The Benefits of Pre-Initial Public Offering (IPO) Trusts

Eleanor Yip, Associate Director - Trust, of Equiom Hong Kong, discusses the benefits of Pre-IPO Trusts.

Despite the obvious challenges of the global pandemic and dull market conditions in 2020, the Hong Kong stock market (HKEX) remains buoyant in 2021 having seen the initial listing of stocks from 147 issuers in 2020. Just this first quarter, there were 31 new listings, only slightly down from the 37 in Q1 2020, the market easily absorbing the offerings of Baidu and Bilibili with each raising more than USD2.5bn through Hong Kong.

While preparing for IPO, company founders have the opportunity to review their company structure and also discuss with their advisors matters relating to their own wealth, such as asset protection, succession planning and opportunities to manage tax regarding their personal holdings in the company. Founders of these newly listed companies often choose to establish a trust to hold their shares before going on to list on a stock exchange.

Surprisingly, according to disclosures made in the offering documents submitted to the HKEX, only 30 of the 147 companies that went for IPO in 2020 opted to have a family trust (pre-IPO trust) established prior to listing. (This excludes companies that have submitted applications for an IPO and waiting to list). 

When including family trusts established for senior executives but not disclosed (as they do not exceed disclosure thresholds of the stock exchange), the popularity of Pre-IPO trusts is growing.

What is a pre-IPO trust?

A pre-IPO trust is a trust arrangement, set up ahead of an IPO, for holding the shares of the company that will be listed. Its purpose is to hold the shares of individual significant shareholders– such as the founder, CEO, chairman and senior executives, before the company is listed.

So what are the benefits of establishing a pre-IPO trust?

There are many benefits to establishing a pre-IPO trust and these can be summarised as follows:

Protection from claims

• Shares are legally owned by the professional trustee and no longer in the name of the founder
• If properly constituted, the trust should shield the shares from claims from the founder’s creditors
• It protects the wealth of a surviving spouse and children from various claims

Ensuring continued control of the shares by the family

• It prevents the family from not being able to exercise the rights attached to the shares due to incapacity / death of the founder as the shares are legally owned by the professional trustee
• The professional trustee has a duty to act in the interest of the beneficiaries
• The trustee will not become incapacitated and will not be prevented from acting due to claims on the personal assets of the founder
• It ensures that the listing process can continue in the event the founder is embroiled in disputes or incapacitated
• It avoids loss of control of the business by the family in case of disputes within the family after the passing of the founder

Avoiding prolonged and expensive probate

• Once the shares are transferred into a trust, the shares no longer form part of the founder’s estate

Planning for the future

• A letter of wishes replaces the need for a will to address the succession of the trust assets
• The professional trustee has more flexibility to distribute assets and to time this to achieve tax efficiency 
• Having a discretionary trust allows the assets to be distributed in the spirit of the client’s wishes as a will cannot deal with unforeseen circumstances where distribution is not advisable; for example divorce proceedings of a child

Limiting stamp duty

• If the company to be listed is an offshore vehicle then typically the transfer of the shares before IPO would prevent stamp duty on the transfer

What are the considerations for trust structuring?

In a typical Pre-IPO trust case, the founder transfers his personal shares in the to-be listed company to a holding company (Hold Co) fully owned by the trustee with which he has established a trust. How the trust is structured will depend on the personal circumstances of the founder and named beneficiaries. Influencing factors are nationality, tax residency of all concerned parties, as well as perceived threats to the wealth such as taxes, business or family disputes or changes in the political environment.

Hong Kong as a mature financial centre has a strong professional services eco-system that can advise founders on these complex matters. Professional legal advice is available on matters such as suitable trust law and jurisdiction of the trustee. PRC, UK and US tax advice is readily available given the well-established wealth management industry servicing ultra-high net worth families that typically have family members either living overseas or taking up alternative nationalities and owning assets across the world.

Given these complex issues, finding the right professional trustee in Hong Kong is critical. It is important that the trustee is familiar with the demanding set up schedule given the deadline which all listing parties (such as sponsor, lawyers, auditors and investor relationship professionals) are subject to. But more importantly the trustee should have the experience of dealing with these cross border issues; especially if there are any US beneficiaries in the structure.

For a trust to offer the above listed benefits, the founder will need to relinquish control of the shares in favour of the professional trustee. It is therefore of utmost importance that professional advice is sought to achieve the right balance of retaining a certain level of control for the founder while not jeopardising the integrity of the trust. If the founder retains too much control, the trust may be seen as a sham trust and the assets may still be subject to claims or may not offer any taxation benefits.

Given that the founder will need to accept loss of control, the choice of the right professional trustee is critical. Considerations will include whether the trust company have sufficient expertise and knowledge of regulatory and taxation matters? Has the trustee demonstrated high standards of care? Most importantly, how available is the trustee and responsive to the requests and needs of the founder and his family?

The Popularity of Employee Stock Ownership Plans (ESOPs)

Trusts can also be used to establish ESOPs. ESOPs have, over the years, become a popular tool for companies to incentivise, motivate and retain employees and can be set up either during the pre-IPO stage or post-IPO. Directors, officers, general employees and consultants can all benefit from an ESOP.

More than half of the companies listing on HKEX have established ESOPs. This has also become a trend for the mainland Chinese companies listing on HKEX. This is understandable as from the company’s perspective an ESOP is a useful tool to motivate key employees to remain with the company for the longer term. Awarding employees a stake in the company means that it is in their interest to see the company grow. The company could also use the ESOP to attract new employees. Furthermore, the company can improve its cash flow position by rewarding employees with stock instead of cash bonuses. For employees this means that they stand to profit from the increase in value in the company’s shares. 

A great opportunity to take care of family and employees

As can be seen from the above there are many advantages in establishing family trusts and ESOPs pre-IPO. Many founders of businesses are too busy with wealth creation to stand still and consider how best to structure their personal affairs. When the company goes for an IPO, the founder has the opportunity to carefully examine his personal holdings and take advice how best to plan for the future. This similarly applies to retaining and motivating key contributors to the business. The founders during the pre-IPO stage can look to secure and reward the company’s brightest and best talent with an ESOP.

Seeking the appropriate advice and choosing the dependable professional trustee will ensure that founders can achieve all their long term goals for the company and their own family.

If you are considering an IPO for your business, or are already on that journey and haven’t yet considered how to structure your changing affairs post-IPO, please contact Eleanor Yip for an informal discussion.

This article has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The article cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact Equiom to discuss these matters in the context of your particular circumstance. Equiom Group, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this article or for any decision based on it.