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 July 23, 2007

Registration No. 333-144282

 


SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


AMENDMENT NO.2

TO

FORM F-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 


PERFECT WORLD CO., LTD.

(Exact name of Registrant as specified in its charter)

Not Applicable

(Translation of Registrant’s name into English)

 

Cayman Islands   7389   Not Applicable

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

8th Floor, Huakong Building,

No. 1 Shangdi East Road, Haidian District

Beijing 100085, People’s Republic of China

(86-10) 5885-8555

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

 


CT Corporation System

111 Eighth Avenue

New York, New York 10011

(212) 664-1666

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

 


Copies to:

 

David T. Zhang, Esq.

Z. Julie Gao, Esq.

Latham & Watkins LLP

41st Floor, One Exchange Square

8 Connaught Place, Central, Hong Kong

(852) 2522-7886

 

W. Clayton Johnson, Esq.

Cleary Gottlieb Steen & Hamilton LLP

Bank of China Tower

One Garden Road

Central, Hong Kong

(852) 2521-4122

 


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

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

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

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

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

 


CALCULATION OF REGISTRATION FEE

 


Title of each class of
securities to be registered
  Amount to be
registered(3)
  Proposed maximum
offering price per share
  Proposed maximum
aggregate offering
price(1)
  Amount of registration
fee(2)

Class B ordinary shares, par value US$0.0001 per share(4)

  67,850,000   US$2.80   US$189,980,000   US$ 5,833

(1) Estimated solely for the purpose of determining the amount of registration fee in accordance with Rule 457(a) under the Securities Act of 1933, as amended.
(2) Paid previously.
(3) 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 purpose of sales outside the United States.
(4) 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.333-144296). Each American depositary share represents five 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 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 we are not soliciting offers to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

Subject to Completion

Preliminary Prospectus Dated     , 2007

11,800,000 American Depositary Shares

LOGO

Perfect World Co., Ltd.

Representing 59,000,000 Class B Ordinary Shares

 


This is an initial public offering of American depositary shares, or ADSs, of Perfect World Co., Ltd., or Perfect World. We are offering 9,000,000 ADSs, and the selling shareholders disclosed in this prospectus are offering 2,800,000 ADSs. Each ADS represents five Class B ordinary shares, par value US$0.0001 per share. The ADSs are evidenced by American depositary receipts, or ADRs. We will not receive any of the proceeds from the sale of ADSs by the selling shareholders.

Prior to this offering, there has been no public market for our ADSs or shares. We anticipate the initial public offering price of the ADSs will be between US$12.00 and US$14.00 per ADS. The ADSs have been approved for listing on the Nasdaq Global Market under the symbol “PWRD.”

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

 


PRICE US$                      PER ADS


 

     Price to
Public
  

Underwriting

discounts and

commissions

  

Proceeds,

before expenses,

to Perfect World

  

Proceeds, before

expenses, to the selling

shareholders

Per ADS

   US$             US$             US$             US$         

Total

   US$             US$             US$             US$         

The underwriters have an option to purchase up to 1,770,000 additional ADSs from certain existing shareholders to cover over-allotments, at the initial public offering price less underwriting discounts and commissions, within 30 days from the date of this prospectus.

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 passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

The underwriters expect to deliver the ADSs to purchasers on or about                     , 2007.

 


 

Morgan Stanley

 

Credit Suisse

CIBC World Markets   Susquehanna Financial Group, LLLP

 


The date of this prospectus is                    , 2007


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You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, the ADSs only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is current only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of the ADSs.

We have not taken any action to permit a public offering of the ADSs outside the United States or to permit the possession or distribution of this prospectus outside the United States. Persons outside the United States who come into possession of this prospectus must inform themselves about and observe any restrictions relating to the offering of the ADSs and the distribution of the prospectus outside the United States.

Until             , 2007 (25 days after the date of this prospectus), all dealers that buy, sell or trade ADSs, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the obligation of dealers to deliver a prospectus when acting as underwriters and with respect to their 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.

Our Company

We are a leading online game developer and operator in China as measured by the popularity of our games in China in 2006, according to a report published by International Data Corporation, or IDC, a leading market research firm. We primarily develop three-dimensional, or 3D, online games based on our proprietary Angelica 3D game engine and game development platform. Our strong technology and creative game design capabilities, combined with our extensive local knowledge and experience, enable us to frequently and rapidly introduce popular games designed to cater to changing customer preferences and market trends in China. In 2006, we launched our first three self-developed 3D massively multiplayer online role playing games, or MMORPGs, namely, Perfect World, Legend of Martial Arts and Perfect World II. In the first quarter of 2007, these games recorded approximately 237,000 average concurrent users in China. We launched a new self-developed 3D MMORPG, Zhu Xian, in late May 2007.

Our core technology capabilities consist of our proprietary 3D game engine, game development platform and real-time anti-cheating expertise, all developed and built by our experienced development team. In particular, our game engine enables us to create superior 3D graphics with impressive visual effects and provides the technical foundation for realizing innovative features in the game environment. Our game development platform is built on modularized functions which allow us to shorten the development cycle of our 3D MMORPGs to approximately six months for our most recent games and to update our games frequently with new features.

We have achieved an impressive game development track record. Our Perfect World and Legend of Martial Arts games were the two most popular domestically developed 3D online games in China in 2006 according to IDC. Perfect World was a winner of the “Best 3D Online Games” award, and Legend of Martial Arts was a winner of the “Best Self-Developed Online Games” award, in 2006 at the China Digital Entertainment Exposition and Conference, or ChinaJoy, a leading Chinese online game industry convention. Legend of Martial Arts was awarded as the “Most Favorite Brand Game among College Students” from the Education Management Information Center of the Ministry of Education in 2006. We expect to launch two additional 3D MMORPGs and one casual game, which is a game that can be played to a conclusion within a short period of time, in 2007 and early 2008. We plan to develop more online games, with a variety of themes, cultural characteristics and features that appeal to different segments of the online game player community.

We use a time-based revenue model for our first game, Perfect World, under which we charge players based on the time they spend playing the game. We use an item-based revenue model for Legend of Martial Arts, Perfect World II and Zhu Xian, under which players can play the games for free, but they are charged for purchases of in-game items, such as performance-enhancing items, clothing, accessories and pets. In 2006 and the first quarter of 2007, 46.9% and 86.5%, respectively, of our online game operation revenues were generated through this item-based model. We will continue to explore new and innovative business models to maximize our revenues and profit. We distribute our physical and virtual prepaid game cards to players in China through a variety of channels, consisting primarily of a network of 27 third-party distributors of our physical cards and one national distributor of our virtual cards. We also sell online points through our proprietary E-sales system and our own website. Although most of our revenues are generated in China, we have licensed our games, Perfect World II and Legend of Martial Arts, to leading game operators in 11 and seven countries and regions, respectively,

 

 

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including Japan and Taiwan, and we plan to license our games to more countries and regions. We have grown significantly since our inception, and generated revenues of RMB99.4 million (US$12.9 million) and RMB87.2 million (US$11.3 million) in 2006 and the first quarter of 2007, respectively. We incurred net losses from our inception in 2004 through the end of 2006. Our net loss of RMB27.9 million (US$3.6 million) in 2006 included one-time share-based compensation charges in the amount of RMB37.8 million (US$4.9 million) incurred in the year. We achieved net income of RMB40.0 million (US$5.2 million) in the first quarter of 2007.

Industry Background

Online games are electronic games played over the Internet. They can be played individually or in large groups of players simultaneously in the same game who interact in a game world. China is a key online game market in the Asia-Pacific region and has substantial growth potential. According to IDC, China’s online game revenues reached US$816 million in 2006, representing a 73.5% increase over 2005. IDC predicts that China’s online game revenues will reach US$3.0 billion by 2011, representing a compound annual growth rate, or CAGR, of 30.2% from 2006 to 2011.

Many factors have supported and we believe are likely to continue to drive the growth in the online game market in China, including the following:

 

   

increasing Internet, broadband and PC penetration;

 

   

online games as an attractive form of entertainment relative to other forms of entertainment;

 

   

low entry cost and convenience of play for users; and

 

   

high degree of user loyalty.

Many players in China view online games as an attractive form of entertainment and desire to have more personalized, customizable and interactive game experiences. In addition, there has been a noticeable trend towards development and operation of 3D online games in China, as 3D games provide a more realistic representation of real-life objects and can depict more complex activities. Domestically developed online games have shown strong competitive advantages in China. According to IDC, in 2006, revenues generated from domestically developed online games reached RMB4.2 billion (US$0.5 billion), accounting for 64.8% of the total online game revenues in China.

Our Strengths

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

 

   

leading market position in 3D online games in China;

 

   

powerful technology capabilities, consisting of our proprietary Angelica 3D game engine, powerful game development platform, flexible hardware requirements and anti-cheating expertise;

 

   

creative utilization of extensive local knowledge and experience to design, market and distribute games;

 

   

strong and consistent operations; and

 

   

experienced management team and game development personnel.

 

 

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Our Strategies

Our goal is to become one of the leading online game companies in the world. Our primary growth strategies include:

 

   

further expand and diversify our game portfolio;

 

   

enhance user experience to increase monetization of our games;

 

   

increase our focus on international expansion;

 

   

strengthen leading-edge technology through continuous research and development; and

 

   

pursue strategic acquisitions, partnerships and alliances.

Our Challenges

The successful execution of our strategies is subject to certain risks and uncertainties, including those relating to:

 

   

our limited operating history;

 

   

our dependence on three MMORPGs for substantially all of our revenues;

 

   

our ability to develop and operate new games that are commercially successful;

 

   

the growth of the online game market and the continuing market acceptance of our games and in-game items in China and elsewhere;

 

   

our ability to protect our intellectual property rights;

 

   

our ability to respond to competitive pressure, including competition that arises from new games introduced by our competitors and other forms of entertainment;

 

   

our ability to maintain an effective system of internal control over financial reporting; and

 

   

regulatory environment in China.

