F-1/A 1 df1a.htm AMENDMENT NO.2 TO FORM F-1 Amendment No.2 to Form F-1
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As filed with the Securities and Exchange Commission on June 16, 2011

Registration No. 333-170485

 

 

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Amendment No. 2

To

Form F-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

Tudou Holdings Limited

(Exact name of registrant as specified in its charter)

 

 

Not Applicable

(Translation of registrant’s name into English)

 

 

 

Cayman Islands   7374   Not Applicable

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

Building No. 6, X2 Creative Park, 1238 Xietu Road, Xuhui District

Shanghai 200032, People’s Republic of China

(86-21) 5170-2355

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

 

 

CT Corporation System

111 Eighth Avenue

New York, NY 10011

(212) 894 8940

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

 

 

Copies to:

 

David T. Zhang

Latham & Watkins

41st Floor, One Exchange Square

8 Connaught Place, Central, Hong Kong

(852) 2912-2503

 

Portia Ku

O’Melveny & Myers LLP

37/F Plaza 66, 1266 Nanjing Road West

Shanghai, People’s Republic of China

(86-21) 2307-7000

 

 

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, 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(1)
  Amount of
Registration Fee

Class B ordinary shares, par value US$0.0001 per share(2)(3)

  US$120,000,000   US$8,556
 
 
(1) Estimated solely for the purpose of determining the amount of registration fee in accordance with Rule 457(o) under the Securities Act of 1933.
(2) Includes 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, and also includes ordinary shares that may be purchased by the underwriters pursuant to an over-allotment option. These ordinary shares are not being registered for the purposes of sales outside of the United States.
(3) American depositary shares issuable upon deposit of the ordinary shares registered hereby will be registered under a separate registration statement on Form F-6 (Registration No. 333-170497). Each American depositary share represents                 Class B ordinary shares.

 

 

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 prospectus is not complete and may be changed. Neither we [nor any of the selling shareholders] may sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and neither we [nor any of the selling shareholders] are soliciting offers to buy these securities in any state where the offer or sale is not permitted.

 

SUBJECT TO COMPLETION

PRELIMINARY PROSPECTUS, DATED                     , 2011

             American Depositary Shares

LOGO

Tudou Holdings Limited

Representing              Class B Ordinary Shares

 

 

This is an initial public offering of American depositary shares, or ADSs, of Tudou Holdings Limited, or Tudou. Each ADS represents              Class B ordinary shares, par value US$0.0001 per share, of Tudou. Tudou is offering              ADSs[, and the selling shareholders are offering              ADSs].

Prior to this offering, there has been no public market for the ADSs or our ordinary shares. We anticipate that the initial public offering price will be between US$             and US$             per ADS. We have applied to have the ADSs listed on the Nasdaq Global Market under the symbol “TUDO.”

The underwriters have an option to purchase up to              additional ADSs from us [and the selling shareholders] at the initial public offering price, less the underwriting discounts and commission, to cover over-allotments of ADSs. [We will not receive any of the proceeds from the sale of the ADSs by the selling shareholders.]

Investing in our ADSs involves risks. See “Risk Factors” beginning on page 13.

 

 

 

     Initial Public
Offering  Price
     Underwriting
Discounts  and
Commissions
     Proceeds,
Before  Expenses,
to Tudou
     Proceeds, Before
Expenses, to
Selling
Shareholders
 

Per ADS

   US$                        US$                        US$                        US$                    

Total

   US$         US$         US$         US$     

Delivery of the ADSs will be made on or about                     , 2011.

Upon the completion of this offering, 10,633,333 Class A ordinary shares and                      Class B ordinary shares of our company will be issued and outstanding. Each Class A ordinary share will be entitled to four votes and each Class B ordinary share will be entitled to one vote on all matters subject to shareholders’ vote. Accordingly, First Easy Group Limited, the sole holder of our Class A ordinary shares and a company controlled by Mr. Gary Wei Wang, our founder, chairman and chief executive officer, will hold             % of our equity interest and             % of our aggregate voting power, respectively. Holders of our Class B ordinary shares will hold             % of our equity interest and             % of our aggregate voting power, respectively.

Neither the United States Securities and Exchange Commission nor any state securities commission or other regulatory body has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

Credit Suisse   Deutsche Bank Securities

 

 

Oppenheimer & Co.

 

 

The date of this prospectus is                     , 2011


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LOGO

 


Table of Contents

TABLE OF CONTENTS

 

     Page  

PROSPECTUS SUMMARY

     1   

THE OFFERING

     8   

RISK FACTORS

     13   

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

     47   

USE OF PROCEEDS

     49   

DIVIDEND POLICY

     50   

CAPITALIZATION

     51   

DILUTION

     52   

EXCHANGE RATE INFORMATION

     54   

ENFORCEABILITY OF CIVIL LIABILITIES

     55   

CORPORATE HISTORY AND STRUCTURE

     57   

SELECTED CONSOLIDATED FINANCIAL DATA

     64   

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     68   

OUR INDUSTRY

     110   

BUSINESS

     115   

REGULATION

     133   
     Page  

MANAGEMENT

     147   

PRINCIPAL [AND SELLING] SHAREHOLDERS

     154   

RELATED PARTY TRANSACTIONS

     159   

DESCRIPTION OF SHARE CAPITAL

     161   

DESCRIPTION OF AMERICAN DEPOSITARY SHARES

     173   

SHARES ELIGIBLE FOR FUTURE SALE

     180   

TAXATION

     182   

UNDERWRITING

     189   

EXPENSES RELATED TO THIS OFFERING

     194   

LEGAL MATTERS

     195   

EXPERTS

     195   

WHERE YOU CAN FIND ADDITIONAL INFORMATION

     195   

CONVENTIONS USED IN THIS PROSPECTUS

     196   

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

     F-1   
 

 

 

You should rely only on the information contained in this document or to which we have referred you. We have not authorized anyone to provide you with information that is different. This document may only be used where it is legal to sell these securities. The information in this document is only accurate on the date of this document.

Until                     , 2011, all dealers that effect transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealer’s obligation to deliver a prospectus when acting as an underwriter and with respect to unsold allotments or subscriptions.

 

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PROSPECTUS SUMMARY

The following summary is qualified in its entirety by, and should be read in conjunction with, the more detailed information and financial statements appearing elsewhere in this prospectus. In addition to this summary, we urge you to read the entire prospectus carefully, especially the risks of investing in our ADSs discussed under “Risk Factors,” before deciding whether to buy our ADSs. This summary and other sections of this prospectus contain information from a 2011 report, which we commissioned Sinomonitor International, or Sinomonitor, an independent market research company, to provide, with certain information on the industry in which we operate, including our market position in that industry, or the Sinomonitor Report.

Our Business

We are a leading online video company in China. Our “Tudou” brand is the most valuable online video brand in China and our website, Tudou.com, is the most favored and recommended online video website by online video users in China, according to the Sinomonitor Report. Our Tudou.com website, which we believe is the first online video site launched in China, provides a robust online platform for Chinese Internet users to upload, watch and share videos via the Internet. By leveraging our leading industry position and recognizable and valuable brand, we have established a large and highly engaged user community. Our registered users increased from approximately 35.6 million as of December 31, 2008 to approximately 78.2 million as of December 31, 2010 and further to approximately 83.6 million as of March 31, 2011. Our average number of new video clips uploaded daily increased from approximately 23,000 in 2008 to approximately 40,000 in 2010 and further to approximately 44,000 during the first quarter of 2011. In addition, the number of monthly unique visitors to our site Tudou.com increased from approximately 50 million in December 2007 to approximately 182 million in December 2010, and to approximately 185 million in April 2011, according to iResearch Consulting Group, or iResearch.

We provide a truly on-demand and interactive viewing experience where our users can find content they want to view, share content they create and connect with other users on our platform. We offer a comprehensive selection of unique and entertaining content including user generated content, or UGC, premium licensed content and in-house developed content. We released our first “Made-for-Internet” in-house production, That Love Comes, in November 2010 and our second production, Utopia Office, in April 2011. Our extensive content library is designed to meet our users’ diverse viewing needs spanning genres from entertainment and animation to finance and music. The volume and quality of our unique content, combined with our enjoyable user experience, have allowed us to establish a large user base, consisting primarily of the young, urban, affluent and educated demographic group that is particularly attractive to advertisers.

We have focused on developing our online platform to provide what we believe is the best user experience in the online video industry in China. We have developed a user friendly and interactive interface that we believe provides our users with a superior viewing experience. Our website allows our users to watch, upload, rate, comment on and recommend videos, creating a highly engaging and interactive experience. Additionally, we have created rich community features to enhance our users’ experience. We encourage the creativity of our user community through signature industry events such as the Tudou Video Festival, through talent development initiatives and by providing monetary incentives to producers of our most viewed UGCs. To ensure an enjoyable user experience, we have built a robust technology platform with access to over 4,000 servers across China, which is optimized for the delivery of online video content and which focuses on stability, scalability and flexibility.

Online video and online advertising have grown rapidly in China in recent years as a result of positive macroeconomic trends, increasing Internet penetration rates and the continuing acceptance of the Internet as a critical channel for advertisers’ marketing strategies. In addition, users are seeking alternatives to traditional television to have more control over their media viewing experience. Content portability is also becoming

 

 

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increasingly important as users want to have the option to access video and other content on their mobile phones and other Internet-enabled devices. We believe we are well positioned to capitalize on these key industry trends.

We generate revenues primarily by delivering online advertising services. We provide advertising services primarily through our Tudou.com website in various formats, including pre-roll or post-roll video advertisements, in-roll logos, background advertisements, banners, buttons, links and stream advertisements. In addition, we provide innovative and differentiated online advertising services, including event sponsorships, interactive advertising and the opportunities to purchase advertising embedded in our in-house developed content.

We also began generating revenues in January 2010 from our mobile video services, which we provide primarily through a video channel with China Mobile, and we had an aggregate of approximately 15.8 million users with a total of approximately 27.7 million clip views in 2010 and an aggregate of approximately 7.3 million users with a total of approximately 12.2 million clip views for the three months ended March 31, 2011. Through our agreement with China Mobile, we select and provide videos based on our assessment of mobile user preferences. Users pay a monthly subscription fee for access to our video channel or pay on a per-clip basis, and we share the fees for such services with China Mobile. In addition, we began providing our mobile video services in April 2011 through two video channels on China Unicom’s wireless video platform.

Since we launched our online video platform in April 2005, our business has grown substantially. As is customary in the advertising industry in China, we typically enter into advertising contracts with third-party advertising agencies. We pay agency fees to third-party advertising agencies that purchase our advertising services and recognize revenues net of these agency fees. Our net revenues are net of sales taxes. Our net revenues increased from RMB26.2 million in 2008 to RMB89.1 million in 2009 and to RMB286.3 million in 2010, representing a compounded annual growth rate, or CAGR, of 121.8% over the three-year period. Our net revenues increased by 166.6% to RMB79.4 million (US$12.1 million) for the three months ended March 31, 2011 from RMB29.8 million for the same period in 2010. Our net loss was RMB212.6 million, RMB144.8 million and RMB347.4 million in 2008, 2009 and 2010, respectively. Our net loss was RMB38.0 million and RMB336.0 million (US$51.3 million) for the three months ended March 31, 2010 and 2011, respectively. Our adjusted net loss, a financial measure not in accordance with accounting principles generally accepted in the United States, or U.S. GAAP, which excludes the impact of non-cash items including share-based compensation expenses, beneficial conversion charge on convertible loan and fair value changes in warrant liabilities from our net loss, was RMB201.3 million, RMB133.3 million and RMB107.2 million in 2008, 2009 and 2010, respectively. Our adjusted net loss was RMB45.3 million and RMB59.0 million (US$9.0 million) for the three months ended March 31, 2010 and 2011, respectively. For a reconciliation of our net loss to our adjusted net loss, see footnote 2 on page 11 of this prospectus.

We are a Cayman Islands holding company and conduct substantially all of our online video services in China through our variable interest entities, or VIEs. We have entered into a series of contractual arrangements with our VIEs through which we exercise effective control over operations of these entities and receive economic benefits generated from these entities. See “—Corporate History and Structure.”

Our Industry

According to the China Internet Network Information Center, or CNNIC, a non-profit state-owned research center in China, the number of Internet users in China reached 457.3 million as of December 31, 2010. Significant growth potential exists as the Internet penetration rate in China was only 34.3% as of December 31, 2010, according to CNNIC. According to ZenithOptimedia, an independent market research firm, the Internet surpassed newspapers as the second largest advertising medium in China after television in 2010. According to ZenithOptimedia, Internet advertising expenditures in China grew from US$2.5 billion in 2008 to US$4.7 billion

 

 

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in 2010. ZenithOptimedia estimates that such expenditures will increase to US$9.7 billion in 2013, representing an expected CAGR of 27.3% from 2010 to 2013.

According to iResearch, the total revenues of China’s online video market grew from RMB0.5 billion in 2006 to RMB3.1 billion in 2010, representing a CAGR of 56.0%. China’s online video market has become increasingly concentrated, with the top five companies accounting for 81.1% of the total user time spent watching online videos in China during the first quarter of 2010, according to iResearch. Online video advertising spending in China increased from RMB100.0 million in 2006 to RMB2.2 billion in 2010, representing a CAGR of approximately 115.3%. Advertisers are recognizing the importance of online video advertising as a major part of their online advertising strategy. The online video industry is one of the fastest growing segments in online advertising, with a CAGR of 138.7% from 2006 to 2009, and is expected to grow at a CAGR of 76.2% from 2009 to 2013, according to iResearch.

Due to the increasing rollout of 3G networks and advanced mobile infrastructure in China, mobile devices are playing an increasingly important role in China’s Internet development. The number of mobile Internet users in China reached approximately 302.7 million as of December 31, 2010, a significant increase from approximately 117.6 million and approximately 233.4 million as of December 31, 2008 and 2009, respectively, according to CNNIC.

Our Strengths

We believe that the following competitive strengths enable us to compete effectively and to capitalize on the rapid growth in the online video industry in China:

 

   

leading online video brand in China;

 

   

unique and diverse selection of content;

 

   

highly engaged user community;

 

   

compelling solutions for advertisers;

 

   

robust technology platform; and

 

   

experienced management team with significant Internet and advertising industry expertise.

Our Strategies

Our objective is to strengthen our leading position in the online video industry and to establish Tudou as a leading media company in China. We intend to achieve our objective by pursuing the following strategies:

 

   

strengthening our brand;

 

   

enhancing our content offering;

 

   

deepening our relationships with advertisers;

 

   

expanding the distribution channels of our content; and

 

   

further investing in developing our technology platform.

 

 

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Our Challenges

We believe that the following are some of the major risks and uncertainties that may materially adversely affect us:

 

   

our history of net losses and uncertainty with respect to our ability to achieve and maintain profitability in the future;

 

   

our incurrence of negative cash flow from operations of RMB183.3 million, RMB94.8 million, RMB98.8 million and RMB22.6 million (US$3.5 million) in 2008, 2009, 2010 and the three months ended March 31, 2011, respectively;

 

   

uncertainty with respect to our ability to generate positive operating cash flow in the future considering that we expect our costs and expenses to increase as we expand our operations;

 

   

uncertainty with respect to our PRC subsidiaries’ and VIEs’ ability to procure short-term loans from commercial banks in China to finance their working capital needs;

 

   

our limited history operating an online video website and providing online advertising services as well as mobile video services;

 

   

uncertainties regarding the growth of the online video industry and user acceptance of our online video content;

 

   

our reliance on the online advertising industry for substantially all of our revenues;

 

   

our ability to maintain and enhance our brand;

 

   

our ability to obtain or extend necessary licenses, permits and approvals to operate our Internet-related and mobile value-added businesses;

 

   

our ability to effectively control our VIEs based upon contract rather than equity;

 

   

uncertainty with respect to our ability to provide Internet information services on our website if Quan Toodou Network Science and Technology Co., Ltd., or Quan Toodou, one of our VIEs, fails to renew its ICP license, a business operating license for value-added telecommunication services, in the future;

 

   

uncertainty with respect to the effectiveness of our control over Quan Toodou as a result of a lawsuit initiated by the ex-wife of Mr. Gary Wei Wang, our founder, chairman and chief executive officer, seeking the division of 76% of the equity interest in Quan Toodou held by Mr. Wang;

 

   

competition in our industry;

 

   

our exposure to copyright infringement and other intellectual property related claims;

 

   

uncertainty with respect to our ability to meet our potential need for additional capital as a result of the expansion of our business, and potential dilution to our shareholders and covenants that may restrict our operations or our ability to pay dividends due to our future capital needs requiring us to sell additional equity or debt securities or obtain short-term loans from commercial banks; and

 

   

restrictions on our ability to use our operating cash flows effectively and the ability of our PRC subsidiaries to obtain financing due to governmental control of currency conversion.

See “Risk Factors” and other information included in this prospectus for a discussion of these and other risks and uncertainties.

 

 

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Corporate History and Structure

We are a Cayman Islands company and conduct our business operations principally in China through our PRC subsidiaries and VIEs. Foreign ownership in Internet-related and mobile value-added service businesses is subject to restrictions under current PRC laws, rules and regulations. To comply with the applicable PRC laws, rules and regulations, we conduct our operations in China through a series of contractual arrangements entered into with our VIEs, namely Quan Toodou, Shanghai Suzao Network Science and Technology Co., Ltd., or Shanghai Suzao, and Chengdu Gaishi Network Science and Technology Co., Ltd., or Chengdu Gaishi, and their respective shareholders, through which we exercise effective control over operations of these entities and receive economic benefits generated from these entities.

However, these contractual arrangements may not be as effective in providing us with control over the VIEs as direct ownership of these companies. In addition, these VIEs or their shareholders may breach the contractual arrangements with us. In such cases, we would have to rely on legal remedies under PRC law, which may not always be effective, particularly in light of uncertainties in the PRC legal system. For detailed analysis of risks associated with these contractual arrangements, see “Risk Factors—Risks Relating to Doing Business in China.”

 

 

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The following diagram illustrates our corporate structure and the place of incorporation of each of our subsidiaries and VIEs, as of the date of this prospectus.

LOGO

 

LOGO

  Direct ownership

LOGO

  Contractual arrangements: See “Corporate History and Structure—Our Corporate Structure—Contractual Arrangements with Quan Toodou and its Shareholders,” “—Contractual Arrangements with Shanghai Suzao and its Shareholders” and “—Contractual Arrangements with Chengdu Gaishi and its Shareholders.”

 

(A) Quan Toodou Network Science and Technology Co., Ltd. is our VIE in China and is 95% owned by Mr. Gary Wei Wang, our founder, chairman and chief executive officer, and 5% owned by Ms. Zhiqi Wang, our employee and a member of our founding team. We rely on Quan Toodou to hold and maintain the ICP license for providing the Internet information services on our website. The ICP license has a term of five years, which is renewable upon the approval of the competent government authorities. Quan Toodou’s ICP license expired in March 2011 but was successfully renewed in May 2011. However, if Quan Toodou fails to renew its ICP license in the future,

 

 

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we may be unable to continue to provide the Internet information services on our website. See “Risk Factors—Risks Related to Doing Business in China—If Quan Toodou fails to renew the ICP license in the future, we may be unable to continue to provide the Internet information services on our website.”

 

     In addition, the ex-wife of Mr. Gary Wei Wang, our founder, chairman and chief executive officer who holds 95% of the equity interests in Quan Toodou, recently initiated a lawsuit against Mr. Wang, seeking the division of 76% of the equity interest in Quan Toodou held by Mr. Wang. Historically almost 100% of our net revenues and approximately 60% to 70% of our costs were attributable to Quan Toodou, and we expect our costs may continue to increase in the future. This lawsuit was concluded through settlement directed by the court in June 2011 and pursuant to a court ruling, Mr. Wang is entitled to the equity interests in any companies that are directly or indirectly held by him. In the meantime, the court also issued an order releasing the conservatory measures imposed by the Assets Conservatory Notification. However, if Mr. Wang fails to fully perform his obligations under the court ruling, Mr. Wang’s personal assets, including the equity interests in the companies that are directly or indirectly held by him, may be subject to the court’s enforcement measures. The ineffectiveness of control over Quan Toodou that may result from this lawsuit could cause significant disruption to our business, operations and financial conditions. For details, see “Risk Factors—Risks Related to Doing Business in China—The ineffectiveness of control over Quan Toodou that may result from a lawsuit initiated by the ex-wife of Mr. Gary Wei Wang, our founder, chairman and chief executive officer, seeking the division of 76% of the equity interest in Quan Toodou held by Mr. Wang, could cause significant disruption to our business, operations and financial conditions.”

 

(B) Shanghai Suzao Network Science and Technology Co., Ltd. is our VIE in China and is 50% owned by Mr. Chengzi Wu, our employee and a member of our founding team, and 50% owned by Ms. Jing Chen, our employee and a member of our founding team.

 

(C) Chengdu Gaishi Network Science and Technology Co., Ltd. is our VIE in China and is 50% owned by Mr. Chengzi Wu and 50% owned by Mr. Xiaoyun Zhang, our employee and a member of our founding team.

Corporate Information

Our principal executive offices are located at Building No. 6, X2 Creative Park, 1238 Xietu Road, Xuhui District, Shanghai 200032, People’s Republic of China. Our telephone number at this address is (86-21) 5170-2355 and our fax number is (86-21) 5170-2366. Our registered office in the Cayman Islands is at the offices of Maples Corporate Services Limited at PO Box 309, Ugland House, Grand Cayman, KY1-1104, Cayman Islands.

Investor inquiries should be directed to us at the address and telephone number of our principal executive offices set forth above. Our website is www.tudou.com. The information contained on our website is not part of this prospectus. Our agent for service of process in the United States is CT Corporation System located at 111 Eighth Avenue, New York, New York 10011.

 

 

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THE OFFERING

 

ADS offered by us

            ADSs

 

[ADS offered by selling shareholders

ADSs]

 

The ADSs

Each ADS represents             Class B ordinary shares, par value US$0.0001 per share. The ADSs may be evidenced by an ADR.

 

  The depositary will be the holder of the ordinary shares underlying the ADSs and you will have the rights of an ADS holder as provided in the deposit agreement among us, the depositary and owners and beneficial owners of ADSs from time to time.

 

  You may surrender your ADSs to the depositary to withdraw the ordinary shares underlying your ADSs. The depositary will charge you a fee for such an exchange.

 

  We may amend or terminate the deposit agreement for any reason without your consent. If an amendment becomes effective, you will be bound by the deposit agreement as amended if you continue to hold your ADSs.

 

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

 

Option to purchase additional shares

We [and the selling shareholders] have granted the underwriters an option, exercisable within 30 days from the date of this prospectus, to purchase up to an aggregate of             additional ADSs representing              Class B ordinary shares.

 

Ordinary shares outstanding immediately after the offering

            ordinary shares, comprised of (i) 10,633,333 Class A ordinary shares and (ii)              Class B ordinary shares ordinary shares, par value US$0.0001 per share.

 

  Holders of Class A ordinary shares and Class B ordinary shares have the same rights except for voting and conversion rights. Each Class A ordinary share is entitled to four votes on all matters subject to shareholders’ vote, and each Class B ordinary share is entitled to one vote on all matters subject to shareholders’ vote. Each Class A ordinary share is convertible into one Class B ordinary share at any time by the holder thereof. Class B ordinary shares are not convertible into Class A ordinary shares under any circumstances. Upon any transfer of Class A ordinary shares by a holder thereof to any person or entity which is not an affiliate of such holder or upon Mr. Gary Wei Wang’s ceasing to be employed as our chief executive officer, such Class A ordinary shares shall be automatically and immediately converted into an equal number of Class B ordinary shares.

 

 

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ADSs outstanding immediately after the offering

            ADSs.

 

Use of proceeds

We will receive net proceeds from this offering of approximately US$             million, after deducting the underwriting discounts and commissions and estimated aggregate offering expenses payable by us. We intend to use a portion of the net proceeds we receive from this offering for the following purposes:

 

   

to fund our content procurement and in-house developed content production;

 

   

to fund our expansion of Internet bandwidth capacity;

 

   

to fund the enhancement of our technology platform; and

 

   

the balance to fund our working capital and for general corporate purposes, including potential acquisitions, partnerships, alliances and licensing opportunities.

 

  [We will not receive any of the proceeds from the sale of the ADSs by the selling shareholders.]

 

NASDAQ trading symbol

TUDO

 

Lock-up

We, each of our directors, executive officers, [all of] our existing shareholders [and optionholders holding vested options within 180 days of this offering] have agreed with the underwriters, subject to certain exceptions, not to sell, transfer or dispose of any of our ADSs, ordinary shares or similar securities for 180 days after the date of this prospectus. See “Underwriting.”

 

Reserved ADSs

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

 

Depositary

The Bank of New York Mellon

 

Risk factors

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

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

 

   

assumes the exercise of all the warrants to purchase up to 9,083,185 Series E preferred shares of our company and automatic conversion of these preferred shares into 9,083,185 of our Class B ordinary shares immediately prior to the completion of this offering (excluding the warrants to purchase 147,693 Series E preferred shares the exercise of which is subject to certain conditions);

 

   

assumes the conversion of all outstanding preferred shares into 69,914,684 Class B ordinary shares immediately prior to the completion of this offering;

 

   

assumes no exercise of the underwriters’ over-allotment option;

 

   

excludes 8,753,245 ordinary shares, consisting of 1,057,500 Class A and 7,695,745 Class B ordinary shares, issuable upon the exercise of options outstanding as of March 31, 2011, at a weighted average exercise price of US$2.09 per share; and

 

   

excludes 3,486,873 Class B ordinary shares reserved for future issuances under our share incentive plan as of March 31, 2011.

 

 

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Summary Consolidated Financial Data

The following summary consolidated statements of operations for the years ended December 31, 2008, 2009 and 2010 and the summary consolidated balance sheet data as of December 31, 2008, 2009 and 2010 have been derived from our audited consolidated financial statements, which are included elsewhere in this prospectus. The summary consolidated statements of operations for the year ended December 31, 2007 have been derived from our audited consolidated financial statements that are not included in this prospectus. Our summary consolidated statements of operations data for each of the three month periods ended March 31, 2010 and 2011 and summary consolidated balance sheet data as of March 31, 2011 have been derived from our unaudited consolidated financial statements included elsewhere in this prospectus. We have prepared the unaudited consolidated financial information 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 presentation of our financial position and operating results for the periods presented. Results for the three months ended March 31, 2011 are not necessarily indicative of results that may be expected for the full year. You should read the summary consolidated financial data in conjunction with those 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. Our historical results are not necessarily indicative of our results expected for future periods.

Our audited consolidated financial statements for the years ended December 31, 2008 and 2009 have been restated to reclassify agency fees we paid to advertising agencies as a reduction of revenues rather than as cost of revenues. The reclassification resulted in a downward adjustment of RMB4.7 million and RMB24.1 million in our net revenues for the years ended December 31, 2008 and 2009, respectively and a corresponding downward adjustment of RMB4.7 million and RMB24.1 million in our cost of revenues for the years ended December 31, 2008 and 2009, respectively. For more details, please see Note 3(b) to our audited consolidated financial statements included elsewhere in this prospectus.

 

 

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    For the Year Ended December 31,     For the Three Months Ended March 31,  
    2007     2008     2009     2010     2010     2011     2011  
          Restated     Restated                          
    (RMB)     (RMB)     (RMB)     (RMB)    

(RMB)

   

(RMB)

   

(US$)

 
   

(in thousands, except per share data)

 

Consolidated Statements of Operations

             

Net revenues

    6,617.7        26,220.2        89,147.3        286,258.1        29,770.4        79,377.0        12,121.8   

Cost of revenues(1)

    (72,394.3     (143,331.5     (127,182.1     (226,399.3     (41,659.1     (80,995.8     (12,369.0
                                                       

Gross profit (loss)

    (65,776.6     (117,111.3     (38,034.8     59,858.8        (11,888.7     (1,618.8 )       (247.2

Operating expenses:

             

Sales and marketing expenses(1)

    (12,996.7     (42,574.3     (73,435.2     (143,224.1     (21,198.3     (76,383.9     (11,664.7

General and administrative expenses(1)

    (11,824.3     (37,781.3     (37,585.6     (104,911.4  

 

 

 

(4,000.4

 

 

 

 

 

(83,887.6

 

 

 

 

 

(12,810.6

 

Impairment of equipment

    —          (8,735.6     (2,372.3     —          —          —          —     
                                                       

Total operating expenses

    (24,821.0     (89,091.2     (113,393.1     (248,135.5     (25,198.7     (160,271.5     (24,475.3
                                                       

Loss from operations

    (90,597.6     (206,202.5     (151,427.9     (188,276.7     (37,087.4  

 

 

 

(161,890.3

 

 

 

 

 

(24,722.5

 

Finance income

    2,545.3        3,572.6        3,103.8        331.0        60.3        76.7        11.7   

Finance expenses

    —          —          —          (12,851.2  

 

 

 

(429.7

 

 

 

 

 

(867.2

 

 

 

 

 

(132.4

 

Other expenses

    (20.8     (236.5     (63.0     1.4     

 

 

 

—  

 

  

 

 

 

 

—  

 

  

 

 

 

 

—  

 

  

Foreign exchange gain (loss)

    (7,810.5     (9,772.2     3,610.0        (10,957.2     (563.3     (2,914.4     (445.1

Beneficial conversion charge on convertible loan

    —          —          —          (10,967.0    
—  
  
   
—  
  
 

 

 

 

—  

 

  

Fair value changes in warrant liabilities

    —          —          —          (124,680.1     —          (170,385.1     (26,019.7
                                                       

Loss before income taxes

    (95,883.6     (212,638.6     (144,777.2     (347,399.8     (38,020.1  

 

 

 

(335,980.3

 

 

 

 

 

(51,308.0

 

Income taxes

    (0.0 )*      —          —          —          —          —          —     

Net loss

    (95,883.6     (212,638.6     (144,777.2     (347,399.8     (38,020.1  

 

 

 

(335,980.3

 

    (51,308.0
                                                       

Net loss attributable to ordinary shareholders

    (85,192.3     (195,100.7     (145,085.6     (362,383.7     (38,071.4  

 

 

 

(340,678.2

 

 

 

 

 

(52,025.4

 

                                                       

Loss per ordinary share Basic and diluted

    (7.10     (16.26     (12.09     (30.20     (3.17     (28.39     (4.34

Weighted average number of ordinary shares used in computing loss per share Basic and diluted

    12,000        12,000        12,000        12,000        12,000        12,000        12,000   

Pro forma loss per share attributable to Class A and Class B ordinary shareholders

             

Basic and diluted

          (3.81       (3.69     (0.56

Pro forma weighted average number of ordinary shares used in computing loss per share

             

Basic and diluted

             

Class A and Class B ordinary shares

          90,998          90,998        90,998   

Non-GAAP Financial Data

             

Adjusted net loss(2)

    (90,180.4     (201,320.5     (133,254.8     (107,176.3     (45,270.6     (58,978.9     (9,006.8

 

* Less than RMB100.
(1) Includes share-based compensation expenses as follows:

 

    For the Year Ended December 31,     For the Three Months Ended March 31,  
          2007                 2008                 2009                 2010           2010     2011  
    (RMB)     (RMB)     (RMB)     (RMB)     (RMB)     (RMB)     (US$)  
   

(in thousands)

 

Share-based compensation expenses:

             

Cost of revenues

    1,217.0        2,762.6        1,875.6        14,133.0        (1,540.4     14,718.0        2,247.6   

Sales and marketing expenses

    2,065.5        3,918.0        3,491.8        31,025.3        (2,433.8     35,048.7        5,352.3   

General and administrative expenses

    2,420.7        4,637.5        6,155.0        59,418.1        (3,276.3     56,849.6        8,681.6   
                                                       

Total:

    5,703.2        11,318.1        11,522.4        104,576.4        (7,250.5     106,616.3        16,281.5   
                                                       

 

 

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(2) We define adjusted net loss, a non-GAAP financial measure, as net loss excluding share-based compensation expenses, beneficial conversion charge on convertible loan and fair value changes in warrant liabilities. We review adjusted net loss together with 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 without the effect of non-cash beneficial conversion charge on convertible loan and fair value changes in warrant liabilities, which will not likely be recurring factors in our business in the future, and share-based compensation expenses, which have been and will continue to be a significant recurring factor in our business. However, the use of adjusted net loss has material limitations as an analytical tool. 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 net loss is not calculated in the same manner by all companies, it may not be comparable to other similar titled measures used by other companies. In light of the foregoing limitations, you should not consider adjusted net loss in isolation from or as an alternative to net loss 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.

