The corporate system is the main carrier of modern business civilization, and equity is the main cornerstone of the corporate system. With China's reform and opening up, a series of commercial laws and regulations centered around the Company Law have gradually improved, becoming one of the key elements for the success of the reform and opening up.
In this era, entrepreneurship has become a new path to change one's destiny, and the way to gain personal wealth and career success is closely related to equity. In today's relatively complete legal environment, understanding the basic principles of business, such as equity and corporate systems, can help entrepreneurs avoid detours and increase their chances of success.
To understand equity, one must understand the corporate system, and to understand the corporate system, one must grasp the legal operational principles and accounting calculations at the ownership level. For most individuals from industrial backgrounds rather than legal or accounting professions, reading laws such as the Company Law, CPA textbooks, and accounting standards can feel like taking sleeping pills. This book attempts to provide a compilation of common knowledge and practical tools related to equity issues through examples, combined with some simple conceptual explanations and numerical calculations. It aims to assist those who lack understanding of laws and regulations related to equity and financial accounting but are interested in the subject.
Limited Company#
Equity, or capital stock, shares, registered capital, and contribution amount, all primarily refer to the same thing: the shares of a company. To clarify these concepts, one must first understand what a company is. Generally speaking, when the concept of a company is mentioned, the average person's mind often conjures images of roaring factories and busy machines, bankers in suits sitting in skyscrapers, countless servers, and busy websites displayed on users' phones, or the fluctuating numbers on a stock exchange... However, all of these are merely the public's intuitive impressions of a business.
My understanding of a company is: a company is an economic community where shareholders invest benefits into this community, expecting to gain greater benefits in the future from these investments, and equity serves as proof of shareholders' ownership shares in the company.
The prototype of a company originated from tax farming groups in ancient Rome, while the modern concept of a joint-stock company emerged during the Age of Exploration in Europe; the most famous examples are the Dutch and British East India Companies. The Dutch East India Company was the first joint-stock company, very close to the concept of a joint-stock company as defined by today's Chinese Company Law. Its main principles can be summarized as follows:
(1) Contributions made to the company cannot be withdrawn; the company conducts business operations with shareholders' contributions, and profits are distributed according to the proportion of shares held;
(2) Shareholders bear limited liability for the company's debts up to the amount of their contributions, meaning that if the company goes bankrupt, shareholders are not required to repay any shortfall after the company's assets have been liquidated to cover debts;
(3) The separation of shareholders from the company's management, with shareholders electing the board of directors based on their voting rights, and the board being responsible for the company's development and strategy;
(4) The company's equity is non-nominative, allowing shareholders to transfer their shares without the consent of other shareholders. Therefore, shareholders can freely sell their shares if they disagree with the company's direction or need cash temporarily.
The basic principles of today's corporate system are merely adjustments and supplements to the above principles, explained as follows:
(1) In the continuous development of the economy and technology, distributing dividends solely based on the number of shares has become inadequate for technology companies based on "people." By separating voting rights, dividend rights, and capital gains rights, the "same share, different rights" system has emerged. World-class tech giants, including Google, Apple, and Facebook, adopt this special treatment, but China's capital market regulatory framework does not currently support it;
Additionally, there are derivatives such as "preferred shares," which, while the capital cannot be withdrawn, have a distribution and liquidation priority over common shares, often with fixed dividend rates;
(2) Before the emergence of limited liability, doing business was a high-risk endeavor: when a business organization could not operate due to poor management, all of its assets would be sold to repay debts, and any shortfall would need to be covered by the personal assets of the business's shareholders; it can be said that failure in business often meant ruin. The introduction of the limited liability system greatly reduced the risks for entrepreneurs and significantly promoted business prosperity; it is also the most widely used system for business organizations today. However, with the implementation and continuous improvement of the business tax system, companies, as independent legal entities, bear a heavy tax burden, leading to the emergence of modern unlimited liability business organization methods; within the framework of Chinese commercial law, this mainly includes individual businesses and partnerships.
(3) As the corporate governance structure further improves, daily operational authority is delegated to a management team led by a general manager, while the board of directors is responsible for important personnel and strategic planning, and a supervisory board is established to oversee the actions of the management and the board. Meanwhile, the shareholders' meeting, as the highest decision-making body of the company, decides on the selection of the board of directors and the supervisory board through regular and special meetings. The board of directors, relatively detached from direct involvement in operations, is responsible for strategic formulation and personnel decisions for the management team, which implements the strategies set by the board. However, in practice, especially in Chinese family businesses, the identities of directors and executives often overlap significantly, leading to confusion between the two roles.
Additionally, it is important to emphasize that the principles of corporate governance are based on the company's articles of association. A legally compliant and effective articles of association binds the company's shareholders, directors, supervisors, and senior management. If amendments to the articles are to be made, the procedures specified in the articles must be followed. Therefore, some interesting business war cases involve battles over special clauses or loopholes in the articles.
(4) In Chinese Company Law, there is another main organizational form of a company, namely the "limited liability company" (although joint-stock companies are also limited liability). Joint-stock companies are more suitable for companies with a large number of shareholders and larger operating scales, but they can easily lead to management chaos and shareholder disputes in smaller companies. Therefore, "limited liability companies" impose restrictions on shareholders' transfer of shares, requiring the consent of other shareholders for equity transfers unless otherwise agreed in advance.
Equity occupies a dominant position in the corporate system. From the above explanations, it can be seen that mastering a company's equity means not only obtaining traditional dividends and capital gains upon transfer but also, after meeting certain conditions, controlling the company's personnel, business, and strategic powers. Meanwhile, the rights enjoyed by ordinary shares after lifting restrictions are generally inviolable unless the company ceases to exist, as long as shareholders do not agree to transfer their shares.
As the second most important form of human social organization after the state system, companies carry most of the social wealth and technological progress of modern industrial civilization; the success of individual careers and the rise and fall of nations are even closely linked to the rise and fall of companies. Understanding the role of equity is closely related to establishing a successful company.
Basic Concepts Related to Equity#
If you do not have a relatively comprehensive knowledge system regarding companies and equity, this section will explain basic concepts through a certain amount of quantitative examples related to equity, laying the groundwork for understanding equity value and some operational techniques in subsequent chapters. This chapter may require some basic knowledge of accounting and law.
(1) Registered Capital
Registered capital refers to the scale of investment made by shareholders as reflected in the registration materials of neutral authoritative departments (such as the industrial and commercial bureau). When the corporate system was first implemented, registered capital reflected the company's "financial strength" and capability; however, in later actual business activities, the company's strength and creditworthiness have no inherent connection to the size of registered capital. Even verified monetary contributions can be withdrawn in countless ways; however, to this day, a considerable number of people still measure a company's strength by its registered capital. After the reform of the commercial registration system, it is now possible to subscribe for any amount, and measuring a company's strength by registered capital has become a misconception.
Additionally, the nominal value of registered capital in China is defaulted to 1 yuan/share, and the relationship with the stock price will be further explained below.
(2) Paid-in Capital
Paid-in capital refers to the actual benefits received by the company from shareholders' contributions as reflected in the registered capital. In contrast, registered capital is merely a "declaration" at the commercial level, while paid-in capital is something that needs to be seriously "proven" at the financial level. Therefore, in the audit reports issued by accounting firms, the concepts of "capital stock" and "paid-in capital" in owners' equity refer to the concepts described here.
