Employee shareholding in unlisted companies

With the heating up of the New Third Board, more unlisted companies have been strengthening cohesiveness and competitiveness through the equity incentive of employee shareholding – mainly in the form of direct shareholding by employees, indirect shareholding through a company, or indirect shareholding through a partnership. Tax costs and capital operation concerns have led nearly 60% of companies to opt for a limited partnership shareholding platform.

Q: What are the advantages of having a limited partnership serving as the shareholding platform? A: A limited partnership platform is more flexible. The incentive recipients are able to realize the equity incentive by becoming limited partners, realize share buyback and cancellation by transferring their units to the general partner, and realize a reduction in their shareholdings by applying to the partnership to sell the shares corresponding to their units. As the general partner handles partnership matters, undertakes the management functions and serves as the representative of the limited partnership in dealings with third parties, the candidate for such a role is usually the controlling shareholder of the company listed on the New Third Board and the employees benefiting from the incentive serving as limited partners. The partnership agreement can specify when a limited partner can be compelled to withdraw from the partnership and bestow upon the matter handling partner the right to remove an incentive recipient who fails to comply with the partnership withdrawal provisions, thereby realizing the forced withdrawal of the incentive recipient.

Q: When should a company establish the shareholding platform, and how can it control the timing? A: According to the Answers to Questions on the Oversight of Unlisted Public Companies: Private Placements (2), companies with legal personality, partnerships and other such shareholding platforms that are established for the purpose of ensuring the clarity of equity, guarding against financing risks and solely for subscribing for shares, and that do not actually operate any business, do not satisfy administrative requirements for investor suitability and may not participate in the share offerings of unlisted public companies. Where an employee shareholding plan established by a company listed on National Equities Exchange and Quotations subscribes for a private equity fund, asset management plan or other such financial product subject to the oversight of the China Securities Regulatory Commission (CSRC), and has completed approval and recordal procedures and fully disclosed information, it may participate in private placements of unlisted public companies.

Private Placements (2) addresses shareholding platforms that do not actually operate any business. If an existing company or partnership that actually operates business is selected as an employee shareholding platform, it is likewise required to comply with regulations, but in terms of business it is additionally required to comply with listing regulations or undertakings such as those on horizontal competition, non-competition, etc. Private Placements (2) applies solely to additional private placements of companies listed on the New Third Board, and accordingly it is recommended that the employee shareholding plan be completed in respect of the due establishment of the partnership that is to serve as the shareholding platform before the listing.

Q: What are the sources of the subject equity? A: The first is transfer of existing equity by the existing shareholders. If the incentive for company employees takes the form of actual shares, in general the shares are transferred to the incentive recipients by the major shareholder. Depending on the consideration paid, the same can be divided into a share grant or share transfer, with the existing shareholder transferring part of the company shares to the equity incentive recipients, either without consideration or for consideration. The price at which the shares are transferred is usually determined by the net book value of the enterprise’s assets. The second takes the form of a capital increase. The company grants the equity incentive recipients the right to take part in the company’s capital increase at a relatively preferential price.

Q: How is the price determined for the incentive recipients to acquire the equity? How is a share-based payment determined? A: According to the Answers to Common Questions on the Offering of Shares by Companies Listed on NEEQ: Share-based Payments, when circumstances such as “the price at which shares are offered to a company’s senior officers, core employees, employee shareholding platform or other investors is clearly lower than the market price or the fair value of the company’s shares … the share offer price is less than the net asset value per share … shares are offered to provide an equity incentive,” etc. apply to a listed company, a determination as to whether a share-based payment applies needs to be made based on the Enterprise Accounting Standards, No. 13: Share-based Payments and in light of the target of the share offering, the objective of the offering, the fair value of the shares and the offer price. Reference may be made to the following circumstances for the fair value of the shares: if there is an active trading market, the market price should serve as the basis, with consideration given to volatility; or if there is no active trading market, valuation techniques may be used or reference made to the relatively fair share offer price in the course of bringing in outside institutional investors during the same period. One point worth noting is that, in practice, if, before the listing of the company, there was a discrepancy in the price at which management or other employees and institutional investors acquired an equity interest on the same occasion, the share-based payment standards will generally apply; if they do not acquire the equity interests on the same occasion, the authors would recommend an interval of at least six months.

Q: How is the divestment mechanism to be determined? A: As the liquidity of the equity of companies listed on the New Third Board is weak, a divestment mechanism for the incentive recipients should be established to ensure that the anticipated incentive effect is achieved. In principle, the equity of incentive recipients cannot be transferred to outside third parties; instead, when divesting, the company or major shareholder will buy back the equity or transfer it to another incentive recipient. After the implementation of an equity incentive plan, an incentive recipient may request divestment or be required to divest for a variety of reasons, e.g. his or her performance failing to meet targets. The company should dispose of the incentive equity held by the incentive recipient based on the predetermined pricing mechanism.

Zheng Xilin is a partner and Wu Di is an associate with AnJie Law Firm