 

        For the Year Ended December 31,     For the Three Months Ended March 31,  
        2007     2008     2009     2010     2010     2011     2011  
        (RMB)     (RMB)     (RMB)     (RMB)         (RMB)             (RMB)             (US$)      
       

(in thousands)

 

Net loss

    (95,883.6     (212,638.6     (144,777.2     (347,399.8     (38,020.1     (335,980.3     (51,308.0

Add back:

 

share-based compensation expenses:

    5,703.2        11,318.1        11,522.4        104,576.4        (7,250.5     106,616.3        16,281.5   
 

beneficial conversion charge on convertible loan:

    —          —          —          10,967.0        —          —          —     
 

fair value changes in warrant liabilities:

    —          —          —          124,680.1        —          170,385.1        26,019.7   
                                                         

Adjusted net loss

    (90,180.4     (201,320.5     (133,254.8     (107,176.3     (45,270.6     (58,978.9     (9,006.8
                                                         

 

     As of December 31,     As of March 31,  
     2008     2009     2010     2011  
     (RMB)     (RMB)     (RMB)     (RMB)     (US$)  
    

(in thousands)

 

Consolidated Balance Sheet Data:

          

Cash and cash equivalents

     260,769.0        62,034.4        263,150.8        208,969.4        31,912.0   

Short term investments

     11,312.2        84,211.6        5,837.2        —          —     

Total current assets

     303,479.2        223,511.0        614,181.6        566,709.1        86,542.9   

Total assets

     339,699.4        263,003.0        698,742.2        671,553.6        102,553.9   

Total current liabilities

     51,864.8        119,945.5        418,358.9        556,765.5        85,024.4   

Total liabilities

     51,864.8        119,945.5        572,398.5        881,190.2        134,567.8   

Mezzanine equity:

          

Series A redeemable convertible preferred shares

     5,908.8        6,756.8        7,381.3        7,512.4        1,147.2   

Series B redeemable convertible preferred shares

     58,094.0        58,039.6        56,292.9        55,729.3        8,510.5   

Series C redeemable convertible preferred shares

     129,857.4        129,735.8        125,831.3        124,571.6        19,023.5   

Series D redeemable convertible preferred shares

     388,205.3        387,841.8        376,169.4        372,403.5        56,870.3   

Series E redeemable convertible preferred shares

     —          —          351,402.1        361,558.1        55,214.0   

Accumulated deficit

     (294,327.9     (439,413.5     (801,797.3     (1,142,475.5     (174,469.0

Total shareholders’ deficit

     (294,230.9     (439,316.5     (790,733.2     (1,131,411.5     (172,779.4

Total liabilities and shareholders’ deficit

     339,699.4        263,003.0        698,742.2        671,553.6        102,553.9   

 

 

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RISK FACTORS

You should carefully consider the risks described below in conjunction with the other information and the financial statements and related notes included elsewhere in this prospectus before making an investment decision. Our business, financial condition or results of operations could be materially and adversely affected by any of these risks. The trading price of our ADSs could decline due to any of these risks, and you may lose all or part of your investment. This prospectus also contains forward-looking statements relating to events subject to risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements due to the material risks that we face as described below.

Risks Relating to Our Business and Our Industry

We have a history of net losses and negative operating cash flow and may incur net losses and negative operating cash flow in the future.

We incurred net losses of RMB212.6 million, RMB144.8 million, RMB347.4 million and RMB336.0 million (US$51.3 million) in 2008, 2009, 2010 and the three months ended March 31, 2011, respectively, and we may incur losses in the future. In addition, we incurred negative cash flow from operations of RMB183.3 million, RMB94.8 million, RMB98.8 million and RMB22.6 million (US$3.5 million) in 2008, 2009, 2010 and the three months ended March 31, 2011, respectively. We expect our costs and expenses to increase as we expand our operations, primarily including costs and expenses associated with leasing Internet bandwidth, acquiring and licensing premium video content, producing in-house developed content and sales and marketing activities. Our ability to achieve and maintain profitability and positive operating cash flow depends on the growth of the online video industry and the online advertising market, the continued acceptance of our online video content by our users, the continued growth and maintenance of our user base, our ability to control our costs and expenses, the expansion and effectiveness of our subscription fee-based and per-clip based mobile video services, our ability to attract and retain advertisers and advertising agencies and our ability to provide new advertising services to meet the demands of our advertisers. We may not be able to achieve or sustain profitability and/or positive operating cash flow, and if we achieve positive operating cash flow, it may not be enough to satisfy our anticipated capital expenditures and other cash needs.

We are a relatively young company subject to risks and uncertainties associated with operating in the rapidly developing and evolving online video industry. Our limited operating history makes evaluating our business and prospects difficult.

We launched our website in 2005. As an early-stage company in the new and rapidly evolving Chinese online video industry, we face numerous risks and uncertainties. Some of these risks relate to our ability to:

 

   

continue to attract a large audience by expanding our online video content library and enhancing our user experience;

 

   

raise our brand awareness and increase our user loyalty;

 

   

maintain and develop relationships with advertisers and advertising agencies;

 

   

continue to acquire premium licensed content at a commercially acceptable cost;

 

   

continue offering innovative advertising services;

 

   

maintain our current and develop new relationships with China Mobile, China Unicom and its joint venture, as well as other telecommunication operators to build our mobile video business;

 

   

attract and retain qualified personnel; and

 

   

successfully adapt our business model to changes in this new and rapidly evolving industry.

You should consider our business and prospects in light of the risks and uncertainties we face as an early-stage company operating in a rapidly evolving market. We may not be successful in addressing the risks and uncertainties listed above, which may materially and adversely affect our business prospects.

 

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We face uncertainties regarding the growth of the online video industry and user acceptance of our online video content, which could adversely affect our revenues and business prospects.

The growth of the online video industry and online advertising services from which we derive most of our revenues, as well as the level of demand and market acceptance of our services, are subject to uncertainties and numerous other factors, some of which are beyond our control. These uncertainties and factors include but are not limited to:

 

   

general economic conditions, particularly economic conditions adversely affecting consumer spending as well as advertising spending;

 

   

the growth of Internet usage and penetration in China, and the rate of any such growth;

 

   

the development and change of government regulation of the Internet industry in general and the online video industry in particular;

 

   

competition between online video and traditional media formats, such as television;

 

   

the popularity and price of online advertising services that we and our competitors launch and distribute; and

 

   

changes in user demographics and their tastes and preferences.

A decline in the popularity of online videos in general, or our website in particular, and a decline of our user base, will adversely affect our revenues and business prospects.

We rely on online advertising sales for substantially all of our revenues. The online advertising market is subject to many challenges and uncertainties. If we fail to retain existing advertisers or attract new advertisers for our online advertising services, our business, results of operations and growth prospects could be seriously harmed.

In 2008 and 2009, we generated all, and in 2010 and the three months ended March 31, 2011, we generated substantially all, of our revenues from online advertising services. The online advertising market continues to evolve in China. Many of our current and potential advertisers have limited experience with the Internet as an advertising medium, have not traditionally devoted a significant portion of their advertising expenditures to online advertising, and may not find the Internet to be effective for promoting their products and services relative to traditional media. Advertising agencies also have limited experience in procuring online video advertising for advertisers. If the Internet does not become more widely accepted as a medium for advertising, our ability to increase our revenues could be negatively affected. Our ability to generate and maintain substantial advertising revenues will depend on a number of factors, many of which are beyond our control, including but not limited to:

 

   

the development and retention of a large user base with demographic characteristics attractive to advertisers;

 

   

the acceptance of online advertising as an effective way for advertisers to market their businesses;

 

   

the maintenance and enhancement of our brand;

 

   

increased competition, potential downward pressure on online advertising prices and limitations on our advertising space;

 

   

the development of independent and reliable means of measuring traffic and verifying the effectiveness of our online advertising inventory;

 

   

popularity of new content and content distribution channels developed by us;

 

   

our ability to continue to have access to content that users want to view, including our ability to continue to get video clips uploaded; and

 

   

our ability to have continued success with innovative advertising services.

 

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Advertisers and advertising agencies will not continue to do business with us if they believe advertising spending on our website does not generate sales to end customers, or if we do not deliver their advertisements in an appropriate and effective manner. In addition, third parties may develop and use certain technologies to block the display of advertisers’ advertisements and other marketing products on our Tudou.com website, which may in turn cause us to lose advertisers and adversely affect our operating results. Moreover, changes in government policy could restrict or curtail our online advertising services. Failure to retain our existing advertisers or attract new advertisers for our online marketing services could seriously harm our business, results of operations and growth prospects.

Our business depends on a strong brand, and if we are not able to maintain and enhance our brand, or if we fail to protect our brand against unauthorized use by third parties, our business and operating results may be harmed.

Our brand “Tudou” is one of the most recognized online video brands in China according to iResearch, and our strong brand has contributed significantly to the success and rapid growth of our business. We also believe that maintaining and enhancing the “Tudou” brand is critical to increasing the number of our users and advertisers. As our market becomes increasingly competitive, maintaining and enhancing our brand will depend largely on our ability to retain our leading position in the online video industry in China.

Historically, we developed our user base primarily by word-of-mouth and incurred limited brand promotion expenses. Positive user experience and media coverage in subsequent years have significantly enhanced our reputation and resulted in increased brand recognition. We have also conducted marketing and brand promotion activities in recent years, but we cannot assure you that these activities will achieve the brand promotion effect as we expect. We rely on trademark law, company brand name protection policies and agreements with our employees, advertisers, advertising agencies, business partners and others to protect our brand. Despite such precautions, we may be unable to prevent third parties from using our brand names without authorization. An independent individual has registered the trademark “ LOGO Toodou” in Class 38 and such individual has also applied for registration of the trademark “ LOGO Toodou” in Class 42. We entered into an agreement to acquire the trademark “ LOGO Toodou” in Class 38 and the trademark application in Class 42 from this independent individual in November 2010 and completed the assignment registration of the trademark application in Class 42 in May 2011. We cannot assure you that the assignment registration of the trademark “ LOGO Toodou” in Class 38 will be timely completed.

We regard our brand as critical to our success. If we fail to maintain and further promote the “Tudou” brand, or if we cannot protect our brand against unauthorized use by third parties, our business and results of operations may be materially and adversely affected. In addition, any negative publicity about our company or our online video content and services, regardless of its veracity, could harm our brand image and in turn adversely affect our business and operating results.

We face significant competition and may be unable to compete successfully against our competitors, which would have a material adverse effect on our business and results of operations.

China’s online video industry is intensely competitive and we face competition from many independent online video websites, large Chinese Internet companies and major TV websites. Amongst the independent online video websites, our major competitors in China include Youku.com and 56.com. In addition, large Chinese Internet companies, including Shanda Interactive Entertainment, SINA Corporation, Baidu, Inc., Sohu.com Inc., Tencent Holdings Limited, NetEase.com, Inc. and/or their affiliates, have launched online video websites. In addition, some of China’s major TV networks, such as China Central Television, or CCTV, Phoenix Satellite TV and Hunan Satellite TV, have launched online video websites. We also potentially compete with software-based streaming video sites. We compete with these entities on the basis of brand recognition, demographic composition of viewers, robust technology platform, ability to provide innovative advertising services to advertisers and advertising agencies, relationships with advertisers and advertising agencies,

 

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advertising prices, as well as the ability to source creative UGC, acquire popular premium licensed content at a reasonable cost and create quality in-house developed content.

Some of these competitors have significantly greater financial resources, longer operating histories or more experience in attracting and retaining users and managing relationships with advertisers and advertising agencies than we do. They may compete with us for users, advertisers, advertising agencies and strategic content partners in a variety of ways, including by investing more heavily in content procurement and improving the features and functionality of their online video platforms. If any of our competitors provide comparable or better user experience, our user traffic could decline significantly. Any such decline in traffic could weaken our brand and result in loss of advertisers, which would have a material adverse effect on our results of operations.

We also face competition from other types of advertising media, such as television, radio, print media, billboards and other forms of outdoor media, for a share of advertisers’ marketing budgets. Large companies in China generally allocate, and will likely continue to allocate, most of their advertising budgets to traditional advertising media and only a small portion of their budgets to online advertising and other forms of advertising media. If these companies do not devote a larger portion of their advertising budgets to online advertising services provided by us, or if our existing advertisers reduce the amount they spend on online advertising, or if advertising agencies do not continue to procure our services for advertisers, our results of operations and growth prospects could be adversely affected.

We have been and expect we will continue to be exposed to intellectual property infringement and other claims, including claims based on content posted on our website, which could be time-consuming and costly to defend and may result in substantial damage awards and/or court orders that may prevent us from continuing to provide certain of our existing services.

Our success depends, in large part, on our ability to operate our business without infringing third-party rights, including third party intellectual property rights. Companies in the Internet, technology and media industries own, and are seeking to obtain, a large number of patents, copyrights, trademarks and trade secrets, and they are frequently involved in litigation based on allegations of infringement or other violations of intellectual property rights or other related legal rights. There may be patents issued or pending that are held by others that cover significant aspects of our technologies, products, business methods or services. Our platform is open to Internet users for uploading video clips. As a result, content posted by our users may expose us to allegations by third parties of infringement of intellectual property rights, unfair competition, invasion of privacy, defamation and other violations of third-party rights. Pursuant to our user agreement, users agree not to use our services in a way that is illegal, obscene or may otherwise violate generally accepted codes of ethics. Our user agreement also requires that users have the right to, or the license of, the content they upload to our website and users agree to be solely liable for all legal liabilities with respect to such content. Although we have set up certain procedures to enable copyright owners to provide us with notice of alleged infringement and have implemented a video fingerprint system to identify infringing content, given the volume of content uploaded it is not commercially feasible to identify and remove all potentially infringing content uploaded by our users.

Third parties may take action and file claims against us if they believe that certain content on our site violates their copyrights or other related legal rights. We have been subject to such claims in the PRC. From the inception of our business to June 8, 2011, we had been subject to 541 copyright infringement cases in the PRC, 349 of which had been concluded and the remaining 192 cases were ongoing. Among the concluded cases, we lost 170 cases, won 16 cases, settled 77 cases and 86 cases had been withdrawn by plaintiffs. The damage awards among the 170 lost cases range from RMB3,000 to RMB50,000 per infringement found, with more popular content typically giving rise to higher monetary damage awards. Although we have set up screening processes to try to filter out popular movie titles currently featured in Chinese cinema and are implementing a video fingerprint system to identify infringing content, we may not successfully filter out all potentially infringing content uploaded by our users and, therefore, anticipate that copyright infringement claims against us in the PRC will continue to arise. Moreover, since 2005, relevant PRC government

 

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authorities have jointly launched annual campaigns specifically aimed to crack down on Internet copyright infringement and piracy, which normally last for three to four months every year. In the past, several websites engaging in serious copyright infringement and piracy were shut down by relevant government authorities during such campaigns. Given the large volume of content uploaded by our users, we do not have the ability to identify and remove all potentially infringing content on our website, and we cannot assure you that we will not receive any penalties in such campaigns. In serious cases, the operating permits of the websites engaging in illegal activities may be revoked.

Furthermore, through cooperation with Tencent, we have established a substation at soso.tudou.com to allow the list of search results from Tencent’s search engine, including links to videos on third parties’ websites, to be presented on our own website. Some content found using such search engine facilities may be protected by copyright or other intellectual property rights. In China, uncertainties still exist with respect to the legal standards as well as the judicial interpretation of such standards for determining liabilities for our providing links to content on third-party websites that infringe others’ copyrights.

Additionally, although we have not previously been subject to legal actions for copyright infringement in jurisdictions other than the PRC, it is possible that we may be in the future. Such other jurisdictions may impose different protections for copyrights, and the claims may result in potentially larger damage awards than have been imposed in the PRC. For example, although our operations are in the PRC and our site is targeted at audiences in Asia, our site includes some English-language content and is accessible by users in the U.S. and elsewhere. There is a risk that a U.S. court may determine that it has jurisdiction over us for claims for U.S. copyrights. Although U.S. copyright laws, including the Digital Millennium Copyright Act (17 U.S.C. § 512), or the DMCA, provide safeguards from claims for monetary relief for copyright infringement for certain entities that host user-uploaded content and that comply with specified statutory requirements, and although we have recently taken additional steps in an effort to comply with the DMCA “safe habor” requirements, it is possible that a U.S. court would conclude that it has jurisdiction and that we are not eligible for the safeguards provided by the DMCA for infringement claims occurring prior to the implementation of those changes. Additionally, for claims of infringement arising after our additional efforts to comply with the DMCA safeguards, it is nonetheless possible that a U.S. court could conclude that we have not complied with all such statutory requirements to qualify for safe harbor status. Under such circumstances, it is possible that we could be subject to claims of copyright infringement in the U.S.

In December 2010, we were notified in a letter sent on behalf of certain American entertainment companies namely, Twentieth Century Fox Film Corporation, Universal City Studios LLLP, Viacom Inc., Paramount Pictures Corporation, and Warner Bros. Entertainment Inc., of alleged copyright infringement issues at and through our website, Tudou.com. This letter did not specify any particular acts of infringement or monetary losses allegedly suffered. We have entered into a copyright protection agreement with these entertainment companies to develop certain copyright protection measures, including filtering. In addition, we are adopting the procedures to improve our copyright protection policy and procedures, including implementing a video fingerprint system to identify infringing content on a real-time basis. We have not made any provision in our audited consolidated financial statements as of each balance sheet date for this matter. However, we cannot assure you that these entertainment companies will not file a claim against us. Any resulting litigation could be time consuming and costly, with inherent uncertainty as to the outcome. If these content owners successfully assert a claim for copyright infringement, the liability could have a material impact on our business, financial condition and results of operation.

In addition, although we have not previously been a party to legal actions for copyright infringement in jurisdictions other than the PRC, it is possible that we may be in the future.

In addition, although our license agreements with licensors of premium licensed content require that the licensors have the legal right to license to us such content, we cannot ensure each licensor has such authorization. If any purported licensor does not actually have sufficient authorization relating to the premium licensed content

 

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or right to license a work of authorship provided to us, we may be subject to claims of copyright infringement from third parties, and we cannot ensure we can be fully indemnified by the relevant licensor for all losses we may incur from such claims.

Any such claims in the PRC, U.S., or elsewhere, regardless of their merit, could be time-consuming and costly to defend, and may result in litigation and divert management’s attention and resources. Furthermore, an adverse determination in any such litigation or proceedings to which we may become a party in the PRC, U.S. or elsewhere could cause us to pay substantial damages. For example, statutory damage awards in the U.S. can range from US$750 to US$30,000 per infringement, and if the infringement is found to be intentional, can be as high as US$150,000 per infringement. Additionally, the risk of an adverse determination in such litigation or an actual adverse determination may result in harm to our reputation or in adverse publicity. The risk of an adverse result or the actual adverse result in litigation may also require us to seek licenses from third parties, pay ongoing royalties or become subject to injunctions requiring us to remove content or take other steps to prevent infringement, each of which could prevent us from pursuing some or all of our business and result in our users, advertisers and advertising agencies or potential users, advertisers and advertising agencies deferring or limiting their use of our services, which could materially adversely affect our financial condition and results of operations.

Maintaining copyright protection controls may be costly and our business may be placed at a competitive disadvantage.

Due to the low cost of piracy in China, some online video sites provide links to and host content on their websites which may infringe the copyright rights or other rights of third parties. We have developed a digital identification system, which codes video clips based on audio and video components and can identify video clips with codes similar to those in our own in-house “black list” of content. After receiving notice from copyright owners and licensees, we will update our black list by adding notified copyrighted content, and remove any UGC matching the listed items. Our copyright policies and user agreement prohibits users from illegally uploading copyright-protected content to our website. In addition, we need to allocate a significant portion of our working capital to purchase licenses for content. However, none of the foregoing procedures can eliminate the potential risk of infringing or illegal material from being posted on our website. Our revenues from online advertising services may not be sufficient to offset the cost of acquiring legally licensed content. On the other hand, our competitors may be able to derive revenues from illegal content which requires little or no capital expenditures. Our business may be placed at a competitive disadvantage compared with our competitors that incur lower operating expenses by offering and not monitoring their websites for illegal content.

We may not be able to adequately protect our intellectual property rights, and any failure to protect our intellectual property rights could adversely affect our revenues and competitive position.

We believe that trademarks, trade secrets, patents, copyrights, and other intellectual property we use are important to our business. We rely on a combination of trademark, copyright, patent 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. We have invested significant resources to develop our own intellectual property and acquire licenses to use and distribute the intellectual property of others for our online video site; failure to maintain or protect these rights could harm our business. In addition, any unauthorized use of our intellectual property by third parties may adversely affect our current and future revenues and our reputation.

The validity, enforceability and scope of protection available under intellectual property laws with respect to the Internet industry in China are uncertain and still evolving. Implementation and enforcement of PRC intellectual property-related laws have historically been deficient and ineffective. Accordingly, protection of intellectual property rights in China may not be as effective as in the United States or other western countries. Furthermore, policing unauthorized use of proprietary technology is difficult and expensive, and we may need to resort to litigation to enforce or defend patents issued to us or our other intellectual property or to determine the

 

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enforceability, scope and validity of our proprietary rights or those of others. Such litigation and an adverse determination in any such litigation, if any, could result in substantial costs and diversion of resources and management attention.

If we fail to continue to innovate and provide high-quality online video content to attract and retain users, we may not be able to generate sufficient user traffic to remain competitive.

Our success depends on providing online video content that enable users to have a high-quality online video viewing experience. We need to closely track evolving user tastes and preferences for online video services in order to maintain and grow our user base and to sell advertising services. In order to attract and retain users and compete effectively against our competitors, we must continue to invest significant resources in Internet bandwidth, content, and improving features and functionality of our online video platform to enhance our video viewing experience.

Historically, we have successfully encouraged our users to upload UGC that is attractive to our user base. However, we cannot assure you that we may continue to succeed in motivating our users to upload appealing UGC. Furthermore, we cannot assure you that our UGC support programs, such as talent development and training programs and monetary reward programs, will continue to incentivize our UGC producers to upload popular UGC. In addition to UGC, we license premium content from third parties. If we are not able to license popular premium content at commercially reasonable prices, or our desired premium content becomes exclusive to our competitors, the attractiveness of our website to users will be severely impaired. We also produce content in-house, and plan to invest significant resources in producing content. In May 2010, we launched “Orange Box,” a program to produce “Made-for-Internet” drama series. However, user tastes and preferences change quickly. If we are unable to anticipate user preferences or industry changes, or if we are unable to select premium licensed content or produce in-house content to meet user tastes and preferences on a timely basis, we may lose users, and our operating results may suffer. Moreover, our competitors may be able to offer video viewing experience that is better than that offered by us. This may force us to expend significant resources in order to remain competitive.

We depend on a limited number of advertisers for a significant portion of our revenues. Failure to maintain relationships with these advertisers may cause significant fluctuations or declines in our revenues.

We depend on a limited number of advertisers for a significant portion of our revenues. Our top 10 advertisers accounted for approximately 32.3%, 29.6%, 21.8% and 21.3% of our net revenues in 2008, 2009, 2010 and the three months ended March 31, 2011, respectively. We generally do not maintain long-term contracts or exclusive arrangements with advertisers, and competition for these advertisers is intense. We cannot assure you that we will be able to maintain our relationships with them. We anticipate that our dependence on a limited number of advertisers will continue in the foreseeable future. Consequently, our failure to maintain relationships with these advertisers could materially and adversely affect our business, financial condition, results of operations and prospects.

We rely on advertising agencies for substantially all of our sales. Our failure to maintain and enhance relationships with advertising agencies could materially and adversely affect our gross margin. In addition, the consolidation of advertising agencies in China could increase the bargaining power of larger advertising agencies, which may adversely impact our net revenues.

As is customary in the advertising industry in China, we typically enter into advertising contracts with third-party advertising agencies. In China’s advertising industry, advertising agencies typically have long-standing relationships with the advertisers they represent. We intend to leverage advertising agencies’ relationships and network resources to increase our sales and expand our advertiser base. Therefore, we typically enter into advertising contracts with third-party advertising agencies, which represent advertisers, although we have direct contact with such advertisers. As a result, we rely on third-party advertising agencies for substantially all of our sales to, and collection of payment from, our advertisers. In addition, we depend on a limited number of

 

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advertising agencies for a significant portion of our revenues. Our top 10 advertising customers, consisting primarily of advertising agencies, accounted for approximately 51%, 52%, 46% and 55% of the net revenues for the years ended December 31, 2008, 2009 and 2010 and the three months ended March 31, 2011, respectively. We do not have long-term or exclusive arrangements with these agencies, and we cannot assure you that we will continue to maintain favorable relationships with them. If we fail to maintain favorable relationships with large advertising agencies or attract additional agencies, we may not be able to retain existing advertisers or attract new advertisers and our business and results of operations could be materially and adversely affected.

In addition, there have been mergers and acquisitions among advertising agencies. If the online advertising market is consolidated and effectively controlled by a small number of large advertising agencies, such advertising agencies may be in a position to demand higher agency fees based on increased bargaining power, which could reduce our net revenues.

The financial soundness and settlement pattern of advertisers and advertising agencies working with us could affect our collection of accounts receivable, as well as our results of operations and cash flows.

Our business depends on our ability to successfully obtain payment of the amounts owed to us for work performed. We typically enter into advertising contracts with third-party advertising agencies and collect payments from them; occasionally we enter into advertising contracts with and collect payments from advertisers. We generally offer credit terms of 90 days; however, the actual payment term is significantly impacted by the settlement from both advertising agencies and advertisers, which is also subject to their payment policies. As of December 31, 2008, 2009 and 2010 and March 31, 2011, our accounts receivable balance net of allowance for doubtful accounts was RMB23.7 million, RMB71.1 million, RMB243.0 million and RMB254.1 million (US$38.8 million), respectively. The average turnover for our accounts receivable was 139 days in 2009, 149 days in 2010 and 210 days for the first quarter of 2011. The average turnover for accounts receivable is the average period it takes for outstanding invoices to be paid in full after issuance, which is equal to the average of accounts receivable at the beginning of a period and the accounts receivable at the end of a period, divided by net revenues adding back sales taxes and agency fees over the period, and multiplied by the number of days during the period. The financial soundness of advertising agencies and advertisers working with us will affect our collection of account receivables. Failure to collect our receivables in a timely manner may adversely affect our cash flows, our operations and our business strategy, such as funding our expansion of internet bandwidth capacity, procuring premium licensed content, and enhancing our technology platform. Since we generally do not require collateral or other security from advertising agencies, we establish a provision for doubtful accounts based upon estimates, historical experience and other factors surrounding the credit risk of specific advertising agencies and advertisers. In 2009, 2010 and the three months ended March 31, 2011, we recorded RMB3.5 million, RMB7.5 million and RMB12.3 million (US$1.9 million) for an allowance for doubtful accounts, respectively. However, actual losses on client receivables balance could differ from those that we anticipate and as a result we might need to adjust our allowance. There is no guarantee that we will accurately assess the creditworthiness of advertising agencies and advertisers. Macroeconomic conditions, including turmoil in the global financial system, could also result in financial difficulties for advertising agencies and advertisers, including limited access to the credit markets, insolvency or bankruptcy, and as a result could cause advertising agencies to delay payments to us, request modifications to their payment arrangements that could increase our receivables balance, or default on their payment obligations to us. We do not expect the age of our accounts receivable to significantly improve in the foreseeable future. Any inability of current or potential advertising agencies to pay us may adversely affect our results of operations and cash flows.

We depend on China Mobile and China Unicom for revenues derived from our mobile video services, and any loss or deterioration of our relationships with China Mobile and China Unicom may result in severe disruptions to our mobile video services.

We rely on China Mobile’s and China Unicom’s wireless video platforms for mobile video services we distribute to their mobile subscribers. The mobile phone users pay a monthly subscription fee or pay on a per-clip

 

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basis, and we share the fees with China Mobile and China Unicom. The agreement with China Mobile has a one-year term originally expiring on November 1, 2010. We have renewed this agreement for another term ending November 1, 2011, but we cannot assure that we will be able to further renew it upon expiration. In addition, we cannot enter into similar arrangements with other telecommunication operators during the term of the agreement with China Mobile pursuant to the exclusivity provision under the agreement. Despite this exclusivity provision, we entered into a cooperation agreement with a joint venture of China Unicom in order to expand our mobile video services business. Although the cooperation model with this joint venture is different from that with China Mobile, China Mobile might deem it as an event of default under our agreement with them, and as a result, claim for termination of the cooperation with us and seek damages caused by such breach from us. The agreement with the joint venture of China Unicom has a three-year term expiring on March 31, 2014, and we cannot assure that we will be able to renew it upon expiration. Any loss or deterioration of our relationships with China Mobile or China Unicom and its joint venture may result in severe disruptions to our mobile video services business and the loss of this source of our revenues, which we regard as an important component of our future growth strategy. In addition, as China Mobile or the joint venture of China Unicom is not prevented under the contract from cooperating with other mobile video providers, our mobile video services also face competition or pricing pressure from such providers.

The increase of Internet bandwidth costs may materially adversely affect our gross margins, our business, financial condition and results of operations.

The procurement of Internet bandwidth has historically accounted for the majority of our cost of revenues. Our Internet bandwidth costs amounted to RMB106.9 million, RMB74.4 million, RMB103.6 million and RMB31.2 million (US$4.8 million) in 2008, 2009, 2010 and the three months ended March 31, 2011, respectively, representing 74.6%, 58.5%, 45.8% and 38.5% of our total cost of revenues in 2008, 2009, 2010 and the three months ended March 31, 2011, respectively. We lease Internet bandwidth from the provincial subsidiaries of China Telecom and China Unicom, as well as independent third-parties that procure Internet bandwidth from telecommunication operators. The provincial subsidiaries of China Telecom and China Unicom currently function as independent companies, and we negotiate leasing prices separately with them or with independent third-party bandwidth vendors. In the near term, we expect our costs of Internet bandwidth to increase in absolute amount given the anticipated increase in our user traffic and online video content library. We cannot assure you that we will be able to lease 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 effectiveness of our website to both users and advertisers. In addition, if China Telecom and China Unicom centralize the pricing of Internet bandwidth, lease Internet bandwidth through competitive tender processes or otherwise increase Internet bandwidth leasing prices, our Internet bandwidth leasing costs may substantially increase, which could significantly increase our cost of revenues and materially adversely affect our gross margins, financial condition and results of operations.

If we are not able to continue to procure premium licensed content at a commercially acceptable cost, our business, financial condition and results of operations will be materially and adversely impacted.

We need to license and acquire popular video content to deliver a differentiated and engaging experience for our users and present attractive advertising opportunities for advertisers. We believe that popular premium licensed content will help increase our user base and overall traffic and is a critical factor in our future success. During the three years ended December 31, 2009, we obtained licenses for more than 830 TV episodes and 240 movies. In 2010, we significantly increased our content procurement and obtained licenses for more than 1,360 TV episodes, 1,180 movies and 180 variety shows. In the three months ended March 31, 2011, we obtained licenses for more than 1,440 TV episodes, 1,260 movies and 210 variety shows. We expect that our investment in premium licensed content will significantly increase in the foreseeable future as we plan to procure more premium licensed content and unit procurement costs, such as licensing fees for TV episodes and movies, continue to increase. If we are unable to procure premium licensed content at a commercially acceptable cost, or generate sufficient revenues to outpace the increase in market prices for premium licensed content, our business, financial condition and results of operations will be materially and adversely impacted.

 

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We rely on proper operation and maintenance of our website and our network infrastructure. Any malfunction, capacity constraint or operation interruption for any extended period may have an adverse impact on our online video business.

The satisfactory performance, stability, security and availability of our Tudou.com site and our network infrastructure are critical to our reputation and our ability to attract and retain users and advertisers. Our information system provides a database of information regarding user data, advertising records, premium licensed content and various other facets of the business to assist management and help ensure effective communication among various departments and offices of our company. A key element of our business is to generate a high volume of user traffic on our Tudou.com site. Accordingly, any failure to maintain the satisfactory performance, stability, security and availability of our website and technology platform may cause significant harm to our reputation and our ability to attract and maintain Internet users, which may affect our advertisers’ interest in advertising their products and services on our site. From time to time, our users in certain locations cannot gain access to our Tudou.com site for a period of time lasting from several minutes to several hours, due to server interruptions, power shutdowns, Internet connection problems or other reasons. Although we have not experienced an extended period of such server interruptions, power shutdowns or Internet connection problems before, we cannot assure you that such instances will not occur in the future. Any server interruptions, break-downs or system failures, including failures which may be attributable to events within or outside our control that could result in a sustained shutdown of all or a material portion of our Tudou.com website, could reduce the attractiveness of our product offerings. In addition, any substantial increase in the volume of traffic on the Tudou.com site will require us to increase our investment in bandwidth, expand and upgrade further our technology platform. There can be no assurance that we will be able to accurately project the rate or timing of such increases or timely expand and upgrade our systems and technology platform to accommodate such increases. Our network systems are also vulnerable to damage from computer viruses, fires, floods, earthquakes, power losses, telecommunication failures, computer hacking and similar events. We do not maintain insurance policies covering losses relating to our network systems. As a result, any capacity constraints or operation interruptions for any extended period may have a materially adverse impact on our revenues and results of operations.