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

Corporate History and Structure

We commenced operations through Beijing Perfect World Network Technology Co., Ltd., or PW Network, a limited liability company established in China in 2004. To enable us to raise equity capital from international investors, our holding company, Perfect World Co., Ltd., or Perfect World, was incorporated under the laws of the Cayman Islands in June 2006. In August 2006, we formed Beijing Perfect World Software Co., Ltd., or PW Software, our wholly-owned subsidiary in China. In September 2006, PW Software entered into contractual agreements with PW Network and its shareholders, pursuant to which PW Network transferred certain fixed assets and certain personnel to PW Software and PW Software provides technical support and research and development services to PW Network. Through these contractual arrangements, we have the ability to effectively control PW Network’s daily operations and financial affairs, appoint senior executives and decide on all matters subject to shareholders’ approval. As a result of these contractual arrangements, we are considered to be the primary beneficiary of PW Network and PW Network is a variable interest entity, or VIE, of our company under generally accepted accounting principles in the United States, or U.S. GAAP. Accordingly, we consolidate PW Network’s results of operations, assets and liabilities in our financial statements. PW Network is considered as our predecessor company. Since both we and PW Network are under common control, our consolidated financial

 

 

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statements reflect this reorganization as a transaction between entities under common control and have been prepared as if the reorganized corporate structure had been in existence throughout all the periods presented. See “Corporate History and Structure” for a description of the contractual arrangements among PW Software, PW Network and its equity owners. If PW Network and/or its equity owners breach the contractual arrangements with us, we may not be able to continue to effectively control PW Network’s operations and remain to be its primary beneficiary. For example, PW Network may distribute dividends to its equity owners who may decide not to remit these dividends to us in accordance with the existing contractual arrangements. In such case, 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. See “Risk Factors—Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could adversely affect us.”

 

 

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The following diagram illustrates our corporate structure.

LOGO

 

Ø Beneficial Interest

 

×---Ø Contractual arrangements including an Exclusive Technology Support and Service Agreement, a Development Cooperation Agreement, a Business Operation Agreement, a Call Option Agreement and an Equity Pledge Agreement. For a description of these agreements, see “Corporate History and Structure.”

 

×Ø Contractual arrangements including a Call Option Agreement, an Equity Pledge Agreement and a Power of Attorney. For a description of these agreements, see “Corporate History and Structure.”

 

* Beijing Shiji Xiangshu Technology Co., Ltd. is 88.03% owned by Mr. Michael Yufeng Chi, the founder, chairman and chief executive officer of our company and an ultimate owner of our ordinary shares, 6.38% owned by Mr. Tongyan Wang, who is a holder of our ordinary shares, and 5.59% owned by Mr. Di He, our vice president and chief technology officer and a holder of our ordinary shares.

 

** Beijing Jiuzhou Tianyuan Investment Management Co., Ltd. is 60% owned by Mr. Huan Su and 35.72% owned by Mr. Furui Chen, both of whom are ultimate owners of our ordinary shares, and 4.28% owned by Mr. Di He, our vice president and chief technology officer and a holder of our ordinary shares. See “Principal and Selling Shareholders.”

Corporate Information

Our principal executive offices are located at 8th floor, Huakong Building, No. 1 Shangdi East Road, Haidian District, Beijing 100085, People’s Republic of China. Our telephone number at this address is (8610) 5885-8555. Our registered office in the Cayman Islands is located at the offices of M&C Corporate

 

 

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Services Limited, P.O. Box 309GT, Ugland House, South Church Street, George Town, Grand Cayman, Cayman Islands, British West Indies. Our agent for service of process in the United States is CT Corporation System, located at 111 Eighth Avenue, New York, New York 10011.

Investors should contact us for any inquiries through the address and telephone number of our principal executive offices. Our principal website is http://www.wanmei.com. The information contained on this website and our other websites is not a part of this prospectus.

 

 

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Conventions Which Apply to this Prospectus

Unless we indicate otherwise, all information in this prospectus reflects the following:

 

   

no exercise by the underwriters of their option to purchase up to 1,770,000 additional ADSs representing 8,850,000 Class B ordinary shares;

 

   

conversion of all outstanding Series A convertible preferred shares into 64,000,000 Class B ordinary shares and 16,000,000 Class A ordinary shares immediately prior to the closing of this offering; and

 

   

all share and per share data have been adjusted to reflect a 10-for-1 share split that became effective on June 19, 2007.

Except where the context otherwise requires and for purposes of this prospectus only:

 

   

“we,” “us,” “our company,” “our” and “Perfect World” refer to Perfect World Co., Ltd., a Cayman Islands company, and its subsidiaries, and, in the context of describing our operations, risk factors and financial results, also include PW Network, a variable interest entity of our company; see “Corporate History and Structure;”

 

   

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

 

   

“PW Software” refers to Beijing Perfect World Software Co., Ltd.;

 

   

“PW Network” refers to Beijing Perfect World Network Technology Co., Ltd.;

 

   

“SAIF” refers to SB Asia Investment Fund II L.P., a holder of our Series A convertible preferred shares, and its affiliates;

 

   

monthly “average concurrent users,” or “ACU,” of any of our games operated in China is determined as follows: we first determine the number of users logged on to the game at 5-minute intervals, then average that data over the course of a day to derive the daily average; the daily average data are averaged over the monthly period to derive the monthly average concurrent users;

 

   

quarterly “average concurrent users,” or “ACU,” of any of our games operated in China is the average of monthly average concurrent users of such game during the quarterly period;

 

   

quarterly “active paying customers,” or “APC,” is the aggregate number of accounts for our games operated in China under the item-based revenue model that have been charged at least once during the quarterly period;

 

   

quarterly “average revenue per user,” or “ARPU,” is our total online game operation revenues derived from operating in China our online games that use the item-based revenue model during the quarterly period divided by the quarterly active paying customers of these games during the quarterly period; our definition of ARPU may not be comparable to similarly titled measures presented by other online game companies;

 

   

“shares” or “ordinary shares” refers to our ordinary shares, par value US$0.0001 per share, which include both Class A ordinary shares and Class B ordinary shares;

 

   

“ADSs” refers to our American depositary shares, each of which represents five Class B ordinary shares, and “ADRs” refers to the American depositary receipts that evidence our ADSs; and

 

   

all references to “RMB” or “Renminbi” refer to the legal currency of China; all references to “US$,” “dollars” and “U.S. dollars” refer to the legal currency of the United States.

 

 

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THE OFFERING

Offering price

We currently estimate that the initial public offering price will be between US$12.00 and US$14.00 per ADS.

 

ADSs offered by us

9,000,000 ADSs.

 

ADSs offered by the selling shareholders

2,800,000 ADSs.

 

ADSs outstanding immediately after this offering

11,800,000 ADSs (or 13,570,000 ADSs if the underwriters exercise their over-allotment option in full).

 

Ordinary shares outstanding immediately after this offering

279,285,720 shares, comprised of (i) 91,309,730 Class A ordinary shares, par value US$0.0001 per share, and (ii) 187,975,990 Class B ordinary shares, par value US$0.0001 per share. (1)

 

Ordinary shares

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 10 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, such Class A ordinary shares shall be automatically and immediately converted into an equal number of Class B ordinary shares.

 

The ADSs

Each ADS represents five of our Class B ordinary shares, par value US$0.0001 per share. The ADSs will be evidenced by American depositary receipts, or ADRs.

 

   

The depositary will hold the shares underlying your ADSs. You will have rights as provided in the deposit agreement.

 

   

If, however, we declare dividends on our ordinary shares, the depositary will pay you the cash dividends and other distributions it receives on our ordinary shares, after deducting its fees and expenses.

 

   

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

 

   

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

 

 

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

 

Over-allotment option

Certain existing shareholders have granted to the underwriters an option, which is exercisable within 30 days from the date of this prospectus, to purchase up to 1,770,000 additional ADSs from these shareholders.

 

Use of proceeds

Our net proceeds from this offering are expected to be approximately US$106.2 million, assuming an initial public offering price per ADS of US$13.00, which is the midpoint of the estimated public offering price range. We plan to use the net proceeds we receive from this offering to expand our research and development efforts and for other general corporate purposes. See “Use of Proceeds” for additional information.

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

 

Lock-up

We, our directors and executive officers and all our existing shareholders and certain option holders have agreed with the underwriters, subject to certain exceptions, not to sell, transfer or dispose of, directly or indirectly, any of our ADSs or ordinary shares or securities convertible into or exercisable or exchangeable for our ADSs or ordinary shares for a period of 180 days following the date of this prospectus. See “Underwriting” for more information.

 

Listing

The ADSs have been approved for listing on the Nasdaq Global Market under the symbol “PWRD.” Our ADSs and shares will not be listed on any other stock exchange or traded on any automated quotation system.

 

Reserved ADSs

At our request, the underwriters have reserved for sale, at the initial public offering price, up to an aggregate of 944,000 ADSs to our directors, officers, employees, business associates and related persons through a directed share program.

 

Risk factors

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

 

Depositary

Deutsche Bank Trust Company Americas.


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

 

 

assumes the conversion of all outstanding Series A convertible preferred shares into 64,000,000 Class B ordinary shares and 16,000,000 Class A ordinary shares immediately prior to the completion of this offering;

 

 

excludes 16,986,620 Class B ordinary shares issuable upon the exercise of options outstanding as of July 11, 2007, at a weighted average exercise price of US$0.26 per share; and

 

 

excludes 15,158,380 Class B ordinary shares reserved for future issuances under our share incentive plan.

