors.[18]
Growing disdain among small businesses and consumers for banks in light of recent scandals in conjunction with new innovative and technological services provided by financial start-ups has sparked a new industry in the United Kingdom. Venture capital firms will without a doubt continue to seize on the opportunity to invest in these financial start-ups.
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[1] Mark Scott, In London, Nimble Start-Ups Offer Alternatives to Stodgy Banks, N.Y. Times DealBook (Oct. 22, 2012, 4:45 PM), http://dealbook.nytimes.com/2012/10/22/in-london-nimble-start-ups-offer-alternatives-to-stodgy-banks/.
[2] Ben Protess & Mark Scott, Barclays Settles Regulators’ Claims Over Manipulation of Key Rates, N.Y. Times DealBook (June 27, 2012, 8:11 AM), http://dealbook.nytimes.com/2012/06/27/barclays-said-to-settle-regulatory-claims-over-benchmark-manipulation/.
[3] Robert Barr, Bank Scandals Tarnish London’s Reputation, The Miami Herald (Aug. 17, 2012), available at http://www.miamiherald.com/2012/08/07/v-fullstory/2938519/bank-scandals-tarnish-londons.html.
[4] Id.
[5] Id.
[6] See Scott, supra note 1.
[7] Bobbie Johnson, Wonga Readies $1.5bn IPO, but Stigma Won’t Go Away, Gigaom (June 6, 2012, 1:26 AM, http://gigaom.com/europe/wonga-ipo/.
[8] http://www.startups.co.uk/wonga.html.
[9] Scott, supra note 1.
[10] See id.
[11] Id.
[12] See Johnson, supra note 7.
[13] Scott, supra note 1.
[14] John Peabody, GoCardless Tries to Disrupt the Credit Card Industry, Reuters (May 15, 2012), http://blogs.reuters.com/small-business/2012/05/15/gocardless-tries-to-disrupt-the-credit-card-industry/.
[15] Scott, supra note 1.
[16] Id.
[17] Id.
[18] Id.
Corporate Venture Capital: Boom, Bust, or Here to Stay?
Corporate Venture Capital has traditionally had a cyclical journey of ups and downs since the mid-1960s. Although its history has had three distinct boom and bust cycles, corporate venture investing has always presented significant advantages to both corporations and start-up companies. Entrepreneurs have often benefited from corporate venture capitalists’ expertise of bringing products to global markets, as well as from their additional funding and customer base.[1] Corporations have also been eager to invest in external start-up companies not only to generate financial returns, but also to develop new products and supplement its own activities.[2]
On October 31, 2012, Boston Consulting Group (“BCG”) released a report that makes a case for corporate venture capital’s permanent tenure in the corporate landscape. BCG points to data gathered by the Global Corporate Venturing, which lists 756 corporations that have corporate venture capital units.[3] The analysis separated the corporations by industry, and focused on the thirty largest corporations in seventeen industries.[4]
The first major trend garnered from the analysis shows a steady growth of CVC within the traditional industries of technology, pharmaceutical, telecommunications, and media and publishing.[5] Within the industries of technology, pharmaceutical, and telecommunications, over half of the thirty largest companies in each industry maintain CVC units.[6] This reflects the increasing corporate acknowledgement of the need to invest into start-ups to supplement their corporate development, research, and competitive advantage. Concurrent with this increase in CVC penetration, the numbers demonstrate a decrease in internal R&D.[7] These trends may indicate that companies are “transferring a share of the innovation investment from R&D into their venture units.”[8]
The second major trend demonstrates that there is a sharp increase in CVC investing within industries that have not traditionally engaged in CVC activity, such as machinery, power and gas production, consumer, and construction.[9] As a response to increasing pressure for “cleaner technology, more sustainable operations, and an improved user experience,” these industries are looking to CVC investing as a way to supplement their own internal R&D and find avenues for innovation.[10]
The third major trend demonstrates that investments are broadening beyond core business sectors towards adjacent sectors that have the potential to disrupt existing industries.[11] For example, the chemical industry diversified from its typical focuses and instead invested in clean technology.[12] This may lead to the discovery of innovative processes to supplant petrochemical processes with biochemical ones.[13] Such discoveries are essential not only to sustainable operations, but also to meet consumer demand and future efficiency.
The last major trend demonstrates that corporate venturing is occurring at earlier stages with many transactions occurring in the seed and Series A funding rounds.[14] Although investing in start-ups is inherently risky, industries such as the pharmaceutical industry rely on innovation in order to maintain a competitive advantage. Also, with the increase in CVC activity, investors are becoming more experienced, and thus, more comfortable with funding risky start-ups.[15]
These trends support the argument that corporate venture capital has changed from what it once was to an attractive and potentially permanent fixture in venture capital. With CVC emerging as an attractive avenue for supplementing R&D and discovering new innovative products and processes, CVC may indeed be able to avoid its typical decline. Thus, the mutually beneficial relationship between entrepreneurs and corporations may become a long-standing one for years to come.