We depend on our key personnel for the success of our business, and losing their services would severely disrupt our business.

Our future success is heavily dependent upon the continued service of our key executives, such as Gary Wei Wang, our founder, chairman and chief executive officer. If we lose the services of any key senior management member or other key employees, we may not be able to locate suitable or qualified replacements, and may incur additional expenses to recruit and train new personnel, which could severely disrupt our business and growth. In addition, if any of these key executives or employees joins a competitor or forms a competing company, we could lose advertisers, advertising agencies and content providers and incur additional expenses to recruit and train personnel. Each of our executive officers has entered into an employment agreement and a confidentiality, non-competition and non-solicitation agreement with us. As we believe is customary in our industry in China, we do not maintain key-man life insurance for any of our key executives.

Competition for personnel in the online video and advertising industry is intense, and the availability of suitable and qualified candidates in China is limited. Competition for qualified individuals could cause us to offer higher compensation and other benefits to attract and retain them, which could materially and adversely affect our financial condition and results of operations. We previously awarded share-based compensation to our senior management and key employees, some of which has not yet vested. Such retention awards may cease to be effective to retain our current employees once the shares vest.

If we fail to keep up with rapid changes in technologies and their impact on user behavior, our future success may be adversely affected.

The industry in which we operate is subject to rapid technological changes. Our future success will depend on our ability to respond to rapidly changing technologies, adapt our services to evolving industry standards and

 

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improve the performance and reliability of our services. Our failure to adapt to such changes could harm our business. In addition, changes in user behavior resulting from technological changes may also adversely affect us. For example, the number of people accessing the Internet through devices other than personal computers, including mobile phones, hand-held devices and other content delivery means or methods has increased in recent years. With the introduction of 3G mobile services by all three mobile carriers in China in 2009, we expect this trend to continue. If we are slow to develop solutions and technologies that are compatible with new mobile networks or new technologies, or if the solutions and technologies we develop are not widely accepted and used by users of non-PC communications devices, we may not be able to capture a significant share of this increasingly important market. In addition, the widespread adoption of new Internet, networking or telecommunications technologies or other technological changes could require substantial expenditures to modify or adapt our products, services or technology platform. If we fail to evolve with rapid technological changes to remain competitive, our future prospects and results of operations may be adversely affected.

Undetected programming errors or flaws or failure to maintain effective customer service could harm our reputation or decrease market acceptance of our video programs, which would materially and adversely affect our results of operations.

The video programs, including our advertising video programs, on our website may contain errors or flaws, which may only become apparent after their release. From time to time, our users inform us of programming flaws affecting their user experience, and we may also detect programming flaws and errors when we monitor our video advertisements. We generally have been able to resolve such flaws and errors. However, we cannot assure you that we will be able to detect and resolve all these programming flaws and errors in a timely manner. Undetected programming errors, defects and resulting unsatisfactory customer service to users can disrupt our operations, adversely affect user experience, harm our reputation, cause our users and advertisers to reduce their use of our services, any of which could materially and adversely affect our results of operations.

If we fail to effectively manage our growth, our business, financial condition, results of operations and business prospects may be materially adversely affected.

We have limited operational, administrative and financial resources, which may be inadequate to sustain our rapid growth. If our user base continues to expand, we will need to increase our investment in Internet bandwidth and technology platform, facilities and other areas of operations, including customer service and sales and marketing. We expect to procure more Internet bandwidth and more premium licensed content to deliver a differentiated and engaging experience for our users and present attractive advertising opportunities for advertisers. Our future success will depend on, among other things, our ability to effectively maintain our relationships with our key advertisers, advertising agencies, content partners, mobile network operators and other strategic partners, to continue training, motivating and retaining our key employees and attract and integrate new employees, to develop and improve our operational, financial, accounting and other internal systems and controls, and to maintain adequate controls and procedures to ensure that our periodic public disclosure under applicable laws, including U.S. securities laws, is complete and accurate.

We have experienced a period of rapid growth and expansion that has placed, and continues to place, significant strain on our management personnel, systems and resources. To accommodate our growth, we anticipate that we will need to implement a variety of new and upgraded operational and financial systems, procedures and controls, including the improvement of our accounting and other internal management systems, all of which require substantial management efforts. We also will need to continue to expand, train, manage and motivate our workforce, and manage our relationships with advertisers, advertising agencies as well as content providers. These efforts require substantial management efforts and skills and may incur additional expenditures. In addition, acquisition of companies that have historical non-compliance issues may bring us more risks. For example, Tudou Limited, a Hong Kong company that we acquired in February 2011, failed to conduct certain corporate actions in compliance with the relevant Hong Kong laws, including making mandatory provident fund contribution for its three employees. We have performed a legal analysis of the acquisition with our counsel and

 

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concluded that it is not likely Tudou Limited will be penalized by the relevant authority. We are not able to estimate the amount of any financial penalty as the relevant authority has the sole discretion to determine it. Our inability to effectively manage our growth may adversely affect our business, financial condition, results of operations and business prospects.

In preparing our consolidated financial statements as of and for the years ended December 31, 2008, 2009 and 2010, we noted a material weakness and a significant deficiency in our internal control over financial reporting. If we fail to achieve or maintain an effective internal control system over financial reporting, our ability to accurately and timely report our financial results or prevent fraud may be adversely affected.

Prior to this offering, we have been a private company with limited accounting personnel and other resources with which to address our internal controls and procedures over financial reporting. In the course of the preparation and the external audit of our consolidated financial statements for the years ended December 31, 2008, 2009 and 2010, we and our independent registered public accounting firm identified a number of deficiencies in our internal control over financial reporting, including a material weakness and a significant deficiency as defined in the standards established by the U.S. Public Company Accounting Oversight Board. The material weakness identified was the lack of resources with appropriate accounting knowledge and experience to prepare and review financial statements and related disclosures in accordance with U.S. GAAP, which was evidenced by (i) the lack of sufficient resources with adequate U.S. GAAP knowledge and experience to identify, evaluate and conclude on certain accounting matters independently, and (ii) the lack of effective controls designed and in place to ensure the completeness and accuracy of the consolidated financial statements and the disclosures in accordance with U.S. GAAP, which resulted in errors mainly in recording and accounting for redeemable convertible preferred shares, share-based compensation, accrual for litigation losses, agency fees, and certain balance sheet line item reclassifications.

The material weakness in our internal control over financial reporting could result in a material misstatement of our financial statements that will not be prevented or detected. For instance, when we historically recorded agency fees as cost of revenues for the years ended December 31, 2008 and 2009, we failed to recognize it as an accounting error as a result of the material weakness in our internal control over financial reporting. We have restated our financial statements to reclassify the agency fees as a reduction of revenues rather than as cost of revenues. The reclassification resulted in a downward adjustment of RMB4.7 million and RMB24.1 million in our net revenues for the years ended December 31, 2008 and 2009, respectively, and a corresponding downward adjustment of RMB4.7 million and RMB24.1 million in our cost of revenues for the years ended December 31, 2008 and 2009, respectively. The adjustment had no other impact on previously reported statements of operations. In addition, the adjustment did not affect our consolidated balance sheets, consolidated statements of change in shareholders’ deficit or consolidated statements of cash flows.

Following the identification of this material weakness and significant deficiency, we are in the process of implementing a number of measures to improve our internal control over financing reporting in order to obtain reasonable assurance regarding the reliability of our financial statements. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Restatement and Internal Control Over Financial Reporting.” However, the implementation of these actions and measures may not be sufficient to address the material weakness and significant deficiency in our internal control over financial reporting to provide reasonable assurance that our internal control over financial reporting is effective, and we may not be able to conclude that such control deficiencies have been fully remedied. Our failure to achieve and maintain effective internal control over financial reporting could result in the loss of investor confidence in the reliability of our financial statements, which in turn could harm our business and negatively impact the market price of our ordinary shares.

In addition, upon completion of this offering, we will become a public company in the United States and will be subject to reporting obligations under the U.S. securities laws. Section 404 of the Sarbanes-Oxley Act of 2002, or Section 404, requires that we include a management report that assesses 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

 

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year ending December 31, 2011. Furthermore, our independent registered public accounting firm will be required to attest to and report on the effectiveness of our internal control over financial reporting. Our management may conclude that our internal control over financial reporting is not effective. Moreover, even if our management concludes that our internal control over financial reporting is effective, our independent registered public accounting firm may still issue a report that is qualified if it is not satisfied with our internal controls or the level at which our controls are documented, designed, operated or reviewed. Our reporting obligations as a public company may place a significant strain on our management, operational and financial resources and systems for the foreseeable future.

Our quarterly revenues and operating results are difficult to predict and could fall below investor expectations, which could cause the trading price of our ADSs to decline.

Our quarterly revenues and operating results have fluctuated in the past and may continue to fluctuate significantly depending upon numerous factors. In particular, our revenues may be affected by seasonality of advertising spending in China. For instance, we typically have slightly lower sales during the first quarter of each year primarily due to Chinese New Year holidays in that quarter. Other factors that may affect our financial results include, among others:

 

   

global economic conditions;

 

   

changes in government policies or regulations, or their enforcement;

 

   

our ability to attract and retain advertisers; and

 

   

our ability to maintain and increase user traffic.

In addition, we expect to continue to experience the impact of major non-cash items on our results of operations. Share-based compensation charges are the primary non-cash item that impact our financial results and we expect to continue to incur substantial charges in the future. Determining the value of our share-based compensation expense in future periods requires the input of highly subjective assumptions, including the expected life of the share-based payment awards, estimated forfeitures and the price volatility of the underlying shares. Furthermore, fluctuations in the fair value of certain warrants we issued in April and July 2010 may affect our financial results. We classified the warrants as liabilities. The warrants are carried subsequently at fair value on each balance sheet date and the changes in their fair value are recognized in the consolidated statements of operations. We recorded RMB124.7 million and RMB170.4 million (US$26.0 million) loss of fair value changes in warrant liabilities for 2010 and the three months ended March 31, 2011, respectively. Fluctuations in the fair value of the ordinary shares will result in corresponding fluctuations in our warrant liabilities, which would in turn have an impact on our financial results. Therefore, if there is any substantial increase in the fair value of our ordinary shares, the expenses as a result of the fair value changes in warrant liabilities will be substantially increased, and our result of operations will be materially and adversely affected as a result. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates—Fair Value Changes in Warrant Liabilities” and “—Description of Certain Statement of Operations Items—share-based compensation.”

The above factors are generally beyond our control, making our quarterly results difficult to predict, which could cause the trading price of our ADSs to decline below investor expectations. You should not rely on our results of operations for prior quarters as an indication of our future results.

Fluctuations in exchange rates have resulted in, and are expected to continue to result in, foreign exchange losses and to adversely impact our profitability.

Fluctuation in the value of the Renminbi may have a material adverse effect on the value of your investment. The value of the Renminbi against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in political and economic conditions. On July 21, 2005, the PRC government

 

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changed its decade-old policy of pegging the value of the Renminbi to the U.S. dollar. Under this policy, the Renminbi was permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. For almost two years after reaching a high against the U.S. dollar in July 2008, the Renminbi traded within a narrow band against the U.S. dollar, remaining within 1% of its July 2008 high. As a consequence, the Renminbi fluctuated sharply since July 2008 against other freely traded currencies, in tandem with the U.S. dollar. In June 2010, the PRC government announced that it would increase Renminbi exchange rate flexibility and since that time the Renminbi has gradually appreciated against the U.S. dollar. However, it remains unclear how this flexibility might be implemented. There remains significant international pressure on the PRC government to adopt a more flexible currency policy, which could result in greater fluctuation of the Renminbi against the U.S. dollar.

Our financial statements are expressed in Renminbi, and most of our assets, costs and expenses are denominated in Renminbi. Substantially all of our revenues were denominated in Renminbi. We principally rely on dividends and other distributions paid to us by our subsidiaries in China. Our results of operations and the value of your investment in our ADSs will be affected by the foreign exchange rate between U.S. dollars and Renminbi. To the extent we hold assets denominated in U.S. dollars, including the net proceeds to us from this offering as well as cash from other financing activities, any appreciation of the Renminbi against the U.S. dollar could result in a charge to our income statement and a reduction in the value of our U.S. dollar denominated assets. On the other hand, a decline in the value of Renminbi against the U.S. dollar could reduce the U.S. dollar equivalent amounts of our financial results, the value of your investment in our company and the dividends we may pay in the future, if any, all of which may have a material adverse effect on the prices of our ADSs.

Limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. We did not enter into any forward contracts to hedge our exposure to Renminbi-U.S. dollar exchange risk, although we bought Euros and Australian dollars in 2009 to diversify our foreign currency balances and to mitigate foreign exchange risk associated with the U.S. dollar’s depreciation against the Renminbi. 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 successfully hedge our exposure 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.

Our principal shareholders, directors and executive officers own a large percentage of our shares and will, following the completion of this offering, have             % of our aggregate voting power, allowing them to exercise substantial influence over matters subject to shareholder approval.

Following the completion of this offering, our executive officers, directors and principal shareholders holding 5% or more of our outstanding shares as well as their affiliates own             % of the our total issued and outstanding shares and             % of our aggregate voting power, assuming no exercise of the underwriters’ over-allotment option. Accordingly, these executive officers, directors and principal shareholders have substantial influence over the outcome of corporate actions requiring shareholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transaction, and their interests may not align with the interests of our other shareholders. These shareholders may also delay or prevent a change of control or otherwise discourage a potential acquirer from attempting to obtain control of us, even if such a change of control would benefit our other shareholders. This significant concentration of share ownership may adversely affect the trading price of our ADSs due to investors’ perception that conflicts of interest may exist or arise.

 

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We may need additional capital, and we may be unable to obtain such capital in a timely manner or on acceptable terms, or at all. Furthermore, our future capital needs may require us to sell additional equity or debt securities that may dilute our shareholders or introduce covenants that may restrict our operations or our ability to pay dividends.

To grow our business and remain competitive, we may require additional capital. Our ability to obtain additional capital is subject to a variety of uncertainties, including:

 

   

our future financial condition, results of operations and cash flows;

 

   

general market conditions for capital raising activities by online video and other Internet companies; and

 

   

economic, political and other conditions in China and internationally.

We may be unable to obtain additional capital in a timely manner or on acceptable terms or at all. In addition, our future capital needs and other business reasons could require us to sell additional equity or debt securities or obtain a credit facility. The sale of additional equity or equity-linked securities could dilute our shareholders. The incurrence of indebtedness would result in increased debt service obligations and could result in operating and financing covenants that would restrict our operations or our ability to pay dividends to our shareholders.

If we grant employee share options, restricted shares or other equity incentives in the future, our net income could be adversely affected.

We adopted a share incentive plan in 2006, as amended and restated in 2008 and 2010, respectively. We are required to account for share-based compensation in accordance with Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, topic 718, Compensation—Stock Compensation, which requires a company to recognize, as an expense, the fair value of share options and other equity incentives to employees based on the fair value of equity awards on the date of the grant, with the compensation expense recognized over the period in which the recipient is required to provide service in exchange for the equity award. As of March 31, 2011, options to purchase a total of 8,753,245 ordinary shares under our share incentive plan were outstanding. As a result, we incurred share-based compensation expenses of RMB11.3 million, RMB11.5 million, RMB104.6 million, negative RMB7.3 million and RMB106.6 million (US$16.3 million) in 2008, 2009, 2010 and the three months ended March 31, 2010 and 2011, respectively. If we grant more options, restricted shares or other equity incentives, we could incur significant compensation charges and our results of operations could be adversely affected. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” and Notes 2(t) and 13 to our consolidated financial statements included in this prospectus for a more detailed presentation of accounting for our share-based compensation plans.

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

Our new amended and restated articles of association will become effective immediately upon the completion of this offering. Our new articles of association limit the ability of others to acquire control of our company or cause us to engage in change-of-control transactions. These provisions could deprive our shareholders of an opportunity to sell their shares at a premium over prevailing market prices by discouraging third parties from seeking to obtain control of our company in a tender offer or similar transaction. For example, our board of directors has the authority, without further action by our shareholders, to issue preferred shares in one or more series and to fix their designations, powers, preferences, privileges and relative participating, optional or special rights and the qualifications, limitations or restrictions, including dividend rights, conversion rights, voting rights, terms of redemption and liquidation preferences, any or all of which may be greater than the rights associated with our ordinary shares, in the form of ADS or otherwise. Preferred shares could be issued quickly with terms calculated to delay or prevent a change in control of our company or to make removal of

 

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management more difficult. If our board of directors issues preferred shares, the price of our ADSs may fall and the voting and other rights of the holders of our ordinary shares and ADSs may be adversely affected.

Our dual-class ordinary share structure with different voting rights could discourage others from pursuing any change of control transactions that holders of our Class B ordinary shares and ADSs may view as beneficial.

On October 28, 2010, our shareholders adopted a dual-class ordinary share structure effective immediately prior to the completion of this offering. Our ordinary shares are divided into Class A ordinary shares and Class B ordinary shares. Holders of Class A ordinary shares are entitled to four votes per share, while holders of Class B ordinary shares are entitled to one vote per share. We will issue Class B ordinary shares represented by our ADSs in this offering. First Easy, a holder of our ordinary shares controlled by Mr. Gary Wei Wang, our founder, chairman and chief executive officer, will hold 10,633,333 Class A ordinary shares. Fast Action, a holder of our ordinary shares, will hold 700,000 Class B ordinary shares, and all our preferred shares, including those issuable upon the exercise of any outstanding warrants, will convert into 69,914,684 Class B ordinary shares immediately prior to the completion of this offering. Upon the completion of this offering, First Easy, the sole holder of our outstanding Class A ordinary shares will represent []% of our aggregate voting power, and holders of our outstanding Class B ordinary shares will represent []% of our aggregate voting power, assuming no exercise of the underwriters’ over-allotment option. We intend to maintain the dual-class ordinary share structure after the completion of this offering. In addition, Mr. Gary Wei Wang beneficially owns an option to purchase a total of 1,057,500 Class A ordinary shares which, if exercised, will increase the number of the Class A ordinary shares controlled by him, resulting in his controlling []% of our aggregate voting power, assuming the option were exercised immediately following this offering. Each Class A ordinary share is convertible into one Class B ordinary share at any time by the holder thereof. Class B ordinary shares are not convertible into Class A ordinary shares under any circumstances. Upon any pledge, transfer or disposition of Class A ordinary shares by a holder thereof to any person or entity which is not an affiliate of this holder, or upon Mr. Gary Wei Wang’s ceasing to be employed by us as chief executive officer, such Class A ordinary shares shall be automatically and immediately converted into an equal number of Class B ordinary shares.

Due to the disparate voting powers attached to these two classes, Mr. Gary Wei Wang will have significant voting power over matters requiring shareholder approval, including election of directors and significant corporate transactions, such as a merger or sale of our company or our assets. This concentrated control could discourage others from pursuing any potential merger, takeover or other change of control transactions that holders of Class B ordinary shares and ADSs may view as beneficial.

We may be classified as a passive foreign investment company, which could result in adverse U.S. federal income tax consequences to U.S. Holders of our ADSs or ordinary shares.

We do not expect to be a passive foreign investment company, or PFIC, for U.S. federal income tax purposes for our current taxable year or in the foreseeable future. However, the application of the PFIC rules is subject to uncertainty in several respects, and we cannot assure you the U.S. Internal Revenue Service will not take a contrary position. A non-U.S. corporation will be a PFIC for any taxable year if either (i) at least 75% of its gross income for such year is passive income or (ii) at least 50% of the value of its assets (based on an average of the quarterly values of the assets) during such year is attributable to assets that produce passive income or are held for the production of passive income. We must make a separate determination after the close of each taxable year as to whether we were a PFIC for that year. Because the value of our assets for purposes of the PFIC test will generally be determined by reference to the market price of our ADSs and ordinary shares, fluctuations in the market price of the ADSs and ordinary shares may cause us to become a PFIC. In addition, changes in the composition of our income or assets may cause us to become a PFIC. If we are a PFIC for any taxable year during which a U.S. Holder (as defined in “Taxation—United States Federal Income Taxation”) holds an ADS or ordinary share, certain adverse U.S. federal income tax consequences could apply to such U.S. Holder. See “Taxation—United States Federal Income Taxation—Passive Foreign Investment Company.”

 

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We are a Cayman Islands company and, because judicial precedent regarding the rights of shareholders is more limited under Cayman Islands law than that under U.S. law, you may have less protection for your shareholder rights than you would under U.S. law.

Our corporate affairs are governed by our memorandum and articles of association, as amended and restated from time to time, the Companies Law (as amended) of the Cayman Islands and the common law of the Cayman Islands. The rights of shareholders to take action against the directors, actions by minority shareholders and the fiduciary responsibilities of our directors to us under Cayman Islands law 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 has persuasive, but not binding, authority on a court in the Cayman Islands. 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 precedent in some jurisdictions in the United States. In particular, the Cayman Islands has a less developed body of securities laws than the United States. In addition, some U.S. states, such as Delaware, have more fully developed and judicially interpreted bodies of corporate law than the Cayman Islands.

As a result of all of the above, public shareholders may have more difficulty in protecting their interests in response to actions taken by management, members of the board of directors or controlling shareholders than they would as shareholders of a U.S. public company.

You may have difficulty enforcing judgments obtained against us.

We are a Cayman Islands company and substantially all of our assets are located outside of the United States. We conduct substantially all of our operations in the PRC. In addition, most of our directors and officers are nationals and residents of countries other than the United States. As a result, it may be difficult for you to effect service of process upon these persons in the United States. It may also be difficult for you to enforce judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us and our officers and directors, most of whom are not residents in the United States and the substantial majority of whose assets are located outside of the United States. In addition, the courts of the Cayman Islands or the PRC may not recognize or enforce judgments of U.S. courts against us or such persons predicated upon the civil liability provisions of the securities laws of the United States or any state. Furthermore, such Cayman Islands or PRC courts may not be competent to hear original actions brought in the Cayman Islands or the PRC against us or such persons predicated upon the securities laws of the United States or any state. See “Enforceability of Civil Liabilities.”

The recent global recession and the challenges the Chinese economy faces as a result could adversely affect the demand for our products and our results of operations.

The global recession in recent years has resulted in a general slowdown of economic growth and higher unemployment rates. It is difficult to predict how long these conditions will persist and when, how fast and where recoveries will take place. In addition, China’s economy experienced a slowdown after the second quarter of 2008, when the quarterly growth rate of China’s gross domestic product reached 10.1%, and was further exacerbated by the recent global financial crisis and economic downturn. In the first quarter of 2009, the growth rate of China’s gross domestic product decreased to 6.2% on an annual basis. Beginning in September 2008, among other measures, the PRC government began to loosen fiscal measures and monetary policies by reducing interest rates and lowering the statutory reserve requirements for banks. In addition, in November 2008, the PRC government announced a US$586 billion economic stimulus package. Due to the stimulus package and other measures implemented by the Chinese government in response to the global economic crisis, China managed to maintain an 8.7% growth rate of its gross domestic product in 2009. It is still uncertain how long the global recession will continue and how much of an adverse impact it will have on the global and the Chinese economy. We cannot assure you that the various fiscal measures and monetary policies adopted by the PRC government, including the economic stimulus package discussed above, will be effective in sustaining the growth of the

 

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Chinese economy. Any of the foregoing events would adversely affect our business, financial conditions and results of operations.

We face risks related to natural disasters and health epidemics in China, which could materially adversely affect our business and results of operations.

Our business could be materially and adversely affected by natural disasters or the outbreak of health epidemics in China. Our operations may be vulnerable to any health epidemic. In the last decade, the PRC has suffered health epidemics related to the outbreak of avian influenza and severe acute respiratory syndrome, or SARS. In April 2009, an outbreak of the H1N1 virus, also commonly referred to as “swine flu,” occurred in Mexico and has spread to other countries, including China. If the outbreak of swine flu were to become widespread in China or increase in severity, it could adversely affect economic activity in China and our business and operations. Any future natural disasters or health epidemics in the PRC could also materially adversely affect our business and results of operations.

Risks Relating to Doing Business in China

The regulation of the Internet industry is new and subject to interpretation in China, and our business could be adversely affected if we are deemed to have violated applicable laws and regulations.

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.

Under current regulations issued by the State Administration of Radio, Film, and Television, or the SARFT, transmission of audio and visual programs online requires a SARFT license; an applicant for engaging in Internet audio-visual program service must be a state-owned entity or a state-controlled entity with full corporate capacity; and the business to be carried out by the applicant must satisfy the overall planning and guidance catalog for Internet audio-visual program service determined by SARFT. See “Regulation—Regulation on Online Transmission of Audio-visual Programs.” Neither our PRC subsidiaries nor our VIEs in China are state-owned or state-controlled companies, and may not be qualified applicants for carrying out Internet audio-visual program services. However, we obtained our SARFT license in September 2008, and amended our license in terms of scope of programs in January 2010. Therefore, we are permitted to continue to operate our online video business in China until January 2013, when our SARFT license will expire. We cannot assure you that we will be able to renew our SARFT license. Our renewal application may be denied because we are not a stated-owned or state-controlled company. If we fail to renew our SARFT license, we will no longer be eligible to engage in transmission of audio and visual programs through Internet, which would have a material adverse effect on our business. In such event, we may be subject to penalties including administrative fines for operation without such SAFRT license and we may be ordered by the PRC government to cease transmission of audio-visual programs through Internet and Internet information services for lack of the SARFT license.

We may also be required to obtain an Internet news license from the State Council News Office, or SCNO, for the dissemination of news through our website. See “Regulation—Regulation on Internet News Dissemination.” We are in process of applying for an Internet news license. We cannot assure you that we will be able to obtain one. Without such license for dissemination of news video clips through Internet, we may receive a warning notice from the PRC government to remove all relevant videos and to cease dissemination of news video clips in the future. We may also be subject to administrative fines from RMB10,000 to RMB30,000, and in severe cases, as determined by the PRC government, we may be ordered to cease Internet information services. To date, we have not received any warning notice or penalties from the relevant governmental authority regarding our dissemination of news through our website.

Furthermore, each film, TV series, TV animation or academic and documentary films to be broadcasted online in China must obtain a prior permit from SARFT. See “Regulation—Regulation on Online Transmission

 

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of Audio-visual Programs.” We cannot assure you that each video clip of such program on our website has obtained such prior permit. We may be subject to administrative penalties including warning, order for rectification, fines and in the worst cases, our SARFT license may be revoked. In addition, we may not legally allow users to view the video clips without such permit, and thus may not be able to recoup licensing costs we have paid for the clips.

In addition, although we currently do not produce and distribute public educational video clips on our online education channel, our website contains promotion videos for education institutions and educational information generated or placed on our website by our users on our online education channel or other channels. The competent education administrative authorities may require us to obtain their approval for distributing such promotion videos and educational information. See “Regulation—Regulation on Online Education Services.” We do not currently have such approval and cannot assure you that we will be able to obtain one if required to do so. Without such approval to distribute educational videos through Internet, we may receive a warning notice from the PRC government to remove all relevant videos and cease to dissemination of educational video clips in the future, and we may also be subject to administrative fines and other penalties.

Moreover, unlike TV dramas and reality shows broadcasted on TV stations, the current PRC law does not specifically require the approval from SARFT or its local branch for production and distribution of “Made-for-Internet” drama series and reality shows. However, in practice and on a case by case basis, SARFT or its local branch may regulate certain “Made-for-Internet” drama series and reality shows in a similar way as TV dramas and reality shows based on the quality, time-limit, production standards and other factors of such “Made-for-Internet” drama series and reality shows compared with TV dramas and reality shows. If SARFT or its local branch requires us to obtain its approval for our production and distribution of “Made-for-Internet” drama series and reality shows, we cannot assure you that we will be able to obtain such approval in a timely manner or at all. In such event, we may be subject to penalties including administrative fines for production and distribution of “Made-for-Internet” drama series and reality shows without required approval.

Finally, new laws and regulations may be promulgated that will regulate Internet activities, including online video industry. In addition, the evolving PRC regulatory system for the Internet industry may lead to the establishment of new regulatory agencies. For example, in May 2011, the State Council announced the establishment of a new department, the State Internet Information Office (with the involvement of the State Council Information Office, the MIIT and the Ministry of Public Security). The primary role of this new agency is to facilitate the policy-making and legislative development in this field to direct and coordinate with the relevant departments in connection with online content administration and to deal with cross-ministry regulatory matters in relation to the Internet industry. If these new laws and regulations are promulgated or any other new Internet regulatory agencies are established, additional licenses may be required for our operations. Given their uncertainties and complexities, we cannot assure you that our operations comply with all these laws and regulations, particularly the laws and regulations governing online video and advertising operations. If we are found to be in violation of any existing or future PRC laws or regulations, the relevant Chinese authorities would have broad discretion in dealing with such a violation, including, without limitation, levying fines, requiring us to rectify in a timely manner, revoking our business license or other licenses or permits for operation, and requiring us to discontinue any portion or all of our business. Any of these actions could cause our business to suffer and the price of our ADSs to decline.

Violation of PRC laws regulating advertisement may result in penalties.

PRC advertising laws and regulations require advertisers, advertising operators and advertising distributors, including online advertising publishers such as us, to ensure that the content of the advertisements they prepare or distribute are fair and accurate and are in full compliance with applicable law. Violation of these laws or regulations may result in penalties, including fines, confiscation of advertising fees, orders to cease dissemination of the advertisements and orders to publish an advertisement correcting the misleading information. In circumstances involving serious violations, the PRC government may force the violator to terminate its

 

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advertising operations or even revoke its business license. Furthermore, advertisers, advertising operators or advertising distributors may be subject to civil liability if they infringe on the right of third parties. Under PRC advertising laws and regulations, we are obligated to monitor the advertising content uploaded on our website. In addition, where a special government review is required for specific categories of advertisements before posting, we are obligated to confirm that such review has been performed and approval has been obtained. Our reputation could be harmed and our results of operations could be adversely affected if advertisements shown on our website are provided to us by advertisers or advertising agencies in violation of relevant PRC advertising laws and regulations, or if the supporting documentation and government approvals provided to us by advertisers or advertising agencies in connection with such advertising content are not complete.

Regulation and censorship of information disseminated over the Internet and wireless telecommunication networks in China may adversely affect our business, and we may be liable for information displayed on, retrieved from, or linked to our website.

China has enacted regulations governing telecommunication service providers, Internet and wireless access and the distribution of news and other information. Under these regulations, Internet content providers, or ICPs, like us, are prohibited from posting or displaying over the Internet or wireless networks content that, among other things, violates PRC laws and regulations, including failure to obtain required licenses and permits for such content, impairs the national dignity of China, or is obscene, superstitious, fraudulent or defamatory. Meanwhile, when ICPs find that information falling within the above scope is transmitted on their website or is stored in their electronic bulletin service system, they must terminate the transmission of such information or delete such information immediately and keep records and report to relevant authorities. Failure to comply with these requirements could result in the revocation of the ICP license and other required licenses and the closure of the concerned websites. The website operator may also be held liable for such prohibited information displayed on, retrieved from or linked to such website. The telecommunications operators like China Mobile and China Unicom, also have their own policies prohibiting or restricting the distribution of inappropriate content. Since December 2009, the Chinese government has been increasing its efforts on cracking down inappropriate content disseminated over the Internet and wireless networks.

As these regulations are relatively new and subject to interpretation by the relevant authorities, it may not be possible for us to determine in all cases the type of content that could result in liability for us as an online and mobile video service operator. In addition, we may not be able to control or restrict the content of other Internet content providers linked to or accessible through our websites, or content generated or placed on our website by our users, despite our attempt to monitor such content. To the extent that regulatory authorities find any portion of our content objectionable or requiring any license or permit that we have not obtained, they may require us to limit or eliminate the dissemination of such information or otherwise curtail the nature of such content on our website, and keep records and report to relevant authorities, which may reduce our user traffic. In addition, we may be subject to significant penalties for violations of those regulations arising from information displayed on, retrieved from or linked to our website, including a suspension or shutdown of our operations. Our reputation among users, advertisers and advertising agencies may also be adversely affected. This would have a material adverse effect on our financial condition and results of operations.

Governmental control of currency conversion may limit our ability to use our operating cash flows effectively and the ability of our PRC subsidiaries to obtain financing.