 

 

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Our Summary Consolidated Financial and Operating Data

The following summary consolidated statement of operations data and cash flow data for the period from March 10, 2004 (date of inception) to December 31, 2004, and for the years ended December 31, 2005 and 2006 and the summary consolidated balance sheet data as of December 31, 2006 have been derived from our audited consolidated financial statements included elsewhere in this prospectus. The summary consolidated statement of operations data and cash flow data for the three months ended March 31, 2006 and 2007 and the summary consolidated balance sheet data as of March 31, 2007 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. Our consolidated financial statements are prepared and presented in accordance with U.S. GAAP, and reflect our current corporate structure as if it had been in existence throughout the relevant periods. The historical results are not necessarily indicative of results to be expected in any future period. In addition, our unaudited results for the three months ended March 31, 2007 may not be indicative of our results for the full year ending December 31, 2007. You should read the following information in conjunction with our consolidated financial statements and related notes, “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

 

 

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For the Period
From March 10,
2004 (Date

of Inception) to
December 31,
2004

    For the Year Ended December 31,     For the Three Months Ended March 31,  
    2005     2006     2006     2007  
    RMB     RMB     RMB     US$     RMB     RMB     US$  
    (in thousands, except for share, per share and per ADS data)  

Consolidated Statement of Operations Data:

             

Revenues:

             

Online game operation revenues

  —       —       98,392     12,740     9,138     76,575     9,915  

Overseas licensing revenues

  —       —       1,014     131     —       10,579     1,370  

Total revenues

  —       —       99,406     12,871     9,138     87,154     11,285  

Cost of revenues

  —       —       (24,604 )   (3,186 )   (3,053 )   (19,196 )   (2,486 )

Gross profit

  —       —       74,802     9,685     6,085     67,958     8,799  

Operating expenses(1)

  (6,875 )   (29,563 )   (102,253 )   (13,240 )   (10,433 )   (25,996 )   (3,366 )

Operating (loss) income

  (6,875 )   (29,563 )   (27,451 )   (3,555 )   (4,348 )   41,962     5,433  

(Loss) income before tax

  (6,812 )   (29,434 )   (27,742 )   (3,592 )   (4,324 )   42,061     5,446  

Net (loss) income

  (6,812 )   (29,434 )   (27,945 )   (3,618 )   (4,324 )   40,012     5,181  

Series A convertible preferred shares accretion

  —       —       (1,834 )   (238 )   —       —       —    

Cumulative unearned dividends of Series A convertible preferred shares

  —       —       (1,019 )   (132 )   —       (767 )   (99 )

Net (loss) income attributable to ordinary shareholders

  (6,812 )   (29,434 )   (30,798 )   (3,988 )   (4,324 )   39,245     5,082  

Net (loss) income per ordinary share

             

Basic

  (0.05 )   (0.20 )   (0.21 )   (0.03 )   (0.03 )   0.25     0.03  

Diluted

  (0.05 )   (0.20 )   (0.21 )   (0.03 )   (0.03 )   0.16     0.02  

Net (loss) income per ADS

             

Basic

  (0.23 )   (0.99 )   (1.02 )   (0.13 )   (0.15 )   1.27     0.16  

Diluted

  (0.23 )   (0.99 )   (1.02 )   (0.13 )   (0.15 )   0.82     0.11  

Weighted average number of ordinary shares used in per share calculations:

             

Basic

  148,571,430     148,571,430     150,403,134     150,403,134     148,571,430     154,285,720     154,285,720  

Diluted

  148,571,430     148,571,430     150,403,134     150,403,134     148,571,430     242,951,028     242,951,028  

(1) Included share-based compensation expenses of RMB38,180,653 (US$4,943,631) for the year ended December 31, 2006, of which RMB30,300,487 (US$3,923,307) was a one-time share-based compensation charge in connection with a founder’s ordinary shares becoming subject to restrictions and the subsequent elimination of these restrictions in 2006, and RMB7,508,775 (US$972,236) was a one-time share-based compensation charge in connection with our issuance of Series A convertible preferred shares to a founding shareholder at par value in 2006.

 

 

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For the Period
From March 10,
2004 (Date

of Inception) to
December 31,
2004

    For the Year Ended
December 31,
    For the Three Months
Ended March 31,
 
     2005     2006     2006     2007  
     RMB     RMB     RMB     US$     RMB     RMB     US$  
     (in thousands)  

Consolidated Cash Flow Data:

              

Net cash (used in) provided by operating activities

   (11,487 )   (8,054 )   66,950     8,669     (2,119 )   62,776     8,128  

Net cash used in investing activities

   (642 )   (2,545 )   (11,577 )   (1,499 )   (113 )   (4,650 )   (602 )

Net cash provided by financing activities

   15,000     12,000     42,511     5,504     1,000     127     16  

 

     As of
December 31, 2006
   As of March 31, 2007
     Actual    Actual    As adjusted(1)
     RMB    US$    RMB    US$    RMB    US$
    

(in thousands)

Consolidated Balance Sheet Data:

                 

Cash and cash equivalents

   101,357    13,124    159,263    20,621    979,495    126,825

Total assets

   127,530    16,512    190,407    24,654    1,010,639    130,858

Total liabilities

   84,030    10,880    106,269    13,760    106,269    13,760

Series A convertible preferred shares

   61,797    8,001    61,797    8,001    —      —  

Total shareholders’ equity

   43,500    5,632    84,138    10,894    904,370    117,098

(1) Our consolidated balance sheet data as of March 31, 2007 is adjusted to give effect to (i) the automatic conversion of all of our outstanding Series A convertible preferred shares into 64,000,000 Class B ordinary shares and 16,000,000 Class A ordinary shares immediately prior to the closing of this offering and (ii) the issuance and sale of 45,000,000 Class B ordinary shares in the form of ADSs by us in this offering, assuming an initial public offering price of US$13.00 per ADS, the midpoint of the estimated range of the initial public offering price, after deducting estimated underwriting discounts, commissions and estimated offering expenses payable by us and assuming no exercise of the underwriters’ over-allotment option. A US$1.00 increase (decrease) in the assumed initial public offering price of US$13.00 per ADS would increase (decrease) the amounts representing cash and cash equivalents, total assets and total shareholders’ equity by US$8.4 million.

The following table presents selected operating data of our games in China for the periods indicated.

 

    

For the Quarter Ended

     March 31,
2006
   June 30,
2006
   September 30,
2006
   December 31,
2006
   March 31,
2007

Selected Operating Data:

              

ACU (in thousands)(1)

   39    44    118    246    237

APC (in thousands)(2)

   —      —      26    602    695

ARPU (RMB)(3)

   —      —      11.8    76.1    95.3

(1) Consist of aggregate data from our online game operations in China with respect to all of our games.
(2) Consist of aggregate data from our online game operations in China with respect to all of our games that use the item-based revenue model.
(3) Consist of aggregate data from our online game operations in China with respect to all of our games that use the item-based revenue model. Our total online game operation revenues derived from operating in China our online games using the item-based revenue model, which are used to calculate ARPU, are RMB0.3 million (US$39 thousand), RMB45.8 million (US$5.9 million) and RMB66.3 million (US$8.6 million), respectively, for the quarters ended September 30, 2006, December 31, 2006 and March 31, 2007.

 

 

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RECENT DEVELOPMENTS

The following is a summary of our selected unaudited consolidated financial results and selected operating data for the three months ended June 30, 2007 compared to our selected unaudited consolidated financial results and selected operating data for the three months ended June 30, 2006 and March 31, 2007, respectively. Results for the second quarter of 2007 may not be indicative of our full year results for the year ending December 31, 2007 or future quarterly periods. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus for information regarding trends and other factors that may influence our results of operations and for recent quarterly operating results.

 

     Three Months Ended  
     June 30, 2006     March 31, 2007     June 30, 2007  
     (in RMB thousands)  

Selected Consolidated Statement of Operations Data

      

Revenues:

      

Online game operation revenues

   15,914     76,575     111,528  

Overseas licensing revenues

   —       10,579     18,179  
                  

Total revenues

   15,914     87,154     129,707  

Cost of revenues

   (3,912 )   (19,196 )   (25,762 )
                  

Gross profit

   12,002     67,958     103,945  

Operating expenses:

      

Research and development expenses

   (4,389 )   (6,951 )   (10,900 )

Sales and marketing expenses

   (3,864 )   (15,308 )   (32,289 )

General and administrative expenses

   (1,473 )   (3,737 )   (6,292 )
                  

Total operating expenses

   (9,726 )   (25,996 )   (49,481 )
                  

Operating income

   2,276     41,962     54,464  

Income tax expense

   —       (2,049 )   (2,892 )

Net income

   2,290     40,012     52,361  

Net income per ordinary share:

      

Basic

   0.02     0.25     0.33  

Diluted

   0.02     0.16     0.21  

Net income per ADS:

      

Basic

   0.08     1.27     1.67  

Diluted

   0.08     0.82     1.06  

Weighted average number of ordinary shares used in per ordinary share calculations:

      

Basic

   148,571,430     154,285,720     154,285,720  

Diluted

   148,571,430     242,951,028     246,869,700  

Share-based compensation expenses included in:

      

Cost of revenues

   —       (27 )   (31 )

Research and development expenses

   —       (278 )   (367 )

Sales and marketing expenses

   —       (36 )   (233 )

General and administrative expenses

   —       (158 )   (563 )

Selected Consolidated Balance Sheet Data:

      

Cash and cash equivalents

   3,734     159,263     236,167  

Total assets

   10,257     190,407     303,055  

Advance from customers

   3,973     24,942     32,222  

Deferred revenues

   6,126     60,540     80,409  

Total liabilities

   33,537     106,269     165,564  

Total shareholders’ equity

   (23,280 )   84,138     137,491  

Selected Operating Data:

      

ACU (in thousands)1

   44     237     446  

APC (in thousands)2

   —       695     1,036  

ARPU (RMB)3

   —       95.3     98.0  

 

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1 Consist of aggregate data from our online game operations in China with respect to all of our games.
2 Consist of aggregate data from our online game operations in China with respect to all of our games that use the item-based revenue model.
3 Consist of aggregate data from our online game operations in China with respect to all of our games that use the item-based revenue model. Our total online game operation revenues derived from operating in China our online games using the item-based revenue model, which are used to calculate ARPU, are RMB66.3 million and RMB 101.6 million, respectively, for the quarters ended March 31, 2007 and June 30, 2007.

