Startup Legal Talks (17)
After talking about the comparison between Zoom and VIE structures in the last episode, many viewers asked me about the concept of red chip. So today, let me explain to you through a few questions about the red chip structure that has been popular for more than 20 years.
Ⅰ. Red Chip Structure
The first question is: What is the red chip structure?
1. The Origin of the Name of Red Chip: The concept of red chip was originally developed because of the listing of domestic enterprises on Hong Kong Exchange, as China is internationally known as Red China, so domestic enterprises listed on Hong Kong Exchange are called "red chips".
2. Red chips and H-shares: What is the difference between red chips and H-shares? Red chips are shares of companies that are registered outside of mainland China, including those registered directly in Hong Kong or in offshore such as Cayman or Virgin, whereas H shares are usually shares of companies that are registered in mainland China and approved by the China Securities Regulatory Commission to be listed on Hong Kong. So a red-chip company is usually a private company and an H-share company is usually a state-owned company.
3. Red Chips and Blue Chips: Whenever we talk about red chips, we have to talk about blue chips. First of all, it should be clear that red chips and blue chips are not directly relative concepts. Red chips are named according to their place of origin, while blue chips are classified according to their performance. Blue chips are the most valuable of all casino chips, so stocks with a good track record are called "blue chips", another name for blue chips is "high performing stocks".
Note that throughout this discussion, the term "domestic capital" is defined in terms of the actual place of business. To be called a red chip or H-share, the majority of shareholders must be from mainland China, and the majority of operating profits must come from mainland China. This means that it is more important to determine the nature of a company by its actual place of business rather than its place of incorporation.
Later on, the concept of red chip was gradually expanded to include domestic companies listed on Hong Kong, Singapore and the United States, but they all had one thing in common: the place of incorporation of the listed entity was outside mainland China. In addition, Westerners have given red chips another name: "China Concept Stocks", or "Chinese stocks" for short, which ties in with the concept of Chinese stocks we talked about in the previous two issues.
Ⅱ. "Big Red Chip" and "Small Red Chip"
The red chip structure is also divided into "big red chips" and "small red chips". We have just said that red-chip companies should be registered outside of mainland China, right? Then we must first understand a concept that "foreign" and "offshore" have different meanings. Hong Kong is in a very delicate position, belongs to the "domestic" but "outside China", so the permutations are formed in several ways:
H shares are shares of companies which are registered in mainland China and listed on Hong Kong Exchange. Big red-chip stocks are stocks of companies which are registered in Hong Kong by domestic enterprises and listed on Hong Kong Exchange.Small red-chip stocks are stocks of companies which are offshore company registered by domestic enterprises and listed on Hong Kong Exchange. So we can see that H-share companies are the most strictly regulated, followed by big red-chip company and small red-chip companies are the loosest, resulting in H shares are basically shares of state-owned enterprises, large red-chip stocks are usually stocks of state-owned enterprises, and small red-chip stocks are usually stocks of private enterprises.
The red chips we are going to analyse are mainly the "small red chips". Small red chips, in fact, are what we most often hear of as VIE structures.
Of course, all these concepts, although originating from the Hong Kong Stock Exchange, have since been extended to all other foreign stock exchanges such as Singapore and the United States.
Ⅲ.The Classic Model in Red-Chip Structure - VIE Structure
This topic has been repeatedly introduced in many previous episodes, and here I will take the structure of Bilibili as an example.
1. First Tier: the founding teams each set up shareholding companies in the British Virgin Islands and the purpose here is to increase confidentiality. The shareholding companies can be set up in either Cayman or Viking, but it is cheaper in Viking .
2. Second Tier: all Viking shareholding company jointly establish a Cayman company as a shareholder, which in theory can also be in Viking, but you cannot save money on this tier as the Viking company is too modest to be recognised by the major stock exchanges, so this tier is usually set up in Cayman.
3. Third Tier: the Hong Kong company, Phantom Power Limited, is in the middle of the Cayman company and the domestic Phantom Power Technology Shanghai Limited. Some of you may ask, "What is the purpose of this Hong Kong company? Simply put, this company is essentially a "vehicle". The profits earned in the country are usually subject to a 10% withholding tax when they are distributed to companies outside of Hong Kong. In addition, due to the tax incentive agreement between the Mainland and Hong Kong, Phantom Power Technology Shanghai Limited has been able to achieve a tax benefit by paying a reduced tax rate of 5% on dividends to Hong Kong Phantom Power Limited.
4. Fourth Tier: the Wholly Owned Foreign Enterprise (WFOE) is set up on the mainland by the overseas company. The actual operating company on a par with the WOFE, which in the case of Bilibili are Shanghai Kuanyu Digital Technology Co., Ltd. and Shanghai Huandian Technology Co., Ltd.These two companies have no "blood ties" to the previous string of equity structures, and are entirely "adopted children", but are the main source of revenue for the entire Bilibili VIE structure. Through an agreement to control, all profits from the two domestic operating companies are eventually transferred to the Cayman company. Understandably, it is this "adopted son" that supports the entire family, from the grandfather (Cayman) and the father (Hong Kong) to the son (WFOE).
At this point, I believe that you have an understanding of the typical red chip structure. The red chip structure is not complicated, it is layered with every step of the process, and each step has its own necessity and reason for existence.
Ⅳ. the Equity Control Model in the Red Chip Structure
In addition to the classic VIE model above, there is another popular small red chip that is the equity control model. As the name suggests, it is the model which the WFOE in the last tier and the operating entity company is no longer a brotherly relationship between son and adopted son, but has become a biological father-son relationship.
This is done because control by agreement is still relatively loose after all, and there is still the possibility that the adopted son may one day tear up the treaty and leave the family. If it became a direct blood relationship, then it would be much more stable. But then came the restriction of the "Provisions on Merger and Acquisition of Domestic Enterprises by Foreign Investors" , and in order to circumvent this restriction, methods such as the "change of nationality law" and the "two-step method" were created. We will not dwell on them here today.
V. The "Old and New" Model in the Red Chip Structure
In addition to the agreement and equity control, there is also a way to gradually transfer the business, assets and management team of the domestic entity to the offshore structure, and finally shut down the old business entity.
This will give the offshore entity more stability in its operations, and will also circumvent the requirements of "Provisions on Merger and Acquisition of Domestic Enterprises by Foreign Investors".
If you are planning to set up a red chip structure for an offshore listing, however, as analysed in the last issue, the VIE structure is no longer applicable under the existing legal system. In addition to the drawbacks mentioned before, there is also a huge pitfall in the VIE structure, which is the inescapable Circular 37. In the next issue, I will also explain this mysterious document that founders must study - Circular 37.
