Financing Your Business

This section mostly discusses debt financing. We begin by talking about general commercial loans, both from offshore and onshore sources. We then discuss specialized types of financing, which include two non-debt types: venture capital and private equity.

Keep in mind when seeking loans that China sets upper limits on the amount of debt a business can have relative to its registered capital. The maximum ratio varies by investment size, and it gets higher as the investment gets larger.

Before reading further, you should know some terminology. Collateral for loans is often called security. When a borrower provides security, it’s called pledging — for example, a borrower can pledge its production equipment as security for a loan.

Borrowing from offshore

In theory, your company can borrow either from banks offshore or within China. Consider a number of factors when deciding where to borrow from. Here are the advantages of borrowing from offshore banks:

✓	If your offshore parent has good credit and this is its first time investing in China, getting financing from offshore will probably be easier. Banks in China are interested in your asset base (which won’t be big if you’re just established) and your track record in China.
✓	Sometimes the interest rates are lower offshore.
✓	If you expect the RMB to appreciate against your loan currency, and your foreign-invested enterprise’s (FIE’s) revenue is in RMB, your loan will become cheaper to repay as the RMB goes up.

The main disadvantage of borrowing from offshore is that all foreign debt must be registered. China has no similar regulation for domestic debt; therefore, if you have foreign debt, where your company stands in relation to its maximum permitted debt-to-capital ratio will be more obvious to the authorities.

The minimum loan size from an offshore bank to an FIE is usually around US$10 million. However, if your parent company has an existing relationship with an offshore bank, the parent may borrow the money and then lend it to your FIE in the form of a shareholder loan. Shareholder loans are an easy way to get some of your investment back because FIEs repay them in foreign currency, not RMB. The parent may also contribute any money it borrows in its own name as registered capital.

Shareholder loans must comply with most lending laws and regulations. Whenever an FIE submits a loan contract (whether shareholder or third party) to the State Administration of Foreign Exchange (SAFE) for verification of a loan payment, SAFE reviews the interest rate to ensure that it’s in line with market interest rates. That means that you can’t get extra cash out of your FIE by charging an excessive interest rate!

If you borrow from offshore, you may have to pledge your shares in the FIE as security. If you pledge your shares, you have to get approval from the original approval authority for your FIE. After you receive approval, the pledge must be registered with the local Administration of Industry and Commerce (AIC), one of the key approval authorities that companies deal with. See Chapter 7 for more info on approvals.

Borrowing from onshore

When looking to borrow onshore, you can borrow from foreign banks as well as domestic ones. In many cases, you borrow from the bank where the business accounts are — especially for small loans — but you do have other options. (You may want to consider your borrowing options when selecting your bank — see the earlier section called “Choosing a Bank for Your Business.”)

Your company can borrow from onshore banks in foreign currencies, regardless of whether the banks are foreign or Chinese. However, borrowing foreign currencies from onshore banks is rare because your proceeds are almost always used to pay for expenses within China.

Considering loans from onshore foreign banks

Although most onshore loans come from Chinese banks, the government is opening the banking industry to foreign banks. As a result, foreign banks are becoming bigger players in onshore deposits and lending. If your parent company has an offshore relationship with a foreign bank, you may get the best loan terms at one of the foreign bank’s China branches. Citibank is becoming particularly aggressive among foreign banks in lending to small and medium FIEs.

Foreign banks in China tend to be more interested in cash flow than assets.

Getting loans from Chinese banks

Traditionally, when most FIEs have borrowed from onshore, they’ve borrowed from Chinese banks. Chinese banks usually offer better borrowing terms on RMB loans because they have a lot more RMB to lend than foreign banks do. Also, if you borrow from a Chinese bank, the loan agreements when you borrow from onshore are simpler than what you’d get in most Western countries. Often, they’re only seven to ten pages long and are missing many of the financial restrictions that Western loan agreements have (for example, many Western loan agreements place a limit on how much overall debt a company may have).

Chinese banks have historically made asset-based loans, and the banks are still leaning quite heavily toward asset-based lending. Asset-based lenders determine borrowers’ creditworthiness and maximum loan amounts by the values of physical assets on the balance sheet. That way, if a borrower defaults, the bank can foreclose on the assets, sell them, and receive the proceeds.

However, Chinese banks are now beginning to take a more cash flow–based approach. Cash flow lenders make loan decisions according to financial projections of how much money will be available to make the payments. Making cash flow–based loans takes more sophistication because it involves analyzing business prospects. Therefore, when you apply for a loan in China, your company ideally has a good balance sheet and realistic prospects for strong cash flow.