We generate substantially all our operating cash flows in Renminbi, which is not a freely convertible currency with respect to “capital account transactions,” which principally includes investments and loans. Restrictions on currency conversion imposed by the PRC government may limit our ability to use operating cash flows generated in Renminbi to fund our expenditures denominated in foreign currencies or our business activities outside China, if any. Under China’s existing foreign exchange regulations, Renminbi may be freely converted into foreign currency for payments relating to “current account transactions,” which include among other things dividend payments and payments for the import of goods and services, by complying with certain

 

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procedural requirements. However, the PRC government could take measures to restrict access to foreign currencies for current account transactions.

Conversion of Renminbi into foreign currencies, and of foreign currencies into Renminbi, for payments relating to “capital account transactions” generally requires the approval of the SAFE and other relevant PRC governmental authorities. Restrictions on the convertibility of Renminbi for capital account transactions could affect the ability of our PRC subsidiaries to make investments overseas or to obtain foreign currency through debt or equity financing, including by means of loans or capital contributions from us. In particular, if our PRC subsidiaries borrow foreign currency from us or other foreign lenders, they must do so within approved limits that satisfy their approval documentation and PRC debt-to-equity ratio requirements. Further, such loans must be registered with the SAFE or its local counterpart. In practice, it could be time consuming to complete the SAFE registration process.

If we finance our PRC subsidiaries through additional capital contributions, the PRC Ministry of Commerce or its local counterpart must approve the amount of these capital contributions. On August 29, 2008, the SAFE promulgated Circular 142, a notice regulating the conversion by a foreign-invested company of foreign currency- denominated capital into Renminbi by restricting the use of the converted Renminbi. The notice requires that a foreign-invested company can only use Renminbi converted from the foreign currency-denominated capital within the business scope approved by the applicable governmental authority and may not use such converted Renminbi for equity investments in the PRC unless specifically permitted in its business scope or under applicable law. In addition, the SAFE strengthened its oversight of the flow and use of Renminbi funds converted from the foreign currency-denominated capital of a foreign-invested company. The use of such Renminbi may not change without approval from the SAFE, and may not be used to repay Renminbi loans if the proceeds of such loans have not yet been used for purposes within the company’s approved business scope. Violations of Circular 142 may result in severe penalties, including substantial fines set forth in the Foreign Exchange Administration Regulations.

We cannot assure you that we will be able to complete necessary government registrations or obtain the necessary government approvals on a timely basis, if at all, with respect to loans to our PRC subsidiaries or with respect to future capital contributions to our PRC subsidiaries. Failure to complete such registrations or obtain such approvals could limit our ability to use the proceeds we receive from this offering and to capitalize or otherwise fund our PRC operations, which could adversely and materially affect our liquidity and our ability to fund and expand our business.

Adverse changes in political, economic and other policies of the Chinese government could materially adversely affect the overall economic growth of China, which could materially adversely affect the growth of our business.

We conduct substantially all of our operations in China. Accordingly, economic, political and legal developments in China significantly affect our business, financial condition, results of operations and prospects. China’s economy differs from the economies of most developed countries in many respects, including with respect to the amount of government involvement, level of development, growth rate, control of foreign exchange and allocation of resources. While the PRC economy has experienced significant growth in the past three decades, growth has been uneven across different regions and among various economic sectors of China. The PRC government has implemented various measures to encourage economic development and guide the allocation of resources. Some of these measures benefit the overall PRC economy, but may also have a negative effect on us. For example, our financial condition and results of operations may be adversely affected by tightened government control over the Internet or changes in tax regulations that are applicable to us. In addition, future measures to control the pace of economic growth may cause a decrease in the level of economic activity in China, which in turn could adversely affect our results of operations and financial condition.

 

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

We conduct our business primarily through our subsidiaries and VIEs in China. Our operations in China are governed by PRC laws and regulations. Our PRC subsidiaries are generally subject to laws and regulations applicable to foreign investments in China and, in particular, laws applicable to wholly foreign-owned enterprises. The PRC legal system is based on written statutes. 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 general economic matters. The overall effect of legislation since then has been to significantly enhance the protections afforded to various forms of foreign investments in China. However, since these laws and regulations are relatively new and the PRC legal system continues to rapidly evolve, the interpretations of many laws, regulations and rules are not always uniform and enforcement of these laws, regulations and rules involves uncertainties, which may limit legal protections available to us. Even if we endeavor to comply with relevant laws and regulations, we may not always be able to do so due to a lack of detailed implementation rules by relevant government authorities. In addition, some government authorities (including local government authorities) may not consistently apply regulatory requirements issued by themselves or other PRC government authorities, making strict compliance with all regulatory requirements impractical, or in some circumstances, impossible. For example, we may have to resort to administrative and court proceedings to enforce the legal protection that we enjoy either by law or contract. However, since PRC administrative and court authorities have significant discretion in interpreting and implementing statutory and contractual terms, it may be more difficult to evaluate the outcome of administrative and court proceedings and the level of legal protection we enjoy than in more developed legal systems. These uncertainties may impede our ability to enforce the contracts we have entered into with our business partners and advertising agencies. In addition, such uncertainties, including the inability to enforce our contracts, together with any development or interpretation of PRC law adverse to us, could materially and adversely affect our business and operations. Furthermore, intellectual property rights and confidentiality protections in China may not be as effective as in the United States or other developed countries. Accordingly, we cannot predict the effect of future developments in the PRC legal system, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement thereof, or the preemption of local regulations by national laws. These uncertainties could limit the legal protections available to us and other foreign investors, including you. In addition, any litigation in China may be protracted and result in substantial costs and diversion of our resources and management attention.

If the PRC government determines that the contractual arrangements that establish the structure for operating our businesses do not comply with applicable PRC laws and regulations, we could be subject to severe penalties.

We are a Cayman Islands company and, as such, we are classified as a foreign enterprise under PRC laws, and our PRC subsidiary, Reshuffle Technology (Shanghai) Co., Limited, or Reshuffle Technology, is a foreign-invested enterprise. Various regulations in China currently restrict or prevent foreign-invested entities from holding certain licenses required to operate Internet-related and mobile value-added service businesses, including Internet information services, online advertising and mobile value-added services. In light of these restrictions, we rely on Quan Toodou to hold and maintain the licenses necessary to operate our website as well as online advertising and value-added telecommunications services in China, and rely on Shanghai Suzao and Chengdu Gaishi to maintain our network infrastructure, which is necessary to our website operation. We do not have any equity interest in Quan Toodou, Shanghai Suzao or Chengdu Gaishi, but receive their economic benefits through various contractual arrangements and certain corporate governance and shareholder rights arrangements. In addition, we have entered into agreements with Quan Toodou, Shanghai Suzao, Chengdu Gaishi and each of their shareholders which provide us with a substantial ability to control Quan Toodou, Shanghai Suzao and Chengdu Gaishi. For a description of these contractual arrangements with Quan Toodou, Shanghai Suzao and Chengdu Gaishi and their respective shareholders, see “Corporate History and Structure—Our Corporate Structure—Contractual Arrangements with Quan Toodou and its Shareholders,” “—Contractual Arrangements with Shanghai Suzao and its Shareholders,” and “—Contractual Arrangements with Chengdu Gaishi and its Shareholders.”

 

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The Circular on Strengthening the Administration of Foreign Investment in and Operation of Value-added Telecommunications Business, or the Circular, issued by the Ministry of Industry and Information Technology in July 2006, reiterated the regulations on foreign investment in value-added telecommunications businesses, which require foreign investors to set up foreign-invested enterprises and obtain an ICP license, to conduct any Internet information services in China. Under the Circular, a domestic company that holds an ICP license is prohibited from leasing, transferring or selling the ICP license to foreign investors in any form, and from providing any assistance, including providing resources, sites or facilities, to foreign investors that conduct value-added telecommunications business illegally in China. Furthermore, the relevant trademarks and domain names that are used in the value-added telecommunications business must be owned by the value-added telecommunications service provider itself or by its shareholders. The Circular further requires each ICP license holder to have the necessary facilities for its approved business operations and to maintain such facilities in the regions covered by its license. In addition, all value-added telecommunications service providers are required to maintain network and information security in accordance with the standards set forth under relevant PRC regulations. Due to a lack of interpretative materials from the regulator, it is unclear what impact the Circular will have on us or the other Chinese Internet companies that have adopted the same or similar corporate and contractual structures as ours.

In the opinion of Fangda Partners, our PRC counsel, (i) the ownership structure of Quan Toodou, Shanghai Suzao and Chengdu Gaishi are in compliance with all existing PRC laws and regulations, and (ii) each contract under Reshuffle Technology’s contractual arrangements with Quan Toodou, Shanghai Suzao, Chengdu Gaishi and each of their shareholders establishing our corporate structure as described above is valid and binding and will not result in any violation of PRC laws or regulations currently in effect. However, we cannot assure you that we will not be found in violation of any current or future PRC laws and regulations. Our PRC counsel has also advised us that there are substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including the Circular. Accordingly, we cannot assure you that the PRC regulatory authorities and courts will ultimately take a view that is consistent with the opinion of our PRC counsel.

If we are found to be in violation of any existing or future PRC laws or regulations, including the Circular, or fail to obtain or maintain any of the required permits or approvals, the relevant regulatory authorities would have broad discretion in dealing with such violation, including levying fines, confiscating our income, revoking Reshuffle Technology, Quan Toodou, Shanghai Suzao or Chengdu Gaishi’s business license or operating licenses, requiring us to restructure the relevant ownership structure or operations, and requiring us to discontinue all or any portion of our business. Any of these actions could cause significant disruption to our business operations.

If Quan Toodou fails to renew the ICP license in the future, we may be unable to continue to provide the Internet information services on our website.

We rely on the ICP license held by Quan Toodou to provide the Internet information services on our website. The ICP license has a term of five years, which is renewable for another five years upon the approval of the competent government authorities in China. Quan Toodou’s ICP license expired in March 2011 but was successfully renewed in May 2011. However, if Quan Toodou fails to renew its ICP license in the future, we may be unable to continue to provide the Internet information services on our website and our business, financial conditions and results of the operations would be materially and adversely affected.

Our contractual arrangements with Quan Toodou, Shanghai Suzao, Chengdu Gaishi and their respective shareholders may not be as effective in providing control over Quan Toodou, Shanghai Suzao and Chengdu Gaishi as direct ownership of these companies.

We operate our website and conduct our online video and advertising businesses in China through Quan Toodou, Shanghai Suzao and Chengdu Gaishi, respectively. Our contractual arrangements with Quan Toodou, Shanghai Suzao, Chengdu Gaishi and their respective shareholders provide us with effective control over these companies. See “Corporate History and Structure—Our Corporate Structure—Contractual Arrangements with

 

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Quan Toodou and its Shareholders,” “—Contractual Arrangements with Shanghai Suzao and its Shareholders,” and “—Contractual Arrangements with Chengdu Gaishi and its Shareholders.” As a result of these contractual arrangements, we are considered to be the primary beneficiary of Quan Toodou, Shanghai Suzao and Chengdu Gaishi and accordingly, we consolidate the results of operations, assets and liabilities of Quan Toodou, Shanghai Suzao and Chengdu Gaishi in our financial statements. These contractual arrangements may not be as effective in providing us with control over Quan Toodou, Shanghai Suzao and Chengdu Gaishi as direct ownership of these companies. In addition, Quan Toodou, Shanghai Suzao, Chengdu Gaishi or their respective shareholders may breach the contractual arrangements. In any such event, we would have to rely on legal remedies under PRC law. These remedies may not always be effective, particularly in light of uncertainties in the PRC legal system. See “—Uncertainties with respect to the PRC legal system could materially adversely affect us.”

The shareholders, directors and officers of our VIEs may have potential conflicts of interest with us, which may materially and adversely affect our business and financial condition.

Each of our VIEs is jointly owned by our several employees, including Gary Wei Wang, our founder, chairman and chief executive officer. Conflicts of interest between these individuals’ role as shareholders of our VIEs and their duties to our company may arise. In addition, several of these individuals are also directors and executive officers of our VIEs. PRC laws provide that a director or certain members of senior management owes a fiduciary duty to the company he directs or manages. These individuals must therefore act in good faith and in the best interests of the relevant VIEs and must not use their respective positions for personal gain. These laws do not require them to consider our best interests when making decisions as a director or member of management of the relevant VIEs. Conflict may arise between these individuals’ fiduciary duties as director and officer of the VIEs and our company.

We cannot assure you that when conflicts of interest arise, these individuals will act in the best interests of our company or that conflicts of interest will be resolved in our favor. Currently, we do not have arrangements to address potential conflicts of interest between these individuals and our company and a conflict could result in these individuals as directors and officers of our company violating fiduciary duties to us. In addition, these individuals may breach or cause our VIEs to breach or refuse to renew the existing contractual arrangements that allow us to effectively control our VIEs and receive economic benefits from them. If we cannot resolve any conflicts of interest or disputes between us and the shareholders of our VIEs, we would have to rely on legal proceedings, which could result in disruption of our business, and there would be substantial uncertainty as to the outcome of any such legal proceedings.

The ineffectiveness of control over Quan Toodou that may result from a lawsuit initiated by the ex-wife of Mr. Gary Wei Wang, our founder, chairman and chief executive officer, seeking the division of 76% of the equity interest in Quan Toodou held by Mr. Wang, could cause significant disruption to our business, operations and financial conditions.

The shareholders of our VIEs may be involved in personal disputes with third parties that may have an adverse effect on their respective equity interests in the relevant VIE and the validity or enforceability of our contractual arrangements with the relevant VIE and its shareholders. The ex-wife of Mr. Gary Wei Wang, our founder, chairman and chief executive officer who holds 95% of the equity interests in Quan Toodou, recently initiated a lawsuit against him with a local court in Shanghai and claimed, among other things, for the division of 76% of the equity interests in Quan Toodou held by Mr. Wang, which she alleged to form part of the community property during their marriage. We rely on Quan Toodou to hold and maintain the licenses necessary to operate our website as well as online advertising and value-added telecommunications services in China. Upon the plaintiff’s application and as conservatory measures in this lawsuit, the court issued an order, or the Asset Conservatory Notification, to impose restrictions on transfer, dividend distribution and other disposal of 38% of the equity interests in Quan Toodou held by Mr. Wang. This lawsuit was concluded through settlement directed by the court in June 2011 and pursuant to a court ruling, Mr. Wang is entitled to the equity interests in any

 

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companies that are directly or indirectly held by him. In the meantime, the court also issued an order releasing the conservatory measures imposed by the Assets Conservatory Notification. However, if Mr. Wang fails to fully perform his obligations under the court ruling, Mr. Wang’s personal assets, including the equity interests in the companies that are directly or indirectly held by him, may be subject to the court’s enforcement measures.

If Mr. Wang does not fully perform his obligations for whatever reasons, and if as a result of the court’s enforcement measures on his equity interests in Quan Toodou, Mr. Wang must transfer a portion or all of his equity interests in Quan Toodou to his ex-wife or such equity interests are required to be sold to any third party, the proceeds of which to be paid to his ex-wife, the other existing shareholder of Quan Toodou will have a right of first refusal to purchase such equity interests from Mr. Wang in accordance with PRC law. In this case, the other existing shareholder will need to obtain financing sufficient to exercise this right of first refusal. It is uncertain what the valuation of such equity interests would be at that time, and the court could have wide discretion in determining the valuation.

If the other existing shareholder fails to obtain financing or otherwise fails to exercise the right of first refusal, and Mr. Wang’s ex-wife or any other third party obtains any equity interests in Quan Toodou without subject obligations similar to Mr. Wang’s obligations under these existing contractual arrangements, we may have to re-negotiate with Mr. Wang’s ex-wife or such other third party and request such person to become a party to the contractual arrangements with Quan Toodou. If such person does not become a party to these contractual arrangements, with such person obtaining more than one-third of the equity interests in Quan Toodou, such person may have certain protective rights, including the power to veto certain critical corporate actions of Quan Toodou, such as increases or decreases in registered capital, amendment of the articles of association, merger, division or dissolution of Quan Toodou and change of company form of Quan Toodou. In addition, if such person does not become a party to these contractual arrangements, with such person obtaining more than a half of the equity interests in Quan Toodou, we will not be able to continue to consolidate Quan Toodou. Historically almost 100% of our net revenues and approximately 60% to 70% of our costs were attributable to Quan Toodou, and we expect our costs may continue to increase in the future. The ineffectiveness of control over Quan Toodou that may result from this lawsuit could cause significant disruption to our business, operations and financial condition, and could have a negative impact on our ability to execute such corporate actions.

In addition, under certain of our business agreements entered into by Quan Toodou, such as the collaboration agreements with China Mobile and Samsung, the counterparties will have the right to terminate such agreements in the event of any significant changes of the shareholding structure or ownership of Quan Toodou. If the above litigation results in such significant changes, the relevant counterparties may terminate their agreements with us.

Contractual arrangements we have entered into with Quan Toodou, Shanghai Suzao and Chengdu Gaishi may be subject to scrutiny by the PRC tax authorities, and a finding that we or our affiliated entities owe additional taxes could reduce our net income and the value of your investment.

As required by applicable PRC laws and regulations, arrangements and transactions among related parties may be subject to audit or challenge by the PRC tax authorities. We could face adverse tax consequences if the PRC tax authorities determine that the contractual arrangements between our subsidiary in China on the one hand, and Quan Toodou, Shanghai Suzao and Chengdu Gaishi on the other, do not represent an arm’s-length price and adjust Quan Toodou, Shanghai Suzao or Chengdu Gaishi’s income in the form of a transfer pricing adjustment. A transfer pricing adjustment could, among other things, result in a reduction, for PRC tax purposes, of expense deductions recorded by Quan Toodou, Shanghai Suzao or Chengdu Gaishi, which could in turn increase their respective tax liabilities. In addition, the PRC tax authorities may impose late payment fees and other penalties on our affiliated entities for underpaid taxes. Our net income may be adversely affected if our affiliated entities’ tax liabilities increase or if they are found to be subject to late payment fees or other penalties.

 

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The approval of the China Securities Regulatory Commission, or the CSRC, may be required in connection with this offering.

On August 8, 2006, six PRC regulatory authorities, including the Ministry of Commerce, the State-owned Assets Supervision and Administration Commission, the State Administration for Taxation, the State Administration for Industry and Commerce, the CSRC, and the State Administration for Foreign Exchange, or the SAFE, jointly issued the Regulation on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or the M&A Rules, which became effective on September 8, 2006, as amended on June 22, 2009. This regulation, among other things, purports to require that an offshore special purpose vehicle controlled directly or indirectly by PRC companies or individuals and formed for purposes of overseas listing through acquisition of PRC domestic interests held by such PRC companies or individuals obtain the approval of the CSRC prior to the listing and trading of such special purpose vehicle’s securities on an overseas stock exchange.

The CSRC has not issued any definitive rules or interpretations concerning whether offerings such as our offering are subject to the CSRC approval procedures under the M&A Rules. However, our PRC counsel, Fangda Partners, has advised us that based on its understanding of the current PRC laws, rules and regulations and the M&A Rules, prior approval from the CSRC is not required under the M&A Rules for the listing and trading of our ADSs on NASDAQ because we have not acquired any equity interest or assets of a PRC domestic company owned by our beneficial owners that are PRC companies or individuals as defined under the M&A Rules after the effective date of the M&A Rules.

However, Fangda Partners has further advised us uncertainties still exist as to how the M&A Rules will be interpreted and implemented and its opinions summarized above are subject to any new laws, rules and regulations or detailed implementations and interpretations in any form relating to the M&A Rules. If the CSRC or another PRC regulatory agency subsequently determines that prior CSRC approval was required, we may face regulatory actions or other sanctions from the CSRC or other PRC regulatory agencies. These regulatory agencies may impose fines and penalties on our operations, limit our operating privileges, delay or restrict the repatriation of the proceeds from this offering into China or payment or distribution of dividends by our PRC subsidiaries, or take other actions that could materially adversely affect our business, financial condition, results of operations, reputation and prospects, as well as the trading price of our ADSs. The CSRC or other PRC regulatory agencies also may take actions requiring us, or making it advisable for us, to halt this offering before settlement and delivery of the ADSs offered hereby. Consequently, if you engage in market trading or other activities in anticipation of and prior to settlement and delivery, you do so at the risk that settlement and delivery may not occur. Also, if the CSRC later requires that we obtain its approval, we may be unable to obtain a waiver of the CSRC approval requirements, if and when procedures are established to obtain such a waiver. Any uncertainties or negative publicity regarding this CSRC approval requirement could materially adversely affect the trading price of our ADSs.

We cannot predict when the CSRC may promulgate additional implementing rules or other guidance, if at all. If the CSRC issues implementing rules or guidance prior to the completion of this offering and consequently we conclude we are required to obtain CSRC approval, this offering will be delayed until we obtain CSRC approval, which may take several months or longer. Furthermore, any delay in the issuance of such implementing rules or guidance may create additional uncertainties with respect to this offering. Moreover, implementing rules or guidance, to the extent issued, may fail to resolve current ambiguities under the M&A Rules. Uncertainties and/or negative publicity regarding the M&A Rules could materially adversely affect the trading price of our ADSs.

The M&A Rules establish more complex procedures for some acquisitions of Chinese companies by foreign investors, which could make it more difficult for us to pursue growth through acquisitions in China.

The M&A Rules establish procedures and requirements that could make some acquisitions of Chinese companies by foreign investors more time-consuming and complex, including requirements in some instances that prior notification to or approval by the Ministry of Commerce be made or obtained. We may grow our business in part by acquiring complementary businesses in China. Complying with the requirements of the M&A

 

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Rules 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 and maintain our market share.

Recent PRC regulations, particularly SAFE Circular No. 75 relating to acquisitions of PRC companies by foreign entities, may limit our ability to acquire PRC companies and adversely affect the implementation of our strategy as well as our business and prospects.

On October 21, 2005, the SAFE issued the Circular on Several Issues concerning Foreign Exchange Administration for Domestic Residents to Engage in Financing and in Return Investments via Overseas Special Purpose Companies, known as Circular No. 75, which became effective on November 1, 2005. Circular No. 75 and related rules provide, among other things, that prior to establishing or acquiring direct or indirect interest of an offshore company, or the Offshore SPV, for the purpose of financing that Offshore SPV with assets of, or equity interests in, an enterprise in the PRC, each PRC resident (whether a natural or legal person) holding direct or indirect interest in the Offshore SPV must complete prescribed registration procedures with the relevant local branch of the SAFE. Such PRC resident must amend his, her or its SAFE registration under certain circumstances, including upon any injection of equity interests in, or assets of, a PRC enterprise to the Offshore SPV as well as any material change in the capital of the Offshore SPV, including by way of a transfer or swap of shares, a merger or division, a long-term equity or debt investment or the creation of any security interests in favor of third parties. Circular No. 75 applies retroactively and to indirect shareholdings. PRC residents who have established or acquired direct or indirect interest of any Offshore SPVs that have made onshore investments in the PRC in the past are required to complete the registration procedures by March 31, 2006. The SAFE subsequently issued relevant guidance to its local branches with respect to the operational procedures of the SAFE registration under Circular No. 75. See “Regulation—Regulations on Foreign Exchange Registration of Offshore Investment by PRC Residents.” We have requested PRC residents holding direct or indirect interest in our company to our knowledge to make the necessary applications, filings and amendments as required under Circular No. 75 and other related rules. We attempt to comply, and attempt to ensure that PRC residents holding direct or indirect interest in our company comply, with the relevant requirements, and those persons holding direct or indirect interests in our securities whose identities and addresses we know and subject to the Circular No. 75 and other related rules have conducted the registration procedures prescribed by Circular No. 75 and will update such registration in connection with the acquisition of Tudou Limited and its future round-trip investments. However, we may not be informed of the identities of all the PRC residents holding direct or indirect interest in our company, and we cannot provide any assurances that these PRC residents will comply with our request to make or obtain any applicable registrations or comply with other requirements required by Circular No. 75 or other related rules. The failure or inability of these PRC residents to make any required registrations or comply with other requirements under Circular No. 75 and other related rules may subject such PRC residents or our PRC subsidiary to fines and legal sanctions and may also limit our ability to contribute additional capital into or provide loans to (including using the proceeds from this offering) our PRC subsidiary, limit our PRC subsidiary’s ability to pay dividends or otherwise distribute profits to us, or otherwise adversely affect us.

All employee participants in our share incentive plans who are PRC citizens may be required to register with the SAFE. We may also face regulatory uncertainties that could restrict our ability to adopt additional option plans for our directors and employees under PRC law.

In December 2006, the People’s Bank of China promulgated the Administrative Measures for Individual Foreign Exchange, which set forth the respective requirements for foreign exchange transactions by PRC individuals under either current account or the capital account. In January 2007, the SAFE issued the Implementation Rules of the Administrative Measures for Individual Foreign Exchange, 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. On March 28, 2007, the SAFE promulgated the Processing Guidance on Foreign Exchange

 

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Administration for Domestic Individuals Participating in Employee Stock Ownership Plans or Stock Option Plans of Overseas-Listed Companies, or the Stock Option Rule. Under the Stock Option Rule, PRC citizens who are granted stock options by an overseas publicly-listed company are required, through a qualified PRC domestic agent or PRC subsidiary of such overseas publicly-listed company, to register with the SAFE and complete certain other procedures.

We and our PRC citizen employees participating in our stock incentive plan will be subject to the Stock Option Rule after this offering. Failure to comply with the Stock Option Rule and other relevant rules will subject us or our PRC citizen employees participating in our stock incentive plan to fines and other legal or administrative sanctions and impose restrictions on our execution of option plans, including the grant of options under such plans to our employees, which could adversely affect our business operations.

The enforcement of labor contract law and increase in labor costs in the PRC may adversely affect our business and our profitability.

China adopted a labor contract law and its implementation rules effective on January 1, 2008 and September 18, 2008, respectively. The labor contract law and its implementation rules impose more stringent requirements on employers with regard to, among others, minimum wages, severance payment upon permitted termination of the employment by an employer and non-fixed term employment contracts, time limits for probation period as well as the duration and the times that an employee can be placed on a fixed term employment contract. Due to the limited period of effectiveness of the labor contract law and its implementation rules and the lack of clarity with respect to their implementation and potential penalties and fines, it is uncertain how they will impact our current employment policies and practices. Our employment policies and practices may violate the labor contract law or its implementation rules and we may be subject to related penalties, fines or legal fees. Compliance with the labor contract law and its implementation rules may increase our operating expenses, in particular our personnel expenses, as the continued success of our business depends significantly on our ability to attract and retain qualified personnel. In the event that we decide to terminate some of our employees or otherwise change our employment or labor practices, the labor contract law and its implementation rules may also limit our ability to effect those changes in a manner that we believe to be cost-effective or desirable, which could adversely affect our business and results of operations.

We may be classified as a “resident enterprise” for PRC enterprise income tax purposes, which could result in unfavorable tax consequences to us and our non-PRC shareholders.

Under the PRC Enterprise Income Tax Law, or the EIT Law, and its implementation rules, an enterprise established outside of the PRC with “de facto management bodies” within the PRC is considered a PRC resident enterprise and is subject to the enterprise income tax at the rate of 25% on its worldwide income. The implementation rules to the EIT law define the term “de facto management bodies” 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 Administration for Taxation issued the Notice Regarding the Determination of Chinese-Controlled Overseas 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 clarifies that dividends and other income paid by resident enterprises to shareholders that are non-PRC resident enterprises will be considered to be PRC source income, and subject to PRC withholding tax, currently at a rate of 10% unless otherwise reduced or exempted by relevant tax treaties. SAT Circular 82 also subjects such resident enterprises to various reporting requirements with the PRC tax authorities. In addition, SAT Circular 82 provides certain specific criteria for determining whether the “de facto management body” is located in China for an overseas incorporated enterprise controlled by PRC enterprises or PRC enterprise groups. However, it remains unclear how the tax authorities will determine the location of “de facto management bodies” for overseas incorporated enterprises with indirect shareholders being individual PRC residents like us. Therefore, it remains unclear whether the PRC tax authorities would require or permit our overseas registered entities to be treated as PRC resident enterprises. We do not currently consider our company to be a PRC resident enterprise. However, if

 

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the PRC tax authorities disagree with our assessment and determine that we are a PRC resident enterprise, we may be subject to the PRC enterprise income tax at 25% on our global income. In such cases, however, there is no guarantee that the preferential treatments to PRC tax residents will automatically apply to us, such as the withholding tax exemption on dividends between qualified PRC resident companies. In addition, dividends paid by us to our shareholders that are non-PRC resident enterprises as well as capital gains recognized by them with respect to the sale of our shares may be subject to a PRC withholding tax under the EIT Law. This will have an impact on our effective tax rate, will materially adversely affect our net income and results of operations, and may require us to withhold tax on our shareholders that are non-PRC resident enterprises.

Dividends we receive from our operating subsidiaries located in the PRC may be subject to PRC withholding tax.

The EIT Law provides that a maximum income tax rate of 20% may be applicable to dividends payable to non-PRC investors that are “non-resident enterprises,” to the extent such dividends are derived from sources within the PRC, and the State Council has reduced such rate to 10%, in the absence of any applicable tax treaties that may reduce such rate, through the implementation regulations. We are a Cayman Islands holding company and substantially all of our income may be derived from dividends we receive from our operating subsidiaries located in the PRC. China has not entered into any tax treaties with the Cayman Islands. Pursuant to the double taxation avoidance arrangement between the PRC and Hong Kong and subject to the approval of the local tax authorities, dividends paid by Reshuffle Technology to Star Manor Limited, or Star Manor, may be subject to PRC withholding tax at the preferential rate of 5% as long as Star Manor is demonstrated to be a Hong Kong resident enterprise under the EIT Law and directly holds 25% or more equity interest in Reshuffle Technology. However, if the PRC tax authorities would not consider Star Manor as the beneficial owner of any dividends paid from Reshuffle Technology based on the “substance over form” principle under applicable tax rules and thus deny the claim for the preferential withholding tax rate, dividends from Reshuffle Technology to Star Manor would be subject to PRC withholding tax at a rate of 10% instead of 5%. If we are required under the EIT Law to pay withholding tax for any dividends we receive from our subsidiaries, the amount of dividends, if any, we may pay to our shareholders and ADS holders may be materially and adversely affected.

Dividends payable by us to our foreign investors and gains on the sale of our ADSs or ordinary shares by our foreign investors may become subject to taxes under PRC tax laws.

Under the EIT Law and its implementation regulations issued by the State Council, a 10% PRC withholding tax is applicable to dividends payable to investors that are “non-resident enterprises,” which do not have an establishment or place of business in the PRC or which have such establishment or place of business but have income not effectively connected with such establishment or place of business, to the extent such dividends are derived from sources within the PRC. Similarly, any gain realized on the transfer of ADSs or shares by such investors is also subject to a PRC withholding tax, usually at a rate of 10% unless otherwise reduced or exempted by relevant tax treaties, if such gain is regarded as income derived from sources within the PRC. It is unclear whether dividends paid on our ordinary shares or ADSs, or any gain realized from the transfer of our ordinary shares or ADSs, would be treated as income derived from sources within the PRC and would as a result be subject to PRC withholding tax. Especially, if we are considered a PRC “resident enterprise,” then any dividends paid to our overseas shareholders or ADS holders that are “non-resident enterprises” and any gains realized by them from the transfer of our ADSs or ordinary shares may be regarded as being derived from PRC sources and, as a result, would be subject to a 10% PRC withholding tax, unless otherwise reduced or exempted by relevant tax treaties. It is unclear whether, if we are considered a PRC “resident enterprise”, holders of our ADSs or ordinary shares would be able to claim the benefit of income tax treaties or agreements entered into between China and other countries or areas. If dividends payable to our non-PRC investors that are “non-resident enterprises,” or gains from the transfer of our ordinary shares or ADSs by such investors are subject to PRC tax, the value of your investment in our ordinary shares or ADSs may be materially and adversely affected.

 

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We face uncertainty regarding the PRC tax reporting obligations and consequences for certain indirect transfers of the stock of our operating company.

Pursuant to the Notice on Strengthening Administration of Enterprise Income Tax for Share Transfers by Non-PRC Resident Enterprises issued by the PRC State Administration for Taxation on December 10, 2009, where a foreign investor transfers the equity interests in a PRC resident enterprise indirectly by way of the sale of equity interests in 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 foreign investor should report such Indirect Transfer to the competent tax authority of the PRC resident enterprise within 30 days of execution of the equity transfer agreement for such Indirect Transfer. The PRC tax authority will examine the true nature of the Indirect Transfer, and if the tax authority considers that the foreign investor has adopted an abusive arrangement without reasonable commercial purposes and in order to avoid PRC tax, they will disregard the existence of the overseas holding company that is used for tax planning purposes and re-characterize the Indirect Transfer and as a result, gains derived from such Indirect Transfer may be subject to PRC withholding tax at the rate of up to 10%.

