Several Practical Tips for Start-up Entrepreneurs Investing in China
Several Practical Tips for Start-up Entrepreneurs Investing in China
By Lisa Li
Start-up Entrepreneurs or founders of enterprises need to know basic legal knowledge relating to making investment in China so as to prevent / mitigate legal risks. The author, from her past practice experience, summarizes the following practical points which start-up entrepreneurs or founders who are to set up enterprises in China should pay attention to. Please note that the following is dealing with practical points regarding limited liability companies (LLC):
Form of Entity
In China, it can take the form of LLC, company limited by shares, partnerships (including limited partnerships), individual owners without setting up a company / partnership, etc, to do business. As for types of companies, it includes LLC and companies limited by shares. Companies limited by shares can be further categorized into listed companies which are listed on stock exchanges of China and non-listed companies.
LLC is a preferable legal form for doing business in China as compared with partnerships or individually-owned businesses, because shareholders of the LLC shall only be liable for the LLC’s operational risks within the limit of his / her subscribed registered capital of the LLC. For the LLC itself, it shall be liable for the LLC’s debts and liabilities within the limit of the registered capital filed with the competent company registry authorities. Taking as an example, if the LLC’s assets cannot cover the loss of the LLC and the debts become due, generally the shareholders who have paid their subscribed registered capital in full shall not be liable for the debts of the LLC. That means the legal form of the LLC separates the shareholders’ own assets from the LLC’s assets and risks.
Corporate Governance for LLC
The corporate governance structure of the LLC includes shareholders’ meeting (or sole shareholder), board of directors (or managing director for small-sized companies), supervisory board (or supervisor(s) for small-sized companies) and the operational management organ:(a) The shareholders’ meeting (or sole shareholder) is the organ of the highest power, which has the power and authorities to make significant decisions, appointing and removing senior management staff such as directors, receive benefits (dividends) from the LLC, receive allocation of remaining assets of the LLC after liquidation, etc; (b) The board of directors (or managing director) is the executive organ of the LLC and is responsible to the shareholders’ meeting (or sole shareholder). It exercises the powers and authorities of convening and presiding over the shareholders’ meetings, deciding on the company’s operational plan and investment plans, determining the establishment of internal management organization, formulating the basic management rules of the company, formulating annual financial budgets plans, profit distribution plans, etc, appointing and removing managers, deputy managers and staff in charge of finance and determining their remunerations, etc. (c) The function of the supervisory board (or the supervisor(s)) is to inspect the activities of the management, including inspecting the financial status of the company, supervising the activities of the directors and management staff carried out for performing their corporate functions, removing directors or management staff, proposing to hold interim shareholders’ meetings, and initiating lawsuits against directors or management staff etc; (d) the management organization is mainly consisted of general manager, deputy general manager, staff in charge of finance, etc, who are generally appointed and removed by the board of directors (or managing director).
To improve the corporate governance, the basic principle is to set up the above corporate organs in accordance with the Chinese company law and each organ shall perform its functions according to the laws and through the due procedures. Otherwise the resolutions or decisions made by these organs may be cancelled, deemed invalid and void, or may result in liabilities to be borne by directors and management staff.
The Higher Registered Capital, the Better?
On commercial contract negotiating occasions, the author, heard for many times, that one party was requested by the other party to use other affiliate having much higher registered capital to act as the contracting party – actually major projects or projects for tendering and bidding (except for government procurement projects) set registered capital thresholds for companies to submit the bidding. Some entrepreneurs specify high registered capital in the company’s articles of association, because they consider higher registered capital indicates sound financial strength of the company. Actually China witnessed plenty of entrepreneurs adopting higher registered capital following the adoption of amendment to the PRC Company Law in year 2014, as the amendment sets no restriction on the timeframe for contributing the registered capital subscribed by the shareholders – the shareholders can freely stipulate in the articles of association of the company the timeframe for paying the registered capital -which means theoretically the subscribed registered capital is allowed to be paid within a very long time period.
