China Law Insight : China Law Insight: China Commercial and Intellectual Property Lawyers and Attorneys, Full Service Law Firm: King & Wood

These included the establishment of the following:

• Hong Kong Science & Technology Parks
• Hong Kong Applied Science and Technology Research Institute
• Various funding schemes managed by the Innovation and Technology Commission

The main location of the Hong Kong Science Parks located at Pak Shek Kok - now comprising around a dozen state-of-the-art multi-story buildings under its first two phases of construction - stands as a visible testimony to Hong Kong's attempt to put itself on the yellow brick road of innovation and technology. In addition to established tech companies and R&D facilities, its current occupants include some 100 startup companies under its incubation program. Since the program's inception, more than 200 incubatees have graduated.

The Hong Kong Applied Science and Technology Research Institute (“ASTRI”), modeled after the successful Industrial Technology Research Institute (“ITRI”) of Taiwan, was established in 2000 and is engaged in mid-stream R&D in IC designs, communications technologies, enterprise & consumer electronics, and material & packaging technologies. At the end of 2008, ASTRI employed more than 340 researchers.

The Innovation and Technology Commission is an executive government body under the Communications and Technology Branch of the Commerce and Economic Development Bureau. It manages various government innovation and technology funds focused on helping local businesses in the relevant sectors. Among various funding schemes pertinent to startup financing, is the Small Entrepreneur Research Assistance Program (“SERAP”), which provides pre-VC stage financing to startups.

In addition to the above initiatives, the government has had a long-standing policy to invest substantially in higher education. Despite its relatively small size, Hong Kong has eight universities, some of which have won academic acclaim worldwide and are highly ranked in selected fields. Universities in Hong Kong have regularly achieved breakthroughs and successes in their research efforts. Many made significant efforts to commercialize their research results.

In April 2009, based on the recommendation of a government appointed economic advisory committee, Chief Executive Donald Tsang announced that Hong Kong should focus on and encourage businesses in six major industrial areas where Hong Kong is believed to have competitive advantages. These areas include innovation and technology, the cultural and creative industry and the environmental industry.

Some critics charge that much more could have been done by the government to help innovation and technology based entrepreneurial pursuits. None would dispute that the policies now in place, however, are vast improvements compared with the virtual absence of government support under the so-called “Positive Non-interventionist” policies of the pre-1997 British administrations.
 

Venture Capital
A strong venture capital presence to provide follow-on financing for post-angel companies is important to the development and growth of angel financing. In this light, Hong Kong is blessed as a key VC hub in Asia, with 294 venture capital firms operating in the territory as of first half of 2008. It has a strong lead in raising funds, raising US$16 billion in 2007 and about US$8 billion in the first half of 2008.

Before the 1990s, Hong Kong did not have much of a venture capital industry. Financing of new businesses relied largely on one's own savings or pooling of resources from the immediate family members or close friends. In the late 1980s, the first venture capital companies began to emerge in Hong Kong. This marked the first time when newly established companies without self-funding resources were able to seek equity financing from unrelated third parties.

The Internet boom in the late 1990s and the China factor attracted even more foreign venture capital firms to Hong Kong and also spurred the growth of some home-grown VC funds. Today, Hong Kong probably remains the largest VC hub in Asia, having weathered ebbs and flows, including the blow from the dotcom bust and an increasing trend for those VCs focusing on mainland China to locate their operational bases to Beijing or Shanghai.

In terms of size and depth, Hong Kong's venture capital industry pales compared to Silicon Valley. The industry also has perhaps paid too much attention to later stage companies to the neglect of early stage companies. With more quality angel financed companies coming on scene in Hong Kong, a shift of emphasis hopefully will gradually occur to catch up to the needs of early stage companies.

Capital Markets
For years, Hong Kong has been a significant world-class investment banking center servicing IPOs of local and PRC companies both on its own stock exchange and overseas bourses including the NASDAQ. Since the mid-1990s, we have witnessed a spate of listings on the NASDAQ or the Hong Kong Stock Exchange of PRC focused Internet or technology companies, many of which were managed primarily out of Hong Kong.

