F-1 1 df1.htm FORM F-1 Form F-1
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As filed with the Securities and Exchange Commission on November 15, 2010

Registration No. 333-            

 

 

 

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

 

FORM F-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

Youku.com Inc.

 

(Exact name of Registrant as specified in its charter)

Not Applicable

(Translation of Registrant’s name into English)

 

 

 

Cayman Islands   7389   Not Applicable

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

5/F, SinoSteel Plaza

8 Haidian Street

Haidian District

Beijing 100080

The People’s Republic of China

(86-10) 5885-1881

(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

 

 

Law Debenture Corporate Services Inc.

400 Madison Avenue, 4th Floor

New York, New York 10017

(212) 750-6474

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

Copies to:

 

Z. Julie Gao, Esq.

Skadden, Arps, Slate, Meagher & Flom LLP

c/o 42/F, Edinburgh Tower, The Landmark

15 Queen’s Road Central

Hong Kong

(852) 3740-4700

 

Leiming Chen, Esq.

Simpson Thacher & Bartlett LLP

ICBC Tower, 35/F

3 Garden Road, Central

Hong Kong

(852) 2514-7600

 

 

Approximate date of commencement of proposed sale to the public: as soon as practicable after the effective date of this registration statement.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

 

 

CALCULATION OF REGISTRATION FEE

 

 

Title of each class of

securities to be registered

 

Proposed maximum

aggregate offering

price(2)(3)

 

Amount of

registration fee

Class A Ordinary Shares, par value US$0.00001 per share(1)

  US$150,000,000   US$10,695
 
 
(1) American depositary shares issuable upon deposit of the Class A ordinary shares registered hereby will be registered under a separate registration statement on Form F-6 (Registration No. 333-            ). Each American depositary share represents              Class A ordinary shares.
(2) Includes              Class A ordinary shares that are issuable upon the exercise of the underwriters’ option to purchase additional shares. Also includes              Class A ordinary shares initially offered and sold outside the United States that may be resold from time to time in the United States either as part of their distribution or within 40 days after the later of the effective date of this registration statement and the date the shares are first bona fide offered to the public. These Class A ordinary shares are not being registered for the purpose of sales outside the United States.
(3) Estimated solely for the purpose of determining the amount of registration fee in accordance with Rule 457(o) under the Securities Act of 1933.

 

 

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to such Section 8(a), may determine.

 

 

 


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The information in this preliminary prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

Subject to Completion. Dated             , 2010.

             American Depositary Shares

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Youku.com Inc.

Representing              Class A Ordinary Shares

 

 

This is an initial public offering of American depositary shares, or ADSs, each representing              Class A ordinary shares of Youku.com Inc., or Youku.

Youku is offering              ADSs to be sold in the offering. Prior to this offering, there has been no public market for the ADSs or our shares. It is currently estimated that the initial public offering price per ADS will be between US$             and US$            . We will apply to list the ADSs on the New York Stock Exchange, or the NYSE, under the symbol “YOKU.”

See “Risk Factors” on page 16 to read about factors you should consider before buying the ADSs.

 

 

Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

 

 

 

     Per ADS      Total  

Initial public offering price

   US$                    US$                

Underwriting discount

   US$         US$     

Proceeds, before expenses, to Youku

   US$         US$     

To the extent the underwriters sell more than              ADSs, the underwriters have the option to purchase up to an additional              ADSs from Youku at the initial public offering price less the underwriting discount.

 

 

The underwriters expect to deliver the ADSs against payment in U.S. dollars in New York, New York on             , 2010.

Goldman Sachs (Asia) L.L.C.        

 

   Allen & Company LLC       
Piper Jaffray         Pacific Crest Securities   

 

 

Prospectus dated             , 2010


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TABLE OF CONTENTS

 

     Page  

Summary

     1   

Conventions Used in this Prospectus

     7   

Risk Factors

     16   

Special Note Regarding Forward-Looking Statements

     54   

Use of Proceeds

     56   

Dividend Policy

     57   

Capitalization

     58   

Dilution

     59   

Exchange Rate Information

     61   

Enforceability of Civil Liabilities

     62   

Corporate Structure

     64   

Selected Consolidated Financial Data

     71   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     75   

Industry

     105   

Business

     111   

Regulation

     127   

Management

     148   

Principal Shareholders

     157   

Related Party Transactions

     160   

Description of Share Capital

     162   

Description of American Depositary Shares

     171   

Shares Eligible for Future Sales

     182   

Taxation

     184   

Underwriting

     192   

Legal Matters

     198   

Experts

     199   

Additional Information

     200   

Index to Consolidated Financial Statements

     F-1   

 

 

No dealer, salesperson or other person is authorized to give any information or to represent anything not contained in this prospectus or in any free writing prospectus we may authorized to be delivered or made available to you. You must not rely on any unauthorized information or representations. This prospectus is an offer to sell only the ADSs offered hereby, but only under circumstances and in jurisdictions where it is lawful to do so. The information contained in this prospectus is current only as of its date.

Neither we nor the underwriters has done anything that would permit this offering or possession or distribution of this prospectus or any filed free writing prospectus in any jurisdiction where action for that purpose is required, other than in the United States. Persons outside the United States who come into possession of this prospectus or any filed free writing prospectus must inform themselves about, and observe any restrictions relating to, the offering of the ADSs and the distribution of this prospectus or any filed free writing prospectus outside of the United States.

Through and including             , 2010 (the 25th day after the date of this prospectus), all dealers effecting transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to a dealer’s obligation to deliver a prospectus when acting as an underwriter and with respect to an unsold allotment or subscription.

 

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SUMMARY

This summary highlights information contained elsewhere in this prospectus and does not contain all of the information that you should consider in making your investment decision. Before investing in the ADSs, you should carefully read this entire prospectus, including our financial statements and related notes included in this prospectus and the information set forth under the headings “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Youku.com Inc.

Overview

We are the leading Internet television company in China. Our Internet television platform enables consumers to search, view and share high-quality video content quickly and easily across multiple devices. We believe our continuous focus on offering a superior user experience has enabled us to become the largest Internet television company in China and elevated our Youku LOGO brand, which stands for “what’s best and what’s cool” in Chinese, to be the most recognized online video brand in China according to a 2010 survey conducted by an affiliate of the Chinese Academy of Sciences. According to iResearch, we had approximately 203 million monthly unique visitors from homes and offices in September 2010 and approximately 61 million monthly unique visitors from Internet cafes in August 2010. We had a 40% market share in terms of total user time spent viewing online videos in China during the second quarter of 2010, while our closest competitor accounted for a 23% market share during the same period, according to iResearch. In 2009, we had an implied market share of approximately 14% in terms of online video advertising spend in China, based on iResearch’s estimated data of total online video advertising spend in China.

As a video content aggregator in China, we are well-positioned to benefit from the market growth potential in China’s highly fragmented and regulated content production and distribution markets, where less than half of the professionally produced television serial dramas and movies each year are aired on television or released in theaters. We have built a large and comprehensive online video content library. The majority of the videos on our website are professionally produced content, such as television serial dramas, movies, variety shows, current events reports and music videos, and the remainder is comprised of user-generated content and in-house productions. We license video content typically at fixed rates for a specified term. The average term of licenses varies depending on the type of content, with movies and television serial dramas having an average term of approximately 2.5 years and 2 years, respectively. We generally renew our licenses when they expire. As of September 30, 2010, our video content library contained more than 2,200 movie titles, 1,250 television serial drama titles and over 231,000 hours of other professionally produced content, including 194 variety shows.

Our mission is to become the primary source of video content for the Chinese population across any Internet-enabled device. Leveraging our proprietary video content delivery network, or CDN, comprised of over 5,500 servers, we provide fast streaming and upload speeds. At the same time, our comprehensive content library, coupled with an easy-to-use online interface, facilitates our providing a superior user experience, according to a 2010 survey by China Internet Week, a magazine affiliated with the Chinese Academy of Science. As a result, our Internet television platform attracts a nationwide audience, the majority of which resides in China’s more affluent urban areas.

 

 

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We currently derive substantially all of our revenues from online advertising services. Our advertising solutions present brand advertisers with attractive opportunities to combine the visual impact and engagement of traditional television-like multimedia advertisements with the interactivity and precise targeting capabilities of the Internet. We strive to promote a healthy advertising environment on our website to attract mainstream brand advertisers. We believe our differentiated sales proposition has contributed to the rapid increase in the number of international and domestic brand advertisers, which increased from 7 in 2007 to 141 in 2008 and to 303 in 2009, and from 230 in the nine months ended September 30, 2009 to 343 in the nine months ended September 30, 2010.

The desirable demographic characteristics of our large user base as well as our differentiated advertising solutions and environment are key factors driving the fast growth in our online advertising revenues. We believe that wireless and web-based subscription services, which we plan to formally launch in the foreseeable future, will also increasingly contribute to our net revenues over time. We launched Youku.com in December 2006. As is customary in the advertising industry in China, we offer commissions to third-party advertising agencies who purchase our advertising services and recognize revenues net of these commissions. Our net revenues increased from RMB1.8 million in 2007 to RMB33.0 million in 2008 and to RMB153.6 million in 2009, and increased from RMB99.8 million in the nine months ended September 30, 2009 to RMB234.6 million (US$35.1 million) in the nine months ended September 30, 2010.

Due to PRC legal restrictions on foreign ownership and investment in value-added telecommunications services and advertising businesses in China, we operate our business primarily through our consolidated affiliated entities in China. We do not hold equity interests in our consolidated affiliated entities. However, through a series of contractual arrangements with these consolidated affiliated entities and their respective shareholders, we effectively control, and are able to derive substantially all of the economic benefits from, these consolidated affiliated entities.

Our Industry

China’s video media market has developed in a very distinct manner from those in the United States and Western Europe, resulting in a domestic ecosystem highly regulated and fragmented both in terms of production and distribution. This market is undergoing substantial changes partially due to macro trends affecting the global video media market, such as the migration of consumers online, the digitization of both new and existing content, and more convenient access to that content through increasingly faster fixed and mobile broadband connections. The combined effect of these macro trends is that the Internet has emerged as a viable video distribution channel. In China, these changes are magnified by the country’s rapid economic growth, the expansion of the advertising industry, significantly increased consumer spending, and the fragmentation of the legacy production and distribution ecosystems for video content. This has created opportunities for web properties in China with differentiated, desirable video content to aggregate large, nationwide audiences while delivering personalized content whenever users want. With disposable income growing quickly in China, these aggregated audiences have become more attractive to advertisers as well as more capable of paying for content.

China’s Internet television market is early in its development and is evolving rapidly as an increasing number of users search, view and share video content online. For the purposes of this prospectus, Internet television is generally synonymous with online video and refers to consumers’ accessing any type of video content via any Internet-enabled device. The strong consumer reaction to, and the emerging advertiser reception of, Internet television in China represents an increasing convergence of the large and fast-growing Internet market and the large, diverse and highly fragmented video media market.

 

 

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According to iResearch, the size of China’s online video market, as measured by total revenues, grew rapidly from RMB0.5 billion (US$78 million) in 2006 to RMB2.8 billion (US$413 million) in 2009, representing a compound annual growth rate, or CAGR, of 74%. China’s online video market has become increasingly concentrated, with the top five players accounting for 83% of the total user time spent watching online videos in China during the second quarter of 2010, according to iResearch.

Our Competitive Strengths

We believe that the following strengths contribute to our success and differentiate us from our competitors:

 

  Ÿ  

leading Internet television company in China with strong brand recognition;

 

  Ÿ  

network effects and economies of scale resulting in high barriers to entry;

 

  Ÿ  

large and comprehensive video content library tailored to Chinese users;

 

  Ÿ  

substantial investments in infrastructure, know-how and products and services to deliver a superior user experience;

 

  Ÿ  

differentiated sales proposition attracting mainstream brand advertisers; and

 

  Ÿ  

seasoned management team with a proven track record.

Our Strategies

Our mission is to become the primary source of video content for the Chinese population across any Internet-enabled device. We intend to achieve our mission by expanding our content library and user base, enhancing our brand and better monetizing our user traffic. More specifically, we plan to implement the following strategies:

 

  Ÿ  

further improve our user experience;

 

  Ÿ  

increase the breadth and depth of our video content library;

 

  Ÿ  

expand our infrastructure and optimize our services across Internet-enabled devices;

 

  Ÿ  

further enhance our brand recognition; and

 

  Ÿ  

expand and diversify our revenue sources.

Our Challenges

We expect to face risks and uncertainties related to our business and industry, including those relating to our ability to:

 

  Ÿ  

capitalize on our investments to change our historical net loss position and achieve and sustain profitability;

 

  Ÿ  

comply with applicable regulations and government policies;

 

  Ÿ  

generate sufficient revenues to offset the increase in acquisition costs for professionally produced content;

 

  Ÿ  

maintain our product development advantages and keep up with technological developments and users’ evolving demands; and

 

  Ÿ  

protect third-party intellectual property rights.

 

 

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In addition, we expect to face risks and uncertainties related to our corporate structure and doing business in China, including:

 

  Ÿ  

risks associated with our control over our consolidated affiliated entities, which is based upon contractual arrangements rather than equity ownership;

 

  Ÿ  

uncertainties associated with our compliance with various PRC laws and regulations, including regulations requiring domestic telecommunications services providers own domain names and trademarks used in the provision of such services and have necessary facilities for the approved business operations; and

 

  Ÿ  

uncertainties associated with our ability to fund our expansion and operations due to PRC currency transfer and conversion restrictions and the restrictions on loans and direct investments by offshore holding companies to PRC entities.

See “Risk Factors” and other information included in this prospectus for a discussion of these and other risks and uncertainties associated with our business and investing in our ADSs.

Corporate History and Structure

On September 20, 2005, our founder, Victor Wing Cheung Koo, incorporated 1Verge Inc. in the Cayman Islands. On June 20, 2008, we changed the company name from 1Verge Inc. to Youku.com Inc. On November 14, 2005, we established our wholly owned subsidiary, 1Verge Internet Technology (Beijing) Co., Ltd., or 1Verge Internet, in Beijing, China. On April 27, 2010, we acquired all of the equity interest in Jet Brilliant Limited, or Jet Brilliant, a Hong Kong company, which wholly owns Beijing Jet Brilliant Advertising Co., Ltd., or Jet Brilliant Beijing, an advertising company established in Beijing, China. Jet Brilliant operates as our intermediary holding company. For descriptions of the tax implications of having Jet Brilliant as our Hong Kong intermediary holding company and the relevant PRC laws and regulations, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Taxation—PRC” and “Regulation—Regulations on Tax—Dividends Withholding Tax.”

 

 

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The following chart illustrates our corporate structure as of the date of this prospectus:

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(1) 1Verge Information and Jiaheyi are our consolidated affiliated entities established in China and each is 80% owned by Ms. Qiong Qin, the wife of our founder, Mr. Victor Koo, and 20% owned by Mr. Dele Liu, our director, chief financial officer and senior vice president. We effectively control 1Verge Information and Jiaheyi through contractual arrangements. See “Corporate Structure.”

PRC laws and regulations currently limit foreign ownership of companies that provide value-added telecommunications services. To comply with these restrictions, we conduct our online video operations in China primarily through our consolidated affiliated entity, 1Verge Information Technology (Beijing) Co., Ltd., or 1Verge Information. 1Verge Information is our website operator and Internet content provider, and holds the licenses and permits issued by both the telecommunication and broadcast media authorities as well as other ancillary licenses and permits to conduct our online video operations. PRC laws and regulations also restrict foreign ownership of companies that conduct advertising business by requiring a Sino-foreign joint venture’s foreign investor to have previously had two years’ direct advertising operations as its main business outside of China, and a wholly foreign-owned enterprise’s foreign investor to have previously had three years’ direct advertising operations as its main business outside of China. As a Cayman Islands company, we are a foreign legal person under PRC laws and we have not been involved in any advertising business outside of China for the requisite number of years. We conduct our advertising business in China primarily through our consolidated affiliated entities, 1Verge Information and Jiaheyi Advertising (Beijing) Co., Ltd., or Jiaheyi. Jiaheyi is an advertising agency, which plays an immaterial role in our business and contributed less than 1% of our total net revenues in each of 2007, 2008, 2009 and the nine months ended September 30, 2010. We intend to begin the process of liquidating Jiaheyi in 2011. Jet Brilliant is a Hong Kong company which satisfies the requirement of having three years’ direct advertising operations, and therefore was approved by local branch of the State Administration for Industry and Commerce, or the SAIC, to establish Jet Brilliant Beijing on May 19, 2009, a wholly foreign-owned advertisement company. As we acquired Jet Brilliant on April 27, 2010, Jet Brilliant Beijing will conduct

 

 

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our advertising agency business in the future. However, we do not expect that the advertising agency business will play an important role in our overall business in the future.

Our wholly owned subsidiary, 1Verge Internet, has entered into a series of contractual arrangements with 1Verge Information, Jiaheyi and their respective shareholders, which enable us to:

 

  Ÿ  

exercise effective control over the business management and shareholder voting rights of 1Verge Information and Jiaheyi;

 

  Ÿ  

receive substantially all of the economic benefits of 1Verge Information and Jiaheyi through service and licensing fees in consideration for the technical and consulting services provided by and the intellectual property rights licensed by 1Verge Internet; and

 

  Ÿ  

have an exclusive option to purchase all of the equity interests in 1Verge Information and Jiaheyi when and to the extent permitted under PRC laws.

We do not have equity interest in 1Verge Information or Jiaheyi. However, as a result of these contractual arrangements, we are considered the primary beneficiary of 1Verge Information and Jiaheyi, and we treat them as our consolidated affiliated entities under the generally accepted accounting principles in the United States, or U.S. GAAP. We have consolidated the financial results of these companies in our consolidated financial statements in accordance with U.S. GAAP. For the three years ended December 31, 2007, 2008 and 2009, and the nine months ended September 30, 2010, we received nil service or license fees under the amended and restated exclusive technical and consulting services, trademark license and domain name license agreements referred to in “Corporate Structure—Agreements that Transfer Economic Benefits to Us” from 1Verge Information or Jiaheyi as neither of them has yet to achieve profitability. For a description of these contractual arrangements, see “Corporate Structure.” For a detailed description of the regulatory environment that necessitates the adoption of our corporate structure, see “Regulation.” For a detailed description of the risks associated with our corporate structure and the contractual arrangements that support our corporate structure, see “Risk Factors—Risks Related to Our Corporate Structure.”

Corporate Information

Our principal executive offices are located at 5/F, SinoSteel Plaza, 8 Haidian Street, Beijing, 100080, the People’s Republic of China. Our telephone number at this address is +86 (10) 5885-1881. Our registered office in the Cayman Islands is located at Clifton House, 75 Fort Street, P.O. Box 1350, Grand Cayman, KY1-1108 Cayman Islands. Our telephone at this address is +1 (345) 949-4900. We also have three representative offices in Shanghai, Guangzhou and Chengde, and a branch in Xi’an, China.

Investors should submit any inquiries to the address and telephone number of our principal executive offices set forth above. Our website is www.youku.com and the information contained on this website is not a part of this prospectus. Our agent for service of process in the United States is Law Debenture Corporate Services Inc., located at 400 Madison Avenue, 4th Floor, New York, New York 10017.

 

 

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CONVENTIONS USED IN THIS PROSPECTUS

In this prospectus, unless the context indicates otherwise, references to:

 

  Ÿ  

“we,” “us,” “our company,” “our,” and “Youku” refer to Youku.com Inc., its subsidiaries and consolidated affiliated entities;

 

  Ÿ  

“ordinary shares” refer to, prior to the completion of this offering, our ordinary shares, par value US$0.00001 per share, and, after the completion of this offering, collectively our Class A and Class B ordinary shares, par value US$0.00001 per share;

 

  Ÿ  

“preferred shares” refer to our Series A, Series B-1, Series B-2, Series C, Series D, Series E and Series F convertible preferred shares, par value US$0.00001 per share;

 

  Ÿ  

“ADS” refers to American depositary shares, each of which represents                      Class A ordinary shares;

 

  Ÿ  

“China” or the “PRC” refers to the People’s Republic of China excluding, for the purpose of this prospectus only, Hong Kong, Macau and Taiwan;

 

  Ÿ  

“Renminbi” or “RMB” refers to the legal currency of China;

 

  Ÿ  

“$”, “US$”, “dollars” or “U.S. dollars” refers to the legal currency of the United States;

 

  Ÿ  

“monthly unique visitors” means the number of unique visitors to a specific website within a given month. Once an individual has visited a site in a given month, all subsequent visits from the same IP address during such month are not additive to the monthly unique visitor tally; and

 

  Ÿ  

“commissions earned by third-party advertising agencies” means the estimated amount of commissions earned by advertising agencies who purchase our services.

Except as otherwise indicated, all information in this prospectus assumes no exercise by the underwriters of their option to purchase additional ADSs.

 

 

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THE OFFERING

The following assumes that the underwriters will not exercise their option to purchase additional ADSs in the offering, unless otherwise indicated.

 

Price per ADS

US$            .

 

ADSs offered by us

                ADSs.

 

ADS to Class A ordinary share ratio

Each ADS represents the right to receive              Class A ordinary shares, par value US$0.00001 per share.

 

ADSs outstanding immediately after this offering

                ADSs.

 

Ordinary shares outstanding immediately after this offering

            shares, par value $0.00001 per share, comprised of (i)              Class A ordinary shares and (ii)              Class B ordinary shares.

 

The ADSs

The depositary will hold the Class A ordinary shares underlying your ADSs and you will have rights as provided for in the deposit agreement.

We do not expect to pay dividends in the foreseeable future. If, however, we declare dividends on our ordinary shares, the depositary will pay you the cash dividends and other distributions it receives on our ordinary shares, after deducting its fees and expenses.

You may turn in your ADSs to the depositary in exchange for Class A ordinary shares. The depositary will charge you fees for any exchange.

We may amend or terminate the deposit agreement without your consent. If you continue to hold your ADSs, you agree to be bound by the deposit agreement as amended.

To better understand the terms of the ADSs, you should carefully read the “Description of American Depositary Shares” section of this prospectus. You should also read the deposit agreement, which is filed as an exhibit to the registration statement that includes this prospectus.

 

Ordinary shares

After the completion of this offering, our ordinary shares will consist of Class A ordinary shares and Class B ordinary

 

 

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shares. Holders of Class A ordinary shares and Class B ordinary shares have the same rights except for voting and conversion rights. Subject to certain exceptions, in respect of matters requiring shareholders’ vote, each Class A ordinary share is entitled to one vote, and each Class B ordinary share is entitled to three votes. Each Class B ordinary share is convertible into one Class A ordinary share at any time by the holder thereof. Class A ordinary shares are not convertible into Class B ordinary shares under any circumstances. Upon any transfer of Class B ordinary shares by a holder thereof to any person or entity which is not an affiliate of such holder, such Class B ordinary shares shall be automatically and immediately converted into the equal number of Class A ordinary shares.

 

Option to purchase additional ADSs

We have granted to the underwriters an option, exercisable within 30 days from the date of this prospectus, to purchase up to an additional              ADSs.

 

Reserved ADSs

At our request, the underwriters have reserved for sale, at the initial public offering price, up to an aggregate of              ADSs offered in this offering to some of our directors, officers, employees, business associates and related persons through a directed share program.

 

Use of proceeds

We expect that we will receive net proceeds of approximately US$             million from this offering (after deducting underwriting discounts and commissions and estimated offering expenses payable by us).

We intend to use the net proceeds from this offering to invest in technology, infrastructure and product development efforts, acquire additional video content and expand our sales and marketing efforts and for other general corporate purposes, including working capital needs and potential acquisitions (although we are not currently negotiating any such acquisitions). See “Use of Proceeds” for more information.

 

NYSE symbol

YOKU.

 

Depositary

Citibank, N.A.

 

Lock-up

We, our directors and executive officers, all of our shareholders and certain of our option holders have agreed with the underwriters not to sell, transfer or dispose of any ADSs, ordinary shares or similar securities for a period of 180 days after the date of this prospectus, subject to certain exceptions. In addition, through a letter agreement, we will instruct Citibank, N.A., as depositary, not to accept any deposit of any ordinary shares or issue any ADSs for 180 days after the date of this prospectus unless we consent to such deposit or issuance, and

 

 

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not to provide consent without the prior written consent of Goldman Sachs (Asia) L.L.C. The foregoing does not affect the right of ADS holders to cancel their ADSs and withdraw the underlying ordinary shares. Moreover, the shareholders of 1Verge Holdings Ltd., which will directly hold a total of 626,773,147 Class B ordinary shares of our company on an as-converted basis upon the completion of this offering, have agreed among themselves not to sell our shares through 1Verge Holdings Ltd. without the unanimous consent of 1Verge Holdings Ltd.’s board of directors for a period of two years after the completion of this offering. See “Shares Eligible For Futures Sales” and “Underwriting.”

 

Risk factors

See “Risk Factors” and other information included in this prospectus for a discussion of risks you should carefully consider before investing in the ADSs.

The number of ordinary shares that will be outstanding immediately after this offering:

 

  Ÿ  

is based upon              ordinary shares outstanding as of the date of this prospectus, assuming the conversion of all outstanding convertible redeemable preferred shares, or preferred shares, and the preferred shares issuable upon the exercise of all outstanding warrants into              ordinary shares immediately upon the completion of this offering;

 

  Ÿ  

excludes              ordinary shares issuable upon the exercise of options outstanding as of the date of this prospectus, at a weighted average exercise price of US$             per share; and

 

  Ÿ  

excludes              ordinary shares reserved for future issuances under our 2006 Stock Option Scheme, as amended, and our 2010 Share Incentive Plan.

 

 

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SUMMARY CONSOLIDATED FINANCIAL DATA

The following summary consolidated statements of operations data for the years ended December 31, 2007, 2008, 2009 and the summary consolidated balance sheet data as of December 31, 2008, 2009 have been derived from our audited consolidated financial statements included elsewhere in this prospectus. The summary consolidated statement of operations data for the nine month periods ended September 30, 2009 and 2010 and summary consolidated balance sheet data as of September 30, 2010 have been derived from our unaudited condensed consolidated financial statements included elsewhere in this prospectus. You should read this Summary Consolidated Financial Data together with our consolidated financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus. Our consolidated financial statements are prepared and presented in accordance with U.S. GAAP.

 

    Year Ended December 31,     Nine Months Ended September 30,  
    2007     2008     2009     2009     2010  
    RMB     RMB     RMB     RMB     RMB    

US$

 
    (in thousands, except for share and per share date)  
                      (Unaudited)     (Unaudited)     (Unaudited)  

Consolidated Statement of Operations Data

           

Net revenues(1)

    1,778        33,022        153,626        99,784        234,623        35,068   

Cost of revenues(2)

    (46,148     (171,130     (216,708     (157,684     (248,719     (37,175
                                               

Gross loss

    (44,370     (138,108     (63,082     (57,900     (14,096     (2,107

Operating expenses(2):

           

Sales and marketing

    (22,469     (35,086     (72,746     (46,485     (91,527     (13,680

Product development

    (15,530     (15,398     (20,908     (15,003     (21,260     (3,178

General and administrative

    (5,843     (14,367     (18,523     (13,043     (18,716     (2,797
                                               

Total operating expenses

    (43,842     (64,851     (112,177     (74,531     (131,503     (19,655
                                               

Loss from operations

    (88,212     (202,959     (175,259     (132,431     (145,599     (21,762

Interest income

    1,013        5,384        2,054        1,840        1,068        160   

Interest expense

    —          (4,240     (6,835     (5,401     (4,963     (742

Amortization of debt issuance costs

    —          (2,380     —          —          —          —     

Change in fair value of derivative financial liabilities and warrant liability

    (2,422     (264     (2,313     (357     (17,532     (2,620

Others, net

    (62     (1     67        48        65        10   
                                               

Loss from operations before income taxes

    (89,683     (204,460     (182,286  

 

 

 

 

 

(136,301

 

 

 

 

 

 

 

 

(166,961

 

 

 

 

 

 

 

 

(24,954

 

 

Income taxes

    —          —          —          —          —          —     
                                               

Net loss

    (89,683     (204,460     (182,286     (136,301     (166,961     (24,954
                                               

Net loss per share:

           

Basic

    (0.25     (0.56     (0.50     (0.37     (0.46     (0.07

Diluted

    (0.25     (0.56     (0.50     (0.37     (0.46     (0.07

Net loss per ADS(3):

           

Basic

           

Diluted

           

Weighted-average ordinary shares outstanding:

           

Basic

    365,011,250        365,134,375        365,432,916        365,268,611        365,675,115        365,675,115   

Diluted

    365,011,250        365,134,375        365,432,916        365,268,611        365,675,115        365,675,115   

Pro forma net loss per share:

           

Basic

        (0.13       (0.11     (0.02

Diluted

        (0.13       (0.11     (0.02

Pro forma weighted-average ordinary shares outstanding:

           

Basic

        1,454,990,172          1,555,698,080        1,555,698,080   

Diluted

        1,454,990,172          1,555,698,080        1,555,698,080   
Selected non-GAAP Financial Data            

Adjusted revenues(4)

    1,778        39,401        191,492        122,545        288,511        43,122   
                                               

Adjusted net loss(4)

    (86,012     (200,531     (175,408     (132,696     (142,054     (21,232
                                               

 

 

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(1) Net revenues are presented net of commissions earned by third-party advertising agencies, as the term is defined on page 7, as set forth below:

 

     Year Ended December 31,      Nine Months Ended September 30,  
         2007              2008              2009               2009                       2010               
     RMB      RMB      RMB     

RMB

     RMB      US$  
    

(in thousands)

 
                          (Unaudited)     

(Unaudited)

    

(Unaudited)

 

Commissions earned by third-party advertising agencies

     —           6,379         37,866         22,761         53,888         8,054   

 

(2) Including share-based compensation expenses as set forth below:

 

     Year Ended December 31,      Nine Months Ended September 30,  
         2007              2008              2009               2009                       2010               
    

RMB

    

RMB

    

RMB

    

RMB

    

RMB

    

US$

 
    

(in thousands)

 
                         

(Unaudited)

    

(Unaudited)

    

(Unaudited)

 

Allocation of Share-based Compensation Expenses

                 

Cost of revenues

     —           259         283         206         550         82   

Product development

     684         1,401         1,657         1,206         2,038         305   

Sales and marketing

     141         861         1,690         1,161         3,645         545   

General and administrative

     424         1,144         935         675         1,142         170   
                                                     

Total

     1,249         3,665         4,565         3,248         7,375         1,102   
                                                     

 

(3) Each ADS represents              Class A ordinary shares.

