An Analysis on Chinese and Foreign Entrepreneurs’ Equity Disposal Options

(By Wang Qiurui) Selfishness is nature of human beings and difficult to get rid of, out of which a problem arises that employees and even high-level managerial staff of a company care much more about their own interest than the company’s rise and fall when dealing with managerial issues. Adam Smith raised a question related to such problem in his masterpiece the Wealth of Nations, known as ‘Smith’s Difficult Question’.

Many past and living Chinese and foreign entrepreneurs have turned to equity to find a way of thinking a solution to overcome such weakness of human beings. However, being governed by the current Company Law of P.R.China, settlement of a case in such a way would give rise to many legal issues. It should be more advisable for Chinese entrepreneurs to create and apply to their businesses a phantom equity system.

  1. Equity Incentive Programs Applied by Fortune 500 Companies

Some fortune 500 companies, especially those listed companies, usually have equity incentive systems and programs for eligible staff above certain position levels, especially high-level managerial staff, who are given an amount of equity (mostly in the form of stocks) and then become shareholders of the companies.

A company taking such action obviously aims to mobilize high-level managerial staff to work as the company’s owners, make their interests and the interests of the company’s shareholders correlate closely and persuade them to work diligently and wholeheartedly for the company without supervision.

Generally, a listing company practically grants employees joining the equity incentive program tradable shares. Due to the nature of tradable shares and relatively low proportion of the tradable shares given employees to total shares of a company, the equity incentive program in common cases has little effect on a company’s equity structure or control relationship. Employees, including high-level managerial staff, of a company, who join its equity incentive program, mainly obtain real economic interests manifested by tradable share prices, which link the company’s business achievements, and therefore devote themselves to improving the company’s achievements wholeheartedly, creating a win-win situation for both high-level managerial staff and shareholders or actual controllers.

In reality, when introducing the equity incentive program, a few foreign invested companies copy relevant rules and sample equity agreements, made by their parent companies. In some cases, certain provisions or even core provisions, agreed by relevant parties have no applicable legal provisions in the current Company Law of P.R.China or are even in contrary to some provisions of the current Company Law of P.R.China, the equity incentive program fails to be an incentive for high-level managerial staff, but incurs labor or even equity disputes.

  1. Historical Origin of ‘Personal Shares’

As early as hundreds of years ago a program similar to the current equity incentive program was invented in ancient China. A saying handing down from ancient Shanxi merchants goes that those who are paid generous salaries are treated as outsiders by business owners, while those who are granted even a small number of personal shares are treated as intimate partners by business owners. The ‘personal shares’ abovementioned are actually a form of equity incentive traditionally known to Chinese people.

In a nutshell, personal shares, also called top personal shares, refer to the shares held by ancient Chinese bank managers and senior staff, constituting, together with sliver shares held by investors, the share structure of an ancient Chinese business. Top personal share holders actually do not invest any capital into their businesses, but rely on their work to obtain and maintain their right to hold personal shares, so in some places personal shares are also called labor shares. Silver shares are virtually capital shares, while personal shares are purely income shares.

During many years’ evolution, the personal share system had developed into a flexible and balanced system with a set of well-designed rules on, for example, conditions for share acquisition, deduction and deprivation of shares granted.

After being practically tested for many years, the personal share system has been proved to have a few deficiencies ranging from unclear property ownership arising from inexplicit definition of differences between personal shares and silver shares and resulting in failure of business operation due to dividend sharing related problems, inequity of rights and duties in that personal share holders enjoy dividends without being obliged to invest, who as a result focus on short-term interests without caring about long-term interests at all and try to get as many dividends as possible at earliest time regardless of business status, resulting in failure of business operation.

  1. Phantom Equity and Application of Relevant Laws

Enterprises run by Chinese entrepreneurs are generally not listed companies. On the other hand, most Chinese entrepreneurs do not really want to give shares to such ‘outsiders’ as managerial staff. Therefore, most Chinese enterprises do not like to learn from fortune 500 companies to introduce an equity incentive program, in which real equity should be given, nor should they be advised to adopt the past personal share system.

According to the current Company Law, equity is a package of rights pro rata to capital contributed, containing various specific rights like the decision making right, the dividend sharing right, etc. Meanwhile, the Company Law allows companies to ‘autonomously’ operate under unique systems designed by themselves in their articles of association, which makes it possible to separate the ‘dividend sharing right’ from the ‘equity’. As a result, the phantom equity system emerged.

Literally, phantom equity is not really equity. Phantom equity holders only have the right to share dividends with other shareholders without enjoying any other shareholders’ rights. The main purpose of the phantom equity system is to stimulate enthusiasm for hardworking among managerial staff and correlate their work achievements with income.

The current Company Law of P.R.China does not prohibit the phantom equity system, but no laws define or include provisions on matters related to such system. Therefore, whether a company’s phantom equity system can operate smoothly mainly depends on the degree of rigorousness, completeness and adaptability to operational reality of the company, of phantom equity agreements made by and between the company and its phantom equity holders.

Despite variety of circumstances different enterprises may face, generally speaking, a phantom equity agreement should be made to

  1. clarify specific differences between phantom equity and legally defined equity to prevent equity incentives from being evolved to equity disputes;
  2. clarify conditions for acquisition of phantom equity to provide a clear guide for employees;
  3. specify conditions for execution of the dividend sharing right to establish clear working goals for phantom equity holders;
  4. specify circumstances, under which employees should be deprived of the rights to hold phantom equity and receive dividends, to put moderate pressure on the phantom shareholders;
  5. clarify calculation and payment methods of dividends to avoid legal disputes.

Disclaimer of Bridge IP Law Commentary

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