We rely on dividends paid by our subsidiaries for our cash needs, and any limitation on the ability of our subsidiaries to make payments to us could materially adversely affect our ability to conduct our business.

We conduct all of our business through our consolidated subsidiaries and VIEs incorporated in China. We rely on dividends paid by our consolidated subsidiaries for our cash needs, including the funds necessary to pay any dividends and other cash distributions to our shareholders, to service any debt we may incur and to pay our operating expenses. The payment of dividends by entities established in China is subject to limitations. Regulations in China permit payment of dividends only out of accumulated profits determined in accordance with accounting standards and regulations in China. As of March 31, 2011, our PRC subsidiaries had an aggregate accumulated deficit of RMB436.6 million as determined under applicable PRC accounting standards. Each of our PRC subsidiaries is also required to set aside at least 10% of its after-tax profit based on PRC accounting standards each year to its general reserve fund until the aggregate amount of such reserves reaches 50% of its respective registered capital, as well as to allocate a discretional portion of its after-tax profits to its staff welfare and bonus fund. Such statutory reserves are not distributable as loans, advances or cash dividends. We anticipate that in the foreseeable future our PRC subsidiaries will need to continue to set aside 10% of their respective after-tax profits to their statutory reserves. In addition, if any of our PRC subsidiaries 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. Any limitations on the ability of our PRC subsidiaries to transfer funds to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our business, pay dividends and otherwise fund and conduct our business.

Risks Relating to Our ADS and 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.

We are applying to list our ADSs on NASDAQ. Prior to this initial public offering, there has been no public market for our ordinary shares or ADSs. In addition, our ordinary shares will not be listed on any other 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.

The initial public offering price for our ADSs will be determined by negotiations between us and the underwriters and may bear no relationship to the market price for our ADSs after this 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.

 

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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:

 

   

announcements of technological or competitive developments;

 

   

regulatory developments in China affecting us or our competitors;

 

   

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

 

   

changes in financial projections by securities research analysts;

 

   

addition or departure of our senior management and other key personnel;

 

   

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

 

   

sales or perceived sales of additional ordinary shares or ADSs.

In addition, the securities market has experienced significant price and volume fluctuations not related to the operating performance of particular companies. These market fluctuations may also materially adversely affect the market price of our ADSs. In the past, following periods of volatility in the market price of a company’s securities, shareholders have often instituted securities class action litigation against that company. Any such class action suit or other securities litigation would divert the attention of our senior management, require us to incur significant expense and, whether or not adversely determined, could materially adversely affect our business, financial condition, results of operations and prospects.

Because the initial public offering price is substantially higher than our net tangible book value per share, you will incur 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 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 our net tangible book value per ADS as of March 31, 2011 after giving effect to this offering. In addition, you may experience further dilution to the extent that our ordinary shares are issued upon the exercise of share options. See “Dilution” for a more complete description.

Future sales, or perceived sales, of ADSs or ordinary shares by existing shareholders could cause the price of our ADSs to decline.

Additional sales of our Class B 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 10,633,333 Class A ordinary shares and                  Class B ordinary shares outstanding. All shares sold in this offering will be freely transferable without restriction or additional registration under the U.S. Securities Act of 1933, as amended, or the Securities Act. The remaining ordinary shares outstanding after this offering will be available for sale, upon the expiration of the 180-day lock-up period beginning from the closing of this offering, subject to restrictions as applicable under Rule 144 under the Securities Act. Any or all of these shares may be released prior to expiration of the lock-up period at the discretion of the representatives of the underwriters for this offering. To the extent shares are released before the expiration of the lock-up period and these shares are sold into the market, the market price of our ADSs could decline.

In addition, certain holders of our ordinary shares after the completion of this offering will have the right to cause us to register the sale of a total of              shares under the Securities Act. Registration of these shares under the Securities Act would result in these shares becoming freely tradable without restriction under the

 

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Securities Act immediately upon the effectiveness of the registration. Sales of these registered shares in the public market, or the perception that such sales could occur, could cause the price of our ADSs to decline.

Holders of ADSs have fewer rights than shareholders and must act through the depositary to exercise those rights.

Holders of ADSs do not have the same rights as our shareholders and may only exercise voting rights with respect to the underlying ordinary shares in accordance with the provisions of the deposit agreement. If the vote is by show of hands, the depositary will not vote the deposited securities. If the vote is by poll, the depositary will try to vote the deposited securities in accordance with the voting instructions it timely receives from ADS holders. In the event of poll voting, deposited securities for which no instructions are received will not be voted, except as described in the following paragraph. If we ask for your instructions, we will give the depositary notice of any such meeting and details concerning the matters to be voted upon at least 30 days prior to the meeting date and the depositary will send a notice to you about the upcoming vote and will arrange to deliver our voting materials to you. However, we are not required to ask for your instructions, so, when a general meeting is convened, you may not receive sufficient notice of a shareholders’ meeting to allow you to cast your vote with respect to any specific matter. In addition, the depositary and its agents may not be able to send voting instructions to you or carry out your voting instructions in a timely manner. We will use reasonable efforts to cause the depositary to extend voting rights to you in a timely manner, but we cannot assure you that you will receive the voting materials in time to ensure that you can instruct the depositary to vote your shares. Furthermore, the depositary and its agents will not be responsible for any failure to carry out any instructions to vote, for the manner in which any vote is cast or for the effect of any such vote. As a result, you may not be able to exercise your right to vote and you may lack recourse if your ordinary shares are not voted as you requested. In addition, in your capacity as an ADS holder, you will not be able to call a shareholder meeting.

The depositary for our ADSs may give us a discretionary proxy to vote our ordinary shares underlying your ADSs if you do not give voting instructions, which could adversely affect your interests.

Under the deposit agreement for the ADSs, if we asked for your instructions but the depositary does not receive your instructions by the cutoff date it sets, the depositary will give us a discretionary proxy to vote the ordinary shares underlying your ADSs as to all matters at the shareholders’ meeting unless:

 

   

we instructed the depositary we do not wish to receive a discretionary proxy;

 

   

we informed the depositary that there is substantial opposition to the particular matter; or

 

   

the particular matter would have a material adverse impact on shareholders.

The effect of this discretionary proxy is that if you do not give voting instructions, you cannot prevent the ordinary shares underlying your ADSs from being voted, except in the circumstances described above. This may make it more difficult for shareholders to influence the management of our company. Holders of our ordinary shares are not subject to this discretionary proxy.

You may be subject to limitations on transfers 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 to do so 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 deem 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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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 or other distributions 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 any such rights available to you in the United States unless we register such rights and the securities to which such rights relate under the Securities Act or an exemption from the registration requirements is available. Also, under the deposit agreement, the depositary bank will not make rights available to you unless the distribution to ADS holders of both the rights and any related securities are either registered under the Securities Act, or exempted 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. Moreover, we may not be able to establish an 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.

In addition, the depositary has agreed to pay 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 and you will not receive such distribution.

We have not determined any specific use for a portion of the net proceeds to us from this offering and we may use such portion of the net proceeds in ways with which you may not agree.

We have not allocated a portion of the net proceeds to us from this offering for any specific purpose. Rather, our management will have considerable discretion in the application of such portion of the net proceeds received by us. See “Use of Proceeds.” You will not have the opportunity, as part of your investment decision, to assess whether such proceeds are being used appropriately. You must rely on the judgment of our management regarding the application of such proceeds that we receive from this offering. Such proceeds may be used for general corporate purposes that do not improve our profitability or increase our ADS price or may also be placed in investments that do not produce income or that may lose value.

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

Upon completion of this offering, we will become a public company in the United States. As a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as rules and regulations implemented by the SEC and NASDAQ, require significantly heightened corporate governance practices for public companies. We expect that these rules and regulations will increase our legal, accounting and financial compliance costs and will make certain corporate activities more time-consuming and costly. Compliance with these rules and requirements may be especially difficult and costly for us because we may have difficulty locating sufficient personnel in China with experience and expertise relating to U.S. GAAP and U.S. public company reporting requirements, and such personnel may command high salaries relative to similarly experienced personnel in the United States. If we cannot employ sufficient personnel to ensure compliance with these rules and regulations, we may need to rely more on outside legal, accounting and financial experts, which may be costly. In addition, we will incur additional costs associated with our public company reporting requirements. We cannot predict or estimate additional costs that we may incur or the timing of such costs. If we fail to comply with these rules and requirements, or are perceived to have weaknesses with respect to our compliance, we could become the subject of a governmental enforcement action and investor confidence could be negatively impacted and the market price of our ADSs could decline.

 

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We are exempt from certain corporate governance requirements of NASDAQ. This may afford less protection to the holders of our ADSs.

We are exempt from certain corporate governance requirements of NASDAQ by virtue of being a foreign private issuer. As a foreign private issuer, we are permitted to, and plan to, follow home country practice in lieu of certain corporate governance requirements of NASDAQ. We are required to provide a brief description of the significant differences between the corporate governance practices of our home country, the Cayman Islands and the corporate governance practices required to be followed by U.S. domestic companies under the NASDAQ rules.

The standards applicable to us are considerably different than the standards applied to U.S. domestic issuers. The significantly different standards applicable to us do not require us to:

 

   

have a majority of the board be independent (other than due to the requirements for the audit committee under the United States Securities Exchange Act of 1934, as amended, or the Exchange Act);

 

   

have a minimum of three members on our audit committee;

 

   

have a compensation committee, a nominating or corporate governance committee;

 

   

have regularly scheduled meetings of solely independent directors at least twice a year;

 

   

seek shareholder approval for (i) the establishment and material amendments of the terms of share incentive plans, (ii) the issuance of more than 20% of our outstanding ordinary shares, and (iii) an issuance that would result in a change of control; or

 

   

adopt a code of conduct applicable to all directors, officers and employees, which shall be publicly available.

We intend to rely on all such exemptions provided by NASDAQ to a foreign private issuer, except that we expect to establish a compensation committee, and adopt and disclose a code of business conduct and ethics for directors, officers and employees. As a result, you may not be provided with the benefits of certain corporate governance requirements of NASDAQ.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

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

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

 

   

the risks, challenges and uncertainties in the online video industry and for our business generally;

 

   

our beliefs regarding our strengths;

 

   

our beliefs, plans and intentions regarding our strategies;

 

   

our plans to launch and market new services;

 

   

our plans for strategic partnerships with other businesses;

 

   

our plans to diversify the sources of our revenues;

 

   

our ability to maintain strong working relationships with our professional content partners;

 

   

our expectations regarding demand for and acceptance of our services;

 

   

our ability to attract and retain users and advertisers;

 

   

our ability to retain key personnel and attract new talents;

 

   

changes in the online video and advertising industries in China, including changes in the online video, online advertising and mobile Internet policies and regulations of the PRC government;

 

   

technological changes affecting the online video, online advertising and mobile Internet industries;

 

   

competition in the PRC online video, online advertising and mobile Internet industries;

 

   

our ability to comply with all relevant laws and regulations;

 

   

our ability to obtain and maintain permits, licenses and registrations to carry on our business;

 

   

our planned use of proceeds;

 

   

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

 

   

the outcome of ongoing or any future litigation or arbitration, including those relating to copyright or other intellectual property rights;

 

   

the expected growth in the number of the Internet and broadband users in China; and

 

   

fluctuations in general economic and business conditions in China.

This prospectus also contains market data related to online video and advertising industries in China, include projections that are based on a number of assumptions. The online video and advertising industries in China may not grow at the rates projected by the market data, or at all. The failure of the markets to grow at the projected rates 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 and advertising industries in China subjects any projections or

 

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estimates relating to the growth prospects or future condition of our market to significant uncertainties. If any one or more of the assumptions underlying the market data turns out 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.

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 reference 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 materially differ 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, after deducting the underwriting discounts and commissions and estimated offering expenses payable by us. These estimates are based upon an assumed initial offering price of US$              per ADS, the midpoint 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, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us and assuming no exercise of the underwriters’ option to purchase additional ADSs and no other change to the number of ADSs offered by us as set forth on the cover page of this prospectus.

We intend to use the net proceeds we receive from this offering for the following purposes:

 

   

approximately US$             to fund our content procurement and in-house developed content production;

 

   

approximately US$             to fund our expansion of Internet bandwidth capacity;

 

   

approximately US$             to fund the enhancement of our technology platform; and

 

   

the balance to fund our working capital and for general corporate purposes, including potential acquisitions, partnerships, alliances and licensing opportunities.

To the extent that the net proceeds we receive from this offering are not immediately applied for the above purposes, we intend to hold our net proceeds in short-term bank deposits or invest them in interest-bearing government securities.

In utilizing the proceeds of this offering, we, as an offshore holding company, are permitted under PRC laws and regulations to provide funding to our PRC subsidiaries only through loans or capital contributions and to other entities only through loans. Subject to satisfaction of applicable government registration and approval requirements, we may extend inter-company loans to our PRC subsidiaries or make additional capital contributions to our PRC subsidiaries to fund their capital expenditures or working capital. 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 Relating to Doing Business in China—Governmental control of currency conversion may limit our ability to use our operating cash flows effectively and the ability of our PRC subsidiaries to obtain financing.”

[We will not receive any of the proceeds from the sale of the ADSs by the selling shareholders.]

 

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DIVIDEND POLICY

Our board of directors has complete discretion over whether to pay dividends on our ordinary shares. If our board of directors decides to pay dividends on our ordinary shares, 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.

We have never declared or paid any other dividends since our incorporation, nor do we have any present plan to pay any cash dividends on our ordinary shares in the foreseeable future. We intend to retain most, if not all, of our available funds and any future earnings to operate and expand our business. If we pay any dividends, the depositary will pay our ADS holders the dividends it receives on our ordinary shares, after deducting its fees and expenses as provided in the deposit agreement. See “Description of American Depositary Shares.” Cash dividends on our ordinary shares, if any, will be paid in U.S. dollars.

We are a holding company incorporated in the Cayman Islands. In order for us to distribute any dividends to our shareholders and ADS holders, we will rely on dividends distributed by our PRC subsidiaries. Certain payments from our PRC subsidiaries to us are subject to PRC taxes, such as withholding income tax. In addition, regulations in the PRC permit payment of dividends of a PRC company only out of accumulated profits as determined in accordance with its articles of association and the accounting standards and regulations in China. Each of our PRC subsidiaries is required to set aside at least 10% of its after-tax profit based on PRC accounting standards every year to a statutory common reserve fund until the aggregate amount of such reserve fund reaches 50% of the registered capital of such subsidiary. Such statutory reserves are not distributable as loans, advances or cash dividends. Also, our PRC subsidiaries may set aside a portion of its after-tax profits to staff welfare and bonus funds, which allocated portion may not be distributed as cash dividends. The amount to be provided is discretionary and is determined by each such subsidiary’s ultimate decision-making body each calendar year. Instruments governing debt incurred by our PRC subsidiaries may also restrict their ability to pay dividends or make other distributions to us. See “Risk Factors—Risks Relating to Doing Business in China—We rely on dividends paid by our subsidiaries for our cash needs, and any limitation on the ability of our subsidiaries to make payments to us could materially adversely affect our ability to conduct our business.”

 

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CAPITALIZATION

The following table sets forth our capitalization as of March 31, 2011:

 

   

on an actual basis;

 

   

on a pro forma basis to reflect (i) the automatic conversion of all our outstanding redeemable convertible preferred shares into 69,914,684 of our Class B ordinary shares immediately prior to the completion of this offering, and (ii) the exercise of the warrants to purchase up to 9,083,185 of our Class B ordinary shares immediately prior to the completion of this offering (excluding the warrants to purchase 147,693 Series E preferred shares the exercise of which is subject to certain conditions); and

 

   

on a pro forma as adjusted basis to reflect the issuance and sale of                      Class B ordinary shares in the form of ADSs by us in this offering, assuming an initial public offering price of US$             per ADS, the midpoint of the estimated range of the initial public offering price, after deducting estimated underwriting discounts and commissions and estimated aggregate offering expenses payable by us and assuming no exercise of the underwriters’ option to purchase additional ADSs and no other change to the number of ADSs sold by us as set forth on the cover page of this prospectus.

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 March 31, 2011  
    Actual     Pro Forma     Pro Forma as
adjusted
 
    (RMB)     (US$)     (RMB)     (US$)     (RMB)     (US$)  
    (in thousands)  

Mezzanine Equity

           

Series A redeemable convertible preferred shares

 

 

7,512.4

  

 

 

1,147.2

  

    —          —         

Series B redeemable convertible preferred shares

 

 

55,729.3

  

 

 

8,510.5

  

    —          —         

Series C redeemable convertible preferred shares

 

 

124,571.6

  

    19,023.5        —          —         

Series D redeemable convertible preferred shares

 

 

372,403.5

  

 

 

56,870.3

  

    —          —         

Series E redeemable convertible preferred shares

    361,558.1        55,214.0        —          —         

Shareholders’ Equity (Deficit)

           

Ordinary shares

    9.7        1.5        61.5        9.4       

Additional paid-in capital(1)

    11,054.3        1,688.1        1,414,929.7        216,075.9       

Accumulated deficit

    (1,142,475.5     (174,469.0     (1,142,475.5     (174,469.0    
                                   

Total shareholders’ equity/(deficit)(1)

    (1,131,411.5  

 

(172,779.4

    272,515.7        41,616.3       
                                               

Total capitalization(1)

    (209,636.6     (32,013.9     272,515.7        41,616.3       
                                               

 

(1) Assuming the number of ADSs offered by us as set forth on the cover page of this prospectus remains the same, and after deduction of underwriting discounts and commissions and the estimated offering expenses payable by us, a US$1.00 increase (decrease) in the assumed initial public offering price of US$             per ADS would increase (decrease) each of additional paid-in capital, total shareholders’ equity and total capitalization by US$             million.

 

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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 because the initial public offering price per ordinary share substantially exceeds the book value per ordinary share attributable to the existing shareholders for our presently outstanding ordinary shares.

Our net tangible book value as of March 31, 2011 was approximately RMB             million (US$             million), or RMB (US$             ) per ordinary share and US$             per ADS. Net tangible book value represents the amount of our total consolidated tangible assets, minus the amount of our total consolidated liabilities. Without taking into account any other changes in such net tangible book value after March 31, 2011 other than to give effect to (i) the conversion of all of our outstanding redeemable convertible preferred shares into Class B ordinary shares, which will occur immediately prior to the completion of this offering, (ii) the exercise of the warrants to purchase up to 9,083,185 Series E preferred shares and conversion of these preferred shares into 9,083,185 of our Class B ordinary shares, which will occur immediately prior to the completion of this offering (excluding the warrants to purchase 147,693 Series E preferred shares the exercise of which is subject to certain conditions), and (iii) our sale of the ADSs offered in this offering at the assumed initial public offering price of US$             per ADS, the midpoint of the estimated range of the initial public offering price, and after deduction of underwriting discounts and commissions and estimated offering expenses of this offering payable by us, our adjusted net tangible book value as of March 31, 2011 would have increased to US$             million or US$             per 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 shareholder 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 per share dilution:

 

Estimated initial public offering price per ADS

   US$                

Net tangible book value per ordinary share on a pro forma basis as of March 31, 2011 after giving effect to the conversion of all our redeemable convertible preferred shares into Class B ordinary shares immediately prior to the completion of this offering

   US$                

Increase in net tangible book value per ordinary share attributable to this offering

  

Net tangible book value per ordinary share as of March 31, 2011 after giving effect to this offering, the exercise of the warrants to purchase up to 9,083,185 Series E preferred shares and the conversion of all of our outstanding redeemable convertible preferred shares into 9,083,185 Class B ordinary shares immediately prior to the completion of this offering (excluding the warrants to purchase 147,693 Series E preferred shares the exercise of which is subject to certain conditions)

  

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

   US$                

Amount of dilution in net tangible book value per ADS to new investors in this offering

   US$                

A US$1.00 increase (decrease) in the assumed initial public offering price of US$             per ADS would increase (decrease) our pro forma net tangible book value after giving effect to the offering by US$             million, or by US$             per ordinary share and by 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 expenses of the offering. 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 following table summarizes, on a pro forma basis as of March 31, 2011, the differences between existing shareholders and the new investors with respect to the number of ordinary shares (in the form of ADSs

 

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or shares) purchased from us, the total consideration paid and the average price per ordinary share and per ADS. In the case of ADS purchased by new investors, the consideration and price amounts are paid before deducting estimated underwriting discounts and commissions and estimated offering expenses, assuming an initial public offering price of US$             per ADS, the midpoint of the estimated range of the initial public offering price. The total number of ordinary shares in the following table does not include ordinary shares underlying the ADSs issuable upon the exercise of the option to purchase additional ADSs granted to the underwriters. The information in the following table is illustrative only and the total consideration paid and the average price per ordinary share and per ADS for new investors is subject to adjustment based on the actual initial public offering price of our ADSs and the number of ordinary shares newly issued and to be sold in this offering as determined at pricing.

 

     Ordinary Shares
Purchased
    Total Consideration     Average Price  per
Ordinary Share
     Average
Price
per ADSs
 
     Number      Percent     Amount
(in  thousands)
     Percent       

Existing shareholders

                                     

New investors

               
                                       

Total

                                     
                                                   

A US$1.00 increase (decrease) in the assumed initial public offering price of US$             per ADS would increase (decrease) total consideration paid by new investors, total consideration paid by all shareholders and the average price per ADS paid by all shareholders by US$             million, US$             million and US$            , respectively, assuming no change in the number of ADSs sold by us as set forth on the cover page of this prospectus and without deducting underwriting discounts and commissions and other expenses of the offering.

The dilution to new investors will be US$             per ordinary share and US$             per ADS, if the underwriters exercise in full their option to purchase additional ADSs.

The discussion and tables above also assume no exercise of any outstanding share options. As of the date of this prospectus, there were              ordinary shares issuable upon exercise of outstanding share options at an exercise price of RMB             (US$            ) per share and there were              ordinary shares available for future issuance upon the exercise of future grants under our share incentive plan. To the extent that any of these options are granted and exercised, there will be further dilution to new investors.

 

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EXCHANGE RATE INFORMATION

We conduct substantially all of our business in China and substantially all of our revenues are denominated in Renminbi. Periodic reports made to shareholders will be expressed in Renminbi with translations of Renminbi amounts into U.S. dollars at the then-current exchange rate solely for the convenience of the reader. Conversions of Renminbi into U.S. dollars reflected in the following table are based on, for all dates through December 31, 2008, at the noon buying rate in the City of New York for cable transfers in Renminbi per U.S. dollar as certified for customs purposes by the Federal Reserve Bank of New York, or the noon buying rate, and for January 1, 2009 and all later dates and periods, the noon buying rate as set forth in the H.10 statistical release of the Federal Reserve Board. Unless otherwise noted, all translations of financial data from Renminbi to U.S. dollars and from U.S. dollars to Renminbi in this prospectus were made at a rate of RMB6.5483 to US$1.00, the noon buying rate in effect as of March 31, 2011. 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, 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 June 10, 2011, the noon buying rate was RMB6.4801 to US$1.00.

The following table sets forth information concerning exchange rates between the RMB and the U.S. dollar for the periods indicated. These rates are provided solely for your convenience and are not necessarily the exchange rates we used in this prospectus, or will use in the presentation of our periodic reports or any other information to be provided to you.

 

     Noon Buying Rate  

Period

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

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

     6.6000         6.7603         6.8330         6.6000   

December

     6.6000         6.6497         6.6745         6.6000   

2011

           

January

     6.6017         6.5964         6.6364         6.5809   

February

     6.5713         6.5761         6.5965         6.5520   

March

     6.5483         6.5645         6.5743         6.5483   

April

     6.4900         6.5267         6.5477         6.4900   

May

     6.4786         6.4957         6.5073         6.4786   

June (through June 10, 2011)

     6.4801         6.4790         6.4824         6.4754   

 

Source: Federal Reserve Bank of New York

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

 

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ENFORCEABILITY OF CIVIL LIABILITIES

We are registered under the laws of the Cayman Islands as an exempted company with limited liability. We are registered in the Cayman Islands because of certain benefits associated with being a Cayman Islands corporation, such as political and economic stability, an effective judicial system, a favorable tax system, the absence of foreign exchange control or currency restrictions and the availability of professional and support services. However, the Cayman Islands has a less developed body of securities laws compared to, and provides protections for investors to a significantly lesser extent than, the United States. In addition, Cayman Islands companies do not have standing to sue before the federal courts of the United States.

Substantially all of our operations and assets are located in China. In addition, most of our directors and officers are nationals or residents of jurisdictions other than the United States and most of their assets are located outside the United States. As a result, it may be difficult for investors to effect service of process within the United States upon us or 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. It may also be difficult for you to enforce in United States courts judgments obtained in United States courts based on the civil liability provisions of the United States federal securities laws against us, our officers and directors.

We have appointed CT Corporation System as our agent to receive service of process with respect to any action brought against us in the United States District Court for the Southern District of New York under the federal securities laws of the United States or of any state in the United States or any action brought against us in the Supreme Court of the State of New York in the County of New York under the securities laws of the State of New York.

Maples and Calder, our counsel as to Cayman Islands law, and Fangda Partners, our counsel as to PRC law, have advised us that there is uncertainty as to whether the courts of the Cayman Islands or the PRC would, respectively, (1) 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 (2) entertain original actions brought in the Cayman Islands or the PRC against us or our directors or officers predicated upon the securities laws of the United States or any state in the United States.

Maples and Calder have advised that a final and conclusive judgment obtained in federal or state courts in the United States under which a sum of money is payable, other than a sum payable in respect of taxes or other similar charges, fines, other penalties or multiple damages, 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, will be recognized and enforced in the courts of the Cayman Islands at common law, without any re-examination of the merits of the underlying dispute. 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. the courts of the Cayman Islands would recognize as a valid judgment, a final and conclusive judgment in personam obtained in the federal or state courts in the United States under which a sum of money is payable (other than a sum of money payable in respect of multiple damages, taxes or other charges of a like nature or in respect of a fine or other penalty) and would give a judgment based thereon provided that: (a) such courts had proper jurisdiction over the parties subject to such judgment; (b) such courts did not contravene the rules of natural justice of the Cayman Islands; (c) such judgment was not obtained by fraud; (d) the enforcement of the judgment would not be contrary to the public policy of the Cayman Islands; (d) the enforcement of the judgment would not be contrary to the public policy of the Cayman Islands; (e) no new admissible evidence relevant to the action is submitted prior to the rendering of the judgment by the courts of the Cayman Islands; and (f) there is due compliance with the correct procedures under the laws of the Cayman Islands.

 

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Fangda Partners has advised us that the PRC Civil Procedure Law provides for the recognition and enforcement of foreign judgments. PRC courts may recognize and enforce foreign judgments in accordance with the requirements of the PRC Civil Procedure Law based either on treaties between China and the country where the judgment is made or on reciprocity between jurisdictions. Fangda Partners has further advised us that under PRC law, a PRC court may recognize and enforce a foreign judgment that does not otherwise violate basic legal principles, state sovereignty, safety or social public interest, based either on treaties between China and the country where the judgment is made or on reciprocity between jurisdictions. As there currently exists no treaty or other form of reciprocity between China and the United States governing the recognition of judgments, including those predicated upon the civil liability provisions of the United States federal securities laws, there is uncertainty whether and on what basis a PRC court would enforce judgments rendered by United States courts.

 

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CORPORATE HISTORY AND STRUCTURE

Our History

We have been conducting our business of online video sharing and advertising in China through Quan Toodou, which was established in China in December 2004. Quan Toodou holds our licenses required for the above business under PRC laws and is in charge of the operation of our website, www.tudou.com.

In November 2005, StarCloud Media Co., Limited, or StarCloud BVI, our intermediate holding company, was incorporated in the British Virgin Islands.

In January 2006, StarCloud BVI established its wholly owned subsidiary, Reshuffle Technology, in China. We have, through Reshuffle Technology, entered into certain contractual arrangements with Quan Toodou and its shareholders, pursuant to which we gain effective control over the operations of Quan Toodou.

In June 2009, Quan Toodou established its wholly-owned subsidiary, Shanghai Licheng Cultural Communication Co., Ltd., or Shanghai Licheng, in China, which primarily engages in the business of advertisement design and production.

In May and June of 2009, Shanghai Suzao and Chengdu Gaishi were established in China. Shanghai Suzao and Chengdu Gaishi are in charge of the maintenance of our network infrastructure. We have also, through Reshuffle Technology, entered into certain contractual arrangements with Shanghai Suzao and Chengdu Gaishi and their respective shareholders, pursuant to which we gain effective control over the operations of Shanghai Suzao and Chengdu Gaishi.

In February 2010, Star Manor was incorporated in Hong Kong and was acquired by StarCloud BVI in June 2010. Star Manor is engaged in trading and investment businesses. In October 2010, we made it one of our intermediary holding companies by transferring all of StarCloud BVI’s equity interest in Reshuffle Technology to Star Manor.

In anticipation of this offering, we commenced a corporate restructuring in 2010. Set forth below are the key steps of our restructuring.

 

   

In April 2010, Tudou Holdings Limited was incorporated under the laws of the Cayman Islands.

 

   

In August 2010, StarCloud BVI established a wholly owned subsidiary, Wohong Technology (Shanghai) Co., Ltd., or Wohong Technology, in China, which primarily engages in the provision of technology services to our VIEs.

 

   

In September 2010, Tudou Holdings Limited issued its shares to the existing shareholders of StarCloud BVI in exchange for all of the outstanding shares of StarCloud BVI. As a result, Tudou Holdings Limited became the ultimate holding company of our group after this transaction.

In February 2011, StarCloud BVI acquired 100% equity interest in Tudou Limited, a Hong Kong company engaged in the advertising business.

 

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Our Corporate Structure

The following diagram illustrates our current corporate structure and the place of incorporation of each of our significant subsidiaries and VIEs as of the date of this prospectus:

LOGO

 

LOGO

  Direct ownership

LOGO

  Contractual arrangements: See“—Contractual Arrangements with Quan Toodou and its Shareholders,” “—Contractual Arrangements with Shanghai Suzao and its Shareholders,” and “—Contractual Arrangements with Chengdu Gaishi and its Shareholders.”

 

  (A) Quan Toodou Network Science and Technology Co., Ltd. is our VIE in China and is 95% owned by Mr. Gary Wei Wang, our founder, chairman and chief executive officer, and 5% owned by Ms. Zhiqi Wang, our employee and a member of our founding team.

 

  (B) Shanghai Suzao Network Science and Technology Co., Ltd. is our VIE in China and is 50% owned by Mr. Chengzi Wu, our employee and a member of our founding team, and 50% owned by Ms. Jing Chen, our employee and a member of our founding team.

 

  (C) Chengdu Gaishi Network Science and Technology Co., Ltd. is our VIE in China and is 50% owned by Mr. Chengzi Wu and 50% owned by Mr. Xiaoyun Zhang, our employee and a member of our founding team.

 

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We have entered into contractual arrangements with Quan Toodou, Shanghai Suzao, Chengdu Gaishi and their respective shareholders, through which we exercise effective control over operations of these entities and receive economic benefits generated from these entities. As a result of these contractual arrangements, under U.S. GAAP, we are considered the primary beneficiary of Quan Toodou, Shanghai Suzao and Chengdu Gaishi and thus consolidate their results in our consolidated financial statements. See “Risk Factors—Risks Relating to Doing Business in China—If the PRC government determines that the contractual arrangements that establish the structure for operating our businesses do not comply with applicable PRC laws and regulations, we could be subject to severe penalties.”

Contractual Arrangements with Quan Toodou and its Shareholders

Our relationships with Quan Toodou and its shareholders are governed by a series of contractual arrangements. Under PRC laws, each of Quan Toodou and Reshuffle Technology is an independent legal person and neither of them is exposed to liabilities incurred by the other party. Other than pursuant to the contractual arrangements between Quan Toodou and Reshuffle Technology, Quan Toodou is not required to transfer any funds generated from its operations to Reshuffle Technology.

Loan Agreements. The shareholders of Quan Toodou, namely Gary Wei Wang and Zhiqi Wang, have entered into certain loan agreements with Reshuffle Technology. Under these loan agreements, Reshuffle Technology agrees to lend interest-free loans of up to RMB50.0 million (US$7.5 million) to these shareholders, solely for their respective capital contributions in Quan Toodou. Each of these loan agreements has a term of five years, which will be automatically renewed for another periods of five years upon its expiration. However, Reshuffle Technology, with a 30 days’ prior notice, may require, and the shareholders, with a 30 days’ prior application, may apply for, an earlier repayment of part or all of the loans, and Reshuffle Technology shall or has the right to (as the case may be) purchase or have its designated third party purchase the corresponding part of the equity interests in Quan Toodou in proportion to the amount of the loans to be repaid at the purchase price equal to such amount.