In the three months ended June 30, 2007, our revenues increased to RMB129.7 million from RMB15.9 million for the same period in 2006. The increase was primarily attributable to our operations of three MMORPGs launched after the second quarter of 2006, namely Legend of Martial Arts, Perfect World II and Zhu Xian. In the three months ended June 30, 2007, our games recorded approximately 446,000 average concurrent users, a significant increase from approximately 44,000 for the same period in 2006. The increase in our revenues was also attributable to our overseas licensing revenues of RMB18.2 million in the three months ended June 30, 2007, as Perfect World II was launched in several overseas countries and regions in the last quarter of 2006 and the first quarter of 2007. Our cost of revenues also increased to RMB25.8 million for the three months ended June 30, 2007, from RMB3.9 million for the same period in 2006, primarily because of significant expansion of our operations. Our gross profit increased to RMB103.9 million for the three months ended June 30, 2007, from RMB12.0 million for the same period in 2006. The increase in our revenues outpaced the increase in our cost of revenues primarily due to greater economies of scale resulted from operating more games. As a result, our gross margin increased to 80.1% for the three months ended June 30, 2007, from 75.4% for the same period in 2006.

In the three months ended June 30, 2007, our revenues increased by RMB42.5 million to RMB129.7 million from RMB87.2 million in the three months ended March 31, 2007. The increase was primarily attributable to (i) our operations of our fourth MMORPG, Zhu Xian, which was launched in late May 2007, (ii) the increase in our revenues derived from operating Perfect World II in China, and (iii) the increase in our overseas licensing revenues. In the three months ended June 30, 2007, our games recorded approximately 446,000 average concurrent users, compared to approximately 237,000 for the previous quarter. ARPU of our item-based games in the three months ended June 30, 2007 was RMB98.0, a 2.8% increase from RMB95.3 in the previous quarter. In the three months ended June 30, 2007, our overseas licensing revenues increased to RMB18.2 million from RMB10.6 million in the three months ended March 31, 2007, as our game Perfect World II was launched in Vietnam in February 2007, in Malaysia and Singapore in March 2007 and in Japan in April 2007, respectively, and we recorded more licensing revenues from these countries. Our cost of revenues also increased to RMB25.8 million for the three months ended June 30, 2007, from RMB19.2 million for the three months ended March 31, 2007, primarily because of expansion of our operations. Our gross profit increased to RMB103.9 million for the three months ended June 30, 2007, from RMB68.0 million for the three months ended March 31, 2007. The increase in our revenues outpaced the increase in our cost of revenues primarily due to greater economies of scale resulted from the increase in our revenues described above. As a result, our gross margin increased to 80.1% for the three months ended June 30, 2007, from 78.0% for the three months ended March 31, 2007.

For the three months ended June 30, 2007, our total operating expenses were RMB49.5 million, including RMB1.2 million of share-based compensation expenses in connection with the options and restricted shares granted to certain employees. The increase in our operating expenses was primarily due to our expanded operations as compared to the same period in 2006 and the first quarter of 2007. Compared to the three months ended March 31, 2007, our operating expenses increased by 90.3% in the three months ended June 30, 2007, primarily attributable to (i) an increase of our sales and marketing expenses for existing games and for the promotion of our game Zhu Xian launched in late May 2007, (ii) an increase in our research and development expenses primarily due to our hiring more research and development personnel, (iii) an increase in our general and administrative expenses primarily due to our hiring more management level general and administrative personnel in March and April 2007 and the associated share-based compensation expenses, and (iv) a one-time special bonus to all employees.

 

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For the three months ended June 30, 2007, our income tax expense increased to RMB2.9 million from RMB2.0 million for the three months ended March 31, 2007, primarily due to more withholding taxes we incurred on our overseas increasing revenues in various jurisdictions outside China.

As a result of the foregoing, our net income increased to RMB52.4 million for the three months ended June 30, 2007, compared to RMB2.3 million for the same period in 2006 and RMB40.0 million for the first quarter in 2007. Our net margin amounted to 40.4% for the three months ended June 30, 2007, compared to 14.4% for the same period in 2006 and 45.9% for the first quarter of 2007. Our net margin decreased in the second quarter of 2007 from the first quarter of 2007, primarily due to the increase in our expenses as described above.

 

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RISK FACTORS

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

Risks Related to Our Business

We have a limited operating history and the long-term potential of our online games is unproven, which makes it difficult to evaluate our business and prospects.

We commenced our game development business in 2004, and launched our first MMORPG, Perfect World, in January 2006. We launched our other three MMORPGs, Legend of Martial Arts, Perfect World II and Zhu Xian, in September 2006, November 2006 and May 2007, respectively. As such, we have a limited relevant operating history for you to evaluate our business, financial performance and prospects. We may not be able to achieve similar results or growth in future periods. Accordingly, you should not rely on our results of operations for any prior periods as an indication of our future performance. It is also difficult to evaluate our prospects, because we may not have sufficient experience to address the risks frequently encountered by early stage companies entering new and rapidly evolving markets, including the online game market. We may not be able to successfully address these risks and difficulties, which could materially harm our business, financial condition and results of operations.

We have incurred net losses in the past and may experience net losses or earnings declines in the future.

We incurred net losses of RMB6.8 million, RMB29.4 million and RMB27.9 million (US$3.6 million) for the period from inception to December 31, 2004 and for the years ended December 31, 2005 and 2006, respectively. We cannot assure you that we will not incur net losses in the future or that there will not be any earnings or revenue declines in any future periods. Without taking into account share-based compensation expenses, we expect that our total operating expenses will increase as we experience anticipated growth. We incur significant costs and operating expenses to develop, market and operate a game and may not collect revenues in connection therewith for some time or at all. As a result, any decrease or delay in generating more revenues could result in material operating losses and harm our financial condition.

As we currently depend on three MMORPGs, all of which were launched in 2006, for substantially all of our revenues, any adverse developments relating to these games may adversely affect our future results of operations.

In the first three quarters of 2006, substantially all of our revenues were derived from just one MMORPG, Perfect World, which was launched in January 2006. We launched Legend of Martial Arts and Perfect World II in late September and the end of November 2006, respectively. All of our revenues were derived from these three games in the fourth quarter of 2006 and the first quarter of 2007. We anticipate that these three games will continue to account for a significant percentage of our revenues in 2007. Although we launched a new MMORPG, Zhu Xian, in May 2007, are currently developing two new MMORPGs and a casual game and will target to develop and launch more games in the future, we cannot guarantee you that we will be able to successfully develop, launch and operate any of these new games. Accordingly, any of the following could materially and adversely affect our business, financial condition and results of operations:

 

   

any reduction in or failure to grow the player base of these existing games, any decrease in their popularity in the market due to intensifying competition or other factors;

 

   

any decrease in or failure to grow the amount of revenues generated from these three games;

 

   

failure by us to make quality upgrades, enhancements or improvements to these three games in a timely manner; or

 

   

any breach of game-related software security, prolonged server interruption due to network failures, hacking activities or other factors or any other adverse developments relating to our games.

 

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If we are unable to successfully develop, launch and/or operate additional online games that grow our player base and increase our revenues, our future results of operations will be adversely affected.

In order for our business strategy to succeed over time, we will need to continually develop, launch and operate new online games or license or acquire new games that are commercially successful. We will need to do this to both replace our existing online games as they reach the end of their useful economic lives, which we believe are typically two to three years for most online games, and to meet our growth strategy of operating a larger number of online games that grow our overall player base and increase our revenues.

We are currently in the process of developing two new MMORPGs and a casual game. We plan to invest a significant amount of financial and personnel resources in developing, launching and operating these and other new online games in the future. The success of these new online games will largely depend on our ability to anticipate and effectively respond to changing consumer tastes and preferences and technological advances in a timely manner. We cannot assure you that the games we develop will be launched as scheduled, viewed by the regulatory authorities as complying with content restrictions, attractive to players, able to compete with games operated by our competitors or with other games operated by us, or commercially successful. In addition, as we introduce new games, some of our existing customers may switch to the new games. If this transfer of players from our existing games does not grow our overall player base and revenues, our growth and profitability may be materially and adversely affected. In the future, we may also license or acquire new games from other game developers. However, we have no track record in operating games licensed or acquired from other developers, and we may not be able to identify appropriate games or enter into arrangements with those developers to offer these games in China, on terms acceptable to us or at all. If we are not able to develop, license or acquire additional online games that are commercially successful and have continuing appeal to players, our future profitability and growth prospects will decline.

We have adopted an item-based revenue model for some of our games, and we intend to adopt this revenue model for our new games. This relatively new revenue model may have a negative impact on our financial condition and results of operations.

We have adopted an item-based revenue model for our second, third and fourth MMORPGs, Legend of Martial Arts, Perfect World II and Zhu Xian, respectively. For our first MMORPG, Perfect World, we use a time-based model whereby players are charged for their playing time. Going forward, we intend to adopt the item-based model for new games that we operate.

Under the item-based revenue model, players are able to play the online game free of charge for an unlimited amount of time, but are charged for purchases of in-game items, such as performance-enhancing items, clothing, accessories and pets. While several other online game companies have begun to adopt the item-based model, it is still relatively new compared to the more proven time-based model and results in new risks and uncertainties for us and other online game companies. The item-based model will require us to design games that not only attract players to spend more time playing, but also encourage them to purchase in-game items. The sale of in-game items will require us to track even more closely consumer tastes and preferences, especially in-game spending trends. In addition, the item-based model may cause additional concerns with the PRC regulators, who have recently been trying to implement ways to reduce the amount of time that Chinese youths spend on online games. A model that does not charge for time may be viewed by the PRC regulators as inconsistent with this goal. We cannot assure you that the item-based revenue model will be successful, or that it will not have a negative impact on our financial condition and results of operations.

Our revenue recognition policy for the item-based games entails our best estimates of the lives of various items associated with each of our item-based games. As we adopted the item-based revenue model only in November 2006, we have a limited operating history and data for our item-based games on which to base our revenue recognition policy for such games. With respect to permanent ownership items that we sell to players, we recognize revenues over the estimated lives of such items. We consider the average period that players

 

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typically play our games and other player behavior patterns to arrive at our best estimates for the lives of these permanent ownership items, which, in some cases, may be as long as the estimated life of the related game. However, given the relatively short operating history of our item-based games, our estimate of the period that players typically play our games may not accurately reflect the actual lives of the items. We may revise our estimates in the future as we continue to gain operating data and refine our estimation process and results accordingly. Any revised estimates could adversely affect the time period during which we recognize revenues from these items. For example, an increase in the estimated lives of these items would increase the period over which the revenues from the items are recognized. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies - Revenue Recognition.”

