The title of this post was taken from an article in the Economist, worth a look if for nothing else than its wonderful cartoon illustration. The title caught my attention because we have dealt a lot with VIE contracts and challenges to its structure, yet there continues to be a gaping hole in the discussion – specifically, around the ownership of a VIE.
Who owns what in a VIE structured company is critical as the incentives of the VIE owners can be completely misaligned from the interest of investors, as often indicated by companies in the risk sections of their annual filings. Yet for all the acknowledgement of risks, we seldom see companies taking actions to mitigate them.
Generally, VIEs fall into at least one of three different categories of ownership: CEO/Founder-owned, Family-owned, and Employee-owned.
CEO/Founder owned VIEs are common if for no other reason than for its relative simplicity. The founders tend to be PRC nationals who have started a company and then set up a foreign SPV; they can then simply retain ownership of their original company in China and sign the normal VIE contracts with their SPV’s WFOE. This ownership structure is often perceived as the least risky for foreign investors, but certain situations have given foreign investors reason to reflect.
One such situation is exemplified by the divorce proceedings of Tudou’s CEO Gary Wang, where his wife settled to drop the claim of 76% of the equity interest in the company’s operating VIE for cash payments. This led to the now prevalent Tudou clause, which aims to remedy the situation; however, it will be interesting to see if companies that have already listed will also add this to their existing arsenal of VIE agreements.
Another interesting issue that surfaces is the increase of Chinese companies taking a collective beating on the foreign exchanges, causing a misalignment between the incentives for the owner of the VIE with those of shareholders in the public company, as the value of shares in the US is now sometimes even below reported cash balances. The rationale is that there is no reason a company should be listed in the US with a P/E of four, when it could just as easily trade in China at a P/E of 12.
There has been talk about the dangers and difficulties of PE firms delisting a company from a foreign exchange in order to take it public domestically in China instead, but simply cutting the VIE contracts before listing domestically simplifies this process significantly.
Family-owned VIEs work on another level than CEO-held VIEs; there is an overhanging monetary incentive for any member of the family to simply cut the contracts and walk away, as they normally don’t hold equity in the public company. We must then infer that the reason they do not jump ship is because of their bond to the relative who runs the company.
Some observers have pointed out that there are severe unreported risks in the potential deterioration of ties between the VIE owner and their relative within the listed company. For instance, the Tudou situation could have ended worse if the VIE was been owned by the CEO’s ex-wife.
Should family disputes and squabbles be reported in the 20-F annual reports?
It may sound ridiculous, but with some companies, there is the risk that a divorce or a falling out amongst kin could lose the company its entire China operation.
Employee-owned VIEs are another option, and perhaps most interestingly the only viable one for foreign players in the market. Many point to GigaMedia as a prime example of what could happen if there is a falling out between the VIE owner and the company.
The obvious drawback is the amount of power given to a single employee. The employee, as the GigaMedia case showed, becomes impossible to fire. In fact, the employee can hold the company hostage, with the implied threat that the company’s entire operations are under his/her control and could disappear at any point.
Additionally, I question the wisdom of this method of ownership due to historically high employee turnover rates in China. What would happen if the employee joined a rival company? You could in effect “recruit” an entire business, or business segment, from your competitor.
Now, the above cases discuss the purer forms of VIE structures, as in ones where basically the entire company, or at least an independent part of a company, is in a VIE.
One way to minimise adverse incentives created by this form of ownership is to set up your organisation so that no VIE can operate as a separate entity.
The goal should be to hold as much of the business as possible in WFOEs, preferably limiting the VIE to holding nothing but the necessary licenses. This way, a VIE on its own has no real value; its only value is as part of the whole organisation, the listed company. Then, the value of the VIE bargaining chip is lessened substantially because no one stands to gain from picking the company apart.
We do see that companies set up this way better aligned between shareholders and the owners of the VIE; Baidu is one example of this. Not all companies have taken these steps however, and in some cases, it’s difficult to tell to what extent these steps have been implemented at all.
The question of adverse incentives in VIE structures, and how to mitigate them by aligning the interests of investors and VIE owners, deserves attention. PE and VC firms that come into these companies likely have a better chance at instigating real change than shareholders of publicly traded companies, but the issue is a pressing one for any investor who is not the owner of the VIE.