However, the above does not necessarily indicate that shareholders can randomly increase the amount of registered capital. It is not advised to randomly set high amount of registered capital in the articles of associations without taking into consideration the actual business scale and business needs of the company. The reasons are as follows:
a) Decreasing the registered capital shall follow more complicated statutory process. This process involves posting public announcement and providing the report of paying off debts or providing the guaranty for paying off the company’s debts.
b) Even if there is a longer timeframe for paying the subscribed registered capital, such timeframe will be expedited under specific circumstances, such as early termination of the operation of the company, the company going bankrupt, where the shareholders shall be obligated to pay the uncontributed registered capital before expiration of the original timeframe specified in the AoA.
c) If the shareholders delay in contributing the subscribed registered capital, they shall be liable for breach of contract for other shareholders who have performed their obligations of contributing the registered capital and, if the company cannot pay off its debts which become due, such shareholders may be sued by the company’s creditors for paying the debts owed by the company to the creditor within the limitation of their unpaid registered capital which have become due.
d) If the paid-in registered capital is transferred out from the company’s accounts without real transactions and / or justification, it may be deemed as shareholder(s) withdrawing paid-in capital and may result in administrative penalties or even criminal prosecution.
In accordance with the Chinese company law, shareholders may make investments into the company in cash, kind, intellectual property, land use right, etc., value of which can be evaluated and title to which is transferable. If making non-cash investments, the title to such non-cash investments must be transferred to the company, e.g., in case of intellectual property right being invested into the company as the registered capital, such right must be transferred to the company; otherwise it shall be deemed that the shareholders have not fulfilled obligations of contributing the registered capital.
As for non-cash investment, the law does not explicitly require assessment by an authorized appraisal entity (there are exceptions for specific industries or specific types of non-cash investments). It is allowed for the shareholders to negotiate and determine the price of the non-cash investment and the respective proportion of shareholding of the company. However, where it is not easy to determine the value of the non-cash investment, in order to prevent the risks of being regarded as “exaggerating” the real value of the non-cash investment, it is still recommended to evaluate the non-cash investment by an authorized appraisal entity.
Risks for Individuals Acting as Legal Representative
Chairman of the board of directors / managing director, or general manager may act on the position of legal representative.
There is one saying that the legal representatives are on their way to the prison. This is an exaggerated but vivid expression regarding legal risks a legal representative may face. Under Chinese criminal law, when a company is found having committed crimes, sometimes not only may the company itself be imposed on sanctions, but also the major responsible person or the individual directly responsible for the crime will be imposed on criminal punishments. If a legal representative “approves”, “decides on” or “authorizes” to commit the crimes, the legal representative shall be liable for the crime prosecuted against the company. Therefore, an individual who is specified as legal representative on the business license of the company without knowing (nature of) activities of the company and whether the company’s operation is compliant with the law, is possible to face huge legal risks of being prosecuted where the company committed a crime.
Having said the above, if an individual is not a shareholder of the company and is actually not involved in the conducting of the company’s business activities, it is not recommended to “act” on the position of legal representative. Legal representatives must know what business activities the company is conducting and if these activities are compliant with the local laws and regulations.
Like in other countries, companies set up in China shall file the articles of associations (“AoA”) with the local company registry authorities. Plenty of local company registry authorities tend to require that AoA to be filed with them shall be prepared in accordance with their standard templates. However, it is not recommended to directly use such standard templates. If at all possible, the companies should try to file AoAs prepared based on the company’s specific situations and the specific allocation of rights and obligations amongst the shareholders.
It is recommended for shareholders to take a cautious attitude toward the AoA. Shareholders shall, at an early stage of negotiating the shareholders’ agreement / cooperation agreement, pay attention to those parts regarding allocation of rights and obligations amongst the shareholders and passing of resolutions of the shareholders’ meetings, as these terms generally will be included into the AoA at a later stage.
