© 2005 Morrison & Foerster LLP All Rights Reserved Venture Capital Investment in China Charles Comey Managing Partner, Morrison & Foerster ( Shanghai) March 2005

2 ROAD MAP China Market Overview Basic Deal Structures Legal Structuring Issues Deal Process Issues Due Diligence Issues Representative Deal Terms New SAFE Regulation PRC VC Regulation

3 China Market Overview China Market Snapshot VC funds which cover China increased to 170 in 2003, controlling nearly US$6.4B In the first half of 2004, investments from VCs amount to US$1.19B In 2003, investments from offshore VCs account for roughly 90% of total investments of US$1.6B Largest investment in 2003: Semiconductor Manufacturing International Corp. (SMIC) in September 2003 raising US$630M (MoFo advised Shanghai Industrial)

4 China Market Overview (Continued) Largest deal in 2004: Alibaba ($82M from a number of investors, including Fidelity, which is one of our clients) Average deal size: $2.0M ($4.9M for offshore funds and $1.2M for domestic funds) 2003 has seen some parallel investments by offshore and domestic VCs In 2004, IC industry received US$424M, constituting one third of the total investments all industries Source: Asia Venture Capital Journal/China Business News On-Line

5 China Market Overview (Continued) Select VC Clients of MoFo Carlyle Asia Venture Partners Intel Capital Corporation Softbank International Finance Corp. Government Investment Corp. of Singapore Goldman Sachs Draper Fisher Jurvetson Fidelity Capital Baring Asia CDH Fund DragonTech Ventures Acer Technology Ventures JAFCO China Assets Shanghai NewMargin AsiaTech Ventures IDG PAMA KLM Ventures Compass Ventures Legend Capital

6 China Market Overview (Continued) Representative Transactions-Exits  Hurray! IPO-$70M (first China Nasdaq IPO in 2005)  Kongzhong IPO-$100M  Linktone IPO-$86M  Rakuten $110M investment in Ctrip.com  Joyo $75M acquisition by Amazon  Index acquisition of SkyInfo

7 China Market Overview (Continued) Representative Transactions-Exits (cont’d)  Netease IPO and $75M convertible notes offering  Palmweb acquisition by Chinadotcom at $55M  MeMeStar acquisition by Sina.com at over $20M

8 Representative Transactions – Fund Formation Legend Holdings Limited - establishment of Hony Capital II, L.P., the first China fund with offshore/onshore parallel investment structure. Limited partners include Goldman Sachs, Sun Hung Kai, Temasek and Enspire. KLM Capital Management - formation of KLM Current Ventures V, L.P., a private equity fund. Hong Kong-listed Shanghai Industrial Holdings - investment in China private equity fund (lead investment: Semiconductor Manufacturing International Corporation). Koos Group - US$100 million investment in the U.S.-based Milestone Capital Partners, a private equity fund, and the launch of the private equity and financial advisory firm, Milestone Merchant Partners (fund manager). e-Millennium 2 Fund L.P. – formation of e-commerce and technology fund sponsored by Deutsche Bank and Scient Corporation, a strategic investor. Taiwan Semiconductor Manufacturing Co. Ltd. - formation of a $50 million technology venture fund, TSMC Emerging Alliance Fund.

9 Representative Transactions – China VC and private equity investments TL Ventures - Series B financing for Nanotech Corporation, a start-up semiconductor foundry in Changzhou, China. GoGo Technology - corporate restructuring and Series A financing from JAFCO Asia Technology Fund. New Oriental Education & Technology Group – in its Series A financing from Tiger Technology fund. Acer Technology Ventures - Series A financing of Ether Precision, an optical lens manufacturer and a Series B financing of Chipnuts Technology, a developer of multimedia System-on-Chip solutions. Mobile payment service provider Smartpay - equity financing. International Finance Corporation – in a Series A investment in Global Infotech, a developer of financial database management software, and software services provider HiSoft Technology International.

