Exploring the alternatives to VIE structures

Initial public offerings (IPOs) remain a popular exit method for private equity investors. However, for a Chinese company seeking an IPO, due to the Provisions on the Mergers and Acquisitions of PRC Domestic Enterprises by Foreign Investors, the once common “round trip” investment structure used by Chinese founders as the pre-overseas-IPO restructuring mechanism of their companies was largely curtailed.

The variable interest entity (VIE) method, initially used in businesses involving internet portals and other media-related businesses in China, has been used by Chinese companies to overcome the negative impact of the above foreign M&A rules. Under a VIE structure, a domestic Chinese business is controlled, through various contractual arrangements, by a special purpose vehicle (SPV) or an offshore entity. The founding owner of the domestic Chinese business becomes the beneficial owner by forming an SPV and simultaneously entering into a sale and purchase agreement with a Chinese resident for the sale of the PRC business.

The Chinese resident then sells the interest in the PRC business to an independent third party who is a Chinese resident and thus will become the legal owner. At the same time, the founding owner enters into various contractual arrangements with the legal owner, which normally include a technical service or support agreement to pay all or nearly all of the profits of the PRC business in the form of service or support fees to the SPV. As security for such an arrangement a loan agreement, a share pledge and an option agreement will be executed.

Simon Luk is the chairman of Winston & Strawn’s Asia practice and a partner at the Hong Kong office. He can be contacted on +852 2292 2222 or by email at sluk@winston.com