___________________________
[1] Deborah Gage, Corporations Refocus on Venture Investing, Wall Street Journal (March 21, 2012), http://online.wsj.com/article/SB10001424052702304636404577291982192150956.html.
[2] Kent Bernhard, Jr., Why Corporate Venture Capital is a Good Thing for Startups, Upstart Business Journal (November 1, 2012), http://upstart.bizjournals.com/money/loot/2012/11/01/corporate-vc-is-here-to-stay.html.
[3] Falk Bielesch, Michael Brigl, Dinesh Khanna, Alexander Roos, & Florian Schmieg, Corporate Venture Capital: Avoid the Risk, Miss the Rewards, BCG Perspectives by the Boston Consulting Group (Oct. 31, 2012), https://www.bcgperspectives.com/content/articles/innovation_growth_mergers_acquisitions_corporate_venture_capital/.
[4] Id.
[5] Id.
[6] Id.
[7] Id.
[8] Id.
[9] Id.
[10] Id.
[11] Id.
[12] Id.
[13] Id.
[14] Id.
[15] Id.
Decline in Venture Capital Investment in 2012
Many startups and young companies rely on venture capital investments to spur their growth and development, but such investment has decreased over the last fiscal year. With VC investment levels improving since the recession, but still well below what they were prior to it, 2012 reflects a declining trend in VC investment as compared to 2011. Some cite the presidential election as a contributing cause of this, suggesting investors were wary of potentially higher taxation rates on income and capital gains and that lower taxation rates on capital gains provide greater incentives to invest through venture capital firms.[1] Additionally, with the Bush tax cuts expiring in January 2013 if they are not renewed, investors may be more cautious given the uncertainty regarding potentially higher taxes that may be owed upon cashing out investments.[2] Only time will tell how President Obama’s reelection will influence investor behavior in the post-election period and through the next fiscal year.
According to a PricewaterhouseCoopers LLP and National Venture Capital Association (NVCA) report, investment for the first three quarters of 2012 totaled $20 billion in 2,661 deals, down from the results of the same period in 2011.[3] Further, in the third quarter of 2012, venture capital investment decreased in terms of both dollars and deals across all stages of development.[4] Additionally, venture capitalists invested a total of $6.5 billion in some 890 deals, representing an 11% VC investment dollar decline and a 5% deal decline from the second quarter of 2012.[5] First-time financing dollar investments also declined 8% to $1.0 billion in the third quarter, though the number of deals invested in increased 1% to a total of 297 deals.[6] Overall, it is predicted that the record of both dollar investment and deal volume will be appreciably lower at the end of 2012 than the previous year.[7]
Reflecting on this decline, NVCA President Mark Heesen commented, “Information technology investment continues to be very strong, particularly in the Internet arena while life sciences investment remains low, reflecting ongoing concerns regarding regulatory uncertainty, capital intensity and investment time horizons in the space. We also continue to see clean tech investment shifting concentration to smaller, more capital efficient deals. Opportunities continue to abound in each of these sectors, but lower venture fundraising levels will push investment dollars down as the industry recognizes it cannot put out more money than it takes in.”[8] As a result of the recession, the market has been less welcoming and favorable to companies’ initial public offerings, making it quite difficult for their investors to make a profit.[9] Further, poor responses to IPOs mean such investors are unable to recover as much of their investments to direct toward other startups, though this does not by any means leave all promising young companies without hope.
While not all are unable to secure funding and not all venture capital funds are shrinking, there is a very real trend of limited partner financiers favoring less risky investments and investing exclusively in select venture capital firms, rather than investing more broadly.[10] With a new year approaching, it will be interesting to see whether the completion of the election and the tax decisions that follow will reverse the declining investment trend of 2012.
____________________________
[1] Steven Overly, U.S. Companies Find Venture Capital Harder to Find, Wash. Post, Oct. 24, 2012, available at http://www.washingtonpost.com/business/capitalbusiness/us-companies-find-venture-capital-harder-to-find/2012/10/24/0f429b48-1d24-11e2-b647-bb1668e64058_story.html.
[2] Id.
[3] Caroline Traylor and Emily Mendell, Venture Capital Investments Decline in Dollars and Deal Volume in Q3 2012, PwC, Oct. 19, 2012, available at http://www.pwc.com/us/en/press-releases/2012/venture-capital-investments-q3-2012-press-release.jhtml.
[4] Id.
[5] Id.
[6] Id.
[7] Id.
[8] Id.
[9] Steven Overly, supra note 1.
[10] Id.