 

(4) We define adjusted revenues, a non-GAAP financial measure, as the sum of net revenues and commissions earned by third-party advertising agencies, as the term is defined on page 7. We define adjusted net loss, a non-GAAP financial measure, as net loss excluding share-based compensation expenses and change in fair value of derivative financial liabilities and warrant liability. We review adjusted revenues and adjusted net loss together with net revenues and net loss to obtain a better understanding of our operating performance. We also believe it is useful supplemental information for investors and analysts to assess our operating performance with the effect of commissions earned by third-party advertising agencies, as the term is defined on page 7, and without the effect of non-cash share-based compensation expenses and change in fair value of derivative financial liabilities and warrant liability, which have been and will continue to be significant recurring factors in our business. However, the use of adjusted revenues and adjusted net loss has material limitations as an analytical tool. One of the limitations of using non-GAAP adjusted revenues is that it excludes an item that is not typically excluded from net revenues. One of the limitations of using non-GAAP adjusted net loss is that it does not include all items that impact our net loss for the period. In addition, because adjusted revenues and adjusted net loss are not calculated in the same manner by all companies, they may not be comparable to other similar titled measures used by other companies. In light of the foregoing limitations, you should not consider adjusted revenues and adjusted net loss in isolation from or as an alternative to net revenues and net loss, respectively, prepared in accordance with U.S. GAAP. We encourage investors and others to review our financial information in its entirety and not rely on a single financial measure.

 

     Year Ended December 31,      Nine Months Ended September 30,  
     2007     2008         2009               2009                      2010               
     RMB     RMB     RMB      RMB     RMB     US$  
    

(in thousands)

 

Net revenues

     1,778        33,022        153,626         99,784        234,623        35,068   

Add back: Commissions earned by third-party advertising agencies

     —          6,379        37,866         22,761        53,888        8,054   
                                                 

Adjusted revenues

     1,778        39,401        191,492         122,545        288,511        43,122   
                                                 

Net loss

     (89,683     (204,460     (182,286      (136,301     (166,961     (24,954

Add back: share-based compensation expenses

     1,249        3,665        4,565         3,248        7,375        1,102   

Add back: change in fair value of derivative financial liabilities and warrant liability

     2,422        264        2,313         357        17,532        2,620   
                                                 

Adjusted net loss

     (86,012     (200,531     (175,408      (132,696     (142,054     (21,232
                                                 

 

 

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     As of December 31,     As of September 30,  
     2008     2009     2010     2010  
     RMB     RMB     RMB     US$     RMB      US$  
    

(in thousands)

 
                             Pro Forma(1)  
                 (Unaudited)     (Unaudited)  
                                

Consolidated Balance Sheet Data

             

Cash and cash equivalents

     88,915        301,608        440,554        65,848        440,554         65,848   

Total current assets

     228,600        384,322        632,538        94,543        632,538         94,543   

Total assets

     291,746        441,741        738,798        110,426        738,798         110,426   

Total current liabilities

     60,159        132,479        260,042        38,870        260,042         38,870   

Total liabilities

     92,115        146,754        281,833        42,127        281,833         42,127   

Convertible redeemable preferred shares

     507,614        780,599        1,102,325        164,759        —           —     

Total equity (deficit)

     (307,983     (485,612     (645,360     (96,460     456,965         68,299   

 

(1) Pro forma basis reflects the conversion of all outstanding preferred shares on a 1-for-1 basis into an aggregate of 1,190,022,965 ordinary shares as of September 30, 2010.

Additional Non-GAAP Financial Measure—Adjusted EBITDA

To supplement our consolidated financial statements which are presented in accordance with U.S. GAAP and in addition to the previously mentioned non-GAAP financial measures of adjusted revenues and adjusted net loss, we also use Adjusted EBITDA as an additional non-GAAP financial measure. Adjusted EBITDA, as we present it, represents net income or loss before income taxes, interest expenses, interest income, depreciation and amortization, further adjusted for change in fair value of derivative financial liabilities and warrant liability, share-based compensation expense and other non-operating items. We present Adjusted EBITDA because it is used by our management to evaluate our operating performance. We also believe that Adjusted EBITDA provides useful information to investors and others in understanding and evaluating our consolidated results of operations in the same manner as our management and in comparing financial results across accounting periods and to those of our peer companies.

 

 

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The following tables reconcile our Adjusted EBITDA in 2007, 2008, 2009 and the nine months ended September 30, 2009 and 2010, as well as the nine quarters in the period from July 1, 2008 to September 30, 2010 to the most directly comparable financial measure calculated and presented in accordance with U.S. GAAP, which is net loss:

 

     Year Ended December 31,     Nine Months Ended September 30,  
     2007     2008     2009             2009             2010  
     RMB     RMB     RMB     RMB     RMB     US$  
     (in thousands)  

Net loss

     (89,683     (204,460     (182,286     (136,301     (166,961     (24,954

Add (deduct):

            

Income taxes

     —          —          —          —          —          —     

Interest expense

     —          4,240        6,835        5,401        4,963        742   

Interest income

     (1,013     (5,384     (2,054     (1,840     (1,068     (160

Depreciation

     8,726        26,923        36,207        26,335        32,283        4,825   

Amortization of intangible assets

     —          1,450        4,581        2,383        31,935        4,773   

Share-based compensation

     1,249        3,665        4,565        3,248        7,375        1,102   

Amortization of debt issuance costs

     —          2,380        —          —          —          —     

Change in fair value of derivative financial liabilities and warrant liability

     2,422        264        2,313        357        17,532        2,620   

Others, net

     62        1        (67     (48     (65     (10
                                                

Adjusted EBITDA

     (78,237     (170,921     (129,906     (100,465     (74,006     (11,062
                                                

 

    Three Months Ended  
    September 30,
2008
    December 31,
2008
    March 31,
2009
    June 30,
2009
    September 30,
2009
    December 31,
2009
    March 31,
2010
    June 30,
2010
    September 30,
2010
 
   

RMB

   

RMB

   

RMB

   

RMB

   

RMB

   

RMB

   

RMB

   

RMB

   

RMB

 
    (in thousands)  

Net loss

    (55,761     (61,366     (52,196     (44,714     (39,391     (45,985     (51,201     (62,638     (53,122

Add (deduct):

                 

Income taxes

    —          —          —          —          —          —          —          —          —     

Interest expense

    1,519        1,898        1,960        1,813        1,628        1,434        1,403        1,043        2,517   

Interest income

    (1,872     (1,872     (693     (685     (462     (214     (219     (584     (265

Depreciation

    7,545        7,900        8,271        8,746        9,318        9,872        10,508        11,034        10,741   

Amortization of intangible assets

    360        725        644        686        1,053        2,198        3,571        10,229        18,135   

Share-based compensation

    1,044        961        994        1,029        1,225        1,317        1,864        2,095        3,416   

Amortization of debt issuance costs

    869        869        —          —          —          —          —          —          —     

Change in fair value of derivative financial liabilities and warrant liability

    (44     (397     240        50        67        1,956        748        4,808        11,976   

Others, net

    (1     68        25        (69     (4     (19     (77     (30     42   
                                                                       

Adjusted EBITDA

    (46,341     (51,214     (40,755     (33,144     (26,566     (29,441     (33,403     (34,043     (6,560
                                                                       

The use of Adjusted EBITDA has certain limitations because it does not reflect all items of income and expense that affect our operations. Items excluded from Adjusted EBITDA are significant components in understanding and assessing our operating and financial performance. Depreciation expense, amortization, income taxes, interest expenses and interest income as well as change in fair value of derivative financial liabilities and warrant liability, share-based compensation expenses and other non-operating items have been and may continue to be incurred in our business and are not reflected in the presentation of Adjusted EBITDA. Each of these items should also be considered in the overall evaluation of our results. Additionally, Adjusted EBITDA does not consider capital expenditures and other investing activities and should not be considered as a measure of our liquidity. We compensate for these limitations by reconciling this non-GAAP financial measure to the nearest U.S. GAAP performance measure, all of which should be considered when evaluating our performance. The term Adjusted EBITDA is not defined under U.S. GAAP, and Adjusted EBITDA is not a measure of net

 

 

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income, operating income, operating performance or liquidity presented in accordance with U.S. GAAP. When assessing our operating and financial performance, you should not consider such data in isolation or as a substitute for our net income, operating income or any other operating performance measure that is calculated in accordance with U.S. GAAP. Further, Adjusted EBITDA may differ from the non-GAAP information used by other companies, including peer companies, and therefore comparability may be limited. We encourage investors and others to review our financial information in its entirety and not rely on a single financial measure.

 

 

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RISK FACTORS

An investment in our ADSs involves significant risks. You should consider carefully all of the information in this prospectus, including the risks and uncertainties described below, before making an investment in our ADSs. Any of the following risks could have a material adverse effect on our business, financial condition and results of operations. In any such case, the market price of our ADSs could decline, and you may lose all or part of your investment.

Risks Related to Our Business and Industry

Our limited operating history makes it difficult to evaluate our business and prospects.

We launched our website and online video service in December 2006 and have experienced rapid growth since then. We expect our expansion trend to continue as we grow our user and customer bases and explore new market opportunities. However, due to our limited operating history, our historical growth rate may not be indicative of our future performance. We cannot assure you that we will grow at the same rate as we did in the past. You should consider our prospects in light of the risks and uncertainties fast-growing companies with a limited operating history may encounter.

We incurred net losses in 2007, 2008, 2009 and the nine months ended September 30, 2010 and may continue to incur losses in the future.

We incurred net losses in the amount of RMB89.7 million, RMB204.5 million, RMB182.3 million and RMB167.0 million (US$25.0 million) in 2007, 2008, 2009 and the nine months ended September 30, 2010, respectively, primarily due to significant bandwidth and content costs, and capital expenditures required to ramp up our business and operations at the early stage of development of our business. Our net losses increased from RMB136.3 million in the nine months ended September 30, 2009 to RMB167.0 million (US$25.0 million) in the nine months ended September 30, 2010 primarily due to the increases in our sales and marketing efforts, content costs and bandwidth costs. Our ability to achieve profitability is affected by various factors, many of which are beyond our control. For example, our revenues and profitability depend on the continuous development of the online advertising industry in China and brand advertisers’ allocation of more budgets to online video websites. We cannot assure you that online advertising, as a new marketing channel, will become more widely accepted in China or that the advertisers will increase their spending on online video websites. The procurement of Internet bandwidth has historically accounted for the majority of our cost of revenues. Although we expect our bandwidth costs as a percentage of net revenues to decrease over time, we expect our bandwidth costs to increase on an absolute basis as traffic to our website grows. If we cannot successfully offset our increased bandwidth costs with an increase in net revenues, our gross margin, financial condition and results of operations could be materially and adversely affected. Therefore, although we expect our net loss to decrease as a percentage of our total net revenues in the foreseeable future, we may continue to incur net losses in the future due to our continued investments in bandwidth, content and technology. We may also continue to incur net losses in the future due to changes in the macroeconomic and regulatory environment, competitive dynamics and our inability to respond to these changes in a timely and effective manner.

We generate substantially all of our revenues from online advertising. If we fail to retain existing advertisers or attract new advertisers to advertise on our website or if we are unable to collect accounts receivable from the advertisers or advertising agencies in a timely manner, our financial condition, results of operations and prospects may be materially and adversely affected.

We generate substantially all of our revenues from online advertising. We retain existing advertisers and attract new advertisers by maximizing return on their investment. On the one hand, we provide our advertisers with in-video advertisements and cost-effective advertising solutions which

 

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combine the visual impact and engagement of traditional television-like multimedia formats with the interactivity and targeting capability of the Internet. On the other hand, our large user traffic and desirable user demographic characteristics provide advertisers with a broad reach and optimal monetization results. All of our advertisers in 2007 remained as our advertisers in 2008. Over 60% and 70% of our advertisers in 2008 and 2009, respectively, remained as our advertisers in 2009 and 2010, respectively. However, we cannot assure you that we will continue to maintain a high retention rate in the future or attract new advertisers continuously. If, however, our advertisers determine that their expenditures on online video websites do not generate expected returns, they may allocate a portion or all of their advertising budgets to other advertising channels such as television, newspapers and magazines and reduce or discontinue business with us. Since most of our advertisers are not bound by long-term contracts, they may amend or terminate advertising arrangements with us easily without incurring liabilities. Failure to retain existing advertisers or attract new advertisers to advertise on our website may materially and adversely affect our business, financial condition, results of operations and prospects.

Substantially all of our online advertising agreements are entered into with various third-party advertising agencies. In China’s advertising industry, advertising agencies typically have good relationships and maintain longer periods of cooperation with the brand advertisers they represent as compared to media companies which provide advertising services on their properties. As a relatively young media company, we intend to strategically leverage advertising agencies’ relationships and network resources to increase our sales and expand our customer base. Therefore, in order to establish long-term strategic cooperation with third-party advertising agencies, we generally enter into advertising contracts with third-party advertising agencies, which represent advertisers even if we have direct contact with such advertisers. As a result, we rely on third-party advertising agencies for sales to, and collection of payment from, our advertisers. In consideration for the third-party advertising agencies’ services, we pay them commissions based on the volume of business they bring to us. The financial soundness of our advertisers and advertising agencies may affect our collection of accounts receivable. We make a credit assessment of the advertiser and advertising agency to evaluate the collectibility of the advertising service fees before entering into an advertising contract. However, we cannot assure you that we are or will be able to accurately assess the creditworthiness of each advertiser or advertising agency, and any inability of advertisers or advertising agencies to pay us in a timely manner may adversely affect our liquidity and cash flows.

We maintain and enhance our business relationships with these third-party advertising agencies by inviting such agencies to Youku-sponsored seminars and public relationship events. We also attend trade exhibitions or events organized by each other regularly, through which we stay in effective communications with these agencies. We do not have long-term cooperation agreements or exclusive arrangements with these agencies and they may elect to direct business opportunities to other advertising service providers, including our competitors. If we fail to retain and enhance the business relationships with third-party advertising agencies, we may suffer from a loss of advertisers and our business, financial condition, results of operations and prospects may be materially and adversely affected. In addition, there has been some consolidation in China’s online advertising market. If this trend continues, a small number of large advertising agencies may be in a position to demand higher commission for advertising agency services, which could reduce our gross margin.

The online video industry in China and user acceptance of our online video content may not grow as quickly as expected, which may adversely affect our revenues and business prospects.

Our business and prospects depend on the continuing development of the online video industry in China. As an emerging industry, China’s online video industry has experienced substantial growth in recent years both in terms of users and content. We cannot assure you, however, that the online video

 

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industry will continue to grow as rapidly as it has in the past. With the development of technology, new forms of media may emerge and render online video websites less attractive to users. Growth of the online video industry is affected by numerous factors, such as users’ general online video experience, technological innovations, development of Internet and Internet-based services, regulatory changes, especially regulations affecting copyrights, and the macroeconomic environment. If the online video industry in China does not grow as quickly as expected or if we fail to benefit from such growth by successfully implementing our business strategies, our user traffic may decrease and our business and prospects may be adversely affected.

Increases in market prices for professionally produced content may have an adverse effect on our business, financial condition and results of operations.

A majority of our user traffic is attributable to professionally produced content. The market prices for professionally produced content, especially popular movies and television serial dramas, have increased significantly in China during the past few years. For example, according to our internal records, the average license fee for television serial drama has increased in 2009 by more than 200% as compared to 2008, and such fee has increased in 2010 to date by more than 100% as compared to 2009. The average license fee for movies has also increased in 2010 to date by more than 90% as compared to 2009. Due to the improving monetization perspective of online video advertising, online video websites are generating more revenues and are competing aggressively to license popular television serial dramas and movies, and the increasingly intense content bidding process has in turn led to increases in license fees of professionally produced content in general. In addition, as the market develops, the expectations of copyright owners, distributors and industry associations may continue to rise, and as such they may demand higher licensing fees for professionally produced content. Furthermore, with the expansion of our content library, we expect the costs for professionally produced content to continue to increase. If we are unable to generate sufficient revenues to outpace the increase in market prices for professionally produced content, we may incur more losses and our business, financial condition and results of operations may be adversely affected.

We operate in a capital intensive industry and require significant amount of cash to fund our operations and bandwidth, content and technology acquisitions. If we cannot obtain sufficient capital, our business, financial condition and prospects may be materially and adversely affected.

The operation of an online video business requires significant upfront capital expenditures as well as continuous, substantial investment in content, technology and infrastructure. To date, we have financed our operations primarily though private placements of preferred shares to investors, including the issuance of US$50 million Series F preferred shares in September 2010, and to a lesser extent, debt financing and cash flow from operations. We believe that our cash, the anticipated cash flow from operations, the net proceeds we expect to receive from this offering and the borrowings under our loan agreements will be sufficient to meet our anticipated cash needs for the next 12 months. However, in order to implement our development strategies to expand our infrastructure and optimize our services across Internet-enabled devices, and further expand and diversify our revenue sources, we may incur additional capital needs in the future. We may obtain additional financing, including equity offering and debt financing in capital markets, to fund the operation and expansion of our online video business. Our ability to obtain additional financing in the future, however, is subject to a number of uncertainties, including:

 

  Ÿ  

our future business development, financial condition and results of operations;

 

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general market conditions for financing activities by companies in our industry; and

 

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macroeconomic, political and other conditions in China and elsewhere.

 

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If we cannot obtain sufficient capital to meet our capital expenditure needs, we may not be able to execute our growth strategies and our business, financial condition and prospects may be materially and adversely affected.

Videos and other content displayed on our website may be found objectionable by PRC regulatory authorities and may subject us to penalties and other administrative actions.

The PRC government has adopted regulations governing Internet access and the distribution of videos and other information over the Internet. Under these regulations, Internet content providers and Internet publishers are prohibited from posting or displaying over the Internet content that, among other things, violates PRC laws and regulations, impairs the national dignity of China or the public interest, or is obscene, superstitious, fraudulent or defamatory. Furthermore, Internet content providers are also prohibited from displaying content that may be deemed by relevant government authorities as “socially destabilizing” or leaking “state secrets” of the PRC. Failure to comply with these requirements may result in the revocation of licenses to provide Internet content or other licenses, the closure of the concerned websites and reputational harm. The website operator may also be held liable for such censored information displayed on or linked to their website.

In addition to professionally produced content, we allow our users to upload videos to our website. Our users can upload all types of content including user-created and professionally produced content and can upload certain graphical files for limited purposes, such as updating user biographies. After a user registers and before each upload, we require the user to click a check box to confirm that the content to be uploaded is in compliance with the terms and conditions set forth in the user agreement, does not infringe other parties’ legal rights, including copyright, and to confirm that he or she is responsible for the content he or she uploads or otherwise distributes on Youku.com. Pursuant to the user agreement, each user agrees to indemnify us for all damages arising from third-party claims against us caused by violating or infringing content uploaded or linked by the user. If we find a user has violated the user agreement, applicable laws or regulations or other parties’ legal rights, we may terminate the user account and block the user’s future uploads without prior notice. In addition, we remove users’ uploads when we are notified or made aware by copyright owners or from other sources of copyright infringements by users, such as lists of inappropriate or infringing content that the regulatory authorities publish from time to time and market information on releases of movies and television serial dramas. We have a team of over 300 contract employees dedicated to screening and monitoring the content uploaded on our website and removing inappropriate or infringing content. Substantially all of the videos uploaded on our website are manually screened by our contract employees. All of the other content, primarily consisting of comments posted by users, is first screened by our filtering systems and the content containing prohibitive words or images is manually screened by our contract employees. We provide training to these contract employees and supervise their work. Although we have adopted internal procedures to monitor the content displayed on our website, due to the significant amount of content uploaded by our users currently amounting to an average of 60,000 files on a daily basis, we may not be able to identify all the videos or other content that may violate relevant laws and regulations due to the large amount of content uploaded by our users everyday. See “Business—Technology and Infrastructure—Content Monitoring and Copyright Protection” for more details relating to our content monitoring procedures. Failure to identify and prevent illegal or inappropriate content from being displayed on our website may subject us to liability. In addition, these laws and regulations are subject to interpretation by the relevant authorities, and it may not be possible to determine in all cases the types of content that could result in our liability as a website operator. For a detailed discussion, see “Regulation—Regulations on Internet Content Services” and “Regulation—Regulations on Information Security.”

To the extent that PRC regulatory authorities find any content displayed on our website objectionable, they may require us to limit or eliminate the dissemination of such content on our website in the form of take-down orders or otherwise. In the past, we have from time to time received

 

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phone calls and written notices from the relevant PRC regulatory authorities requesting us to delete certain content that the government deemed inappropriate or sensitive. For example, we were requested by the regulatory authority to take down a Chinese movie named “Apple” in 2008 due to certain inappropriate content in the movie. The State Administration of Radio, Film and Television, or SARFT, recently published a list of content that is objectionable, and our content screening team has been reviewing the user-uploaded content and removing those mentioned on the list. In addition, regulatory authorities may impose penalties on us based on content displayed on or linked to our website in cases of material violations, including a revocation of our operating licenses or a suspension or shutdown of our online operations. Although we have not been penalized for objectionable content in the past, in the event that the PRC regulatory authorities find the video content on our website objectionable and impose penalties on us or take other administrative actions against us in the future, our business, results of operations and reputation may be materially and adversely affected. Moreover, the costs of compliance with these regulations may continue to increase as a result of more content uploaded by our increasing number of users.

In addition, we operate our website through our consolidated affiliated entity, 1Verge Information, and our ability to comply with laws and regulations described above depends in large part on the experience and skills of, and our control over, the management of 1Verge Information. We rely on contractual arrangements with 1Verge Information and its shareholders to exercise control over the management and operations of 1Verge Information. These contractual arrangements may not be as effective as direct ownership in providing us with control over 1Verge Information. 1Verge Information and its shareholders may fail to take certain actions required for our business or follow our instructions to comply with the relevant PRC regulations despite their contractual obligations to do so. On the other hand, if we had direct ownership of 1Verge Information, we would be able to directly exercise our rights as a shareholder to effect changes in the board of directors of 1Verge Information, which in turn could effect changes at the management level, subject to any applicable fiduciary obligations. See “—Risks Related to Our Corporate Structure—We rely on contractual arrangements with our consolidated affiliated entities in China and their shareholders for our operations, which may not be as effective as direct ownership in providing operational control.”

We have been, and may continue to be, subject to liabilities for infringement of third-party intellectual property rights or other allegations based on the content available on our website or services we provide.

We have been involved in litigation based on allegations of infringement of third-party copyright and other rights, such as privacy and image rights, due to the content available on our website. We were subject to a total of 2, 34, 252 and 160 lawsuits in China for alleged copyright infringement in 2007, 2008, 2009 and the nine months ended September 30, 2010, respectively. Approximately 70% of these lawsuits were rejected by relevant PRC courts, withdrawn by the plaintiffs or settled by the parties. For those cases we lost, we were ordered by various PRC courts to pay damages in an aggregate amount of approximately RMB0.1 million, RMB0.4 million, RMB1.4 million and RMB0.1 million in 2007, 2008, 2009 and 2010 (from January 1, 2010 to September 30, 2010), respectively. As of December 31, 2009, we accrued RMB2.0 million (US$0.3 million) in expenses and other liabilities related to cases arising on or before December 31, 2009 based on judgments by court and out-of-court settlements made after December 31, 2009. We have implemented internal procedures, with a dedicated team of over 300 contract employees, to review videos uploaded by our users and remove any infringing video promptly after we receive infringement notification from the legitimate rights owner claiming that their rights are infringed by a video on our website. See “Business—Technology and Infrastructure—Content Monitoring and Copyright Protection” for more details relating to our content monitoring procedures. Due to the significant number of videos uploaded by users, which currently amounts to an average of 60,000 files on a daily basis, we may not be able to identify all content that may infringe on third-party rights. Moreover, some rights owners may not send us a notice before

 

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bringing a lawsuit against us. Thus, our failure to identify unauthorized videos posted on our website has subjected us to, and may continue to subject us to, claims of infringement on third-party intellectual property rights or other rights. In addition, we may be subject to administrative actions brought by the National Copyright Administration of the PRC or its local branches for alleged copyright infringement.

Although we have not been subject to claims or lawsuits outside China, we cannot assure you that we will not become subject to copyright laws in other jurisdictions, such as the United States, by virtue of our listing in the United States, the ability of users to access our videos in the United States and other jurisdictions, the ownership of our ADSs by investors, the extraterritorial application of foreign law by foreign courts or otherwise. In addition, as a publicly listed company, we may be exposed to increased risk of litigation. If a claim of infringement brought against us in the United States or other jurisdictions is successful, we may be required to (i) pay substantial statutory or other damages and fines, (ii) remove relevant content from our website or (iii) enter into royalty or license agreements which may not be available on commercially reasonable terms or at all.

We may also face litigation or administrative actions for defamation, negligence, or other purported injuries resulting from the content we provide or the nature of our services. Such litigation and administrative actions, with or without merits, may be expensive and time-consuming and may result in significant diversion of resources and management attention from our business operations. Furthermore, such litigation or administrative actions may adversely affect our brand image and reputation.

In addition, we operate our website through our consolidated affiliated entity, 1Verge Information, and our ability to comply with laws and regulations described above depends in large part on the experience and skills of, and our control over, the management of 1Verge Information. Our control over the management and operations of 1Verge Information through contractual arrangements may not be as effective as that through direct ownership. See “—Risks Related to Our Corporate Structure—We rely on contractual arrangements with our consolidated affiliated entities in China and their shareholders for our operations, which may not be as effective as direct ownership in providing operational control.”

Advertisements shown on our website may subject us to penalties and other administrative actions.

Under PRC advertising laws and regulations, we are obligated to monitor the advertising content shown on our website to ensure that such content is true, accurate and in full compliance with applicable laws and regulations. In addition, where a special government review is required for specific types of advertisements prior to website posting, such as advertisements relating to pharmaceuticals, medical instruments, agrochemicals and veterinary pharmaceuticals, we are obligated to confirm that such review has been performed and approval has been obtained from competent governmental authority, which is generally the local branch of the SAIC. To fulfill these monitoring functions, we include clauses in all of our advertising contracts requiring that all advertising content provided by advertisers must comply with relevant laws and regulations. Under PRC law, advertising agencies are liable for all damages to us caused by their breach of such representations. Before a sale is confirmed and the advertisement is publicly posted on our website, our account execution personnel, which is a separate back-office team, are required to review all advertising materials, including video commercials, flashes and pictures, to ensure there is no racial, violent, pornographic or any other improper content, and will request the advertiser to provide proof of governmental approval if the advertisement is subject to special government review. Violation of these laws and regulations may subject us to penalties, including fines, confiscation of our advertising income, orders to cease dissemination of the advertisements and orders to publish an announcement correcting the misleading information. In circumstances involving serious violations, such as posting a pharmaceutical product

 

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advertisement without approval, or posting an advertisement for fake pharmaceutical product, PRC governmental authorities may force us to terminate our advertising operation or revoke our licenses.