10 Representative venture capital and private equity investments in 2004 Carlyle Group in its Series A investment in Awaken Limited Fidelity in its Series A and B investments in Dianji Holdings Limited Jeboo.com Inc. and its founder in the company's Series A financing from Draper Fisher Jurvetson ePlanet Ventures. Legend Capital and IP Fund One (managed by Acer Technology Ventures) in their Series A investment in Power Genius Holdings Limited (a.k.a. Skyinfo or Xuntian), a wireless value-added service provider based in Shenzhen. Carlyle Asia Venture Partners and Intel Capital Corporation in a Series A investment in eBIS Company Limited, a systems integrator based in Beijing. Multiple transactions in China for Fidelity, Carlyle, IFC, Intel Capital, Acer, IDG, Walden.

11 Experienced, Focused Team Chuck Comey - 14 years (English and Mandarin) Steve Toronto - 14 years (English and Mandarin) Robert Woll - 21 years (English and Mandarin) Xiaohu Ma – 18 years (English and Mandarin) Paul Boltz – 9 years Roger Peng - 8 years (English and Mandarin) Scott Jalowayski - 7 years (English and Mandarin) Sibyl Yang – 6 years (English and Mandarin) Louise Liu – 6 years (English and Mandarin)

12 Basic Deal Structures Basic Deal Structure Permitted Industry FoundersInvestors Offshore Holdco Offshore WFOE (Operating Co.) PRC

13 Basic Deal Structures (Continued) Basic Deal Structure – Variation 1 Partially Restricted Industry InvestorsFounders Offshore Holdco Offshore WFOE ( Operating Co.) PRC Domestic LLC JV ( Operating Co.)

14 Basic Deal Structures (Continued) Basic Deal Structure – Variation 2 Prohibited Industry Investors Founders Offshore Holdco Offshore WFOE ( Operating Co.) PRC Nationals Domestic LLC (License Holder) Contract

15 Basic Deal Structures (Continued) Basic Deal Structure – Variation 3 Parallel Investments Founders Domestic LLC Affiliate of Domestic Investor Investors Offshore Holdco WFOE (Operating Co.) Founders Contract Domestic Investor Offshore PRC

16 Legal Structuring Issues The 2-level structure almost always calls for restructuring of domestic entities Different ownership structures at different levels may cause misalignment of interests Restrictions in certain industries require contractual arrangements for certain important assets (e.g. ICP license) Foreign exchange restrictions may cause problems for restructuring and co-investment by domestic investors

17 Legal Structuring Issues (Continued) The 2-level structure means no direct control over operating assets in PRC (especially assets linked by contractual arrangement) Control provisions in offshore documentation may not be easily enforceable in PRC Differences between international corporate governance standards and PRC ones

18 Deal Process Issues Deal management Multiple jurisdictions Multiple parties Multiple time zones Multiple locations Multiple counsels

19 Deal Process Issues (continued) Roles of Counsels International Counsel – documentation, offshore corporate work, onshore and offshore due diligence, deal manager Offshore jurisdiction counsel – basic corporate secretarial, jurisdiction compliance review of constitutional and deal documents, legal opinion PRC Counsel – restructuring, PRC due diligence, regulatory and legal opinion work

20 Deal Process Issues (continued) Unrealistic Timing Expectations Investee lack of sophistication Investor lack of attention to legal structuring matters Re-defining of Term Sheet General gaming Desire to close before basic conditions satisfied

21 Deal Process Issues (continued) Cultural Issues “Get the money in and see what happens” mindset Unrealistic expectations of fees and responsibilities of counsel Lack of transparency in due diligence and disclosure process Inattention to compliance with laws and regulations (imperfection in PRC legal system and enforcement problems)

22 Due Diligence Issues Proper PRC licenses, properly held IP chain of title secured Lack of basic corporate maintenance Compliance with tax and social fund requirements Founders loans Shares held “in trust” for others Founder affiliated companies / related party transactions

23 Representative Deal Terms Valuation; Investment Amount Mostly early stage investments (Series A and B) Small absolute pre-money valuation Down rounds less frequent Investment Amounts mostly small (in the $1M to $10M range) Valuation may be buoyed by recent slew of U.S. IPOs in wireless and internet

24 Representative Deal Terms (Continued) Liquidation Preference Multiple liquidation preference (1x – 3x purchase price) Almost always senior to previous rounds Almost always participating without cap Some use of IRR as basis for calculation Deemed liquidation (trade sale ) Dividends Cumulative dividends not prevalent

25 Representative Deal Terms (Continued) Anti-dilution Provisions Almost always full ratchet adjustment Investors often demand performance based adjustment Redemption Right Most investors require redemption right Typically 4 to 5-year timeframe Common use of liquidation preference as redemption price