Convertible Equity
Innovative. In the world of private equity and venture capital this term is usually reserved to describe the entrepreneur. These days however, its not just the entrepreneurs developing new ideas. The Founder Institute and law firm Wilson Sonsini have created a new “startup-friendly seed-financing” tool – convertible equity. [1]
Traditionally, convertible debt has been the chosen vehicle to fund startup businesses.[2] The pervasive use of convertible debt has uncovered its shortcomings. First, some states’ laws create unique liabilities for the directors of startups if creditors, who hold convertible debt, are not paid upon its maturity.[3] Also, accounting principles dictate that convertible debt must be recorded on the books as a liability.[4] This may result in some startups being technically deemed insolvent.[5] Also, debt on the books is a road-block if the startup seeks a line of credit from a supplier or to close a deal with a large corporation.[6]
The risk that investors may demand repayment is also now a greater concern than it was in the past. When the conversion period occurs, which may be in as little as a year after issuance, an investor has the right to call the debt. This may result in the startup filing for bankruptcy or putting the startup in a weak position to renegotiate financing terms.[7] Adeo Ressi, creator of the Founder Institute, notes that while this “isn’t traditionally a problem in tight-knit Silicon Valley circles, first-time investors may be more prone to go against tradition and enforce their legal rights.”[8] Further aggravating the situation is the fact that “the percentage of companies with convertible debt that successfully raise Series A funding is shrinking, due to an explosion in new angel financings and just moderate growth in venture funding.”[9]
How does convertible equity solve these problems? It solves, because convertible equity is basically “convertible debt without the debt.”[10] Investors still get a discount for purchased shares that are realized upon conversion.[11] However, startups do not carry the corresponding debt on their books.[12] An example of the documents used to draft a convertible equity agreement can be found at TechCrunch.
The Startup Company Lawyer blog outlines the four following advantages of using convertible equity as opposed to using convertible debt:
1. Convertible debt may need to be repaid. The risk that an investor might demand repayment of a convertible note is eliminated with convertible equity.
2. Convertible debt holders must be paid interest. Convertible debt must have interest at the applicable federal rate (AFR) published by the IRS or higher, or the IRS will deem that the lender should have received imputed interest at AFR. If convertible debt with a price cap is supposed to mimic the economics of equity, then removing interest seems logical. (Of course, one may argue that some preferred stock financings contain a feature called cumulative dividends that is similar to interest on debt, but I find the provision to be fairly unusual in typical West Coast venture financings.) In addition, when a financing occurs and the convertible debt converts, creating the spreadsheet to track interest on the notes to the penny, especially when notes have been issued on different days, ends up being a painful task — especially as the closing date of a financing may be delayed and the amount of interest increases, resulting in more shares being issued to note holders.
3. Convertible equity is “equity” and probably can be characterized as qualified small business stock, which may have a tax benefit for investors.
4. Convertible debt with a maturity date longer than one year creates problems for California-based investors due to licensing requirements under the California Finance Lenders Law. Making it equity removes this issue. [13]
However, convertible equity is not without its critics. Some concerns raised by skeptics are that investors may be reluctant to give up their position as a creditor of the company.[14] Investors would also lose a return on their investment in the form of paid principle and interest.[15] Will the loss of these benefits undermine convertible equity’s chance of being the financing vehicle of the future? Or will it go away as quickly as it came? Creators are optimistic believing “all it takes is one major player to adopt it.”[16] Deals made in the upcoming year should determine whether or not they are right.
_________________________________
[1] Convertible Equity, a New Early-Stage Funding Concept, First Venture Legal (Oct. 2, 2012), http://www.firstventurelegal.com/convertible-equity-a-new-early-stage-funding-concept/.
[2] Id.
[3] What is Convertible Equity (or a Convertible Security)?, Startup Company Lawyer (Aug. 31, 2012) http://www.startupcompanylawyer.com/2012/08/31/what-is-convertible-equity-or-a-convertible-security/.
[4] Adeo Ressi Introduces ‘Convertible Equity’, Convertible Debt Without Debt, Forbes (Aug. 31, 2012) http://www.forbes.com/sites/jjcolao/2012/08/31/adeo-ressi-introduces-convertible-equity-convertible-debt-without-debt/ .
[5] Startup Company Lawyer, supra note 3.
[6] Forbes, supra note 4.
[7] Id.
[8] Id.
[9] Leena Rao, Convertible Equity, A Better Alternative To Convertible Debt?, Tech Crunch (Aug. 31, 2012) http://techcrunch.com/2012/08/31/thefunded-founder-institute-and-wilson-sonsini-debut-startup-friendly-seed-financing-vehicle-convertible-equity/ .
[10] Forbes, supra note 4.
[11] Id.
[12] Id.
[13] Startup Company Lawyer, supra note 3.
[14] First Venture Legal, supra note 1.