The first wave from mid- to late-1990s included the listing of Sina.com, Sohu, and Netease on the NASDAQ, followed in more recent years by Baidu, C-Trip, Tencent (operator of QQ) and Alibaba, etc. on the NASDAQ or in Hong Kong. These listings provided the ultimate exit for their founders and investors and a road map and prized goal for countless other striving startups and entrepreneurs.

Angel Profiles

A recent article on Hong Kong’s VC industry has an interesting analysis of angel investors in Hong Kong. It put them into five categories :

• Sophisticated – the “true” and knowledgeable angel investment practitioners;
• Businessmen – knowledgeable but less intense investors in start-ups doing deals as an alternative investment form;
• Corporate – manufacturers seeking tech startups to extend their product lines or services;
• Incidental – highly wealthy individuals investing to prove themselves or kill time; and
• Traditional entrepreneurs – traditionally minded bosses who will invest only if they are in control, not the founders who came up with the original ideas.

Outside certain portions of the above circles, the concept of angel financing is only beginning to be understood or practiced widely.

Angel Networks

Angels acting in concert or in organized groups is a more effective way to invest. Accordingly, organized angel networks have begun to emerge in recent years. We cite a few better known examples below.

• British Chamber of Commerce Business Angel Programme (http://www.britcham.com/baker-tilly-business-angel-programme) was initiated by the British Chamber’s IT and SME committees and sponsored by a local audit and business service advisory firm. This program has been running two or three meetings a year, where a number of shortlisted investee companies are given the opportunity to make presentations.
• China Business Angel Network (CBAN) (http://chinabusinessangelnetwork.angelgroups.net/) Hong Kong Chapter is the local chapter of CBAN, an established network of more than 140 angels with chapters in Shenzhen, Shanghai and Beijing. CBAN members enjoy reciprocal membership with Business Angel Network South East Asia (BANSEA) in Singapore.
• Hong Kong Angel Capital Network (www.facebook.com/group.php?gid=4505959039) is created as a joint venture among its members and Dr. Samson Tam, founder of Group Sense Limited and currently a legislator in Hong Kong. Member admission is by invitation or referral only, requiring declaration of not less than HK$20,000,000 of investable fund and investment in at least one project of the Network in a 12-month period.
• Tolo Habour Business Angel Support Group (www.baf.cuhk.edu.hk/research/gem/_new/EN/education/thbasg/index_thbasg.html) is an initiative of the Chinese University of Hong Kong Centre for Entrepreneurship to match companies with good potential with prospective angel investors through the University’s alumni network.

Angel clubs, Angel funds or investment groups

Going beyond networks, angels might band together to invest collectively as angel clubs, angel funds or investment groups. So far, such efforts in Hong Kong seem far and few in between. A few of the budding ones may include:

• Black Horse (www.darkhorseinvest.com), a small angel investment group that typically invests US$50,000 to US$1,000,000 in each company and looks to co-invests with other venture funds in Asian companies with capital requirement of US$1,000,000 to US$5,000,000 and a valuation of US$2,000,000 to US$10,000,000. Its industry focus is IT, telecom, education and environmental protection.
• Catalyst Group (www.catalistgroup.com)
• Hong Kong Angel Investment Network (www.investmentnetwork.hk) is a London-based investment company. It provides a web-based matching service for angel investors seeking investment opportunities and entrepreneurs seeking capital. Entrepreneurs are charged upfront referral fees for the service

Amounts and Structure of Financing

Based on general observations, the deal size of angel investment in Hong Kong seem to largely fall under the norms elsewhere. Individual investors generally takes one or more units of roughly US$50,000 each, resulting in rounds of financing aggregating roughly between US$0.5 million to US$1.0 million per round.