(3) Contribution
Contribution refers to the process by which shareholders invest their resources into the company in exchange for equity. Contributions can be made in cash or non-cash forms. Cash contributions refer to direct monetary investments, where banks transfer cash directly into the company. The process for non-cash contributions is more complex: first, non-cash contributions typically only accept "physical assets, intellectual property rights, and land use rights that can be valued in monetary terms and legally transferred." In terms of the contribution process, evaluations are usually required to determine their value. Although management of certain types of assets (such as intellectual property and trademarks) is relatively lax now, using these assets lacking fair value for contributions can cause trouble for companies needing to enter the capital market, as they may be required to undergo impairment and tax adjustments. It is worth mentioning that these assets used for contributions must also undergo ownership transfer to be considered truly contributed.
(4) Premium Capital Increase
The reason why paid-in capital is not the total investment of shareholders is that the commercial status among shareholders varies: the cost per share for founders is the lowest, requiring only 1 yuan per share, while subsequent financial investors generally must pay more than 1 yuan to acquire 1 yuan of registered capital (1 share), and the excess amount is regarded as a gratuitous investment by shareholders in the company, recorded under "capital reserve - capital premium"; this is a commonly confused area.
For example, in the phrase "new investors subscribe for the company's newly issued shares at a price of 3 yuan/share," the 3 yuan is the price paid by the investor to obtain 1 yuan of registered capital (1 share). After the capital increase is completed, the number of registered capital for this investor in the registered capital is actually the number of shares they subscribed for, while the additional 2 yuan per share premium enters the company's capital reserve - capital premium.
(5) IPO
A company's IPO is the issuance price determined through inquiries and other methods, publicly issuing shares to the public. The number of shares subscribed by the public is a certain proportion after the increase (mainly divided into 10% and 25%). For example, if the company's capital before issuance is 75 million yuan, the issuance price is 10 yuan/share, and the capital after issuance is 100 million yuan, not considering underwriting fees and other factors, the company receives cash of 2,500×10=25 million yuan, increasing capital by 25 million yuan and increasing capital reserve - capital premium by 22.5 million yuan.
(6) Relationship Between Secondary Market Prices and the Company
Changes in secondary market prices do not directly affect the company's financial statements because trading in the secondary market occurs between shareholders, and the company does not receive any funds. However, fluctuations in secondary market prices can affect the pricing of a listed company's refinancing, as according to Chinese laws and regulations, the refinancing price must be based on the weighted average price of trades over a certain number of past days. When a listed company conducts refinancing, the accounting treatment is similar to that of an IPO, increasing capital and capital reserve - capital premium.
(7) Equity Transfer
The equity transfer behavior of a company does not affect the company's own balance sheet; it merely changes the ownership of the capital stock due to the transfer between shareholders. That is, the buyer pays the transfer price for the company's equity in the form accepted by the seller; upon completion, the seller obtains the company's equity while the buyer receives the payment made by the seller.
The above statement may sound convoluted—mainly because the transfer price of equity does not necessarily involve an immediate exchange of money for goods; it may also involve using equity with market value as the consideration. For instance, a listed company may use its equity (the acquirer) to fully acquire the equity held by the shareholders of a non-listed company (the target). After the transaction is completed, the shareholders of the target become shareholders of the acquirer, and the target becomes a wholly-owned subsidiary of the acquirer. This leads to the next concept to be discussed.
(8) Mergers and Acquisitions
Mergers and acquisitions aim to achieve a change in control by increasing equity holdings. The vast majority of mergers and acquisitions are implemented through cash or equity acquisitions. Cash acquisitions are relatively straightforward, involving a direct exchange of cash for shares. However, equity acquisitions are more complex, as the acquirer seeks to inflate its own valuation while depressing the target's valuation; the target does the same. After both parties reach a compromise through negotiation, an agreement is signed at a determined price. This is commonly referred to as "issuing shares to purchase assets," equivalent to the target contributing its held equity as consideration to the acquirer in exchange for subscribing to its equity.
(9) Consolidation
The primary goal of mergers and acquisitions is to achieve "consolidation." Consolidation refers to the ability of the consolidating party to include the assets and liabilities of the consolidated party in its consolidated financial statements after certain processing, significantly enhancing the financial strength of the consolidating party.
The condition for consolidation is achieving "actual control," with the core goal being the ability to control the board of directors. Therefore, in common scenarios, holding more than 50% of shares is usually considered sufficient to meet consolidation conditions; in some cases, holding less than 50% but being the largest shareholder with a significant gap from the second-largest shareholder (e.g., 40% vs. 5%) can often occur in some publicly listed companies with dispersed equity. We believe that the latter can also meet the consolidation standard.
(10) Valuation
The equity of listed companies has a dynamic price formed by market participants. Generally speaking, this price is usually closest to fair value in the long-term trend (though not necessarily in the short term). In practical applications, we also calculate the total market value of a company by multiplying the reference stock price of the listed company by the total number of shares. The total market value does not mean that all of the company's stocks are sold on the market—if that were done, the stock price would plummet to near zero—but rather indicates the price that others would need to pay to acquire the company.
For non-listed companies, there is no price reference, so the company's value actually depends on the financing amount and ratio of each round of private equity financing. For example, if a startup raises 10 million yuan for a 10% stake post-investment, it can generally be roughly estimated that the post-investment valuation of the company is 10 million ÷ 10% = 100 million yuan. Meanwhile, subtracting the investment amount gives a pre-investment valuation of 90 million yuan.
(11) Price-to-Earnings Ratio Valuation Method
The price-to-earnings ratio method is one of the most commonly used valuation methods. The commonly referred to "×× times" price-to-earnings ratio can be simply understood as how many years it would take to recover the initial investment based on the current net profit level remaining unchanged. Suppose we purchase shares of a company at a price of 10 yuan per share, and the net profit per share is 0.2 yuan; based on the above definition, the price-to-earnings ratio = stock price ÷ net profit per share, i.e., 10 ÷ 0.2 = 50 times. If we multiply the left side of the above formula by the total number of shares, the rewritten formula becomes: price-to-earnings ratio = total valuation ÷ net profit.
What is the significance of the price-to-earnings ratio? For companies with profits greater than 0, it is positively correlated with investors' confidence in the company's future profit growth.
According to the above formula, net profit is a relatively static indicator because financial reports are released periodically, and even predictions of future performance are based on year-end or quarter-end figures, while total valuation depends on the performance of stock price and total shares. Among these, total shares are also a relatively static indicator, so generally speaking, the price-to-earnings ratio depends on stock price, which in turn depends on the balance of supply and demand for the stock. Investors will sell stocks they believe are overvalued and buy those they think are undervalued. Therefore, when investors have more confidence in the company's profit growth prospects, they are willing to accept a higher price-to-earnings ratio; conversely, if investors' confidence in the company's profit growth prospects declines, they will only accept a lower price-to-earnings ratio.
Thus, the trading price of stocks is merely a surface phenomenon; the main representation of the market's recognition of a company is actually the price-to-earnings ratio. Of course, due to the emergence of new business models and new modes, valuation methods are no longer limited to the price-to-earnings ratio. However, the price-to-earnings ratio, as the simplest and most direct valuation method, remains widely used as the basic language of the investment industry.