We face the risks of uncertainties regarding the growth of the online game industry and market acceptance of our online games and in-game items.

The online game industry, from which we derive all of our revenues, is a relatively new and evolving industry and concept. The growth of the online game industry and the level of demand and market acceptance of our online games are subject to a high degree of uncertainty. Our future operating results will depend on numerous factors beyond our control. These factors include:

 

   

the growth of PC, Internet and broadband users and penetration in China and other markets in which we offer our games, and the rate of any such growth;

 

   

whether the online game industry, particularly in China and the rest of the Asia-Pacific region, continues to grow and the rate of any such growth;

 

   

general economic conditions, particularly economic conditions adversely affecting discretionary consumer spending;

 

   

the availability and popularity of other forms of entertainment, particularly games of console systems, such as those made by Sony, Nintendo and Microsoft, which are already popular in developed countries and may gain popularity in China and other countries in which we market our games;

 

   

changes in consumer demographics and public tastes and preferences;

   

the popularity and price of new online games and in-game items that we and our competitors launch and distribute; and

 

   

our ability to timely upgrade and improve our existing games to extend their life spans and to maintain their competitive positions in the online game market.

Our ability to plan for product development and distribution and promotional activities will be significantly affected by our ability to anticipate and adapt to relatively rapid changes in consumer tastes and preferences. Currently, 3D MMORPGs are popular in China. However, there is no assurance that MMORPGs will continue to be popular in China or elsewhere. A decline in the popularity of online games in general, or the MMORPGs that we operate, will likely adversely affect our business and prospects. We must be able to track and respond to these changes in consumer preferences in a timely and effective manner. Furthermore, given that the item-based revenue model relies on in-game purchases, we must be able to track and respond quickly to changes in game preferences and consumer spending trends.

Our business could suffer if we do not successfully manage our current growth and potential future growth.

We have experienced a period of rapid growth and expansion that has placed, and continues to place, strain on our management personnel, systems and resources. To accommodate our growth pursuant to our strategies, we anticipate that we will need to implement a variety of new and upgraded operational and financial systems, including online payment systems and related security systems, procedures and controls, and the improvement of

 

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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 our distributors, customers and third party service providers. All of these endeavors will require substantial management effort and skill and the incurrence of additional expenditures. We cannot assure you that we will be able to efficiently or effectively implement our growth strategies and manage the growth of our operations, and any failure to do so may limit our future growth and hamper our business strategy.

We may not be able to maintain our revenues and profitability as we operate in a highly competitive industry and compete against many companies.

We believe that there are over 100 online game operators in China. Given the relatively low entry barriers to operating online games, we expect more companies to enter the online game industry in China and a wider range of online games to be introduced to the China market. Our principal competitors in China include Shanda Interactive Entertainment Limited, or Shanda, The9 Limited, or The9, Netease.com, Inc., or Netease, Kingsoft Corporation, or Kingsoft, and Shanghai ZTGame Co., Ltd., or ZTGame. Our potential competitors also include major Internet portal operators, other domestic and foreign game developers and publishers, and alliances between our existing and new competitors. Many of our competitors have significantly greater financial and marketing resources and name recognition than we have. Some of our competitors or potential competitors, especially major foreign online game developers, have greater game development resources than we have. In addition, many of our competitors have developed and operated games that have proven commercially successful for a longer period of time than our games and have a larger portfolio of MMORPGs and other online game offerings than we do. As a result, they may be able to take greater risks and endure lower than expected performances from some of their games.

In addition, our competitors may introduce new business models, and if these new business models are more attractive to customers than the business models we currently use, our customers may switch to our competitors’ games, and we may lose market share. We believe that competition in the online game market in China may become more intense as increasing numbers of online games are introduced in the market. We cannot assure you that we will be able to compete successfully against any new or existing competitors, or against any new business models implemented by them. In addition, the increased competition we anticipate in the online game industry may also reduce the number of our players or growth rate of our player base, or cause us to reduce usage fees or the prices of certain in-game items. All of these competitive factors could have a material adverse effect on our revenues and profitability.

Our failure to anticipate or successfully implement new technologies could render our game engine, game development platform or games uncompetitive or obsolete, and reduce our revenues and market share.

Our proprietary Angelica 3D game engine, game development platform and anti-cheating expertise are critical to our success. The online game industry is subject to rapid technological change. We need to anticipate the emergence of new technologies and assess their market acceptance. We also need to invest significant financial resources in research and development to keep pace with technological advances in order to make our development capabilities and our games competitive in the market. However, development activities are inherently uncertain, and we might encounter practical difficulties in commercializing our development results. Our significant expenditures on research and development may not generate corresponding benefits. Given the fast pace with which online game technology has been and will continue to be developed, we may not be able to timely upgrade our game engine or our game development platform in an efficient and cost-effective manner, or at all. New technologies in online game programming or operations could render our technologies, our existing online games or the games that we are developing or expect to develop in the future obsolete or uncompetitive, thereby potentially resulting in a decline in our revenues and market share.

 

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We face risks associated with the licensing of our games overseas, and if we are unable to effectively manage these risks, they could impair our ability to expand our business internationally.

As of the date of this prospectus, we have licensed Perfect World II and Legend of Martial Arts to game operators in 11 and seven countries and regions, respectively. We plan to further license our existing and new games in more countries and regions. The offering of our games in the international markets exposes us to a number of risks, including:

 

   

difficulties in identifying and maintaining good relationships with licensees who are knowledgeable about, and can effectively distribute and operate our games in, overseas markets;

 

   

difficulties in developing games catering to overseas markets;

 

   

difficulties in maintaining the reputation of our company and our games, given that our games are operated by licensees in the overseas markets pursuant to their own standards;

 

   

difficulties and costs in protecting our intellectual property rights overseas;

 

   

difficulties and costs relating to compliance with the different commercial and legal requirements of the overseas markets in which we offer our games, such as game import regulatory procedures, taxes and other restrictions and expenses;

 

   

fluctuations in currency exchange rates; and

 

   

interruptions in cross-border Internet connections or other system failures.

Certain countries in Europe are considering banning the distribution of violent games. Korea also requires online game companies to obtain a ratings classification for online games and implement procedures to restrict the distribution of online games to minors. As a result, our international expansion may also be adversely affected by public opinion or government policies overseas.

Unauthorized character enhancements and other hacking or cheating activities could harm our business and reputation and materially and adversely affect our results of operations.

With the increase in the number of online game players in China, online game operators have increasingly encountered problems arising from the use of unauthorized character enhancements and other hacking or cheating activities. We have from time to time detected a number of players who have gained an unfair in-game advantage by installing hacking or cheating tools to facilitate character progression. In response to these activities, we have installed built-in detection mechanisms in our games to identify various hacking and cheating activities, and have expanded our technical team dedicated to detecting unauthorized character enhancements and resolving other hacking issues. Continued occurrences of unauthorized character enhancements and other manipulations may negatively impact the image of our online games and players’ perception of their reliability, decrease the number of players, reduce the players’ interest in purchasing in-game items, shorten the life span of the games and adversely affect our results of operations. Furthermore, once we detect the players who have engaged in hacking or cheating activities, we generally suspend their access to their respective accounts, which may result in significant user dissatisfaction and cause some of these players to cease to play the game altogether.

In addition, our games may be affected by other hacking or cheating activities. For example, on June 11 and June 12, 2007, all four online games that we operated in China encountered a large-scale denial of service attack by a third party, which resulted in constraints in our network capacity. Many players could not get access to our servers during that period to play our games. We cannot assure you that we will be able to defend against these attacks promptly and effectively in the future. Furthermore, we cannot assure you that we will be able to identify and eliminate new unauthorized character enhancements or other hacking or cheating activities in a timely manner, or at all. Unauthorized character enhancements and other hacking or cheating activities could harm our business and reputation and adversely affect our results of operations. Furthermore, a constant recurrence of these activities may require us to shift our management’s and personnel’s attention from research and

 

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development and other operations to focus instead primarily on anti-hacking programs and activities, which could hurt our ability to develop and launch new games and grow our business.

We may not be able to prevent others from infringing upon our intellectual property rights, which may harm our business and expose us to litigation.

We regard our proprietary software, domain names, trade names, copyrights, trademarks, trade secrets and similar intellectual properties as critical to our success. In particular, we have spent significant amounts of time and resources in developing our Angelica 3D game engine and must continue to protect the technology. We do not hold any patents in China or elsewhere, and intellectual property rights and confidentiality protection in China may not be as effective as in the United States or other countries. Policing unauthorized use of proprietary technology is difficult and expensive. We have taken steps to prevent the misappropriation of our proprietary technology, including registration of our existing online games and our Angelica 3D game engine for copyright protection, registration of our domain names and entering into non-competition and confidentiality agreements with our key employees. However, these steps may be inadequate. Any misappropriation of intellectual property used in our business, whether licensed to us or owned by us, could have an adverse effect on our business and operating results. The validity, enforceability and scope of protection of intellectual property in Internet-related industries are uncertain and still evolving. In particular, the laws and enforcement procedures of the PRC and certain other countries are uncertain or do not protect intellectual property rights in this area to the same extent as do the laws and enforcement procedures of the United States. We rely on our licensees for copyright, domain names and trademark protection outside China, although no such protection has been secured to date. We may need to resort to court proceedings to enforce our intellectual property rights in the future. Litigation relating to our intellectual property might result in substantial costs and diversion of resources and management attention away from our business. See “Risk Factors—Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could adversely affect us.”

We may be subject to future intellectual property rights claims or other claims which could result in substantial costs and diversion of our financial and management resources away from our business.