Exclusive Call Option Agreement. Quan Toodou and its shareholders have entered into an exclusive call option agreement with Reshuffle Technology, under which each shareholder of Quan Toodou irrevocably granted Reshuffle Technology an exclusive option to purchase or have its designee purchase his/her equity interest in Quan Toodou at the purchase price equal to the amount of the registered capital of Quan Toodou in proportion to the equity interest to be purchased or the lowest price permitted by the PRC laws. Reshuffle Technology may exercise such option at any time to the extent permitted by the PRC laws. In addition, Quan Toodou and its shareholders agree that without Reshuffle Technology’s prior written consent, they will not engage in certain actions including transferring or otherwise disposing of the equity interest in Quan Toodou or declaring any dividend.

Proxy Agreement. Quan Toodou and its shareholders have entered into a proxy agreement with Reshuffle Technology, under which each shareholder of Quan Toodou irrevocably undertakes to execute powers of attorney to persons designated by Reshuffle Technology that irrevocably authorize them to vote as the shareholders’ attorneys-in-fact on all of the matters of Quan Toodou requiring shareholders’ approval, including the appointment and election of board members and senior management members.

Exclusive Consultancy and Service Agreement. Under the exclusive consultancy and service agreement between Quan Toodou and Reshuffle Technology, Quan Toodou engages Reshuffle Technology as its exclusive provider of technical consulting and services and shall pay to Reshuffle Technology service fees consisting of the performance service fee equal to the amount of 50% of Quan Toodou’s total annual revenues before tax and the fees for specific technical consulting and services requested by Quan Toodou and provided by Reshuffle Technology from time to time. We set this service fee rate in order to retain sufficient cash in Quan Toodou to fund its operating needs and manage liquidity. We also retain the flexibility to adjust in our discretion the service fee rate in the future. Reshuffle Technology shall exclusively own any intellectual properties arising from the

 

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performance of this agreement unless for those technologies independently developed by Quan Toodou and subject to certain conditions under this agreement including that Reshuffle Technology shall have the right to purchase such technologies at the purchase price of RMB1.00 or the lowest price permitted by law. This agreement will continue to be effective until it is terminated by both parties in writing or either party’s business period expires without any extension.

Equity Interest Pledge Agreement. The shareholders of Quan Toodou have entered into an equity interest pledge agreement with Reshuffle Technology, under which each shareholder of Quan Toodou pledged all of his/her equity interest in Quan Toodou to Reshuffle Technology to secure his/her and Quan Toodou’s obligations under certain agreements above and this agreement and as collateral for all of his/her payment of compensation for any losses suffered by Reshuffle Technology due to any event of default by Quan Toodou and/or its shareholders and for any expenses incurred to Reshuffle Technology for enforcing Quan Toodou and/or its shareholders to perform their obligations. If any event of default as defined under this agreement occurs, Reshuffle Technology, as the pledgee, will be entitled to dispose of the pledged equity interests. In addition, any dividend from Quan Toodou as permitted by Reshuffle Technology will be deposited into the account designated by Reshuffle Technology and be further pledged in favor of Reshuffle Technology. The above pledge has been registered with the relevant local branch of the State Administration for Industry and Commerce in China.

Contractual Arrangements with Shanghai Suzao and its Shareholders

Our relationships with Shanghai Suzao and its shareholders are governed by a series of contractual arrangements. Under PRC laws, each of Shanghai Suzao and Reshuffle Technology is an independent legal person and neither of them is exposed to liabilities incurred by the other party. Other than pursuant to the contractual arrangements between Shanghai Suzao and Reshuffle Technology, Shanghai Suzao is not required to transfer any funds generated from its operations to Reshuffle Technology.

Loan Agreements. The shareholders of Shanghai Suzao, namely Chengzi Wu and Jing Chen, have entered into two loan agreements with Reshuffle Technology. Under these loan agreements, Reshuffle Technology agrees to lend interest-free loans of up to RMB6.0 million (US$0.9 million) to these shareholders, solely for their respective capital contributions in Shanghai Suzao. Each of these loan agreements has a term of five years, which will be automatically renewed for another periods of five years upon its expiration. However, Reshuffle Technology, with a 30 days’ prior notice, may require, and the shareholders, with a 30 days’ prior application, may apply for, an earlier repayment of a part or all of the loans, and Reshuffle Technology shall or has the right to (as the case may be) purchase or have its designated third party purchase the corresponding part of the equity interests in Shanghai Suzao in proportion to the amount of the loans to be repaid at the purchase price equal to such amount.

Exclusive Call Option Agreement. Shanghai Suzao and its shareholders have entered into an exclusive call option agreement with Reshuffle Technology, under which each shareholder of Shanghai Suzao irrevocably granted to Reshuffle Technology an exclusive option to purchase or have its designee purchase his/her equity interest in Shanghai Suzao at the purchase price equal to the amount of the registered capital of Shanghai Suzao in proportion to the equity interest to be purchased or the lowest price permitted by the PRC laws. Reshuffle Technology may exercise such option at any time to the extent permitted by the PRC laws. In addition, Shanghai Suzao and its shareholders agree that without Reshuffle Technology’s prior written consent, they will not engage in certain actions including transferring or otherwise disposing of the equity interest in Shanghai Suzao or declaring any dividend.

Proxy Agreement. Shanghai Suzao and its shareholders have entered into a proxy agreement with Reshuffle Technology, under which each shareholder of Shanghai Suzao irrevocably undertakes to execute powers of attorney to persons designated by Reshuffle Technology that irrevocably authorize them to vote as the shareholders’ attorneys-in-fact on all of the matters of Shanghai Suzao requiring shareholders’ approval, including the appointment and election of board members and senior management members.

 

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Exclusive Consultancy and Service Agreement. Under the exclusive consultancy and service agreement between Shanghai Suzao and Reshuffle Technology, Shanghai Suzao engages Reshuffle Technology as its exclusive provider of technical consulting and services and shall pay to Reshuffle Technology service fees consisting of the performance service fee equal to the amount of 20% of Shanghai Suzao’s total annual revenues before tax and the fees for specific technical consulting and services requested by Shanghai Suzao and provided by Reshuffle Technology from time to time. We set this service fee rate in order to retain sufficient cash in Shanghai Suzao to fund its operating needs and manage liquidity. We also retain the flexibility to adjust in our discretion the service fee rate in the future. Reshuffle Technology shall exclusively own any intellectual properties arising from the performance of this agreement unless for those technologies independently developed by Shanghai Suzao and subject to certain conditions under this agreement including that Reshuffle Technology shall have the right to purchase such technologies at the purchase price of RMB1.00 or the lowest price permitted by law. This agreement will continue to be effective until it is terminated by both parties in writing or either party’s business period expires without any extension.

Equity Interest Pledge Agreement. The shareholders of Shanghai Suzao have entered into an equity interest pledge agreement with Reshuffle Technology, under which each shareholder of Shanghai Suzao pledged all of his/her equity interest in Shanghai Suzao to Reshuffle Technology to secure his/her and Shanghai Suzao’s obligations under certain agreements above and this agreement and as collateral for all of his/her payment of compensation for any losses suffered by Reshuffle Technology due to any event of default by Shanghai Suzao and/or its shareholders and for any expenses incurred to Reshuffle Technology for enforcing Shanghai Suzao and/or its shareholders to perform their obligations. If any event of default as defined under this agreement occurs, Reshuffle Technology, as the pledgee, will be entitled to dispose of the pledged equity interests. In addition, any dividend from Shanghai Suzao as permitted by Reshuffle Technology will be deposited into the account designated by Reshuffle Technology and be further pledged in favor of Reshuffle Technology. The above pledge has been registered with the relevant local branch of the State Administration for Industry and Commerce in China.

Contractual Arrangements with Chengdu Gaishi and its Shareholders

Our relationships with Chengdu Gaishi and its shareholders are governed by a series of contractual arrangements. Under PRC laws, each of Chengdu Gaishi and Reshuffle Technology is an independent legal person and neither of them is exposed to liabilities incurred by the other party. Other than pursuant to the contractual arrangements between Chengdu Gaishi and Reshuffle Technology, Chengdu Gaishi is not required to transfer any funds generated from its operations to Reshuffle Technology.

Loan Agreement. The shareholders of Chengdu Gaishi, namely Chengzi Wu and Xiaoyun Zhang, have entered into a loan agreement with Reshuffle Technology. Under this loan agreement, Reshuffle Technology agrees to lend an interest-free loan of up to RMB1.0 million (US$149.5 thousand) to these shareholders, solely for their respective capital contributions in Chengdu Gaishi. The loan agreement has a term of five years, which will be automatically renewed for another periods of five years upon its expiration. However, Reshuffle Technology, with a 30 days’ prior notice, may require, and the shareholders, with a 30 days’ prior application, may apply for, an earlier repayment of a part or all of the loan, and Reshuffle Technology shall or has the right to (as the case may be) purchase or have its designated third party purchase the corresponding part of the equity interests in Chengdu Gaishi in proportion to the amount of the loans to be repaid at the purchase price equal to such amount.

Exclusive Call Option Agreement. Chengdu Gaishi and its shareholders have entered into an exclusive call option agreement with Reshuffle Technology, under which each shareholder of Chengdu Gaishi irrevocably granted to Reshuffle Technology an exclusive option to purchase or have its designee purchase his equity interest in Chengdu Gaishi at the purchase price equal to the amount of the registered capital of Chengdu Gaishi in proportion to the equity interest to be purchased or the lowest price permitted by the PRC laws. Reshuffle Technology may exercise such option at any time to the extent permitted by the PRC laws. In addition, Chengdu

 

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Gaishi and its shareholders agree that without Reshuffle Technology’s prior written consent, they will not engage in certain actions including transferring or otherwise disposing of the equity interest in Chengdu Gaishi or declaring any dividend.

Proxy Agreement. Chengdu Gaishi and its shareholders have entered into a proxy agreement with Reshuffle Technology, under which each shareholder of Chengdu Gaishi irrevocably undertakes to execute powers of attorney to persons designated by Reshuffle Technology that irrevocably authorize them to vote as the shareholders’ attorneys-in-fact on all of the matters of Chengdu Gaishi requiring shareholders’ approval, including the appointment and election of board members and senior management members.

Exclusive Consultancy and Service Agreement. Under the exclusive consultancy and service agreement between Chengdu Gaishi and Reshuffle Technology, Chengdu Gaishi engages Reshuffle Technology as its exclusive provider of technical consulting and services and shall pay to Reshuffle Technology service fees consisting of the performance service fee equal to the amount of 20% of Chengdu Gaishi’s total annual revenues before tax and the fees for specific technical consulting and services requested by Chengdu Gaishi and provided by Reshuffle Technology from time to time. We set this service fee rate in order to retain sufficient cash in Chengdu Gaishi to fund its operating needs and manage liquidity. We also retain the flexibility to adjust in our discretion the service fee rate in the future. Reshuffle Technology shall exclusively own any intellectual properties arising from the performance of this agreement unless for those technologies independently developed by Chengdu Gaishi and subject to certain conditions under this agreement including that Reshuffle Technology shall have the right to purchase such technologies at the purchase price of RMB1.00 or the lowest price permitted by law. This agreement will continue to be effective until it is terminated by both parties in writing or either party’s business period expires without any extension.

Equity Interest Pledge Agreements. Each of the shareholders of Chengdu Gaishi has entered into an equity interest pledge agreement with Reshuffle Technology, under which he pledged all of his equity interest in Chengdu Gaishi to Reshuffle Technology to secure his and Chengdu Gaishi’s obligations under certain agreements above and such equity interest pledge agreement and as collateral for all of his payment of compensation for any losses suffered by Reshuffle Technology due to any event of default by Chengdu Gaishi and/or its shareholders and for any expenses incurred to Reshuffle Technology for enforcing Chengdu Gaishi and/or its shareholders to perform their obligations. If any event of default as defined under these agreements occurs, Reshuffle Technology, as the pledgee, will be entitled to dispose of the pledged equity interests. In addition, any dividend from Chengdu Gaishi as permitted by Reshuffle Technology will be deposited into the account designated by Reshuffle Technology and be further pledged in favor of Reshuffle Technology. The above pledge has been registered with the relevant local branch of the State Administration for Industry and Commerce in China.

Furthermore, the shareholders of these VIEs may be involved in personal disputes with third parties which may have adverse effect on their respective equity interests in the relevant VIE and the validity or enforceability of our contractual arrangements with the relevant VIE and its shareholders. The ex-wife of Mr. Gary Wei Wang recently initiated a lawsuit against him with a local court in Shanghai and claimed for her share of community property during their marriage, including claiming for share of 76% equity interests in Quan Toodou held by Mr. Wang. This lawsuit was concluded through settlement directed by the court in June 2011 and pursuant to a court ruling, Mr. Wang is entitled to the equity interests in any companies that are directly or indirectly controlled by him. In the meantime, the court also issued an order releasing the conservatory measures imposed by the Assets Conservatory Notification. However, if Mr. Wang fails to fully perform his obligations under the court ruling, Mr. Wang’s personal assets, including the equity interests in the companies that are directly or indirectly held by him, may be subject to the court’s enforcement measures. If Mr. Wang does not fully perform his obligations for whatever reasons, and as a result of the court’s enforcement measures, Mr. Wang should transfer all or part of his equity interests in Quan Toodou to his ex-wife or such equity interests are required to be sold to any third party, in each case subject to the right of first refusal of the other existing shareholder of Quan Toodou, we may need to finance such existing shareholder to exercise the right of first refusal to purchase such

 

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equity interests in Quan Toodou. See “Risk Factors—Risks Relating to Doing Business in China—The ineffectiveness of control over Quan Toodou that may result from a lawsuit initiated by the ex-wife of Mr. Gary Wei Wang, our founder, chairman and chief executive officer, seeking the division of 76% of the equity interest in Quan Toodou held by Mr. Wang, could cause significant disruption to our business, operations and financial conditions.”

 

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SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated statements of operations for the three years ended December 31, 2008, 2009 and 2010 and the selected consolidated balance sheet data as of December 31, 2008, 2009 and 2010 have been derived from our audited consolidated financial statements, which are included elsewhere in this prospectus. The selected consolidated statements of operations for the year ended December 31, 2007 have been derived from our audited consolidated financial statements that are not included in this prospectus. The selected consolidated statements of operations data for each of the three month periods ended March 31, 2010 and 2011 and selected consolidated balance sheet data as of March 31, 2011 have been derived from our unaudited consolidated financial statements included elsewhere in this prospectus. We have prepared this unaudited consolidated financial information on the same basis as our audited consolidated financial statements. This unaudited financial information includes all adjustments, consisting only of normal and recurring adjustments, that we consider necessary for a fair presentation of our financial position and operating results for the periods presented. Results for the three months ended March 31, 2011 are not necessarily indicative of results that may be expected for the full year.

You should read the selected consolidated financial data in conjunction with those 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. Our historical results are not necessarily indicative of our results expected for future periods.

Our audited consolidated financial statements for the years ended December 31, 2008 and 2009 have been restated to reclassify agency fees we paid to advertising agencies as a reduction of revenues rather than as cost of revenues. The identification of this error in classification resulted in a downward adjustment of RMB4.7 million and RMB24.1 million in our net revenues for the years ended December 31, 2008 and 2009, respectively, and a corresponding downward adjustment of RMB4.7 million and RMB24.1 million in our cost of revenues for the years ended December 31, 2008 and 2009, respectively. For more details, please see Note 3 (b) to our audited consolidated financial statements included elsewhere in this prospectus.

The selected consolidated statements of operations for the fiscal year ended December 31, 2006 and the selected consolidated balance sheet data as of December 31, 2006 and 2007 have been omitted, as such information is not available on the basis that is consistent with the consolidated financial data included in this prospectus and cannot be prepared in accordance with U.S. GAAP without unreasonable effort or expense.

 

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    For the Year Ended December 31,     For the Three Months Ended March 31,  
    2007     2008     2009     2010       2010         2011         2011    
          Restated     Restated                          
    (RMB)     (RMB)     (RMB)     (RMB)     (RMB)     (RMB)     (US$)  
   

(in thousands, except per share data)

 

Consolidated Statements of Operations

             

Net revenues

    6,617.7        26,220.2        89,147.3        286,258.1        29,770.4        79,377.0        12,121.8   

Cost of revenues(1)

    (72,394.3     (143,331.5     (127,182.1     (226,399.3     (41,659.1     (80,995.8     (12,369.0
                                                       

Gross profit (loss)

    (65,776.6     (117,111.3     (38,034.8     59,858.8        (11,888.7     (1,618.8     (247.2

Operating expenses:

             

Sales and marketing expenses(1)

    (12,996.7     (42,574.3     (73,435.2     (143,224.1     (21,198.3     (76,383.9     (11,664.7

General and administrative expenses(1)

    (11,824.3     (37,781.3     (37,585.6     (104,911.4     (4,000.4     (83,887.6     (12,810.6

Impairment of equipment

    —          (8,735.6     (2,372.3     —          —          —          —     
                                                       

Total operating expenses

    (24,821.0     (89,091.2     (113,393.1     (248,135.5     (25,198.7     (160,271.5     (24,475.3
                                                       

Loss from operations

    (90,597.6     (206,202.5     (151,427.9     (188,276.7     (37,087.4     (161,890.3     (24,722.5

Finance income

    2,545.3        3,572.6        3,103.8        331.0        60.3        76.7        11.7   

Finance expenses

    —          —          —          (12,851.2     (429.7     (867.2     (132.4

Other expenses

    (20.8     (236.5     (63.0     1.4        —          —          —     

Foreign exchange gain (loss)

    (7,810.5     (9,772.2     3,610.0        (10,957.2     (563.3     (2,914.4     (445.1

Beneficial conversion charge on convertible loan

    —          —          —          (10,967.0     —          —          —     

Fair value changes in warrant liabilities

    —          —          —          (124,680.1     —          (170,385.1     (26,019.7
                                                       

Loss before income taxes

    (95,883.6     (212,638.6     (144,777.2     (347,399.8     (38,020.1     (335,980.3     (51,308.0

Income taxes

    (0.0 )*      —          —          —          —          —          —     
                                                       

Net loss

    (95,883.6     (212,638.6     (144,777.2     (347,399.8     (38,020.1     (335,980.3     (51,308.0
                                                       

Net loss attributable to ordinary shareholders

    (85,192.3     (195,100.7     (145,085.6     (362,383.7  

 

(38,071.4

 

 

(340,678.2

 

 

(52,025.4

                                                       

Loss per ordinary share

             

Basic and diluted

    (7.10     (16.26     (12.09     (30.20     (3.17     (28.39     (4.34

Weighted average number of ordinary shares used in computing loss per share:

             

Basic and diluted

    12,000        12,000        12,000        12,000        12,000        12,000        12,000   

Pro forma loss per share attributable to Class A and Class B ordinary shareholders basic and diluted

          (3.81       (3.69     (0.56

Pro forma weighted average number of ordinary shares used in computing loss per share basic and diluted:

             

Class A and Class B ordinary shares

          90,998          90,998        90,998   

Non-GAAP Financial Data

             

Adjusted net loss(2)

    (90,180.4     (201,320.5     (133,254.8     (107,176.3     (45,270.6     (58,978.9     (9,006.8

 

* Less than RMB100.

 

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(1) Includes share-based compensation expenses as follows:

 

    For the Year Ended December 31,     For the Three Months
Ended March 31,
 
          2007                 2008                 2009                 2010                 2010                 2011        
    (RMB)     (RMB)     (RMB)     (RMB)     (RMB)     (RMB)     (US$)  
    (in thousands)  

Share-based compensation expenses:

             

Cost of revenues

    1,217.0        2,762.6        1,875.6        14,133.0        (1,540.4     14,718.0        2,247.6   

Sales and marketing expenses

    2,065.5        3,918.0        3,491.8        31,025.3        (2,433.8     35,048.7        5,352.3   

General and administrative expenses

    2,420.7        4,637.5        6,155.0        59,418.1        (3,276.3     56,849.6        8,681.6   
                                                       

Total:

    5,703.2        11,318.1        11,522.4        104,576.4        (7,250.5     106,616.3        16,281.5   
                                                       

 

(2) We define adjusted net loss, a non-GAAP financial measure, as net loss excluding share-based compensation expenses, beneficial conversion charge on convertible loan and fair value changes in warrant liabilities. We review adjusted net loss together with 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 without the effect of non-cash beneficial conversion charge on convertible loan and fair value changes in warrant liabilities, which will not likely be recurring factors in our business in the future, and share-based compensation expenses, which have been and will continue to be a significant recurring factor in our business. However, the use of adjusted net loss has material limitations as an analytical tool. 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 net loss is not calculated in the same manner by all companies, it may not be comparable to other similar titled measures used by other companies. In light of the foregoing limitations, you should not consider adjusted net loss in isolation from or as an alternative to net loss 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.

 

        For the Year Ended December 31,     For the Three Months
Ended March 31,
 
        2007     2008     2009     2010     2010     2011  
        (RMB)     (RMB)     (RMB)     (RMB)     (RMB)     (RMB)     (US$)  
        (in thousands)  

Net loss

    (95,883.6     (212,638.6     (144,777.2     (347,399.8     (38,020.1     (335,980.3     (51,308.0

Add back:

  share-based compensation expenses:     5,703.2        11,318.1        11,522.4        104,576.4        (7,250.5     106,616.3        16,281.5   
  beneficial conversion charge on convertible loan:     —          —          —          10,967.0        —          —          —     
  fair value changes in warrant liabilities:     —          —          —          124,680.1        —          170,385.1        26,019.7   
                                                         

Adjusted net loss

    (90,180.4     (201,320.5     (133,254.8     (107,176.3     (45,270.6     (58,978.9     (9,006.8
                                                         

 

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     As of December 31,     As of March 31,  
     2008     2009     2010     2011  
     (RMB)     (RMB)    

(RMB)

    (RMB)     (US$)  
     (in thousands)  

Consolidated Balance Sheet Data:

          

Cash and cash equivalents

     260,769.0        62,034.4        263,150.8        208,969.4        31,912.0   

Short term investments

     11,312.2        84,211.6        5,837.2        —          —     

Total current assets

     303,479.2        223,511.0        614,181.6        566,709.1        86,542.9   

Total assets

     339,699.4        263,003.0        698,742.2        671,553.6        102,553.9   

Total current liabilities

     51,864.8        119,945.5        418,358.9        556,765.5        85,024.4   

Total liabilities

     51,864.8        119,945.5        572,398.5        881,190.2        134,567.8   

Mezzanine equity:

          

Series A redeemable convertible preferred shares

     5,908.8        6,756.8        7,381.3        7,512.4        1,147.2   

Series B redeemable convertible preferred shares

     58,094.0        58,039.6        56,292.9        55,729.3        8,510.5   

Series C redeemable convertible preferred shares

     129,857.4        129,735.8        125,831.3        124,571.6        19,023.5   

Series D redeemable convertible preferred shares

     388,205.3        387,841.8        376,169.4        372,403.5        56,870.3   

Series E redeemable convertible preferred shares

     —          —          351,402.1        361,558.1        55,214.0   

Accumulated deficit

     (294,327.9     (439,413.5     (801,797.3     (1,142,475.5     (174,469.0

Total shareholders’ deficit

     (294,230.9     (439,316.5     (790,733.2     (1,131,411.5     (172,779.4

Total liabilities and shareholders’ deficit

     339,699.4        263,003.0        698,742.2        671,553.6        102,553.9   

 

 

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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 our audited consolidated financial statements. 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 a leading online video company in China. Our “Tudou” brand is the most valuable online video brand in China and our website, Tudou.com, is the most favored and recommended online video website in China, according to the Sinomonitor Reports. Our Tudou.com website, which we believe is the first online video site launched in China, provides a robust online platform for Chinese Internet users to upload, watch and share videos through the Internet.

Since we launched our online video website in April 2005, our business has grown substantially, particularly in recent years. We have experienced rapid traffic and user growth. Our registered users increased from approximately 35.6 million as of December 31, 2008 to approximately 78.2 million as of December 31, 2010 and further to approximately 83.6 million as of March 31, 2011. Our average number of new video clips uploaded daily increased from approximately 23,000 in 2008 to approximately 40,000 in 2010 and to approximately 44,000 in the first quarter of 2011. The number of monthly unique visitors to our site Tudou.com increased from approximately 50 million in December 2007 to approximately 182 million in December 2010, and to approximately 185 million in April 2011, according to iResearch.

We generate revenues primarily by providing online advertising services through our Tudou.com website. These online advertising services include pre-roll or post-roll video advertisements, in-roll logos, background advertisements, banners, buttons, links and stream advertisements. In addition, we provide innovative and differentiated online advertising services, including event sponsorships, interactive advertising and opportunities, to purchase advertising embedded in our in-house developed content. We provided our advertising services to 170, 320 and 512 advertisers in 2008, 2009 and 2010, respectively. We provided our advertising services to 174 and 230 advertisers for the three months ended March 31, 2010 and 2011, respectively.

We also began generating revenues in January 2010 from our mobile video services, which we provide primarily through a channel on China Mobile’s wireless video platform. Under the agreement with China Mobile, we select and provide video programs based on our assessment of mobile phone users’ preferences. Users pay a monthly subscription fee for access to the video channel or pay on a per-clip basis, and we share the fees for such services with China Mobile. We began providing our mobile video services in April 2011 through two video channels on China Unicom’s wireless video platform. In addition, since the third quarter of 2010, we have generated revenues from sub-licensing some premium content that we licensed from third party vendors.

Our net revenues increased from RMB26.2 million in 2008 to RMB89.1 million in 2009 and to RMB286.3 million in 2010, representing a CAGR of 121.8% over the three-year period. Our net revenues increased by 166.6% to RMB79.4 million (US$12.1 million) for the three months ended March 31, 2011 from RMB29.8 million for the same period in 2010. As is customary in the advertising industry in China, we typically enter into advertising contracts with third-party advertising agencies. We offer agency fees to third-party advertising agencies that purchase our advertising services and recognize revenues net of these agency fees. Our net revenues are net of sales taxes. Our net loss was RMB212.6 million, RMB144.8 million and RMB347.4 million in 2008, 2009 and 2010, respectively. Our net loss was RMB38.0 million and RMB336.0 million (US$51.3 million) for the three months ended March 31, 2010 and 2011, respectively. Our adjusted net loss, a non-GAAP financial measure, which excludes the impact of non-cash items including share-based compensation expenses, beneficial

 

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conversion charge on convertible loan and fair value changes in warrant liabilities from our net loss, was RMB201.3 million, RMB133.3 million and RMB107.2 million in 2008, 2009 and 2010, respectively. Our adjusted net loss was RMB45.3 million and RMB59.0 million (US$9.0 million) for the three months ended March 31, 2010 and 2011, respectively. For a reconciliation of our net loss to our adjusted net loss, see footnote 2 on page 11 of this prospectus.

Factors Affecting Our Results of Operations

Our business, financial condition and results of operations have been and will continue to be subject to general conditions affecting the online video and online advertising industries in China. These conditions, among others, include the stability and growth of China’s economy and advertising and mobile Internet industries, the growth of the Internet and increasing penetration rate in China, and the increasing acceptance of online advertising as part of advertisers’ overall Internet marketing strategy and spending. In addition, our business, financial condition and results of operations are affected by a number of company-specific factors including the following:

 

   

Our Ability to Provide Innovative and Effective Advertising Services. Our financial condition and results of operations depend on the demand for and the effectiveness of our advertising services. We aim to provide innovative and effective online advertising services to increase advertisers’ advertising spending on our platform and attract new advertisers. Our Tudou.com website allows advertisers to display their advertisements in different placement formats to optimize the advertisements effectiveness against their marketing objectives. We strive to continue to offer innovative and effective advertising services to advertisers to further grow our revenues.

 

   

Our Ability to Maintain and Expand Our Highly Engaged User Community and Drive Traffic to Our Website. Our business depends on our ability to maintain and expand our highly engaged user community and drive traffic to our website. We have built up a valuable user base consisting primarily of highly engaged young, urban, affluent and educated users between the ages of 18 and 35, which is a particularly attractive demographic to advertisers, increasing our registered users from approximately 35.6 million as of December 31, 2008 to approximately 78.2 million as of December 31, 2010 and further to approximately 83.6 million as of March 31, 2011. A visitor to Tudou.com becomes a registered user by creating an account with our website. To create an account, a visitor follows certain registration steps, including creating a user name and password and accepting our standard user agreement. In addition, the number of monthly unique visitors to our site Tudou.com increased from approximately 50 million in December 2007 to approximately 182 million in December 2010, and approximately 185 million in April 2011, according to iResearch. We believe that a key factor in our ability to continue to drive traffic to our website is our ability to provide unique and differentiated content, including UGC, premium licensed content and in-house produced content, that is attractive to a broad base of users. In addition, advertisers use our site as a powerful branding platform. The number of our users, their engagement in our website and interactivity directly affect our revenues, because under our advertising plans and advertising contracts, we charge based primarily on the number of user views of advertisements.

 

   

Our Ability to Obtain Popular Video Content at a Commercially Acceptable Cost. In addition to UGC and in-house produced content, we need to license and acquire popular video content to deliver a differentiated and engaging experience for our users and present attractive advertising opportunities for advertisers. We believe that popular premium licensed content will help increase our user base and overall traffic and is a critical factor in our future success. During the three years ended December 31, 2009, we obtained licenses for more than 830 TV episodes and 240 movies. In 2010, we significantly increased our content procurement and obtained licenses for more than 1,360 TV episodes, 1,180 movies and 180 variety shows. In the three months ended March 31, 2011, we obtained licenses for more than 1,440 TV episodes, 1,260 movies and 210 variety shows. We usually procure premium licensed content at prevailing market prices. We expect that our investment in premium licensed

 

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content will significantly increase in the foreseeable future as we plan to procure more premium licensed content and the unit procurement cost of premium licensed content, such as licensing fees for TV episodes and movies, continues to increase.

 

   

Our Ability to Procure Internet Bandwidth Cost-effectively and in a timely manner. Internet bandwidth procurement costs accounted for a majority of our cost of revenues in recent periods. We have increased Internet bandwidth capacities in recent years following the growth of our user base and traffic on our website. While Internet bandwidth costs have increased in absolute terms, they have decreased as a percentage of our net revenues in each period, which is a result of our ability to control the Internet bandwidth procurement cost per unit primarily due to the use of our own content delivery network, or CDN, our efficient use of Internet bandwidth, our bandwidth saving technology, such as our innovative “Fast Tudou” software functioning as a peer-to-peer, or P2P, content delivery system, and our unit price negotiation efforts. We procure Internet bandwidth from provincial subsidiaries of telecommunication operators such as China Telecom and China Unicom, and other independent third parties which purchase bandwidth lines from telecommunications operators. The provincial subsidiaries of China Telecom and China Unicom currently function as independent companies, and we negotiate bandwidth prices separately with them or other bandwidth vendors.

 

   

Our Ability to Control Sales and Marketing Expenses. Sales and marketing expenses account for a significant portion of our operating expenses. Our sales and marketing expenses increased from RMB42.6 million in 2008 to RMB73.4 million in 2009 and to RMB143.2 million in 2010, primarily due to an increase in salaries and benefits as we hired additional sales professionals and an increase in our revenues resulting in the increase in performance-based salary and bonus expenses. However, over the same periods, our sales and marketing expenses decreased as a percentage of our total net revenues primarily due to our increases in revenues and operating efficiency. Our sales and marketing expenses increased from RMB21.2 million for the three months ended March 31, 2010 to RMB76.4 million (US$11.7 million) over the same period of 2011 primarily resulting from the increase in the share-based compensation expenses. Our ability to further enhance our sales efforts and control our sales and marketing expenses will affect our revenues and operating expenses.

 

   

Our Ability to Grow Our Mobile Video Services. We began offering mobile video services to mobile phone users in China in January 2010 through our Tudou channel on China Mobile’s wireless video platform. We began providing our mobile video services in April 2011 through two video channels on China Unicom’s wireless video platform. We also collaborate with certain major mobile handset manufacturers such as Blackberry, Motorola, Nokia and Samsung, as well as handset design houses and application store operators, to promote these services. We believe our mobile video business offers substantial growth potential and is an important component of our growth strategy. Our success in the mobile video business depends on our ability to provide quality content that attracts subscribers, maintain our relationships with telecommunication operators such as China Mobile and China Unicom as well as their affiliates, mobile handset companies and application store operators and promote our content to wireless users.

 

   

Our Ability to Maintain Leading Brand and Market Position. We believe that advertisers select us largely because we possess the leading brand and market position in the online video market. The online video industry in China is intensely competitive. We compete with independent other online video sites in China, major domestic Internet companies, other companies engaged in online advertising and potentially, software-based streaming video sites. See “Business—Competition.” Our ability to compete effectively and to maintain our leading brand and market position as an online video platform is key to our ability to attract new advertisers, maintain and enhance relationships with our existing advertisers and advertising agencies and increase our revenues.