A majority of the advertisements shown on our website are provided to us by third-party advertising agencies on behalf of advertisers. While significant efforts have been made to ensure that the advertisements shown on our website are in full compliance with applicable laws and regulations, we cannot assure you that all the content contained in such advertisements is true and accurate as required by the advertising laws and regulations, especially given the uncertainty in the application of these laws and regulations. For example, Article 38 of the Advertisement Law provides that an advertisement operator who knows or should have known the posted advertisement is false or fraudulent will be subject to joint and several liability. Under Article 16 of the Detailed Implementation Rules on the Administrative Regulations for Advertisement, a website must not post any advertisements that are untrue or lacking the requisite governmental approval if such type of advertisements are subject to special governmental review. However, for the determination of the truth and accuracy of the advertisements and the actual or constructive knowledge of the website, there are no implementing rules or official interpretations, and such a determination is at the sole discretion of the relevant local branch of the SAIC, which results in uncertainty in the application of these laws and regulations. Although we have not been subject to penalties or administrative sanctions in the past for the advertisements shown on our website, if we are found to be in violation of applicable PRC advertising laws and regulations in the future, we may be subject to penalties and our reputation may be harmed, which may have a material and adverse effect on our business, financial condition, results of operations and prospects.

In addition, we operate our website through our consolidated affiliated entity, 1Verge Information, and our ability to comply with laws and regulations described above depends in large part on the experience and skills of, and our control over, the management of 1Verge Information. Our control over the management and operations of 1Verge Information through contractual arrangements may not be as effective as that through direct ownership. See “—Risks Related to Our Corporate Structure—We rely on contractual arrangements with our consolidated affiliated entities in China and their shareholders for our operations, which may not be as effective as direct ownership in providing operational control.”

Ineffective implementation of separation of our advertising sales and regulatory compliance functions may result in insufficient supervision over the content of advertisements shown on our website and may subject us to penalties or administrative actions.

We keep our advertising sales function separate from our team in charge of government compliance to address the potential conflicts between our compliance with relevant PRC advertising laws and regulations and advertising business, where we derive substantially all of our revenues. Before a sale is confirmed and the relevant advertisements are publicly posted on our website, our account execution personnel, which is a separate back-office team that does not interface directly with advertisers, are required to review all advertising materials, including video commercials, flashes and pictures, to ensure there is no racial, violent, pornographic or any other improper content. They will request the advertiser to provide proof of governmental approval if the advertisement is subject to special governmental review and such process is designed to enhance our regulatory compliance efforts. However, in the event that the separation of advertising sales and regulatory compliance functions is not effectively implemented, the content of our advertisements may not be in full compliance with applicable laws and regulations. Although we have been subject to nil penalties for the three years ended December 31, 2007, 2008 and 2009, and the nine months ended September 30, 2010, and have not been subject to any administrative actions in the past for the advertisements shown on our website, if we are found to be in violation of applicable laws and regulations in the future, we may be subject to penalties and our reputation may be harmed. This may have a material and adverse effect on our business, financial condition and results of operations.

 

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Changes in government policies or regulations may have a material and adverse effect on our business, financial condition and results of operations.

Our online video business is subject to strict government regulations in the PRC. Under the current PRC regulatory scheme, a number of regulatory agencies, including the SARFT, Ministry of Culture, Ministry of Industry and Information Technology, or MIIT, the General Administration of Press and Publication, or GAPP, and the State Council Information Office, or SCIO, jointly regulate all major aspects of the Internet industry, including the online video industry. Operators must obtain various government approvals and licenses, including an Internet content provider license, or ICP license, and an Internet audio/video program transmission license, prior to the commencement of online video operations. We have obtained the licenses and permits essential for our business operations. We have obtained the ICP license, the Internet audio/video program transmission license (currently covering the self-broadcast programs service and the Internet user uploaded audio/video program service) and a permit from the Beijing Drug Administration to post approved non-prescription drug advertisements on our website. We are in the process of upgrading our Internet audio/video program transmission license and applying for the approval from the SCIO to publish news on our website or disseminate news through the Internet. We currently operate a current events channel on our website which includes audio/video content relating to current topics and social events. We have made oral inquiries with the SCIO, and were orally informed that such operations do not violate the regulations on Internet news publication. Before obtaining the drug information permit, there were a small number of advertisements for non-prescription drugs shown on our website, which may not have been in compliance with the Administration Measures on Internet Drug Information Services and may subject us to administrative warnings, termination of any Internet drug advertisements on our website and other penalties which are not clearly defined in the measures, although we have not been sanctioned by the relevant governmental authority in the past. We are now qualified to post approved non-prescription drug advertisements on our website pursuant to the drug information permit, and we believe the risk of any penalties imposed on our past conduct is low. If the PRC government finds that we were operating without the proper licenses or approvals, promulgates new laws and regulations that require additional licenses or imposes additional restrictions on the operation of online video businesses and/or wireless and web-based subscription services that we plan to launch, the PRC government has the power to, among other things, levy fines, confiscate our income or the income of our affiliates, revoke our business licenses or the business licenses of our affiliates, and require us to discontinue or impose restrictions on the affected portion or our business. Any of these actions by the PRC government may have a material and adverse effect on our results of operations. In addition, the PRC government may promulgate regulations restricting the types and content of advertisements that may be transmitted online, which could have a direct adverse impact on our business.

Any lack of requisite permits for any of our online video content may expose us to regulatory sanctions.

On March 30, 2009, SARFT released a Notice on Strengthening the Administration of Online Audio/Video Content, or Notice. This Notice reiterated, among other things, that all movies and television shows released or published online must be in compliance with relevant regulations on the administration of radio, film and television. In other words, these movies and television shows, whether produced in the PRC or overseas, must be pre-approved by SARFT and distributors of these movies and television shows must obtain an applicable permit before releasing any movie or television show.

We rely on written representations from the content providers regarding the SARFT approval status of the content licensed to us. Under our content licensing agreements, the content providers generally represent and warrant that (i) the content they provide has legitimate copyright or authorization, and they are entitled to grant us the rights of communication through information networks; (ii) the content itself as well as the authorization or rights granted to us neither breach any applicable laws, regulations or public morals, nor impair any third party rights; and (iii) that they will

 

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indemnify us for any loss resulting from both the non-compliance of such content with the law and claims from third parties. However, we cannot guarantee that the remedies provided by these content providers, if any, will be sufficient to compensate us for potential regulatory sanctions imposed by SARFT due to violations of the approval and permit requirements. Nor can we ensure that any such sanctions will not adversely affect either the general availability of video content on our website or our reputation. In addition, such risks may persist due to ambiguities and uncertainties relating to the implementation and enforcement of the Notice.

If the online advertising industry does not further grow in China, our profitability and prospects may be materially and adversely affected.

Both the Internet and broadband penetration rates in China are relatively low as compared to those in many developed countries. Many advertisers in China have limited experience with online advertising, have historically allocated an insignificant portion of their advertising budgets to online advertising and may consider online advertising a less attractive channel than traditional broadcast and print media in promoting their products and services. Our profitability and prospects depend on the continuing development of the online advertising industry in China and may be affected by a number of factors, many of which are beyond our control, including:

 

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development of a larger user base with demographic characteristics attractive to advertisers;

 

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our ability to keep up with technological innovation and improvements in the measurement of user traffic and online advertising;

 

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acceptance of online advertising as an effective marketing channel;

 

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changes in government regulations or policies affecting the online advertising industry; and

 

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increased Internet usage in China.

We operate in a highly competitive market and we may not be able to compete successfully against our competitors.

We face significant competition, primarily from those companies that operate online video websites in China, such as Tudou.com, as well as from major Chinese Internet portals which provide online video products, such as SINA and Sohu. We compete with these companies for both users and advertisers. Some of our competitors have a longer operating history and significantly greater financial resources than we do, and in turn may be able to attract and retain more users and advertisers. Our competitors may compete with us in a variety of ways, including by obtaining exclusive online distribution rights for popular content, conducting brand promotions and other marketing activities, and making acquisitions. In addition, certain online video websites may continue to derive their revenues from providing content that infringes third-party copyright and may not monitor their websites for any such infringing content. As a result, we may be placed at a disadvantage to some of these websites that do not incur similar costs as we do with respect to content acquisition and content monitoring. If any of our competitors achieves greater market acceptance than we do or are able to offer more attractive online video content, our user traffic may decrease and our market share may decrease, which may result in a loss of advertisers and have a material and adverse effect on our business, financial condition and results of operations.

We also face competition from traditional advertising media such as television, newspapers, magazines, billboards, radio and other forms of out-of-home media. Most large companies in China allocate, and will likely continue to allocate, a significant portion of their advertising budgets to traditional advertising media, particularly television. If online advertising, as a new marketing channel, does not become more widely accepted in China, we may experience difficulties in competing with traditional advertising media.

 

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The success of our business depends on our ability to maintain and enhance our brand.

We believe that maintaining and enhancing our Youku LOGO brand is of significant importance to the success of our business. A well-recognized brand is critical to increasing our user base and, in turn, enhancing our attractiveness to advertisers. Since the online video market is highly competitive, maintaining and enhancing our brand depends largely on our ability to remain the market leader in China, which may be difficult and expensive.

With our large and comprehensive content library and an easy-to-use online interface, we have developed our reputation and established a leading position by providing our users with a superior online video experience. As a company with a limited operating history, we have conducted, and may continue to conduct, various marketing and brand promotion activities, mainly through cooperation with our business partners. We cannot assure you, however, that these activities will be successful and achieve the brand promotion effects we expect. In addition, any negative publicity in relation to our services or products, regardless of its veracity, could harm our brand image and, in turn, result in a reduced number of users. If we fail to maintain and enhance our brand, or if we incur excessive expenses in this effort, our business, financial condition and results of operations may be materially and adversely affected.

If we fail to continue to anticipate user preferences and provide products and services to attract and retain users, we may not be able to generate sufficient user traffic to remain competitive.

Our success depends on our ability to generate sufficient user traffic through provision of attractive products and services. To attract and retain users and compete against our competitors, we must continue to offer high-quality content that provides our users with a satisfactory online video experience. To this end, we must continue to source new professionally produced content, produce new in-house content or encourage more user-generated content, while balancing the value of each type of content to our advertising services. For example, with professionally produced content, we attract a majority of our user traffic and our advertisers can place targeted advertisements focusing on certain user demographics; with user-generated content, users can upload and share their own videos and spend longer time on our website, and a “community-like” environment enhances users’ loyalty to our website and such network effect broadens advertisers’ reach of audience; and with our in-house productions, we tailor such content to users’ preferences based on our industry experience and combine these productions with targeted advertising services such as product placements, which benefits both the users and our advertisers.

Based on the feedback on our website design and our statistics regarding users’ watching behavior, we keep developing new website features that appeal to users, such as designing more user-friendly content searching tools, creating additional interactive social functions or offering better website compatibility with new Internet-enabled devices. Due to our leading market position, we maintain a large content library to serve our users, which in turn leads to our continuing need to license more content covering a wider range of categories from the licensors of professionally produced content. Therefore, the licensors of professionally produced content have been willing to maintain good business relationships with us and value our relationships with them. We frequently attend industry seminars and public relationship events with professional content licensors to enhance such relationships. Other than the fees we pay to license content, we do not provide any additional compensation or benefits to professional content providers and their affiliates. Therefore, we must continue to grow our platform and content demand to keep our key customer status in order to maintain good relationships with current licensors of professionally produced content to renew our current licenses and license new content from them. Given that we operate in a rapidly evolving industry, we also need to continuously anticipate user preferences and industry changes and respond to such changes in a timely and effective manner. If we fail to cater to the needs and preferences of

 

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our users and, as a result, fail to deliver satisfactory user experience, we may suffer from reduced user traffic and our business and results of operations may be materially and adversely affected.

We operate in a rapidly evolving industry. If we fail to keep up with the technological developments and users’ changing requirements, our business, results of operations and prospects may be materially and adversely affected.

The online video industry is rapidly evolving and subject to continuous technological changes. Our success will depend on our ability to keep up with the changes in technology and user behavior resulting from the technological developments. For example, the development of broadband enabled the enjoyment of high definition videos online. In addition, the number of people accessing the Internet via devices other than personal computers, including mobile phones and other hand-held devices, has increased in recent years. If we do not adapt our products and services to such changes in an effective and timely manner, we may suffer from a decreased user traffic, which may result in a reduced number of advertisers using our online advertising services. Furthermore, changes in technologies may require substantial capital expenditures in product development as well as in modification of products, services or infrastructure. We may not execute our business strategies successfully due to a variety of reasons such as technical hurdles, misunderstanding or erroneous prediction of market demand or lack of necessary resources. Failure in keeping up with technological development may result in our products and services being less attractive, which in turn, may materially and adversely affect our business, results of operations and prospects.

Our quarterly revenues and operating results may fluctuate, which makes our results of operations difficult to predict and may cause our quarterly results of operations to fall short of expectations.

Our quarterly revenues and operating results have fluctuated in the past and may continue to fluctuate depending upon a number of factors, many of which are out of our control. For these reasons, comparing our operating results on a period-to-period basis may not be meaningful, and you should not rely on our past results as an indication of our future performance. Our quarterly and annual revenues and costs and expenses as a percentage of our revenues may be significantly different from our historical or projected rates. Our operating results in future quarters may fall below expectations. Any of these events could cause the price of our ADSs to fall. Other factors that may affect our financial results include, among others:

 

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global economic conditions;

 

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our ability to maintain and increase user traffic;

 

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our ability to attract and retain advertisers;

 

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changes in government policies or regulations, or their enforcement;

 

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geopolitical events or natural disasters such as war, threat of war, earthquake or epidemics.

Our operating results tend to be seasonal. For instance, we may have slightly lower revenues during the first quarter of each year primarily due to the Chinese New Year holidays in that quarter. In addition, advertising spending in China has historically been cyclical, reflecting overall economic conditions as well as the budgeting and buying patterns of our customers.

We may not be able to manage our expansion effectively.

We have experienced rapid growth since we commenced our online video business in 2006. According to iResearch, the number of our monthly unique visitors from homes and offices increased from approximately 50 million in December 2007 to approximately 203 million in September 2010, and

 

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the number of monthly unique visitors from Internet cafes increased from approximately 36 million in December 2008 to approximately 61 million in August 2010. Our market share in terms of total user time spent viewing online videos in China increased from 36% in 2009 to 40% in the second quarter of 2010, according to iResearch, and the number of our brand advertisers increased from 7 in 2007 to 303 in 2009, and from 230 in the nine months ended September 30, 2009 to 343 in the nine months ended September 30, 2010. In addition, the number of our employees grew rapidly from 100 as of December 31, 2007 to 507 (exclusive of over 300 contract employees responsible for content screening and monitoring) as of September 30, 2010. To manage the further expansion of our business and the growth of our operations and personnel, we need to continuously expand and enhance our infrastructure and technology, and improve our operational and financial systems, procedures and controls. We also need to expand, train and manage our growing employee base. In addition, our management will be required to maintain and expand our relationships with content providers, advertisers, advertising agencies and other third parties. We cannot assure you that our current infrastructure, systems, procedures and controls will be adequate to support our expanding operations. If we fail to manage our expansion effectively, our business, results of operations and prospects may be materially and adversely affected.

Disruption or failure of our systems could impair our users’ online video experience and adversely affect our reputation.

Our ability to provide users with a high-quality online video experience depends on the continuous and reliable operation of our systems. We cannot assure you that we will be able to procure sufficient bandwidth in a timely manner or on acceptable terms or at all. Failure to do so may significantly impair user experience on our website and decrease the overall effectiveness of our website to both users and advertisers. Disruptions, failures, unscheduled service interruptions or a decrease in connection speeds could hurt our reputation and cause our users and advertisers to switch to our competitors’ websites. Our systems and proprietary CDN are vulnerable to damage or interruption as a result of fires, floods, earthquakes, power losses, telecommunications failures, undetected errors in software, computer viruses, hacking and other attempts to harm our systems. We have experienced service interruptions for up to three hours in the past which typically were caused by (i) overload of our servers; (ii) unexpected overflow of user traffic; and/or (iii) service malfunction of the telecommunications operators, such as power outage of Internet data centers or network transmission congestion. We may continue to experience similar interruptions in the future despite our continuous efforts to improve our systems. Since we host our servers at third-party Internet data centers, any natural disaster or unexpected closure of Internet data centers operated by third-party providers may result in lengthy service interruptions.

If we experience frequent or persistent service disruptions, whether caused by failures of our own systems or those of third-party service providers, our users’ experience with us may be negatively affected, which in turn, may have a material and adverse effect on our reputation. We cannot assure you that we will be successful in minimizing the frequency or duration of service interruptions.

Undetected programming errors could adversely affect our user experience and market acceptance of our video programs, which may materially and adversely affect our business and results of operations.

The video programs, including advertising video programs, on our website may contain programming errors that may only become apparent after their release. We receive user feedbacks in connection with programming errors affecting their user experience from time to time, and such errors may also come to our attention during our monitoring process. We generally have been able to resolve such programming errors in a timely manner. However, we cannot assure you that we will be able to detect and resolve all these programming errors effectively. Undetected audio or video programming

 

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errors or defects may adversely affect user experience and cause our advertisers to reduce their use of our services, any of which could materially and adversely affect our business and results of operations.

Our business, financial condition and results of operations may be adversely affected by the downturn in the global or Chinese economy.

The global financial markets have experienced significant disruptions since 2008 and the effect of the crisis persisted in 2009. China’s economy has also faced challenges. To the extent that there have been improvements in some areas, it is uncertain whether such recovery is sustainable. Since we derive substantially all of our revenues from online advertising in China and the advertising industry is particularly sensitive to economic downturns, our business and prospects may be affected by economic conditions in China. A slowdown in China’s economy may lead to a reduced amount of advertising activities, which could materially and adversely affect our financial condition and results of operations.

Moreover, a slowdown in the global or Chinese economy or the recurrence of any financial disruptions may have a material and adverse impact on financings available to us. The weakness in the economy could erode investors’ confidence, which constitutes the basis of the equity markets. The recent financial turmoil affecting the financial markets and banking system may significantly restrict our ability to obtain financing in the capital markets or from financial institutions on commercially reasonable terms, or at all. Although we are uncertain about the extent to which the recent global financial and economic crisis and slowdown of the Chinese economy may impact our business in the long term, there is a risk that our business, results of operations and prospects would be materially and adversely affected by the global economic downturn and the slowdown of the Chinese economy.

The continuing and collaborative efforts of our senior management and key employees are crucial to our success, and our business may be harmed if we were to lose their services.

Our success depends on the continuous efforts and services of Mr. Victor Koo, our founder, chairman and chief executive officer, and other members of our experienced senior management team, including Mr. Dele Liu, our director, chief financial officer and senior vice president, Mr. Leo Jian Yao, our chief technology officer, Mr. Frank Ming Wei, our senior vice president of operations, and Mr. Sunny Xiangyang Zhu, our chief content editor. We have not experienced attrition of our senior management team since we were established. If however, one or more of our executives or other key personnel are unable or unwilling to continue to provide services to us, we may not be able to find suitable replacements easily or at all. Competition for management and key personnel is intense and the pool of qualified candidates is limited. We may not be able to retain the services of our executives or key personnel, or attract and retain experienced executives or key personnel in the future. If any of our executive officers or key employees joins a competitor or forms a competing company, we may lose advertisers, know-how and key professionals and staff members. Each of our executive officers and key employees has entered into an employment agreement with us, which contains non-compete provisions. However, if any dispute arises between us and our executives or key employees, these agreements may not be enforceable in China, where these executives and key employees reside, in light of uncertainties with China’s legal system. See “—Risks Relating to Doing Business in China—Uncertainties with respect to the PRC legal system could adversely affect us.”

Our operations depend on the performance of the Internet infrastructure and telecommunications networks in China.

The successful operation of our business depends on the performance of the Internet infrastructure and telecommunications networks in China. Almost all access to the Internet is maintained through state-owned telecommunications operators under the administrative control and

 

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regulatory supervision of the MIIT. Moreover, we have entered into contracts with various subsidiaries of a limited number of telecommunications service providers in each province and rely on them to provide us with data communications capacity through local telecommunications lines and Internet data centers to host our servers. We have limited access to alternative networks or services in the event of disruptions, failures or other problems with China’s Internet infrastructure or the telecommunications networks provided by telecommunications service providers. Our Youku.com website regularly serves a large number of users and advertisers. With the expansion of our business, we may be required to upgrade our technology and infrastructure to keep up with the increasing traffic on our website. However, we have no control over the costs of the services provided by telecommunications service providers. If the prices we pay for telecommunications and Internet services rise significantly, our results of operations may be materially and adversely affected. If Internet access fees or other charges to Internet users increase, our user traffic may decline and our business may be harmed. Moreover, the agreements we have entered into with domestic telecommunications carriers to host our servers typically have terms of approximately one year and are renewable subject to early termination. If we are not able to renew such hosting services agreements with the telecommunications carriers when they expire and are not able to enter into agreements with alternative carriers at commercially reasonable terms or at all, the quality and stability of our services may be adversely affected.

We have granted, and may continue to grant, stock options under our stock option scheme, which may result in increased share-based compensation expenses.

We adopted a stock option scheme, or the Plan, on December 1, 2005, which was amended on March 26, 2007, June 20, 2008, December 16, 2009 and September 9, 2010. As of November 12, 2010, options to purchase a total of 139,520,233 ordinary shares of our company were outstanding. See “Management—2006 Stock Option Scheme” for detailed discussion. For the years ended December 31, 2007, 2008, 2009 and the nine months ended September 30, 2010, we recorded RMB1.2 million, RMB3.7 million, RMB4.6 million and RMB7.4 million (US$1.1 million), respectively, in share-based compensation expenses. We believe the granting of stock options is of significant importance to our ability to attract and retain key personnel and employees, and we will continue to grant stock options to employees in the future. As a result, our expenses associated with share-based compensation may increase, which may have an adverse effect on our results of operations.

In preparing our consolidated financial statements, we have identified material weaknesses and other control deficiencies in our internal control over financial reporting. If we fail to maintain an effective system of internal control over financial reporting, we may be unable to accurately report our financial results or prevent fraud, and investor confidence in our company and the market price of our ADSs may be adversely affected.

We will be subject to reporting obligations under the U.S. securities laws after this offering. Our reporting obligations as a public company will place a significant strain on our management, operational and financial resources and systems for the foreseeable future. Prior to this offering, we have been a private company and have had limited accounting personnel and other resources with which to address our internal control over financial reporting. In preparing our consolidated financial statements, we and our independent registered public accounting firm identified material weaknesses and other control deficiencies, each as defined in the standards established by U.S. Public Company Accounting Oversight Board, in our internal control over financial reporting as of December 31, 2009. As defined in the standards established by U.S. Public Company Accounting Oversight Board, a “material weakness” is a significant deficiency, or combination of significant deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.

 

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The material weaknesses identified related to an insufficient number of financial reporting personnel with an appropriate level of knowledge, experience and training in the application of U.S. GAAP and SEC regulations in internal control over our financial reporting obligations, a lack of qualified staff to support our chief financial officer in financial reporting activities, a lack of an appropriate level of oversight, and communication of internal control, policies and procedures to support our activities, and a lack of effective monitoring activities to ensure the accuracy and completeness of our financial statements and related disclosures. Neither we nor our independent registered public accounting firm undertook a comprehensive assessment of our internal control for purposes of identifying and reporting material weaknesses and other control deficiencies in our internal control over financial reporting as we and they will be required to do once we become a public company. In light of the number of control deficiencies that were identified as a result of the limited procedures performed, we believe it is possible that, had we performed a formal assessment of our internal control over financial reporting or had our independent registered public accounting firm performed an audit of our internal control over financial reporting, additional control deficiencies may have been identified.

Following the identification of the material weaknesses and other control deficiencies, we have taken measures and plan to continue to take measures to remedy these deficiencies. However, the implementation of these measures may not fully address these deficiencies in our internal control over financial reporting, and we cannot conclude that they have been fully remedied. Our failure to correct these control deficiencies or our failure to discover and address any other control deficiencies could result in inaccuracies in our financial statements and could also impair our ability to comply with applicable financial reporting requirements and related regulatory filings on a timely basis. As a result, our business, financial condition, results of operations and prospects, as well as the trading price of our ADSs, may be materially and adversely affected. Moreover, ineffective internal control over financial reporting significantly hinders our ability to prevent fraud.

Upon completion of this offering, we will become subject to the Sarbanes-Oxley Act of 2002. Section 404 of the Sarbanes-Oxley Act, or Section 404, will require that we include a report from management on the effectiveness of our internal control over financial reporting in our annual report on Form 20-F beginning with our annual report for the fiscal year ending December 31, 2011. In addition, beginning at the same time, our independent registered public accounting firm must report on the effectiveness of our internal control over financial reporting. If we fail to remedy the material weaknesses identified above, our management and our independent registered public accounting firm may conclude that our internal control over financial reporting is not effective. This could adversely impact the market price of our ADSs due to a loss of investor confidence in the reliability of our reporting processes. We will need to incur costs and use management and other resources in order to comply with Section 404.

We have limited business insurance coverage.

Insurance companies in China currently do not offer as extensive an array of insurance products as insurance companies do in more developed economies. We do not have any business liability or disruption insurance to cover our operations. We have determined that the costs of insuring for these risks and the difficulties associated with acquiring such insurance on commercially reasonable terms make it impractical for us to have such insurance. Any uninsured occurrence of business disruption may result in our incurring substantial costs and the diversion of resources, which could have an adverse effect on our results of operations and financial condition.

 

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Risks Related to Our Corporate Structure

If the PRC government finds that the agreements that establish the structure for operating our businesses in China do not comply with PRC governmental restrictions on foreign investment in Internet business, or if these regulations or the interpretation of existing regulations change in the future, we could be subject to severe penalties or be forced to relinquish our interests in those operations.

Current PRC laws and regulations place certain restrictions on foreign ownership of companies that engage in Internet business, including the provision of online video and online advertising services. Specifically, foreign ownership in an Internet content provider or other value-added telecommunication service providers may not exceed 50%. We conduct our operations in China principally through contractual arrangements among our wholly-owned PRC subsidiary, 1Verge Internet and two consolidated affiliated entities in the PRC, namely, 1Verge Information and Jiaheyi, and their respective shareholders. 1Verge Information holds the licenses and permits necessary to conduct our online video, online advertising and related businesses in China. Our contractual arrangements with 1Verge Information and Jiaheyi and their respective shareholders enable us to exercise effective control over these entities and hence treat them as our consolidated affiliated entities and consolidate their results. For a detailed discussion of these contractual arrangements, see “Corporate Structure.”

We cannot assure you, however, that we will be able to enforce these contracts. Although we believe we are in compliance with current PRC regulations, we cannot assure you that the PRC government would agree that these contractual arrangements comply with PRC licensing, registration or other regulatory requirements, with existing policies or with requirements or policies that may be adopted in the future. PRC laws and regulations governing the validity of these contractual arrangements are uncertain and the relevant government authorities have broad discretion in interpreting these laws and regulations. If the PRC government determines that we do not comply with applicable laws and regulations, it could revoke our business and operating licenses, require us to discontinue or restrict our operations, restrict our right to collect revenues, block our website, require us to restructure our operations, impose additional conditions or requirements with which we may not be able to comply, or take other regulatory or enforcement actions against us that could be harmful to our business. The imposition of any of these penalties would result in a material and adverse effect on our ability to conduct our business.

We rely on contractual arrangements with our consolidated affiliated entities in China and their shareholders for our operations, which may not be as effective as direct ownership in providing operational control.

Since PRC laws restrict foreign equity ownership in companies engaged in online video and advertising businesses in China, we rely on contractual arrangements with our consolidated affiliated entities and their respective shareholders to operate our business in China. If we had direct ownership of 1Verge Information and Jiaheyi, we would be able to exercise our rights as a shareholder to effect changes in the board of directors of 1Verge Information or Jiaheyi, which in turn could effect changes at the management level, subject to any applicable fiduciary obligations. However, under the current contractual arrangements, we rely on our consolidated affiliated entities and their respective shareholders’ performance of their contractual obligations to exercise effective control. In addition, our contractual arrangements generally have a term of ten years with an automatic extension of another ten years, which is subject to 1Verge Internet’s unilateral termination right. In general, neither our consolidated affiliated entities nor their respective shareholders may terminate the contracts prior to the expiration date. However, the shareholders of 1Verge Information or Jiaheyi may not act in the best interests of our company or may not perform their obligations under these contracts, including the obligation to renew these contracts when their initial ten-year term expires. Such risks exist throughout

 

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the period in which we intend to operate our business through the contractual arrangements with our consolidated affiliated entities. We may replace the shareholders of our consolidated affiliated entities at any time pursuant to our contractual arrangements with them and their shareholders. However, if any dispute relating to these contracts remains unresolved, we will have to enforce our rights under these contracts through the operations of PRC law and courts and therefore will be subject to uncertainties in the PRC legal system. See “—Any failure by our consolidated affiliated entities or their respective shareholders to perform their obligations under our contractual arrangements with them may have a material adverse effect on our business.” Therefore, these contractual arrangements may not be as effective as direct ownership in providing us with control over these consolidated affiliated entities.

