This is a guest post by†Fredrik ÷qvist†, one of my former students who remains active in this field. Mr. Oqvist can be reached at†firstname.lastname@example.org.
VIE structures still appear to be very common among the new Chinese IPOs in the US. They’ve been around for a good while now so investors should be fairly well informed about what they are and how they operate. At this point in time the general set-up has been largely standardized, although not always in ways that I like, but I found an interesting quirk in one of the recent structures.
ZTO (IPO pending) is a company that sits on the delivery side of China’s rising ecommerce tide. As such it sees ideally placed to see strong growth on the back of expressed government support for increased consumption among the general populace. It recently filed to list in the US, and due to regulations in the delivery industry it set up a VIE structure to be able to list the company.
For those that do not know a VIE structure is basically a set of contracts drafted to mimic ownership and allow a listed entity to consolidate the financials of the contractually controlled VIE. In order to meet the requirements for consolidation the listed entity should be able to control the VIE, and also bear the majority of the risks and rewards from the company’s operations.
To meet these demands companies draw up a series of contracts that are either control agreements (voting rights, proxy, equity pledges etc.), or economic transfer agreements (exclusive consulting, IP transfer, set fees etc.). These economic transfer agreements, in order to ensure consolidation, usually stipulate that the VIE shall pay a certain % of all profits to a subsidiary of the listed entity. This percentage is usually around 100%, or in some cases the listing docs will state that the sum effect of all contracts together will allow them to claim substantially all of the profits in the VIE. This has been the standardized version of a VIE structure, although it might be a bit overkill.
Now, the ZTO VIE structure is interesting for a couple of reasons. Firstly, the company is fairly VIE heavy, meaning that essentially all of the business is actually conducted in the VIE. This is likely to be because of the PRC regulations, but it still means that the ownership of assets and control over all the company income is reliant on the VIE contracts.
† † † † † † † †Assets † † † Revenue † † †Income
VIE † † † 8,048,457 † 6,086,455 † †1,331,621
Total † 10,582,223 † †6,086,455 † 1,331,618
† † % † † † †76% † † † † † 100% † † † † † †100%
Source: SEC filings, numbers in RMB '000
The company only has one economic transfer agreement listed and filed with the IPO prospectus. This is the Exclusive Consulting and Services Agreement. In this agreement we can find an interesting passage relating to the fees to be paid between the parties.
“With respect to the Services to be provided by Party A pursuant to this Agreement, Party A and Party B estimate that within fifty (50) years Party B will pay to Party A the Service Fees of RMB 10 billion.”
I have never seen a disclosure of this kind in a VIE contract before, which makes it interesting in and of itself. However, the most interesting part of this is of course the company’s own estimate of how much will be paid through the only economic transfer agreement that the documents disclose.
RMB 10 billion over 50 years equates to 200 million per year, or put another way about 15% of the company’s current income. The company also includes the relatively standard disclosure that:
our wholly-owned subsidiary in China, has entered into a series of contractual arrangements with ZTO Express and its 43 shareholders, which enable us to (1) exercise effective control over ZTO Express, (2) receive substantially all of the economic benefits of ZTO Express, and (3) have an exclusive option to purchase all or part of the equity interests and assets in ZTO Express when and to the extent permitted by PRC law. Because of these contractual arrangements, we have control over and are the primary beneficiary of ZTO Express and hence consolidate its financial results as our variable interest entity under U.S. GAAP.
- Bolded text added for emphasis
If the company’s own estimates that their WFOE will only be paid 15% of current income is to be taken at face value, it should be hard to argue that this would constitute substantially all of the economic benefits from the VIE. Now, it is of course possible that the company can and will claim substantially all of the VIE profits, the next line from the contract regarding the fees is:
Notwithstanding the foregoing, Party A and Party B will separately negotiate to determine the amount of annual service fees payable by Party B to Party A after the end of each calendar year throughout the term of this Agreement.
And they provide for the option to defer the payment of fees so that the business of the VIE is not negatively impacted. This is all standard VIE contract talk, they can claim all the money, but may choose to defer the payments so that they can meet the consolidation requirements but not actually have to take any money out of the VIE.
So the 10 billion within 50 years might refer to the amount of money they expect to actually be transferred from the VIE into the WFOE, not counting the deferred portion, which presumably would cover the other 75% of current income. So perhaps what we have here is an idea regarding how the VIE structure will operate de facto, rather than how much will be claimed on paper. This should show investors that there is a real need to look at the details regarding any investments VIE structure, as well as how the company intends to use said structure.