[15] Id.
[16] Startup Company Lawyer, supra note 3.
Private Equity Funds in China: Structures, Opportunities and Challenges
Private equity (PE) funds formed to make investments in the People’s Republic of China (PRC) come within three main types of structures. This post identifies and analyzes the characteristics, advantages and disadvantages of each structure, and highlights recent legal developments pertaining to how international investors can build or sponsor an onshore RMB funds.
Introduction
PRC’s economic growth has created a steady flow of investment opportunities. Especially after the global financial crisis, more and more global PE funds seek to deploy capital in this region. The financial crisis turns out to be a starting point for PRC to usher in a completely new phase for its opening-up and become one of the favorite investment destinations. To date, PE industry enjoyed a steady growth as can be seen in the chart below.
Chart 1 Annual Fundraising Amount by PE Funds focusing on Greater China between 2002 and 2011 Source: Preqin as of 2012
PE funds could be formed in PRC in one of the three structures:
1) offshore US Dollar-denominated funds;
2) onshore domestic-invested RMB-denominated funds;
3) onshore foreign-invested RMB-denominated funds.
Offshore US Dollar-denominated Funds
Offshore US Dollar-denominated funds are formed in non-PRC jurisdictions, most commonly in the Cayman Islands or British Virgin Islands.
Advantages:
· As offshore funds are typically organized as limited partnership, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the availability of pass-through tax treatment, i.e. it avoids dividend tax and double taxation because only owners or investors are taxed on the revenue.
· As offshore funds are organized under laws of Cayman Islands or British Virgin Islands, there are greater certainty and predictability pertaining to the legal enforceability of contracts and limited liability protection of limited partners than entities governed by PRC law.
Disadvantages:
Offshore funds are not governed by PRC law, but their investments made in PRC will be. As they are registered in non-PRC jurisdictions and funded by foreign investors, offshore funds are classified as foreign investors under PRC’s regulatory regime pertaining to foreign investment, and thus are subject to many special restrictions.
According to Foreign Investment Industrial Guidance Catalogue enacted by PRC’s State Council, many sectors and industries are closed to foreign investment. Even for accessible industries, every investment needs government approval. While not difficult to obtain, the great latitude of administrative authorities has generated huge space for rent-seeking. Moreover, the application process can be time-consuming since it involves extensive negotiations with various approval authorities. For example, a large factory may have serious land use or environmental issues. Thus, the exact time frame for approval is never certain. It depends on the type of project and the location. Foreign investors must be prepared for this uncertainty from the outset.
· Since offshore funds are denominated in USD yet invest in RMB, government approvals are also required for the conversion of USD into RMB and associated repatriation.
· As there are no PRC tax rules specifically ensuring pass-through tax treatment for offshore funds, investors must be very cautious to make sure that a “permanent establishment” is not created in PRC as the tax exposure of both general partners and limited partners could be adversely affected.
It should be noted that offshore funds used to be able to circumvent the restrictions stated above through “round-trip investment”: typically a PRC national established or controlled an offshore holding company to control a Chinese domestic company by captive contractual arrangement. The Chinese domestic company makes investment in China as a domestic investor while the international investors invest at the offshore level. However, the “round-trip investment” is no longer an easy shortcut as PRC had made significant policy changes in recent years to close related regulatory loopholes.
Since then, more and more PE funds prioritize setting up RMB funds. As can be seen in the graph below, most of the newly-raised funds are denominated in RMB.
Chart 2 PRC Private Equity Fundraising. USD Funds vs. RMB Funds, denominated in $US Billons Source: Preqin as of 2012
Onshore Domestic-Invested RMB-Denominated Funds
Onshore domestic-invested RMB-Denominated funds are registered in PRC, comprising exclusively of domestic source of capital. The vast increase in its popularity in recent years could be partially attributed to the corresponding growth of Chinese sources of capital available to onshore RMB funds, including, among others, 1) PRC’s National Social Security Foundation; 2) local government funds held by several provincial and municipal authorities, such as Beijing, Shanghai, Tianjin and Jiangsu; 3) an increasing number of wealthy Chinese entrepreneurs.
It is crucial to note that onshore domestic-invested RMB-Denominated funds are closed to foreign capital, but not to foreign investors. In other words, international investors could sponsor an onshore domestic-invested RMB-Denominated fund as its general partner. First, they should register a management entity in PRC to raise and manage the RMB fund as its general partner. Then, they would raise limited partner capital from domestic Chinese investors. Specific regulations pertaining to such type of transaction vary across provinces and municipalities, as there is not yet a unified set of rules governing investor solicitation and private offering on a national level.
Advantages:
· As onshore funds are typically organized as limited partnership under PRC’s Partnership Enterprise Law, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the exemption from double taxation.