26 Representative Deal Terms (Continued) Voting Rights Preferred shares vote together with all shareholders on as-converted basis Class veto rights broad and intrusive on operations Veto rights at both offshore holding company level and PRC operating company level

27 Representative Deal Terms (Continued) Board Representation Usually consistent with shareholding Investors becoming more demanding of board control Control over audit and compensation committees

28 Representative Deal Terms (Continued) Transfer Restrictions Right of first refusal and co-sale right (often given by investors) Absolute prohibition on transfer (1 – 4 years) Reach up to founders’ holding companies Drag-Along Right Some investors demand right of forced sale Valuation multiples or IRR as criteria for forced sale for exit

29 Representative Deal Terms (Continued) Registration Rights Customary registration rights borrowed from U.S. style transactions Increasing inclusion of equivalent rights in connection with regional listings (e.g. Hong Kong)

30 Representative Deal Terms (Continued) General Trends Valuation premium Investors demanding more certainty in performance and returns Investors becoming more involved in operations of portfolio companies Shift toward regional listings and trade sales Increase in exits via U.S. listings in certain industries

31 New SAFE Regulation New SAFE Notice (Notice on Strengthening Foreign Exchange Control in Foreign Acquisitions) Promulgated and effective on January 24, 2005 SAFE approval required for domestic enterprises acquiring interest offshore using domestic assets or shares SAFE approval required for offshore enterprises acquiring domestic enterprises ■ SAFE examines the acquisition agreement to see whether offshore enterprise was established/controlled by PRC persons and whether companies involved in acquisition have the same management team. ■ SAFE closely monitors foreign exchange activities and shareholding changes of the domestic companies acquired by offshore companies set up by PRC persons. No implementing rules as yet

32 PRC VC Regulation (Full name: The Regulation on the Administration of Foreign-Invested Venture Capital Enterprises; effective March 1, 2003) Highlights Improvements Limitations Market Reaction

33 PRC VC Regulation (Continued) Highlights Reconfirms Non-Legal Person Enterprise as a form of venture capital enterprise (similar to a limited partnership) Reduces capital requirement for each investor and aggregate capital requirement to $1M and $10M, respectively; reduces principal investor’s (similar to general partner) capital requirement to 1% of total Eliminates qualitative requirements regarding credit-worthiness and availability of funding More compatible with international practice in terms of capital payment, reduction, transfer and repatriation (e.g. foreign capital need not exceed 25%; capital can be paid in installments and in full within 5 years)

34 PRC VC Regulation (Continued) Non-principal investors may transfer their interest without any government approval (although principal investors may transfer only in special circumstances) Capital reduction/repatriation does not require government approval, but only advance notice, provided remaining capital sufficient for investment obligations VC funds may contract out their operations to VC management enterprises (which can be a domestic entity, an FIE or a purely offshore entity) Prohibited activities include investment in publicly traded securities, provision of loans and investment in fixed assets, etc. Investors in a VC fund may elect to pay taxes separately on an individual basis or collectively (essentially avoiding double taxation)

35 PRC VC Regulation (Continued) Improvements Officially introduces the limited partnership operating model into China Confirms the pass-through tax status of investors in a VC fund Substantially reduces quantitative and qualitative requirements for investors in a VC fund Introduces certain regulatory breakthroughs such as the elimination of approvals for certain capital transfer and repatriation and allowing offshore management companies to operate in China without having to establish an FIE

36 PRC VC Regulation (Continued) Limitations Still subject to Foreign Investment Industry Guidelines Portfolio companies still subject to the rigidity and inadequacies of the PRC Company Law (e.g. no legal basis for issuance of preferred stock or convertible equity instruments or redemption of stock by a portfolio company) Does not provide for reduced capital gains rate for disposition of investments Approval-based foreign exchange regime remains unchanged

37 PRC VC Regulation (Continued) Market Reaction Generally lukewarm Most practitioners notice the improvement from previous regulations but also recognize that the basic framework did not change (Industry Guidelines, PRC Company Law, foreign exchange control, etc.) Offshore investors want more clarity on tax and foreign exchange issues Have not seen many newly established foreign- invested VC enterprises or big-name offshore investors rushing to set up onshore funds

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