Personal Guarantee Required for Venture Debt!? Legal, Accounting, and Finance for Start-Ups in China

In the US, the failure of start-ups rarely leads to the bankruptcy of the founders. In many cases, founders who failed once will become serial entrepreneurs and start new companies later. However, founders in China are not so lucky. In this blog post, I’ll share the key differences in terms of a founder’s responsibility and the root cause of the differences.

What does it mean to be a start-up founder in China?

A few years ago, ofo was the leader in the bike-sharing industry. Many people may have seen its iconic yellow bike. However, as ofo is getting close to bankruptcy, its CEO/founder (Dai Wei) is now on the list of Restricting High Consumption of Judgment Debtors. At this point, Dai Wei cannot travel by plane, stay in hotels with more than three stars, purchase a new house, or send his kids to private schools. Although ofo is a Limited Liability Company, Dai Wei is almost taking unlimited liability for the company.

This phenomenon is very typical in China. Failure of the company almost equals the failure of the founder at a personal level. As a result, many founders choose to take consulting projects to survive instead of filing chapter 11.

Getting a loan or venture debt from a bank is almost impossible in China unless the company is super-profitable. In many cases, getting a loan from a bank requires a personal guarantee from the founder. If the loan is judged to be irrecoverable, the founder’s national ID card will be locked. In China, without a national ID card, one cannot do anything. It’s almost a death sentence for any businessperson.

Many VCs also ask founders to show their commitment by providing a personal guarantee. In many cases, VCs ask founders to guarantee a certain level of liquidation preference. Redemption rights are typical as well, usually linked to some sort of Valuation Adjustment Mechanism (VAM).

So, founders in China must take on a significantly higher risk to start a company. What are the underlying reasons behind this?

Reasons for Personal Guarantee

Multiple accounting books – Potential for accounting fraud

Almost any start-up in China will have multiple financials—at least, actual financials for internal purposes and another set for the tax agency.

In China, to recognize any expense for tax deduction purposes, the company must submit something called “Fapiao”. However, in practice, it’s almost impossible to secure “Fapiao” for all expense items. Many small vendors and shops don’t provide it. To fill the gap, it’s common practice to purchase “Fapiao” from unprofitable companies to create a separate accounting book.

Some companies have separate financials for banks as well.

Because a company has multiple accounting books, the founder can more easily cook the books. It’s not easy for investors or banks to run a full audit. If they cannot trust the financials, one easy solution is to ask for the personal guarantee of the founder.

Corporate governance – Complex portfolio structure

To make it even more complicated, most Chinese companies have many subsidiaries. Some of them may not be owned by the holding companies but, in practice, they’re treated as fully owned subsidiaries. This creates an opportunity for founders to move around the capital from one subsidiary to another so that investors cannot reach it.

One example is the VIE structure. In China, many businesses cannot be operated by a fully owned subsidiary of a foreign company. However, many start-ups that raised money from US VC funds are treated as foreign companies. To solve this issue, typically, a WFOE (wholly foreign-owned enterprise) will establish a VIE arrangement with the actual Chinese company that can operate in China legally. However, the WFOE doesn’t own any shares in this Chinese company. This type of ambiguous corporate structures becomes a breeding ground for corruption.

Tough to file Chapter 11

In China, each year roughly 1.5 million companies go under. Only slightly more than 10,000 companies go through the formal bankruptcy process.

Based on the current standard in China, to file for bankruptcy, a company must meet some very strict requirements. If a company simply has cash flow issues and owns more assets than liabilities, it cannot declare bankruptcy. The government will look into the books to check on whether it meets the requirements. Because usually a company has multiple books, the founders are afraid that they will get punished by the tax agency for malpractice. In addition, only certain types of corporations can file for bankruptcy. For example, a company similar to an LLC cannot file for bankruptcy in China.

The biggest reason might be that the bankruptcy process can take a few years. During this process, the founder’s national ID card will be locked. Not only the founders themselves, but usually also their family members and relatives, will be put on the list of Restricting High Consumption of Judgment Debtors.

Instead of bankruptcy, many founders choose to run away, especially to a foreign country. That’s why so many Chinese businesspeople are willing to pay a premium to purchase real estate in foreign countries and get permanent residence cards.

Immature VC ecosystem

The VC industry has only about 20 years of history in China. Most VCs started after the last financial crisis. Most of them had never started VC funds before, so their reputation is unclear. This makes it difficult for other keyholders (e.g., banks) to establish long-term partnerships with VCs.

Typically, in the US, a reputable VC can attract banks to provide venture debt. This is because banks believe that when things don’t go well, VCs will put in more capital to do an insider round. This is based on the long-term partnership and requires time to nurture.

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