Tips for the Chinese Entrepreneur Accessing U.S. Small and Micro Cap Capital Markets
This article is meant to address the commitments a Chinese entrepreneur interested in accessing the US capital markets should be prepared to make. Our intention is to address the company or businessperson who is interested in raising capital through a public vehicle listed on one of the dominant US exchanges, NASDAQ, the NYSE or the MKT (the “Exchange”). Since it is highly government and market regulated, the process tends to be complex and impossible to navigate without the aid of a team of professionals that specialize in the area of Corporate and Securities law. Generally, the team consists of attorneys, auditors and investor relations advisors and investment bankers, particularly if the company is raising capital. In some instances, the company also may involve a “Promoter”. For purposes of this article we will use the term Promoter to mean a person or company that agrees to provide general business advice and cover some or all the expenses of the going public/financing process. We will discuss more about the role of the Promoter later; but at the outset we think it is important to note and point out that many Chinese companies have gotten themselves into great difficulty by choosing dishonest or inexperienced Promoters, both in the US and China.
To get listed on an Exchange, the company will also need a Board of Directors, the majority of whom must be “independent” and one of which must be conversant with reading financial statements in United States Generally Accepted Accounting Principles (the “US GAAP”) and or International Financial Reporting Standards (“IFRS”). The company must also adhere to certain corporate governance standards imposed by the Sarbanes Oxley Act of 2002 (“SOX”) and the Exchange will have certain additional corporate governance standards. It is up to management and the Board of Directors to insure these standards are adhered to. The consequences for the failure to comply with corporate governance can be serious.
We have no doubt that many are aware of the off-again on-again love affair that the US small and micro-cap markets have had with China. China, in our opinion, is the most promising country in the world for investors to deploy capital. Some of the reasons are obvious, the sheer size of the Chinese domestic market for consumer goods and services, the ability to manufacture huge quantities of complex systems, large and small, and export them efficiently at reasonable prices, and on and on. Foxcon and Lenovo are perfect examples.
The more subtle reasons are in part, the lack of ready domestic sources of capital for expansion of small businesses, the desire of entrepreneurs to find homes abroad for some of their wealth, the perceived prestige and recognition that a US listing brings and the simple fact that people in the US relate well to their Chinese counterparts on all sorts of business and cultural levels. As access to capital for relatively small businesses goes, one should bear in mind that going public in China is a very different process than in the US. In China, the process is regulated by the China Securities Regulatory Commission (the “CSRC”) which unlike its US counterpart, the SEC, makes qualitative determinations concerning whether or not a company in question is a proper candidate to go public, on the Shanghai or Shenzhen Exchange. As a result only the largest, often state owned companies are deemed worthy of the privilege. In the US, the SEC makes no such determinations. The SEC’s role is to make sure that the company going public fully discloses all relevant financial and other facts and risks about its business to the investing public. It is up to each investor to determine how worthy he or she feels the company is.
An additional reason for China’s allure that cannot be ignored is that in many respects China is still a developing country in terms of foreign and domestic business; “developing” in the sense of presenting opportunities for business, profit, expansion, excitement, etc. As people in the trenches when it comes to the small Cap and micro-Cap markets, we can say that very few professional investment businesses in the US have had much success in other developing countries when it comes to deploying the type of capital we are focused on in this article.
BDs, placement agents and private funds have explored India, Vietnam, other parts of Southeast Asia, Argentina, Brazil with little to show for it. We are sure there are some but we don’t know of many successful small cap listings that have endured from any of the above. A look at the countries of origin listed on the Exchanges would seem to prove the point. That is not to say that India, Brazil, Argentina have no successful business using US capital in whole or in part, but, they are not small or microcap businesses.
Why “Off Again On Again”?