Any failure by our consolidated affiliated entities or their respective shareholders to perform their obligations under our contractual arrangements with them may have a material adverse effect on our business.

Our consolidated affiliated entities and their respective shareholders may fail to take certain actions required for our business or follow our instructions despite their contractual obligations to do so. If they fail to perform their obligations under their respective agreements with us, we may have to rely on legal remedies under PRC law, including seeking specific performance or injunctive relief, which may not be effective.

Under the equity pledge agreements among 1Verge Internet and the respective shareholders of 1Verge Information and Jiaheyi, these shareholders pledged all of their equity interests in 1Verge Information and Jiaheyi to 1Verge Internet. Our PRC counsel, TransAsia Lawyers, has advised us that these pledges were duly created and effective given that such pledges have already been duly registered with the relevant local branch of the SAIC in accordance with the PRC Property Rights Law. As a result, if any of 1Verge Information, Jiaheyi or any of their respective shareholders breaches its obligations under the contractual arrangements, we may be able to successfully enforce the pledges.

All of these contractual arrangements are governed by PRC law and provide for the resolution of disputes through arbitration in the PRC. Accordingly, these contracts would be interpreted in accordance with PRC law and any disputes would be resolved in accordance with PRC legal procedures. The legal environment in the PRC is not as developed as in certain other jurisdictions, such as the United States. As a result, uncertainties in the PRC legal system could limit our ability to enforce these contractual arrangements, which may make it difficult to exert effective control over our consolidated affiliated entities, and our ability to conduct our business may be adversely affected.

Contractual arrangements with our consolidated affiliated entities may result in adverse tax consequences to us.

Under applicable PRC tax laws and regulations, arrangements and transactions among related parties may be subject to audit or scrutiny by the PRC tax authorities within ten years after the taxable year when the arrangements or transactions are conducted. We could face material and adverse tax consequences if the PRC tax authorities were to determine that the contractual arrangements among 1Verge Internet, our wholly-owned subsidiary in China, our consolidated affiliated entities in China and their respective shareholders were not entered into on an arm’s-length basis and therefore constituted unfavorable transfer pricing arrangements. Unfavorable transfer pricing arrangements could, among other things, result in an upward adjustment on taxation. In addition, the PRC tax authorities may impose interest on late payments on our consolidated affiliated entities for the adjusted but unpaid taxes. Our results of operations may be materially and adversely affected if our consolidated affiliated entities’ tax liabilities increase significantly or if they are required to pay interest on late payments.

 

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The shareholder of our consolidated affiliated entities may have potential conflicts of interest with us, which may materially and adversely affect our business.

Ms. Qiong Qin and Mr. Dele Liu are shareholders of the consolidated affiliated entities. Ms. Qin is the wife of our founder and chief executive officer, and she does not have any equity interest or management position at our company. Mr. Liu is our director, chief financial officer and senior vice president. We provide no incentives to Ms. Qin and Mr. Liu for the purpose of encouraging them to act in our best interests in their capacity as the shareholders of our consolidated affiliated entities. We may replace Ms. Qin and Mr. Liu as the shareholders of our consolidated affiliated entities at any time pursuant to the amended and restated equity option agreements. As a director and executive officer of our company, Mr. Liu has a duty of loyalty and care to us under Cayman Islands law. In addition, each of Ms. Qin and Mr. Liu has executed a power of attorney to appoint Mr. Victor Koo, the person designated by 1Verge Internet and the founder of our company, to vote on her/his behalf and exercise the full voting rights as the shareholder of the consolidated affiliated entities. We are not aware that other publicly listed companies with a similar corporate and ownership structure as ours have brought conflicts of interests claims against the shareholders of their respective consolidated affiliated entities. However, we cannot assure you that when conflicts arise, Ms. Qin and Mr. Liu will act in the best interests of our company or that conflicts will be resolved in our favor. If we cannot resolve any conflicts of interest or disputes between us and Ms. Qin and Mr. Liu, we would have to rely on legal proceedings, which may be expensive, time-consuming and disruptive to our operations. There is also substantial uncertainty as to the outcome of any such legal proceedings.

We may rely principally on dividends and other distributions on equity paid by our PRC and Hong Kong subsidiaries to fund any cash and financing requirements we may have. Any limitation on the ability of our PRC and Hong Kong subsidiaries to pay dividends to us could have a material adverse effect on our ability to conduct our business.

We are a holding company, and we rely principally on dividends and other distributions on equity paid by our wholly-owned PRC subsidiary, 1Verge Internet, and our wholly-owned Hong Kong subsidiary, Jet Brilliant, which is the direct holding company of Jet Brilliant Beijing, for our cash and financing requirements, including the funds necessary to pay dividends and other cash distributions to our shareholders and service any debt we may incur. If 1Verge Internet or Jet Brilliant, as the case may be, incurs debt on its own behalf in the future, the instruments governing the debt may restrict its ability to pay dividends or make other distributions to us. In addition, the PRC tax authorities may require us to adjust our taxable income under the contractual arrangements 1Verge Internet currently has in place with our consolidated affiliated entities in a manner that would materially and adversely affect its ability to pay dividends and other distributions to us.

Under PRC laws and regulations, 1Verge Internet and Jet Brilliant Beijing, as wholly foreign-owned enterprises in the PRC, may pay dividends only out of their accumulated profits as determined in accordance with PRC accounting standards and regulations. In addition, wholly foreign-owned enterprises such as 1Verge Internet and Jet Brilliant Beijing are required to set aside at least 10% of their accumulated after-tax profits each year, if any, to fund certain statutory reserve funds, until the aggregate amount of such a fund reaches 50% of their respective registered capital. At their discretion, they may allocate a portion of their after-tax profits based on PRC accounting standards to staff welfare and bonus funds. These reserve funds and staff welfare and bonus funds are not distributable as cash dividends. As of September 30, 2010, the registered capital of 1Verge Internet and Jet Brilliant Beijing was US$95,200,000 and RMB1,000,000, respectively. 1Verge Internet and Jet Brilliant Beijing have not made any profits to date. Thus, they have not been subject to the statutory reserve fund requirements and have not set aside any money to fund the statutory reserve funds or staff welfare and bonus funds. Our PRC subsidiaries have not and will not be able to pay dividends to our offshore entities until they generate accumulated profits and meet the requirements for statutory reserve funds. As of September 30, 2010,

 

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our PRC subsidiaries had accumulated deficits of approximately RMB109 million (US$16.3 million) in accordance with PRC accounting standards and regulations. Substantially all of their revenues have been used to fund our business operations or expansion.

Any limitation on the ability of 1Verge Internet or Jet Brilliant Beijing to pay dividends or make other distributions to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our business, pay dividends, or otherwise fund and conduct our business. See also “—Risks Related to Doing Business in China—Our global income and the dividends that we may receive from our PRC subsidiaries may be subject to PRC taxes under the PRC Enterprise Income Tax Law, which would have a material adverse effect on our results of operations.”

PRC regulation of loans to, and direct investment in, PRC entities by offshore holding companies and governmental control of currency conversion may limit our use of the proceeds we receive from this offering to fund our expansion or operations.

In utilizing the proceeds we receive from this offering in the manner described in “Use of Proceeds,” as an offshore holding company with PRC subsidiaries, we may (i) make additional capital contributions to our PRC subsidiaries, (ii) establish new PRC subsidiaries and make capital contributions to these new PRC subsidiaries, (iii) make loans to our PRC subsidiaries or consolidated affiliated entities, or (iv) acquire offshore entities with business operations in China in an offshore transaction. However, most of these uses are subject to PRC regulations and approvals. For example:

 

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capital contributions to our PRC subsidiaries, whether existing ones or newly established ones, must be approved by the PRC Ministry of Commerce or its local counterparts;

 

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loans by us to our PRC subsidiaries, each of which is a foreign-invested enterprise, to finance their activities cannot exceed statutory limits and must be registered with the PRC State Administration of Foreign Exchange, or SAFE, or its local branches; and

 

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loans by us to our consolidated affiliated entities, which are domestic PRC entities, must be approved by the National Development and Reform Commission and must also be registered with SAFE or its local branches.

On August 29, 2008, SAFE promulgated the Circular on the Relevant Operating Issues Concerning the Improvement of the Administration of the Payment and Settlement of Foreign Currency Capital of Foreign Invested Enterprises, or SAFE Circular 142, regulating the conversion by a foreign-invested enterprise of foreign currency registered capital into Renminbi by restricting how the converted Renminbi may be used. SAFE Circular 142 provides that the Renminbi capital converted from foreign currency registered capital of a foreign-invested enterprise may only be used for purposes within the business scope approved by the applicable governmental authority and may not be used for equity investments within the PRC, unless it is provided for otherwise. In addition, SAFE strengthened its oversight of the flow and use of the Renminbi capital converted from foreign currency registered capital of a foreign-invested company. The use of such Renminbi capital may not be altered without SAFE approval, and such Renminbi capital may not in any case be used to repay Renminbi loans if the proceeds of such loans have not been used. Violations of SAFE Circular 142 could result in severe monetary or other penalties. We expect that if we convert the net proceeds we receive from this offering into Renminbi pursuant to SAFE Circular 142, our use of Renminbi funds will be for purposes within the approved business scope of our PRC subsidiaries. Such business scope includes “technical services,” which we believe permits our PRC subsidiaries to purchase or lease servers and other equipment for their own technical data and research and to provide operational support to our consolidated affiliated entities. However, we may not be able to use such Renminbi funds to make equity investments in the PRC through our PRC subsidiaries.

 

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We expect that the PRC regulations of loans and direct investment by offshore holding companies to PRC entities may continue to limit our use of the proceeds we receive from this offering. There are no costs associated with registering loans or capital contributions with relevant PRC governmental authorities, other than nominal processing charges. Under the relevant PRC laws and regulations, the PRC governmental authorities are required to process such approvals or registrations or deny our application within a prescribed time period, which is usually less than 90 days. The actual time taken, however, may be longer due to administrative delays. We cannot assure you that we will be able to obtain these government registrations or approvals on a timely basis, if at all, with respect to our future plans to use the U.S. dollar proceeds we receive from this offering for our expansion and operations in China. If we fail to receive such registrations or approvals, our ability to use the proceeds of this offering and to capitalize our PRC operations may be negatively affected, which could materially and adversely affect our liquidity and ability to fund and expand our business.

We may be unable to collect long-term loans extended to the shareholders of our consolidated affiliated entities.

As of September 30, 2010, we made long-term interest-free loans in an aggregate principal amount of RMB20.1 million (US$2.9 million) to the shareholders of our consolidated affiliated entities to enable them to fund the initial capitalization and the subsequent financial requirements of our consolidated affiliated entities. The initial term for such loans is ten years and will be automatically extended for another ten years unless we give a three-month written notice prior to the expiration of the initial term. We may in the future make additional loans to the shareholders of our consolidated affiliated entities in China in connection with any increase in the capitalization or financial requirements of these entities to the extent necessary and permissible under applicable PRC laws and regulations. Our ability to collect these long-term loans will depend on the profitability and results of operations of these consolidated affiliated entities, which is uncertain.

Risks Related to Doing Business in China

Changes in China’s economic, political or social conditions or government policies could have a material adverse effect on our business and operations.

Substantially all of our assets and operations are located in China. Accordingly, our business, financial condition, results of operations and prospects may be influenced to a significant degree by political, economic and social conditions in China generally and by continued economic growth in China as a whole.

The Chinese economy differs from the economies of most developed countries in many respects, including the level of government involvement, level of development, growth rate, control of foreign exchange and allocation of resources. Although the Chinese government has implemented measures emphasizing the utilization of market forces for economic reform, the reduction of state ownership of productive assets, and the establishment of improved corporate governance in business enterprises, a substantial portion of productive assets in China is still owned by the government. In addition, the Chinese government continues to play a significant role in regulating industry development by imposing industrial policies. The Chinese government also exercises significant control over China’s economic growth through allocating resources, controlling payment of foreign currency-denominated obligations, setting monetary policy, and providing preferential treatment to particular industries or companies.

While the Chinese economy has experienced significant growth over the past decades, growth has been uneven, both geographically and among various sectors of the economy. The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures may benefit the overall Chinese economy, but may have a negative effect on us. For example, our financial condition and results of operations may be

 

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adversely affected by government control over capital investments or changes in tax regulations. In addition, in the past the Chinese government has implemented certain measures, including interest rate increases, to control the pace of economic growth. These measures may cause decreased economic activity in China, which may adversely affect our business and operating results.

Uncertainties with respect to the PRC legal system could adversely affect us.

We conduct our business primarily through our PRC subsidiaries and consolidated affiliated entities in China. Our operations in China are governed by PRC laws and regulations. Our PRC subsidiaries are foreign-invested enterprises and are subject to laws and regulations applicable to foreign investment in China and, in particular, laws applicable to foreign-invested enterprises. The PRC legal system is a civil law system based on written statutes. Unlike the common law system, prior court decisions may be cited for reference but have limited precedential value.

In 1979, the PRC government began to promulgate a comprehensive system of laws and regulations governing economic matters in general. The overall effect of legislation over the past three decades has significantly enhanced the protections afforded to various forms of foreign investments in China. However, China has not developed a fully integrated legal system, and recently enacted laws and regulations may not sufficiently cover all aspects of economic activities in China. In particular, the interpretation and enforcement of these laws and regulations involve uncertainties. Since PRC administrative and court authorities have significant discretion in interpreting and implementing statutory and contractual terms, it may be difficult to evaluate the outcome of administrative and court proceedings and the level of legal protection we enjoy. These uncertainties may affect our judgment on the relevance of legal requirements and our ability to enforce our contractual or tort rights. In addition, the regulatory uncertainties may be exploited through unmerited or frivolous legal actions or threats in attempts to extract payments or benefits from us.

Furthermore, the PRC legal system is based in part on government policies and internal rules, some of which are not published on a timely basis or at all and may have a retroactive effect. As a result, we may not be aware of our violation of any of these policies and rules until some time after the violation. In addition, any administrative and court proceedings in China may be protracted, resulting in substantial costs and diversion of resources and management attention.

We believe that trademarks, trade secrets, copyright, and other intellectual property we use are important to our business. We rely on a combination of trademark, copyright and trade secret protection laws in China and other jurisdictions, as well as confidentiality procedures and contractual provisions to protect our intellectual property and our brand. Protection of intellectual property rights in China may not be as effective as in the United States or other jurisdictions, and as a result, we may not be able to adequately protect our intellectual property rights, which could adversely affect our revenues and competitive position.

We may be adversely affected by the complexity, uncertainties and changes in PRC regulation of Internet business and companies.

The PRC government extensively regulates the Internet industry, including foreign ownership of, and the licensing and permit requirements pertaining to, companies in the Internet industry. These Internet-related laws and regulations are relatively new and evolving, and their interpretation and enforcement involve significant uncertainty. As a result, in certain circumstances it may be difficult to determine what actions or omissions may be deemed to be in violations of applicable laws and regulations. Issues, risks and uncertainties relating to PRC regulation of the Internet business include, but are not limited to, the following:

 

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We only have contractual control over our website.    We do not own the website due to the restriction of foreign investment in businesses providing value-added telecommunication

 

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services in China, including Internet content provision services. This may significantly disrupt our business, subject us to sanctions, compromise enforceability of related contractual arrangements, or have other harmful effects on us.

 

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There are uncertainties relating to the regulation of the Internet business in China, including evolving licensing practices. This means that permits, licenses or operations at some of our companies may be subject to challenge, or we may fail to obtain permits or licenses that may be deemed necessary for our operations or we may not be able to obtain or renew certain permits or licenses. The major permits and licenses that could be involved include, without limitation, the Internet Audio/Video Program Transmission License (including ancillary licenses covering services of live broadcasting on general social and cultural activities, sports games or other similar activities, search functionality for services of online audio/video programs and services of distribution of audio/video programs to mobile phones) issued by the SARFT, the Internet Culture Operation Permit issued by the Ministry of Culture, the Value-Added Telecommunications Services Operation Permit issued by the MIIT, the Telecommunications and Information Services Operation Permit issued by the Beijing Communications Administration, the Internet News Information Services License issued by the SCIO, the Internet Medical Information Services License issued by the State Food and Drug Administration and the Internet Publication License issued by the GAPP. If we fail to maintain any of these required licenses or approvals, we may be subject to various penalties, including fines and the discontinuation of or restriction on our operations. Any such disruption in our business operations may have a material and adverse effect on our results of operations.

 

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New laws and regulations may be promulgated that will regulate Internet activities, including online video and online advertising businesses. If these new laws and regulations are promulgated, additional licenses may be required for our operations. If our operations do not comply with these new regulations after they become effective, or if we fail to obtain any licenses required under these new laws and regulations, we could be subject to penalties.

On July 13, 2006, the MIIT, the predecessor of which is the Ministry of Information Industry, issued the Notice of the Ministry of Information Industry on Intensifying the Administration of Foreign Investment in Value-added Telecommunications Services. This notice prohibits domestic telecommunications services providers from leasing, transferring or selling telecommunications business operating licenses to any foreign investor in any form, or providing any resources, sites or facilities to any foreign investor for their illegal operation of a telecommunications business in China. According to this notice, either the holder of a value-added telecommunications business operating license or its shareholders must directly own the domain names and trademarks used by such license holders in their provision of value-added telecommunications services. The notice also requires each license holder to have the necessary facilities, including servers, for its approved business operations and to maintain such facilities in the regions covered by its license. Currently, all contracts with telecommunications carriers and other service providers to host the servers used in our business were entered into by 1Verge Information, our PRC consolidated affiliated entity, and such arrangements are in compliance with the notice. 1Verge Information also owns the related domain names and holds the ICP license necessary to conduct our operations in China, while the related trademarks are owned by 1Verge Internet, our wholly-owned subsidiary. There remain significant uncertainties with respect to the procedural requirements involved in effecting the transfer of trademarks from 1Verge Internet to our consolidated affiliated entity, 1Verge Information. It is also unclear as to which of the trademarks that 1Verge Internet owns, if not all, will be subject to the transfer requirement under the Notice. To our knowledge, in practice, the notice has not been enforced in respect of trademarks. We have not been required by the MIIT or its local branch to transfer the relevant trademarks held by 1Verge Internet to 1Verge Information. If the relevant government authority strictly enforces the notice, we will be required to transfer the related trademarks to 1Verge Information, which may be time consuming. If we fail to do

 

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so, the relevant governmental authority has the discretion to revoke 1Verge Information’s value-added telecommunications license or impose other penalties, including fines.

The interpretation and application of existing PRC laws, regulations and policies and possible new laws, regulations or policies relating to the Internet industry have created substantial uncertainties regarding the legality of existing and future foreign investments in, and the businesses and activities of, Internet businesses in China, including our business. We cannot assure you that we have obtained all the permits or licenses required for conducting our business in China or will be able to maintain our existing licenses or obtain any new licenses required under any new laws or regulations. There are also risks that we may be found to violate the existing or future laws and regulations given the uncertainty and complexity of China’s regulation of Internet business.

Fluctuations in exchange rates may have a material adverse effect on your investment.

The value of the Renminbi against the U.S. dollar and other currencies is affected by, among other things, changes in China’s political and economic conditions and China’s foreign exchange policies. The conversion of Renminbi into foreign currencies, including U.S. dollars, has been based on exchange rates set by the People’s Bank of China. On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the Renminbi solely to the U.S. dollar. Under this revised policy, the Renminbi is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. Following the removal of the U.S. dollar peg, the Renminbi appreciated more than 20% against the U.S. dollar over the following three years. Since July 2008, however, the Renminbi has traded within a narrow range against the U.S. dollar. As a consequence, the Renminbi has fluctuated significantly since July 2008 against other freely traded currencies, in tandem with the U.S. dollar. On June 20, 2010, the People’s Bank of China announced that the PRC government would further reform the Renminbi exchange rate regime and increase the flexibility of the exchange rate. It is difficult to predict how this new policy may impact the Renminbi exchange rate.

Substantially all of our revenues and costs are denominated in Renminbi. At the Cayman Islands holding company level, we rely entirely on dividends and other fees paid to us by our subsidiary and consolidated affiliated entities in China. Any significant revaluation of the Renminbi may materially and adversely affect our cash flows, net revenues, earnings and financial position, and the value of, and any dividends payable on, our ADSs in U.S. dollars. For example, an appreciation of the Renminbi against the U.S. dollar would make any new Renminbi-denominated investments or expenditures more costly to us, to the extent that we need to convert U.S. dollars into Renminbi for such purposes. Conversely, a significant depreciation of the Renminbi against the U.S. dollar may significantly reduce the U.S. dollar equivalent of our earnings, which in turn could adversely affect the price of our ADSs.

Very limited hedging options are available in China to reduce our exposure to exchange rate fluctuations. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may decide to enter into hedging transactions in the future, the availability and effectiveness of these hedges may be limited and we may not be able to adequately hedge our exposure or at all. In addition, our currency exchange losses may be magnified by PRC exchange control regulations that restrict our ability to convert Renminbi into foreign currency. As a result, fluctuations in exchange rates may have a material adverse effect on your investment.

Governmental control of currency conversion may limit our ability to utilize our revenues effectively and affect the value of your investment.

The PRC government imposes controls on the convertibility of the Renminbi into foreign currencies and, in certain cases, the remittance of currency out of China. We receive substantially all of our revenues in Renminbi. Under our current corporate structure, our Cayman Islands holding

 

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company primarily relies on dividend payments from our wholly-owned PRC subsidiary, 1Verge Internet, and our wholly-owned Hong Kong subsidiary, Jet Brilliant, which is the direct holding company of Jet Brilliant Beijing, to fund any cash and financing requirements we may have. Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and trade and service-related foreign exchange transactions, can be made in foreign currencies without prior SAFE approval by complying with certain procedural requirements. However, approval from or registration with appropriate government authorities is required where the Renminbi is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment of loans denominated in foreign currencies. Specifically, under the existing exchange restrictions, without prior approval of SAFE, cash generated from the operations of our subsidiaries in China may be used to pay dividends by our PRC subsidiaries to our company either directly or through Jet Brilliant and pay employees of our PRC subsidiaries who are located outside China in a currency other than the Renminbi. With prior approval from SAFE, cash generated from the operations of our PRC subsidiaries and affiliated entities may be used to pay off debt in a currency other than the Renminbi owed by our subsidiaries and affiliated entities to entities outside China, and make other capital expenditures outside China in a currency other than the Renminbi. If either or both of our consolidated affiliated entities liquidate, the proceeds from the liquidation of their assets may be used outside of the PRC or be given to investors who are not PRC nationals. The PRC government may at its discretion restrict access to foreign currencies for current account transactions in the future. If the foreign exchange control system prevents us from obtaining sufficient foreign currencies to satisfy our foreign currency demands, we may not be able to pay dividends in foreign currencies to our shareholders, including holders of our ADSs.

The approval of the China Securities Regulatory Commission may be required in connection with this offering under a regulation adopted in August 2006, and, if required, we cannot assure you that we will be able to obtain such approval.

On August 8, 2006, six PRC regulatory agencies, including the China Securities Regulatory Commission, or CSRC, promulgated the Regulations on Mergers and Acquisitions of Domestic Companies by Foreign Investors, which became effective on September 8, 2006 and was amended on June 22, 2009. This regulation, among other things, requires offshore special purpose vehicles, or SPVs, formed for the purpose of an overseas listing and controlled by PRC companies or individuals, to obtain CSRC approval prior to listing their securities on an overseas stock exchange. The application of this regulation remains unclear. Our PRC counsel, TransAsia Lawyers, has advised us that, based on their understanding of the current PRC laws, rules and regulations:

 

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CSRC currently has not issued any definitive rule or interpretation concerning whether offerings like ours under this prospectus are subject to this regulation; and

 

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given that 1Verge Information and 1Verge Internet were established before September 8, 2006, the effective date of this regulation, and that no provision in this regulation clearly classified contractual arrangements as a type of transaction subject to its regulation, we are not required to submit an application to CSRC for its approval of the listing and trading of our ADSs on the NYSE.

Because there has been no official interpretation or clarification of this regulation since its adoption, there is uncertainty as to how this regulation will be interpreted or implemented. If it is determined that the CSRC approval is required for this offering, we may face sanctions by CSRC or other PRC regulatory agencies for failure to seek the CSRC approval for this offering. These sanctions may include fines and penalties on our operations in the PRC (although to our knowledge, no definitive rules or interpretations have been issued to determine or quantify such fines or penalties), delays or restrictions on the repatriation of the proceeds from this offering into the PRC, restrictions on or prohibition of the payments or remittance of dividends by our PRC subsidiaries, or other actions that

 

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may have a material adverse effect on our business, financial condition, results of operations, reputation and prospects, as well as the trading price of our ADSs. CSRC or other PRC regulatory agencies may also take actions requiring us, or making it advisable to us, to halt this offering before the settlement and delivery of the ADSs that we are offering. Consequently, if you engage in market trading or other activities in anticipation of and prior to the settlement and delivery of the ADSs we are offering, you would be doing so at the risk that the settlement and delivery may not occur.

Recently enacted regulations in the PRC may make it more difficult for us to pursue growth through acquisitions.

Among other things, the regulation discussed in the preceding risk factor established additional procedures and requirements that could make merger and acquisition activities by foreign investors more time-consuming and complex. Such regulation requires, among other things, that the Ministry of Commerce be notified in advance of any change-of-control transaction in which a foreign investor takes control of a PRC domestic enterprise or a foreign company with substantial PRC operations, if certain thresholds under the Provisions on Thresholds for Prior Notification of Concentrations of Undertakings, issued by the State Council on August 3, 2008, were triggered.

We may grow our business in part by directly acquiring complementary businesses in China. Complying with the requirements of these regulations to complete such transactions could be time-consuming, and any required approval processes, including obtaining approval from the Ministry of Commerce, may delay or inhibit our ability to complete such transactions, which could affect our ability to expand our business or maintain our market share.

PRC regulations relating to the establishment of offshore SPVs by PRC residents may subject our PRC resident beneficial owners or our PRC subsidiaries to liability or penalties, limit our ability to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to increase their registered capital or distribute profits to us, or may otherwise adversely affect us.

SAFE has promulgated several regulations, including the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-Raising and Round-trip Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or SAFE Circular No. 75, effective on November 1, 2005, and the Notice of the General Affairs Department of the State Administration of Foreign Exchange on Printing and Distributing the Implementing Rules for the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-Raising and Round-trip Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or SAFE Circular No. 106, issued on May 29, 2007. These regulations require PRC residents and PRC corporate entities to register with local branches of SAFE in connection with their direct or indirect offshore investment activities. These regulations apply to our shareholders who are PRC residents and may apply to any offshore acquisitions that we make in the future.

Under these foreign exchange regulations, PRC residents who make, or have previously made prior to the implementation of these foreign exchange regulations, direct or indirect investments in SPVs will be required to register those investments. In addition, any PRC resident who is a direct or indirect shareholder of a special purpose vehicle, or an SPV, is required to update the previously filed registration with the local branch of SAFE, with respect to that SPV, to reflect any material change. Moreover, the PRC subsidiaries of that SPV are required to urge the PRC resident shareholders to update their registration with the local branch of SAFE. If any PRC shareholder fails to make the required registration or update the previously filed registration, the PRC subsidiaries of that SPV may be prohibited from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to their SPV parent, and the SPV may also be prohibited from injecting additional capital into its PRC subsidiaries. Moreover, failure to comply with the various foreign exchange

 

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registration requirements described above could result in liabilities for such PRC subsidiaries under PRC laws for evasion of applicable foreign exchange restrictions, including (i) the requirement by SAFE to return the foreign exchange remitted overseas within a period specified by SAFE, with a fine of up to 30% of the total amount of foreign exchange remitted overseas and deemed to have been evasive and (ii) in circumstances involving serious violations, a fine of no less than 30% of and up to the total amount of remitted foreign exchange deemed evasive. Furthermore, the persons-in-charge and other persons at such PRC subsidiaries who are held directly liable for the violations may be subject to administrative sanctions.