The following is an example regarding why shareholders / founders should attach importance to AoA terms and conditions. There is one case in which the majority shareholder from overseas worked with a minor shareholder from China to establish a foreign invested company in China. The majority shareholder relied on the minor shareholder to manage the company and the minor company would act on the CEO position. In the AoA of the company, it stipulated that CEO’s termination of employment with the company would trigger transfer of the minor shareholder’s shareholding in the company to the majority shareholder. The AoA provided for different calculation methods for determining the transfer price subject to the reasons of terminating the employment. With such provisions in place in the AoA, the shareholding transfer process was relatively smooth and it prevented future disputes on whether the shareholding shall be transferred and how to determine the transfer price. The foregoing is an example of majority shareholder protecting its rights and benefits through negotiating favorable terms and conditions to be included in the AoA.
On the contrary, minor shareholders don’t necessarily have to accept all terms and conditions set by the majority shareholder. From perspective of minor shareholders, they should try their best to negotiate favorable AoA terms and conditions, such as veto right for those issues that matter for them, Tag-Along Right, etc. Start-up entrepreneurs shall also attach more importance on terms and conditions of the cooperation / shareholders’ agreement and the AoA terms when introducing financial or strategy investors into the company.
Having said the above, it is necessary for start-up entrepreneurs to adopt beneficial shareholders’ agreement and AoA when establishing the company, with the assistance from professionals. The rights and obligations of the shareholders' agreement and the AoA shall be clearly provided for so as to prevent confusion and / or future disputes. Otherwise it might be not possible to revise and adopt a new version AoA in case of disputes. It is typical that poorly drafted AoAs may result in shareholders’ dilemma and may even finally lead to the early dissolution and liquidation of the company under specific situations.
Dissolution of Company Required When Stopping Operation in China
When a company stops operations, it shall be liquidated and then de-registered with the competent company registry authorities. There are legal risks for failing to dissolve and de-register the company with the competent authorities.
According to the Chinese company law, if a company fails to commence operation for 6 months after its establishment, or stops its operation for over 6 months, the company registry authorities may cancel its business license. Whether the company’s business license is cancelled or not, the company shall set up a liquidation committee to conduct dissolution and liquidation process within the statutory timeframe. Otherwise, the creditors of the company shall be entitled to request the court to designate members to set up the liquidation committee.
If shareholders fail to set up the liquidation committee to conduct the liquidation within the statutory timeframe, which results in the depreciation, loss or destruction of the company assets, the creditors of the company shall be entitled to claim compensation by the respective shareholder for debts owed by the company within the limit of the loss incurred by the company due to the foregoing failure. If the aforesaid failure resulted in the loss of the major company assets, accounting books and important files etc and therefore it is not possible to conduct the liquidation, the creditors of the company may request the respective shareholders to be jointly liable for the company’s debts. In case of de-registering the company without conducting liquidation, which renders it impossible to liquidate the company, creditors of the company may request the respective shareholders to be liable for the debts owed by the company.
Basic Accounting Principle Start-up Entrepreneurs Must Know
The basic requirement shall be that making payments or receiving payments shall be through the company’s bank accounts. The bookkeeping shall reflect the real transactions. Otherwise there might be risks of “piercing the corporate veil” and shareholders may be liable for the company’s debts. Consulting the accountants and tax advisors is highly recommended.
Non-competition and Confidentiality
Start-up companies need to consider if to sign non-competition agreements and confidentiality agreements with those employees on important positions, as those employees not bound by non-competition and / or confidentiality obligations may become strong competitors competing with the company in the future.
Investors are recommended to consult lawyers and tax advisors to understand basic legal and taxation requirements where the company is to be set up. Start-up companies are recommended to consult lawyers in order to establish internal compliance rules and regulations covering corporate governance, anti-bribery and corruption, labour, intellectual property protection, environment protection, etc and other compliance requirements peculiar to the respective sectors so as to prevent / mitigate various legal and compliance risks.
Disclaimer: This article does not constitute legal advice or suggestion on specific legal matters, nor does it constitute full interpretation of laws and regulations; it shall also not constitute the opinion of the law firm under which the author is registered as a lawyer.
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