So if the US investment business loves China and China demands US capital to fund its smaller and growing business, where is the “off-again” part? Simply put, (1) there have been ugly instances of fraud and negligence in connection with a not insignificant number of Chinese offerings and (2) like their US counterparts, the listed shares of many Chinese public companies have not performed as well as their Chinese backers expected. Because of the unique interplay of US and Chinese laws (particularly in the case of China, laws governing foreign ownership of Chinese businesses) the most often business model used by Chinese companies going public in the US, from Alibaba on down, is known as the VIE structure. Simply put, the VIE structure separates the operating business (Chinese) from the management and the entity entitled to the profits; US. The relationship is governed by an agreement between the Chinese and the US entity. However, because it is so difficult to judicially enforce a contract in China, many disappointed entrepreneurs simply “go dark” or opt to stop their SEC reporting and hence for all practical purposes being a US public company or simply walk away with continuing to own their operating company.
We think that it is a fair statement that the majority of companies that go public on any market, be it the NYSE, NASDAQ, LSE, Bourse, etc., have moments where they struggle or fail. After all, as someone looking to enter these markets you must already realize that the markets award companies that perform and punish companies that don’t.
How to Go Public
There are several methods for a corporation to become a public company subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (“Exchange Act”) and have its shares traded in a U.S. public market. Under a traditional initial public offering (“IPO”) process, a company will engage an underwriter to sell shares to the public and file a preliminary registration statement under the Securities Act of 1933, as amended (“Securities Act”) with the Securities and Exchange Commission (“SEC”). Once the SEC has reviewed the registration statement and its comments are addressed, the company will file an acceleration request to allow the registration statement to go effective and the shares will be offered to the public. In conjunction with this process, the company will typically apply to have its shares listed on the Exchange, as opposed to trading on the OTC market. The traditional IPO process is not used by small companies to the extent it was in prior years. Smaller companies that would not meet Exchange listing requirements even after an IPO often enlist an alternate going public method as a Reverse Merger. For smaller companies that cannot utilize the traditional IPO process, there are several alternative methods available to become publicly traded, and thus reap the benefit of greater access to capital (which is typically seen as the main benefit of being a publicly traded corporation). One such alternative method of going public is through a process known as “self-registration.” This involves the filing of a registration statement under the Securities Act on Form S-1 shares of the original shareholders’ to be registered for sale to the public. The effectiveness of the company registration statement will subject the company to the reporting requirements of the Exchange Act and if the Company is qualified, will allow the company to list on an Exchange.
Another alternative method popular among Chinese companies is a “reverse merger,” which is the acquisition by a public company (“Pubco”) by a private company (“Privco”) pursuant to which the Privco shareholders obtain a controlling interest in Pubco and have the power to appoint the directors and officers of Pubco. As part of the transaction, the shareholders of Privco give up their shares in Privco in exchange for shares of Pubco. For legal purposes, the Pubco entity does not change, only the composition of the shareholders, however, for accounting purposes, Privco is considered the acquiring company and the financial statements of Privco become those of Pubco. There are numerous benefits to reverse mergers, including shorter time process, more control over the timing of the process, lower costs, less commitment of management resources, less dilution to the Privco shareholders and an existing shareholder base. Typically, the shareholders of Privco will receive between 90-99% of the outstanding shares of Pubco upon completion of the reverse merger, with the remaining 1-10% consisting of the shareholders of Pubco prior to the merger. Of course a reverse merger does not involve raising capital. Often a reverse merger is done in conjunction with a broker dealer raising money in a private placement.
Regardless of the method of going public, being a public company in the United States requires specialized attorneys and accountants. The selection of the professionals, or the team, is of paramount importance. Without an experienced team, the process will be long and needlessly expensive. There are many ways to find your team but the best advice is to look for people that do this as a substantial part of their practice. In short, professionals that do it all the time. Your underwriter or placement agent can be very helpful in recommending your team. They will select people that they have dealt with before and that have proven themselves capable of the task.
Going public and functioning as a public company is highly regulated by the federal government, some state governments and self-regulatory organizations such as the Exchanges themselves. This complexity demands engaging lawyers and law firms that are very experienced in these areas and, in effect, do it every day.
