Introduction

Recently, while providing legal services for an equity financing project of a tech-innovation company, the founder of the company had an in-depth discussion with me regarding how to set up the company’s structure before investors acquire shares. Considering that many equity financing projects encounter similar common issues, I have written this article to share some modest insights for the reference and exchange of professionals in the industry.

I. Key Points of Equity Structure Design Prior to Company Equity Financing

(I) Aggregate the revenues of various business sectors under the actual controller through equity consolidation.

In the course of servicing equity financing projects, I often find that some projects have a situation where the actual controller of the company owns multiple companies, and the business revenues are scattered across these companies. This leads to an unclear financing entity, severe related-party transactions, and significant horizontal competition by the actual controller.

Generally speaking, when investment institutions decide whether to invest in a project, they mainly consider the competitiveness and growth potential of the target company’s products, as well as the authenticity of its current performance; they do not typically impose excessively strict requirements on the target company’s compliance. This is because before a company meets the requirements for IPO tutoring, forcing it to fully comply with IPO standards would generate compliance costs so high that they could harm the development of the business.

However, the aforementioned situation of “scattered equity holdings across multiple entities” is not within the tolerable range of investment institutions, and its presence often deters potential investors. This is because, in the eyes of investors, scattered equity holdings lead to the following consequences: (1) The equity financing entity of the project is unclear, and the existence of multiple related entities generates related-party transactions that undermine the credibility of the project’s financial statements; (2) Companies established by the actual controller outside the financing entity not only distract the actual controller’s energy but also facilitate horizontal competition and tunneling of benefits by the actual controller.

Therefore, before launching equity financing, the company should promptly clarify and define the target company that serves as the equity financing entity, and adjust the company’s equity structure accordingly. That is, the actual controller’s scattered equity holdings should be consolidated under a single equity financing entity that aggregates the same category of businesses intended for financing.

(II) Design a clear and stable control structure

A clear and stable control structure helps the company make decisions rapidly, avoids corporate deadlocks, and is a necessary condition for accessing capital markets. (Although there are successful cases of companies listing on the A-share market without a designated actual controller, such cases are extremely rare and mostly involve listed companies whose controlling shareholders are foreign entities without an actual controller, meaning they lack general applicability).

From the perspective of investors, if a target company performs exceptionally well but has scattered equity and an unclear control structure, this will undoubtedly deter their desire to invest. This is because, on one hand, when assessing investment projects, investors usually need to communicate first with the actual controller of the target company. When entering negotiations for investment agreements, investors often require the actual controller to make VAM (valuation adjustment mechanism) commitments. If the actual controller is not clearly defined, investors are left aiming at a shifting target. On the other hand, as mentioned earlier, an unclear actual controller can plant the seeds of failure for the company, let alone successfully ringing the opening bell at an IPO.

Therefore, if a company intends to conduct equity financing by introducing institutional investors, it should design corresponding mechanisms to safeguard the actual controller’s control. Meanwhile, since such companies usually target an IPO, generally speaking, the following two equity percentages should be kept in mind when designing control protection mechanisms:

1. Fifty percent of voting rights.

According to the provisions of the Company Law, a shareholder controlling a company’s majority stake means their voting rights should be above 50%. Before the company enters a mature phase, in order to ensure the stability of control, the voting rights controlled by the actual controller should be kept above 50% as much as possible to avoid plans to access the capital markets falling through due to arbitrary changes in control.

2. Thirty percent of voting rights.

If the company’s equity is scattered at the time of IPO filing, the largest shareholder holding more than 30% is generally recognized as the actual controller. Therefore, if the largest shareholder’s shareholding ratio is diluted to below 30% after the IPO, there is significant uncertainty as to whether the largest shareholder can still be recognized as the actual controller.

By considering the above two equity percentages, and combining the IPO requirement that public shares must constitute no less than 25% of the company’s shares (or no less than 10% of the total share capital if the total share capital exceeds RMB 400 million), one can calculate back how much equity can be reserved for equity financing or equity incentives while ensuring the stability of the actual controller’s control.

(III) Strip out relative shareholders in a timely manner to achieve risk isolation

In the early stages of a startup, due to unstable operations, founders often have to rely on extended family members, to the point where some relatives of the founder become shareholders of the company. Typical examples include husband-and-wife or father-and-son companies.

