Amidst China’s ongoing stock-market boom, a new company has seemingly come out of nowhere to take the investing public by storm. Baofeng Technology, a streaming and online video game company, might be little known in the West, but its stock has skyrocketed since its listing on the Shenzhen Stock Exchange in March.

Baofeng has truly lived up to its name, which literally translates to English as “storm.” From its offer price of 7.14 yuan (US$1.2) in March, the stock has surged more than 2000 percent to 190 yuan. For 29 consecutive days, the share price rose by the 10 percent daily limit.

And the rapid rise of Baofeng’s stock has been representative of China’s stock markets, with the country’s main stock index more than doubling since last November. It is now the best–performing index in the world.

But the significance of Baofeng’s listing goes beyond its frenetic debut. It has become the first Internet company to successfully move away from the hitherto extremely popular Variable Interest Entity (VIE) structure, phasing out foreign capital altogether as it listed in China.

“As the first Internet company to come back to China’s A-share markets, Baofeng’s return is widely representative,” says Chengwei (Alex) Liu, the partner at Global Law office who led the Baofeng deal. “Given Baofeng’s typical VIE structure before, and its impressive performance after getting listed, the case is a good reference for many companies in the TMT industry which are now seeking finance.”

An increasing number of Chinese Internet companies that either listed or prepared to list abroad under the VIE structure are seeking to come back to China’s lucrative stock markets.

Zhang Yin, the founder and managing partner of Matrix Partners China, an affiliate of the U.S. venture capital firm Matrix Partners, revealed in an Internet conference in May that among the 110 companies the company has invested in using U.S dollars, more than 40 are now tearing down the VIE structure and seeking to list back in China’s stock markets.

“There is no doubt that a stream of the best Chinese Internet companies will be listing in China’s A-share markets in the coming three to five years,” Zhang says. He predicts that the trend is irresistible. And the number of Internet companies already listed on the A-share markets will increase by 10 times to 30 times in the coming years.

And for Internet companies, not to mention TMT companies overall, the first step to listing back in China is taking down the VIE structure and ensuring the company is wholly owned by Chinese investors.

VIE DILEMMA

The structure known as Variable Interest Entity or VIE, has been in a grey area since it was first introduced 15 years ago.

Under the current rules, foreign investors can’t invest directly in Chinese companies operating in sensitive industries like Internet, telecommunications and education.

To circumvent government restrictions, many companies set up an operating company based in China and a holding company based abroad, and created such VIE structures by signing a series of agreements that allowed foreign investors control over the operating part that they did not actually own.

The structure was first introduced in 2000 when SINA had its initial public offering on the NASDAQ. And it soon became the most popular way for Chinese Internet companies to list in the U.S. Alibaba, Baidu and Renren, for example were among the Chinese giants that follow suit by using the VIE structure to get listed in the States. The significance of it is easy to see: Without a VIE structure, Alibaba’s $25 billion initial public offering on the New York Stock Exchange would have been impossible.

“VIE is a very smart invention. Without the VIE, China’s Internet giants which are now widely embraced overseas would not have gone so far,” says Steven Yu, another partner at Global Law Office.

With more Chinese TMT companies listing in the U.S. under such a structure, the VIE structure became a hotly debated topic in recent years. Many foreign analysts claimed that such structure was fundamentally risky, since the Chinese government could outlaw it someday.

In the past decade, there has been no law banning the VIE structure though the government has clearly been aware of its existence. Its tremendous benefits to China’s booming TMT industry in the past decade have prevented the government back from issuing a straightforward ban.

“I think the government is in a love-and-hate relationship with the structure.” Yu says.

It was only early this year that China’s Ministry of Commerce unveiled a draft of the new foreign investment rules and addressed VIEs for the first time. The draft focused on the nationality of the controller of the company rather than the origins of the shareholders. If foreign nationals are in control, the company will be regarded as foreign-invested companies — making them subject to the same foreign ownership restrictions as any other.

This draft has made the prospects of the VIE structure even murkier at the moment.

“From a short-term perspective, the draft of the new foreign investment rules will increase the cost of compliance for those companies working on building up the VIE structure. In the long run, the rules will encourage companies to come back to the domestic capital markets.” Yu adds.

MARKET CALLS

In the past decade, because the difficulties of getting listed in China, many Internet giants have been forced to venture overseas using the VIE structure.

“At the beginning, the government didn’t realise how important emerging industries such as TMT were. But now that it sees the ‘demographic dividend’ of Internet companies, it doesn’t want to let go of the benefits, so it wants them back,” says Yu.

The murkier prospects of the VIE structure could be a reason prompting a number of Chinese companies to come back to seek a legal sanction listing. But for many, the lucrative market, along with policy incentives for listing domestically are the more crucial reasons.

Last month Beijing started the countdown to the establishment of a more relaxed initial public offering (IPO) registration system to replace the current time-consuming approval process.

A registration system - used in mature markets such as the United States, where the market decides who gets to list, when, and for how much - will make redundant the China Securities Regulatory Commission’s role as the approval agency, industry sources say, and leave companies to register with stock exchanges to float shares.

In addition to the easier process and lower threshold for IPOs, the high valuation of the technology companies listed on China’s New Third board and main board is another motivation.

It was roughly estimated that by the end of April, China’s Growth Enterprise Market is trading at 104.4 times earnings, overshadowing that of most Chinese TMT companies listed in the U.S., which on average is traded at 40 times earnings. Baofeng is trading at almost 650 times earnings, while giants like Alibaba, Thunderbolt and Qihoo 360 are all trading at below 50 times earnings.

With such motivations, the urgency of Chinese companies to list back on China’s strong markets is escalating.

Liu says that many foreign investors are shorting overseas listed Chinese companies, and many are even facing class-action lawsuits for failing to comply in a unfamiliar environment. These factors are beginning to discourage Chinese TMT companies from pursing listings abroad.

“The sharp contrast between the domestic market and the overseas market is certainly facilitating the trend of removing red chips and the VIE structure, thus encouraging Chinese companies to come back,” he added.

The essence of tearing down the VIE structure and getting listed back in China involving phasing out the foreign investment. TMT companies including Focus Media, Perfect World Jiayuan.com and Shanda Games, are all planning a comeback to the domestic market.

The government has promulgated the drafts of various important laws to influence the capital markets this year, including new foreign investment rules and the securities law.

But the overhaul of those laws won’t work independently. They are consistent and coordinated with one and another with a clear underlying message from the central government: it wants to use domestic capital markets to encourage an innovative economy.

“With the successfully listing of Baofeng, a number of TMT companies have started the planning to come back to domestic A-share markets and the New Third board,” Liu concludes. “The necessity of the VIE structure has been greatly weakened. And it has come at the right time for the government to clearly address the structure. Let’s wait and see.”