Since the authors of this article are attorneys, we bring our own unique perspective to the topic of choosing and working with attorneys in a public financing. Two simple facts that the entrepreneur should be mindful of is: a) most investors, underwriters or placement agents like companies they are financing to hire attorneys they know – which diminishes the risk of something going wrong either with the financing source, the SEC or investors and b) there are a tremendous number of law firms in the US that can and do securities work so there is a lot to choose from and you need to be sure you have someone that is competent. Always select a firm that your financing source approves and always select one that is known to have expertise in public company financing matters.
The role of the law firm in the process is principally to draft the disclosure document that your company and the underwriter or placement agent will give prospective investors prior to accepting their money. A disclosure document informs investors about the company’s history, business, the risks inherent in the business, future plans and what the company intends to do with the money raised, the management of the company, management’s compensation and the terms, characteristics of the securities they will be buying (most often Common Stock) and audited financial statements for at least the past two years. Of course, the financial statements are provided by the Company and audited by the auditor not the attorneys but the financial statements incorporate a great deal of the narrative prepared by your attorneys. In the case of an IPO, the attorneys draft the company’s registration statement that is filed with the SEC and contains a prospectus in the case of an IPO. The SEC reviews the registration statement and most often comes back with comments or questions about the narrative or the financial statements. The lawyers and the company, with the assistance of auditors, respond to these comments or questions. There are often several rounds of comments and responses before the SEC declares the registration statement “effective” and the public offering can commence.
Once your company is public, the attorneys will help you maintain compliance with the various aspects of securities laws as well as the rules of the Exchange. In addition to filing quarterly and annual financial reports, public companies must make various filings with the SEC and the Exchange in the course of their business. For example, entering into a “material agreement” or making a “significant acquisition” triggers various reporting requirement. Putting matters before the shareholders to vote on requires special filings. The requirements are very specific and highly technical and require the professional assistance of attorneys. It is essential that you keep your lawyers updated on the development of your company, whether it is the appointment of new director, entry into a material agreement, adoption of a stock incentive plan or even trading of the company’s stock by affiliates, as companies are usually afforded a short time period to satisfy such reporting requirements.
Some of the larger law firms have offices in China and other countries but most of the law firms working on Chinese financing deals do not. Having said that, it is very important when selecting a law firm to make sure that the firm has a team of native Mandarin speaking lawyers. In our experience, even if the founder/entrepreneur does not speak English, most Chinese companies thinking about financing in the US have English speaking employees usually at the management level. That is always helpful but having Mandarin speaking attorneys is critical in going through the company documents needed to draft the disclosure statement as well as in the due diligence process. Due diligence is an investigation conducted by the underwriter or placement agent, generally through their attorneys, to confirm everything they believe and have been told by the company about its history and business. The due diligence process is almost always conducted at the company’s offices or plant and involves generally a law firm partner and one or more associates. At least one member of the team must be fluent in Chinese or the task will take an extraordinarily long time, be disruptive to the company’s business and frustrating for everyone involved.
Of course, financial arrangements are a critical issue when dealing with a law firm. Most law firms have a pretty good idea what a particular transaction should cost whether it is an IPO, reverse merger or private placement. If they do not, that is a sign that you have the wrong firm. Most law firms bill by the hour multiplied by an hourly rate and bill monthly. That type of billing is generally not acceptable to emerging companies or companies doing early stage financings. This can be particularly devastating if for some reason the financing is not successfully completed. Most law firms today are willing to use an alternate billing structure. They may be willing to quote a fixed fee or capped fee. In any case, the company typically makes an initial payment when the work begins, another payment at some milestone, perhaps the completion of the disclosure document or the filing of a registration statement and the balance, which is usually 50%-70% of the fee is paid at the closing of the transaction when the company receives the proceeds of the financing. If for whatever reason, financing is not successful, most firms agree in advance to a “broken deal” fee which is some fraction of the balance.
