Alibaba (BABA), China’s largest tech corporation, prides itself on having the third largest IPO in history. However, China’s Internet sector is quite a contradiction– it reaps benefits from foreign equity investments, without letting the foreigners own a single share.
VIE – A Peculiar Regulatory Loophole
According to the laws of China, it is illegal for foreigners to own stocks in a few industries such as Internet commerce and finance.
Alibaba is an Internet company and thus cannot have foreigners as stockholders. This raises an important question as to how Alibaba could have managed to float an IPO on an American stock exchange. The answer to this is VIE or variable interest entity.
The structure entails the setting up of two entities, one in China and one abroad. The China based entity – the VIE— holds the essential permits and licenses, which are mandatory to do business in China.
The second entity is an offshore holding company. This is the company in which foreigners are allowed to buy shares.
The Chinese subsidiary is controlled by the holding company’s top executives – it pays fees and royalties to the offshore company according to contracts between the two.
Therefore, investors who bought shares of Alibaba on the NYSE actually purchased stocks of the holding company called Alibaba Group Holding Ltd registered in the Cayman Islands with a claim on some of Alibaba’s profits but no real ownership stake.
This means that investors do not own shares of the actual Alibaba and therefore no voting rights in the company. They also therefore have no rights against any of its assets, including Taobao and Tmall. All they get is a share in Alibaba’s profits.
Who Owns Alibaba then?
According to a post on the New York Times Deal book blog, Alibaba co-founders Jack Ma and Simon Xie actually own Alibaba.
Risks of a VIE
Many experts in Chinese law doubt this structure and the risks are evident. The contractual claims on Alibaba’s profits are going to be enforceable only in a Chinese court. This is so because, according to the structure, the contract for profit sharing is between the Chinese subsidiary of the Cayman Islands-based BABA and the Chinese company Alibaba, both of which are based in China.
Moreover, there is a question about the legality of a VIE in the first place. While the Chinese government hasn’t objected to the VIE structure, this is mainly because it enables foreign investment in China’s growth with no strings attached (literally). Chinese courts on the other hand have not taken a favorable view in the past while maintaining the vagueness of the government’s stand on the issue. So the situation can change at any time the government feels the concept is not going in China’s favor.
We Shouldn’t Forget The AliPay spinoff
In 2011 for example, when Yahoo! (YHOO) was among the biggest investors in Alibaba, its founder Jack Ma created Alipay, an online payment service. That same year the People’s Bank of China declared that it would be imposing new laws curtailing foreign investment in online payment services. Fearing that this would end up limiting AliPay’s ability to operate if it continued to be a part of the Alibaba/Yahoo! Partnership, Jack Ma spun it off as a company without the approval or even knowledge of majority shareholders, Yahoo! and Softbank.
Yahoo! was unable to prove any wrongdoing and eventually, along with Softbank, was forced to accept whatever paltry compensation Ma was willing to offer. So a key Chinese asset was lost even though Yahoo had ownership rights simply because the Chinese government suddenly decided not to recognize those rights.
Other Companies on the VIE Route
The VIE structure has been utilized by many Chinese firms and no major disputes have arisen thus far. But that’s because no Chinese firm using the structure to raise capital from the west has refused to honor the terms of its contract.
JD.com (JD), Baidu (BIDU), Sohu (SOHU) and Sina (SINA) have already taken this route and others may be expected to follow. But these companies are all in the growth phase. It will be interesting to see how much profit the companies are willing to part with once the market matures.
Looking Ahead
Beijing wants to keep foreign control out of significant sectors of the economy. However, it understands that companies in these sectors require foreign investment to flourish.
Permitting VIEs means Beijing can permit Chinese businesses to raise capital from abroad while retaining the authority to crack down on the activities of Chinese businesses.
So investment in Chinese companies always involves a certain amount of risk and while it’s a good idea to ride the growth wave, a better plan could be to get out while the going’s still good.
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