· As onshore funds are classified as “domestic investors” under PRC law, government approval for investment and currency conversion could be avoided, so as the associated lag-time and rent-seeking, resulting in greater efficiency and lower cost.
· As domestic investors, onshore funds can invest in industries restricted to foreigners like television stations and publishing, thus have access to more deals in a broader share of PRC’s economy.
Disadvantages:
· Onshore domestic-invested RMB-Denominated funds are by its nature inaccessible to foreign sources of capital, and thus very difficult to scale their business. As of now, most of them are relatively small in size, with whole funding below US$100 Million.
· Compared to Cayman Island and BritishVirginIsland, there are less certainty and predictability in PRC’s legal matrix, especially pertaining to enforcing contracts in PRC courts. PRC has a lot of capital, but not a large group of seasoned investors. It could be tricky when dispute arise between foreign sponsors and domestic investors, who are unfamiliar with private equity, regarding terms such as capital calls and years-long commitment.
Onshore Foreign-Invested RMB-Denominated Funds
Onshore foreign-invested RMB-Denominated funds are registered in PRC, comprising at least partially of foreign source of capital. They could be organized either as foreign-invested venture capital enterprises (FIVCEs) or foreign-invested limited partnerships (FILPs).
With respect to regulatory framework, of particular importance are the passage of Waishang Touzi Chuanye Touzi Qiye Guanli Guiding (外商投资创业投资企业管理规定) [Administrative Rules on Foreign-Invested Venture Capital Enterprises] (the “FIVCE Rules”) on March 1, 2003, [1] and the Waishang Touzi Hehuo Qiye Dengji Guanli Guiding (外商投资合伙企业登记管理规定) [Administrative Measures on Establishment of Partnership Enterprises by Foreign Enterprises or Individuals in China] (the “FILP Measures”) on March 1, 2010. [2]
According to FIVCE Rules, the scope of investment of FIVCEs is limited to high-tech or new-tech industries. Additionally, FIVCEs are forbidden to make investment by borrowed funds. Thus FIVCE can be a very ineffective model for making PE investment in PRC.
FILPs, as a new investment avenue opened in 2010, offers another promising option for international investors to engage in PE investments in the foreseeable future. The Carlyle-Fosun RMB fund, registered in March 3, 2010, is the first reported FILP. With initial investment of US$100 million, the co-branded fund is a 50/50 joint venture between Carlyle and Fosun, both of which are general partners [3]. Afterwards, Blackstone formed the Shanghai Blackstone Equity Investment Partnership, while TPG launched the TPG Shanghai RMB Fund and the TPG Western China Growth Partners I. Goldman Sachs and Morgan Stanley also reportedly have RMB funds in the pipeline.
Advantages:
· As onshore RMB funds are typically organized as limited partnership under PRC’s Partnership Enterprise Law, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the exemption from double taxation.
· Capital contribution could be made in cash or in kind, subject to valuation and filing requirements.
· Previously, PE investments by foreign investments are subject to approval of Ministry of Commerce (MOFCOM), which could be very intrusive, paper-intensive and time-consuming. But according to FILP Measures, FILPs could be set up by registration with State Administration of Industry and Commerce only, thus bypassing the burdensome process of MOFCOM approval.
· It could use RMB to invest more easily in domestic companies in PRC, thus help take them public in PRC, on the Shanghai or Shenzhen stock markets. By contrast, offshore USD funds typically made investment into companies that were structured for a public listing outside PRC. Since IPO valuations are at least twice as high in PRC as they are in Hong Kong or USA, investment through RMB funds leading to a Chinese IPO can earn foreign investors a much higher return, likely over 300% higher, than otherwise.
Disadvantages:
· When organized as offshore funds governed by Cayman law, the general partner and the fund manager are typically exempted from taxation. But as the general partner and the fund manager of FILP are treated as PRC tax resident, the carried interest and management fee payments are taxed at the PRC corporate income tax rate at 25%.
· FILPs are still subject to the previously mentioned Foreign Investment Industry Guidance Catalogue, thus could not invest in industries restricted to foreigners like television stations and publishing.
· The local limited partners may not be as sophisticated as the international investors. Their lack of experience and unrealistic expectation of high yields may possibly damage the business cooperation.
Recent Regulatory Developments
In 2011, the four direct-controlled municipalities of PRC: Beijing [4], Shanghai[5] , Tianjin [6] and Chongqing [7], initiated significant pilot programs as to RMB funds organized as FILP. Under these programs, certain FILP could avoid more regulatory hurdles. For example, foreign capital contribution by foreign general partners and qualified limited partners may not be subject tot foreign currency conversion approval.