Apart from the US counsel, companies should also retain local PRC lawyers who will advise the company on the PRC laws and regulations with respect to going public in the US, particularly on the structuring of the public company in compliance with the PRC laws
For Chinese companies listed in the US, there are two commonly-used structures: (i) the straightforward offshore restructuring where the offshore holding company would acquire the domestic company’s equity interest from its PRC shareholders and (ii) the VIE structure where the offshore holding company would form a new wholly owned subsidiary in China which would control and receive the economic benefits of the domestic company (the “VIE”) through a series of contractual arrangements. The VIE structure is required because foreign ownership of certain types of businesses is subject to restrictions under the PRC laws. The VIE structure is very popular and many leading Chinese internet companies with this structure are listed on NASDAQ or NYSE.
Despite its popularity, the VIE structure presents a number of risks such as lack of official approval from the Chinese authorities and avoidance of Chinese regulatory supervision. Although the VIE agreements do not allow their foreign investors to directly own an equity stake in the operating company, the PRC authorities might view such indirect ownership as a foreign investment in a restricted sector without obtaining all the necessary approvals. The PRC government has not promulgated any law or regulations to endorse or deny the legality of VIE structure yet but the PRC governments have taken different positions and views on the VIE structure. If the state or local government disapproved the VIE structure, the company would face risks that the authorities may require the VIE structure to be unwound, depending on different government policies.
It is important that entrepreneurs consult with their PRC counsel to clearly understand how VIE structures work, why they are used, and the risks involved with using a VIE structure.
When it comes to establishing investor confidence in a public offering or any public financing, particularly among institutional investors, we think most professionals will agree that the selection of the auditor is arguably the most important factor.
Most large-cap companies which deal with very established underwriters usually use one of the top four international accounting firms, namely Ernst & Young, Deloitte & Touche, PWC and KPMG.
When it comes to microcap and small-cap offerings, it is often very difficult for smaller issuers to justify the expense of a top four or perhaps even a top ten firm. There are a number of smaller auditors that are very experienced in working with Chinese companies and some that are particularly popular with Chinese companies. Pursuant to US Corporate Governance and Sarbanes-Oxley, public company auditors are selected not by the management of the company but by the Audit Committee of the Board of Directors. The Audit Committee is generally composed of three independent directors, with at least one member being well versed in reading and understanding financial statements in GAAP and/or IFRS.
The auditors not only audit the company’s annual financial statements which are filed with the SEC but also review the company’s unaudited quarterly financial statements which are also filed with the SEC.
The role of the auditor is not to assemble or draft a company’s financial statements but to certify their accuracy. The audit report in the financial statements states in essence that in the auditor’s “opinion”, the financial statements fairly present the company’s financial condition. With respect to Chinese public companies, historically most of the problems in terms of fraud or misleading financial information resulted from the fact that in some cases the financial statements put forth were either inaccurate or were the product of the Company fraudulently altering the Company’s financial results. For example, there was a Chinese company that went public a few years ago in the United States where the company’s management paid middle level people at its bank to lie about the company’s cash deposits to the auditors and the people doing due diligence on the company.
In selecting an auditor for a public company, again you would be best advised to speak to your underwriter or placement agent about what firms they recommend. Price is always a factor but should not be the paramount factor. There are auditing firms that will work very cheaply but often the work is not accurate or looked at suspiciously by the SEC and the general public. Look for a well-established auditor that has done a number of deals in China, and preferably has people in the country. The SEC in fact has complained that many United States auditors that have done work in China simply to perform the work using local mid-tier resident accountants that are not really part of the audit firm. Ask other public companies for recommendations and how they feel about their auditors. There are many auditors that are Public Company Accounting Oversight Board (“PCAOB”) approved and have had extensive experience with Chinese companies.
In addition to being established and well regarded, auditors doing work for a public company have to be approved by the PCAOB, who establishes standards for audit work on public companies. It is easy to see if your auditor is a PCAOB member by going to the PCAOB website and looking at the list of approved firms.
It is pretty near impossible for a small/medium sized US company to raise any significant capital without the help of an underwriter or placement agent and it is virtually impossible for a Chinese company to do so.