These foreign exchange regulations provide that PRC residents include both PRC citizens, meaning any individual who holds a PRC passport or resident identification card, and individuals who are non-PRC citizens but primarily reside in the PRC due to their economic ties to China. SAFE Circular No. 106 further defines individuals who are non-PRC citizens but primarily reside in the PRC due to their economic ties to the PRC.

The shareholders of our consolidated affiliated entities, Ms. Qiong Qin and Mr. Dele Liu, both of whom are PRC citizens, have not conducted any direct or indirect offshore investment activities or held any shares, directly or indirectly in any of our offshore entities. Therefore, these PRC resident shareholders are not required to file the registrations and amendments pursuant to SAFE Circular No. 75 and related rules. Mr. Victor Koo, our founder and chief executive officer, who is a permanent resident of Hong Kong, stays in mainland China for over 183 days per annum. However, as a result of our inquiries with the competent local branch of SAFE responsible for our PRC subsidiaries’ foreign exchange registrations, we were informed that, given the lack of any publicly-available implementing rules or official interpretations issued by the SAFE regarding the issue of whether the registration and amendment filing requirements under SAFE Circular No. 75 and related rules should apply to non-PRC citizens, Mr. Koo should not be deemed a PRC resident for these purposes, and any attempt to submit an application to such local SAFE branch with respect to Mr. Koo’s investment and shareholdings in our offshore SPV will not be officially accepted or examined. In addition, Ms. Qiong Qin should not be required to make an application with respect to Mr. Koo’s offshore SPV activities merely by virtue of being Mr. Koo’s wife.

However, we cannot conclude that the SAFE or the local branch responsible for our PRC subsidiaries’ foreign exchange registrations will not later alter their position on and interpretation of the applicability of these foreign exchange regulations to Mr. Koo or the PRC resident shareholders of our consolidated affiliated entities. In the event that the registration procedures set forth in these foreign exchange regulations become applicable to Mr. Koo or the PRC resident shareholders of our consolidated affiliated entities, we will urge these individuals to, and they will, file necessary registrations and amendments as required under SAFE Circular No. 75 and related rules. However, as SAFE regulations and policies have been evolving rapidly in the past few years, we cannot assure that all of these individuals can successfully make or update any applicable registration or obtain the necessary approval required by these foreign exchange regulations as these individuals may not be able to fully satisfy the new requirements or interpretations that SAFE or its local branch may impose or adopt from time to time. The failure or inability of such individuals to comply with the registration procedures set forth in these regulations may subject us to fines or legal sanctions, restrictions on our cross-border investment activities or our PRC subsidiary’s ability to distribute dividends to, or obtain foreign-exchange-dominated loans from, our company, or prevent us from making distributions or paying dividends. As a result, our business operations and our ability to make distributions to you could be materially and adversely affected.

Furthermore, as these foreign exchange regulations are still relatively new and there is uncertainty concerning the reconciliation of the new regulations with the approval requirements under other existing PRC laws and regulations, such as tax laws, it is unclear how these regulations, and any

 

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future regulation concerning offshore or cross-border transactions, will be interpreted, amended and implemented by the relevant government authorities. We cannot predict how these regulations will affect our business operations or future strategy. For example, we may be subject to a more stringent review and approval process with respect to our foreign exchange activities, such as remittance of dividends and foreign-currency-denominated borrowings, which may adversely affect our financial condition and results of operations. In addition, if we decide to acquire a PRC domestic company, we cannot assure you that we or the owners of such company, as the case may be, will be able to obtain the necessary approvals or complete the necessary filings and registrations required by the foreign exchange regulations. This may restrict our ability to implement our acquisition strategy and could adversely affect our business and prospects.

Failure to comply with PRC regulations regarding the registration requirements for employee stock ownership plans or share option plans may subject the PRC plan participants or us to fines and other legal or administrative sanctions.

In December 2006, the People’s Bank of China promulgated the Administrative Measures of Foreign Exchange Matters for Individuals, which set forth the respective requirements for foreign exchange transactions by individuals (both PRC or non-PRC citizens) under either the current account or the capital account. In January 2007, SAFE issued implementing rules for the Administrative Measures of Foreign Exchange Matters for Individual, which, among other things, specified approval requirements for certain capital account transactions such as a PRC citizen’s participation in the employee stock ownership plans or stock option plans of an overseas publicly-listed company. In March 2007, SAFE promulgated the Application Procedures of Foreign Exchange Administration for Domestic Individuals Participating in Employee Stock Ownership Plan or Stock Option Plan of Overseas-Listed Company, or the Stock Option Rules. Under these rules, PRC citizens who participate in an employee stock ownership plan or a stock option plan in an overseas publicly-listed company are required to register with SAFE and complete certain other procedures. For participants of an employee stock ownership plan, an overseas custodian bank should be retained by the PRC agent, which could be the PRC subsidiary of such overseas publicly-listed company, to hold on trusteeship all overseas assets held by such participants under the employee share ownership plan. In the case of a stock option plan, the PRC agent is required to retain a financial institution with stock brokerage qualification at the place where the overseas publicly-listed company is listed or a qualified institution designated by the overseas publicly-listed company to handle matters in connection with the exercise or sale of stock options for the stock option plan participants. For participants who had already participated in an employee stock ownership plan or stock option plan before the date of the Stock Option Rules, the Stock Option Rules require their PRC employers or PRC agents to complete the relevant formalities within three months of the date of this rule. We and our PRC citizen employees who participate in an employee stock ownership plan or a stock option plan will be subject to these regulations when our company becomes a publicly-listed company in the United States. If we or our PRC optionees fail to comply with these regulations, we or our PRC optionees may be subject to fines and other legal or administrative sanctions. See “Regulation—Regulations on Employee Stock Options Plan.”

We face uncertainty with respect to indirect transfers of equity interests in PRC resident enterprises by their non-PRC holding companies.

Pursuant to the Notice on Strengthening Administration of Enterprise Income Tax for Share Transfers by Non-PRC Resident Enterprises, or SAT Circular 698, issued by the State Administration of Taxation, or the SAT, on December 10, 2009 with retroactive effect from January 1, 2008, where a non-resident enterprise transfers the equity interests of a PRC resident enterprise indirectly by disposition of the equity interests of an overseas holding company, or an Indirect Transfer, and such overseas holding company is located in a tax jurisdiction that: (i) has an effective tax rate less than 12.5% or (ii) does not tax foreign income of its residents, the non-resident enterprise, being the

 

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transferor, shall report to the competent tax authority of the PRC resident enterprise this Indirect Transfer. Using a “substance over form” principle, the PRC tax authority may disregard the existence of the overseas holding company if it lacks a reasonable commercial purpose and was established for the purpose of reducing, avoiding or deferring PRC tax. As a result, gains derived from such Indirect Transfer may be subject to PRC withholding tax at a rate of up to 10%. SAT Circular 698 also provides that, where a non-PRC resident enterprise transfers its equity interests in a PRC resident enterprise to its related parties at a price lower than the fair market value, the relevant tax authority has the power to make a reasonable adjustment to the taxable income of the transaction.

There is uncertainty as to the application of SAT Circular 698. For example, while the term “Indirect Transfer” is not clearly defined, it is understood that the relevant PRC tax authorities have jurisdiction regarding requests for information over a wide range of foreign entities having no direct contact with China. Moreover, the relevant authority has not yet promulgated any formal provisions or formally declared or stated how to calculate the effective tax rates in foreign tax jurisdictions, and the process and format of the reporting of an Indirect Transfer to the competent tax authority of the relevant PRC resident enterprise remain unclear. In addition, there are not any formal declarations with regard to how to determine whether a foreign investor has adopted an abusive arrangement in order to reduce, avoid or defer PRC tax. SAT Circular 698 may be determined by the tax authorities to be applicable to our private equity financing transactions where non-resident investors were involved, if any of such transactions were determined by the tax authorities to lack reasonable commercial purpose. As a result, we and our non-resident investors may become at risk of being taxed under SAT Circular 698 and may be required to expend valuable resources to comply with SAT Circular 698 or to establish that we should not be taxed under SAT Circular 698, which may have a material adverse effect on our financial condition and results of operations or such non-resident investors’ investments in us.

Discontinuation of any of the preferential tax treatments or imposition of any additional taxes could adversely affect our financial condition and results of operations.

China passed a new PRC Enterprise Income Tax Law, or the New EIT Law, and its implementation rules, both of which became effective on January 1, 2008. The New EIT Law significantly curtails tax incentives granted to foreign-invested enterprises under the PRC Enterprise Income Tax Law concerning Foreign-Invested Enterprises and Foreign Enterprises, or the Old EIT Law, which was effective prior to January 1, 2008. The New EIT Law, however, (i) reduces the statutory rate of the enterprise income tax from 33% to 25%, (ii) permits companies established before March 16, 2007 to continue to enjoy their existing tax incentives, adjusted by certain transitional phase-out rules promulgated by the State Council on December 26, 2007, and (iii) introduces new tax incentives, subject to various qualification criteria.

The New EIT Law and its implementation rules permit certain “high and new technology enterprises strongly supported by the state” which hold independent ownership of core intellectual property to enjoy a preferential enterprise income tax rate of 15% subject to certain new qualification criteria. 1Verge Information, our consolidated affiliated entity, was recognized by the Beijing Municipal Science and Technology Commission as a “high and new technology enterprise” on April 27, 2006 and was reaffirmed on December 14, 2009, and therefore was eligible for the reduced 15% enterprise income tax rate upon its filing with the relevant tax authority. The qualification as a “high and new technology enterprise” is subject to annual evaluation and a three-year review by the relevant authorities in China. If 1Verge Information fails to maintain its “high and new technology enterprise” qualification or renew its qualification when the relevant term expires, its applicable enterprise income tax rate may increase to 25%, which could have a material adverse effect on our financial condition and results of operations.

 

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Preferential tax treatment granted to our subsidiaries and consolidated affiliated entities by the local governmental authorities is subject to review and may be adjusted or revoked at any time. The discontinuation of any preferential tax treatments currently available to us and our wholly-owned PRC subsidiary will cause our effective tax rate to increase, which could have a material adverse effect on our financial condition and results of operations. We cannot assure you that we will be able to maintain our current effective tax rate in the future.

Our global income and the dividends that we may receive from our PRC subsidiaries may be subject to PRC taxes under the PRC Enterprise Income Tax Law, which would have a material adverse effect on our results of operations.

Under the New EIT Law and its implementation rules, both became effective on January 1, 2008, an enterprise established outside of the PRC with “de facto management body” within the PRC is considered a resident enterprise and will be subject to the enterprise income tax at the rate of 25% on its global income. The implementation rules define the term “de facto management body” as “establishments that carry out substantial and overall management and control over the manufacturing and business operations, personnel, accounting, properties, etc. of an enterprise.” The State Tax Administration issued the Notice Regarding the Determination of Chinese-Controlled Offshore Incorporated Enterprises as PRC Tax Resident Enterprises on the Basis of De Facto Management Bodies, or SAT Circular 82, on April 22, 2009. SAT Circular 82 provides certain specific criteria for determining whether the “de facto management body” of a Chinese-controlled offshore-incorporated enterprise is located in China. See “Regulation—Regulations on Tax—PRC Enterprise Income Tax.” Although SAT Circular 82 only applies to offshore enterprises controlled by PRC enterprises, not those controlled by PRC individuals, the determining criteria set forth in the SAT Circular 82 may reflect the State Administration of Taxation’s general position on how the “de facto management body” test may be applied in determining the tax resident status of offshore enterprises.

According to the SAT Circular 82, a Chinese-controlled offshore incorporated enterprise will be regarded as a PRC tax resident by virtue of having “de facto management body” in China and will be subject to PRC enterprise income tax on its worldwide income only if all of the following conditions set forth in the SAT Circular 82 are met: (i) the primary location of the day-to-day operational management is in the PRC; (ii) decisions relating to the enterprise’s financial and human resource matters are made or are subject to approval by organizations or personnel in the PRC; (iii) the enterprise’s primary assets, accounting books and records, company seals, and board and shareholder resolutions are located or maintained in the PRC; and (iv) at least 50% of voting board members or senior executives habitually reside in the PRC.

We do not believe that either Youku.com Inc. or its Hong Kong subsidiary, Jet Brilliant, meets all of the conditions above. Each of Youku.com Inc. and Jet Brilliant is a company incorporated outside the PRC. As holding companies, these two entities’ key assets and records, including the resolutions of their respective board of directors and the resolutions of their respective shareholders, are located and maintained outside the PRC. In addition, we are not aware of any offshore holding companies with a similar corporate structure as ours ever having been deemed a PRC “resident enterprise” by the PRC tax authorities. Therefore, we believe that neither Youku.com Inc. nor Jet Brilliant should be treated as a “resident enterprise” for PRC tax purposes if the criteria for “de facto management body” as set forth in the SAT Circular 82 were deemed applicable to us. However, as the tax resident status of an enterprise is subject to determination by the PRC tax authorities and uncertainties remain with respect to the interpretation of the term “de facto management body” as applicable to our offshore entities, we may be considered a resident enterprise and may therefore be subject to the enterprise income tax at 25% on our global income. If we are considered a resident enterprise and earn income other than dividends from our PRC subsidiary, a 25% enterprise income tax on our global income could significantly increase our tax burden and materially and adversely affect our cash flow and profitability.

 

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In addition to the uncertainty regarding how the new “resident enterprise” classification may apply, it is also possible that the rules may change in the future, possibly with retroactive effect.

Under the Old EIT Law applicable to us prior to January 1, 2008, dividend payments to foreign investors made by foreign-invested enterprises in China, such as 1Verge Internet and Jet Brilliant Beijing, were exempt from PRC withholding tax. Pursuant to the New EIT Law and its implementation rules, however, dividends generated after January 1, 2008 and payable by a foreign-invested enterprise in China to its foreign investors, which are non-PRC tax resident enterprises without an establishment in China, or whose income has no connection with their institutions and establishments inside China, are subject to withholding tax at a rate of 10%, unless any such foreign investor’s jurisdiction of incorporation has a tax treaty with China that provides for a different withholding arrangement. We are a Cayman Islands holding company and we plan to conduct our advertising business and derive substantially all of our income from dividends through Jet Brilliant Beijing, which is 100% owned by Jet Brilliant, our wholly owned subsidiary located in Hong Kong. As long as our Hong Kong subsidiary is considered a non-PRC resident enterprise and holds at least 25% of the equity interest of Jet Brilliant Beijing, dividends that it receives from Jet Brilliant Beijing may be subject to withholding tax at a preferential rate of 5% under the Arrangement between the PRC and the Hong Kong Special Administrative Region on the Avoidance of Double Taxation and Prevention of Fiscal Evasion, effective on January 1, 2007, upon receiving approval from the local tax authority. However, if our Hong Kong subsidiary is not considered to be the beneficial owner of such dividends under applicable tax regulations, such dividends would be subject to withholding tax at a rate of 10%. See “Regulation—Regulations on Tax—Dividends Withholding Tax.” Our PRC subsidiaries have not paid any dividends, and do not currently plan to pay dividends in the future as they continue to incur losses, to our company or our Hong Kong subsidiary, as the case the may be. We have not obtained the approval mentioned above from the local tax authority and do not currently plan to do so in the near future.

We have been advised by our PRC counsel, TransAsia Lawyers, that because there remains uncertainty regarding the interpretation and implementation of the New EIT Law and its implementation rules, it is uncertain whether, if we are regarded as a PRC resident enterprise, any dividends to be distributed by us to our non-PRC shareholders and ADS holders would be subject to any PRC withholding tax. If we are required under the New EIT Law to withhold PRC income tax on our dividends payable to our non-PRC enterprise shareholders and ADS holders, your investment in our ordinary shares or ADSs may be materially and adversely affected.

The enforcement of the Labor Contract Law and other labor-related regulations in the PRC may adversely affect our business and our results of operations.

On June 29, 2007, the Standing Committee of the National People’s Congress of China enacted the Labor Contract Law, which became effective on January 1, 2008. The Labor Contract Law introduces specific provisions related to fixed-term employment contracts, part-time employment, probation, consultation with labor union and employee assemblies, employment without a written contract, dismissal of employees, severance, and collective bargaining, which together represent enhanced enforcement of labor laws and regulations. According to the Labor Contract Law, an employer is obliged to sign an unlimited-term labor contract with any employee who has worked for the employer for ten consecutive years. Further, if an employee requests or agrees to renew a fixed-term labor contract that has already been entered into twice consecutively, the resulting contract must have an unlimited term, with certain exceptions. The employer must also pay severance to an employee in nearly all instances where a labor contract, including a contract with an unlimited term, is terminated or expires. In addition, the government has continued to introduce various new labor-related regulations after the Labor Contract Law. Among other things, new annual leave requirements mandate that annual leave ranging from five to 15 days is available to nearly all employees and further require that the employer compensate an employee for any annual leave days the employee is unable to take in

 

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the amount of three times his daily salary, subject to certain exceptions. As a result of these new regulations designed to enhance labor protection, our labor costs are expected to increase. In addition, as the interpretation and implementation of these new regulations are still evolving, we cannot assure you that our employment practice will at all times be deemed in full compliance with the new regulations. If we are subject to severe penalties or incur significant liabilities in connection with labor disputes or investigations, our business and results of operations may be adversely affected.

Risks Related to this Offering

There has been no public market for our ordinary shares or ADSs prior to this offering, and you may not be able to resell our ADSs at or above the price you paid, or at all.

Prior to this initial public offering, there has been no public market for our ordinary shares or ADSs. We will apply to list the ADSs on the NYSE. Our ordinary shares will not be listed on any exchange or quoted for trading on any over-the-counter trading system. If an active trading market for our ADSs does not develop after this offering, the market price and liquidity of our ADSs will be materially and adversely affected.

Negotiations with the underwriters will determine the initial public offering price for our ADSs which may bear no relationship to their market price after the initial public offering. We cannot assure you that an active trading market for our ADSs will develop or that the market price of our ADSs will not decline below the initial public offering price.

The market price for our ADSs may be volatile.

The market price for our ADSs is likely to be highly volatile and subject to wide fluctuations in response to factors including the following:

 

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regulatory developments affecting us, our advertisers or our industry;

 

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announcements of studies and reports relating to the quality of our services or those of our competitors;

 

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changes in the economic performance or market valuations of other companies that provide online video or online advertising;

 

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actual or anticipated fluctuations in our quarterly results of operations and changes of our expected results;

 

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changes in financial estimates by securities research analysts;

 

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conditions in the online video or online advertising industry;

 

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announcements by us or our competitors of new services, acquisitions, strategic relationships, joint ventures or capital commitments;

 

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additions to or departures of our senior management;

 

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fluctuations of exchange rates between the Renminbi and the U.S. dollar;

 

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release or expiry of lock-up or other transfer restrictions on our outstanding ordinary shares or ADSs; and

 

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sales or perceived potential sales of additional ordinary shares or ADSs.

In addition, the securities market has from time to time experienced significant price and volume fluctuations that are not related to the operating performance of any particular companies. These market fluctuations may also have a material adverse effect on the market price of our ADSs.

 

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Our proposed dual-class voting structure will limit your ability to influence corporate matters and could discourage others from pursuing any change of control transactions that holders of our Class A ordinary shares and ADSs may view as beneficial.

Immediately prior to the completion of this offering, we expect to create a dual-class voting structure such that our ordinary shares will consist of Class A ordinary shares and Class B ordinary shares. Subject to certain exceptions, in respect of matters requiring the votes of shareholders, holders of Class A ordinary shares will be entitled to one vote per share, while holders of Class B ordinary shares will be entitled to three votes per share. We will issue Class A ordinary shares represented by our ADSs in this offering. Immediately prior to the completion of this offering, (i) all ordinary shares held by 1Look Holdings Ltd., which is wholly owned by our founder, chairman and chief executive officer, Victor Koo, and its affiliates will be automatically re-designated as Class B ordinary shares on a 1-for-1 basis, (ii) all preferred shares held by Chengwei Partners, L.P., Chengwei Ventures Evergreen Fund, L.P. and Chengwei Ventures Evergreen Advisors Fund, LLC, collectively referred to as Chengwei Funds, and their affiliates will be automatically converted into Class B ordinary shares each on a 1-for-1 basis, and (iii) all preferred shares held by our shareholders other than Chengwei Funds or their affiliates will be automatically converted into Class A ordinary shares on a 1-for-1 basis. Each Class B ordinary share is convertible into one Class A ordinary share at any time by the holder thereof, while Class A ordinary shares are not convertible into Class B ordinary shares under any circumstances. Upon any transfer of Class B ordinary shares by a holder thereof to any person or entity which is not an affiliate of such holder, such Class B ordinary shares shall be automatically and immediately converted into the equal number of Class A ordinary shares. Due to the disparate voting powers attached to these two classes, we anticipate that Victor Koo and Chengwei Funds will beneficially own approximately             % of the aggregate voting power of our company immediately after this offering and will have considerable influence over matters requiring shareholder approval, subject to certain exceptions. This concentrated control will limit your ability to influence corporate matters and could discourage others from pursuing any potential merger, takeover or other change of control transactions that holders of Class A ordinary shares and ADSs may view as beneficial.

Because our initial public offering price is substantially higher than our net tangible book value per share, you will experience immediate and substantial dilution.

If you purchase ADSs in this offering, you will pay more for your ADSs than the amount paid by our existing shareholders for their Class A ordinary shares on a per ADS basis. As a result, you will experience immediate and substantial dilution of approximately US$             per ADS, representing the difference between the assumed initial public offering price of US$             per ADS, the mid-point of the estimated range of the initial public offering price, and our net tangible book value per ADS as of                     , after giving effect to the automatic conversion of our preferred shares, immediately upon the completion of this offering and net proceed, to us from this offering. In addition, you may experience further dilution to the extent that our ordinary shares are issued upon the exercise of share options.

Because we do not expect to pay dividends in the foreseeable future after this offering, you must rely on price appreciation of our ADSs for return on your investment.

We currently intend to retain most, if not all, of our available funds and any future earnings after this offering to fund the development and growth of our business. As a result, we do not expect to pay any cash dividends in the foreseeable future. Therefore, you should not rely on an investment in our ADSs as a source for any future dividend income.

Our board of directors has complete discretion as to whether to distribute dividends. Even if our board of directors decides to declare and pay dividends, the timing, amount and form of future dividends, if any, will depend on, among other things, our future results of operations and cash flow,

 

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our capital requirements and surplus, the amount of distributions, if any, received by us from our subsidiaries, our financial condition, contractual restrictions and other factors deemed relevant by our board of directors. Accordingly, the return on your investment in our ADSs will likely depend entirely upon any future price appreciation of our ADSs. There is no guarantee that our ADSs will appreciate in value after this offering or even maintain the price at which you purchased the ADSs. You may not realize a return on your investment in our ADSs and you may even lose your entire investment in our ADSs.

Substantial future sales or perceived potential sales of our ADSs in the public market could cause the price of our ADSs to decline.

Sales of our ADSs or Class A ordinary shares in the public market after this offering, or the perception that these sales could occur, could cause the market price of our ADSs to decline. Upon completion of this offering, we will have              ordinary shares outstanding including              Class A ordinary shares represented by ADSs. All ADSs sold in this offering will be freely transferable without restriction or additional registration under the Securities Act. The remaining Class A ordinary shares outstanding after this offering will be available for sale, upon the expiration of the 180-day lock-up period beginning from the date of this prospectus, subject to volume and other restrictions as applicable under Rules 144 and 701 under the Securities Act. Any or all of these shares may be released prior to the expiration of the lock-up period at the discretion of the representatives. To the extent shares are released before the expiration of the lock-up period and sold into the market, the market price of our ADSs may decline. In addition, the shareholders of 1Verge Holdings Ltd., which will directly hold a total of 626,773,147 Class B ordinary shares of our company on an as-converted basis upon the completion of this offering, have agreed among themselves not to sell our shares through 1Verge Holdings Ltd. without the unanimous consent of 1Verge Holdings Ltd.’s board of directors for a period of two years after the completion of this offering. In the event that the shareholders of 1Verge Holdings Ltd. decide to release themselves from the two-year lock-up restrictions and sell our shares into the market, the market price of our ADSs may decline.

Upon completion of this offering, certain holders of our ordinary shares will have the right to cause us to register under the Securities Act the sale of their shares, subject to the 180-day lock-up period in connection with this offering. Registration of these shares under the Securities Act would result in ADSs representing these shares becoming freely tradable without restriction under the Securities Act immediately upon the effectiveness of the registration. Sales of these registered shares in the form of ADSs, in the public market could cause the price of our ADSs to decline.

You may not have the same voting rights as the holders of our ordinary shares and may not receive voting materials in time to be able to exercise your right to vote.

Except as described in this prospectus and in the deposit agreement, holders of our ADSs will not be able to exercise voting rights attaching to the Class A ordinary shares represented by our ADSs on an individual basis. Holders of our ADSs will appoint the depositary or its nominee as their representative to exercise the voting rights attaching to the Class A ordinary shares represented by the ADSs. You may not receive voting materials in time to instruct the depositary to vote, and it is possible that you, or persons who hold their ADSs through brokers, dealers or other third parties, will not have the opportunity to exercise a right to vote. For details of voting rights of our ordinary shareholders, please refer to “Description of Share Capital—Ordinary Shares—Voting Rights”, and for details of voting rights for our ADS holders, please refer to “Description of American Depositary Shares—Voting Rights.”

 

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The depositary for our ADSs will give us a discretionary proxy to vote our ordinary shares underlying your ADSs if you do not vote at shareholders’ meetings, except in limited circumstances, which could adversely affect your interests.

Under the deposit agreement for the ADSs, if you do not vote, the depositary will give us a discretionary proxy to vote the Class A ordinary shares underlying your ADSs at shareholders’ meetings unless:

 

  Ÿ  

we have failed to timely provide the depositary with notice of meeting and related voting materials;

 

  Ÿ  

we have instructed the depositary that we do not wish a discretionary proxy to be given;

 

  Ÿ  

we have informed the depositary that there is substantial opposition as to a matter to be voted on at the meeting;

 

  Ÿ  

we have informed the depositary that a matter to be voted on at the meeting would have a material adverse impact on shareholders; or

 

  Ÿ  

the voting at the meeting is to be made on a show of hands.

Your right to participate in any future rights offerings may be limited, which may cause dilution to your holdings, and you may not receive cash dividends if it is impractical to make them available to you.

We may from time to time distribute rights to our shareholders, including rights to acquire our securities. However, we cannot make rights available to you in the United States unless we register both the rights and the securities to which the rights relate under the Securities Act or an exemption from the registration requirements is available. Under the deposit agreement, the depositary will not make rights available to you unless both the rights and the underlying securities to be distributed to ADS holders are either registered under the Securities Act or exempt from registration under the Securities Act. We are under no obligation to file a registration statement with respect to any such rights or securities or to endeavor to cause such a registration statement to be declared effective and we may not be able to establish a necessary exemption from registration under the Securities Act. Accordingly, you may be unable to participate in our rights offerings and may experience dilution in your holdings.

The depositary of our ADSs has agreed to pay to you the cash dividends or other distributions it or the custodian receives on our ordinary shares or other deposited securities after deducting its fees and expenses. You will receive these distributions in proportion to the number of ordinary shares your ADSs represent. However, the depositary may, at its discretion, decide that it is inequitable or impractical to make a distribution available to any holders of ADSs. For example, the depositary may determine that it is not practicable to distribute certain property through the mail, or that the value of certain distributions may be less than the cost of mailing them. In these cases, the depositary may decide not to distribute such property to you.

You may be subject to limitations on transfer of your ADSs.

Your ADSs are transferable on the books of the depositary. However, the depositary may close its transfer books at any time or from time to time when it deems expedient in connection with the performance of its duties. In addition, the depositary may refuse to deliver, transfer or register transfers of ADSs generally when our books or the books of the depositary are closed, or at any time if we or the depositary deems it advisable to do so because of any requirement of law or of any government or governmental body, or under any provision of the deposit agreement, or for any other reason.

 

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You may face difficulties in protecting your interests, and your ability to protect your rights through the U.S. federal courts may be limited because we are incorporated under Cayman Islands law, we conduct substantially all of our operations in China and substantially all of our directors and officers reside outside the United States.

We are incorporated in the Cayman Islands and conduct substantially all of our operations in China through our PRC subsidiaries and consolidated affiliated entities. Substantially all of our directors and officers reside outside the United States and a substantial portion of their assets are located outside of the United States. As a result, it may be difficult or impossible for you to bring an action against us or against these individuals in the Cayman Islands or in China in the event that you believe that your rights have been infringed under the securities laws or otherwise. Even if you are successful in bringing an action of this kind, the laws of the Cayman Islands and of China may render you unable to enforce a judgment against our assets or the assets of our directors and officers. There is no statutory recognition in the Cayman Islands of judgments obtained in the United States, although the courts of the Cayman Islands will generally recognize and enforce a non-penal judgment of a foreign court of competent jurisdiction without retrial on the merits. For more information regarding the relevant laws of the Cayman Islands and China, see “Enforceability of Civil Liabilities.”

