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Biotechnology has become the hottest topic around for private equity investors. Yet investing in the sector must not be undertaken lightly – especially in emerging markets. CMS McKenna discusses these issues for the Chinese venture capital industry.

Introduction

Investing in life sciences is a hot topic and this article provides a summary of the major issues discussed in our seminar for VCs considering investing in life sciences in Hong Kong and China.

Categories that fall under life sciences

? Pharmaceutical

? Biotechnology

? Medical devices

? Medical services

? Traditional Chinese Medicine

Employees

Employees such as scientists are one of the most important assets of life sciences businesses. Therefore, it is essential to ensure that the key employees are locked in with the investee company for a minimum period of time and that they are contractually bound by non-competition and confidentiality obligations. In China, it is not uncommon to find certain employees selling their services to different competing companies so this is something to watch out for.

Management

Key managers need to be incentivised to perform well. This can be done by giving the management share options so that they are rewarded for success with shares or by way of ratchets in favor of the VCs so that the VC's shareholding increases (and the managers' diluted) if certain milestones are not reached. It is important to remember to provide in the documentation for a transfer back of vested shares from departing employees.

Previous funding

Since there are so many government-appointed bodies or research institutions (eg the Applied Research Council, the Hong Kong Jockey Club, etc), providing funding to early-stage life sciences firms, VCs should ensure that the IPR arising from the funded projects would not consequently belong to the funding institutions because the most valuable assets of the subject companies are the intellectual property rights (‘IPR').

Valuations

It is extremely difficult to value many of these life sciences companies, especially those researching a drug since vast amounts of money and years can be spent on research that comes to nothing or which produces a groundbreaking remedy worth millions. And how do you place a value on intangible assets such as intellectual property rights?

A particular problem arises when acquiring the business or assets of a state owned enterprise since, under PRC law, these must be valued by a government-appointed valuer (who might not be the most objective and independent of choices) and the consideration must not be lower than 90 per cent of the appraised value.

Verification of IPR title

VCs may find verification of IPR title most difficult when conducting due diligence. In both Hong Kong and China, registration of trademark, design, patent and domain name are available. Copyright registration is not available in Hong Kong but voluntary registration is available in China. All copyrighted works specified under the laws of Hong Kong and China will enjoy automatic copyright protection whether or not there is registration. VCs are strongly advised to inspect the registration certificates of the various IPR and confirm the registrations with the relevant authorities like the Trademark Office, Patents Office and the Domain Name Registries, etc.

It is advisable to register IPR particularly in China because IPR registrations are prima facie evidence of ownership. This can save time and costs in court and administrative proceedings, as the courts in China are not experienced in determining IPR ownership.

In the absence of registration in Hong Kong, a passing off action provides relief to infringement of IPR but not so in China. To establish a passing off action, there must be a misrepresentation made by one party in the course of trade to prospective customers that the goods or services supplied by him are related to the plaintiff and the plaintiff suffers loss and damage to reputation as a result. The plaintiff will have to prove substantial reputation to succeed in a passing off action.