Looking at special considerations for new businesses

If you’re just starting your business in China and want to borrow from onshore banks, all is not lost — you just have to work a little harder to get the loan. Because many newly-established FIEs don’t yet have significant assets, you have to make a pitch to the bank based on your business’s projected cash flows. The feasibility study you include in your FIE application packet (see Chapter 7) shows the bank that your company will be able to repay the loan.

If your offshore parent company is financially strong, it can help the FIE get a loan by providing a parent guarantee — that is, the parent agrees to be responsible for the debt in case the FIE defaults.

If your company is just starting up and you plan on purchasing fixed assets (land, buildings, or machinery), getting mortgages for those assets is probably easier than getting a general business loan. We discuss mortgages and other special types of financing in the next section.

If your FIE is a joint venture (JV — see Chapter 7) and it wants to borrow money, onshore banks often want the shareholders to the JV to each guarantee loans in full. For example, if the JV borrows 10 million RMB, the bank may want each parent company to guarantee the 10 million RMB. The problem is that the law limits how much Chinese JV partners can guarantee to the amount of registered capital that they own. In this example, if the Chinese side owns 5 million RMB of registered capital, by law it can guarantee only 5 million RMB of JV debt.

Checking out special types of debt financing

Even if your company is able to get enough funding internally or from general business loans, you may want to consider the following types of specialized financing. The financing costs or other terms of these alternatives may be more attractive.

Mortgages

A mortgage is a loan specifically to purchase a fixed asset, and it’s also secured by that asset. In other words, if a borrower defaults on the loan, the bank can seize that particular asset in order to recover the loan. Usually, banks lend only up to a certain percentage of the purchase price because they want to make sure they have enough of a financial cushion if they have to foreclose. Therefore, you have to put up at least some of the money yourself. How much the bank lends as a percentage of the asset’s value (called loan to value, or LTV) mostly depends on the type of asset, the bank, and your company’s strength.

In general, you can get two types of mortgages: mortgages for land or buildings and equipment mortgages. You usually get a larger LTV for land-building mortgages. Again, the LTV depends on several factors, but 70 percent is usually a reasonable expectation for land-building mortgages. Equipment mortgages usually have lower LTVs.

Letters of credit

Two main types of letters of credit (LCs) are available. One is called a standby letter of credit, and it’s usually connected with a general bank loan. Standby LCs are issued based on the same lending criteria as general business loans.

The other type of LC is a commercial LC, which is vital to the import/export business. A commercial LC is a guarantee from a bank for payment of a trade-related expense. For example, say your company wants to import some raw materials from a supplier that you haven’t dealt with before. Because the seller doesn’t know you, it wants payment before it ships the goods; however, you don’t want to make payment until you know the goods are on the way.

Commercial LCs are easy to come by because they’re usually not very risky for the bank. Depending on your company’s credit standing with the bank, it may have to put aside the money for the LC in a separate bank account.

As we discuss in Chapter 12, inspecting a product before you pay for it is a good idea. When a bank issues an LC, you’re on the hook for the money. Therefore, you do run the risk of not getting what you bargained for.

Working capital loans

Working capital loans are small loans used for day-to-day expenses, such as purchasing inventory, paying rent, and paying salaries. Because working capital loans are small, getting them from your bank usually isn’t hard. Sometimes you don’t even have to provide security. If your company does have to provide security, it’s usually the business’s inventory.

To get a working capital loan, you have to show the bank that the amount is a reasonable size for your business and that your cash flow can support the loan.

One caveat with working capital loans is that they’re often uncommitted. In other words, the bank can demand repayment at any time.

Getting private equity financing

You may be able to get equity financing, in which your company sells partial ownership to an investor. Instead of agreeing to receive a fixed amount of money in return (as with a loan), the investor shares the upside (or downside) of the business as a shareholder.

Public equity is raising money by selling stock to the general public, with the equity sold (stock) able to trade on a stock exchange. However, public equity isn’t an option for startup companies. This section discusses private equity (PE), an invitation-only type of financing — in other words, the general public can’t participate in the financing. In addition, the equity the investors purchase can’t be traded (at least initially) on a stock exchange.