First, what is an underwriter or placement agent? Without becoming too technical and tied up in legal/SEC definitions, an underwriter raises money for a company through a public offering (often an IPO) and a placement agent raises money for the company without going through the securities registration process that is required by the SEC for a public offering. It does so by limiting the people to whom it can sell securities to sophisticated investors and gives them detailed information about the company, its history and financial condition – much like what would be available in a public offering but somewhat abbreviated. Both the underwriter and placement agents are broker/dealers (“BDs”) and as such are “licensed” by the SEC and are members of FINRA, a quasi-government industry regulatory body. As a general rule, BDs raising capital for companies generally do both public and private offerings at one time and another.
Although larger BDs have offices in other countries including China, for the most part their offices are in the US and thus not readily accessible to Chinese entrepreneurs. Since China boasts the second highest number of US publicly traded companies second only to the US itself, people known as “Promoters” have made a business of introducing Chinese companies to underwriters and placement agents. The types of arrangements with Promoters differ widely as does the legality under US law. A company contemplating this type of arrangement should not do so without the advice of counsel, references from other companies that have worked with the Promoter as well as looking at a number of deals they have completed to assess how they have done as public companies (not solely the responsibility of the Promoter). It is not unusual for a prompter to front all or a large portion of the costs of going public including auditor fees, legal fees and fees for the investor relations firm. This type of arrangement is both legal and insures your Promoter has a deep interest in seeing the project through to a happy conclusion. Under US securities law a Promoter cannot be compensated solely for introducing a company to a source of direct or indirect financing.
More often than not and aligned with having a deep interest in the project, Promoters take their fees in stock. The amount of stock a company is willing to give up should depend on how much of the cost burden and work the Promoter is doing. A good Promoter will be at the company’s premises on several occasions to get a thorough understanding of the business and the people involved. He will generally accompany the underwriter or placement agent on their visits and will consult with all involved to make sure the company is getting a fair valuation.
The Investor Relations Firm
Virtually every public company in the US has one or more investor relations/public relations (“IR”) firms on retainer. The role of the IR Firm is important yet somewhat amorphous. It tends to be what the company and the IR Firm make of it. At the very least, the IR firm will help drafting press releases which are generally done whenever something material, good or bad, that happened to the company (often in conjunction with required SEC filings the lawyers are required to make). They also help management conduct quarterly earnings calls if management decides to hold these calls. Earnings calls are quarterly conference calls that management makes when it is ready to release quarterly financial results. These calls are open to investors, BDs and members of the financial press. After management (usually the CFO if he or she is reasonably fluent) presents the results, there is often a discussion of what the future may look like and then questions and answers. The IR firm helps management prepare their remarks and rehearse possible questions. The IR firm will generally have someone sitting with management during the call.
IR firms draft descriptions of the company for general distribution, help with maintaining the company’s website and organize non-deal road shows. Non-deal road shows are trips set up by the IR firms to meet with various BDs and institutional investors around the country whom they would like to take an active interest in the company’s stock—recommend it to their clients to purchase. The term “non-deal” simply means that the road show is not for the purpose of promoting a particular financing that the company is engaged in.
Not all IR firms do all the above which is why some companies engage more than one IR firms. For example, a particular IR firm may be great at putting road shows together but not so much at conducting earnings calls. Also, IR firms come in all sizes from one man shops to boutiques to national firms with offices in many cities. There are also IR firms that specialize in certain industries such as healthcare.
IR firms are generally engaged by contract for a year or more and paid monthly. Often with micro and small cap companies, the fees are paid partially in cash and partially in securities of the company (stock or options). These contracts should have a breakup fee so the company can terminate if it is not happy with the services and not being happy with IR services is the most common complaint companies will have towards their team. One obvious reason is that companies hire IR firms in the hope that, among other things, their efforts will cause the company’s stock to go up and hence the market cap of the company to increase. That will also make it easier for the company to raise additional capital. Of course no IR firm can guarantee that result and that result or lack of result most often lies with the performance of the company. On the other hand, there are IR firms that do little or nothing other than send press releases to the press, often releases drafted by the company.
The selection of the proper IR firm is of primary importance and as important as it is hard it is to find competent IR people.
About the authors