As the company’s business grows, family members of the founders may become overconfident. The existence of a large number of relative shareholders and relative employees can create several issues for the company:

1. Relative shareholders or employees occupying key positions in the company over the long term deprives other employees of promotion pathways, making it impossible for the company to attract truly outstanding talent. At the same time, the company cannot form internal control mechanisms featuring mutual check-and-balance or verification, creating potential significant defects in corporate governance—a flaw that investors find difficult to tolerate.

2. According to regulatory rules of capital markets, at the time of IPO filing, if the spouse or direct relatives of the actual controller hold 5% or more of the company’s shares, or hold less than 5% but serve as directors or senior executives and play an important role in business decisions, such spouse or direct relatives will generally also be recognized as joint actual controllers. Therefore, when negotiating investment agreements with the founder, investors also tend to identify the founder’s spouse or direct relatives as joint actual controllers. This leads to the following two consequences:

   (1) As mentioned earlier, investors often require the actual controller of the company to assume VAM obligations. If the spouse or direct relatives of the actual controller are also recognized as joint actual controllers, the liability of the actual controller for violating VAM obligations will extend to all of their family assets, putting immense pressure on the actual controller. I once handled an equity financing project where the founder’s spouse held shares in the company before the investor acquired shares, and the investor demanded that both the founder and the spouse jointly bear the VAM obligations.

   (2) After the company is listed, the shares held by the spouse or direct relatives of the actual controller will be locked up for three years, whereas ordinary pre-IPO shareholders generally face a lock-up period of only one year. This undoubtedly delays the opportunity for the actual controller’s spouse or direct relatives to realize their wealth by two full years.

(IV) Setup of employee equity incentive platforms

Before investors acquire shares is a more suitable time for the company to implement employee equity incentives.

On one hand, the value of the company’s equity is about to be endorsed by professional investors, which makes the value of the equity more prominent, and the incentive effect will be correspondingly better. Many failed employee equity incentive plans occurred because employees could not see the value of the equity, leaving it feeling like a hollow promise—tasteless to eat but a pity to throw away—and sometimes even worthless.

On the other hand, prior to the entry of investors, the value of the incentive shares granted to employees is usually determined based on the company’s net assets. Consequently, the share-based payment expenses that the company needs to recognize in its accounting are relatively low, and the individual income tax risks for employees arising from acquiring incentive shares at low prices are also smaller. However, if the employee equity incentive plan is implemented after investors have acquired shares, the value of the company’s equity will have a reference standard (which is usually relatively high). At this point, the share-based payment expenses that the company must recognize financially will be extremely high. This will inevitably affect current accounting profits, thereby hindering the company’s listing process, and the individual income tax risk borne by employees will also be higher.

Therefore, to avoid significant adverse impacts on the company’s listing process and the employees’ tax burden on equity incentives, companies intending to finance should implement their equity incentive plans before investors enter.

(V) The founder’s holding structure in the company

After the founder accepts the investor’s investment, driven by professional investors, various past financial non-compliance practices of the company will be largely rectified, and dual-bookkeeping practices will basically no longer be permitted.

Considering that the income the founder derives from the company primarily comes from company dividends and share transfers, from the perspectives of tax optimization and wealth inheritance, it is recommended that the founder adopt a hybrid holding model that combines indirect holdings through a family company with direct personal holdings (for specific reasons, please refer to my previous article Five Dimensions to Consider When Building an Equity Structure).

Before investors enter, there are few obstacles preventing the founder from reorganizing the company’s equity. However, once investors enter, it becomes difficult to easily change the equity. Therefore, to facilitate tax optimization and wealth inheritance for the founder, it is recommended to set up the aforementioned hybrid holding structure before investors acquire shares.

II. Conclusion

Philosophers say that no two leaves in the world are exactly alike. Of course, no two leaves are completely different either. The key points of equity structure design summarized above are for the reference of companies planning to undergo equity financing, but they should not be copied blindly. Considering that the design of an equity structure is constrained by various variables such as the actual paid-in capital of the company, the cooperative intent of other shareholders, and the tax burden of equity changes, companies planning to undergo equity financing must design their holding structures based on actual conditions.