Indeed PRC is taking cautious steps to further open up its PE market. On November 23, 2011, PRC’s National Development and Reform Committee (NDRC) promulgated the first nationwide regulation of PE industry: Guojia Fazhan Gaigewei Bangongting Guanyu Cujin Guquan Touzi Qiye Guifan Fazhan De Tongzhi (国家发展改革委办公厅关于促进股权投资企业规范发展的通知) [The Notice on Promoting the Standardized Development of Equity Investment Enterprises]. [8] On one hand, it tightens regulation of PE funds by requiring that all the PE funds shall register with NDRC or its counterparts at provincial level. On the other hand, the notice further opens PRC’s PE market to international participation as it does not reverse or limit any of the pilot programs’ initiatives to circumvent the foreign current regulations. In other words, this state-level regulation’s “hands-off” approach implicitly encourages local authorities to offer new incentives to attract international capital, and implicitly encourages international investors to continue forum shopping among these competing programs.
Summary
To sum up, the PE industry in PRC is blessed, as nowhere else is, with abundant capital, stellar investment opportunities and favorable IPO markets. With respect to investment avenues, the advantages of onshore RMB funds are clear: they can make investment without foreign exchange controls, they face much less red tape and they can raise funds from PRC’s local sources. Carlyle, TPG and Blackstone, as the earliest market entrants in this regard, have each launched their own RMB funds in partnership with leading PRC private company, and point the way forward for many of its peers in US. As PRC authorities gradually opens up its PE market to foreign capital, an increasing number of PRC’s strong private enterprises will get growth capital from international PE investors with the know-how and pools of RMB to build great public companies.
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*Chenhao Zhu received a JSM (Master of Science of Law) from Stanford University in 2011, where he was the recipient of Franklin Family Fellowship and an editor of Stanford Journal of International Law. He is now an associate in the Palo Alto office of K&L Gates LLP, focusing on US-China business transactions, especially venture capital and private equity investments.
[1] Promulgated by the Ministry of Commerce (formerly, Ministry of Foreign Trade and Economic Cooperation), Ministry of Science and Technology, State Administration of Industry and Commerce, State Administration of Taxation and State Administration of Foreign Exchange on Jan. 30, 2003, effective on Mar. 1, 2003.
[2] Promulgated by the State Administration of Industry and Commerce on Jan. 29, 2010, effective on Mar. 1, 2010.
[3] See Shanghai Approves Carlyle and Fosun Joint RMB Fund; First Business License Granted to Foreign-Funded Equity Investment Partnership Enterprise. http://thecarlylegroup.com/news-room/news-release-archive/shanghai-approves-carlyle-and-fosun-joint-rmb-fund-first-business-license- (last visited Oct. 13, 2012)
[4] See Beijing Shi Guanyu Benshi Kaizhan Guquan Touzi Jijin Jiqi Guanli Qiye Zuohao Liyong Waizi Gongzuo Shidian De Zanxing Banfa (北京市关于本市开展股权投资基金及其管理企业做好利用外资工作试点的暂行办法) [Interim Measure on Pilot Program of Utilization of Foreign Capital By Equity Investment Fund and Its Management Entity of Beijing Municipality] (promulgated by Beijing Bureau of Finance, Beijing Commission of Commerce and Beijing Administration of Industry and Commerce on Feb. 28, 2011, effective on Feb. 28, 2011).
[5] See Shangha Shi Guanyu Benshi Kaizhan Waishang Touzi Guquan Touzi Qiye Shidian Glongzuo De Shishi Banfa (上海市关于本市开展外商投资股权投资企业试点工作的实施办法) [Implementation Measures for Foreign-Invested Equity Investment Enterprises Pilot Programs of Shanghai Municipality] (promulgated by Shanghai Financial Service Office, Shanghai Commission of Commerce and Shanghai Administration of Industry and Commerce on Dec. 24, 2010, effective on Jan. 23, 2011.
[6] See Tianjin Shi Guanyu Benshi Kaizhan Waishang Touzi Guquan Touzi Qiye Jiqi Guanli Jigou Shidian Gongzuo De Zanxing Banfa (天津市关于本市开展外商投资股权投资企业及其管理机构试点工作的暂行办法) [Interim Measure on Pilot Program of Foreign-Invested Equity Investment Enterprises and Its Management Entity of Tianjin Municipality] (jointly promulgated by Tianjin Development and Reform Committee, Tianjin Financial Service Office, Tianjin Commission of Commerce and Tianjin Administration of Industry and Commerce on Oct. 14, 2011, effectively on Dec. 13, 2011.
[7] See Chongqing Shi Guanyu Kaizhan Waishang Touzi Guquan Touzi Qiye Shidian Gongzuo De Yijian (重庆市关于开展外商投资股权投资企业试点工作的意见) [Implementation Measures for Foreign-Invested Equity Investment Enterprises Pilot Programs of Chongqing Municipality] (promulgated by Chongqing Administration of Industry and Commerce, Chongqing Foreign Economics and Trade Commission and Chongqing Office of Finance on Mar. 31, 2011, effectively on Mar. 31, 2011.