We cannot assure you that our online games or other content posted on our websites, such as the information posted on our in-game bulletin boards, do not or will not infringe upon patents, valid copyrights or other intellectual property rights held by third parties. We may be subject to legal proceedings and claims from time to time relating to the intellectual property of others. In addition, some of our employees were previously employed at other companies, including our current and potential competitors. We also intend to hire additional personnel to expand our product development and technical support teams. To the extent these employees are involved in research at our company similar to research in which they have been involved at their former employers, we may become subject to claims that such employees or we may have used or disclosed trade secrets or other proprietary information of the former employers of our employees. In addition, our competitors may file lawsuits against us in order to gain an unfair competitive advantage over us. We may also become subject to claims from our customers from time to time. Although we are not aware of any significant pending or threatened claims, if any such claim arises in the future, litigation or other dispute resolution proceedings may be necessary to retain our ability to offer our current and future games, which could result in substantial costs and diversion of our financial and management resources. Furthermore, if we are found to have violated the intellectual property rights of others, we may be enjoined from using such intellectual property rights, incur additional costs to license or develop alternative technologies or games and be forced to pay fines and damages, any of which may materially and adversely affect our business and results of operations.

Moreover, our results of operations may be materially and adversely affected if our licensors cannot prevail on future intellectual property rights claims brought against them by third parties. We currently derive, and expect to continue to derive, substantial revenues and profits from online games based on intellectual property licensed to us exclusively by third parties. See “Business—Intellectual Property.” Any of our licensors may be subject to intellectual property rights claims with respect to those aspects of the online game licensed to us. If any

 

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of our licensors cannot prevail on the intellectual property rights claims brought against it, we might lose our license from such licensor and may not be able to obtain the license from the legitimate owner of the intellectual property, and our results of operations could be materially and adversely affected.

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

Our games may contain errors or flaws, which may only become apparent after their release, particularly as we launch new games or introduce new features to existing games under tight time constraints. From time to time, our players informed us of programming flaws affecting their game play experience, which we were generally able to resolve promptly. Furthermore, customer service, including in-game masters, is critical for retaining customers, and we may not be able to maintain and continuously improve the quality of our services to meet customers’ expectations. If our games contain programming errors or other flaws, or if we inadvertently delete our customers’ records or otherwise fail to provide effective customer service, our customers may be less inclined to continue or resume playing our games or recommend our games to other potential customers, and may switch to our competitors’ games. Undetected programming errors, game defects and unsatisfactory customer service can disrupt our operations, adversely affect the game experience of our customers, harm our reputation, cause our customers to stop playing our games, and delay market acceptance of our games, any of which could materially and adversely affect our results of operations.

Network interruptions or loss of critical customer data caused by system failures or other internal or external factors may lead to player attrition and revenue reduction and harm our business and reputation.

Any failure to maintain the satisfactory performance, reliability, security and availability of our network and computer infrastructure may cause significant harm to our reputation and our ability to attract and maintain players. From time to time, our customers in certain locations could not gain access to our online game services for a period of time lasting from several minutes to several hours, due to server interruptions, power shutdowns, Internet connection problems or other reasons. 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 services or loss of critical customer data, could adversely impact our ability to service our players and lead to player attrition and revenue reduction.

Our network systems are also vulnerable to damage from computer viruses, fire, flood, earthquake, power loss, telecommunications failures, computer hacking and similar events. We do not maintain insurance policies covering losses relating to our systems and do not have business interruption insurance.

If our system and network infrastructure fails to operate effectively, our business may be harmed.

We use internally developed software systems that support nearly all aspects of our billing and payment transactions. Our business may be harmed if we are unable to upgrade our systems fast enough to accommodate future traffic levels, avoid obsolescence or successfully integrate any newly developed or acquired technology with our existing systems. Furthermore, our network capacity depends on our owned and leased network servers and the communication bandwidth that we lease. Constraints in network capacity could cause unanticipated system disruptions and slower response times, affecting data transmission and game play. These factors could, among other things, cause us to lose existing or potential customers, which could, in turn, materially and adversely affect our business and results of operations.

We rely on services from third parties to carry out our businesses, and if there is any interruption or deterioration in the quality of these services, our customers may cease playing our games.

We rely on a network of distributors throughout China for sales of our online game services to our customers. As a result, a substantial portion of our sales are carried out via a distribution network composed of

 

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non-exclusive third party distributors which also distribute games for our competitors. We do not have long-term agreements with any of our distributors, and cannot assure you that we will continue to maintain favorable relationships with them. In addition, we rely on various Internet data centers to host our servers. Any interruption in our ability to obtain the services of these or other third parties or deterioration in their performance could impair the timeliness and quality of our service. Furthermore, if our arrangements with any of these third parties are terminated or modified against our interest, we may not be able to find alternative channels of distribution or services on a timely basis or on terms favorable to us or at all.

We could be liable for breaches of security of our website and third party online payment channels, which may have a material adverse effect on our reputation and business.

Currently, a portion of our online game operation revenues are generated from sales through third-party online payment platforms. In such transactions, secured transmission of confidential information, such as customers’ credit card numbers and expiration dates, personal information and billing addresses, over public networks, in some cases including our website as well, is essential to maintain consumer confidence. While we have not experienced any breach of our security measures to date, we cannot assure you that our current security measures are adequate. In addition, we expect that an increasing amount of our sales will be conducted over the Internet as a result of the growing use of online payment systems over time. In the meantime, the associated online crime will likely increase as well and we must be prepared to increase our security measures and efforts so that our customers have confidence in the reliability of the online payment systems that we use. We do not have control over the security measures of our third party online payment vendors and we cannot assure you that these vendors’ security measures are adequate or will be adequate with the expected increased usage of online payment systems. Security breaches of the online payment systems that we use could expose us to litigation and possible liability for failing to secure confidential customer information and could harm our reputation, ability to attract customers and ability to encourage customers to purchase in-game items.

We have experienced and may continue to experience fluctuations in quarterly operating results.

Our quarterly operating results have experienced fluctuations and may continue to fluctuate in the future due to a variety of factors, including the demand for our products and services and our competitors’ products and services, the level of usage of illegal game servers, the level of usage of the Internet, the size and rate of growth of the online game market, development and promotional expenses related to the introduction of new products, network interruptions and other system problems. For example, our operating results in the third quarter of 2006 were affected by summer holidays, when many students spent less time playing online games.

As an online game operator, our revenues in any quarter are substantially dependent on the amount of the game playing time spent by our players in that quarter and, in connection with our item-based revenue model, the amount of in-game items purchased, which is influenced by the overall game playing time and price of the items. To a significant degree, our operating expenses are based on planned expenditures and our expectations regarding prospective customer usage and purchases. Failure to meet our expectations or our inability to accurately estimate customer usage and purchases, could disproportionately and adversely affect our operating results in any given quarter. Given the relative newness of our online games and adoption of the item-based model, it may be difficult to estimate customer usage and purchases. As a result, we believe that period-to-period comparisons of operating results are not necessarily indicative of our future results.

Future acquisitions or alliances may have an adverse effect on our business.

Selective acquisitions of online game development and operating companies and alliances with key players in the online game industry and other related industry sectors form part of our strategy to further expand our business. However, our ability to grow through future acquisitions or alliances, such as joint ventures, will depend on the availability of suitable acquisition targets or joint venture partners at reasonable terms, our ability

 

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to compete effectively to attract these targets or partners, the availability of financing to complete larger acquisitions or joint ventures, and our ability to obtain any required governmental approvals.

Future acquisitions could also expose us to potential risks, including risks associated with the assimilation of new operations, technologies and personnel, unforeseen or hidden liabilities, the inability to generate sufficient revenue to offset the costs and expenses of acquisitions and potential loss of, or harm to, our relationships with employees, customers, licensors and other suppliers as a result of integration of new businesses. Furthermore, we may not be able to maintain a satisfactory relationship with our joint venture or other partners or handle other risks associated with our future alliances, which could adversely affect our business and results of operations. We lack experience in identifying, financing or completing large acquisitions or joint venture transactions. Such transactions and the subsequent integration processes would require significant attention from our management. The diversion of our management’s attention and any difficulties encountered with respect to the acquisitions or alliances or in the process of integration could have an adverse effect on our ability to manage our business.

Our business and growth are substantially dependent on the continuing efforts of our senior executive officers, and our business may be severely disrupted if we lose their services.

Our future success depends substantially on the continued services of our senior executive officers and key employees, especially Mr. Michael Yufeng Chi, our founder, chairman and chief executive officer, Mr. Kelvin Wing Kee Lau, our chief financial officer, Mr. Di He, our vice president and chief technology officer, Mr. Qing Li, our vice president and chief design officer, and Mr. Qi Zhu, our vice president who is in charge of operations. We do not maintain key-man life insurance for any of our key executives. If one or more of our executive officers were unable or unwilling to continue in their present positions, we might not be able to replace them easily, timely, or at all. Our business may be severely disrupted and our financial conditions and results of operations may be materially and adversely affected. If any of our executive officers joins a competitor or forms a competing company, we may lose distributors, customers, service providers, know-how and key professionals and staff members. Each of our executive officers has entered into an employment agreement with us, which contains non-competition provisions. However, if any dispute arises between our executive officers and us, these agreements may not be enforceable in China, where these executive officers reside, in light of the uncertainties with China’s legal system. See “Risk Factors—Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could adversely affect us.”

If we are unable to attract, train and retain key employees, our business may be adversely affected.

We will need to hire and retain additional qualified employees, particularly experienced game development personnel with expertise in the online game industry. Since our industry is characterized by high demand and intense competition for talent, we may need to offer higher compensation and other benefits in order to retain key personnel in the future. We cannot assure you that we will be able to attract or retain the qualified key personnel that we will need to achieve our business objectives. In addition, as we are still a relatively young company and our business has grown rapidly since our establishment, at times our ability to train and integrate new employees into our operations may not meet the increasing demands of our business.

During the course of the preparation and external audit of our consolidated financial statements for the period ended December 31, 2004 and the years ended December 31, 2005 and 2006, we and our independent registered public accounting firm noted a material weakness and a significant deficiency in our internal control over financial reporting; if we fail to maintain an effective system of internal control over financial reporting, we may be unable to accurately report our financial results or prevent fraud, and investor confidence and the market price of our ADSs may, therefore, be adversely impacted.

