China's entrepreneurs look for an exit strategy

There is little doubt that Li Qin Fu is a successful entrepreneur. He is the Chairman of Shanghai Matsuoka, which manufactures low cost work wear and runs printing operations. The company is 42% invested by a Japanese company, Matusoka Corporation, and announced third quarter profits of RMB103 million, a 39% increase on the previous period.

Li won his stripes in the 1980s when he was given working capital amounting to just RMB500 ($60) by the management of the state-run company he was working for.

Under the recently introduced contract system he took over the operations of one the SOE's plants under the condition that he would pay the parent company a fixed return every year and keep the rest for himself.

The company went from strength to strength and grabbed the prize much coveted by China's private sectorá- a foreign currency B-share listing in 1999 which raised $28 million, and opened the door to Japan's Matsuoka participation.

The company also managed to get listed on the domestic currency A-share market in June 2001, by special permission of the China Securities Regulatory Commission, even though this was off-limits to foreign-invested companies until November this year.

But according to the annual report, Li Qin Fu does not own any shares in the company. According to the share structure described in the annual report, the listed vehicle's major stake holder is the Matsuoka corporation of Japan and Zhejiant Pinghu Xincang No. 2 garment factory.

So how can Li cash in on his success in establishing a thriving company?

Currently, an individual may not issue shares in his name, which bars private companies from listing. Bankers therefore need to create paper state-owned companies, which in reality are owned by the entrepreneur.

According to company sources, Liááoriginally hoped that he would be able to set up a share option scheme, but the Ministry of Finance does not allow this.á

He therefore had no choice but to use a front of state-owned companies who hold shares in the listed company. These shares are known as legal person shares. Although officially held by the SOE, the proceeds of selling these shares will make their way back to an individual. They differ from state-owned shares, which are usually government stakes in long-established SOEs which have been restructured as shares-issuing entities.

Interestingly, according to sources within the company, one SOE which is a major stakeholder of Matsuoka Shanghai, is also the one which originally established the contract relationship with Li at the start of his career.

Legal person shares sell at a much less than the market rate, since they may not be traded directly in the secondary market but over the counter. Sellers suffer a discount for the lack of liquidity, but since the share were originally bought at par, and the shares have soared on the back of China's stock market boom in the meantime, the seller can still make a healthy profit when negotiating a price with the buyer.

Alternatively, entrepreneurs like Li hope they will be able to cash out their stake at market price when the authorities permit the flotation of private companies.

Some companies have dealt with the problems of exit strategies in other ways.

Other companies have different exit strategies.Zhengzhong Liang is the president and CEO of SinoBanker, a company based in Shanghai, but with the holding company registered in the Cayman Islands. Liang was educated in the US and obtained work experience with computer giant Hewlett Packard before moving back to Shanghai.

SinoBanker is involved in investor relations within Shanghai's growing financial community, but Liang also sees opportunities in transferring medium-level technology to China from abroad.

"Our exit strategy is to invest in a Chinese listed company and take a roughly 30% stake. But we attach a put option to this stake, which means that once we have grown the company very rapidly within one or two years, we can sell our stake back to the listed company and use the proceeds to make further investment," explains Liang.

Another advantage to this kind of deal is that both sided of the transaction have a track record. The technology provider should already have proven that the product his company has supplied has worked, while the Chinese company is not an unknown start-up but a listed company.

Still, Sinobanker will end up holding RMB which can not currently be converted freely into hard currencies, but then again, most experts agree it's only a matter of time before this changes.

But the classic way for a Chinese entrepreneur to ensure they can cash out with the minimum amount of fuss is by setting up a company registered abroad and then coming to China classified as a foreign investor, which means he can share in the tax holidays and other incentives which are offered by provincial governments.

The advantage of the holding company based abroad is that it can be sold to a foreign buyer without disturbing the share structure at the JV level in China. So the Chinese JV partner could wake up one day to find that the offshore company has been sold off, although his own stake in the JV remains undisturbed.

In the meantime, China's entrepreneurs must still await the creation of a second board, which will finally permit entrepreneurs to get some reward for their hard work in building up their companies. That could be as soon as next year.