Tudou Holdings Limited, a leading online video company in China, ended its initial public offering saga this week, limping onto Nasdaq (under the symbol TUDO) at a price equal to 16 times revenues in the 12 months through March 31. That valuation is about half the 31 times revenue rival Youku.com Inc. (NYSE: YOKU) received in its December 2010 initial public offering.
What a difference eight months can make. In between these two IPOs, investors sued 29 U.S.-listed China concept companies in class action lawsuits alleging securities fraud. And then there were the Congressional shenanigans that brought America to the brink of default, caused a downgrading in our national debt and triggered the market sell-off in the midst of which Tudou launched its IPO.
In November 2010, Tudou had a slight lead on Youku in the IPO race. The company publicly filed its F-1 registration statement with the Securities and Exchange Commission on November 9, 2010, while Youku completed its public filing six days later. So why did Youku reach market in early December 2010, enjoying a 161 percent rise on the first day of trading, while Tudou didn’t arrive on Nasdaq until this week, and then promptly traded down 28 percent during the first two days on the exchange? The answer is the newest China risk factor – the founder’s wife.
As disclosed in Tudou’s public filings, the now ex-wife of founder Gary Wang filed a lawsuit against him demanding a large portion of his equity interest in the company. Normally, a messy divorce for the founder wouldn’t derail an IPO, particularly when he holds only 12.7% of the company’s shares, as was the case for Tudou. But in the world of Chinese internet companies, with byzantine corporate structures designed to evade China’s foreign ownership restrictions, that is exactly what happened.
Mr. Wang’s ex-wife didn’t restrict her claim to his 12.7% ownership interest in Tudou’s offshore holding company that is now listed on Nasdaq. She also went after his 95% ownership interest in Quan Toodou, the variable interest entity, or VIE, that has historically accounted for nearly all of Tudou’s revenue and holds the vital government licenses necessary to carry on Tudou’s business. In order to comply with China’s foreign ownership restrictions, Mr. Wang holds these shares as a nominee for Reshuffle Technology, an indirect wholly-owned subsidiary of Tudou. Mr. Wang has himself entered into a series of contractual arrangements that make it clear he is simply a nominee shareholder and that Reshuffle Technology is the true beneficiary of Quan Toodou. Mr. Wang’s ex-wife, however, hasn’t signed a thing.
As a result, the divorce lawsuit might have enabled Mr. Wang’s ex-wife to acquire a large stake in Quan Toodou without any of the accompanying nominee shareholder restrictions. That outcome could have cut deeply into Todou’s revenue and even prevented inclusion of Quan Toodou’s results in the Tudou group’s consolidated financial statements. So while Youku completed its IPO three weeks after its public filing, Tudou’s IPO went on hold until Mr. Wang and his ex-wife reached a settlement over half a year later. By that time, very different market conditions prevailed.
So how much did Mr. Wang’s divorce cost Tudou? If the company had completed its IPO in December 2010 and received the same revenue multiple as Youku, Tudou would have been valued at $1,026 million, which is over $200 million more than its actual IPO valuation. That translates into a loss for Tudou and the selling shareholders of $43 million.
Tudou is not, however, the only U.S.-listed Chinese internet company that uses a VIE structure. They all do. Which means the Tudou story may give investors yet another reason to worry. Consider NetEase (Nasdaq: NTES) – founder William Ding holds 90% of the equity interest in its core VIE company, Guangzhou NetEase. How is he getting along with his wife? Or what about Charles Zhang, founder of Sohu (Nasdaq: SOHU)? He holds 80% of High Century, Sohu’s primary VIE holding company. Should investors ask about his home life on the next earnings call? How about the really expensive one, Baidu (Nasdaq: BIDU), which has a market capitalization of nearly $60 billion? Founder Robin Li is the controlling shareholder of Baidu Netcon, the company’s key VIE company. Investors better hope Robin is keeping his wife happy.
Tudou isn’t the only Chinese company that has suffered from weaknesses in the VIE structure. You can read about the sad story of Gigamedia (Nasdaq: GIGM), Wang Ji and Shanghai T2 Entertainment here. For a failed VIE outside of the internet sector, see this filing from Buddha Steel.
When the annual reports for China’s internet companies are released next year, many will most likely include our new VIE risk factor. Perhaps a few brave founders will even address the risk, asking their wives to sign the same nominee shareholder documents as the founder himself.
Greg Pilarowski is the founder of a boutique international law firm focused upon the internet and digital media industries in China. Firm website: www.pilarlegal.com.