Investors will likely hand over $20 billion to Chinese company Alibaba Group Holding Ltd. soon. But what will they get in return?
The IPO launch is set to kick off Sept. 8 according to The Wall Street Journal. Trading could start as soon as Sept. 18 after the company gets SEC approval, sets an issue price, and holds meetings with potential investors. The deal could value the company up to $200 billion, making it one of the most valuable U.S.-traded companies.
However, Alibaba’s complicated corporate structure puts investors at the mercy of the company and its Chinese owners without much legal recourse.
Variable Interest Entity
Alibaba’s online and mobile commerce businesses will be controlled by a “variable interest entity,” an arrangement meant to allow investors to buy into Internet and other businesses in which Beijing bans or limits foreign ownership.
Used since the 1990s by Internet operators such as Baidu Inc. and Sina Corp., variable interest entities (VIEs) are based on contracts that say an offshore entity in the Cayman Islands—Alibaba’s jurisdiction—or another corporate haven will control a Chinese company. Foreign shareholders get a stake in that offshore vehicle and profits but no ownership of the Chinese company.
“The relevant variable interest entities, which are 100 percent owned by PRC [People’s Republic of China] citizens or by PRC entities owned by PRC citizens, hold the … licenses and operate the various websites for our Internet businesses,” Alibaba’s SEC filing states.
In Alibaba’s case, these VIEs are owned by Jack Ma, the company’s founder and principal shareholder of the Cayman entity Alibaba Holding Ltd. Future shareholders of Alibaba Holding are dependent on Ma’s management of these VIEs because they can’t fire him.
“The VIE structure is the only way at present to play this game,” said Paul Gillis, a professor at Peking University’s Guanghua School of Management. “So if you want to invest in restricted sectors of China’s economy, you have to get comfortable with the VIE structure.”
In the SEC filing, Alibaba states certain “contractual relationships” with Alibaba Holding will give shareholders “effective control” over economic interests. Still, it warns regulators “may not agree” they are legal. Also, contracts can be changed at any time and without investor consent.
An Alibaba spokeswoman, Florence Shih, declined to comment, citing the “quiet period” required by U.S. securities rules ahead of an IPO.
Investors can find a VIE gives them less control than they expect, according to a March report by Tom Pugh, a lawyer for the firm Mayer Brown JSM in Hong Kong. He cited the case of shareholders who lost control of a Chinese company when its founder blocked them from firing him by seizing the seals used to sign corporate documents.
In a dispute, foreign shareholders have to work through the Chinese legal system, which “may not be adequate or effective,” Pugh wrote.
In 2012, China’s Supreme People’s Court threw out contracts used by a Hong Kong businesswoman to invest in China Minsheng Bank. The ruling said agreements that “conceal illegal intentions” were invalid. A year earlier, an arbitration panel rejected a VIE contract involving Singapore-based GigaMedia Ltd. and a Chinese online gaming business.
Chinese regulators have left the status of VIEs ambiguous. Most operate uneventfully, but courts have rejected contracts if they were deemed to be an attempt to evade ownership curbs.
Regulators could shut down VIEs, but “that would be too disruptive,” said Gillis. “They don’t mind the ambiguity because it puts them in a position of strength over the companies to make sure that they comply with government policy.”
However, there is another problem. Shareholders in Alibaba Group, such as Yahoo and Japan’s Softbank as well as future investors in the IPO will never be able to have a majority on the company’s board of directors.
This privilege is reserved to the Alibaba Partnership, a group of 27 people close to the company and its founder, Ma. Most of them are Chinese except for Timothy Steinert, the company’s general counsel and corporate secretary, who joined Alibaba in 2007.
“Our articles of association … will have the effect of allowing the Alibaba Partnership to nominate a simple majority of our board of directors,” it states in the SEC filing. These people may or may not be shareholders of Alibaba Group, but they will have control of the company.
The partnership elects new members annually after existing members put forth a recommendation.
On the plus side, Alibaba, based in Ma’s hometown of Hangzhou, southwest of Shanghai, represents an especially appealing industry. Investors in Alibaba Group will be entitled to receive a possible future dividend—coming from the Chinese subsidiaries—and participate in a rising share price.
Despite having no plan to pay a dividend in the moment, the prospectus assures investors that “we will pay our ADS holders to the same extent as holders of our ordinary shares.”
As for the business, Alibaba’s Taobao, TMall and other platforms account for some 80 percent of Chinese online commerce. Online spending by Chinese shoppers is forecast to triple from its 2011 size by 2015. In addition, Alibaba is expanding into online banking, entertainment and other services.
For the 2013 fiscal year, which ended March 31, Alibaba’s revenue rose by more than 50 percent to $8.45 billion, with profits nearly tripling to $3.75 billion.
In addition, Alibaba appears to have done its best to avoid problems by keeping the amount of business done through VIEs to a minimum, said Gillis.
Only 11.8 percent of Alibaba’s revenue last year was generated by VIEs, according to the SEC filing. The rest went to entities that can be directly owned by foreign shareholders.
“They have one of the better VIE structures among Internet companies,” said Gillis.
Also there is talk of officially opening online commerce to foreign competitors as part of efforts to make China’s state-dominated economy more productive. That has raised hopes they might lift the ownership ban.
“There is some hope that China will fix this problem,” said Gillis, “and that will be a good thing for investors.”
The Associated Press contributed to this report.