Prior to this offering, we have been a young, private company with limited accounting and other resources with which to adequately address our internal controls and procedures. During the course of the preparation and external audit of our consolidated financial statements for the period ended December 31, 2004 and the years

 

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ended December 31, 2005 and 2006, we and our independent registered public accounting firm noted a material weakness and a significant deficiency in our internal control over financial reporting. A “material weakness” is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected. A “significant deficiency” is a control deficiency, or combination of control deficiencies, that adversely affects a company’s ability to initiate, authorize, record, process or report external financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the company’s annual or interim financial statements that is more than inconsequential will not be prevented or detected. The material weakness observed is our lack of sufficient competent staff to perform period end reporting procedures, to address complex U.S. GAAP accounting issues, and to prepare and review financial statements and related disclosures under U.S. GAAP. This material weakness resulted in material audit adjustments and corrections to our financial statements. The significant deficiency observed is that we lacked adequate control over program development and program change within our revenue billing and recognition systems. As a result, it would be possible for erroneous code to be distributed to the revenue billing and recognition systems, which could negatively impact management’s ability to properly initiate and record basic transactional data that are relied upon in generating revenue figures.

Following the identification of this material weakness and significant deficiency, we undertook certain remedial steps to address them, including hiring additional accounting staff and training our new and existing accounting staff. However, the implementation of these measures may not fully address the material weakness and significant deficiency in our internal control over financial reporting, and we cannot yet conclude that they have been fully remedied. We plan to continue to address and remediate this material weakness and significant deficiency and other deficiencies in our internal control over financial reporting in time to meet the deadline for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. If, however, we fail to timely achieve and maintain the adequacy of our internal control over financial reporting, we may not be able to conclude that we have effective internal control over financial reporting. Moreover, effective internal control over financial reporting is necessary for us to produce reliable financial reports and is important to help prevent fraud. Our failure to achieve and maintain effective internal control over financial reporting could impair our ability to comply with applicable financial reporting requirements and related regulatory filings on a timely basis and result in the loss of investor confidence in the reliability of our financial statements. As a result, our business, financial condition, results of operations and prospects, as well as the trading price of our ADSs, could be materially and adversely affected.

We will be subject to the reporting obligations under the U.S. securities laws following this offering. The Securities and Exchange Commission, or the SEC, as required under Section 404 of the Sarbanes-Oxley Act, has adopted rules requiring every public company to include a report of management on the effectiveness of such company’s internal control over financial reporting in its annual report. In addition, an independent registered public accounting firm must issue an attestation report on the effectiveness of the company’s internal control over financial reporting. These requirements will first apply to our annual report on Form 20-F for the fiscal year ending December 31, 2008. 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 an adverse report on the effectiveness of our internal control over financial reporting or may issue a report that is qualified if such firm is not satisfied with our internal control over financial reporting or the level at which our controls are documented, designed, operated or reviewed, or if such firm interprets the relevant requirements differently from us. During the course of such evaluation, documentation and testing, we may identify deficiencies which we may not be able to remedy in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. We also anticipate that we will incur considerable costs and devote significant management time and efforts and other resources to comply with Section 404 of the Sarbanes-Oxley Act.

 

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We face risks related to health epidemics and other outbreaks.

Our business could be adversely affected by the effects of avian flu, severe acute respiratory syndrome, or SARS, or another epidemic or outbreak. From 2005 to 2007, there have been reports on the occurrences of avian flu in various parts of China and elsewhere in Asia, including a few confirmed human cases and deaths. Any prolonged recurrence of avian flu, SARS or other adverse public health developments in China may have a material adverse effect on our business operations. Our operations may be impacted by a number of health-related factors, including, among other things, quarantines or closures of our offices which could severely disrupt our operations, the sickness or death of our key officers and employees, closure of Internet cafés and other public areas where people access the Internet, and a general slowdown in the Chinese economy. Any of the foregoing events or other unforeseen consequences of public health problems could adversely affect our business and results of operations. We have not adopted any written preventive measures or contingency plans to combat any future outbreak of avian flu, SARS or any other epidemic.

If tax benefits currently available to PW Software and PW Network are reduced or repealed, our business and results of operations could suffer.

Pursuant to the applicable tax laws in China, companies established in China are generally subject to a state and local enterprise income tax, or EIT, at statutory rates of 30% and 3% respectively. Under current PRC rules and policies, an enterprise qualified both as a “software enterprise” and a “high and new technology enterprise” is entitled to a preferential EIT rate of 15% and is further entitled to a two-year EIT exemption for the first two years during which it has cumulative taxable income, and a 50% reduction of its applicable EIT rate for the succeeding three years. In addition, an enterprise qualified as a “high and new technology enterprise” located in the Beijing New Industry Development Pilot Zone is entitled to a preferential EIT rate of 15% and is further entitled to a three-year EIT exemption from either its first year of operation or, if it is incorporated in the second half of a calendar year, its second year of operation if so selected, and a 50% reduction of its applicable EIT rate for the succeeding three years. PW Network is currently qualified both as a “software enterprise” and a “high and new technology enterprise” in China and enjoying preferential tax treatments as a result of this status. PW Network did not have any cumulative taxable income during the period from March 10, 2004 (date of inception) to December 2004 and for the years ended December 31, 2005 and 2006. We expect 2007 and 2008 to be the first two years during which PW Network will have cumulative taxable income. Therefore, PW Network is expected to be exempted from EIT in 2007 and 2008 and be subject to a 7.5% EIT rate from 2009 to 2011. PW Software is currently qualified as a “high and new technology enterprise” located in the Beijing New Industry Development Pilot Zone and enjoying preferential tax treatments as a result of this status. PW Software was incorporated in the second half of 2006, and has elected to be exempted from EIT from 2007 to 2009 and be subject to a 7.5% EIT rate from 2010 to 2012. However, such qualifications are subject to an annual or biennial assessment by the relevant government authority in China. There is no assurance that PW Software and PW Network will continue to meet the qualifications or that the relevant government authority will not revoke their “software enterprise” or “high and new technology enterprise” status.

On March 16, 2007, the National People’s Congress of China enacted a new enterprise income tax law, under which foreign invested enterprises, or FIEs, such as our subsidiary, PW Software, and domestic companies would be subject to EIT at a uniform rate of 25%. Preferential tax treatments will continue to be granted to entities that are classified as “high and new technology enterprises strongly supported by the State” or conduct business in encouraged sectors, whether FIEs or domestic companies. The new tax law will become effective on January 1, 2008. Under the new tax law, enterprises that were established and already enjoyed preferential tax treatments before March 16, 2007 will continue to enjoy them (i) in the case of preferential tax rates, for a period of five years from January 1, 2008, or (ii) in the case of preferential tax exemption or reduction for a specified term, until the expiration of such term. Therefore, PW Network and PW Software will continue to be entitled to the preferential tax treatments currently enjoyed by them during such transition period. The new tax law, however, does not define “high and new technology enterprises strongly supported by the State,” nor does it specify which encouraged sectors will be eligible for preferential tax treatments. Because the detailed

 

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implementing rules for the new tax law have not yet been promulgated, we cannot assure you that PW Network or PW Software will be classified as a “high and new technology enterprises strongly supported by the State” or an enterprise that conducts business in encouraged sectors, and continue to be entitled to the preferential EIT rate of 15% after the transition period expires. Moreover, under the new tax law, enterprises organized under the laws of jurisdictions outside China with their de facto management bodies located within China may be considered PRC resident enterprises and therefore subject to PRC enterprise income tax at the rate of 25% on their worldwide income. The new tax law, however, does not define the term “de facto management bodies.” If a majority of the members of our management team continue to be located in China after the effective date of the new tax law, we may be considered a PRC resident enterprise and therefore subject to PRC enterprise income tax at the rate of 25% on our worldwide income.

In addition, pursuant to relevant tax rules, prior to the end of 2010, PW Network is entitled to a refund of the portion of value-added tax, or VAT, that exceeds 3% of its sales proceeds. Moreover, PW Software is entitled to an exemption from business tax with respect to the game development business and related technology consultancy services that it engages in, which falls within the definition of technology development business. Expiration of, or changes to, these tax benefits or treatments will have a material adverse effect on our operating results.

We have limited business insurance coverage in China.

The insurance industry in China is still at an early stage of development. Insurance companies in China offer limited business insurance products. As a result, we do not have any business liability, loss of data or disruption insurance coverage for our operations in China. Any business disruption, litigation or natural disaster might result in our incurring substantial costs and the diversion of our resources.

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 September 6, 2006, our shareholders amended and restated our memorandum and articles of association to provide for a dual-class ordinary share structure. Our ordinary shares are divided into Class A ordinary shares and Class B ordinary shares. Holders of Class A ordinary shares are entitled to 10 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. Some of our existing shareholders, including our founders, directors and officers, will continue to hold our Class A ordinary shares, and our outstanding Series A convertible preferred shares will convert into 64,000,000 Class B ordinary shares and 16,000,000 Class A ordinary shares immediately prior to the closing of this offering. Upon the completion of this offering, holders of our outstanding Class A ordinary shares will represent 82.9% of our aggregate voting power, and holders of our outstanding Class B ordinary shares will represent 17.1% 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 closing of 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 transfer of Class A ordinary shares by a holder thereof to any person or entity which is not an affiliate of such holder, 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, our existing shareholders 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.

 

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Our corporate actions are substantially controlled by our principal shareholders and affiliated entities.

After this offering, our principal shareholders and their affiliated entities will own approximately 56.1% of our outstanding ordinary shares, representing approximately 81.8% of our voting power due to our dual-class ordinary share structure. These shareholders, acting individually or as a group, could exert control and substantial influence over matters such as electing directors and approving mergers or other business combination transactions. This concentration of ownership and voting power may also discourage, delay or prevent a change in control of our company, which could deprive our shareholders of an opportunity to receive a premium for their shares as part of a sale of our company and might reduce the price of our ADSs. These actions may be taken even if they are opposed by our other shareholders, including those who purchase shares in this offering.

Risks Related to Our Corporate Structure

If the PRC government finds that the arrangements that establish the structure for operating our business do not comply with PRC government restrictions on foreign investment in the online game industry, we could be subject to severe penalties.