The funding vehicle and the corporate structure in Hong Kong are often more complex and less uniform than those elsewhere, such as Silicon Valley. This is a reflection of the need to adapt to the varying requirements to operate multi-jurisdictionally. For instance, companies of Hong Kong based founders that operate in the mainland will need to set up a corporate structure not only in Hong Kong but also on the mainland. Typically, ordinary shares are used for the initial rounds. However, following the financing practice of the US, some investments are taking on more sophisticated structures, including the use of preferred shares and convertible notes.
 

Startups tend to concentrate in business areas offering the greatest potential for business growth, from those relating to TMT (technologies, media and telecom) on the one hand to those targeting the huge China market, in particular the consumer market, on the other or areas where the two overlaps. Specific industry areas of the startups are extremely wide ranging, from retail business to language instruction, cartoon production, fast food, semiconductor, E-commerce, outdoor media, health supplements, and on and on.

Accordingly, business angels in Hong Kong have an abundance of choices in investment targets.

Developmental History

The quintessential angel financing model probably did not emerge in Hong Kong until the 1990s. Before that time, entrepreneurs seeking early-stage funding were largely left to chance or the luck of knowing the “right” people or groups to approach. Knowledge of angel investing practices was largely lacking. Occasionally, founders of a startup might obtain loan or equity money from an unrelated party or a distant relative. However, the lack of a standardized or well-conceived practice for structuring the loan or investment often resulted in poorly fitted documentation leaving room for later disputes or unfairly skewed arrangements leaving sour taste among the parties.

As the Silicon Valley tech success rippled across the Pacific in the 1980s, its effects, including the tech based startup and angel financing approaches to building new businesses, began to be felt in Hong Kong. I recall handling a case as a lawyer in Hong Kong in the mid-90s where an Internet startup in Hong Kong received angel funding in the range of several million US dollars. The financing was syndicated by a well known investment banker to seven or eight local individuals where each invested in several investment units of US$100,000 per unit. The documentation for the investment followed the preferred share model prevalent in California. In most respects, that transaction was not much different from similar deals structured in the US at the time.

Since the 1990s, the concept of angel investment has gradually taken root and started to proliferate in the business circles, especially among the startup and tech sectors, expatriates and returnees, VC and capital markets practitioners, and a younger generation of business executives and professionals.
 

A. Ease of Approving Holding Companies

On March 6th 2009, MOFCOM issued the Notice on Delegating the Approval Authority for Foreign Invested Holding Companies to streamline the establishment of foreign investment holding companies.

 This notice provides:

 1. Proposed holding companies with a registered capital of USD 100,000,000 or less will be examined and approved by the competent MOFCOM counterparts at the provincial or vice-provincial city level. Previously, the establishment of a holding company required MOFCOM level approval regardless of scale.

 2. Any amendments to established holding companies (i.e. such as name change, revisions to business scope) can be approved by MOFCOM provincial level counterparts except for cases where a single capital injection increases its value by over USD 100,000,000 or where shareholders of holding companies change.

 3. Despite the positive developments, MOFCOM also reinforces in the Notice that holding companies cannot invest in areas that are restricted or forbidden to foreign investment, or in industries that are subject to macro-control by the government. Further, if required by relevant industry rules, investments by holding companies will still need approval from the industry authorities even if approved at the local MOFCOM level.

B. Delegation of Approval Authority for FIVCEs and FIVCE Management Firms

MOFCOM further issued, on March 5 the Notice on Approving Foreign Invested Venture Capital Enterprises and Foreign Invested Venture Capital Management Enterprises (the “No. 9 Notice”) which simplifies the approval process for FIVCEs and FIVCE Management Firms.

The legal basis for setting up FIVCEs and FIVCE Management Firms are the Management Rules on Foreign Invested Venture Capital Emperies (the “FIVCE Rules”) promulgated by MOFCOM, the Ministry of Science and Technology, the State Administration for Commerce and Industry, the State Tax Administration, and the State Administration on Foreign Exchange on January 30, 2003. According to the FIVCE Rules, foreign investors are permitted to set up a FIVCE to invest in unlisted high-tech enterprises, provide management services to such enterprises and are also able to enjoy capital gains from such investments.