Venture capital

Venture capital (VC) is a type of private equity financing. Companies raising venture capital are in their very early stages. In many cases, VC investors invest in a business that’s little more than a business plan. Venture capital is sometimes called “vulture capital” because VC investors usually require entrepreneurs to give up large amounts of equity (and sometimes control).

VC investors take a lot of risk by investing in young companies; therefore, they want a lot of reward if things work out (hence their vulture nickname). If you’re looking for VC money, you mainly need to be able to show VC investors two things:

✓	That your company will be successful (so present a solid business plan)
✓	How and when they can exit the investment — in other words, how and when they can make their money

Far and away, VC investors like to plan to exit by having the company go public — that is, to have its stock listed on a stock exchange. After the company’s stock is listed, finding buyers for the stock is easy for investors.

On rare occasions, some VC investors invest with the hope of receiving large annual cash flows. However, pitching this type of strategy to VC investors is difficult because they usually don’t want to hold onto an investment for more than a few years. Even if they’re getting cash yields of 20 percent on their investment starting immediately (which would be an incredible feat for your company), investors would still need five years just to break even. For most VCs, that’s an unacceptably long time.

China’s special VC features

China venture capital (VC) investing has a number of special characteristics not found in most countries. The main source of these differences is the currency controls (see “Introducing China’s Currency: The Tricky RMB” at the beginning of this chapter).

You can’t directly take an FIE public in another country for a number of reasons. For one, because a limited liability corporation (LLC) — the standard form of Chinese corporation — doesn’t have shares, it can’t sell shares of stock to be traded on an exchange. And listing on China’s domestic stock exchanges (in Shanghai and Shenzhen) is currently not a workable option for FIEs for a host of legal and practical reasons.

If you want your FIE to go public, first set up a special offshore company to hold your investment in the FIE. Setting up your offshore holding company first, rather than setting up your FIE and then transferring ownership to the holding company, is by far the better option. If you instead set up the FIE first, you need to go through the lengthy application process to set it up. You then need to go through another lengthy approval process to transfer the ownership to the holding company.

The government doesn’t usually want People’s Republic of China (PRC) investors to invest at the offshore level for onshore ventures (an act called round-tripping) because round-tripping defeats currency controls and can be a way to evade paying tax; therefore, PRC investors — either PRC citizens or PRC registered companies — need SAFE approval to join you at the offshore level for an investment in China. If you don’t heed this warning, SAFE may revoke your company’s foreign exchange privileges. For more, see Chapter 7.

If your Chinese partner brings up the idea of joining you offshore, you may want to kill the idea then and there. Some Chinese are used to ignoring these laws, and by the time they find out that they can’t get the approvals (likely to be the case), you’ll have wasted a lot of time. Also, a company that’s directly or indirectly (through other companies) controlled by a PRC investor needs the same approvals.

Because of the numerous China-specific issues with VC — including getting cash offshore (see the earlier “Getting Your Money Out of China” section) and issuing stock options to your employees — make sure you work with a law firm experienced in VC. Most VC work is currently done at foreign law firms, but some Chinese law firms (especially those with U.S.-trained partners) are now doing a lot of VC work as well. Your VC investor usually chooses the law firm. Before pitching to a potential investor, though, try to bone up more on legal issues with China VC. Large foreign law firms that do a lot of VC work in China often have useful articles on the topic on their Web sites.

VC is common in China, but you have an uphill battle if you’re going to pitch to VC investors who aren’t yet familiar with China’s markets — they may be scared off when they first hear about the numerous complexities. Decide whether you’re willing to take the risk.

Evaluate your VC investors carefully — and not just in terms of how much money they’re willing to invest. Look at how much control they want, whether they can provide useful advice, and whether they have a track record of bringing China businesses public. The Asian Venture Capital Journal (www.avcj.com) is a good source of information on China’s VC players, market, and challenges.

Non-VC private equity

Non-VC private equity (PE) investors invest in more mature companies. Here are the two types of PE investors:

✓	Strategic: Strategic investors invest because of some relationship with their existing business. For example, a European car company may buy part of a Chinese car manufacturer because the two companies want to produce cars in China together.
✓	Financial: Financial buyers buy businesses purely for profit reasons. Unlike most VC investors, these buyers may be interested in making their money back through cash flows. Their motivation may also be to bring the company public: Sometimes financial PE buyers buy public companies, make them more efficient, and then bring them public again a few years later.

If you’re thinking of eventually looking for PE investment, the offshore holding company structure is a good idea as well. You’ll save a PE investor a lot of headache that way.