Our corporate affairs are governed by our memorandum and articles of association, as amended and restated from time to time, and by the Companies Law (2010 Revision) and common law of the Cayman Islands. The rights of shareholders to take legal action against us and our directors, actions by minority shareholders and the fiduciary responsibilities of our directors are to a large extent governed by the common law of the Cayman Islands. The common law of the Cayman Islands is derived in part from comparatively limited judicial precedent in the Cayman Islands as well as from English common law, which provides persuasive, but not binding, authority. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as they would be under statutes or judicial precedents in the United States. In particular, the Cayman Islands has a less developed body of securities laws than the United States and provides significantly less protection to investors. In addition, shareholders in Cayman Islands companies may not have standing to initiate a shareholder derivative action in U.S. federal courts.

As a result, our public shareholders may have more difficulty in protecting their interests through actions against us, our management, our directors or our major shareholders than would shareholders of a corporation incorporated in a jurisdiction in the United States.

You must rely on the judgment of our management as to the use of the net proceeds from this offering, and such use may not produce income or increase our ADS price.

We intend to use the net proceeds of this offering for, among other things, video content acquisition, investment in bandwidth and purchases of servers and equipment for our CDN infrastructure, expansion of product development and sales and marketing efforts. However, our management will have considerable discretion in the application of the net proceeds received by us. For more information, see “Use of Proceeds.” You will not have the opportunity, as part of your investment decision, to assess whether proceeds are being used appropriately. You must rely on the judgment of our management regarding the application of the net proceeds of this offering. The net proceeds may be used for corporate purposes that do not improve our efforts to maintain profitability or increase our ADS price. The net proceeds from this offering may be placed in investments that do not produce income or that lose value.

 

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Our memorandum and articles of association will contain anti-takeover provisions that could adversely affect the rights of holders of our ordinary shares and ADSs.

We will adopt an amended and restated memorandum and articles of association that will become effective immediately upon the closing of this offering. Our new memorandum and articles of association will contain certain provisions that could limit the ability of others to acquire control of our company, including a provision that grants authority to our board directors to establish from time to time one or more series of preferred shares without action by our shareholders and to determine, with respect to any series of preferred shares, the terms and rights of that series. The provisions could have the effect of depriving our shareholders of the opportunity to sell their shares at a premium over the prevailing market price by discouraging third parties from seeking to obtain control of our company in a tender offer or similar transactions.

Our corporate actions are substantially controlled by our directors, executive officers and other principal shareholders, who can exert significant influence over important corporate matters, which may reduce the price of our ADSs and deprive you of an opportunity to receive a premium for your shares.

After this offering, our directors, executive officers and principal shareholders will beneficially own approximately             % of our outstanding ordinary shares, representing             % of our total voting power. These shareholders, if acting together, could exert substantial influence over matters such as electing directors and approving material mergers, acquisitions or other business combination transactions. This concentration of ownership may also discourage, delay or prevent a change in control of our company, which could have the dual effect of depriving our shareholders of an opportunity to receive a premium for their shares as part of a sale of our company and reducing the price of our ADSs. These actions may be taken even if they are opposed by our other shareholders, including those who purchase ADSs in this offering. In addition, these persons could divert business opportunities away from us to themselves or others.

We are likely treated as a passive foreign investment company for United States federal income tax purposes for our taxable year that includes this offering and may be so classified for subsequent taxable years.

We are likely treated as a “passive foreign investment company,” or PFIC, for U.S. federal income tax purposes, for our taxable year that includes this offering. Depending upon the value of our ordinary shares and ADSs and the nature of our assets and income over time, we may continue to be treated as a PFIC for 2011 or subsequent taxable years United States federal income tax purposes. A non-United States corporation will be treated as a PFIC for any taxable year if either (i) 75% or more of its gross income for such year consists of certain types of “passive” income, or (ii) 50% or more of the value of its assets (determined on the basis of a quarterly average) during such year is attributable to assets that produce passive income or are held for the production of passive income, or the asset test. Passive income is any income that would be foreign personal holding company income under the Internal Revenue Code of 1986, as amended, including, without limitation, dividends, interest, royalties, rents, annuities, net gains from the sale or exchange of property producing such income, net gains from commodity transactions, net foreign currency gains and income from notional principal contracts. For purposes of this test, we will be treated as owning a proportionate share of the assets and earning a proportionate share of the income of any other corporation in which we own, directly or indirectly, more than 25%, by value, of the stock. Although the law in this regard is unclear, we treat 1Verge Information and Jiaheyi as being owned by us for United Stated federal income tax purposes, not only because we exercise effective control over the operation of such entities but also because we are entitled to substantially all of their economic benefits, and, as a result, we consolidate their results of operations in our consolidated financial statements. Assuming that we are owner of such entities for United States federal income tax purposes, based on our current income and assets and projections

 

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as to the value of our ordinary shares and ADSs pursuant to this offering, we do not expect to continue to be treated as a PFIC for 2011 taxable year or the foreseeable future. Therefore, if you make a “deemed sale” or “deemed dividend” election (as each is described in “Taxation—Material United States Federal Income Tax Considerations—Passive Foreign Investment Company Considerations”), your ADSs or ordinary shares with respect to which such election was made should not be treated as shares in a PFIC unless we subsequently become a PFIC. While we do not anticipate continuing being a PFIC in 2011, because the value of our assets for purposes of the asset test will generally be determined by reference to the market price of our ADSs or ordinary shares, fluctuations in the market price of our ADSs or ordinary shares may cause us to continue being a PFIC for 2011 or subsequent taxable years. Because there are uncertainties in the application of the relevant rules and PFIC status is a factual determination made annually after the close of each taxable year on the basis of the composition of our income and the value of our active versus passive assets, there can be no assurance that we will not continue being a PFIC for the taxable year 2011 or any future taxable year.

We have not sought a ruling from the United States Internal Revenue Service, or the IRS, with respect to our PFIC status, and there can be no assurance that the IRS will agree with our determination. The overall level of our passive assets will be affected by (i) future growth in activities that may potentially produce passive income, and (ii) how, and how quickly, we spend our liquid assets and the cash raised in this offering. Under circumstances where revenues from activities that produce passive income significantly increase relative to our revenues from activities that produce non-passive income or where we determine not to deploy significant amounts of cash for active purposes, our risk of continuing to be treated as a PFIC may substantially increase. In addition, if it were determined that we are not the owner of 1Verge Information and Jiaheyi for United States federal income tax purposes, we would likely be treated as a PFIC for our current taxable year and any subsequent taxable year.

If we were to be or become treated as a PFIC, a U.S. Holder (as defined in “Taxation—Material United States Federal Income Tax Considerations—General”) may incur significantly increased United States income tax on gain recognized on the sale or other disposition of the ADSs or ordinary shares and on the receipt of distributions on the ADSs or ordinary shares to the extent such gain or distribution is treated as an “excess distribution” under the United States federal income tax rules. Further, if we are so treated, our ADSs or ordinary shares generally will continue to be treated as shares in a PFIC for all succeeding years during which such U.S. Holder holds our ADSs or ordinary shares, unless we cease to be a PFIC and the U.S. Holder makes a “deemed sale” election or “deemed dividend” election with respect to the ADSs or ordinary shares. You are urged to consult your tax advisor concerning the United States federal income tax consequences of acquiring, holding, and disposing of ADSs or ordinary shares if we are or become treated as a PFIC. For more information see “Taxation—Material United States Federal Income Tax Considerations—Passive Foreign Investment Company Considerations.”

We expect to be a controlled foreign corporation, or CFC, for U.S. federal income tax purposes.

We are likely treated as a CFC for U.S. federal income tax purposes. We will be a CFC for

any year in which U.S. Holders (as defined in “Taxation—Material United States Federal Income Tax Considerations—General”) that each own (directly, indirectly or by attribution) at least 10% of our voting shares and together own more than 50% of the total combined voting power of all classes of our voting shares or more than 50% of the total value of our shares. Our classification as a CFC has many complex results, but one is that any U.S. Holder that is a 10% U.S. Holder on the last day of our taxable year would be required to recognize as ordinary income his or her pro rata share of “Subpart F Income” of our company and our subsidiaries (which, in our company’s case, should not generally include our subsidiaries’ operating income) for the taxable year, whether or not the U.S. Holder received any distributions on his or her ADSs or ordinary shares during that taxable year. For this purpose, Subpart F Income includes, without limitations, sales or services income that is generated

 

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outside of the CFC’s country of organization and that involves affiliates, dividends, interest, royalties, rent, annuities, net gains from the sale or exchange of property producing such income, net gains from commodity transactions, net foreign currency gains and income from notional principal contracts, and certain other income. For more information see “Taxation—Material United States Federal Income Tax Considerations—Controlled Foreign Corporation Status and Related Tax Consequences.”

We will incur increased costs as a result of being a public company.

As a public company, we will incur significant accounting, legal and other expenses that we did not incur as a private company. The Sarbanes-Oxley Act, as well as rules subsequently implemented by the Securities and Exchange Commission and the NYSE, have detailed requirements concerning corporate governance practices of public companies including Section 404 relating to internal control over financial reporting. We expect these and other rules and regulations applicable to public companies to increase our accounting, legal and financial compliance costs and to make certain corporate activities more time-consuming and costly. We are currently evaluating and monitoring developments with respect to these new rules, and we cannot predict or estimate with reasonable certainty the amount of additional costs we may incur or the timing of such costs, though we expect such additional costs not to exceed US$2 million in each of the next two years.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements that reflect our current expectations and views of future events. The forward looking statements are contained principally in the sections entitled “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.” Known and unknown risks, uncertainties and other factors, including those listed under “Risk Factors,” may cause our actual results, performance or achievements to be materially different from those expressed or implied by the forward-looking statements.

You can identify some of these forward-looking statements by words or phrases such as “may,” “will,” “expect,” “anticipate,” “aim,” “estimate,” “intend,” “plan,” “believe,” “is/are likely to,” “potential,” “continue” or other similar expressions. We have based these forward-looking statements largely on our current expectations and projections about future events that we believe may affect our financial condition, results of operations, business strategy and financial needs. These forward-looking statements include statements relating to:

 

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our goals and strategies;

 

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our future business development, financial condition and results of operations;

 

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the expected growth of the online video market in China;

 

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our expectations regarding demand for and market acceptance of our services;

 

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our expectations regarding the retention and strengthening of our relationships with key advertisers and customers;

 

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our plans to enhance user experience, infrastructure and service offerings;

 

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competition in our industry in China; and

 

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relevant government policies and regulations relating to our industry.

These forward-looking statements involve various risks and uncertainties. Although we believe that our expectations expressed in these forward-looking statements are reasonable, our expectations may later be found to be incorrect. Our actual results could be materially different from our expectations. Important risks and factors that could cause our actual results to be materially different from our expectations are generally set forth in “Prospectus Summary—Our Challenges,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business,” “Regulation” and other sections in this prospectus. You should thoroughly read this prospectus and the documents that we refer to with the understanding that our actual future results may be materially different from and worse than what we expect. We qualify all of our forward-looking statements by these cautionary statements.

This prospectus contains certain data and information that we obtained from various government and private publications. Statistical data in these publications also include projections based on a number of assumptions. The online video industry may not grow at the rate projected by market data, or at all. The failure of this market to grow at the projected rate may have a material adverse effect on our business and the market price of our ADSs. In addition, the rapidly changing nature of the online video industry results in significant uncertainties for any projections or estimates relating to the growth prospects or future condition of our market. Furthermore, if any one or more of the assumptions underlying the market data is later found to be incorrect, actual results may differ from the projections based on these assumptions. You should not place undue reliance on these forward-looking statements.

 

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The forward-looking statements made in this prospectus relate only to events or information as of the date on which the statements are made in this prospectus. Except as required by law, we undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise, after the date on which the statements are made or to reflect the occurrence of unanticipated events. You should read this prospectus and the documents that we refer to in this prospectus and have filed as exhibits to the registration statement, of which this prospectus is a part, completely and with the understanding that our actual future results may be materially different from what we expect.

 

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USE OF PROCEEDS

We estimate that we will receive net proceeds from this offering of approximately US$             million, or approximately US$             million if the underwriters exercise their option to purchase additional ADSs in full, after deducting underwriting discounts and the estimated offering expenses payable by us. These estimates are based upon an assumed initial public offering price of US$             per ADS (the mid-point of the range shown on the front cover page of this prospectus). A US$1.00 increase (decrease) in the assumed initial public offering price of US$             per ADS would increase (decrease) the net proceeds to us from this offering by US$             million, assuming the number of ADSs offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated expenses payable by us.

The primary purposes of this offering are to create a public market for our shares for the benefit of all shareholders, retain talented employees by providing them with equity incentives, and obtain additional capital. We plan to use the net proceeds of this offering as follows:

 

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approximately US$              million for investments in technology, infrastructure and product development efforts;

 

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approximately US$              million for video content acquisition;

 

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approximately US$              million for the expansion of sales and marketing efforts; and

 

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the balance for other general corporate purposes, including working capital needs and potential acquisitions (although we are not currently negotiating any such acquisitions).

The foregoing represents our current intentions based upon our present plans and business conditions to use and allocate the net proceeds of this offering. Our management, however, will have significant flexibility and discretion to apply the net proceeds of this offering. If an unforeseen event occurs or business conditions change, we may use the proceeds of this offering differently than as described in this prospectus.

Pending any use as described above, we plan to invest the net proceeds we will receive from this offering in short-term debt instruments or demand deposits.

In using the proceeds of this offering, as an offshore holding company, we are permitted, under PRC laws and regulations, to provide funding to our PRC subsidiaries only through loans or capital contributions and to our consolidated affiliated entities only through loans. Subject to satisfaction of applicable government registration and approval requirements, we may extend loans to our PRC subsidiaries and consolidated affiliated entities or make additional capital contributions to our PRC subsidiaries to fund its capital expenditures or working capital. There are no costs associated with registering loans or capital contributions with relevant PRC authorities, other than nominal processing charges. Under PRC laws and regulations, the PRC governmental authorities are required to process such approvals or registrations or deny our application within a prescribed time period which is usually less than 90 days. The actual time taken, however, may be longer due to administrative delays. We cannot assure you that we will be able to obtain these government registrations or approvals on a timely basis, if at all. See “Risk Factors—Risks Related to Our Corporate Structure—PRC regulation of loans to, and direct investment in, PRC entities by offshore holding companies and governmental control of currency conversion may limit our use of the proceeds we receive from this offering to fund our expansion or operations.”

 

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DIVIDEND POLICY

We have not paid in the past and do not have any present plan to pay any cash dividends on our ordinary shares in the foreseeable future after this offering. We currently intend to retain most, if not all, of our available funds and any future earnings to operate and expand our business.

As we are a holding company, we rely, in part, on dividends paid to us by our PRC subsidiaries for our cash requirements, including funds to pay dividends and other cash distributions to our shareholders, service any debt we may incur and pay our operating expenses. In China, the payment of dividends is subject to limitations. PRC laws and regulations currently permit payment of dividends only out of accumulated profits as determined in accordance with PRC accounting standards and regulations. Under current PRC laws and regulations, our PRC subsidiaries are required to set aside at least 10% of their respective accumulated profits each year, if any, to fund certain reserve funds until such reserve funds reach 50% of their registered capital. At the discretion of our PRC subsidiaries, they may allocate a portion of their after-tax profits based on PRC accounting standards to staff welfare and bonus funds. These reserves may not be distributed as cash dividends. Further, if our PRC subsidiaries incur debt on their own behalf in the future, the instruments governing the debt may restrict their ability to pay dividends or make other payments to us.

Our board of directors has complete discretion on whether to declare dividends, subject to the approval of our shareholders. Even if our board of directors decides to pay dividends, the form, frequency and amount will depend upon our future operations and earnings, capital requirements and surplus, general financial condition, contractual restrictions and other factors that the board of directors may deem relevant. If we pay any dividends, they will be paid in accordance with Cayman Islands law, which provides, in summary, that dividends may be paid out of profits and/or our share premium account provided that in the case of our share premium account, no such distribution or dividend paid to our shareholders will cause us to be unable to pay our debts as they fall due in the ordinary course of our business. In addition, the Companies Law (2010 Revision) of the Cayman Islands prevents us from offering our shares or securities to individuals within the Cayman Islands which may limit our ability to distribute a dividend comprised of our shares or other securities. We will pay our ADS holders to the same extent as holders of our Class A ordinary shares, subject to the terms of the deposit agreement, including the fees and expenses payable thereunder. See “Description of American Depositary Shares.” Cash dividends on our ordinary shares, if any, will be paid in U.S. dollars.

 

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CAPITALIZATION

The following table sets forth our capitalization as of September 30, 2010:

 

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on an actual basis;

 

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on a pro forma basis to reflect the automatic conversion of all of our outstanding preferred shares and the preferred shares issuable upon the exercise of all outstanding warrants into              Class A ordinary shares and              Class B ordinary shares immediately prior to the closing of this offering; and

 

  Ÿ  

on a pro forma as adjusted basis to reflect the automatic conversion of all of our outstanding preferred shares and the preferred shares issuable upon the exercise of all outstanding warrants into              Class A ordinary shares and              Class B ordinary shares immediately prior to the closing of this offering, and the sale of              Class A ordinary shares in the form of ADSs by us in this offering at an assumed initial public offering price of US$              per ADS, after deducting the underwriting discounts and commissions and estimated offering expenses payable by us.

You should read this table together with our consolidated financial statements and the related notes included elsewhere in this prospectus and the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

     As of September 30, 2010  
     Actual     Pro Forma     Pro Forma
As Adjusted
 
     RMB     RMB     RMB  
     (in thousands)  
     (Unaudited)     (Unaudited)     (Unaudited)  

Convertible redeemable preferred shares, US$0.00001 par value, 1,202,581,047 shares authorized, 1,190,022,965 shares issued and outstanding:

      

Series A convertible redeemable preferred shares

     24,523        —          —     

Series B convertible redeemable preferred shares

     94,248        —          —     

Series C convertible redeemable preferred shares

     183,998        —          —     

Series D convertible redeemable preferred shares

     204,845        —          —     

Series E convertible redeemable preferred shares

     272,985        —          —     

Series F convertible redeemable preferred shares

     321,726        —          —     
                        

Total convertible redeemable preferred shares

     1,102,325        —          —     
                        

Equity:

      

Ordinary shares, US$0.00001 par value, 5,000,000,000 shares authorized, 365,000,000 shares issued and outstanding, and 1,555,698,080 shares issued and outstanding on a pro forma basis

     30        114     

Additional paid-in capital

     19,951        1,122,192     

Statutory reserve

     —          —       

Retained earnings

     (661,817     (661,817  

Accumulated other comprehensive loss

     (3,524     (3,524  
                        

Total shareholder’s equity

     (645,360     456,965     
                        

Noncontrolling interest

     —          —          —     

Total shareholders’ equity

     (645,360     456,965     
                        

Total capitalization

     456,965        456,965     
                        

 

(1)

A US$1.00 increase (decrease) in the assumed initial public offering price of US$             would increase (decrease) each of additional paid-in capital, total shareholders’ equity and total capitalization by US$            .

 

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DILUTION

If you invest in our ADSs, your interest will be diluted to the extent of the difference between the initial public offering price per ADS and our net tangible book value per ADS after this offering. Dilution results from the conversion of our preferred shares and the fact that the initial public offering price per Class A ordinary share is substantially in excess of the book value per ordinary share attributable to the existing shareholders for our presently outstanding ordinary shares.

Our net tangible book value as of September 30, 2010 was approximately US$60.0 million, or US$0.16 per ordinary share as of that date, and US$             per ADS. Net tangible book value represents the amount of our total consolidated tangible assets, less the amount of our total consolidated liabilities. Dilution is determined by subtracting net tangible book value per ordinary share, after giving effect to the conversion of all outstanding preferred shares into ordinary shares immediately upon the completion of this offering and the additional proceeds we will receive from this offering, from the assumed initial public offering price per ordinary share, which is the mid-point of the estimated initial public offering price range set forth on the cover page of this prospectus adjusted to reflect the ADS-to-ordinary share ratio, and after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

Without taking into account any other changes in net tangible book value after September 30, 2010, other than to give effect to the conversion of all outstanding preferred shares into ordinary shares immediately prior to the completion of this offering and our sale of the ADSs offered in this offering at the assumed initial public offering price of US$             per ADS after deduction of the underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma net tangible book value as of September 30, 2010 would have been US$             million, or US$             per outstanding ordinary share and US$             per ADS. This represents an immediate increase in net tangible book value of US$             per ordinary share and US$             per ADS to the existing shareholders and an immediate dilution in net tangible book value of US$             per ordinary share and US$             per ADS to investors purchasing ADSs in this offering. The following table illustrates such dilution:

 

     Ordinary Share      ADS  

Assumed initial public offering price

     US$                     US$               

Net tangible book value per share as of September 30, 2010

     US$                     US$               

Pro forma net tangible book value per share after giving effect to the conversion of our preferred shares

     US$                     US$               

Pro forma net tangible book value per share after giving effect to the conversion of our preferred shares and this offering

     US$                     US$               

Amount of dilution in net tangible book value per share to new investors in the offering

     US$                     US$               

The amount of dilution in net tangible book value to new investors in this offering set forth above is calculated by deducting (i) the pro forma net tangible book value after giving effect to the automatic conversion of our preferred shares from (ii) the pro forma net tangible book value after giving effect to the automatic conversion of our preferred shares and this offering.

 

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The following table summarizes, on a pro forma basis as of September 30, 2010, the differences between existing shareholders, including holders of our preferred shares that will be automatically converted into ordinary shares immediately upon the completion of this offering, and the new investors with respect to the number of ordinary shares (in the form of ADSs or shares) purchased from us, the total consideration paid and the average price per ordinary share/ADS paid before deducting the underwriting discounts and commissions and estimated offering expenses. The total number of ordinary shares does not include ordinary shares underlying the ADSs issuable upon the exercise of the over-allotment option granted to the underwriters.

 

     Ordinary Shares Purchased     Total Consideration     Average Price
Per Ordinary
Share
     Average
Price Per
ADS
 
     

      Number      

           Percent           Amount      Percent               
     (in thousands of US$, except number of shares and percentages)  

Existing shareholders

                             

New investors

                             
                                       

Total

        100.0        100.0     

A US$1.00 increase (decrease) in the assumed public offering price of US$              per ADS would increase (decrease) our pro forma net tangible book value after giving effect to the offering by US$              million, the pro forma net tangible book value per ordinary share and per ADS after giving effect to the automatic conversion of our preferred shares and this offering by US$              per ordinary share and US$              per ADS and the dilution in pro forma net tangible book value per ordinary share and per ADS to new investors in this offering by US$              per ordinary share and US$              per ADS, assuming no change to the number of ADSs offered by us as set forth on the cover page of this prospectus, and after deducting underwriting discounts and commissions and other offering expenses.

The pro forma information discussed above is illustrative only. Our net tangible book value following the completion of this offering is subject to adjustment based on the actual initial public offering price of our ADSs and other terms of this offering determined at pricing.

The discussion and tables above also assume no exercise of any outstanding stock options. As of             , 2010 there were              ordinary shares issuable upon exercise of outstanding stock options at a weighted average exercise price of US$              per share, and there were              ordinary shares available for future issuance upon the exercise of future grants under our 2006 Stock Option Scheme, as amended, and our 2010 Share Incentive Plan. To the extent that any of these options are exercised, there will be further dilution to new investors.

 

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EXCHANGE RATE INFORMATION

Substantially all of our operations are conducted in China and all of our revenues are denominated in Renminbi. This prospectus contains translations of Renminbi amounts into U.S. dollars at specific rates solely for the convenience of the reader. Unless otherwise noted, all translations from Renminbi to U.S. dollars and from U.S. dollars to Renminbi in this prospectus were made at a rate of RMB6.6905 to US$1.00, the exchange rate set forth in the H.10 statistical release of the Federal Reserve Board on September 30, 2010. We make no representation that any Renminbi or U.S. dollar amounts could have been, or could be, converted into U.S. dollars or Renminbi, as the case may be, at any particular rate, at the rates stated below, or at all. The PRC government imposes control over its foreign currency reserves in part through direct regulation of the conversion of Renminbi into foreign exchange and through restrictions on foreign trade. On November 5, 2010, the noon buying rate was RMB6.6622 to US$1.00.

The following table sets forth information concerning exchange rates between the Renminbi and the U.S. dollar for the periods indicated. These rates are provided solely for your convenience and are not necessarily the exchange rates that we used in this prospectus or will use in the preparation of our periodic reports or any other information to be provided to you. For all dates and periods through December 31, 2008, exchange rates of Renminbi into U.S. dollars are based on the noon buying rate in The City of New York for cable transfers of Renminbi as certified for customs purposes by the Federal Reserve Bank of New York. For January 1, 2009 and all later dates and periods, the exchange rate refers to the exchange rate as set forth in the H.10 statistical release of the Federal Reserve Board.

 

      Noon Buying Rate  

Period

   Period End      Average(1)      Low      High  
     (RMB per US$1.00)  

2005

     8.0702         8.1826         8.2765         8.0702   

2006

     7.8041         7.9579         8.0702         7.8041   

2007

     7.2946         7.5806         7.8127         7.2946   

2008

     6.8225         6.9193         7.2946         6.7800   

2009

     6.8259         6.8295         6.8470         6.8176   

2010

           

May

     6.8305         6.8275         6.8310         6.8245   

June

     6.7815         6.8184         6.8323         6.7815   

July

     6.7735         6.7762         6.7807         6.7709   

August

     6.8069         6.7873         6.8069         6.7670   

September

     6.6905         6.7396         6.8102         6.6869   

October

     6.6705         6.6675         6.6912         6.6397   

November (through November 5, 2010)

     6.6622         6.6766         6.6906         6.6622   

 

Source: Federal Reserve Statistical Release

 

(1) Annual averages are calculated using the average of month-end rates of the relevant year. Monthly averages are calculated using the average of the daily rates during the relevant period.

 

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ENFORCEABILITY OF CIVIL LIABILITIES

We were incorporated in the Cayman Islands in order to enjoy certain benefits, such as political and economic stability, an effective judicial system, a favorable tax system, the absence of exchange control or currency restrictions, and the availability of professional and support services. However, certain disadvantages accompany incorporation in the Cayman Islands. These disadvantages include a less developed body of Cayman Islands securities laws that provide significantly less protection to investors as compared to the laws of the United States, and the potential lack of standing by shareholders of Cayman Islands companies to sue before the federal courts of the United States.

Our organizational documents do not contain provisions requiring disputes, including those arising under the securities laws of the United States, between us, our officers, directors and shareholders, be arbitrated.

Substantially all of our operations are conducted in China, and substantially all of our assets are located in China. A majority of our officers are nationals or residents of jurisdictions other than the United States and a substantial portion of their assets are located outside the United States. As a result, it may be difficult for a shareholder to effect service of process within the United States upon these persons, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States.

We have appointed Law Debenture Corporate Services Inc. as our agent upon whom process may be served in any action brought against us under the securities laws of the United States.

Appleby, our counsel as to Cayman Islands law, and TransAsia Lawyers, our counsel as to PRC law, have advised us, respectively, that there is uncertainty as to whether the courts of the Cayman Islands and China, respectively, would:

 

  Ÿ  

recognize or enforce judgments of United States courts obtained against us or our directors or officers predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States; or

 

  Ÿ  

entertain original actions brought in each respective jurisdiction against us or our directors or officers predicated upon the securities laws of the United States or any state in the United States.

Appleby has further advised us that a final and conclusive judgment in the federal or state courts of the United States under which a sum of money is payable, other than a sum payable in respect of taxes, fines, penalties or similar charges, and which was neither obtained in a manner nor is of a kind enforcement of which is contrary to natural justice or the public policy of the Cayman Islands, nor based on an error in Cayman Islands law or obtained by fraud, may be the subject of enforcement proceedings as a debt in the courts of the Cayman Islands under the common law doctrine of obligation by action on the debt evidenced by the judgment of such foreign court without any re-examination of the merits of the underlying dispute, provided that the court which gave the judgment was competent to hear the action in accordance with private international law principles as applied in the Cayman Islands. However, the Cayman Islands courts are unlikely to enforce a punitive judgment of a United States court predicated upon the liabilities provision of the federal securities laws in the United States without retrial on the merits if such judgment gives rise to obligations to make payments that may be regarded as fines, penalties or similar charges.

