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First, the good news. After months of on-again, off-again plans to go public on Nasdaq, Chinese-language portals Netease.com and Sina.com -- which boast two of the most popular sites in China -- seem to have won permission from Beijing to proceed with their IPOs. The companies are likely to launch their public offerings in the coming weeks.
This is a watershed moment, not just for Netease and Sina. They're among the most established of China's dot-coms, and their ability to access the public equity markets in the U.S. will influence countless other Chinese Internet startups. Many of these other companies had put their own listing plans on hold as they waited to see how Beijing would deal with Netease and Sina.
But the Chinese government's deep-seated ambivalence about the Internet also means somes bad news. Netease and Sina will not be allowed to include their operating subsidiaries in mainland China in their IPOs. These companies, which hold the licenses to operate in China, must be shorn off and kept separate from any entity -- such as a Nasdaq-listed company -- that has foreign investment.
ISLANDS-BOUND?
What does that leave? The parts of Sina and Netease that are registered overseas. In Sina's case, those companies include portals based in Hong Kong, Taiwan, and the U.S. Netease doesn't have any such subsidiaries outside China. But that doesn't necessarily mean Netease lacks an overseas company, since its parent company may be registered in the British Virgin Islands, or the Cayman Islands, or even Delaware -- a common practice for other Chinese Internet companies.
China's rulers have centuries of experience in fashioning decrees to preserve their control while opening a window to the outside world, and this measure fits the pattern. But it would appear to be a devastating blow to the ambitions of China's Net entrepreneurs. How do you convince investors to put money into an IPO that is missing the most important part of the business -- the operating companies at the core?
Beijing's challenge: Controlling the Net in China while not turning off all foreign investors
The story gets more convoluted. While Beijing appears to be determined to keep foreigners out of a vital part of the business, the government is also intent on developing the Internet in China. The men whispering in the ears of President Jiang Zemin and Premier Zhu Rongji know that if China doesn't join the Internet Age, the Chinese economy will suffer, which could lead to greater social unrest and ultimately threaten the Communist Party's rule.
So, Beijing is trying to figure out a compromise, and China's Net entrepreneurs and foreign investors seem inclined to accept. It's a solution as typical of China's bureaucrats as the policy that it seeks to undermine. Here's why: The government rule is unlikely to be as ironclad as it seems. The dot-coms have loopholes to exploit that can help them appeal to Nasdaq investors, even without a direct fiduciary connection to the Chinese-based operating companies.
BLIND EYE.
Step inside the mind of China's policymakers for a moment. The companies that go public in the U.S. cannot own the licenses, nor can they operate the actual Web sites inside China. But they can do everything else. They can own the brand names, URLs, the software, and the content. The listed portals can have exclusive arrangements with the Chinese-owned, Chinese-based companies to provide them with all these essentials. While the listed companies are barred from owning equity in the Chinese Web site operators, they can still count on the revenue from those companies, which aren't about to ditch them for some other sugar daddy.
Obtuse, to be sure. But foreign investors in China have seen this sort of structure before. It formed the basis of several telecom deals in China in the 1990s, since telecommunications, like the Internet, is an area that the Chinese government has made off-limits to direct foreign investment. China's No. 2 telecom operator, China Unicom, has structured many of its investment agreements using this pretext -- and Beijing has turned a blind eye, content that the de jure interpretation of the law does not hinder the de facto development of the industry.
But here again is a hitch. The Unicom model did not prove as enduring as people had hoped. Last year, the Chinese government had a change of heart about the Unicom deals. Suddenly, just as the money was starting to flow, the foreigners had to leave. Their operating agreements and revenue-sharing deals gave them little leverage. After all, they didn't own equity in the Chinese companies themselves.
HOW LONG?
That's the big risk that investors will need to assess as they weigh whether or not to jump into Netease and Sina. Sure, the government implies today that it's willing to tolerate a little flouting of the rules in order to help the industry develop. But who knows how long it will be before Beijing changes its mind and turns on the foreigners as it did with Unicom?
The hope among many outsiders -- Netease counts News Corp. among its investors, while Sina's include Dell Computer, Pacific Century CyberWorks, and Goldman Sachs -- is that this is just a temporary measure. If all goes according to plan, China will soon be in the World Trade Organization, and Beijing will continue liberalizing its rules governing foreign investment in telecoms and Internet companies.
It's a big risk, but then multinationals know that China is an uncertain place to invest their money, and they're prepared to put up with that risk. The question is, are Nasdaq investors willing to be as tolerant?
Einhorn is Business Week's Hong Kong-based Asian technology correspondent. His column appears every Monday on Business Week Online EDITED BY PAUL JUDGE
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