 

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Description of Certain Statement of Operations Items

Net Revenues

For the years ended December 31, 2008 and 2009, we derived all of our revenues from sales of online advertising services. For the year ended December 31, 2010 and the three months ended March 31, 2011, we derived most of our revenues from sales of online advertising services. Our net revenues from online advertising services amounted to RMB26.2 million, RMB89.1 million and RMB265.2 million in 2008, 2009 and 2010, respectively. Our net revenues from online advertising services increased to RMB70.2 million (US$10.7 million) for the three months ended March 31, 2011 from RMB29.3 million for the same period in 2010. In addition, we began generating revenues from our mobile video services in January 2010. For the year ended December 31, 2010 and the three months ended March 31, 2010 and 2011, our net revenues from mobile video services amounted to RMB19.1 million, RMB0.5 million and RMB8.9 million (US$1.4 million), representing 6.7%, 1.7% and 11.2% of our net revenues for the period, respectively. Also, since the third quarter of 2010, we have generated revenues from sub-licensing some of the premium content that we licensed from third party vendors. For the year ended December 31, 2010 and the three months ended March 31, 2010 and 2011, our net revenues from sub-licensing premium content amounted to RMB2.0 million, zero and RMB0.3 million (US$0.1 million), representing approximately 0.7%, zero and 0.4% of our net revenues for the period, respectively.

We sell online advertising services primarily through our Tudou.com website, such as pre-roll or post-roll video advertisements, in-roll logos, banners, buttons, links and stream advertisements. We also offer background advertisements appearing behind a selected video screen concurrently with a user viewing a video, which most of our key competitors do not offer, and sponsorship rights for a particular area of our website or for a particular event. We expect that our online advertising service revenues will continue to be the primary source of, and constitute the substantial majority of, our revenues for the foreseeable future.

As is customary in the advertising industry in China, we typically enter into advertising contracts with third-party advertising agencies. We offer agency fees to third-party advertising agencies that purchase our advertising services and recognize revenues net of these agency fees. The agency fees we incurred were RMB4.7 million, RMB24.1 million and RMB55.0 million in 2008, 2009 and 2010, respectively. The agency fees we incurred were RMB6.9 million and RMB15.3 million (US$2.3 million) for the three months ended March 31, 2010 and 2011, respectively. Our net revenues from online advertising services are net of business taxes and related surcharges incurred in connection with our operations. Our advertising service revenues are subject to a business tax of approximately 5.0% and a cultural and educational related surcharge of 4.5% on revenues earned from our advertising services provided in China. We deduct these amounts from our advertising service revenues to arrive at our net revenues attributable to advertising services.

The growth of our online advertising service revenues is driven by the number of our advertisers as well as revenues from individual advertisers. We had an aggregate of 170, 320 and 512 advertisers in 2008, 2009 and 2010, respectively. We provided our advertising services to 174 and 230 advertisers for the three months ended March 31, 2010 and 2011, respectively. The number of advertisers during any period is affected by our services, our sales and marketing efforts and influenced by our market position and advertisers’ perception of the effectiveness of our online advertising services. The size of our advertiser base is also driven by customer-specific factors such as the timing of the introduction of new advertising campaigns, our ability to maintain favorable demographic user base, seasonality of advertisers’ operations and growth of business sectors in which our advertisers operate. Our valuable user base in China consisting primarily of young urban educated users between the ages of 18 and 35, also contributes to attracting advertisers to our services. Net revenues from our top 10 advertisers collectively amounted to approximately RMB8.5 million, RMB26.4 million and RMB62.3 million in 2008, 2009 and 2010, respectively, representing 32.3%, 29.6% and 21.8% of our net revenues in 2008, 2009 and 2010, respectively. Net revenues from our top 10 advertisers collectively amounted to approximately RMB9.7 million and RMB16.9 (US$2.6 million) for the three months ended March 31, 2010 and 2011, representing 32.5% and 21.3% of our net revenues for the three months ended March 31, 2010 and 2011, respectively. We expect that the revenues generated from our top 10 advertisers will continue to increase in an absolute amount, but will decrease as a percentage of our total revenues as our advertiser base further grows.

 

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We believe our revenues from online advertising services are subject to seasonal fluctuations. For example, revenues of China-based online advertising companies like us are usually lower during the Chinese New Year period in the first quarter when advertisers tend to spend less on online advertising. However, due to the rapid growth of our online advertising business recently, such seasonality currently may not appear as prominent as other online advertising companies.

In addition, we began generating revenues from mobile video services in January 2010. We provide mobile phone users in China with access to video programs through a channel on China Mobile’s wireless video platform. To have access to the services, the users must pay a monthly subscription fee or pay on a per-clip basis. We share the fees with China Mobile.

We began providing our mobile video services in April 2011 through two video channels on China Unicom’s wireless video platform. As of May 31, 2011, we had not generated revenues from our services for these two channels under China Unicom.

Our revenues from mobile video services provided in China are subject to a turnover tax consisting of approximately 3.0% business tax and related surcharges of 0.3%. We deduct these amounts from our mobile video services revenues to arrive at our net revenues attributable to such services.

In the third and fourth quarters of 2010 as well as the first quarter of 2011, we generated revenues by sub-licensing some of the premium content that we license from third party vendors. We do not expect to generate significant revenues from sub-licensing of premium content as we do not intend to significantly invest in the exclusive webcasting rights for premium content.

Cost of Revenues

Our cost of revenues consists of Internet bandwidth cost, advertisement production expenses, amortization and write-down of content procurement and production costs, wireless service fees and other costs. Our total cost of revenues amounted to RMB143.3 million, RMB127.2 million and RMB226.4 million in 2008, 2009 and 2010, respectively. Our total cost of revenues amounted to RMB41.7 million and RMB81.0 million (US$12.4 million) for the three months ended March 31, 2010 and 2011, respectively.

Internet bandwidth cost represents the fees we pay to bandwidth vendors, which are typically provincial subsidiaries of telecommunications operators such as China Telecom and China Unicom, or independent third parties that purchase bandwidth from major telecommunications operators in China. In the foreseeable future, we expect our Internet bandwidth costs to continue to increase in absolute amount given the anticipated increase in the volume of our website traffic, and to decrease as a percentage of our total net revenues as we continue to increase our revenues and to control the Internet bandwidth procurement cost per unit through the adoption of in-house built CDN system instead of leasing from third-party CDN service providers, our optimal use of Internet bandwidth, our bandwidth saving technology such as our innovative “Fast Tudou” software, and our unit price negotiation efforts.

Cost of revenues relating to content procurement and production is primarily comprised of amortization and write-down associated with premium licensed and in-house produced content. We expect cost of revenues in relation to content procurement and production to significantly increase in the foreseeable future because we plan to procure more premium licensed content and produce more in-house developed content such as our “Made-For-Internet” drama series and because the unit procurement cost of premium licenses content, such as licensing fees for TV episodes and movies, continues to increase. During the three years ended December 31, 2009, we obtained licenses for more than 830 TV episodes and 240 movies. In 2010, we significantly increase our content procurement and obtained licenses for more than 1,360 TV episodes, 1,180 movies and 180 variety shows. In the three months ended March 31, 2011, we obtained licenses for more than 1,440 TV episodes, 1,260 movies and 210 variety shows.

 

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Advertisement production expenses are primarily comprised of the outsourcing fees we pay to third parties for processing the advertisement materials provided by advertisers to a form or size that fits online display, for which we do not request our customers to reimburse us or pay additional prices and expenses associated with our integrated marketing programs, such as the “Internet Millionaire” competition program for Nokia and “Win Gold by One Smile” for Minute Maid, one of Coca-Cola’s sub-brands. We expect such expenses to increase corresponding to the increase in our advertising service revenues.

Other costs consist primarily of depreciation for servers, other computer hardware and equipment that are directly related to our business operations and technical support as well as labor cost related to our technical support personnel. We expect the depreciation recognized under cost of revenues to increase in absolute amounts as a result of the purchase of additional equipment due to the traffic growth of our website. While we expect our labor costs recognized under cost of revenues to increase, we expect such cost of revenues as a percentage of our total cost of revenues to remain relatively insignificant.

We began incurring service fees for mobile video services starting in the first quarter of 2010. These service fees represent the service fees paid to mobile application store operators and handset design houses in connection with our mobile video services. We expect such costs to increase proportionally with the increase in our mobile video service revenues.

Operating Expenses

Our operating expenses consist of sales and marketing expenses, general and administrative expenses, and impairment of equipment.

Sales and marketing expenses

Our sales and marketing expenses primarily consist of salaries and benefits for our sales and marketing staff, sales commission paid to our sales team and marketing expenses. Sales and marketing expenses were RMB42.6 million, RMB73.4 million and RMB143.2 million in 2008, 2009 and 2010, respectively, accounting for approximately 162.4%, 82.4% and 50.0% of our net revenues in 2008, 2009 and 2010, respectively. Sales and marketing expenses were RMB21.2 million and RMB76.4 million (US$11.7 million) for the three months ended March 31, 2010 and 2011, accounting for approximately 71.2% and 96.2% of our net revenues for the three months ended March 31, 2010 and 2011, respectively. Our share-based compensation charges allocated under sales and marketing expenses amounted to RMB3.9 million, RMB3.5 million and RMB31.0 million in 2008, 2009 and 2010, respectively. Our share-based compensation charges allocated under sales and marketing expenses amounted to negative RMB2.4 million and RMB35.0 million (US$5.4 million) for the three months ended March 31, 2010 and 2011, respectively. Salary and benefit expenses generally correspond to fluctuations in our net revenues as salary and bonus expenses are usually tied to the performance of our sales team. Marketing expenses primarily consist of advertising expenses. Our total advertising expenses were RMB6.3 million, RMB7.2 million and RMB19.6 million in 2008, 2009 and 2010, respectively. Our total advertising expenses were RMB2.1 million and RMB10.2 million (US$1.6 million) for the three months ended March 31, 2010 and 2011, respectively. Our sales and marketing expenses have increased in recent years, primarily due to our hiring additional sales professionals and the increased performance-based salary and bonus expenses for our sales professionals following the increase in our revenues. We expect that our sales and marketing expenses will increase in absolute amount as we further enhance our sales and marketing efforts. However, we expect our sales and marketing expenses to continue to decrease as a percentage of our total revenues as we continue to gain more operating efficiencies while scaling up our business.

General and administrative expenses

Our general and administrative expenses primarily consist of salaries and benefits for our general administrative, finance and human resources personnel, office rentals, professional service fees and other

 

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expenses incurred in connection with general corporate purposes. General and administrative expenses were RMB37.8 million, RMB37.6 million and RMB104.9 million in 2008, 2009 and 2010, respectively, accounting for approximately 144.1%, 42.2% and 36.6% of our total net revenues in 2008, 2009 and 2010, respectively. General and administrative expenses were RMB4.0 million and RMB83.9 million (US$12.8 million) for the three months ended March 31, 2010 and 2011, accounting for approximately 13.4% and 105.7% of our net revenues for the three months ended March 31, 2010 and 2011, respectively. Our share-based compensation charges allocated under general and administrative expenses amounted to RMB4.6 million, RMB6.2 million and RMB59.4 million in 2008, 2009 and 2010, respectively. Our share-based compensation charges allocated under general and administrative expenses amounted to negative RMB3.3 million and RMB56.8 million (US$8.7 million) for the three months ended March 31, 2010 and 2011, respectively. We expect our general and administrative expenses to increase in absolute amount in the near future as we incur additional expenses in connection with the expansion of our business and our operations as a publicly traded company, which include expenses related to improving and maintaining our internal control over financial reporting and complying with our reporting obligations. However, we expect our general and administrative expenses to continue to decrease as a percentage of our total revenues in the future as we continue to gain more operating efficiencies while scaling up our business.

Impairment of equipment

We assess the impairment of equipment in accordance with the guidance under ASC 360-10-35 by comparing the carrying value of the equipment with the estimated undiscounted future cash flows we expect to receive from (i) use of the equipment and (ii) their eventual disposition. If the sum of the estimated undiscounted future cash flows is less than the carrying value, we recognize an impairment loss equal to the excess of the carrying value over the fair value of the equipment.

In 2008 and 2009, due to our relatively limited ability to generate operating cash flow and the decrease in future cash flow from disposition following our use of the equipment, we incurred impairment charges. We recognized impairment charges of RMB8.7 million, RMB2.4 million related to servers, other computer hardware and equipment in 2008 and 2009, respectively. The impairment of equipment may decrease when our ability to generate operating cash flow is further enhanced following the growth of our revenues. For 2010 and the three months ended March 31, 2011, we did not record impairment of equipment charges. See “—Critical Accounting Policies and Estimates—Impairment of Long-lived Assets.”

Finance Income/Finance Expenses

Finance income consists of income earned on cash and cash equivalents and short term investments. Cash and cash equivalents represent cash on hand and demand deposits placed with banks or other financial institutions with maturity terms of three months or less. Short term investments comprise time deposits with maturity terms of three months or more but less than one year. We recognized finance income of RMB3.6 million, RMB3.1 million and RMB0.3 million in 2008, 2009 and 2010, respectively. We recognized finance income of RMB60,322 and RMB76,657 (US$11,706) for the three months ended March 31, 2010 and 2011, respectively.

We incurred finance expenses of RMB12.9 million in 2010, primarily related to (i) interest expenses of RMB10.2 million for the accretion of the convertible loan during the period, and (ii) interest expenses of various short-term loans extended to us by certain commercial banks. We incurred finance expenses of RMB0.4 million and RMB0.9 million (US$0.1 million) in the first quarter of 2010 and 2011, respectively, primarily related to interest expenses of the short-term loans extended to us by certain commercial banks.

Foreign Exchange Gain (Loss)

Our functional currency is the Renminbi, the official currency in the PRC. Our cash flow from financing activities were primarily denominated in U.S. dollars, but our revenues and purchases are generally denominated

 

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in Renminbi. We are thus exposed to foreign exchange risks. Foreign exchange transactions are required by law in the PRC to be transacted only by authorized financial institutions.

In 2009, we bought Euros and Australian dollars to diversify our foreign currency balances and to mitigate foreign exchange risk associated with U.S. dollar’s depreciation against the Renminbi. As of March 31, 2011, we had cash balances of US$28.7 million and insignificant amounts of Australian dollars. We recorded foreign exchange losses of RMB9.8 million in 2008 primarily attributable to the depreciation of the U.S. dollar, and a foreign exchange gain of RMB3.6 million in 2009 primarily attributable to the appreciation of Australian dollars. We recorded a foreign exchange loss of RMB11.0 million in 2010 primarily due to the depreciation of U.S. dollars, Australian dollars and Euros during the same period. We recorded a foreign exchange loss of RMB0.6 million in the first quarter of 2010 primarily due to the depreciation of U.S. dollars. We recorded a foreign exchange loss of RMB2.9 million (US$0.4 million) in the first quarter of 2011 primarily attributable to the depreciation of U.S. dollars during the same period.

Share-based Compensation

In February 2006, we adopted a share incentive plan that provides for the granting of options to employees to acquire our ordinary shares at an exercise price as determined by the administrator of our share incentive plan or our board of directors. As of March 31, 2011, 12,240,118 ordinary shares were reserved for option issuance under the share incentive plan, of which options to purchase 8,753,245 ordinary shares granted to our employees were outstanding. The options granted contain service conditions generally with a vesting period of four years, with 25% of the options vesting every year. The vesting period of the options to purchase 1,057,500 ordinary shares granted on August 20, 2008 to certain of our directors is sixteen months.

We account for share options granted to employees under provisions of ASC 718, “Stock Compensation.” In accordance with ASC 718, we determine whether a share option should be classified and accounted for as a liability award or equity award. All grants of share-based awards to employees classified as equity awards are recognized in the financial statements based on their grant date fair values which are calculated using an option pricing model. All grants of share-based awards to employees and directors classified as liability are re-measured at the end of each reporting period with an adjustment for fair value recorded to the current period expense in order to properly reflect the cumulative expense based on the current fair value of the vested rewards over the vesting periods. The changes in the fair value of vested awards are recognized immediately as compensation cost. We granted share options which contained an exercise price denominated in US dollar. Since this denomination is neither our functional currency nor the currency in which the grantee is paid, they are accounted for as liability awards that are remeasured at fair value with changes recognized in the consolidated statements of operations.

We have elected to recognize compensation expenses on a straight-line basis over the requisite service period, which is generally the vesting period. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from initial estimates. Share-based compensation expense was recorded net of estimated forfeitures such that expense was recorded only for those share-based awards that are expected to vest.

During the years ended December 31, 2008 and 2009, certain employees leaving us applied to us to extend the exercise period of the vested options from 90 days since the termination date to the actual date of our initial public offering, or IPO. We approved such applications and extended the exercise period of the vested options granted until the IPO date and subsequently in July 2010 further extended the exercise period to 90 days after the completion of the registration with the SAFE of our share incentive plan after our IPO, because under the PRC law they cannot legally exercise these options prior to the completion of such registration. Such extension was limited and was at our sole discretion and was considered based on the employment terms or contribution of the respective employees to us. Total incremental value arising from modification of the options amounted to RMB0.5 million. We recorded the incremental compensation cost of approximately RMB0.3 million, approximately RMB27,000 and approximately RMB0.2 million for years ended December 31, 2008, 2009 and

 

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2010 respectively, on the date the vested options are modified. We recorded nil of the incremental compensation cost in the first quarter of 2011 as there were no modifications in the vested options during this period.

The following table sets forth amounts of our share-based compensation expenses and their allocation to certain line items on our consolidated statements of operations for the periods indicated:

 

    For the Year Ended
December 31,
    For the Three Months Ended
March 31,
 
        2008             2009             2010             2010             2011      
    (RMB)     (RMB)     (RMB)    

(RMB)

   

(RMB)

   

(US$)

 
   

(in thousands)

   

(in thousands)

 

Share-based compensation expenses:

           

Cost of revenues

    2,762.6        1,875.6        14,133.0        (1,540.4     14,718.0        2,247.6   

Sales and marketing expenses

    3,918.0        3,491.8        31,025.3        (2,433.8     35,048.7        5,352.3   

General and administrative expenses

    4,637.5        6,155.0        59,418.1        (3,276.3     56,849.6        8,681.6   
                                               

Total:

    11,318.1        11,522.4        104,576.4        (7,250.5     106,616.3        16,281.5   
                                               

Taxation

Cayman Islands

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

China

Prior to January 1, 2008, foreign-invested enterprises established in the PRC were generally subject to a 30% national and 3% local enterprise income tax rate. Various preferential tax treatments promulgated by national tax authorities were available to these foreign-invested enterprises or enterprises located in certain areas of China. In addition, some local tax authorities allowed certain enterprises registered in their tax jurisdiction to enjoy lower preferential tax treatment. Under the relevant local tax preferential treatments, our subsidiary and VIE that are registered in the Pudong New District of Shanghai were subject to a 15% preferential income tax rate in 2007. Prior to August 2007, Quan Toodou was considered a small business, and subject to an effective income tax rate of 2.3% of its revenues.

The new EIT Law in the PRC was enacted in March 2007 and became effective on January 1, 2008. The new EIT Law applies a uniform 25% enterprise income tax rate to both foreign-invested enterprises and domestic enterprises. However, the new EIT Law also permits certain enterprises to continue to enjoy their preferential tax treatments, adjusted by certain transitional phase-out rules, under which enterprises that were subject to an enterprise income tax rate lower than 25% prior to January 1, 2008, may continue to enjoy the lower rate and gradually transition to the new tax rate within a maximum of five years after the effective date of the new EIT Law. In addition, under the phase-out rules, enterprises established before March 16, 2007 and which were granted tax holidays under the then effective tax laws or regulations may continue to enjoy their tax holidays until expiration of their tax holidays. Dividends paid by our PRC subsidiaries out of the profits earned after December 31, 2007 to their immediate holding company out of China would be subject to PRC withholding tax at 10%, if such immediate holding company is considered a “non-resident enterprise” under the new EIT Law, unless such immediate holding company’s jurisdiction of incorporation has a tax treaty or arrangement with China that provides for a reduced rate of withholding tax. Pursuant to the double taxation avoidance arrangement between the PRC and Hong Kong and subject to the approval of the local tax authorities, dividends paid by Reshuffle Technology to Star Manor may be subject to PRC withholding tax at the preferential rate of 5% as long as Star Manor is demonstrated to be a Hong Kong resident enterprise under the EIT Law and directly holds 25% or more equity interest in Reshuffle Technology. However, if the PRC tax authorities would not consider Star Manor as the beneficial owner of any

 

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dividends paid from Reshuffle Technology based on the “substance over form” principle under applicable tax rules and thus deny the claim for the preferential withholding tax rate, dividends from Reshuffle Technology to Star Manor would be subject to PRC withholding tax at a rate of 10% instead of 5%.

Under the new EIT Law, enterprises that are established under the laws of foreign countries or regions and whose “de facto management bodies” are located within the PRC territory may be deemed by the PRC tax authorities as PRC tax resident enterprises, and will be subject to the PRC enterprise income tax at the rate of 25% on their worldwide income. Under the detailed implementation rules of the new EIT Law, “de facto management bodies” is defined as the bodies that have material and overall management and control over the business, personnel, accounts and assets of the enterprise. In addition, the State Administration for Taxation issued the SAT Circular 82 on April 22, 2009. SAT Circular 82 clarifies that dividends and other income paid by resident enterprises to shareholders that are non-PRC resident enterprises will be considered to be PRC source income, and subject to PRC withholding tax, currently at a rate of 10% unless otherwise reduced by relevant tax treaties. SAT Circular 82 also subjects such PRC resident enterprises to various reporting requirements with the PRC tax authorities. In addition, SAT Circular 82 provides certain specific criteria for determining whether the “de facto management body” of a Chinese-controlled overseas-incorporated enterprise is located in China. However, as SAT Circular 82 only applies to PRC enterprises established outside of China that are controlled by PRC enterprises or groups of PRC enterprises, it remains unclear how the tax authorities will determine the location of “de facto management bodies” for overseas incorporated enterprises with indirect shareholders being individual PRC residents like us. Although substantially all of our operational management is currently based in the PRC, it is unclear whether PRC tax authorities would require (or permit) us to be treated as a PRC resident enterprise. As a result, we are uncertain as to whether we will be subject to the tax applicable to resident enterprises or non-resident enterprises under the new EIT Law. If we are considered to be PRC resident enterprises, we would be subject to the PRC enterprise income tax at the rate of 25% on our worldwide income. In such cases, however, there is no guarantee that the preferential treatments to PRC tax residents will automatically apply to us, such as the withholding tax exemption on dividends between qualified PRC resident companies.

We are also subject to business taxes of 5.0% and 4.0% of cultural surcharges on the provision of online advertising services. Our revenues from mobile video services are subject to a turnover tax consisting of approximately 3.0% business tax. Effective from January 1, 2011, the cultural surcharges have been revised to 3.0%.

Critical Accounting Policies and Estimates

The following descriptions of critical accounting policies, judgments and estimates should be read in conjunction with our consolidated financial statements and other disclosures included in this prospectus. When reviewing our financial statements, you should consider (i) our selection of critical accounting policies, (ii) judgment and other uncertainties affecting the application of such policies and (iii) the sensitivity of reported results to changes in conditions and assumptions.

Revenue Recognition

We primarily derive revenues from sales of online advertising services. Our online advertising services allow advertisers to place their advertisements on our online video platform in different types and formats. Our advertising products include:

 

   

pre-roll or post-roll video screen advertisements that appear on-screen before or after a user selects a video, which is typically a 5-, 15- or 30-second slot,

 

   

in-roll logos placed on a selected video,

 

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background advertisements that appear behind a selected video screen concurrently with a user viewing a video,

 

   

banners, buttons, links and stream advertisements placed in various areas of our Tudou.com website, and

 

   

sponsorship right to select events.

In accordance with ASC 605, we recognize revenues when the following criteria are met: persuasive evidence of an arrangement exists, the sales price is fixed or determinable, delivery has occurred and collectability is reasonably assured. Revenues are recorded net of business taxes and related surcharges.

Most of our advertising contracts are multiple element arrangements, including placements of different types of advertisements on our website which entitle us to bill and collect from our customers only after all of the elements of the arrangement have been delivered. There is generally no objective evidence available with respect to the fair values of the individual elements to be delivered. Revenue is recognized for these contracts upon completion.

On January 1, 2011, we adopted ASU No.2009-13 Revenue Recognition — Multiple-Deliverable Revenue Arrangements (“ASU No.2009-13”) prospectively. ASU 2009-13 requires us to allocate multi-element revenue arrangement to each element using the relative selling price method according to the best estimated selling price for each element in a multi-element arrangement. As noted above our entitlement to payment from customers is contingent upon the completion of the delivery of all elements within the multiple element revenue arrangements. As a result, we continue to recognize the revenues upon completion of delivery of all the elements involved in the arrangements according to our contractual rights and obligations in the multiple element advertising contracts with the customers. The adoption of ASU No. 2009-13 did not have an impact to our financial statements.

A relatively few multiple element customer contracts entered into in 2010 provided that each of the elements within the arrangement be delivered in uniform combination and allow us to payment as the elements are delivered. The revenue was recognized based on the proportion of the obligation performed. Prior to 2010, we also entered into a small number of single element revenue arrangements with the customers. The revenue was recognized either on a straight line basis over the contract period when the performance obligations were uniform over the contract period; or based on the proportion of the obligation performed when the performance obligation was based on number of clicks.

As is customary in the advertising industry in China, we typically enter into advertising contracts with third-party advertising agencies. We offer agency fees to third-party advertising agencies that purchase our advertising services and recognize revenues net of these agency fees. The agency fees paid by us to advertising agencies are based on certain percentage of revenue generated involving the advertising agencies and such percentage is agreed with the advertising agencies based on the different target revenue volumes. We record revenues on a net basis and the associated advertising agency fees are recorded as a reduction to the revenue in our consolidated statement of operation over the period when the related revenue was recognized.

We also generate revenues from mobile video services through an agreement with China Mobile. We provide video clips to China Mobile for its mobile phone users. Users pay a monthly subscription fee to China Mobile for access to the video channel or pay on a per-clip basis, and we share fees collected by China Mobile for such services. Revenues from mobile video services are recognized in the month in which the service are performed.

We receive monthly reports from China Mobile which provide details of the total revenues collected by China Mobile relating to the mobile video services and our share of such revenues. We also have access to a platform operated by China Mobile for its content partners where we can monitor on a real time basis when our content is being downloaded by the mobile users. The information is then reconciled with the monthly report

 

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from China Mobile, any differences noted are adjusted at each month end. We have not noted any significant differences between the information China Mobile’s platform and its monthly report.

The revenues recognized under this arrangement represent our share of the revenues to be received from the mobile network operator. We are not the primary obligor in this arrangement as we do not enter into contracts with end customers nor have price setting capabilities, rather we provide the content in accordance with China Mobile’s overall strategy and requirements.

We began providing our mobile video services in April 2011 through two video channels on China Unicom’s wireless video platform. As of May 31, 2011, we had not generated revenues from our cooperation with China Unicom.

We also have generated revenues by sub-licensing some of the premium content that we license from third-party vendors since the third quarter of 2010. The exclusive licensing agreements we entered into with these third-party vendors had a definitive license period and included the rights to sublicense certain premium content to other third parties. We entered into a non-exclusive sub-license agreement with the sub-licensee for a period that fell within the original license period of the exclusive licensing agreements. We received a fixed amount of the sub-license fee upfront under the sub-licensing arrangements and did not have any future obligation once we provided the underlying tape/disk to the sub-licensee (which was provided at or before the beginning of the sub-license period). In accordance with ASC 926-605, Entertainment-Films, Revenue Recognition, we recognized the amount of the sub-license fee as revenue at the beginning of the sublicense period as we met all the following criteria: persuasive evidence of a sub-licensing arrangement with a customer existed, the content was delivered or available for immediate and unconditional delivery, the sub-license period of the arrangement had begun and the customer could begin its exploitation, exhibition, or sale, the arrangement fee was fixed or determinable and collection of the arrangement fee was reasonably assured.

Consolidation

We assess the consolidation of VIEs under ASC 810, which provides guidance on the identification of and financial reporting for entities over which control is achieved through means other than voting interests, which requires certain VIEs to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Through a series of contractual arrangements, we hold all the variable interests of the VIEs and have been determined to be the primary beneficiary of the VIEs.

The ex-wife of Mr. Gary Wei Wang, our founder, chairman and chief executive officer, recently initiated a lawsuit against him in a local court in Shanghai and claimed for her share of community property during their marriage, which included a share of the 76% equity interests in Quan Toodou held by Mr. Wang. In connection with this lawsuit, the court issued the Asset Conservatory Notification to impose restrictions on transfer, dividend distribution and other disposal of 38% of the equity interests in Quan Toodou held by Mr. Wang as conservatory measures in this lawsuit. In June 2011, this lawsuit was concluded through settlement directed by the court and the court also issued an order releasing the conservatory measures imposed by the Assets Conservatory Notification. In response to this lawsuit and the Asset Conservatory Notification, we evaluated the potential impact on the contractual arrangements we have currently in place with Quan Toodou based on the legal advice from our PRC counsel.

Based on the legal analysis of our PRC legal counsel, the restrictions imposed under the Asset Conservatory Notification during the period it remained effective did not impact the validity of any of the agreements entered into between Reshuffle Shanghai and Mr. Wang as the nominee shareholder of Quan Toodou and between Reshuffle Shanghai and Quan Toodou and the performance of such agreements prior to the litigation and issuance of the Asset Conservatory Notification. Consequently, it did not impact our previous or then current accounting conclusion on the consolidation of Quan Toodou.

Based on the legal analysis performed by our PRC legal counsel and us, upon the issuance of the conservatory measures as set out in the Asset Conservatory Notification, we concluded that all of the agreements

 

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discussed in the section titled “Corporate History and Structure” of this prospectus had still been valid. While the overall performance of these agreements were still intact, certain restrictions had been imposed as a result of the conservatory measures that restricts transfer, dividend distribution and other disposal of the 38% equity interests in Quan Toodou held by Mr. Wang.

Although the conservatory measures imposed certain restrictions on the above agreements, these restrictions did not affect the ability of Reshuffle Shanghai’s control over Quan Toodou, as it could continue to duly exert full control on its operations and finance decisions, enforce the equity pledge and loan agreements as long as it did not dispose, transfer or distribute dividends on the 38% equity interests in Quan Toodou that were subject to the conservatory measures. In addition, Reshuffle Shanghai would continue to absorb the losses and fund the operations of Quan Toodou through a series of loan agreements and obtain a majority of the potential benefits of Quan Toodou through the enforcement of the exclusive technical consulting and service agreement entered into between Reshuffle Shanghai and Quan Toodou. Consequently, the contractual agreements that were in place continued to enable Reshuffle Shanghai to have control over Quan Toodou, and Quan Toodou remained our consolidated VIE. In addition, we would continue to absorb the 100% of the cumulative deficit of Quan Toodou during the period the conservatory measures were in effect as the restrictions imposed did not alleviate our obligations to absorb losses.

This lawsuit was concluded through settlement directed by the court in June 2011 and pursuant to a court ruling, Mr. Wang is entitled to the equity interests in any companies that are directly or indirectly held by him. In the meantime, the court also issued an order releasing the conservatory measures imposed by the Assets Conservatory Notification. However, if Mr. Wang fails to fully perform his obligations under the court ruling, Mr. Wang’s personal assets, including the equity interests in the companies that are directly or indirectly held by him, may be subject to the court’s enforcement measures. If Mr. Wang does not fully perform his obligations for whatever reasons, and as a result of the court’s enforcement measures, Mr. Wang must transfer a portion or all of his equity interests in Quan Toodou to his ex-wife or such equity interests are required to be sold to any third party, the proceeds of which to be paid to his ex-wife, then the other existing shareholder of Quan Toodou will have a right of first refusal to purchase such equity interests from Mr. Wang in accordance with PRC law. In this case, the other existing shareholder will need to obtain financing sufficient to exercise this right of first refusal. If the other existing shareholder fails to obtain financing or otherwise fails to exercise the right of first refusal, and Mr. Wang’s ex-wife or any other third party obtains any equity interests in Quan Toodou without subject obligations similar to Mr. Wang’s obligations under these existing contractual arrangements, we may have to re-negotiate with Mr. Wang’s ex-wife or such other third party and request such person to become a party to the contractual arrangements with Quan Toodou. If such person does not become a party to these contractual arrangements, with such person obtaining more than one-third of the equity interests in Quan Toodou, such person may have certain protective rights including the power to veto certain critical corporate actions of Quan Toodou, such as increases or decreases in registered capital, amendment of the articles of association, merger, division or dissolution of Quan Toodou and change of company form of Quan Toodou. In addition, if such person does not become a party to these contractual arrangements, with such person obtaining more than a half of the equity interests in Quan Toodou, we will not be able to continue to consolidate Quan Toodou. Historically almost 100% of our net revenues and approximately 60% to 70% of our costs were attributable to Quan Toodou, and we expect our costs may continue to increase in the future. The ineffectiveness of control over Quan Toodou that may result from the lawsuit could cause significant disruption to our business, operations and financial condition which could have a negative impact on our execution of such corporate actions. See “Risk Factors—Risks Related to Doing Business in China—The ineffectiveness of control over Quan Toodou that may result from a lawsuit initiated by the ex-wife of Mr. Gary Wei Wang, our founder, chairman and chief executive officer, seeking the division of 76% of the equity interest in Quan Toodou held by Mr. Wang could cause significant disruption to our business, operations and financial conditions.”