Pursuant to the FIVCE Rules, the establishment of a FIVCE adopts a multi tier approval process regardless of scale. A FIVCE requires preliminary examination at the MOFCOM provincial level with final approval from the central MOFCOM with the consent of the Ministry of Science and Technology. On the other hand the establishment of a FIVCE Management Firm only requires MOFCOM provincial level counterpart approval.

The No. 9 Notice simplifies the approval process in the following regards:

1. Proposed FIVCEs and FIVCE Management Firms with registered capital of no more than 100 million USD can be approved by MOFCOM counterparts at the provincial level (1), vice-provincial city level, or national economic development zone level. It is important to note that FIVCE Management Firms which were previously approved at the provincial level should now obtain approval from central MOFCOM in cases where its registered capital exceeds USD 100,000,000. Accordingly, the new policy is that establishment of a FIVCE can be approved locally except if the registered capital exceeds USD 100,000,000.

2. The provincial MOFCOM counterpart is required to complete the approval process and decide upon approval within 30 days after receiving the complete application documents. It is noteworthy that under FIVCE Rules, due to the two tier approval level regime, the mandatory approval timeframe is 60 days (15 days for preliminary review at the provincial level and 45 days for final approval by MOFCOM). Furthermore, following the delegation of approval authority in respect of FIVCEs, the No. 9 Notice requires that when establishing a FIVCE, the provincial approval authority shall request the opinion from the science and technology administration of the same level (i.e. the Ministry of Science and Technology provincial counterpart).

3. The basic rule has always been for amendments to the corporate structure for a FIVCE or FIVCE Management Firm to be approved by the original approval authority. The No.9 Notice changes this by allowing FIVCE or FIVCE Management Firms originally approved by MOFCOM to have subsequent commercial changes approved by MOFCOM's provincial counterparts except for capital increases where the increase exceeds USD 100,000,000 or the change of “requisite investors (2)” in the FIVCE.

It should be borne in mind that although the No. 9 Notice simplifies the approval process and shortens the approval timeframe considerably the substantial requirements provided in the FIVCE Rules will still need to be strictly followed in many cases. These requirements include the restrictions on the business scope of a FIVCE, notably a FIVCE being prohibited from (i) obtaining loans to finance venture capital investments, (ii) investing in areas prohibited to foreign investment, (iii) directly or indirectly investing in the real estate market, (iv) directly or indirectly investing in publicly traded stocks or bonds, except for shares of the invested enterprises held by the FIVCE which are publicly traded after listing.)

Summary

The devolution of approval competency for holding companies, FIVCEs and FIVCE Management Firms will simplify and speed up the approval process for foreign investors as well as lower the work burden on MOFCOM. In addition, the new policy will simplify the operations of existing holding companies, FIVCEs and FIVCE Management Firms in that many will be able to bypass central MOFCOM approval for operational actions such as capital increases less than USD 100,000,000.
Although, there is no apparent negative impact upon foreign investors in these notices, it should be also noted that MOFCOM and other approvals still remain in place under specific circumstances. Foreign investors will need to carefully check which approvals at which level will be required in order to have a valid establishment and which restrictions remain in place.
 

(1) Vice-provincial cities, as an administrative division in China, are not treated as a province from an administrative perspective, but are distinct from a financial perspective.

(2) According to the FIVCE Rules, one shareholder of the proposed FIVCE must be a requisite investor i.e. a investor that meets the following requirements or thresholds: (i) the business of the requisite investor is venture investment; (ii) the capital under its management is not less than USD 100 million in the last three years prior to the application and at least USD 50 million of which has been used for venture investment; (iii) the investor shall have at least three professional management personnel with not less than three years experience in venture investment business; (iv) the requisite investors shall not have been prohibited by the judicial authorities or other relevant regulatory authorities from engaging in venture investment or investment and consultancy business or punished due to any fraud; (v) the amount of capital contribution subscribed to and paid in by the requisite investors shall not be less than 30% of the total subscribed capital and 30% of the total paid in capital of the FIVCE respectively.