(12) Betting
Some sensational statements may appear in news headlines, such as "×× bets with capital tycoon ×× that the performance will reach ×× billion in 20×× year." In reality, betting is a very common technique in investment. Due to early investors being relatively disadvantaged in terms of information asymmetry and holding a small proportion of shares without decisive influence on the board, they use betting to protect their rights. The main method of betting is through so-called valuation adjustments. We can illustrate this using the simplest price-to-earnings ratio method:
Company A is performing well, with a net profit of 10 million yuan in year T, and it is expected to double each year for the next two years with sufficient funding. The actual controller of Company A, A, needs to supplement cash to achieve the aforementioned rapid development and market capture, and investor B agrees with the company's development prospects, willing to invest 30 million yuan at a post-investment valuation corresponding to a net profit of 20 million yuan in year T+1 at a 15 times post-investment price-to-earnings ratio. However, for B, a 15 times post-investment price-to-earnings ratio is not low, and the investment amount is also considerable. To protect their rights, they propose a betting clause: "A promises that Company A's net profit will not be less than 20 million yuan in year T+1." If we disregard some more detailed conditions, if the audited report of Company A in year T+1 shows that it fails to meet the target, the investor will adjust their equity holdings based on the unchanged valuation corresponding to their shareholding in the company. Note that the adjustment of equity is a matter between shareholders A and B and is unrelated to the company; betting between the company and shareholders is invalid.
Assuming Company A fails to meet the commitment in year T+1, for example, only achieving a net profit of 15 million yuan, the company's total valuation would be adjusted to 15 million × 15 = 22.5 million yuan, and 30 million ÷ 22.5 million = 13.33%. Generally speaking, A will transfer 3.33% of the equity to B as compensation at a symbolic price. Betting may also be agreed to be compensated in cash, equivalent to A compensating the investor for the shortfall in cash, but this is difficult to execute and has a low probability of occurrence.
(13) Buyback and Liquidation
Buyback and liquidation are relatively routine clauses in investment agreements, generally triggered when investors cannot exit for a long time or when significant risks arise, such as financial fraud, embezzlement, or severe business underperformance. The obligor in the buyback clause is usually the major shareholder, who, after raising funds, repurchases equity from investors at an agreed price; liquidation occurs when the company can no longer operate, selling remaining assets for distribution—generally, investors will require priority liquidation rights. The so-called priority liquidation right means that the company's remaining assets will first be returned to investors, and if there are any remaining, they will be distributed to the founders. Of course, in most cases, if it reaches the point of liquidation, investors will hardly receive anything, let alone the founders. To put it another way, if any project reaches liquidation or buyback, even if performance does not meet expectations, it is a lose-lose situation for both parties.
(14) Limited Partnership
A limited partnership is a form of enterprise that differs from limited liability companies and joint-stock companies, governed by the Partnership Enterprise Law. General partnerships consist of general partners, all of whom bear unlimited liability, which has been mentioned previously; unlimited liability business entities are very rare today. However, partnerships have a significant tax cost advantage compared to corporate entities, as they only incur a single layer of income tax on partners' income rather than corporate income tax. Thus, a compromise solution, the limited partnership, was introduced.
The characteristics of a limited partnership are that partners are divided into general partners (GP) and limited partners (LP): general partners bear unlimited liability and are responsible for the actual operations of the limited partnership, while limited partners only bear limited liability but can enjoy lower tax rates. Therefore, this business form is most commonly used in private equity investment funds.
(15) Financing Rounds
The name is not important; it is just a habit. Perhaps one day when Chinese VCs dominate global startup projects, they will be renamed A, B, C, D rounds. The currently popular full set of financing rounds is as follows:
① Seed Round
The company has not yet been established, but the team is in place and eager to go, just lacking funds. Introducing an investor to inject the first capital into the company is called the so-called "seed round," which is basically at a nominal value of 1 yuan per share. Generally speaking, this stage involves either family, wealthy friends, or personal savings accumulated from work for one's own seed round. Very few investors get involved this early; they must have a strong belief in the business model or the team.
② Angel Round
Angel investors, as a category of investment, have become deeply ingrained with the rapid rise of the internet industry, with extremely rare cases of thousands of times returns driving many funds into such early-stage projects. A classic angel investment typically ranges from 2 to 5 million yuan, accounting for 10% to 20% of equity, corresponding to a company valuation in the range of 10 to 50 million yuan.
However, angel investing is extremely high-risk. If all angel investments in the market were bundled into a fund, the overall return of that fund would be negative in most cases, even during better market conditions. In other words, the invested funds often exceed the returns generated, and this return structure is essentially akin to winning the lottery.
Therefore, in this round, investors focus on whether the company has the potential to become a "unicorn" (referring to a star startup valued at over 1 billion USD). If there is a clear market ceiling or at least the company cannot prove to investors that it has the potential for exponential growth, it will be difficult to secure angel investment during poor market conditions or more rational times.
③ Pre-A Round, A Round
After the screening in the angel round, most unreliable ideas are eliminated, entering the Pre-A or A round. In my opinion, investors in this round need to confirm the real existence of market demand externally and the team's ability to collaborate internally. The Pre-A round is an extension of the angel round; for those who have not yet met the above standards but have an attractive business model, some investors may be willing to take a chance.
After an A round of financing, the company's post-investment valuation typically reaches the hundred million level, with financing amounts in the tens of millions, which may vary significantly depending on the industry. However, regardless, after the A round is completed, a considerable amount of funds will be received, allowing the company to promote the business model validated in the angel round or to begin mass production of the product prototype.
④ B Round and C Round
Most companies that secured angel rounds are eliminated after the A round, leaving those that reach the B and C rounds, which are relatively later financing rounds. At this stage, the company's operational results will be primarily tested. If profits can be achieved or even a preliminary break-even point is reached, that is naturally the best outcome; however, they usually still focus on business revenue and other indicators. Losses are not a concern; what matters is whether market share can be gained. For some "burning money" O2O startups, each round of financing needs to be timed carefully, as failure to secure financing often means defeat in competition due to depletion of resources, hence the origin of the term "C round death."
At this stage, the market begins to concentrate on a few companies, and competition becomes fierce. Companies at this stage often attract the attention of BAT (Baidu, Alibaba, Tencent); whoever can first gain support from the three giants often wins in competition.
⑤ Pre-IPO Round
Companies that survive to the C round typically begin to approach the milestone of an IPO, but whether in the Chinese or American market, IPOs are very harsh for unprofitable companies. Only the most outstanding and attention-grabbing star companies (like JD.com) are likely to successfully IPO while still in a loss-making state. In fact, the market's attitude toward IPOs is quite realistic, which is why funding similar to Pre-A is needed to allow companies to enter overtime to prove their value and ultimately achieve an IPO. Unfortunately, during poor market conditions, many so-called "unicorns" experience price inversions during their IPOs compared to private financing prices. More companies ultimately get acquired by giants or merge under capital facilitation to complete their exit.
How Equity Realizes Value
Because equity can yield future benefits, it undoubtedly has value. But how should one identify the value of equity? Here, I will provide references from three perspectives: control rights, income rights, and liquidity premiums.
- Control Rights
First, using a metaphor, this economic community is like a parliamentary small country, with a head, government, legislative body, and judicial body. Our equity is the ballot for this small government; with the amount of equity we hold, we can vote to obtain board seats at the shareholders' meeting, and the board of directors formed by the directors is the permanent decision-making body of this small country, determining its strategy and important matters; the board can decide on the management team, including the general manager and executive team, who are the prime minister and cabinet of this small country, responsible for daily affairs and operational decisions. Through the amount of equity, we can also vote to obtain supervisory seats at the shareholders' meeting, where the supervisory board can oversee the daily operations, major decision-making, and financial status of the board and management. Therefore, holding equity in a company means having a portion of control over that company.
When equity is traded on exchanges and other secondary markets, it is more commonly referred to as "stocks." Due to the large scale of listed companies, the equity held by small and medium investors—or what is commonly referred to as "retail investors"—has very little control over the company, let alone appoint directors or control personnel decisions. However, in extreme cases, such as hostile takeovers or battles for control of a listed company, the scattered equity held by small and medium investors can be concentrated to provide the control that the attacking party urgently needs, which is why stock prices often experience significant premiums during hostile takeovers or other special events. This value was previously only found in economics or finance textbooks, and for most retail investors in the market, it was merely a distant story from America. Hostile takeovers signify the comprehensive maturity of the capital market, and the value of control rights will be rediscovered and excavated.
For capital tycoons, controlling a company in various ways (reaching a level where it can be consolidated financially, including several standards: being the largest shareholder, absolute control, controlling the board, etc.) brings benefits not only from the company's financial statements but also from driving the entire company to implement their greater interests and higher will with relatively small equity. Very tangible benefits, such as significantly expanding the group's financial strength after consolidation, can lead to more credit or acquiring similar assets under the same control. At the very least, the company's business jet, luxury car, and ocean-view office will belong to the actual controller. As the capital market matures further in the future, events such as hostile takeovers will become more common, and investors will increasingly understand the value of control rights attached to the stocks they hold.
- Income Rights
Secondly, holding equity serves as a distribution certificate for the benefits obtained from the operations of this economic community. Classic equity distribution is based on the proportion of shares held relative to the total number of shares. Suppose a company has 1,000 shares, and someone holds 1 share, and the company decides to distribute 1,000 yuan in dividends that year; then that person holding one share can receive 1 yuan.
Next comes the content from political classes. As a certificate for company dividends, the expected future dividends discounted over time and summed up represent the intrinsic value of the stock. But is it really that simple? Clearly not; companies are not static, deterministic machines but rather living organisms that grow, age, become ill, and die. A company that can continuously adapt to market demands and make changes will see its income grow in line with the overall growth of the human economy in the long run. For example, some companies that have been listed for over 50 years have seen their equity appreciation far exceed the aforementioned original estimation methods. Although countless companies have failed and disappeared throughout history, if we examine the entire securities market as a whole, the probability of equity outperforming inflation is the highest.
Therefore, when considering the factors influencing stock prices, growth potential must also be taken into account—not only the company itself but also the industry in which the company operates and even the growth potential of the country in which the company is located. In emerging markets like China, listed companies are often subject to a controlled number, and more often than not, they carry a premium for horizontal integration of industries: through mergers and acquisitions of non-listed companies by listed companies, the scale of net assets per share and net profits per share can be expanded.
- Liquidity Premium
Finally, to facilitate the trading and exchange of the aforementioned control rights and income rights, companies generally need to be public or listed. Non-listed companies, except for a few specific industries, find it difficult to survive in fierce competition over a decade, especially after the departure of the founding figure. This is because the capital market can provide listed companies with convenient financing channels, social recognition, and help attract talented individuals, which are scarce resources for most enterprises, while non-listed companies struggle to compete with the efficiency of obtaining these resources.
The term "listing" not only refers to IPOs but also includes the option of being acquired by listed companies, transforming the equity of the acquired company into equity of the listed company through a share exchange. In this process, the company's equity becomes a standardized product, which we refer to as capitalization.
The most important characteristic of capitalized equity is its liquidity, meaning many people want to trade the stock. We know that the price of any commodity depends on supply and demand—in China, due to the issuance system's suppression of supply, new stocks often experience excessive demand upon listing, leading to significant appreciation in stock prices before and after issuance. Of course, star startups in the U.S. also enjoy similar "treatment" upon listing, but comparatively, the average quality of IPOs in China is still lower.
Thus, obtaining liquidity premiums is a value that startup teams in China can relatively easily acquire. In industries such as machinery manufacturing, chemicals, and metallurgy, in developed capital markets, companies can only seek to be acquired by giants to achieve securitization; however, in China, as long as there is a certain scale of net profit, independent IPOs are still entirely possible.
Equity Incentives#
Equity incentives refer to the additional rewards provided by company shareholders and management to key talents to encourage them to work better, linked to the company's equity, maximizing the interests of both parties.
The main purpose of establishing equity incentives is to resolve the conflict of interest between key talents needed by the company and the company's shareholders. In simple terms, it is to ensure that these key talents can receive corresponding returns when shareholders benefit, which encourages them to consider shareholder returns more during their work. The simplest way to achieve this is to make these key talents shareholders of the company and grant them equity conditionally based on set indicators.
Although the principle seems uncomplicated, implementing options is not so easy. For employees, if the conditions are too harsh or the consideration is too high, the attractiveness of equity incentives is poor, and it would be more practical to offer cash; if the conditions are too lenient or the consideration is too low, it would mean giving away equity for free to the founders. Of course, this book does not aim to propose a universally applicable method for setting up equity incentives; a mutually agreed-upon equity incentive plan is not a conclusion derived from a mathematical formula or financial economic model but rather a consensus reached through continuous exchanges of interests and negotiations between both parties. The intention of this book is to provide some references for the negotiation between employees and companies by introducing different methods of equity incentives and their corresponding advantages and disadvantages.
- Classification of Equity Incentive Plans
(1) By legal form, it can be divided into actual shares, options, restricted stocks, virtual stocks, etc.;
Actual shares are directly given to the company through capital increase or transfer from existing shareholders; options refer to contracts that allow obtaining company shares at an agreed price at a future time with additional conditions; restricted stocks refer to initially acquiring shares at a low price, then being assessed based on performance at a future time, with unqualified portions being canceled, while qualified portions become actual shares; virtual stocks do not involve signing a shareholding agreement or being reflected in business registration materials but distribute company profits according to certain rules.
(2) By granting object, it can be divided into partners, key personnel, all employees, etc.;
Partners refer to leadership talents who can bring unique resources to the company or independently manage various aspects of the company's business departments, designing the company's business development direction and strategy; key personnel refer to expert talents who can lead teams to achieve business goals, obtain orders, or complete research and development.
(3) By income method, it can be divided into common stock, indirect shareholding, cash income rights, etc.;
Common stock refers to the equity directly held by shareholders as reflected in business registration and shareholder lists, corresponding to indirect shareholding; indirect shareholding refers to holding equity through a specialized shareholding platform, then indirectly holding company equity by becoming a shareholder of the equity incentive platform; cash income rights refer to direct cash distribution according to certain rules.
(4) By entrepreneurial stage, it can be divided into startup, growth, and maturity stages;
The stages are relative and do not have particularly strict divisions. Even in the commonly understood maturity stage marked by an IPO, there may still be significant growth potential after the company becomes a listed company. Therefore, we simply assume here: the startup stage is when the company is in the early investment phase, promoting exploration and validation of the business model; the growth stage is when the company finds its business model and generally determines its direction, gaining market recognition and starting to see an increasing market share; the maturity stage is when the company begins to generate profits or occupies a significant market share, influencing the market itself.
- Differentiated Considerations for Equity Incentives Based on Different Classifications
The above classification methods are not isolated; there are correspondences between these methods. For example, for different levels of granting objects, appropriate granting methods and approaches should be considered in conjunction with actual situations. Next, I will briefly explain according to the above classifications.
(1) Different granting objects have different characteristics and demands
In my opinion, the characteristics and demands of different granting objects can refer to the following table:
For partners, their participation in entrepreneurship is an expectation to ride the wave of future BAT and become figures remembered in Chinese business history; offering money or very little equity or options may not be necessary for them, as they might have more stable and well-paying positions in large companies.
For mid-level key personnel, they hope to achieve financial freedom through the appreciation of equity while not wanting their current standard of living to be significantly impacted by entrepreneurship. Therefore, they are usually provided with options that come with performance conditions. They do not need to invest cash upfront, but if they perform well, they can receive a promise of attractive returns.
For ordinary employees, I personally believe it is not advisable to use full employee equity incentives in the early stages of development: on one hand, the company's failure probability is still high, and the value of equity incentives is low, so employees may not appreciate it; on the other hand, if the company succeeds, excessive equity incentives issued early may be overly generous for some early employees who contributed little. This perspective may differ from that of other practitioners and is for reference only.
However, it is certain that it is inappropriate for startup companies to distribute equity to all employees like crowdfunding; it is not just a cost issue but also because the governance costs of the company will become unprecedentedly high—holding a shareholders' meeting would require signatures from a dozen or twenty people, and if there are differing opinions, it may lead to disputes and lengthy legal processes. Moreover, if the number of shareholders in a limited company exceeds 50, it would be illegal. Additionally, ordinary employees do not inherently have a demand for control rights over the company; even if given to them, they may not utilize them effectively.
(2) Different legal forms of equity incentives have different applicable scopes
Actual share incentives are the simplest to give away, but the cost of reclaiming them is high. As previously mentioned, equity obtained without accompanying restrictions is difficult to reclaim through means other than buyback, and for a company with a promising future and enthusiastic investors, the cost of buyback is also significant. Additionally, changes to actual shares require going through business registration procedures, which vary by location; they also require various shareholder signatures, leading to substantial time and effort costs. If a company is preparing for an A-share IPO, shareholders generally cannot change.
Options are the most flexible, as they can be fully effective, partially effective, or entirely void. There is no initial investment required, and if the company fails, there is no risk, making the initial costs for both parties the lowest. However, if an individual signs an options contract with the company, there may be tax issues. Exercising options will reduce the company's net profit, affecting performance against investors; individuals will also need to pay taxes, and crucially, startup companies may not be listed, making it difficult to quickly liquidate the equity while still needing to pay a significant income tax upfront. Of course, in actual entrepreneurship, most companies will not take such risks, and relying on professional guidance incurs additional costs.
In restricted stock plans, employees initially invest at a relatively low price, and if they meet the conditions of the incentive plan, the stocks are unlocked in stages; if they fail to meet the targets, the corresponding portions or all shares will be forcibly repurchased and canceled. This method often appears in A-share listed companies and companies on the New Third Board, but startups generally do not use it, as it is less convenient and does not mitigate risks compared to options.
Virtual stocks are even less common, resembling a company raising funds from employees and distributing cash profits according to agreed amounts or ratios when the company generates profits in the future. However, this system carries significant legal risks, and ordinary companies should avoid casually engaging in it, as it can easily lead to illegal fundraising situations that harm both parties.
(3) The convenience of cashing out from different equity incentive methods varies
Cashing out common stock is relatively straightforward, whether through actual shares, options, restricted stocks, or other methods. Ultimately obtaining shares from a listed company or the most likely company to go public is undoubtedly the most convenient, as it not only facilitates sales and simplifies value assessment but also provides full autonomy.
However, indirect shareholding is relatively more complicated. Indirect shareholding is held through a shareholding platform, typically in the form of a limited partnership. The advantage of indirect shareholding through a limited partnership is that it allows for unified management of a small amount of equity, and for companies preparing to go public, it is crucial to avoid the hassle of frequent business registration changes due to personnel fluctuations. For incentive recipients, limited partners in a limited partnership generally do not have voting or management rights, so the voting rights of the company equity held by the limited partnership are actually in the hands of the general partner. When conditions are met and liquidation is needed, the limited partnership must first reduce its holdings before distributing profits to the incentive recipients.
Cash income rights are essentially a special bonus linked to stock price performance, with a straightforward implementation method that directly distributes cash based on calculated results. However, non-listed companies find it difficult to assess the price of equity, making it challenging to distribute this bonus. Moreover, I personally feel that designing cash income rights is not very necessary; it would be more scientific to directly distribute bonuses based on performance commissions or other performance evaluations.
(4) The tax burden and timing of tax payments differ among various equity incentive methods
The equity incentive process involves numerous personal income tax matters; understanding the tax burden and timing of tax payments is beneficial for assessing whether an equity incentive plan is worthwhile:
① Market Price Benchmark Capital Increase
Commonly seen in some listed companies' private placement plans. Generally speaking, this method has a high entry cost but a low tax burden; there is no tax burden at the time of capital increase, and only a 20% tax is levied on the difference between the selling price and the cost when sold. However, due to the severe information asymmetry in Chinese listed companies, private placements targeting insiders often establish positions at a low point in a phase. Of course, this approach carries considerable market risk and should be decided cautiously.
② Options
The advantage of options is that no upfront investment is required, and they can be settled in stages based on final results. The amount obtained is calculated based on the fair price on the exercise date (usually the market price) and then included in the total salary income; personal income tax is calculated based on different brackets, with the highest bracket reaching 45%. Since the exercise price is often symbolic, even if the stock has not yet been sold, cash outflows may occur during the exercise. For the actual controller of the company, the only downside of options is that they are not supported for companies preparing for an IPO.
③ Restricted Stocks
Restricted stocks are a structure widely used in listed companies, primarily where the incentivized party increases capital at a relatively low price, and after assessment, the unqualified portions are canceled, and the capital invested at that time is returned, while the qualified portions are unlocked as common stock. The tax burden is similar to that of options, but it requires upfront investment, creating significant financial pressure. Additionally, the funds for the unqualified portions must undergo share cancellation procedures after being returned, which typically only listed companies can do.
④ Cash Income Rights
Using cash settlements linked to performance evaluations or stock price performance as rewards is generally included in salary income. For the same reasons as before, this will be briefly mentioned.
(5) Different equity incentive methods and objects should be considered based on the company's development stage
In the early stages of a company's establishment, partners should be allowed to contribute capital, but the number of partners should not be too large. As entrepreneurship becomes increasingly youthful and diverse, many startups attract numerous partners at the outset, but by the time the company has gone through two or three rounds of financing, the stock value has risen significantly, often leading to "partners" who are part-time or do nothing. Since actual shares can only be repurchased and there are no other ways to reclaim equity, various troubles may arise; therefore, it is recommended to only grant actual shares to partners who are fully committed to entrepreneurship.
Once partners are determined, it is best not to change them easily. It may be considered to agree on a certain period of service with partners; if they leave before the term expires, a portion of their equity can be repurchased at a certain price to avoid situations where "when people leave, equity is still held." However, if such clauses are included, they will inevitably reduce the attractiveness to partners; the balance between these considerations is what entrepreneurs must contemplate.
In the startup phase, as the team is usually small, it is challenging to distinguish between "key personnel" and ordinary employees; therefore, we recommend setting up a certain options pool, with the founders holding them initially. As the company grows, the team expands, and the previously flat company structure begins to show some hierarchy, options should be recognized and rewarded as a form of acknowledgment for key positions such as technical talents, sales experts, and administrative managers, rather than as a "universal" benefit. Additionally, it is advisable to set the exercise price based on the most recent round of investors' pricing and tie it to continued employment in the company, so that when it comes time to liquidate, employees, while not needing to invest upfront, can accumulate a considerable profit, enhancing their commitment to continue serving the company and effectively reducing turnover rates for key positions.
I personally believe that only after the company matures should it consider full employee equity incentives or employee shareholding; by then, the company's equity will have a relatively fair price reference, and employees will have clearer expectations for their future exits. Therefore, establishing plans such as full employee shareholding, allowing employees to purchase shares at a certain discount based on market prices in private placements, is a common practice among A-share listed companies.
- Different financing rounds have different values and cash-out methods
Equity incentives exchange future equity for employees' hard work; therefore, to make a rough judgment on the value of equity incentives, one must first have a concept of the approximate price of equity.
In the seed round, equity pools or a small number of options are often set up, as the team is still in the process of adjustment and trial and error; if disagreements arise, both the company and employees can be more open to adjusting their initial choices.
By the A round, the team typically begins to rapidly increase in size as the business is officially commercialized, with veteran employees who have successfully navigated the business stepping into small leadership roles—if in some highly competitive industry categories, instances of mutual poaching may already occur. Therefore, after completing A round financing, providing options to these veteran employees with strong business qualities is a good opportunity; on one hand, the company's prospects become more optimistic with the arrival of A round funds, making employees more willing to participate in equity incentives at the expense of some cash compensation; on the other hand, if the company can successfully exit in the future, the consideration for the A round will be relatively appropriate for those who have contributed to the company since its inception.
By the B and C rounds, the company has grown into a relatively well-known entity, and the options gradually become exercisable. After exercising options, the company's equity in subsequent financing rounds often allows for a small amount of sale to subsequent investors. The price of this equity is based on the pricing of subsequent financing rounds, but it should be noted that exercising options theoretically requires paying personal income tax, and converting options into actual shares requires a sum of exercise funds. B and C rounds will also continue to issue options, but the consideration will inevitably be higher.
As for companies approaching an IPO, the value of the options held increases, and holding company equity becomes a form of wealth; the premise is that the company can successfully go public. As employees, it is essential to fully understand the company's future prospects—how much annualized return can be obtained is secondary; the most important thing is whether an exit can be realized. At this stage, the issuance of options will become more cautious, as the likelihood of cashing out increases, making them more attractive than cash compensation.
Entrepreneurs and Equity#
The content of this section is based on my not-so-senior experiences in the primary market. It merely provides a perspective and should not be taken as a standard answer.
- The equity distribution at the beginning of entrepreneurship is crucial for success or failure
To put it further: successful startups often have a reasonably designed equity structure; conversely, if the equity structure is poorly designed, the probability of failure increases significantly.
Here are a few unfavorable situations:
(1) Excessively dispersed equity
Everyone has their own ideas, especially when there are many shareholders, each hoping the company operates according to their vision. If the shareholders are very dispersed at the company's inception, the limited resources will be consumed in endless disagreements and disputes. There may be seven or eight ways to handle a particular issue, of which two or three might be correct; generally speaking, it suffices to choose one approach and proceed. While choosing the right direction is crucial, quick decision-making and implementation are equally important for startups.
Even if the company manages to navigate through disputes over operational direction, when most shareholders unconditionally support a particular leader's decision, they often find that their equity is insufficient when the company needs financing. Losing absolute control is not the end for founders, but if the founders' equity is too small, it may lead investors to worry that the founders have lost their motivation to strive, resulting in them not investing in the business from the outset.
Equity is a long-term resource; using it to exchange for easily replaceable and short-term resources would be very unwise. Of course, in a sense, equity financing is also unwise, but there are no other options.
(2) Partners who contribute capital but not effort
Many startups initially attract enthusiastic partners who eagerly draft resignation letters, invest money, and wait for year-end bonuses before quitting to embark on a grand venture. When the promised time arrives, some individuals find themselves unable to participate for various reasons—yet they promise to handle the company's affairs in their spare time, waiting for the company to secure angel funding before they fully commit. Friends, seeing that they are all old acquaintances, hesitate to speak up, and they push through to keep the company going. However, when the company begins to seek A round financing, they discover that this individual’s equity has skyrocketed from tens of thousands to millions, and when it comes time to contribute, their regular job is too demanding. When asked to come out full-time, they demand a salary far beyond what the startup team can afford. What began as a friendly partnership can quickly turn sour, but actual shares cannot be expelled. Ultimately, they may have to be removed during the A round, incurring significant costs.
Such stories are not uncommon, and the lesson for entrepreneurs is: partners who do not commit full-time should only be granted equity if they are truly exceptional and indispensable; otherwise, those who will do the work should hold the equity temporarily until they are fully on board. It is advisable to impose certain constraints on partners during the startup phase to minimize such free-riding situations—remaining in the company while those who work hard are unfairly treated and occupy valuable equity space.
(3) Coal bosses as financiers
There is no intention to demean all coal mine owners; this is merely a depiction for readers: individuals over 40, from traditional industries, with low educational backgrounds, but who are quick to fund and can bear losses. For some traditional industries, finding a financier is a good thing.
However, for some emerging industries, having such a financier may not be beneficial. Due to their past business experiences, financiers instinctively propose many "suggestions" and "ideas," even intervening in company operations. Simultaneously, due to their concerns about the safety of their investments, they often demand to hold a significant amount of shares or even control. If both of these situations occur, it essentially signals the end of that startup.
For professional investors, controlling a company in the early stages is not a good idea. On one hand, once the entrepreneurial team loses control, their stance will gradually change, as legally, the company no longer belongs to the entrepreneurs, leading to a loss of motivation and morale; on the other hand, while investors may have researched the industry, they generally cannot truly operate a company. If investors cannot deploy a management team while holding a majority stake, they must rely on the entrepreneurial team with minority stakes, which can lead to moral hazards for the entrepreneurial team. Therefore, investors obtaining control of the company too early is something both the entrepreneurial team and investors want to avoid.
However, for companies in later rounds, why is it not a problem if the founders' equity has been significantly diluted? Because when the company is larger (after the B round), financing cannot come from a single investor, and the founding team usually retains significant decision-making power. Additionally, the interests of the founding team have become substantial; even a 20% to 30% stake is still a considerable number, ensuring sufficient incentive effects.
- Establishing a reasonably planned equity usage strategy is crucial for the company's long-term development
We often hear the term "financing rhythm." Financing rhythm includes not only the timing of financing but also considerations of financing ratios. Below are some matters worth considering regarding financing rhythm:
(1) Financing time windows
Generally speaking, financing is based on the company's planned use of funds over the next few months, calculating when funds will run out and allowing for a buffer of several months. Additionally, the company needs to consider whether its business can achieve breakthroughs during the financing window or whether certain technologies or products can be developed during this period, which significantly aids the success rate of financing.
(2) Financing efficiency
Equity is a limited resource, and each round of financing incurs substantial costs, including the time required for communication between founders and multiple potential investors, the time for various discussions and negotiations, travel expenses, and the time and costs associated with due diligence. These can become significant fixed expenses. Moreover, the monetary costs are merely a small part; the most crucial aspect is that it consumes the founders' valuable energy and intellect in outsmarting investors.
Therefore, generally speaking, except for the relatively short interval between the seed round and the A round, subsequent financing rounds are usually recommended to be spaced at least one year apart. Thus, entrepreneurs should conduct detailed calculations regarding their funding usage and cash flow situation. Ultimately, entrepreneurs should consider the balance between efficiency and consideration: the more mature the company, the higher the financing consideration; the earlier the company finances, the lower the consideration, but it can lead to faster maturity.
(3) Reasonable equity distribution planning
In traditional industries, a company often requires a long time to accumulate before becoming a listed company, and typically, after reaching basic maturity, it will push for a performance surge before introducing investors. Therefore, in such companies, the proportion of investors is often small, and it is not uncommon for the actual controller to hold over 50% of the equity even years after going public. In some extreme cases, companies may accumulate rapidly without ever introducing investors before going public.
However, it is challenging for emerging industries to achieve this, mainly because the risk capital forces in society have significantly increased, meaning that the priority of achieving profits is overshadowed by the priority of capturing market share, leading to unprecedented competition, and even causing first movers to be crushed by later entrants through financing. Therefore, mastering the financing rhythm requires not only considering the current round but also planning for the next round in advance.
An ideal rhythm from an investor's perspective is to release 10% to 15% in each round, allowing the company to achieve overall exit after about three rounds of financing, with founders retaining approximately 30% to 40% and employees taking around 10% to 15%, resulting in a win-win situation. Of course, entrepreneurship is brutal; each round of financing is a hurdle, and most companies will be filtered out at each round, so there is no need to make equity planning overly precise.
- Some small common knowledge about company governance and equity
(1) Joint-stock companies must adhere to the principle of "same share, same rights," meaning that each vote's rights and obligations must be identical. When extended to equity-related transactions, the same batch of equity must be at the same price. However, limited companies do not necessarily have to comply with this, so investment agreements for limited companies can be very diverse—if it is a VIE structure with dollar funds, the terms can even be more varied, with investors writing all favorable terms for themselves into the investment agreement.
(2) The articles of association of limited liability companies can be highly customized, as long as they comply with the requirements of the Company Law and other regulations, allowing for many stipulations in the articles. However, a customized articles of association may lead to complications during the due diligence process for financing. Joint-stock companies do not have as much freedom; if they are listed on the New Third Board or in the stock market, their articles are subject to regulations issued by the exchange.
(3) Supervisors may seem to hold a trivial position, but they also have the power to convene temporary shareholders' meetings, attend board meetings, and submit proposals to the board. However, directors can also serve as company executives, while supervisors cannot.
(4) Entrepreneurs, especially in startups, should not use company funds for personal matters, as investors are extremely wary of such situations; this could even lead investors to demand early buybacks.
(5) In the event of a shareholder exit, it is generally done through transfer, meaning that funds are provided by the shareholder to the exiting party, and the company typically does not return funds to shareholders. The main reason is that shareholder exits must be announced to all creditors and require their consent. Additionally, if there is more than one investor, investment agreements often include binding exit clauses, meaning that if one party proposes to exit, they can also request to exit under the same conditions. For example, if the company has only 3 million yuan in cash, and investors A and B each invested 5 million yuan, if one wants to exit, the other may demand equal treatment, meaning each can only receive 1.5 million yuan, which is insufficient. Therefore, once a company faces problems, it is challenging for investors to retrieve their funds.
(6) In extreme cases, when investors demand liquidation of the company, they often have priority liquidation rights in their investment terms, meaning that in the unfortunate event of bankruptcy, the remaining value will first be used to repay the investors' contributions.
(7) It is best to avoid situations where there is a single natural person shareholder, as this can lead to problems in the event of poor management, such as "piercing the corporate veil" and pursuing unlimited liability.
(8) The so-called "preemptive right" means that if a limited company shareholder intends to transfer equity externally, existing shareholders have the right to purchase it at the same price; if they are unwilling to match the price, this right becomes invalid—this restriction does not apply to joint-stock companies.
(9) Anti-dilution clauses refer to investors' unwillingness to see their equity devalued, requiring that the entry price for subsequent investors cannot be lower than theirs; otherwise, compensation is required (ratchet clauses). Of course, in some extreme cases, to ensure the survival of the company or to achieve an exit with minimal losses, existing investors may also make certain concessions. As of the completion of this book, some "unicorns" experienced price inversions during their IPOs compared to previous rounds of private financing, triggering the aforementioned compensation clauses. Such clauses are not permissible in the mainland A-share market.
New Third Board Companies and Equity#
The New Third Board has evolved from being relatively unknown in 2012 to gaining prominence in 2013, and now it frequently appears in media reports. What exactly is it? What is its relationship with listing? As a practitioner, I will discuss the New Third Board comprehensively.
- Origin of the New Third Board
The New Third Board originated in Beijing's Zhongguancun, primarily involving relatively high-tech enterprises. The term "New" Third Board refers to the existence of an "Old" Third Board, which mainly facilitated the transfer of shares for delisted companies, including the STAQ and NET transfer systems from long ago. The Old Third Board has essentially died out, as the number of companies in Zhongguancun was limited, leading to very few transactions on the New Third Board at that time, resulting in extremely low trading activity.
In 2012, the New Third Board expanded to four national-level high-tech parks, significantly broadening its project sources. At this point, it is essential to mention Shenwan Hongyuan. The investment banking department of Shenwan was relatively low-profile, but while other brokerages focused on IPOs, Shenwan quietly engaged in a large number of New Third Board projects that others overlooked.
At the end of 2013, the China Securities Regulatory Commission announced the nationwide expansion of the New Third Board, opening it to all companies. On January 24, 2014, the New Third Board saw 285 companies listed at once, reaching a total of 621 listed companies, marking the official establishment of the New Third Board as a national securities trading market.
By March 6, 2015, a total of 2,026 companies had been listed on the New Third Board, making it relatively large in terms of both quantity and total market value.
- Requirements for Opening a New Third Board Account
First, the threshold for opening a New Third Board account is relatively high, with the following conditions:
(1) Individual New Third Board Account Opening Conditions
① Requires more than 2 years of securities investment experience (the starting point for investment experience is the date of the first stock transaction in the investor's name in the national small and medium-sized enterprise share transfer system, Shanghai Stock Exchange, or Shenzhen Stock Exchange), or a background in accounting, finance, investment, or related fields.
② The market value of the investor's securities assets in their account on the previous trading day must exceed 5 million yuan. Securities assets include customer trading settlement funds, stocks, funds, bonds, and collective financial products from securities firms, excluding credit securities account assets.
(2) Institutional New Third Board Account Opening Conditions
① Legal entities with registered capital of over 5 million yuan;
② Partnerships with a total paid-in capital of over 5 million yuan.
Compared to the main board, small and medium board, and growth enterprise board, the threshold is significantly higher. This also determines that under the current threshold, generally only professional investors participate in this market, leading to relatively low activity.
- Trading Methods on the New Third Board
The trading methods on the New Third Board mainly include the following two types, plus one that is planned for launch:
(1) Agreement Transfer
This method is relatively informal; one can place orders for others to click and complete transactions or set a secret code for the transfer, requiring that the transaction amount, code, and price must be identical, with opposing buy and sell directions. Additionally, there are no limits on price fluctuations, leading to significant price volatility. Generally speaking, liquidity for agreement transfers on the New Third Board is poor, and the vast majority of companies listed have never completed a transaction.
(2) Market Making Transfer
A brief introduction to the concept of "market makers." Market makers are essentially like wholesalers, obtaining inventory shares from market-making companies. When investors need to buy or sell stocks, transactions do not occur directly between investors but rather through market makers as counterparties, who have an obligation to transact as long as the price is within the quoted range. Therefore, market makers provide liquidity to the New Third Board, making equity more liquid compared to agreement transfers.
(3) Auction Trading
This has not yet been launched but is tentatively planned to use the same auction trading method as the main board and growth enterprise board, with some thresholds such as investor access being similar to those of the main board. At the same time, we expect that companies participating in auction trading will introduce a dedicated trading tier, with thresholds being more lenient compared to the above two methods; of course, correspondingly, companies in the auction trading tier will also be the most outstanding.
- Conditions for Listing on the New Third Board
(1) Must have a clear main business and a record of sustainable operations;
(2) The governance structure of New Third Board companies must be sound and operations must be 规范；
(3) The issuance and transfer of shares must be legal and compliant;
(4) Sponsored by a broker;
(5) Must have been in continuous operation for 2 accounting years;
Compared to IPOs, the above requirements are not problematic; the key is whether the enterprise has long-term development potential and the entrepreneur's determination to operate 规范. From the entrepreneur's perspective, the requirements for the New Third Board are essentially as follows:
(1) It is inconvenient; the company's money belongs to the company, and the entrepreneur cannot use it casually; external small wallets must be managed and consolidated. Although the company's decisions are still ultimately made by the major shareholder, there must be decision-making procedures, and everything must be handled according to procedures;
(2) Taxes must be paid 规范；some companies have not paid income taxes, and past dues must be compensated, which involves real cash outflows;
(3) The company's financial statements and operational conditions are publicly displayed, which can lead to awkward situations or even disputes with competitors, customers, and suppliers.
Thus, the cost of the New Third Board is not merely the direct fees for intermediary agencies but also includes the above considerations. We hope that enterprises can genuinely consider whether they can meet these three requirements.
- What is the process and time frame for the New Third Board?
The main process is as follows:
(1) Due Diligence and Plan Design
Brokers, accountants, lawyers, and enterprises reach a preliminary cooperation intention, spending 1 to 2 weeks conducting initial due diligence to identify significant issues, followed by discussions on the following questions:
① Is it feasible? Are there any insurmountable obstacles under the current circumstances?
② What major issues can be resolved over time, and how long will it take?
③ What are the estimated compliance costs, and how can they be balanced with the time required?
④ Specific rectification and implementation plans, briefly mentioned;
If the initial due diligence results are favorable, the findings will be submitted to their respective risk control departments for internal review. Once the internal review is approved, a formal cooperation relationship is established, and work begins.
(2) The three institutions enter the scene to conduct comprehensive due diligence and write a public transfer statement.
The workload for accountants is the largest, as they provide the foundational data required for subsequent decision-making and declaration documents, establishing the company's accounting system to meet the basic requirements of the New Third Board.
Lawyers and brokers collaborate to review the company's history, checking for any equity issues, related transactions, and competition; if any exist, they must be resolved. They also verify that all relevant regulatory authorities have been legally operating; if issues arise, they assist in resolving them.
Once the company has undergone sufficient rectification, it will convert from a limited liability company to a joint-stock company based on the timing of the audit report. If a few companies were initially established as joint-stock companies, this step can be skipped.
(3) Formal Application
First, the three institutions submit their internal reviews to their respective risk control departments again; once approved, they can submit applications to the National Small and Medium-sized Enterprise Share Transfer Company.
After the materials are submitted, the share transfer company will inquire about certain issues from the project team and the enterprise. If there are no problems after feedback, they will receive a "no objection letter" from the share transfer company, allowing them to handle equity registration and allocation of abbreviations and codes.
(4) Listing
After listing, stocks can begin trading, but generally, it is quiet, unlike the lively ringing of bells during an IPO. Most companies involved in agreement transfers remain relatively unknown, and the public's entry threshold is high. More importantly, compared to IPOs, the New Third Board lacks a public issuance phase, meaning external investors do not hold shares, resulting in little trading activity...
This is a brief overview of the listing process. If the company's history is relatively simple and its finances are well-organized, it can be completed in as little as six months.
- Significance of the New Third Board
The value of the New Third Board lies in:
(1) Standardizing the company's equity
The reform process of the New Third Board effectively transforms the company into one that meets the basic requirements of the capital market. Therefore, compared to non-listed companies, if a listed company seeks to acquire it, the financial data of New Third Board companies is authentic, and the foundational work is generally well done, significantly reducing the risk of information asymmetry.
(2) Certain financing capabilities
Many institutions tell companies that listing on the New Third Board will enable equity financing and allow for equity pledge financing, but the reality is often less rosy. Indeed, there are many financing cases on the New Third Board, and some large-scale financing amounts reach billions, but the financing capability ultimately depends on the company's operational status rather than merely being listed on the New Third Board. The New Third Board undoubtedly helps with financing limits and costs, but it does not mean that poorly performing companies will definitely secure financing after listing under relaxed conditions.
If a company is in good condition, it can raise funds through private placements, and some relatively advanced and well-managed companies are pursued as eagerly as those on the main board and growth enterprise board, but this is still rare.
(3) Providing price discovery
For companies that have essentially met the legal requirements for the growth enterprise board or even higher, the valuation premium provided by the New Third Board is undoubtedly valuable. The consideration for mergers and acquisitions of non-listed companies is generally below 15 times, with a few better industries being slightly higher, while the consideration for New Third Board companies is significantly higher than that of non-listed companies in the same industry.
Market makers significantly enhance the overall valuation of companies; on one hand, market making requires brokers to invest real money in enterprises, with strict screening, implicitly guaranteeing the brokers' reputations; on the other hand, market making provides the New Third Board with the liquidity that is scarce—allowing for easy buying and selling. Undoubtedly, liquidity also carries a price.
Thus, the aforementioned valuation enhancement greatly increases the acquisition value of the shares held by shareholders. To clarify, the wealth realization measured by market value does not mean that shareholders will sell all their stocks—if they did, the stock price would plummet to rock bottom—but rather indicates the price that external investors would need to pay to acquire the company.
Therefore, the overall acquisition consideration for the company also increases. For some small, refined companies looking to "sell themselves," the New Third Board is undoubtedly valuable.
(4) Enhancing visibility and investor recognition
When a company lists on the New Third Board, it gains hidden credibility from brokers, accountants, lawyers, and the share transfer company, making it easier for investors to find them. Since the company's information is displayed on a national platform, it undoubtedly has advantages in seeking investors, provided the company is performing well. Additionally, to my current knowledge, many asset management subsidiaries or funds of brokers have begun raising New Third Board investment funds, targeting selective investments in New Third Board companies. In the future, perhaps the financing function of New Third Board companies can indeed be enhanced.
Moreover, as the company showcases itself on a national market, it benefits both the company's image and employee recognition.
(5) Serving as a test for IPOs
The entire process of the New Third Board can serve as a test for the company team, the service level of intermediary institutions, and the market's understanding of the company. Compared to non-listed companies, those listed on the New Third Board will undoubtedly face different levels of scrutiny, especially after the future review is delegated to exchanges.
As for the channel for transferring to a higher board, I advise non-internet companies not to take this too seriously, as it is quite challenging.
- The Future of the New Third Board
Before the New Third Board, China's private enterprises mainly fell into two categories: listed companies and non-listed companies. The financing convenience of listed companies, the equity payment value (equity incentives and mergers), and the recognition of talent are all far superior to those of non-listed companies under the same operational conditions, creating a significant gap that has also been a major incentive for fraudulent listings.
The New Third Board offers a diversified and multi-tiered capital market path, allowing companies to gradually upgrade through the New Third Board, from agreement transfers to market-making transfers, and eventually to auction trading in the future. Optimistically, if the investor access threshold for the auction trading segment is lowered to 50,000 to 100,000 yuan, the distinction from the growth enterprise board may become negligible.
Since the New Third Board's access threshold is primarily based on compliance requirements rather than performance indicators, any company can list at the agreement transfer level, while relatively outstanding companies will rise to market-making transfers and eventually to auction trading. In this process, relatively professional investors vote with their feet, creating a healthy mechanism for survival of the fittest, which is of significant importance for promoting the prosperity of the entire business system.
- Summary
Debt financing has a limit on borrowing (debt-to-asset ratio) and must be repaid in cash. This also determines that companies capable of utilizing debt financing require stable cash flow, which is challenging for startups and small businesses. This inherent contradiction leads to high risks for small and medium enterprises' loans, with high risks necessitating high-interest rates to cover them. Those who truly default and run away cannot repay, leaving normal operating small and medium enterprises to bear the high-interest rates to make up for the losses caused by those who fled. This mechanism leads to adverse selection among entrepreneurs, fostering a culture of wrongdoing.
However, equity investment is different. By participating in investing in companies, investors can achieve high returns from well-performing enterprises while facing penalties for poor investments. This mechanism encourages investors to discover better companies and compensate for other investment losses with substantial equity returns. Here, the adverse selection mentioned earlier is eliminated; if there are no significant systemic errors, it will promote the development of both investors and small and medium enterprises.