After almost 10 years of discussion and gestation, China’s growth enterprise market (GEM) is finally coming together. On March 31, 2009, the China Securities Regulatory Commission (CSRC) enacted Interim Measures on the Administration of Initial Public Offerings and Listings on the Growth Enterprise Market, which took effect on May 1, 2009. The Interim Measures pave the way for the imminent launch of China’s GEM.
The GEM is designed to provide a convenient financing platform for start-ups, particularly hightech companies, as well as an exit strategy for venture capitals and other private equity funds. Traditionally, companies listed on GEM-type markets feature high development potential, a short operational history, small-scale operations and limited business performance records. Therefore, compared to the main board, the GEM will have a lower entry threshold, higher risk ventures and stricter supervision.
The listing thresholds under the Interim Measures are much lower than those for the main board. Specifically, a company that wishes to list on the GEM must meet four basic requirements. First, it must be a company limited by shares with a continuous operational history of at least three years. There is one exception to this requirement: if a company limited by shares is transformed from a limited liability company on the basis of its net book value, the continuous operation of the company limited by shares may be calculated from the establishment date of the limited liability company. Second, the company must have been profitable for the last two consecutive years, with sustained growth and an accumulated net profit of at least RMB10 million. Alternatively, it must have been profitable for the last fiscal year with a net profit of at least RMB5 million and revenue of at least RMB50 million, with a sales growth over the last two years of at least 30 percent. The aforementioned net profit should be calculated on the basis of the amount before or after deducting the non-recurring profit and loss, whichever is lower. Third, the company’s pre-IPO assets must be at least RMB20 million, and the company must not have any unrecovered losses at the end of the latest financial period. Fourth, the company’s post-IPO share capital must be at least RMB30 million.
Though the Interim Measures state that one of their purposes is to promote the development of innovative and other growth-type companies, they do not specifically address the types of companies that may list on the GEM. Nonetheless, analysts have surmised that the GEM will favor high-tech, high-growth and high value-added companies, as well as companies that focus on new types of economies, technologies, materials, energies and services.
Due to the high-risk nature of the GEM, the Interim Measures call for establishing an investor access system that analyzes investors’ risk-bearing capacity and discloses the investment risks associated with GEM stocks. Detailed rules and regulations regarding the kinds of investors permitted to engage in trading of GEM stocks are currently being formulated. According to certain reports, the investor entry threshold may be as high as RMB300,000. The entry requirements may also touch on investors’ credit record and investment experience.
The Interim Measures do not provide for a lock-up period during which shareholders may not sell, transfer or otherwise dispose of their shares in the issuer after the issuer goes public. Rather, this issue is covered in the Listing Rules for the Growth Enterprise Market of the Shenzhen Stock Exchange, issued by Shenzhen Stock Exchange on June 5, 2009. The Shenzhen GEM Listing Rules provide that the controlling shareholder and actual controlling person of the issuer will be locked into their investment for three years following the issuer’s listing. In addition, other shareholders who hold pre-IPO shares in the issuer may be subject to a lock-up period of 12 months. Furthermore, if a shareholder purchases new shares issued by the issuer within the six months before the issuer submits an application for an IPO, it may not sell or transfer more than 50 percent of those shares for 12 to 24 months after the issuer’s IPO. The remaining shares will not be tradable until 24 months have passed.
Given the current regulatory restrictions on round-trip investment, foreign venture capitals and private equity funds are increasingly seeking onshore structure by directly investing in Chinese start-ups. The launch of the GEM may encourage this trend, by providing an exit strategy for foreign investors. However, foreign-invested enterprises need to weigh several factors under the current regulatory regime when considering whether or not to list on the GEM.
First, an FIE, which is usually incorporated as a limited liability company, must be converted into a foreign-invested company limited by shares before it can apply for listing on the GEM. Although the Interim Measures shorten the required record of profitability that a company must have in order to qualify for a GEM listing, an FIE is not allowed to be converted into a company limited by shares unless it has been profitable for the last three consecutive years, according to relevant FIE regulations. Furthermore, such conversion is subject to approval by the Ministry of Commerce of the PRC.
Second, the new listing rules issued on September 4, 2008 for the main board at Shanghai Stock Exchange and Shenzhen Stock Exchange have reduced the post-IPO lock-up period for non-controlling shareholders to one year. The Shenzhen GEM Listing Rules also follow this principle. However, according to the Provisional Regulation on Several Issues Concerning the Establishment of Foreign-Invested Companies Limited by Shares, if an investor holds equity in an FIE limited by shares, its equity interest in the company will be locked up for three years after the company’s establishment, regardless of whether or not the investor is a controlling shareholder.
Third, according to the new Enterprise Income Tax Law of the PRC (the New EIT Law) and its implementation rules, foreign investors are treated as non-resident enterprises and the dividends and/or gains from the transfer of shares in Chinese companies by such investors are subject to an income tax at the rate of 10 percent, unless lower applicable rates are provided for in tax treaties between China and the countries in which the investors are registered. Previously, under the old Foreign-Invested Enterprise Income Tax Law, which the New EIT Law superseded, foreign investors were not subject to any income tax on dividends and/or gains from the transfer of shares in Chinese companies.
In sum, the launch of the GEM will undoubtedly stimulate the development of emerging Chinese companies and diversify the Chinese capital market. It also represents a possible exit strategy for venture capitals and other private equity funds, which may lead business for onshore venture capitals and other private placement firms to increase dramatically. However, current FIE regulations make it more difficult for FIEs than domestic enterprises to list on the GEM. To level the playing field for FIEs, the government should adjust FIE regulations accordingly.