TransAsia Lawyers has further advised us that the recognition and enforcement of foreign judgments are provided for under the PRC Civil Procedures Law. PRC courts may recognize and enforce foreign judgments in accordance with the requirements of the PRC Civil Procedures Law based either on treaties between China and the country where the judgment is made or on principles of

 

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reciprocity between jurisdictions. China does not have any treaties or other form of reciprocity with the United States or the Cayman Islands that provide for the reciprocal recognition and enforcement of foreign judgments. In addition, according to the PRC Civil Procedures Law, courts in the PRC will not enforce a foreign judgment against us or our directors and officers if they decide that the judgment violates the basic principles of PRC law or national sovereignty, security or public interest. As a result, it is uncertain whether and on what basis a PRC court would enforce a judgment rendered by a court in the United States or the Cayman Islands.

In addition, it will be difficult for U.S. shareholders to originate actions against us in China based upon Cayman Islands, U.S. or PRC laws, because we are incorporated under the laws of the Cayman Islands and it is difficult for U.S. shareholders, by virtue only of holding our ADSs or common shares, to establish a connection to the PRC as required by the PRC Civil Procedures Law in order for a PRC court to have jurisdiction. U.S. shareholders may be able to originate actions against us in the Cayman Islands based upon Cayman Islands laws. However, we do not have any substantial assets other than certain corporate documents and records in the Cayman Islands and it may be difficult for a shareholder to enforce a judgment obtained in a Cayman Islands court in China, where all of our operations are conducted.

 

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CORPORATE STRUCTURE

On September 20, 2005, our founder, Victor Koo, incorporated 1Verge Inc. in the Cayman Islands. On June 20, 2008, we changed the company name from 1Verge Inc. to Youku.com Inc. On November 14, 2005, we established our wholly-owned subsidiary, 1Verge Internet in Beijing, China. On April 27, 2010, we acquired all of the equity interest in Jet Brilliant, a Hong Kong company, which wholly owns Jet Brilliant Beijing, an advertising company established in Beijing, China. For a description of the tax implications of having Jet Brilliant as our Hong Kong intermediary holding company and the relevant PRC laws and regulations, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Taxation—PRC” and “Regulation—Regulations on Tax—Dividends Withholding Tax.”

The following chart illustrates our corporate structure as of the date of this prospectus:

LOGO

 

(1) 1Verge Information and Jiaheyi are our consolidated affiliated entities established in China and each is 80% owned by Ms. Qiong Qin, the wife of our founder, Mr. Victor Koo, and 20% owned by Mr. Dele Liu, our director, chief financial officer and senior vice president. We effectively control 1Verge Information and Jiaheyi through contractual arrangements. See “Corporate Structure.”

Applicable PRC laws and regulations currently restrict foreign ownership of companies that provide value-added telecommunications services. To comply with these foreign ownership restrictions, we conduct our online video operations in China primarily through our consolidated affiliated entity, 1Verge Information. 1Verge Information is our website operator and Internet content provider, and holds the licenses and permits issued by both the telecommunication and broadcast media authorities as well as other ancillary licenses and permits to conduct our online video operations. PRC laws and regulations also restrict foreign ownership of companies that conduct advertising business by requiring a sino-foreign joint venture’s foreign investor to have previously had two years’ direct advertising operations as its main business outside of China, and a wholly foreign-owned enterprise’s foreign investor to have previously had three years’ direct advertising operations as its main business outside of China. As a Cayman Islands company, we are a foreign legal person under PRC laws and we have not involved in any advertising business outside of China for the

 

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requisite number of years. We conduct our advertising business in China primarily through our consolidated affiliated entities, 1Verge Information and Jiaheyi. Jet Brilliant is a Hong Kong company which satisfies the requirement of having three years’ direct advertising operations, and therefore was approved by local branch of the SAIC to establish Jet Brilliant Beijing on May 19, 2009, a wholly foreign-owned advertising company. As we acquired Jet Brilliant on April 27, 2010, Jet Brilliant Beijing will conduct our advertising agency business.

The business operations of 1Verge Internet and Jet Brilliant Beijing are both within the approved business scope as set forth in each of their business licenses. In particular, the business scope of 1Verge Internet includes research, development and production of computer software and hardware; provision of computer network system integration service; provision of computer utility system installation and maintenance services; provision of technical and business consulting, technical services, technology transfer, and technical training; and sale of self-produced goods. The business scope of Jet Brilliant Beijing includes: designing, producing, publishing and providing agency services for domestic and foreign advertisements; corporate image planning; business consulting; information consulting; conference services.

1Verge Information and Jiaheyi are both limited liability companies established in China. Qiong Qin and Dele Liu, both of whom are PRC citizens, owned 80% and 20% of Jiaheyi, respectively. Ms. Qin is our founder Mr. Koo’s wife and is not currently involved in our management. Mr. Liu is our director, chief financial officer and senior vice president. As of December 31, 2009, Jiaheyi, Ms. Qin and Mr. Liu owned 95%, 4% and 1% of 1Verge Information, respectively. On May 19, 2010, Jiaheyi transferred its 95% equity interest in 1Verge Information to Ms. Qin and Mr. Liu. As a result of this transfer, 1Verge Information is 80% owned by Ms. Qin and 20% owned by Mr. Liu. We intend to begin the process of liquidating Jiaheyi in 2011, and Jet Brilliant Beijing as our wholly owned subsidiary will conduct our advertising agency business in the future. However, we do not expect that the advertising agency business will play an important role in our overall business in the future.

Our wholly owned subsidiary 1Verge Internet has entered into a series of contractual arrangements with 1Verge Information, Jiaheyi and their respective shareholders, which enable us to:

 

  Ÿ  

exercise effective control over the business management and shareholder voting rights of 1Verge Information and Jiaheyi;

 

  Ÿ  

receive substantially all of the economic benefits of 1Verge Information and Jiaheyi through service and licensing fees in consideration for the technical and consulting services provided by and the intellectual property rights licensed by 1Verge Internet; and

 

  Ÿ  

have an exclusive option to purchase all of the equity interests in 1Verge Information and Jiaheyi when and to the extent permitted under PRC laws, regulations and legal procedures.

We do not have any equity interest in our consolidated affiliated entities. However, we have been and are expected to continue to be dependent on our consolidated affiliated entities to operate our business if the then PRC law does not allow us to directly operate such business in China, or our direct operations will cause a material adverse impact on our business, including but not limited to, the inability to maintain or renew the qualifications, licenses or permits necessary for our business in China. We believe that under these contractual arrangements, we have substantial control over our consolidated affiliated entities and their respective shareholders to renew, revise or enter into new contractual arrangements prior to the expiration of the current arrangements on terms that would enable us to continue to operate our business in China after the expiration of the current arrangements, or pursuant to certain amendments and changes of the current applicable PRC laws, regulations and rules on terms that would enable us to continue to operate our business in China legally. For a detailed description of the regulatory environment that necessitates the adoption of our

 

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corporate structure, see “Regulation.” For a detailed description of the risks associated with our corporate structure and the contractual arrangements that support our corporate structure, see “Risk Factors—Risks Related to Our Corporate Structure.”

The following is a summary of the currently effective contracts among our subsidiary 1Verge Internet, our consolidated affiliated entities 1Verge Information and Jiaheyi, and the respective shareholders of 1Verge Information and Jiaheyi.

Agreements that Provide Us Effective Control over 1Verge Information and Jiaheyi

Amended and Restated Business Operations Agreements.    Pursuant to the amended and restated business operations agreement dated August 16, 2010 among 1Verge Internet, 1Verge Information and its shareholders, 1Verge Information must appoint the persons designated by 1Verge Internet to be its executive director or directors, general manager, chief financial officer and any other senior officers. 1Verge Information agrees to accept the proposal provided by 1Verge Internet from time to time relating to employment, daily business and financial management. Without 1Verge Internet’s prior written consent, 1Verge Information shall not conduct any transaction which may materially affect its assets, obligations, rights or operations, including but not limited to, incurrence or assumption of any indebtedness, sale or purchase of any assets or rights, incurrence of any encumbrance on any of its assets or intellectual property rights in favor of a third party, or transfer of any rights or obligations under this agreements to a third party. The term of this agreement is ten years and will be extended automatically for another ten years unless 1Verge Internet provides written notice requesting no extension three months prior to the expiration date. 1Verge Internet may terminate the agreement at any time by providing 30 days’ advance written notice to 1Verge Information and to each of its shareholders. Neither 1Verge Information nor any of its shareholders may terminate this agreement prior to the expiration date or during the ten-year extension period.

The amended and restated business operations agreement dated August 16, 2010 among 1Verge Internet, Jiaheyi and its shareholders contains terms substantially similar to the business operations agreement described above.

Amended and Restated Equity Interest Pledge Agreements.    Pursuant to the amended and restated equity interest pledge agreement dated August 16, 2010 among 1Verge Internet and the shareholders of 1Verge Information, the shareholders of 1Verge Information pledge all of their equity interest in 1Verge Information to 1Verge Internet, to guarantee 1Verge Information and its shareholders’ performance of their obligations under, where applicable, the amended and restated loan agreement, the amended and restated exclusive technical and consulting services agreement, the amended and restated trademark license agreement, the amended and restated domain name license agreement and the amended and restated equity option agreement. If 1Verge Information and/or any of its shareholders breach their contractual obligations under these agreements, 1Verge Internet, as pledgee, will be entitled to certain rights, including the right to sell the pledged equity interests. Without 1Verge Internet’s prior written consent, shareholders of 1Verge Information shall not transfer or assign the pledged equity interests, or create or allow any encumbrance that would prejudice 1Verge Internet’s interests. During the term of this agreement, 1Verge Internet is entitled to receive all of the dividends and profits paid on the pledged equity interests. The equity interest pledge will be effective upon the completion of the registration of the pledge with the competent local branch of the SAIC, and expire on the earlier of (i) the date on which 1Verge Information and its shareholders have fully performed their obligations under the amended and restated loan agreement, the amended and restated exclusive technical and consulting services agreement, the amended and restated trademark license agreement, the amended and restated domain name license agreement and the amended and restated equity option agreement; or (ii) 1Verge Internet enforces the pledge pursuant to the terms and conditions under this agreement, to fully satisfy its rights under such agreements. We have registered

 

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the pledge of the equity interests in 1Verge Information and Jiaheyi with the competent local branch of the SAIC. To date, 1Verge Information and Jiaheyi have fully performed their obligations under the relevant agreements but such obligations will remain on them until the expiration of the terms of such agreements, which are typically ten years subject to automatic renewal for an additional ten-year term or earlier termination as set forth in such agreements.

The amended and restated equity interest pledge agreement dated September 27, 2010 among 1Verge Internet and the shareholders of Jiaheyi is substantially similar to the equity interest pledge agreement described above, and guarantees the performance by Jiaheyi and its shareholders of their obligations under, where applicable, the amended and restated loan agreement, the amended and restated exclusive technical and consulting services agreement and the amended and restated equity option agreement.

Power of Attorney.    Pursuant to the power of attorney dated August 16, 2010, the shareholders of 1Verge Information each irrevocably appointed our chief executive officer, Mr. Victor Koo, the person designated by 1Verge Internet, as their attorney-in-fact to vote on their behalf on all matters of 1Verge Information requiring shareholder approval under PRC laws and regulations and 1Verge Information’s articles of association. The appointment of Mr. Koo as the attorney-in-fact is conditional upon his being the employee and the designated person of 1Verge Internet. Each power of attorney will remain in force for ten years until the earlier of the following events: (i) Mr. Koo loses his title or position in 1Verge Internet or 1Verge Internet issues a written notice to dismiss or replace Mr. Koo with another person; and (ii) the business operations agreement among 1Verge Internet, 1Verge Information and its shareholders terminates or expires.

The shareholders of Jiaheyi have also each executed an irrevocable power of attorney dated August 16, 2010 appointing Mr. Koo, the person designated by 1Verge Internet, as their attorney-in-fact to vote on their behalf on all matters of Jiaheyi requiring shareholder approval, with terms substantially similar to the power of attorney executed by the shareholders of 1Verge Information described above.

Agreements that Transfer Economic Benefits to Us

Amended and Restated Exclusive Technical and Consulting Services Agreements.     Pursuant to the amended and restated exclusive technical and consulting services agreement dated August 16, 2010 between 1Verge Internet and 1Verge Information, 1Verge Internet has exclusive right to provide technical and consulting services relating to, among other things, maintenance of the machine room and website, provision and maintenance of the office network, integrated security services for the website, and certain other business areas to 1Verge Information. Without 1Verge Internet’s prior written consent, 1Verge Information shall not engage any third party for any of the technical and consulting services provided under this agreement. In addition, 1Verge Internet exclusively owns all intellectual property rights resulting from the performance of this agreement. 1Verge Information agrees to pay a service fee to 1Verge Internet based on a set formula defined in this agreement, and during the term of this agreement, 1Verge Internet shall have the right to adjust the service fee at its sole discretion without the consent of 1Verge Information. The term of this agreement is ten years and will be extended automatically for another ten years unless terminated by 1Verge Internet’s written notice three months prior to the expiration date. 1Verge Internet can terminate the agreement at any time by providing 30 days’ prior written notice. 1Verge Information is not permitted to terminate the agreement prior to the expiration date, unless 1Verge Internet fails to comply with any of its obligations under this agreement and such failure renders the continued performance of this agreement impossible.

The amended and restated exclusive technical and consulting services agreement dated August 16, 2010 between 1Verge Internet and Jiaheyi is substantially similar to the exclusive technical

 

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and consulting services agreement described above, except that the services provided by 1Verge Internet are relevant to the advertising business and operations of Jiaheyi.

For the three years ended December 31, 2007, 2008 and 2009, and the nine months ended September 30, 2010, 1Verge Internet has received nil service fees under these amended and restated exclusive technical and consulting services agreements from 1Verge Information or Jiaheyi for the technical and consulting services provided as neither 1Verge Information nor Jiaheyi has yet to achieve profitability.

Amended and Restated Trademark License Agreement and Amended and Restated Domain Name License Agreement.    Pursuant to the amended and restated trademark license agreement and the amended and restated domain name license agreement dated August 16, 2010 between 1Verge Internet and 1Verge Information, 1Verge Internet grants a non-exclusive and non-transferable license, without sublicense rights, to 1Verge Information to use its trademarks and domain names. 1Verge Information may only use the trademarks and the domain names in its own business operations. The license fee under each agreement dated August 16, 2010 is 5% of the total revenue of the licensee and is to be paid every quarter within 15 days after the end of the quarter. Additionally, if the licensor believes that it would be helpful to the licensee’s business, the licensor may reduce or exempt the licensee from all or part of the license fee. The term of each agreement is ten years, and will be extended for another ten years with both parties’ consent. 1Verge Internet may terminate each agreement at any time by providing a 30 days prior written notice. Any party may terminate each agreement immediately with written notice to the other party if the other party materially breaches the relevant agreement and fails to cure its breach within 30 days from the date it receives written notice of its breach from the non-breaching party. The parties will review each agreement at three-month intervals and determine if any amendment is needed. For the three years ended December 31, 2007, 2008 and 2009, and the nine months ended September 30, 2010, 1Verge Internet has received nil license fees under these amended and restated trademark license and domain name license agreements from 1Verge Information for the trademark and domain name licenses as 1Verge Information has not yet to achieve profitability.

Agreements that Provide Us the Option to Purchase the Equity Interest in 1Verge Information and Jiaheyi

Amended and Restated Equity Option Agreements.    Pursuant to the amended and restated equity option agreement dated August 16, 2010 among 1Verge Internet and the shareholders of 1Verge Information, 1Verge Information’s shareholders grant 1Verge Internet or its designated representative(s) an exclusive option to purchase, to the extent permitted under PRC law, all or part of their equity interest in 1Verge Information in consideration for the loans extended to 1Verge Information’s shareholders under the amended and restated loan agreement mentioned below. In addition, 1Verge Internet has the option to acquire the equity interest at the lowest price then permitted by PRC law in consideration of the cancellation of all or part of the loans extended to 1Verge Information’s shareholders under the loan agreement. 1Verge Internet or its designated representative(s) have sole discretion to decide when to exercise such options, either in part or in full. 1Verge Internet or its designated representative(s) is entitled to exercise the options an unlimited number of times until all of the equity interests have been acquired, and can freely transfer the option, in whole or in part to any third party. Without 1Verge Internet’s consent, 1Verge Information’s shareholders shall not transfer, donate, pledge, or otherwise dispose of their equity shareholdings in any way. The equity option agreement will remain in full force and effect until the earlier of: (i) the date on which all of the equity interest in 1Verge Information has been acquired by 1Verge Internet or its designated representatives; or (ii) 1Verge Internet giving 30 days’ advance written notice of termination to the shareholders of 1Verge Information. The key factor for us to decide whether to exercise the option is whether the current regulatory restrictions on foreign investment in the value-added

 

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telecommunications services and advertising business will be relaxed in the future, the likelihood of which we are not able to predict. If such restrictions are relaxed, we will, through 1Verge Internet, exercise the option and purchase all or part of the equity interest in 1Verge Information and Jiaheyi.

The amended and restated equity option agreement dated August 16, 2010 among 1Verge Internet and shareholders of Jiaheyi contain terms substantially similar to the equity option agreement described above.

Amended and Restated Loan Agreements.    Under the loan agreement dated August 16, 2010 between 1Verge Internet and the shareholders of 1Verge Information, 1Verge Internet had made interest-free loans in several tranches with an aggregate amount of RMB20,000,000 to the shareholders of 1Verge Information solely for the initial capitalization and the subsequent financial requirements in 1Verge Information. The loans can be repaid only with the proceeds from the sale of all of the equity interest in 1Verge Information to 1Verge Internet or its designated representatives, pursuant to the amended and restated equity option agreement. The term of each loan is ten years from the first withdrawal of such loan by 1Verge Information’s shareholders, and will be automatically extended for another ten years unless terminated by written notice from 1Verge Internet to the shareholders of 1Verge Information three months prior to the due date.

The amended and restated loan agreement dated August 16, 2010 among 1Verge Internet and the shareholders of Jiaheyi contain terms substantially similar to the amended and restated loan agreement described above, except that the amount of loan extended to the shareholders of Jiaheyi is RMB100,000.

In the opinion of TransAsia Lawyers, our PRC legal counsel:

 

  Ÿ  

the ownership structures of our consolidated affiliated entities and our subsidiary in China, both currently and after giving effect to this offering, comply with all existing PRC laws and regulations;

 

  Ÿ  

the contractual arrangements among 1Verge Internet and our consolidated affiliated entities and their respective shareholders that are governed by PRC law are valid, binding and enforceable, and will not result in any violation of PRC laws or regulations currently in effect; and

 

  Ÿ  

each of our PRC subsidiaries and each of our consolidated affiliated entities has all necessary corporate power and authority to conduct its business as described in its business scope under its business license. The business licenses of our PRC subsidiaries and each of our consolidated affiliated entities are in full force and effect. Each of our PRC subsidiaries and our consolidated affiliated entities is capable of suing and being sued and may be the subject of any legal proceedings in PRC courts. To the best of TransAsia’s knowledge after due inquires, none of our PRC subsidiaries, consolidated affiliated entities or their respective assets is entitled to any immunity, on the grounds of sovereignty, from any action, suit or other legal proceedings; or from enforcement, execution or attachment.

We have been advised by our PRC legal counsel, however, that there are substantial uncertainties regarding the interpretation and application of current and future PRC laws, regulations and rules. Accordingly, the PRC regulatory authorities may in the future take a view that is contrary to the above opinion of our PRC legal counsel. We have been further advised by our PRC counsel that if the PRC government finds that the agreements that establish the structure for operating our PRC online video and online advertising businesses do not comply with PRC government restrictions on foreign investment in value-added telecommunication services, we could be subject to severe penalties including being prohibited from continuing operations. See “Risk Factors—Risks Related to Our

 

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Corporate Structure—If the PRC government finds that the agreements that establish the structure for operating our businesses in China do not comply with PRC governmental restrictions on foreign investment in Internet business, or if these regulations or the interpretation of existing regulations change in the future, we could be subject to severe penalties or be forced to relinquish our interests in those operations” and “Risk Factors—Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could adversely affect us.”

PRC Regulations on Loans and Direct Investment by Offshore Holding Companies

We are an offshore holding company conducting our operations in China through our PRC

subsidiaries and consolidated affiliated entities. PRC regulations of loans and direct investment by offshore holding companies to PRC entities may limit our use of the proceeds we expect to receive from this offering. See “Risk Factors—Risks Related to Our Corporate Structure—PRC regulation of loans to, and direct investment in, PRC entities by offshore holding companies and governmental control of currency conversion may limit our use of the proceeds we receive from this offering to fund our expansion or operations.”

 

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SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated financial information for the periods and as of the dates indicated should be read in conjunction with our audited consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

Our selected consolidated financial data presented below for the years ended December 31, 2007, 2008 and 2009 and our balance sheet data as of December 31, 2008 and 2009 have been derived from our audited consolidated financial statements included elsewhere in this prospectus. Our audited consolidated financial statements are prepared in accordance with U.S. GAAP and have been audited by Ernst & Young Hua Ming, an independent registered public accounting firm. We were incorporated in September 2005 and launched our website, www.youku.com, in December 2006. We have not included financial information for the period from inception (September 20, 2005) to December 31, 2005 and the year ended December 31, 2006, as such information is not available on a basis that is consistent with the consolidated financial information for the years ended December 31, 2007, 2008 and 2009, and cannot be provided on a U.S. GAAP basis without unreasonable effort or expense.

The selected consolidated statement of operations data for the nine months ended September 30, 2009 and 2010 and the selected consolidated balance sheet data as of September 30, 2010 have been derived from our unaudited condensed consolidated financial statements included elsewhere in this prospectus and have been prepared on the same basis as our audited consolidated financial statements. The unaudited financial information includes all adjustments, consisting only of normal and recurring adjustments, that we consider necessary for a fair statement of our financial position and operating results for the periods presented. Our historical results do not necessarily indicate results expected for any future periods.

 

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    Year Ended December 31,     Nine Months Ended September 30,  
    2007     2008     2009     2009     2010  
    RMB     RMB     RMB     RMB     RMB    

US$

 
    (in thousands, except for share and per share date)  
                      (Unaudited)     (Unaudited)     (Unaudited)  

Consolidated Statement of Operations Data

           

Net revenues(1)

    1,778        33,022        153,626        99,784        234,623        35,068   

Cost of revenues(2)

    (46,148     (171,130     (216,708     (157,684     (248,719     (37,175
                                               

Gross loss

    (44,370     (138,108     (63,082     (57,900     (14,096     (2,107

Operating expenses(2):

           

Sales and marketing

    (22,469     (35,086     (72,746     (46,485     (91,527     (13,680

Product development

    (15,530     (15,398     (20,908     (15,003     (21,260     (3,178

General and administrative

    (5,843     (14,367     (18,523     (13,043     (18,716     (2,797
                                               

Total operating expenses

    (43,842     (64,851     (112,177     (74,531     (131,503     (19,655
                                               

Loss from operations

    (88,212     (202,959     (175,259     (132,431     (145,599     (21,762

Interest income

    1,013        5,384        2,054        1,840        1,068        160   

Interest expense

    —          (4,240     (6,835     (5,401     (4,963     (742

Amortization of debt issuance costs

    —          (2,380     —          —          —          —     

Change in fair value of derivative financial liabilities and warrant liability

    (2,422     (264     (2,313     (357     (17,532     (2,620

Others, net

    (62     (1     67        48        65        10   
                                               

Loss from operations before income taxes

    (89,683     (204,460     (182,286  

 

 

 

(136,301

 

 

 

 

 

(166,961

 

 

 

 

 

(24,954

 

Income taxes

    —          —          —          —          —          —     
                                               

Net loss

    (89,683     (204,460     (182,286     (136,301     (166,961     (24,954
                                               

Net loss per share:

           

Basic

    (0.25     (0.56     (0.50     (0.37     (0.46     (0.07

Diluted

    (0.25     (0.56     (0.50     (0.37     (0.46     (0.07

Net loss per ADS(3):

           

Basic

           

Diluted

           

Weighted-average ordinary shares outstanding:

           

Basic

    365,011,250        365,134,375        365,432,916        365,268,611        365,675,115        365,675,115   

Diluted

    365,011,250        365,134,375        365,432,916        365,268,611        365,675,115        365,675,115   

Pro forma net loss per share:

           

Basic

        (0.13       (0.11     (0.02

Diluted

        (0.13       (0.11     (0.02

Pro forma weighted-average ordinary shares outstanding:

           

Basic

        1,454,990,172          1,555,698,080        1,555,698,080   

Diluted

        1,454,990,172          1,555,698,080        1,555,698,080   
Selected non-GAAP Financial Data            

Adjusted revenues(4)

    1,778        39,401        191,492        122,545        288,511        43,122   
                                               

Adjusted net loss(4)

    (86,012     (200,531     (175,408     (132,696     (142,054     (21,232
                                               

 

(1) Net revenues are presented net of commissions earned by third-party advertising agencies, as the term is defined on page 7, as set forth below:

 

     Year Ended December 31,      Nine Months Ended September 30,  
         2007              2008              2009               2009                       2010               
     RMB      RMB      RMB     

RMB

     RMB      US$  
    

(in thousands)

 
                          (Unaudited)      (Unaudited)      (Unaudited)  

Commissions earned by third-party advertising agencies

     —           6,379         37,866         22,761         53,888         8,054   

 

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(2) Including share-based compensation expenses as set forth below:

 

     Year Ended December 31,      Nine Months Ended September 30,  
     2007      2008          2009                2009            2010  
    

RMB

    

RMB

    

RMB

    

RMB

    

RMB

    

US$

 
    

(in thousands)

 
                          (Unaudited)     

(Unaudited)

    

(Unaudited)

 

Allocation of Share-based Compensation Expenses

                 

Cost of revenues

     —           259         283         206         550         82   

Product development

     684         1,401         1,657         1,206         2,038         305   

Sales and marketing

     141         861         1,690         1,161         3,645         545   

General and administrative

     424         1,144         935         675         1,142         170   
                                                     

Total

     1,249         3,665         4,565         3,248         7,375         1,102   
                                                     

 

(3) Each ADS represents              Class A ordinary shares.

 

(4) We define adjusted revenues, a non-GAAP financial measure, as the sum of net revenues and commissions earned by third-party advertising agencies, as the term is defined on page 7. We define adjusted net loss, a non-GAAP financial measure, as net loss excluding share-based compensation expenses and change in fair value of derivative financial liabilities and warrant liability. We review adjusted revenues and adjusted net loss together with net revenues and net loss to obtain a better understanding of our operating performance. We also believe it is useful supplemental information for investors and analysts to assess our operating performance with the effect of commissions earned by third-party advertising agencies, as the term is defined on page 7, and without the effect of non-cash share-based compensation expenses and change in fair value of derivative financial liabilities and warrant liability, which have been and will continue to be significant recurring factors in our business. However, the use of adjusted revenues and adjusted net loss has material limitations as an analytical tool. One of the limitations of using non-GAAP adjusted revenues is that it excludes an item that is not typically excluded from net revenues. One of the limitations of using non-GAAP adjusted net loss is that it does not include all items that impact our net loss for the period. In addition, because adjusted revenues and adjusted net loss are not calculated in the same manner by all companies, they may not be comparable to other similar titled measures used by other companies. In light of the foregoing limitations, you should not consider adjusted revenues and adjusted net loss in isolation from or as an alternative to net revenues and net loss, respectively, prepared in accordance with U.S. GAAP. We encourage investors and others to review our financial information in its entirety and not rely on a single financial measure.

 

     Year Ended December 31,     Nine Months Ended September 30,  
     2007     2008         2009               2009                       2010               
     RMB     RMB     RMB     RMB     RMB     US$  
    

(in thousands)

 

Net revenues

     1,778        33,022        153,626        99,784            234,623            35,068   

Add back: Commissions earned by third-party advertising agencies

     —          6,379        37,866        22,761        53,888        8,054   
                                                

Adjusted revenues

     1,778        39,401        191,492        122,545        288,511        43,122   
                                                

Net loss

     (89,683     (204,460     (182,286     (136,301     (166,961     (24,954

Add back: share-based compensation expenses

     1,249        3,665        4,565        3,248        7,375        1,102   

Add back: change in fair value of derivative financial liabilities and warrant liability

     2,422        264        2,313        357        17,532        2,620   
                                                

Adjusted net loss

     (86,012     (200,531     (175,408     (132,696     (142,054     (21,232
                                                

 

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     As of December 31,     As of September 30,  
     2008     2009     2010     2010  
     RMB     RMB     RMB     US$     RMB      US$  
    

(in thousands)

 
                       Pro Forma(1)  
                

(Unaudited)

   

(Unaudited)

 

Consolidated Balance Sheet Data:

             

Cash and cash equivalents

     88,915        301,608        440,554        65,848        440,554         65,848   

Total current assets

     228,600        384,322        632,538        94,543        632,538         94,543   

Total assets

     291,746        441,741        738,798        110,426        738,798         110,426   

Total current liabilities

     60,159        132,479        260,042        38,870        260,042         38,870   

Total liabilities

     92,115        146,754        281,833        42,127        281,833         42,127   

Convertible redeemable preferred shares

     507,614        780,599        1,102,325        164,759        —           —     

Total equity (deficit)

     (307,983     (485,612     (645,360     (96,460     456,965         68,299   

 

(1) Pro forma basis reflects the conversion of all outstanding preferred shares on a 1-for-1 basis into an aggregate of 1,190,022,965 ordinary shares as of September 30, 2010.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the section headed “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and elsewhere in this prospectus.