[8] Promulgated by the Office of Staff of National Development and Reform Commission on Nov. 23, 2011, effectively on Nov. 23, 2011.
Impact Investing
Impact investing has become the new hot topic in the social impact world. Similar to social entrepreneurship and social enterprise, impact investing attempts to amalgamate social good and more traditional models of finance arrangements. Rather than dividing the world into the classic for-profit/non-profit dichotomy, impact investing is another example of the trend that attempts to build a new path.
Impact funds span a range of investment philosophies. Lok Capital, for example, puts a high value on base of the pyramid companies that “have clear alignment with [investors] in terms of profitability and growth.” [1] Acumen Fund, one of the earliest impact investing funds, puts a higher value on portfolio companies’ social impact, viewing their financing as supporting growth in a market that takes longer to show impact and return.[2]
Closer to home, the University of Michigan Ross School of Business Social Venture Fund approaches investments based on a nuanced balance of social and financial returns, with the exact details largely dependent on the focus of the investment. [3] These three funds represent only a small fraction of the variety in this sector. Additionally, the space consists of numerous organizations that help seed organizations, but view themselves more as incubators than as any type of investment vehicle.
Traditional private equity and venture capital funds have a relatively clear principle mission – provide support for and help create more value in companies in which the fund invests. This takes the form of financial investment and control through different ownership tools. Impact investment, however, is based on the thesis that the social impact of a company is as important to foster as the financial returns. While this is a wonderful vision, the reality of balancing financial and social returns can get very messy.
Just as traditional investment vehicles put a high value on thorough due diligence, impact funds attempt to apply tried metrics to understand the impact and potential return of a social company – one that is likely to move more slowly in terms of financial returns, but with potentially life-changing impact for customers and clients.
Many of these funds focus on base of the pyramid customers due to the sheer number of these customers and the clear lack of service that has been provided to this market segment in the past. Rather than viewing individuals making less than two dollars a day as customers, many governments and companies see this group as a massive charity case – give them more and their lives will be better.
Impact investors, and a multitude of international conglomerates and new start-ups, see these billion-plus individuals as potential consumers who can contribute to the local and the international economy and through this process, can be pulled out of the most extreme poverty. This thesis, that poverty can be eliminated and social problems can be solved through the market, is not new but it remains somewhat radical. The challenge many impact funds encounter is how to balance the breadth and depth of impact with the opportunity cost of not applying a good business model to new customers, who may not be quite as needy as those who were originally the target market.
Impact investing is continuing to evolve and have a range of success. As companies, governments, and non-profits see alternative forms of activities, this space will grow and the potential value of the base of the pyramid market, and viewing opportunities in a combination of social and financial returns will become increasingly important.
[1] Lok Capital Investment Thesis, http://www.lokcapital.com/investment_approach.html (last visited Oct. 13, 2012).
[2] See David Bank, Acumen Fund’s Transparent Experiment, Impact (Oct. 13, 2012), http://impactiq.org/acumen-funds-transparent-experiment/.
[3] See Social Venture Fund, http://www.umsocialventure.com/philosophy (last visited Oct. 13, 2012); University of Michigan Social Venture Fund, YouTube (Oct. 13, 2012), http://www.youtube.com/watch?feature=player_embedded&v=1oNdU9mJ8L0 (describing the Social Venture Fund’s investment philosophy).
Growing Singapore’s Venture Capital Industry
What is the state of venture capital and entrepreneurship in Singapore? For six years in a row, the World Bank has named Singapore the friendliest country in which to conduct business.[1] Its business friendly laws, well educated population, and easy to absorb culture have combined to make Singapore one of Asia’s financial and commercial centers. [2] The amount of venture capital funding for small medium sized enterprises, however, lags behind that of other countries. Recently, Singapore has attempted to rectify the situation by encouraging technology startups and venture capital.
Is the problem the people, or a lack of financing? According to one survey, conducted by the Zoltan Acs of George Mason University and Erkko Autio of the Imperial College Business School, it is not necessarily the people; Singapore has a population with entrepreneurial spirit and aspirations, but lacks access to venture capital finance.[3] In 2011, there were less than twenty venture capital funds focused on investing in Singapore based businesses. [4]
Over the past year, the Singaporean government has attempted to bolster venture capital investment in Singapore. One way in which it is doing this is to increase the amount of funding available from the government itself. In 2011, the government had around $300 million of funding available to startups. Recently this year, Singapore’s National Research Foundation, a governmental department, announced that it would make approximately S$4 billion in additional funding available for startups.[5] It is, however, currently unclear exactly how, when and to whom the funds will be dispersed.