We are a Cayman Islands company and, as such, we are classified as a foreign enterprise under Chinese laws, and our wholly-owned PRC subsidiary, PW Software, is a foreign-invested enterprise. Various regulations in China currently restrict or prevent foreign-invested entities from holding certain licenses required to operate online games, including Internet content provision, Internet culture operation and Internet publishing licenses. In light of these restrictions, we rely on PW Network to hold and maintain the licenses necessary to operate our online games in China. PW Network is a Chinese company controlled by Beijing Shiji Xiangshu Technology Co., Ltd., a PRC company controlled by Mr. Michael Yufeng Chi, our founder, chairman and chief executive officer. PW Network and its equity owners have entered into a series of contractual arrangements with PW Software to provide PW Software with effective control over PW Network. These include an exclusive technology support and service agreement, a development cooperation agreement, a business operation agreement, a call option agreement, an equity pledge agreement and a power of attorney. For a description of these contractual arrangements, see “Corporate History and Structure” and “Related Party Transactions.” Under the equity pledge agreement, the shareholders of PW Network pledged their equity interests in PW Network to PW Software. Such pledge was duly created by recording the pledge on PW Network’s register of shareholders in accordance with the PRC Collateral Law, and is currently effective. However, according to the PRC Property Rights Law to be effective as of October 1, 2007, the effectiveness of such pledge will be denied if the pledge is not registered with the relevant administration for industry and commerce. PW Software applied for such registration, but the application was denied as no registration procedures were available. PW Software will continue to endeavor to register such pledge when the administration for industry and commerce implements registration procedures in accordance with PRC Property Rights Law in the future. We cannot assure you that PW Software will be able to register the pledge on or prior to October 1, 2007, and if PW Software is unable to do so, the effectiveness of such pledge may be affected.

A circular issued by the Ministry of Information Industry, or MII, in July 2006, reiterated the regulations on foreign investment in telecommunications businesses, which require foreign investors to set up foreign-invested enterprises and obtain a business operating license for Internet content provision, or ICP license, to conduct any value-added telecommunications business in China. Under this circular, a domestic company that holds an ICP license is prohibited from leasing, transferring or selling the 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 local ICP license holder. 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

 

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from the regulator, it is unclear what impact this circular will have on us or the other Chinese Internet companies that have adopted the same or similar corporate and contractual structures as ours. We have made verbal inquiries with the officials at the MII, but have not been able to get a definitive answer as to the applicability of the above circular to our corporate structure and to the enforcement and performance of the contractual arrangements between PW Software, PW Network and its shareholders.

In the opinion of King & Wood, our PRC counsel, (i) the ownership structure and the business and operation model of each of PW Software and PW Network are in compliance with all existing PRC laws and regulations, and (ii) each contract under PW Software’s contractual arrangements with PW Network and its shareholders 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. There are substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including the above MII circular. Accordingly, we cannot assure you that the PRC regulatory authorities 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 MII circular, the relevant regulatory authorities would have broad discretion in dealing with such violation, including levying fines, confiscating our income, revoking PW Software’s business license or PW Network’s business or operating license, requiring us to restructure the relevant ownership structure or operations, and requiring us to discontinue all or any portion of our online game operations. Any of these actions could cause significant disruption to our business operations and may materially and adversely affect our business, financial condition and results of operations.

PW Software’s contractual arrangements with PW Network may result in adverse tax consequences to us.

We could face material and adverse tax consequences if the PRC tax authorities determine that PW Software’s contractual arrangements with PW Network were not made on an arm’s length basis and adjust our income and expenses for PRC tax purposes in the form of a transfer pricing adjustment. A transfer pricing adjustment could result in a reduction, for PRC tax purposes, of adjustments recorded by PW Network, which could adversely affect us by (i) increasing PW Network’s tax liability without reducing PW Software’s tax liability, which could further result in late payment fees and other penalties to PW Network for underpaid taxes; or (ii) limiting the ability of PW Software or PW Network to maintain preferential tax treatments and other financial incentives.

PW Software’s contractual arrangements with PW Network and its equity owners may not be as effective in providing control over PW Network as direct ownership of PW Network.

We conduct substantially all of our operations, and generate substantially all of our revenues, through contractual arrangements with PW Network and its equity owners that provide us with effective control over PW Network. We depend on PW Network to hold and maintain certain licenses necessary for our online game business. PW Network also owns all of the intellectual property, facilities and other assets relating to the operation of our online games, and employs the personnel for our online game operation and distribution. We have no ownership interest in PW Network. Although we have been advised by King & Wood, our PRC legal counsel, that each contract under PW Software’s contractual arrangements with PW Network is valid, binding and enforceable under current PRC laws and regulations, these contractual arrangements may not be as effective in providing us with control over PW Network as direct ownership of PW Network. In addition, PW Network or its equity owners may breach the contractual arrangements. For example, PW Network may distribute dividends to its equity owners who may decide not to remit these dividends to us in accordance with the existing contractual arrangements.

PW Network is wholly-owned by Beijing Shiji Xiangshu Technology Co., Ltd. and Beijing Jiuzhou Tianyuan Investment Management Co., Ltd., which are companies controlled by Mr. Michael Yufeng Chi, our founder, chairman and chief executive officer, and several other shareholders of our company. Conflicts of

 

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interest between their duties to our company and to PW Network may arise. We cannot assure you that when conflicts of interest arise, the ultimate equity owners of PW Network will act completely in our interests or that conflicts of interest will be resolved in our favor. These ultimate equity owners could violate their non-competition or employment agreements with us or their legal duties by diverting business opportunities from us to others.

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 “Risk Factors—Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could adversely affect us.”

Risks Related to Doing Business in China

Our business may be adversely affected by public opinions and government policies and regulations in China.

Due to the high degree of user loyalty to MMORPGs, easy access to PCs and Internet cafés, and lack of more appealing forms of entertainment in China, many teenagers frequently play online games. This may result in these teenagers spending less time on or refraining from other activities, including academics and sports. Furthermore, excessive game play may adversely affect the health of players, especially teenage players. Internet cafés, which are currently the most important outlets for online games, have been criticized by the general public in China for having exerted a negative influence on the youth of China. Due primarily to such adverse public reaction, local and central governments in China have tightened their regulation of Internet café operations. A notice jointly issued by several central governmental agencies in February 2007 suspended nationwide the approval for the establishment of new Internet cafés in 2007 and increased the punishment for Internet cafés admitting minors. This notice also tightened the administration of in-game currency, and its impact on us and other operators of item-based online games is uncertain. Also, local and higher-level governmental authorities may from time to time decide to more strictly enforce the customers’ age limit and other requirements relating to Internet cafés as a result of the occurrence of, and the media attention on, gang fights, arson or other incidents in or related to Internet cafés. As most of our customers access our games from Internet cafés, any restrictions on Internet café operations could result in a reduction of the amount of time our customers spend on our online games or a reduction in or slowdown in the growth of our customer base or customer purchases of in-game items, thus adversely affecting our business and results of operations. Given the relatively limited use of personal computers in China and the relatively high cost of high-speed Internet access, closures or reduction in business hours of these cafés would significantly reduce the number of game players in China.

In April 2007, the General Administration of Press and Publication of China, or GAPP, and several other governmental authorities issued a circular requiring the implementation of an “anti-fatigue system” and a real-name registration system by all PRC online game operators in an effort to curb addictive game play behaviors of minors under the age of eighteen. The item-based model that we adopted for our more recent games, Legend of Martial Arts, Perfect World II and Zhu Xian, may raise additional concerns with the PRC regulators who may find that a model that does not charge for time is inconsistent with the goal of reducing the overall playing time of young game players. As this is a relatively new revenue model for online games in China, it is uncertain how the PRC government authorities will react to the model and its effect on overall playing time.

The implementation of the aforementioned systems and regulations may discourage or otherwise prevent or restrict our young and other customers from playing our online games, which could limit the growth of or reduce our revenues, thus adversely affecting our business and results of operations. If we fail to implement these systems timely and successfully, the relevant government authorities may have broad discretion in dealing with our noncompliance, including rejecting our application for the operation of new games, suspending our online game operations and revoking our relevant licenses. In addition, it is also possible that the PRC government authorities may decide to adopt more stringent policies to monitor the online game industry as a result of adverse

 

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public reaction or otherwise. Any such restrictions on online game playing would adversely affect our business and results of operations.

The limited use of personal computers in China and the relatively high cost of Internet access may limit the development of the Internet in China and impede our growth.

Although the use of personal computers in China has increased in recent years, the penetration rate for personal computers in China is significantly lower than in the United States and other developed countries. Furthermore, despite a decrease in the cost of Internet access in China due to a decrease in the cost of personal computers and the introduction and expansion of broadband access, the cost of Internet access still remains relatively high. The limited use of personal computers in China and the relatively high cost of Internet access may limit the growth of our business. In addition, this will create serious challenges for our business and growth if the Chinese government authorities continue to more stringently regulate Internet cafés, including possibly closing a significant number of Internet cafés or reducing the hours that they are allowed to operate. See “—Our business may be adversely affected by public opinions and government policies and regulations in China.” In addition, there is no assurance that there will not be any increase in Internet access or telecommunication fees in China. If that happens, the number of our players may decrease and the growth of our player base may be materially impeded.

The continued growth of China’s Internet market depends on the establishment of an adequate telecommunications infrastructure.

Although private sector Internet service providers currently exist in China, almost all access to the Internet is maintained through state-owned telecommunications operators under the administrative control and regulatory supervision of the MII. We rely on this infrastructure to provide data communications capacity primarily through local telecommunications lines. Although the government has announced plans to develop aggressively the national information infrastructure, we cannot assure you that this infrastructure will be developed as planned or at all. In addition, we will have no access to alternative networks and services, on a timely basis if at all, in the event of any infrastructure disruption or failure. The Internet infrastructure in China may not support the demands necessary for the continued growth in Internet usage.

Adverse changes in political and economic policies of the PRC government could have a material adverse effect on the overall economic growth of China, which could reduce the demand for our services and adversely affect our competitive position.

Substantially all of our operations are conducted in China and substantially all of our revenues are sourced from China. Accordingly, our results of operations, financial condition and prospects are subject to a significant degree to the economic, political and legal developments of China. Since the late 1970s, the PRC government has been reforming the economic system in China. These reforms have resulted in significant economic growth. However, we cannot predict the future direction of economic reforms or the effects such measures may have on our business, financial position or results of operations. