Overview of early stage and venture capital investment in Hong Kong

1. Startup market overview in Hong Kong

1.1 What is the typical corporate structure of a startup?

1. The common business vehicle used is a private company limited by shares. A private company limited by shares is an independent legal entity which is responsible for its own liabilities, but which is owned by other persons who are, generally speaking, not personally liable to the business. Separate corporate personality helps to separate the risks and liabilities of the business from the personal liability of the founders. A single person may be the sole shareholder and sole director of a private company limited by shares.


2. Normally a single company, formed in Hong Kong, is used for a Hong Kong based startup business initially. Once the business has reached meaningful milestones, the founders may restructure the business so that there is a simple holding company / subsidiary structure. This often coincides with the first formal investment round of the business. The place of incorporation of the holding company will be determined by factors such as the standards and flexibility of corporate law and regulation, tax optimisation and investor preference. The advantages include separation of investor and operational risks, ease of expanding the business operationally and tax optimisation. For these reasons, it is fairly common for startups in Hong Kong to use an offshore holding company structure.

1.2 What are the typical stages of funding for a startup?

1. Many startups are initially funded by the founder’s own personal funds, or through loans and investments from friends and family.


2. Startup-specific loan or funding schemes are also available from government bodies or private entities. Schemes are often industry-specific, and aim to foster entrepreneurial activity within their own industry. For example:


1. The Innovation and Technology Fund with different programmes under it, including the Innovation and Technology Venture Fund targeting innovation and technology start-ups, and the Enterprise Support Scheme to fund R&D projects on a matching basis;


2. The Patent Application Grant;


3. Hong Kong Science and Technology Parks’ incubation programmes for biomedical technology (Incu-Bio), deep tech research (Incu-Tech), and technological applications (Incu-App);


4. The Innovation and Technology Fund for Better Living;


5. The CreateSmart Initiative;


6. The Retail Technology Adoption Assistance Scheme for Manpower Demand Management;


7. The Social Innovation and Entrepreneurship Development Fund;


8. SME Funding Schemes from the Trade and Industry Department; and


9. Research and Development Cash Rebate Scheme;


10. The Technology Voucher Programme;


11. Dedicated Fund on Branding, Upgrading and Domestic Sales
3. Some startups may prefer to raise funds using equity-backed instruments. These instruments include:
   
   
   
   1. Convertible Loan Note: These are debt instruments that carry a conversion right so that the debt may convert into equity at the next equity financing round or on a liquidity event trigger. The loan will become repayable if a trigger event does not occur by a longstop date.
   
   
   2. Future Equity Deed This is a promise by the startup to issue shares at the next equity financing round or on a liquidity event trigger. The promise is given in return for cash funding up front. This is not a debt instrument or immediate equity. These documents can take a number of forms, some of which are publicly available. Common US-based examples (which are often used as a starting point by Hong Kong companies) include Simple Agreement for Future Equity (SAFE) by Y Combinator, and Keep It Simple Security (KISS) for equity used by 500 Startups. These documents need to be conformed to Hong Kong law.
   
   The advantages of an equity-backed instrument include the speed and ease with which the documents can be completed and the money received by the issuer, and that it does not result in a formal valuation milestone for future investment rounds.
    
   A key element in equity-backed instruments is to negotiate the discount and cap terms. A discount is the percentage discount given to the holder of the price per share at the next equity financing round or liquidity trigger event. A cap is the maximum price per share at which the debt or advance will convert to equity, even if the actual price per share is higher. The market standard for sophisticated investors is to include both a cap and a discount, and to allow for the investor to avail of the more favourable of them.


4. An equity financing round will typically occur when a credible milestone has been reached that demonstrates the viability of the business strategy. Depending on the industry sector, this could be, for example, development of a working prototype, submission of a patent filing, achieving a revenue milestone, or a similar achievement.

1.3 Who are the typical investors?

1. Equity investors may generally be divided into four types:


1. Family and friends: These are investors in the immediate close network of the founders. Their interests are usually driven by loyalty to the founders, less than financial profit.


2. Angel investors: Angel investors include individuals and family offices that make personal investments in companies from their own wealth. Angel investors can range from those who wish to be actively involved, to passive investors. Angel investors are likely to be involved up to a Seed round or a Series A round only.


3. Family offices: A family office describes the investment team engaged to manage private wealth. The family office can be directly formed and engaged within family business structures, or engaged independently with investment professionals who manage the investments of a number of families. There is an increasing interest among family offices in allocating capital to investments in alternative asset classes such as venture capital. This can be because technology represents potentially strategic value to family business interests. Also, there can be an appetite for higher risk, but higher return, on investment among younger generations within the family. There is a particularly strong family office community in Hong Kong.


4. Corporate investors: Many large companies have investment divisions that are tasked with monitoring new technologies, and making investments that align with vision and business plans of the company. Corporate investors are sometimes referred to as strategic investors.


5. Venture capital (VC) funds: VC funds are focused on obtaining a return-on-investment (RoI) within a fixed period of time.
2. Hong Kong investors tend to be risk-averse. While Seed and pre-Series A funding is generally available, many start-ups find funding for Series A and B rounds more challenging in Hong Kong. However, Hong Kong is beginning to see the gradual entry of institutional investors focussing on Series A and later investments.

1.4 What due diligence is conducted by investors on startup companies?

1. Before concluding a Term Sheet with a startup company, a prudent investor is likely to:


1. verify the facts and assumptions presented in the initial investment proposal;


2. carry out independent investigations on the product or service offered by the startup, the market in which it operates, and the level of the competition present;


3. review the financial plans of the startup;


4. make enquiries in respect of the founders and key management team;


5. review public information about the startup;


6. require full disclosure by the startup in respect of its financial, legal and operational matters.
2. Given the relatively low risk appetite in Hong Kong, startups should expect that investors will carry out reasonably stringent due diligence.

1.5 What are the market trends?

1. Presently, VC funds in HK have been most active in fintech startups. Government authorities such as the HK Monetary Authority (HKMA), the Securities and Futures Commission (SFC) and the Insurance Authority (IA) have developed contact points dedicated to facilitating contact between fintech companies and regulators, and they have each introduced a regulatory sandbox to provide a safe harbour for fintech and insurtech innovation before the full application of regulation is brought to bear.


2. Areas of interest for the Hong Kong VC community include medical technology (medtech), the internet of things (IoT), and blockchain technology.


3. The 2019-2020 Budget introduced measures to promote innovation and technology in Hong Kong. These include:
   
   
   1. HK$5.5 billion will be injected into Cyberport 5 for an expansion project. The project is expected to provide about 66,000 m² space for technology companies and startups by 2024;
   
   
   2. Maximum annual funding for each university under the Technology Start-up Support Scheme for Universities will be raised from HK$4 million to HK$8 million to better nurture university start-ups;
   
   
   3. Hong Kong Science and Technology Park will expand the Corporate Venture Fund (CVF) to HK$200 million to support the growth of its tenants and incubatees; and
   
   
   4. HK$2 billion will be injected into the Innovation and Technology Fund (ITF) to launch a Re-industrialisation Funding Scheme to subsidise manufacturers on a matching basis to help them set up smart production lines in Hong Kong.
   
   
4. The Department of Immigration has made it easier for persons intending to establish or join a startup business in Hong Kong to obtain a visa to do so, provided that the startup belongs to a government-backed programme, e.g. StartmeupHK Venture Programme administered by InvestHK.

2. Main characteristics of VC investment in Hong Kong

2.1 Are VC funds active?

Yes. VC activity falls into two groups:

1. Investments conducted in Hong Kong because the VC fund has its operations in Hong Kong. In this case, much of the work will involve professionals in other locations.


2. Investments conducted in Hong Kong because the startup has operations that include Hong Kong (among other locations). Many startups have their management or holding company structure in Hong Kong, but their main operations elsewhere. Hong Kong is a gateway for investments into operating in Mainland China. Hong Kong may serve as a beta market for startups, but in most sectors the market is too small in itself to provide the scalability and return of investment that VC funds will seek.

2.2 What legal structure(s) are most commonly adopted by VC funds?

1. Many VC funds are domiciled in offshore locations such as the Cayman Islands- because of flexible legal structures and tax optimisation.


2. Most VC funds are formed as limited partnerships. Limited partnerships provide greater flexibility to accommodate drawdown and distribution of capital, and that structure tends to receive better tax treatment for investors based, for instance, in the US.


3. On 20 March 2020, the Hong Kong Government gazetted the Limited Partnership Fund Bill.  If approved by the Legislative Council, the bill will allow VC funds to be set up as limited partnerships in Hong Kong.

2.3 How are VC funds regulated in Hong Kong? Are licences required for a VC fund’s principals, managers and promotors?

1. Generally, a licence is required from the Securities and Futures Commission of Hong Kong for a company, and its officers or employees, engaged in, dealing in, advising on or managing a portfolio of securities.


2. VC funds dealing or advising in “private equity” involving only the shares or debentures of a “private company” do not require a licence. A company is a “private company” for these purposes if:
   
   
   1. the company has been incorporated in Hong Kong;
   
   
   2. the Articles of Association of the company restrict a member’s right to transfer shares;
   
   
   3. the Articles of Association of the company limit the number of members to 50;
   
   
   4. the Articles of Association of the company prohibit any invitation to the public to subscribe for any shares or debentures of the company; and
   
   
   5. it is not a company limited by guarantee^[1].
   
   
3. If the VC fund deals in, advises on or manages other types of investments, or if the target of investment is not a “private company”, then it will require a licence from the Securities and Futures Commission.

2.4 How are investors of a VC fund protected?

1. Investors in a VC fund typically receive an Information Memorandum before their investment. This document will contain various statements and representations by the VC fund. Investors may have a claim against the VC fund for misrepresentation if there are false or misleading statements in the Information Memorandum.


2. Investors may have certain rights under the Limited Partnership Deed. These rights will include:
   
   
   1. information and reporting rights;
   
   
   2. exit and withdrawal rights; and
   
   
   3. limited participation in certain fundamental decisions, usually through participation in committees.

2.5 At what stage of growth of a startup business do VC funds make investments?

The common investment rounds in which VC funds participate are:

1. Seed (typically US$1 – 5 million);


2. Series A (typically US$5 – 15 million); and


3. Series B (typically over US$15 million).

There is a degree of flexibility around the designation of the investment rounds in early stage financing.

2.6 What forms of interests do VC funds take on investments?

1. The nature of investments may be classified as equity or debt investments.


2. An equity investment will typically be a subscription for Preferred Shares in the company, with preferred rights that include one or more of the following:
   
   
   1. Liquidation preference: A preferred distribution on a liquidation or liquidity event. These events include a sale (whether share sale, asset sale or merger), IPO, or liquidation.
   
   
   2. Redemption rights: This is a right of the investor to require the company to redeem the shares of the investor at an agreed or fair market value.
   
   
   3. Conversion rights: This is a right to convert Preferred Shares into the same class of Ordinary Shares held by founders, according to a conversion ratio that may be adjusted to take account of various events. This may be advantageous depending on the terms of the liquidation preference, or if an IPO is intended.
   
   
   4. Dividend rights: Preferred shareholders may wish to receive preferential rights to dividends. Dividend rights may be cumulative (that is, an agreed amount is due regardless of declaration by the directors) or non-cumulative (that is, only due if declared by directors).
   
   
   5. Registration rights: This is a right to require the company to register securities for the purpose of a listing in the US.
   
   
   6. Information rights: This is a right to receive financial information from the company, and usually includes inspection rights in respect of books and accounts of the company.
   
   
   7. Anti-dilution protection: These rights will include a right of first refusal on future issuances, and weighted average anti-dilution protection (see para. 5.5 below).
   
   
   8. Decision rights: These rights will require that a threshold level of approval of the holders of Preferred Shares will be required before certain critical decisions are made by the company.
   
   
   9. Board representation: This is a right to appoint one or more directors to the board of directors of the company.
   
   See our Glossary of VC Terms.


3. VC funds may also finance a company by way of debt in the forms of:
   
   
   1. Convertible Loan Instruments;
   
   
   2. Mezzanine or other loan financing; or
   
   
   3. Specialised debt instruments.

   2.7 What incubation and acceleration programmes are available in Hong Kong?

   A list of incubation and acceleration programmes in Hong Kong is maintained by the Startmeup.hk website, which can be found at this link.  They include:

   1. Betatron[2], a start-up investment firm and accelerator program which provides financing as well as an intensive acceleration program involving mentorship and demo days;
   
   
   2. Brinc[3], a venture capital and accelerator firm running a number of accelerator programmes spanning Hong Kong and mainland China in areas including hardware and IoT, manufacturing, food technology, and clean energy; and
   
   
   3. Pre-incubation, incubation, and accelerator programmes run by the Hong Kong Science and Technology Park[4] such as the Science and Technology Entrepreneur Programme which offers seed funding as well as a co-working space, the Incu-Bio incubation program for biomedical start-ups, and the Leading Enterprises Acceleration Programme, which provides funding up to HK$4.7 million in value.

   3. Legal documentation

   3.1 What are the key legal documents used in investment rounds?

   1. The key investment documents are:
      
      
      1. Term Sheet;
      
      
      2. Subscription Agreement;
      
      
      3. Shareholder Agreement; and
      
      
      4. Restated Articles of Association.
   
   
   2. Depending on the investment, other documents may include:
      
      1. Future Equity Agreement;
      
      
      2. Convertible Loan Note;
      
      
      3. Disclosure Letter;
      
      
      4. Director Indemnification Deed;
      
      
      5. Reverse Vesting Deed;
      
      
      6. IP Assignment and Protective Covenants Deed; and
      
      
      7. Executive Services Deed.

   3.2 What are the key provisions in investment documentation?

   1. Term Sheet:The Term Sheet will include binding and non-binding terms. The non-binding provisions will set out the main terms of the investment. There will be three main parts:
      
      
      1. The offering section will set out the key investment provisions such as valuation, investment amount, price per share, investment timing, post-investment cap table, and intended completion date;
      
      
      2. The equity section will set out the key terms of the shares being offered to investors, and will describe rights to dividends, distributions on liquidation or other liquidity events, conversion and voting; and
      
      
      3. The investment section will set out other investment terms, such as information rights, director appointment rights, pre-emption right, anti-dilution rights, co-sale right, permitted transfers, compulsory sale, warranties, liability and other general terms.
      
      There will also be binding obligations with respect to confidentiality, exclusivity and governing law and jurisdiction.
   
   
   2. Subscription Agreement: This is an agreement between the investors and the company that issues shares in an investment round. Its key provisions include the number of shares to be issued, their subscription price, and warranties of the company in respect of the company and its affairs. Founders should be mindful that they may be requested to provide warranties in respect of the affairs of the company. This significantly increases the potential personal liability of the founders.
   
   
   3. Shareholder Agreement: This is an agreement between the company and the founders. Its key provisions include:
      
      
      1. management of the company, and decisions reserved to shareholders;
      
      
      2. composition and governance of the board of directors;
      
      
      3. funding and future share issuances;
      
      
      4. share transfers, pre-emption rights, co-sale and compulsory share transfer rights, and permitted transfers;
      
      
      5. deadlock and termination; and
      
      
      6. protective covenants.
   
   
   4. Restated Articles of Association: The Articles of Association will be amended to set out the rights of any new equity share class formed with the investment round. This is normally a Preferred Share class that is named according to the designation of the investment round (for instance, Seed Share Class, Preferred A Share Class, and so on). A common issue to consider is whether the Articles of Association should be amended to fully align and reflect the terms of the Shareholder Agreement. This would represent best practice, and investors frequently insist upon it. However, a Shareholder Agreement will stand as an independently enforceable agreement among the shareholders, even if it varies from the Articles of Association. Sometimes expediency and budget constraints mean only minor consistency points are aligned.

   4. Founders’ and employee incentivisation

   4.1 How are founders and employees incentivised?

   Typical incentive arrangements include:

   1. Bonus: Cash bonuses may be ad hoc, or based on the performance of the company or individual.
Equity-based incentives: There are three equity-based incentive schemes that are seen in Hong Kong:


1. Employee share option plans (ESOP): A startup company may grant certain employees, advisers or contractors options to purchase a number of the company’s shares. The option exercise price is pre-determined at the time of grant and is usually the fair market value of the company’s shares on the date of grant. The options will vest over a period of time after the date of grant – typically between three to five years. A class of non-voting ordinary shares will be formed for the purpose of the ESOP. This is the most common form of equity based incentive for startups in Hong Kong.


2. Employee restricted share plans (ERSP): A startup company may grant certain employees, advisers or contractors a number of the company’s shares. The share grant will typically be free or for a significant discount to market value. Restrictions on rights to transfer the shares will be imposed according to a reverse vesting schedule – typically between three to five years.


3. Phantom or notional unit plans: A startup company may grant certain employees, advisers or contractors a right to receive cash payments calculated by reference to the value of the company’s shares. This is seldom seen as the obligations are classified as a liability for accounting purposes.

4.2  How are ESOP awards taxed?

1. Employees have to pay salaries tax on any benefits associated with stock-based awards arising from their office or employment. Employees who hold a share option will be taxed on a notional gain on that share option calculated at the time of its exercise. The notional gain is assessed by reference to the market value of the shares at the time of exercise of the option, less any price paid by the employee for the option at the time of its grant.


2. Employers and employees must observe tax reporting obligations in respect of share options. Failure to do so may result in heavy penalties.


3. Any gain or loss employees realise from any subsequent sale of shares is usually non-taxable or non-deductible.

4.3 How do founders exercise control of the startup after investment rounds?

Founders will seek to retain operational and management control by:

1. issuing fewer shares to minimise dilution (though this typically means less capital raised);


2. maintaining majority control of the board of directors;


3. restricting the matters for which investor approval is required; and


4. limiting the information and inspection rights of investors.

5. Investor protection

5.1 How do investors ensure the founders have long-term commitment to the startup?

Typical requirements include:

1. Reverse vesting: Under a reverse vesting arrangement, the founder is required to accept restrictions that may lead to the company repurchasing his shares if he leaves before milestones on a reverse vesting schedule are reached.  Normally, if a reverse vesting event occurs, the shares will be repurchased by the company or the other founders for a nominal amount (but no less than the amount of any capital contributed by the founder). Reverse vesting schedules are typically between three and five years.


2. Lock-up: The founder may be restricted from transferring his shares to any third party (other than on a permitted liquidation or liquidity event) for a fixed period, usually two to three years.


3. Employment agreement: The founder may be required to enter into a formal, long-term Employment Agreement under which he commits to work full-time for the startup for a fixed term, usually two to three years.


4. Restrictive covenants: A founder commits to covenants that prevent him from working for a competing business, or dealing with or soliciting employees or customers, for a period of time after he ceases to be a shareholder or employee of the company. The prescribed period can vary, but may be between one to three years (depending on enforceability concerns).

5.2 What are the common restrictions on shareholders to limit transfer of shares?

Common restrictions on share transfers include:

1. Pre-emption rights: No shareholder may transfer his shares to a third party unless those shares are first offered to existing shareholders on the same terms.  A variation on this would require the shares to be offered within the same share class as the selling shareholder, before other share classes may exercise their pre-emption rights.


2. Lock-up: No shareholder may transfer his shares for a fixed period of time.


3. No transfer to a competitor: No shareholder may transfer his shares to a competing business to the startup.


4. Financing: No shareholder may offer up his shares as security for financing, or grant any encumbrance or security interest in or over his shares.


5. Permitted transfers: There will be a specified list of persons to whom a shareholder may transfer shares on a non-pre-emptive basis. For instance, in the case of individual shareholders, these persons may include family members. In the case of corporate shareholders, shares may be transferred to group companies.

5.3 Is it common to provide right of first refusal to investors on the issuance of shares?

1. Yes, it is common. This provides investors the right to participate in new issuance of shares so as to maintain their shareholding equity percentage in the startup.


2. Sometimes founders may negotiate waivers of first refusal rights if the proposed share issuance is based on a target valuation, or if a majority of investors agree to the waiver.


3. The grant of share options under an ESOP should be carved out and considered as an exception from first refusal rights.

5.4 What other provisions on share transfers are common?

Other common provisions on share transfers include:

1. Co-sale and tag-along rights: This is a right that is exercised after a pre-emption process has completed, and the selling shareholder may proceed with a sale to the third party. This right permits other shareholders to require that their shares must be included in the sale to the third party. The provision may be drafted so that it requires all or a proportionate number of shares to be included.


2. Drag-along rights: This is a right that is exercised in place of a pre-emption process. It arises in a situation where a shareholder wishes to accept an offer from a third party that requires all shareholders to sell their shares. That proposition receives the support of a qualifying percentage. This is usually the support of shareholders holding more than 50% of the voting rights in each share class. Then those supporters may require and compel the other shareholders to complete the sale to the third party.


3. Compulsory sale: A shareholder may also be compelled to sell his shares if he becomes bankrupt or insolvent, or if he breaches certain fundamental provisions of the Shareholder Agreement.

5.5 What anti-dilution mechanisms are preferred in Hong Kong VC investments?

Apart from the first refusal rights explained in para. 5.3 above, other anti-dilution measures include:

1. Weighted average: Weighted average anti-dilution provisions are more common in Hong Kong. This approach takes into account both the lower price and the actual number of shares issued in a down round. In calculating the price to which an existing series converts, the outstanding shares are treated as though they were sold at the same price as the series being adjusted, thus lessening the impact of a down round. It takes into account the average equity value of all shares, including the subsequently issued shares. For narrow-based weighted average, the dilutive issuance is only weighted against currently issued shares, and does not include convertible securities. For broad-based weighted average, the dilutive issuance is weighted against the fully diluted securities of the company. This means the calculation assumes conversion of all preferred stock, warrants, stock options and other convertible securities.


2. Full ratchet: A full ratchet lowers the conversion price to the price at which any new share is sold, regardless of the number of shares. Although sometimes proposed by investors, full ratchet anti-dilution does not represent market practice in Hong Kong.

6. Exit strategies

6.1 What are the common investment exits?

1. Trade sale: This is the most common form of exit. A trade sale may be structured as a share sale, an asset transfer, or a merger and consolidation. The acquirer may be another company in the industry sector, or a different group of investors, for instance a private equity fund in a secondary sale.


2. IPO: Floating the startup on a stock market usually benefits not only just the investors but also the founders and employees. The choice of market for listing is critical. Extensive restructuring may be required before an IPO can occur. IPOs are subject to market sentiment, and the returns may exceed or fall below expectations accordingly. A public company is subject to higher standards of accountability and governance.


3. Spin offs: Startups may pivot or expand their business lines in the course of their growth cycles. This can give rise to the opportunity to spin off of different business lines into new companies, and derive value from that spin off that is returned to investors.


4. Voluntary liquidation: Certain companies may be more valuable on a break-up basis. The business may be wound-up and its assets sold or distributed in the course of a solvent voluntary members winding-up.


5. Share repurchase: There may be circumstances where an exit is not foreseeable, even though the company is performing well. If a VC fund investor has its own liquidity needs, and its shares in the company are redeemable, it may require the company to redeem its shares.

6.2 What are the common forms of exit for an unsuccessful company?

1. Liquidation: An unsuccessful startup may be liquidated and its assets sold off. While this may not generate any profits for the investors, it may reduce losses before the startup gets into a worse financial situation.


2. Founder sale or management buyout: The founders or the startup management team may be willing to pay market value for the company. This may be attractive to the founders as it would give full autonomy to managing the business, and may be a way for investors to realise some cash and reduce losses on the investment in the startup.

Pádraig Walsh

To enquire further about venture capital and investments in Hong Kong, please reach out to Tanner De Witt Solicitors:

Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.

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[1] Section 11 of the Companies Ordinance (Cap. 622)
[2] https://www.betatron.co/
[3] https://www.brinc.io/accelerators
[4] https://www.hkstp.org/