Overview

We are the leading Internet television company in China. Our Internet television platform enables consumers to search, view and share high-quality video content quickly and easily across multiple devices. We believe our continuous focus on offering a superior user experience has enabled us to become the largest Internet television company in China and elevated our Youku LOGO brand to be the most recognized online video brand in China according to a 2010 survey conducted by an affiliate of the Chinese Academy of Sciences. According to iResearch, we had 40% market share in terms of total user time spent viewing online videos in China during the second quarter of 2010, while our closest competitor accounted for approximately 23% market share during the same period. In 2009, we had an implied market share of approximately 14% in terms of online video advertising spend in China, based on iResearch’s estimated data of total online video advertising spend in China.

We currently operate our business as a single segment. We derive substantially all of our revenues from online advertising services. Our advertising solutions present brand advertisers with attractive opportunities to combine the visual impact and engagement of traditional television-like multimedia advertisements with the interactivity and precise targeting capabilities of the Internet. We believe our differentiated sales proposition has contributed to the rapid increase in the number of international and domestic brands that advertise on our Internet television platform. We also participate in affiliate advertising programs run by third-party Internet search companies, which place links to their customers’ advertisements on our website.

As is customary in the advertising industry in China, we offer commissions to third-party advertising agencies who purchase our advertising services and recognize revenues net of these commissions. Our net revenues increased from RMB1.8 million in 2007 to RMB33.0 million in 2008 and to RMB153.6 million in 2009, and increased from RMB99.8 million in the nine months ended September 30, 2009 to RMB234.6 million (US$35.1 million) in the nine months ended September 30, 2010. The number of our brand advertisers increased from 7 in 2007 to 141 in 2008 and to 303 in 2009, and from 230 in the nine months ended September 30, 2009 to 343 in the nine months ended September 30, 2010. Net revenues derived from brand advertising sales have grown significantly over the years and accounted for 65.2%, 89.0%, 91.6% and 94.9% of our total net revenues in 2007, 2008, 2009 and the nine months ended September 30, 2010, respectively. We incurred net losses of RMB89.7 million, RMB204.5 million, RMB182.3 million and RMB167.0 million (US$25.0 million) in 2007, 2008, 2009 and the nine months ended September 30, 2010, respectively. The increase in net losses from RMB136.3 million in the nine months ended September 30, 2009 to RMB167.0 million (US$25.0 million) in the nine months ended September 30, 2010 was primarily due to the increases in our sales and marketing efforts, content costs and bandwidth costs. We expect our net losses to decrease as a percentage of our total net revenues in the foreseeable future.

Our results of operations are affected by the PRC laws, regulations and policies relating to online video and advertising businesses. Due to current legal restrictions on foreign ownership and

 

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investment in value-added telecommunications services and advertising businesses in China, we rely on a series of contractual arrangements with 1Verge Information and Jiaheyi to conduct most of our business, though in the future we intend to conduct our advertising agency business through our newly acquired subsidiary, Jet Brilliant Beijing. We do not hold equity interests in 1Verge Information and Jiaheyi. As a result of these contractual arrangements, we are the primary beneficiary of 1Verge Information and Jiaheyi and treat them as consolidated affiliated entities under U.S. GAAP. In the opinion of TransAsia Lawyers, our PRC legal counsel, the ownership structures of our consolidated affiliated entities, both currently and after giving effect to this offering, do not violate, breach, contravene or conflict with any applicable PRC laws or regulations. However, there are substantial uncertainties regarding the interpretation and application of current and future PRC laws and regulations related to such ownership structures. See “Risk Factors—Risks Related to Our Corporate Structure” and “Risk Factors—Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could adversely affect us.”

Selected Statements of Operations Items

Net Revenues

We currently derive substantially all of our net revenues from online advertising services. Our online advertising sales consist of brand advertising services and affiliate advertising programs, which accounted for approximately 91.6% and 6.3%, respectively, of our net revenues in 2009 and approximately 94.9% and 3.3%, respectively, of our net revenues in the nine months ended September 30, 2010. As is customary in the advertising industry in China, we offer commissions to third-party advertising agencies and recognize revenues net of these commissions. We also derive a minimal portion of our net revenues from other sources, such as our web-based and wireless subscription video services, and sub-licensing fees from authorized sub-licensing of content which we license from content provider the exclusive rights for self-use and sub-licensing for online distribution to other online video websites. Such other revenues accounted for approximately 2.1% of our net revenues in 2009 and approximately 1.8% of our net revenues in the nine months ended September 30, 2010, respectively. The following table sets forth the principal components of our net revenues by amount and as a percentage of our total net revenues for the periods presented.

 

    Year Ended December 31,     Nine Months Ended September 30,  
    2007     2008     2009     2009     2010  
    RMB     %     RMB     %     RMB     %     RMB     %     RMB     US$     %  
    (in thousands, except for percentages)  
                                        (Unaudited)     (Unaudited)     (Unaudited)  

Brand advertising revenues(1)

    1,160        65.2        29,376        89.0        140,716        91.6        91,565        91.8        222,691        33,285        94.9   

Affiliate advertising program revenues

    618        34.8        3,626        11.0        9,747        6.3        6,672        6.7        7,779        1,163        3.3   

Other revenues

    —          —          20        *        3,163        2.1        1,547        1.5        4,153        620        1.8   
                                                                                       

Net revenues(1)

    1,778        100.0        33,022        100.0        153,626        100.0        99,784        100.0        234,623        35,068        100.0   
                                                                                       

 

* Amount less than 0.1.
(1) Net revenues are presented net of commissions earned by third-party advertising agencies, as the term is defined on page 7, as set forth below:

 

     Year Ended December 31,      Nine Months Ended September 30,  
         2007              2008              2009                  2009                      2010          
     RMB      RMB      RMB     

RMB

     RMB      US$  
    

(in thousands)

 
                          (Unaudited)      (Unaudited)      (Unaudited)  

Commissions earned by third-party advertising agencies

     —           6,379         37,866         22,761         53,888         8,054   

 

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Brand Advertising.    We derive our revenues primarily from brand advertising sales. We provide in-video, display, sponsorships and other forms of advertising solutions on our website to a broad base of brand advertisers, including leading international and domestic companies in various industries. We derived a majority of our brand advertising revenues from in-video advertisements. Advertisers purchase our online advertising services primarily through third-party advertising agencies, and the number of our advertisers increased significantly from 7 in 2007 to 303 in 2009, and from 230 in the nine months ended September 30, 2009 to 343 in the nine months ended September 30, 2010. We price our advertising services based on various factors, including the form of third-party advertising, the specific targeting requirements, the duration of the time slot purchased and popularity of the content in which the advertisements will be placed. Prices for the aggregate time slots purchased by each advertiser or advertising agency are fixed under sales contracts, typically at a discount to our list prices. We review and adjust our list prices annually.

Net revenues derived from brand advertising sales grew significantly in the past and accounted for 65.2%, 89.0%, 91.6% and 94.9% of our net revenues in 2007, 2008, 2009 and the nine months ended September 30, 2010, respectively. The increase in such revenues from 2007 to the three quarters of 2010 was attributable to an increase in the number of advertisers and rising average spend per advertiser. We expect our brand advertising revenues to continue to grow as we focus on expanding our advertiser base and increasing the advertising spend of key advertisers.

The most significant factors that directly or indirectly affect our brand advertising sales revenues include the following:

 

  Ÿ  

the number of users visiting our website and the amount of time they spend on our website;

 

  Ÿ  

the amount of total online video advertising budgets of advertisers;

 

  Ÿ  

the number of brand advertisers;

 

  Ÿ  

the list prices of our advertising services and the discount we offer to customers;

 

  Ÿ  

the commissions earned by third-party advertising agencies; and

 

  Ÿ  

the evolving perception of the increasing effectiveness of online video advertising as compared to advertising in more traditional media, particularly television.

Affiliate Advertising Programs.    We participate in affiliate advertising programs run by third-party Internet search companies Baidu and Google. Under these programs, the third-party Internet search companies place links to their customers’ advertisements on our website and these advertisements are related to the video content or search queries on our website. Our share of their revenues is contractually negotiated and varies depending on calculations that take into account the amount of user traffic and the number of user clicks on these advertisements that appear on our website. Net revenues derived from these affiliate advertising programs as a percentage of our total net revenues decreased from 34.8% in 2007 to 6.3% in 2009 and to 3.3% in the nine months ended September 30, 2010, and are expected to continue to decrease over time relative to our brand advertising revenues.

Other Revenues.    We seek to diversify our revenue sources over time by expanding our wireless and web-based subscription services and other product offerings. We trial-launched our subscription-based online video services in early 2010, enabling users to watch advertisement-free premium content, such as high-definition movies. We are testing our platform to allow users to access live, streaming events, such as concerts, on a pay-per-view basis. In addition, we cooperate with China’s major mobile phone manufacturers to develop and pre-install our Youku software client on a variety of major 3G mobile phones to allow users to enjoy wireless video services. Though we currently derive minimal revenues from subscription-based and pay-per-view services, we seek to grow these

 

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businesses over time. We license from content providers the exclusive rights for both self-use and sub-licensing of certain content. We sub-license such content within its authorized sub-licensing scope to other video websites and receive sub-licensing fees from such websites. Our other revenues accounted for nil, less than 0.1% , 2.1% and 1.8% of our net revenues in 2007, 2008, 2009 and the nine months ended September 30, 2010, respectively. Moreover, we are working with e-commerce companies, such as Taobao, to provide video-enabling merchandise demonstration services to their premium retail members. We share revenues with the e-commerce companies for the service fees they charge their members.

Cost of Revenues

Cost of revenues consists primarily of (i) bandwidth costs, (ii) depreciation of our servers and other equipment, (iii) content costs, and (iv) business tax and surcharges. The following table sets forth the components of our cost of revenues for the periods indicated.

 

     Year Ended December 31,     Nine Months Ended September 30,  
     2007     2008     2009     2009     2010  
     RMB     RMB     RMB     RMB     RMB     US$  
    

(in thousands)

 
                       (Unaudited)     (Unaudited)     (Unaudited)  

Net revenues

     1,778        33,022        153,626        99,784        234,623        35,068   
                                                

Cost of revenues:

            

Bandwidth costs

     (35,733     (131,926     (149,479     (111,299     (139,994     (20,924

Depreciation of servers and other equipment

     (7,155     (25,364     (33,692     (24,506     (29,008     (4,336

Content costs

     (3,109     (10,335     (16,913     (11,269     (56,476     (8,441

Business tax and surcharges

     (151     (3,505     (16,624     (10,610     (23,241     (3,474
                                                

Total cost of revenues

     (46,148     (171,130     (216,708     (157,684     (248,719     (37,175
                                                

Bandwidth Costs.    Bandwidth costs are the fees we pay to telecommunications carriers and other service providers for telecommunications services and for hosting our servers at their Internet data centers. Bandwidth is a significant component of our cost of revenues and therefore an important factor affecting our profitability. We expect our bandwidth costs to increase on an absolute basis as traffic to our website grows. However, we expect our bandwidth costs as a percentage of our net revenues to decrease over time, consistent with historical trends of decreasing unit cost of data hosting and transmission services.

Depreciation of Servers and Other Equipment.    We include depreciation expense for servers and other equipment that are directly related to our business operations and technical support in our cost of revenues. Our depreciation expense increased significantly from 2007 to 2009 and from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 as we made substantial investments in building out our CDN infrastructure during this period. We expect our depreciation expense to increase on an absolute basis as we continue to invest in additional servers and other equipment. However, we expect our depreciation expense as a percentage of our net revenues to decrease over time since we made substantial upfront capital expenditures at an early stage of our development that are not expected to increase as quickly as our net revenues.

Content Costs.    Content costs consist of fees we pay to license content from copyright owners or content distributors, salaries and benefits for our content team, as well as costs of our self-produced content. Our content costs increased significantly from 2007 to 2009 and from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 as we built a large and comprehensive online video content library during this period. The increase in content cost since the

 

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second half of 2009 was also due to a substantial increase in unit acquisition cost of professionally produced content, such as licensing fees for television serial dramas and movies. According to our internal records, the average license fee for television serial drama has increased in 2009 by more than 200% as compared to 2008, and such fee has increased in 2010 to date by more than 100% as compared to 2009. The average license fee for movies has also increased in 2010 to date by more than 90% as compared to 2009. The term of licenses for our professionally produced content generally ranges from one to five years. The average term of licenses varies depending on the types of content, with movies and television serial dramas each having an average term of approximately 2.5 years and 2 years, respectively. We expect our content costs to grow on an absolute basis as we expand our content library and market prices for professionally produced content increase.

Business Tax and Surcharges.    Our subsidiaries and consolidated affiliated entities are subject to business tax and surcharges on the revenues generated from our services rendered in China. The effective rate of the aggregate amount of business tax, surcharges and cultural development fees on our revenues before deduction of commissions earned by third-party advertising agencies is approximately 8.5% per year.

Our cost of revenues includes share-based compensation charges. See “—Critical Accounting Policies—Share-Based Compensation Expenses.”

Operating Expenses

Our operating expenses consist of (i) sales and marketing expenses, (ii) product development expenses, and (iii) general and administrative expenses. We expect our operating expenses as a percentage of our net revenues to decrease over time due to an expected higher growth rate for our net revenues. The following table sets forth the components of our operating expenses for the periods indicated.

 

     Year Ended December 31,     Nine Months ended September 30, 2010,  
     2007     2008     2009               2009                                     2010                  
     RMB     RMB     RMB    

RMB

    RMB         US$      
    

(in thousands)

 
                       (Unaudited)     (Unaudited)     (Unaudited)  

Sales and marketing

     (22,469 )     (35,086 )     (72,746     (46,485     (91,527     (13,680

Product development

     (15,530 )     (15,398 )     (20,908     (15,003     (21,260     (3,178

General and administrative

     (5,843 )     (14,367 )     (18,523     (13,043     (18,716     (2,797
                                                

Total operating expenses

     (43,842 )     (64,851 )     (112,177     (74,531     (131,503     (19,655
                                                

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of salaries and benefits and commissions for our sales and marketing personnel and marketing and promotional expenses. Our sales and marketing expenses increased significantly from 2007 to 2009 and from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 primarily reflecting the rapid expansion of our sales team and our increased spending on marketing and brand promotional activities. We expect that our sales and marketing expenses will increase in absolute amount in the near term as we expect to hire additional sales personnel and invest in brand enhancement efforts.

Product Development Expenses

Product development expenses consist primarily of salaries and benefits for product development personnel. We expect our product development expenses on an absolute basis to increase as we intend to hire additional product development personnel to further expand our technology platform, enhance user experience and support the expected growth of our business.

 

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General and Administrative Expenses

General and administrative expenses consist primarily of salaries and benefits for our general and administrative personnel. Our general and administrative expenses increased from 2007 to 2009 and from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 as our business expanded, including the hiring of additional management and administrative staff. We expect our general and administrative expenses to increase in the future as our business grows and we incur increased costs related to complying with our compliance and reporting obligations under the U.S. securities laws as a public company.

Our operating expenses include share-based compensation charges. See “—Critical Accounting Policies—Share-Based Compensation Expenses.”

Taxation

Cayman Islands

We are incorporated in the Cayman Islands. Under the current laws of the Cayman Islands, we are not subject to income or capital gains tax. In addition, dividend payments are not subject to withholding tax in the Cayman Islands.

Hong Kong

Our wholly-owned subsidiary in Hong Kong, Jet Brilliant, is subject to Hong Kong profits tax on its activities conducted in Hong Kong. No provision for Hong Kong Profits tax has been made in the consolidated financial statements as Jet Brilliant has no assessable income for the nine months ended September 30, 2010. Dividends from our Hong Kong subsidiary to us are exempt from withholding tax.

PRC

Prior to the effective date of the New EIT Law on January 1, 2008, enterprises in China were generally subject to an enterprise income tax at a statutory rate of 33% unless they qualified for certain preferential treatment. Effective as of January 1, 2008, the New EIT Law applies a uniform enterprise income tax rate of 25% to all domestic enterprises and foreign-invested enterprises and defines new tax incentives for qualifying entities. Enterprises established before March 16, 2007 that were entitled to the then available preferential tax treatment may continue to enjoy such treatment (i) in the case of preferential tax rates, for a maximum of a five-year period starting from January 1, 2008; during such period, the tax rate will gradually increase to 25%, or (ii) in the case of preferential tax exemption or reduction for a specified term, until the expiration of such term.

1Verge Information, a company incorporated in PRC and a consolidated affiliated entity of which 1Verge Internet is the primary beneficiary, is located in the Beijing Zhongguancun Science Park and was granted “High and New Technology Enterprise” status and was entitled to a preferential income tax rate of 15% from January 1, 2006 to December 31, 2007 and is entitled to the same preferential income tax rate from January 1, 2010 to December 31, 2011. The high and new technology enterprise status is subject to approval and renewal every three years. Jiaheyi is our other consolidated affiliated entity and carries on no material operational activities.

In addition, the New EIT Law treats enterprises established outside of China that have “effective management and control” located in China as a PRC resident enterprise for tax purposes. The term “effective management and control” is generally defined as exercising overall management and control over the business, personnel, accounting, properties of an enterprise. We believe that neither Youku.com Inc. nor Jet Brilliant should be treated as a “resident enterprise” for PRC tax purposes. See “Regulations—Regulations on Tax—PRC Enterprise Income Tax.” However, if considered a “PRC resident enterprise” for tax purposes, our company would be subject to the PRC enterprise income tax

 

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at a rate of 25% on its worldwide income. We will continue to monitor our tax status. See “Risk Factors—Risks Related to Doing Business in China—Our global income and the dividends that we may receive from our PRC subsidiaries may be subject to PRC taxes under the PRC Enterprise Income Tax Law, which would have a material adverse effect on our results of operations.”

Under the New EIT Law and its implementation rules, dividends from our PRC subsidiaries out of earnings generated after January 1, 2008 are subject to withholding tax. Distributions of earnings generated before January 1, 2008 are exempt from PRC withholding tax. Dividends of 1Verge Internet, which is our PRC subsidiary directly held by our company, to our company is subject to withholding tax at a rate of 10%. Dividends of Jet Brilliant Beijing, which is our PRC subsidiary directly held by our Hong Kong subsidiary Jet Brilliant, will, upon approval from the local tax authority, benefit from a reduced withholding tax rate of 5% under the Arrangement between the PRC and Hong Kong Special Administrative Region on the Avoidance of Double Taxation and Prevention of Fiscal Evasion with respect to Taxes on Income and Capital. However, if our Hong Kong subsidiary is not considered to be the beneficial owner of any such dividends, such dividends would be subject to withholding tax at a rate of 10% rather than a preferential rate of 5%. Jet Brilliant has not obtained the approval for a withholding tax rate of 5% from the local tax authority and does not plan to obtain such approval in the near future, because Jet Brilliant Beijing has paid nil dividends from April 27, 2010 to September 30, 2010 and does not plan to pay dividends in the future as it may continue to incur losses. See “Risk Factors—Risks Related to Doing Business in China—Our global income and the dividends that we may receive from our PRC subsidiaries may be subject to PRC taxes under the PRC Enterprise Income Tax Law, which would have a material adverse effect on our results of operations.”

For more information on PRC tax regulations, see “Regulation—Regulations on Tax.”

Internal Control over Financial Reporting

In preparing our consolidated financial statements, we and our independent registered public accounting firm identified material weaknesses and other deficiencies in our internal control over financial reporting as of December 31, 2009. As defined in standards established by the PCAOB, a “material weakness” is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.

The material weaknesses identified related to an insufficient number of financial reporting personnel with an appropriate level of knowledge, experience and training in the application of U.S. GAAP and SEC regulations in internal control over our financial reporting obligations, a lack of qualified staff to support our chief financial officer in financial reporting activities, a lack of an appropriate level of oversight and communication of internal control, policies and procedures to support our activities, and a lack of effective monitoring activities to ensure the accuracy and completeness of our financial statements and related disclosures. Neither we nor our independent registered public accounting firm undertook a comprehensive assessment of our internal control for purposes of identifying and reporting material weaknesses and other control deficiencies in our internal control over financial reporting, as we and they will be required to do once we become a public company. Had we performed a formal assessment of our internal control over financial reporting or had our independent registered public accounting firm performed an audit of our internal control over financial reporting, additional control deficiencies may have been identified.

Following the identification of these material weaknesses and other control deficiencies and in connection with preparation of our consolidated financial statements, we performed additional review procedures, including a thorough review of journal entries and reconciliations for key accounts, to ensure the completeness and accuracy of the consolidated financial statements prepared in accordance with U.S. GAAP.

 

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To remedy our control deficiencies, we have adopted several measures to improve our internal control over financial reporting. As part of our efforts to address the identified material weaknesses and other control deficiencies, in September 2010, we appointed a financial director who is a certified public accountant with U.S. GAAP expertise and work experience in the financial reporting function of a publicly listed company for approximately four years. We also appointed an internal audit director with prior U.S. GAAP accounting and internal control assessment experience in October 2010. We have started to provide, and intend to continue to provide, on-going training to our existing financial reporting personnel on the accounting and reporting requirements under the U.S. GAAP and SEC regulations. We are in the process of, among other things, (i) actively searching for candidates for additional financial and accounting personnel, including additional associates to support our chief financial officer in financial reporting activities; (ii) establishing processes and oversight measures with the assistance of an independent third-party consultant we engaged in July 2010 in an effort to comply with the requirements under the U.S. GAAP, SEC regulations and Section 404; (iii) developing and implementing an accounting policy manual; and (iv) establishing effective monitoring and oversight controls to ensure the accuracy and completeness of our financial statements and related disclosures. We expect to complete the measures above as soon as practicable upon the completion of this offering and will continue to implement measures to remedy our internal control deficiencies in order to meet the deadline imposed by Section 404. However, the implementation of these measures may not fully address the deficiencies in our internal control over financial reporting. We are not able to estimate with reasonable certainty the costs that we will need to incur to implement these and other measures designed to improve our internal control over financial reporting. See “Risk Factors—Risks Related to Our Business and Industry—In preparing our consolidated financial statements, we have identified material weaknesses and other control deficiencies in our internal control over financial reporting. If we fail to maintain an effective system of internal control over financial reporting, we may be unable to accurately report our financial results or prevent fraud, and investor confidence in our company and the market price of our ADSs may be adversely affected.”

Critical Accounting Policies

We prepare our financial statements in conformity with U.S. GAAP, which requires us to make estimates and assumptions that affect our reporting of, among other things, assets and liabilities, contingent assets and liabilities and net revenues and expenses. We regularly evaluate these estimates and assumptions based on the most recently available information, our own historical experiences and other factors that we believe to be relevant under the circumstances. Since our financial reporting process inherently relies on the use of estimates and assumptions, our actual results could differ from what we expect. This is especially true with some accounting policies that require higher degrees of judgment than others in their application. We consider the policies discussed below to be critical to an understanding of our audited consolidated financial statements because they involve the greatest reliance on our management’s judgment.

Revenue Recognition

We derive revenues primarily from online advertising services. We recognize revenues only when the price is fixed or determinable, persuasive evidence of an arrangement exists, the service is performed and collectability of the related fee is reasonably assured. Specifically, we recognize revenues based on the following revenue recognition principles:

For online advertising services we provide to brand advertisers, advertising contracts are signed to establish the fixed price and advertising services to be provided. Pursuant to the advertising contracts, we provide advertisement placements on our web pages in different formats, including but not limited to video, banners, links, logos and buttons. Before entering into an advertising contract, we make a credit assessment of the advertiser to evaluate the collectability of the related service fees

 

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under the contract. For those contracts the collectability of which was assessed as not reasonably assured, we recognize revenues only when the cash payments were received and all revenue recognition criteria were met. For contracts where we provide customers with marketing services that contain multiple deliverables, such as advertisements in different formats to be delivered over different periods of time, since we sell the marketing services over a broad price range, there is a lack of objective and reliable evidence of fair value for each deliverable included in the arrangement, and depending on the nature of customer arrangement, revenues may be contingent upon the delivery of undelivered items. Accordingly, a combined unit of accounting is used pursuant to Accounting Standards Codification 605-25 Revenue Recognition: Multiple-Element Arrangements, and such revenues are recognized ratably over the performance period of the last deliverable in the arrangement. Revenue is deferred when non-refundable payments are received from customers prior to satisfaction of the revenue recognition criteria discussed above.

We participate in affiliate advertising programs run by third parties and place links to their customers’ advertisements on our website. On a monthly basis, we obtain data on the user traffic and the number of visitors’ clicks from these third parties. Under these programs, we recognize revenues based on contractual rates applied to user traffic and the number of visitors’ clicks on the advertisements on our website.

For advertising-for-advertising barter transactions, which are cross-promotional activities we enter into with third parties, we follow Accounting Standards Codification subtopic 605-20, which provides that advertising-for-advertising barter transactions should be recorded at fair value only if the value of such advertising surrendered in the transaction is determinable within reasonable limits. We do not recognize revenues for such barter transactions since the fair value is not determinable for any of the periods presented.

Share-based Compensation Expenses

On December 1, 2005, we adopted our 2006 Stock Option Scheme, or the Plan, to attract and retain the best personnel and provide additional incentives to employees, directors, officers, directors, advisors or consultants of the company. We amended the Plan on March 26, 2007, June 20, 2008, December 16, 2009 and September 9, 2010, respectively. Our board of directors authorized the issuance and reservation of up to 140,441,231 ordinary shares on December 16, 2009 under the Plan. As of September 30, 2010, options to purchase 128,751,901 ordinary shares were outstanding. The following table sets forth the options granted under the Plan that were outstanding as of September 30, 2010.

 

Date of Option Grant

   Options Outstanding      Exercise Price      Weighted-average
Fair Value of Option
     Fair Value of
Ordinary Shares
 
            (US$)      (US$)      (US$)  

Prior to 2009

     70,288,834            

February 1, 2009

     9,180,000         0.143036134         0.0511         0.1048   

February 21, 2009

     200,000         0.143036134         0.0513         0.1056   

August 1, 2009

     9,854,667         0.143036134         0.0575         0.1143   

February 1, 2010

     19,505,400         0.190850707         0.1062         0.1849   

August 1, 2010

     19,723,000         0.40         0.2005         0.3855   
                 

Total:

     128,751,901            
                 

On November 10, 2010, we granted options to purchase 11,487,000 ordinary shares of our company at an exercise price of US$0.48 per share under the Plan to some of our directors and employees. In determining the fair value of our ordinary shares underlying the options granted on November 10, 2010, we intend to use the mid-point of the estimated initial public offering price range shown on the front cover of this prospectus adjusted to reflect the ADS-to-ordinary share ratio and apply

 

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a 10% discount for lack of marketability to reflect the fact that there was no public market for our shares as we were a closely held private company as of the option grant date. As of November 12, 2010, options to purchase a total of 139,520,233 ordinary shares were outstanding.

Share-based compensation expense for all share-based awards granted to employees is determined based on fair value of the shares on the grant date. Share-based compensation is expensed ratably on a straight-line basis for awards with vesting schedules based on service conditions only over the requisite service period, which is generally the vesting term of the share-based awards.

We engaged American Appraisal China Limited, or American Appraisal, an independent third-party appraiser, to assist us in our determination of the fair value of our equity securities as of February 1, 2009, February 21, 2009, August 1, 2009, February 1, 2010 and August 1, 2010. Our management is ultimately responsible for such determination.

In determining the fair value of our stock options, the binomial lattice option pricing model was applied. The key assumptions used to determine the fair value of the options at the relevant grant dates in 2009 and 2010 were as follows:

 

      Year Ended 2009      Nine Months Ended
September 30, 2010
 

Risk-free interest rate

     3.26% to 3.98%         2.96% to 4.41%   

Expected volatility rate

     65.40% to 66.40%         61.8% to 63%   

Expected dividend yield

     0.00%         0.00%