Share-based Compensation

We use a fair-value based method to account for share-based compensation. Accordingly, share-based compensation is measured at the grant date, based on the fair value of the award, and is recognized as expense

 

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over the employees’ requisite service period. Share-based compensation for options granted with service conditions are recognized, net of a forfeiture rate, over the requisite service period of the award, which is the vesting term, based on the fair value of the award on the grant date. Total share-based compensation expense in 2008, 2009 and 2010 was RMB11.3 million, RMB11.5 million and RMB104.6 million, respectively. Total share-based compensation for the three months ended March 31, 2010 and 2011 was negative RMB7.3 million and RMB106.6 million (US$16.3 million), respectively. Determining the value of our share-based compensation expense in future periods requires the input of highly subjective assumptions, including the expected life of the share-based payment awards, estimated forfeitures and the price volatility of the underlying shares. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our share based compensation expense could be materially different in the future. For example, as of December 31, 2009 and 2010 and March 31, 2011, approximately RMB8.8 million, RMB41.4 million and RMB102.9 million (US$15.7 million), respectively, of total unrecognized compensation costs related to unvested share options, which were expected to be recognized over a weighted-average period of 2.61 years, 2.78 years and 3.18 years, respectively.

Determining the fair value of options requires making complex and subjective judgments. In assessing the fair value of the options we have granted, we considered the following principal factors:

 

   

the nature of our business and the contracts and agreements relating to our business;

 

   

the global economic outlook in general and the specific economic and competitive elements affecting our business;

 

   

the nature and prospects of our industry in China;

 

   

the growth of our operations; and

 

   

the risks facing our business.

We are responsible for estimating the fair value of options and ordinary shares. To determine the fair value of our ordinary shares, the three generally accepted approaches were considered: the cost, market and income approaches. While useful for certain purposes, the cost approach is generally not considered applicable to the valuation of companies which are a going concern, as it does not capture the future earnings potential of the business. Given that our current stage of development is different from those of other publicly listed companies in the same industry, comparability of the financial metrics of peer companies and the relevance of the market approach were considered low. In view of the above, we considered the income approach to be the most appropriate method to derive the fair values of our ordinary shares, and market approached was also considered for verifying the result.

For the income approach, we utilized a discounted cash flow, or DCF, analysis based on our management’s best estimates of projected cash flows as of each of the valuation dates. The projected cash flows include among other things, an analysis of projected revenue growth, gross margins, effective tax rates, capital expenditures, working capital requirements and depreciation and amortization. The income approach involves applying appropriate discount rates to estimated cash flows that are based on earnings forecasts. The assumptions used in deriving the fair value of our ordinary shares are consistent with our business plan. These assumptions include: we have no significant contingent liabilities, unusual contractual obligations or substantial commitments; there are no significant pending or threatened litigation involving our company; there are no violations of any regulations or laws by us; and we have no redundant assets. These assumptions are inherently uncertain and subjective. The discount rates reflect the risks management perceived as being associated with achieving the forecasts and were derived by using the Capital Asset Pricing Model, after taking into account systematic risks and company-specific risks. The risks associated with achieving our forecasts were assessed in selecting the appropriate discount rates, which ranged from 21% to 24%. If different discount rates had been used, the

 

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valuations would have been different and the amount of share-based compensation would also have been different because the fair value of the underlying common shares for the options granted would be different.

We also applied discounts for lack of marketability or, DLOM, to our equity value to reflect the fact that there is no ready public market for our shares as we are a closely held private company. When determining the DLOM, the Black-Scholes option pricing model was used. Under this method, the cost of a put option that could be used to hedge the price change before a privately held share can be sold, is considered as a basis to determine the appropriate discount factor for lack of marketability. Based on the analysis, DLOM of 32% was used for the valuation of our ordinary shares as of each of the option grant dates in 2008, 2009 and 2010, respectively. DLOM of 5% was used for the valuation of our ordinary shares as of September 30, 2010, December 31, 2010, January 26, 2011 and March 31, 2011.

The enterprise value of our company determined at the respective valuation dates based on the above assumptions was allocated between the preferred shares and ordinary shares using the option pricing allocation method and straight allocation method. We have also taken into consideration the transaction price of our private equity financing transactions with independent third parties closest to the respective valuation dates in our valuation process.

Valuation Assumptions: We estimated the fair value of share options using Black-Scholes option pricing model. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:

 

     For the Years Ended December 31,      For the three months ended
March 31,
 
         2008          2009              2010          2010      2011  

Expected volatility (%)

     55 – 60         60 – 75         35 – 60         50 – 65         40 – 60   

Expected dividend yield (%)

     —           —           —           —           —     

Expected term (years)

     2.92 – 4.00         1.42 – 4.00         0.25 – 3.58         1.00 – 3.00         0.17 – 3.83   

Risk-free interest rate (per annum) (%)

     3.28 – 4.58         1.38 – 3.59         0.99 – 1.83         1.23 – 2.43         1.28 – 2.08   

Expected Volatility: We estimated the expected volatility at the date of grant based on average annualized standard deviation of the share prices of comparable listed companies.

Expected Dividend Yield: The Black-Scholes option pricing model calls for a single expected dividend yield as an input. We have not declared or paid any cash dividends on our capital stock, and we do not anticipate any dividend payments on our ordinary shares in the foreseeable future.

Expected Term: We estimated the expected term based on the timing of the expected public offering, the vesting schedule and the exercise period of the options.

Risk-Free Interest Rate: We base the risk-free interest rate used in the Black-Scholes option pricing model on the derived market yield of the traded zero-coupon U.S. Treasury bond for the term approximating the expected life of award at the time of grant.

Estimated Pre-vesting Forfeitures: When estimating forfeitures, we consider both voluntary and company termination behavior.

 

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The grant date, number of options granted, exercise price, fair value and intrinsic value of the options granted to date are set forth below. As of March 31, 2011, there were 8,753,245 share options outstanding. The number of options, price and value information below are based upon ordinary shares.

 

Grant Date

   Number
of Options
Granted
     Exercise
Price (US$)
     Fair Value of
the Options as
of the Grant
Date (US$)
     Fair Value of
Underlying
Ordinary
Shares as of the
Grant Date

(US$)
     Type of Valuation    Intrinsic
Value (US$)
 

February 28, 2006

     1,190,000         0.001         0.03         0.03       Retrospective   

June 6, 2006

     355,000         0.10         0.43         0.49       Retrospective   

October 11, 2006

     134,400         0.30         0.35         0.50       Retrospective   

March 20, 2007

     179,200         0.30         0.26         0.51       Retrospective   

April 13, 2007

     207,200         1.40         0.30         0.77       Retrospective   

July 27, 2007

     28,800         1.40         0.35         0.86       Retrospective   

October 19, 2007

     57,600         1.40         0.30         0.87       Retrospective   

January 25, 2008

     1,218,400         1.40         0.55         1.29       Retrospective   

April 29, 2008

     394,000         1.40         0.69         1.50       Retrospective   

July 30, 2008

     354,800         1.40         0.67         1.50       Retrospective   

August 15, 2008

     528,750         1.40         0.65         1.49       Retrospective   

August 20, 2008

     1,410,000         1.40         0.65         1.49       Retrospective   

October 30, 2008

     390,400         1.40         0.71         1.50       Retrospective   

January 21, 2009

     186,800         1.40         0.92         1.82       Retrospective   

April 22, 2009

     30,400         1.40         0.93         1.82       Retrospective   

July 23, 2009

     209,800         1.40         0.94         1.82       Retrospective   

October 29, 2009

     281,600         1.40         0.92         1.82       Retrospective   

February 10, 2010

     513,000         2.8         0.20         1.20       Retrospective   

May 12, 2010

     309,200         2.8         0.25         1.40       Retrospective   

July 29, 2010

     907,500         2.7         0.23         1.37       Contemporaneous   

January 26, 2011

     1,755,300         4.95         1.64         4.96       Retrospective   

We conducted contemporaneous valuations for the options granted on July 29, 2010 as our valuation work was started on July 12, 2010 and was completed on October 9, 2010. Retrospective valuations were used for all the options previously granted.

For the June 6, 2006 grants, we attributed to the ordinary shares underlying the options a fair value of US$0.49 per share, compared to a fair value of US$0.03 per share for the February 28, 2006 grants. The difference in fair value primarily resulted from the issuance of Series B preferred shares to a group of investors in May 2006. The proceeds we received from this private placement were US$8.5 million, and as a result our total equity value increased to approximately US$22.0 million in May 2006.

The increase in the fair value of the ordinary shares underlying the options from US$0.49 of June 6, 2006 grants, US$0.50 of October 11, 2006 grants and US$0.51 of March 20, 2007 grants to US$0.77 of April 13, 2007 grants was primarily because we issued Series C preferred shares to a group of investors in April 2007, from which we received proceeds of US$19.0 million. The increase was also because our ability to generate future cash flow increased rapidly, evidenced by:

 

   

an increase in the average daily page view of our website from approximately 2 million as of June 2006 to approximately 25 million as of April 2007; and

 

   

an increase in the average new video clips uploaded daily from approximately 1,300 as of June 2006 to approximately 15,000 as of April 2007.

 

 

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The increase in the fair value of the ordinary shares underlying the options from US$0.86 of July 27, 2007 and US$0.87 of October 19, 2007 grants to US$1.29 of January 25, 2008 grants, primarily because we launched our online advertising business in the second half of 2007 and began generating revenues during that period.

The increase in the fair value of the ordinary shares underlying the options from US$1.29 of January 25, 2008 grants to US$1.50 of April 29, 2008 primarily because we issued Series D preferred shares to a group of investors in April 2008. The proceeds we received from this private placement were US$56.8 million, and our total equity value increased to approximately US$166.3 million in April 2008.

The increase in the fair value of the ordinary shares underlying the options from US$1.50 of April 29, 2008 grants, US$1.50 of July 30, 2008 grants, US$1.49 of August 15, 2008 grants, US$1.49 of August 20, 2008 grants and US$1.50 of October 30, 2008 grants to US$1.82 of January 21, 2009 grants primarily because our ability to generate cash increased substantially evidenced by

 

   

our net revenues increased substantially to RMB26.2 million for 2008 from RMB6.6 million for 2007;

 

   

the number of advertisers increased from 63 in 2007 to 170 in 2008;

 

   

our registered users increased from 16.3 million as of December 31, 2007 to 37.1 million as of December 31, 2008; and

 

   

an increase in the average new video clips uploaded daily from approximately 16,000 in 2007 to approximately 23,000 in 2008.

The fair value of the ordinary shares underlying the options of US$1.82 for each grant on January 21, 2009, April 22, 2009, July 23, 2009 and October 29, 2009 remained unchanged because:

 

   

there were no significant changes during this period on the macro economics and industry policy that might explicitly change our expectation on our operational environment;

 

   

there were no significant merger or acquisition events during this period in the online video industry that may impact our competitive environment;

 

   

we did not conduct new preferred share issuances or other funding events which may significant enhance our operation during this period; and

 

   

our operational and financial results had no significant variances from those we expected at the beginning of this period.

The fair value of the ordinary shares underlying the options decreased to US$1.20 per share for February 10, 2010 grants from US$1.82 for the October 29, 2009 grants, primarily because:

 

   

our ability to generate cash decreased, evidenced by an increase of net loss from RMB31.4 million for the third quarter of 2009 to RMB38.0 million for the first quarter of 2010;

 

   

in December 2009, Youku.com, a “pure-play” online video website and one of our major competitors, conducted a private placement with the proceeds of US$40 million, which enhanced competition in the online video market in China; and

 

   

in December 2009 and January 2010, CCTV, one of China’s major TV networks, and Baidu.com, the largest Chinese language search engine, launched their respective online video website, which further enhanced competition in China’s online video market.

 

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The fair value of the ordinary shares underlying the options increased from US$1.20 per share for February 10, 2010 grants to US$1.40 for May 12, 2010 grants and US$1.37 for July 29, 2010 grants, primarily because:

 

   

we issued a convertible loan and warrants to a group of investors in April 2010. The proceeds we received from this issuance were US$15.0 million. The cash received from this issuance allowed us to invest further in the business; and

 

   

we issued Series E preferred shares and warrants to a group of investors in July 2010. The proceeds we received from this private placement were US$50.0 million (including the conversion of the convertible loan issued in April 2010), and our total equity value increased to approximately US$241 million in July 2010.

We determined the fair value of our ordinary shares for each of the reporting dates using the same valuation methodologies as those used for previous valuations. We determined that the fair value of the ordinary shares as of September 30, 2010 was US$1.57. In determining the fair value of the ordinary shares as of September 30, 2010, we applied a discounted cash flow analysis to determine its equity value, and then applied the option pricing method to allocate the equity value among our ordinary shares, preferred shares, stock options and warrants.

The increase in the fair value of our ordinary shares from US$1.37 as of July 29, 2010 to US$1.57 as of September 30, 2010 resulted from an increase in the IPO probability from 50% as of July 28, 2010 to 70% as of September 30, 2010. Under the redemption and liquidation scenarios, the fair value of ordinary shares would be less than that under the IPO scenario because ordinary shareholders have the lowest seniority and the least protection. Under the IPO scenario, the preferred shares will be automatically converted into ordinary shares, and our equity value is allocated to each equity class on a pro rata basis, which makes the fair value of ordinary shares greater than that under non-IPO scenarios. The IPO probability substantially increased because (i) we made our first confidential submission of the draft registration statement on August 17, 2010, and received the first round comments on September 15, 2010, and (ii) we achieved gross profit for the first time in the third quarter of 2010.

In addition, the increase in the fair value of our ordinary shares reflected the general improvement in the capital markets in our valuation analysis performed for the third quarter of 2010 compared to those performed for the first and second quarters of 2010, as well as the general improvement in the market capitalization of companies in our industry over the same period.

The fair value of our ordinary shares increased from US$1.57 per share as of September 30, 2010 to US$4.96 per share as of December 31, 2010 and January 26, 2011. We determined the fair value of the ordinary shares as of January 26, 2011 by taking into account the valuation of our ordinary shares as of December 31, 2010. The fair value of our ordinary shares remained unchanged as of January 26, 2011 compared to December 31, 2010 because there were no significant changes during the period between December 31, 2010 and January 26, 2011.

In determining the fair value of our ordinary shares as of December 31, 2010, we used the same valuation methodologies as those used for previous valuations. We applied a discounted cash flow analysis to determine our equity value, and then applied the option pricing method to allocate our equity value among our ordinary shares, preferred shares, stock options and warrants.

 

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The fair value of our ordinary shares increased from US$1.57 per share (total equity value of US$161 million) as of September 30, 2010 to US$4.96 per share (total equity value of US$488 million) as of December 31, 2010 and January 26, 2011, primarily due to the following events and factors,:

 

   

We revised upward our forecasted growth in revenue and net income due to the following events and factors:

 

   

The market conditions for online advertising continued to improve in the fourth quarter of 2010 and the online video advertisement has become a more widely accepted advertising platform based on our market insights gained through our discussion and negotiation with advertisers and advertising agencies. As a result, we saw the prospect of an increasing advertising pipeline, including an increase in the allocation of advertising spending to online video from new advertisers and increasing online video advertising budget from existing advertisers;

 

   

With the benefit of more publicly available information from our primary competitor, which was not readily available in September 2010 and became available during the fourth quarter of 2010, we believed we could further raise our advertising rates and such increases could be conducted on a more regular basis. This was evidenced by our 20% raise in advertising rates on January 1, 2011 to a rate 50% higher than the rate at beginning of 2010, a higher rate than we expected in September 2010, and the acceptance of this rate increased by our customers. Our ability to successfully raise rates has also increased our confidence in achieving faster revenue growth;

 

   

In November 2010, we launched our first “Made-for-Internet” drama series on our website and the feedback from our users and advertisers was very positive, as this type of content is a key differentiator from our primary competitor. Our in-house drama, “That Love Comes”, which received over 40 million user views as of December 31, 2010, exceeding our expectation. Our in-house produced content also attracted in-series advertisement in addition to online brand advertising revenue to us. We also began production on our second in-house drama, “Utopia Office”. We believe this success is a testament to the effectiveness of our “Orange Box” program that will provide more diversified advertising solutions to our customers as well as increase both the viewership and users and advertiser loyalty, which will enhance our ability to grow and meet our financial forecasts;

 

   

In late 2010, we introduced a number of business initiatives to accelerate the growth of our business, including a cooperation with one of the leading real name social networking Internet platforms in China to increase our online UGC and user base.

 

   

With the U.S. IPO of our major competitor in the fourth quarter of 2010, more relevant information on the public perception of the online advertising industry and the valuation of online video companies in China became publicly available, and we further evaluated our future business plan to (1) significantly increase our content procurement and in-house developed content production to attract more users from our competitor and (2) significantly increase our investment in bandwidth to maintain our quality user experience while achieving a sustainable increase in user traffic. We believe that all these efforts, together with our ability to integrate our UGC and other marketing efforts, will increase our brand recognition, user base, visitor traffic and popularity of our website, which will in turn attract more advertisers and enable us to achieve greater growth over the long term than what we expected in September 2010.

 

   

We revised downward the discount rate used for the valuation of our ordinary shares from 21% for the September 30, 2010 valuation to 18% for the December 31, 2010 valuation due to the following factors:

 

   

Due to the growth and expansion of our business, the viability of our business strategy was increased and the results of our operations improved. In deriving the discount rate, the size premium decreased from 6% for a low-cap company to 3% for a mid-cap company;

 

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With the U.S. IPO of our major competitor, recent market transactions and public information demonstrate that the discount rate implied in such transactions is lower than the 21% we used as of September 30, 2010.

 

   

As we were closer in time to our initial public offering and capital markets conditions became more favorable, the IPO probability increased from 70% as of September 30, 2010 to 85% as of December 31, 2010.

In addition, the increase in the fair value of our ordinary shares reflected the general improvement in capital markets conditions in the fourth quarter of 2010 compared to those during the first three quarters of 2010, and the significant improvement in the market capitalization of companies in our industry, especially that of our major competitor which completed its U.S. IPO in the fourth quarter of 2010.

Fair value change in warrant liabilities

The fair value change in warrants from the date of issuance primarily resulted from the decrease in the expected terms of the warrants and the change in the fair value of the Series E preferred shares underlying such warrants or the expected price volatility of the Series E preferred shares as discussed below. Specially, the decrease in the fair value of the warrants issued in connection with the convertible loan in April 2010 from RMB11.0 million as of April 8, 2010 to RMB8.2 million as of June 30, 2010 mainly resulted from (i) the decrease in the expected terms of the warrants and (ii) the expected price volatility of our Series E preferred shares.

The decrease in the fair value of the warrants from RMB8.2 million as of June 30, 2010 to RMB7.9 million as of July 28, 2010 mainly resulted from the decrease in the expected terms of the warrants partially offset by the increase in the fair value of the Series E preferred shares underlying the warrants. The decrease in the fair value of the warrants from RMB26.3 million as of July 28, 2010 to RMB12.5 million as of September 30, 2010 mainly resulted from the decrease in (i) the expected terms of the warrants and (ii) the fair value of the Series E preferred shares underlying the warrants. The increase in the fair value of the warrants from RMB12.5 million as of September 30, 2010 to RMB154 million as of December 31, 2010 mainly resulted from the increase in (i) the fair value of the Series E preferred shares underlying the warrants and (ii) the expected price volatility of the Series E preferred shares. The increase in the fair value of the warrants from RMB154 million as of December 31, 2010 to RMB324 million as of March 31, 2011 mainly resulted from the increase in the fair value of Series E preferred shares underlying the warrants.

Fair value change in the Series E preferred shares

In determining the fair value of the Series E preferred shares as of each valuation date, we applied a discounted cash flow analysis to determine its equity value and applied the option pricing method to allocate the equity value among our ordinary shares, preferred shares, stock options and warrants. In allocating the equity value among our ordinary shares, preferred shares, stock options and warrants, we considered initial public offering, redemption and liquidation scenarios and their respective dates and probabilities, based on management’s best estimates, to derive a probability-weighted equity allocation. We treated our ordinary shares and preferred shares as call options on their equity value, with exercise prices based on the redemption preference, liquidation preference and conversion threshold of the preferred shares.

The slight increase in fair value of the Series E Preferred Shares from US$2.69 as of April 15, 2010 to US$2.72 as of June 30, 2010 and US$2.74 as of July 28, 2010, and the slight fluctuation in fair value of ordinary shares from US$1.39 as of April 8, 2010 to US$1.40 as of June 30, 2010 and US$1.37 as of July 28, 2010 mainly resulted from a combination of the following factors:

 

   

Our operating and financial results during this period were in line with the financial forecast made for the period from April 15, 2010 to July 28, 2010. Our equity value increased as of April 15, 2010 solely

 

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due to the proceeds of US$15 million from the convertible loan and as of July 28, 2010 solely because of the proceeds of US$35 million from the sale of Series E preferred shares and warrants, which did not increase the per share fair value of any equity class. The appreciation of Reminbi dominated assets owned by us contributed to the slight increase in the per share fair value of Series E preferred shares from April 15, 2010 to July 28, 2010 and ordinary shares from April 15, 2010 to June 30, 2010. The decrease in the per share fair value of ordinary shares from US$1.40 as of June 30, 2010 to US$1.37 as of July 28, 2010 was mainly attributable to the reasons stated below;

 

   

The observed ordinary share price volatility under the redemption scenario (with an estimated probability of 35% for the redemption scenario from April 30, 2010 to July 28, 2010) as an input in allocating our equity value among each equity class decreased from 65% as of April 15, 2010 and June 30, 2010 to 60% as of July 28, 2010. The decrease in the price volatility resulted in the decrease in the fair value of our ordinary shares as of July 28, 2010.

The decrease in the fair value of Series E Preferred Shares from US$2.74 as of July 28, 2010 to US$2.48 as of September 30, 2010 mainly resulted from an increase in the probability of our initial public offering, or IPO. Under the redemption and liquidation scenarios, the fair value of the Series E preferred shares would be greater than under the IPO scenario due to the seniority and protection terms enjoyed by the Series E preferred shareholders. Under the IPO scenario, the Series E preferred shares will be automatically converted into ordinary shares, and our equity value is allocated to each equity class on a pro rata basis, which made the fair value of Series E preferred shares much lower than under non-IPO scenarios. Therefore, the increase in the IPO probability and the decrease in the probability of a redemption or liquidation increased the fair value of our ordinary shares and decreased the fair value of our Series E preferred shares.

The increase in the fair value of the Series E Preferred Shares from US$2.48 as of September 30, 2010 to US$5.21 as of December 31, 2010 was in line with the increase in the fair value of the ordinary shares. For detailed reasons for the increase in the fair value of the ordinary shares, see “—Critical Accounting Policies—Share-based Compensation”.

The increase in the fair value of the Series E Preferred Shares from US$5.21 as of December 31, 2010 to US$8.08 as of March 31, 2011 was in line with the increase in the fair value of the ordinary shares. The fair value of our ordinary shares increased from US$4.96 per share as of December 31, 2010 and January 26, 2011 to US$7.86 per share as of March 31, 2010, primarily due to a combination of the following events and factors:

 

   

The prospect of our mobile video business improved as a result of significant progress we had made in negotiating commercial terms with telecom operators in China, including a three-year contract with the joint venture of China Unicom;

 

   

We revised downward the discount rate used for the valuation of our ordinary shares from 18% for the December 31, 2010 valuation to 16% for the March 31, 2011 valuation due to our positive business developments, the progress of our IPO preparation, and favorable capital market conditions in the first quarter of 2011, particularly as evidenced by the increase of the NASDAQ China Index from 195.23 as of December 31, 2010 to 226.13 as of March 31, 2011 and significant improvement in the performance of the share prices of China-based companies listed in the United States.

Income Taxes

Our current income taxes are provided on the basis of income for financial reporting purposes, adjusted for income and expense items which are not assessable or deductible for tax purposes, in accordance with the regulations of the relevant tax jurisdictions. We follow ASC 740, “Income Taxes,” and account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for tax consequences attributable to differences between carrying amounts of existing assets and liabilities in financial statements, their respective tax basis, and operating loss carry-forwards. Deferred tax assets and liabilities are measured using

 

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enacted tax rates to be applied to taxable income in the year in which those temporary differences are expected to be recovered or settled.

A valuation allowance is provided to reduce the carrying amount of deferred tax assets if it is considered more likely than not that some portion, or all, of the deferred tax assets will not be realized. Accordingly, we consider various tax planning strategies, forecasts of future taxable income and our most recent operating results in assessing the need for a valuation allowance. The effect on deferred tax assets and liabilities arising from changes in tax rates is recognized in statements of operations in the period of such change.

We had no material uncertain tax positions for the years 2008, 2009 and 2010 and the three months ended March 31, 2011 and we do not anticipate any significant increases or decreases to its liability for unrecognized tax benefits within the next twelve months. For our subsidiary and VIEs, the years 2004 to 2010 remain subject to examination by the PRC tax authorities.

Impairment of Long-Lived Assets

We apply ASC 360-10-35, Property, Plant and Equipment, and review our long-lived assets, such as property and equipment and purchased or internally developed intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may no longer be recoverable. When these events occur, we measure impairment by comparing the carrying value of the long-lived assets to the estimated undiscounted future cash flows expected to receive from use of the assets and their eventual disposition. If the sum of the estimated undiscounted future cash flow is less than the carrying value of the assets, we recognize an impairment loss equal to the excess of the carrying value over the fair value of the assets. When impairment is recognized, the adjusted carrying amount of the underlying property, plant and equipment becomes its new cost basis. The new cost basis is depreciated over the remaining useful life of the asset.

We use estimates and judgments in our impairment tests and if different estimates or judgments had been utilized, the timing or the amount of any impairment charges could be different. In calculating the future cash flows, certain assumptions are required to be made in respect of highly uncertain matters such as revenue growth rates and gross margin percentages. We recognized impairment charges of RMB8.7 million, RMB2.4 million, zero and zero related to computer hardware and other equipment for the years ended December 31, 2008, 2009 and 2010 and the three months ended March 31, 2011.

Amortization and Write-down of Premium Licensed and In-house Produced Contents

We incur content procurement costs primarily as a result of our obtaining copyright licenses of third-party content, such as TV series and movies, as well as producing in-house developed content.

Following the guidance under ASC 920, the premium licensed contents are capitalized upon acquisition and is amortized over its licensing period on a straight line basis, given the nature of the licensed contents are all re-runs, the Company generates benefits from the overall content library, the availability for continuous access and unlimited viewing during the licensing period, and the viewing pattern observed with the limited tracking for certain content licensed.

The term of the licensing period is driven by various factors, such as the availability in the market, different terms set by the vendors, cost and types of content. The weighted average amortization period of the premium licensed content was 1.1 years, 1.0 years, 1.7 years and 1.6 years during 2008, 2009, 2010 and the three months ended March 31, 2011, respectively.

 

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Following the guidance under ASC 926-20-25, we also capitalize direct costs incurred in physical production of our in-house produced contents. With respect to production costs of episodic television series, until we can establish estimates of secondary market revenue, such revenues are not considered when assessing the recovery of in-house produced content. We consider the initial market to be the advertising revenue generated from the Company’s overall content library, including both advertising contracts that are specifically linked to the in-house contents and general advertising contracts. As of March 31, 2011, we were not able to reasonably and reliably establish any estimates of secondary market revenue. Therefore, we have not considered secondary market revenue when assessing the recovery of the in-house produced content. The in-house produced contents are amortized over the projected useful life, which currently equals to the contracted revenue period of 8 months.

We continue to monitor the amortization policy and its assessment of write down on the purchased and in-house produced content regularly and would adjust the amortization policy when there are changes in circumstances or as more information become available that would support a different amortization period or method.

Consistent with our business model and objectives, we purchase and produce contents to build an online content library to increase our brand recognition, user base, visitor traffic and popularity of the “Tudou” website to attract more advertisers. We view our revenue growth from the entire content library, our website, our viewer demographic base rather than from individual content, consistent with our value proportion to our advertising customers. Advertisers generally do not require advertisements to be linked to specific videos, and only occasionally the advertising contracts are specifically linked to our in-house produced contents. There is no pricing difference for advertisements attached to purchased and non-purchased content. Accordingly, we believe that it is reasonable to consider all of the purchased and in-house produced content together for assessing net realizable value for recoverability in accordance with ASC 920.

The premium licensed and in-house produced contents are carried at the lower of amortized cost or net realizable value. Under the net realizable value approach, we compare the total carrying value of the premium licensed and in-house produced content to the expected cash inflows that are attributable to the content library, less the direct costs to deliver the content library, to derive the net realizable value of the premium licensed and in-house produced contents at the end of each quarter. A write-down is recorded if the net realizable value is lower than the net carrying value. Once the write-down is recorded, it establishes a new cost basis and cannot be subsequently reversed.

When estimating the expected net cash flows for the content library, we base the estimate on the existing and expected future advertising contracts, existing and estimated future direct cost as well as the operating plan to derive the cash inflows available to recover the cost of premium licensed and in-house produced content over the estimated useful life. We also apply a discount rate consistent with our stock valuation to adjust the projected net cash inflows beyond one year.

Restatement and Internal Control Over Financial Reporting

In the course of the preparation and the external audit of our consolidated financial statements for the years ended December 31, 2008, 2009 and 2010, we and our independent registered public accounting firm identified a number of deficiencies in our internal control over financial reporting, including one material weakness and one significant deficiency as defined in the standards established by the U.S. Public Company Accounting Oversight Board.

The material weakness identified was the lack of resources with appropriate accounting knowledge and experience to prepare and review financial statements and related disclosures in accordance with U.S. GAAP, which was evidenced by (i) the lack of sufficient resources with adequate U.S. GAAP knowledge and experience to identify, evaluate and conclude on certain accounting matters independently, and (ii) the lack of effective controls designed and in place to ensure the completeness and accuracy of the consolidated financial statements and the disclosures in accordance with U.S. GAAP, primarily including lack of clearly documented and approved

 

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communication processes with appropriately designated process owners in our sales and marketing and accounting functions to make informed decisions on the proper application of U.S. GAAP to the fees paid to advertising agencies, which resulted in errors mainly in recording and accounting for redeemable convertible preferred shares, share-based compensation, accrual for litigation losses and agency fees and certain balance sheet reclassifications.

We historically recorded agency service fees as cost of revenues for the years ended December 31, 2008 and 2009. We further analyzed the classification of the fees paid to advertising agencies as cost of revenues versus a reduction of revenue in accordance with ASC 605-45 and after performing a detailed review of these arrangements, we concluded that advertising agencies are in fact our direct customers based on our contractual relationship, and there is insufficient evidence to support the argument that the agency fees paid by us represent an identifiable benefit that is sufficiently separable from the agencies’ purchase of our advertising services. As a result, we have restated our audited consolidated financial statements to reclassify the agency fees as a reduction of revenues rather than as cost of revenues. The reclassification resulted in a downward adjustment of RMB4.7 million and RMB24.1 million in net revenues for the years ended December 31, 2008 and 2009, respectively and a corresponding downward adjustment of RMB4.7 million and RMB24.1 million in cost of revenues for the years ended December 31, 2008 and 2009, respectively. The adjustment had no other impact on previously reported statements of operations. In addition, the adjustment did not affect our consolidated balance sheets, consolidated statements of change in shareholders’ deficit or consolidated statements of cash flows.

The significant deficiency related to the lack of formally documented corporate accounting policies in certain areas and chart of accounts in accordance with U.S. GAAP.

Following the identification of the material weakness and significant deficiency, in connection with the preparation of our consolidated financial statements for the years ended December 31, 2008, 2009 and 2010, we performed additional manual review procedures, such as an extensive review of journal entries and a thorough review of account reconciliations for key accounts, to ensure the completeness and accuracy of the underlying financial information used to generate the consolidated financial statements. In addition, we have implemented a number of measures to improve our internal control over financial reporting in order to obtain reasonable assurance regarding the reliability of financial statements, which include, but not limited to:

 

  (i) hiring