The Singapore government has also increased other resources available to startups. For example, the Singaporean government is providing startups with office facilities, training, and mentoring.[6] Additionally, the government has a tech incubator, and various incentive programs such as a three-year tax exemption and joint funding options. [7] Finally, the number of contracts between government research departments and entrepreneurs has tripled over the past year. [8]
There is one catch with these programs; in order to gain access to many of these government programs, a startup company must be at least partially owned by a Singaporean person or business entity.[9] Thus, foreigners looking to start companies in Singapore must either find a Singaporean cofounder, or give equity to Singaporean VCs or government funds. [10] Very new startups will also struggle to bring foreigners to Singapore, as the government’s visa program imposes minimum paid-in-capital and local hiring requirements. [11]
Investment activity is not entirely government driven, however. [12] Singapore is a large financial center and, in 2011, its private equity and venture capital sector has an estimated $26.5 billion in total assets under management. [13] Of that total, a 2011 PriceWaterhouseCoopers survey found that $500 million was invested in venture capital deals with startups inside Singapore. [14]
The private venture capital industry appears to be growing since that survey. The Singapore Venture Capital and Private Equity Association’s membership is increasing every year.[15] Recently, Facebook co-founder Eduardo Saverin gave up his American citizenship, and moved to Singapore to invest in startups. [16]
Singapore makes for an attractive destination for investors due to low corporate and personal tax rates, highly educated population, its business friendly government, and position as a regional hub for conducting business in other Southeast Asian countries. [17]
Despite these advantages, however, Singapore remains a small country of only five million people, limiting the growth opportunities for domestic companies, and making its domestic market unique in ways that may not translate easily to other places. [18] Overcoming the limitations of the domestic market for goods and services is one of the key challenges for startups seeking to attract capital; startups must be able to show how they will reach markets outside of Singapore.[19]
[1] Anthony Kuhn, Singapore’s Rising Tech Industry Draws Expat Innovators and Investors National Public Radio, (Sept. 17, 2012), http://www.capradio.org/news/npr/story?storyid=161267393.
[2] http://www.ivcpost.com/articles/5939/20120928/economist-reviews-asias-tech-start-up-environments.htm; http://news.asiaone.com/print/A1Business/General%2BNews/Story/A1Story20120928-374378.html
[3] Jo-Ann Huang, Venture Capital Industry Needs More Support, Channel News Asia (Mar. 23, 2011), http://www.channelnewsasia.com/stories/singaporebusinessnews/view/1118413/1/.html
[4] Id.
[5] Singapore Offers $4bn Funding to Startups , PRWeb (Sept. 10, 2012), http://www.prweb.com/releases/SingaporeStartup/4bnFunding/prweb9884734.htm
[6] Eileen Elliott, Economist Reviews Asia’s Tech Start-Up Environments, International Venture Capital and Private Equity News (Sept. 28, 2012), http://www.ivcpost.com/articles/5939/20120928/economist-reviews-asias-tech-start-up-environments.htm.
[7] Jacky Yap, A Taiwanese Opinion on Singapore for Foreign Startups, E27 (Oct. 3, 2012), http://e27.sg/2012/10/03/a-taiwanese-opinion-on-singapore-for-foreign-startups/
[8] Singapore Offers $4bn Funding to Startups , PRWeb (Sept. 10, 2012), http://www.prweb.com/releases/SingaporeStartup/4bnFunding/prweb9884734.htm
[9] Jacky Yap, A Taiwanese Opinion on Singapore for Foreign Startups, E27 (Oct. 3, 2012), http://e27.sg/2012/10/03/a-taiwanese-opinion-on-singapore-for-foreign-startups/
[10] Id.
[11] Id.
[12] Bernard Leong, A Map on Venture Capital in Singapore, SGE (Mar. 5, 2009), http://sgentrepreneurs.com/2009/03/05/a-map-on-venture-capital-in-singapore/
[13] Nisha Ramchandani, S’Pore a Magnet for PE and VC Firms, AsiaOne (Oct. 1, 2012), http://news.asiaone.com/print/A1Business/General%2BNews/Story/A1Story20120928-374378.html
[14] Id.
[15] Singapore Offers $4bn Funding to Startups , PRWeb (Sept. 10, 2012), http://www.prweb.com/releases/SingaporeStartup/4bnFunding/prweb9884734.htm
[16] Anthony Kuhn, Singapore’s Rising Tech Industry Draws Expat Innovators and Investors National Public Radio, (Sept. 17, 2012), http://www.capradio.org/news/npr/story?storyid=161267393.
[17] Id .
[18] Id., Jo-Ann Huang, Venture Capital Industry Needs More Support, Channel News Asia (Mar. 23, 2011), http://www.channelnewsasia.com/stories/singaporebusinessnews/view/1118413/1/.html
[19] Id.