VIE variable interest entity

To achieve IPO, Chinese companies have 2 options either

onshore (A share) listing or offshore (red chip) listing. Most
companies use red chip listing because conditions lower and
faster. For red chip listing, two options straightforward
offshore listing structure or VIE structure.
First used by SINA in 2000. In china, FDI is not totally open to
foreign investors. Industries are classified into 4 categories
encouraged, permitted, restricted and prohibited. Vie
structure created to circumvent legal restrictions
More than 100 Chinese companies have adopted VIE structure
Alibaba, Tencent, Baidu, Sina, Tudou etc.

As indicated in the diagram above, foreign investors and PRC

individuals establish SPV1 in Cayman; then SPV1 sets up a whollyowned SPV2 in Hong Kong; and then SPV2 establishes the wholly
foreign-owned enterprise ("WFOE") in the PRC. The domestic
company usually is the one which owns licenses or approvals for the
business. However, due to restrictions on foreign investment, the
WFOE cannot obtain licenses or approvals from the PRC authorities
to operate in the desired industry. Through a set of contractual
arrangements among the WFOE, PRC individuals (usually PRC
individuals are the companies founders) and the domestic

company, the WFOE may be able to actually control the domestic

company as if it directly owned the equity interests in such domestic
company. Thus SPV1 may consolidate the financials of the domestic
company into the groups overall financial statements, which is
permitted and accepted by the US General Accepted Accounting
Principles.
In practice, the contractual arrangements include:
(i) the Consulting and Service Agreement entered into by and
between the WFOE and the domestic company, which provides that
the WFOE shall provide certain services (for example, the consulting
or strategic services and technical services) to the domestic
company for a fee, typically determined by the WFOE with the
intended result of shifting the domestic companys profits to the
WFOE;
(ii) the Asset License Agreement entered into by and between the
WFOE and the domestic company, under which the WFOE licenses
certain assets including intellectual properties to the WFOE for
royalty fees;
(iii) the Voting Rights Agreement or Proxy entered into by and
among the WFOE, PRC individuals and the domestic company, in
which the domestic companys shareholderPRC individuals
authorize the WFOE to exercise their shareholders rights in the
domestic company, including voting rights, inspection/information
rights, signing rights and election rights, etc.;
(iv) the Call Option Agreement entered into by and among the
WFOE, PRC individuals and the domestic company, in which PRC
individuals grant the WFOE an option to purchase all or a portion of
their equity interests in the domestic company at a lowest possible
price permitted by PRC law;
(v) the Equity Pledge Agreement entered into by and among the
WFOE, PRC individuals and the domestic company, through which
the PRC individuals pledge their equity interests in the domestic
company to the WFOE as a guarantee of the performance of their
and the domestic companys obligations under other agreements
among the three (3) parties in the VIE structure; and
(vi) the Loan Agreement entered into by and between the WFOE and
PRC individuals, in which the WFOE extends a loan to PRC
individuals to use for capitalization of the domestic company.
The cash flow goes like this: SPV1 will fund the SPV2. SPV2 will
make a capital contribution to the WFOE. The WFOE will extend a
loan to the PRC individuals, who will in turn establish and finance the
PRC domestic company. When the PRC domestic company makes a
profit, it will distribute a dividend to the PRC individuals. The PRC
individuals will make a repayment of the loan to the WFOE. The
WFOE will use the proceeds of the loan together with other funds to
be discussed below to make a dividend distribution offshore to
SPV2, which will in turn make a dividend distribution to SPV1. In
addition, through the contractual arrangements between the WFOE
and the PRC domestic company, the domestic company will also

make certain payments to the WFOE for provision of services. This

payment will be part of the dividend to be distributed by the WFOE
offshore, thus completing the chain of cash flow.
At the beginning, the VIE structure was used primarily for asset-light
companies, such as internet companies, advertising companies,
software companies, education companies and media companies,
etc. However, after several years development, the asset-heavy
companies also began to choose VIE structures for their financing or
offshore listing and the typical example was China Qinfa Group
Limited. Recently, the VIE structure has been increasingly used by
asset-heavy companies.
Alibaba files for US IPO!
Licenses to operate websites in China are held by VIEs 100%
owned by Chinese citizens. Basically licenses owned by Jack Ma and
not owned by main Alibaba company filing for IPO.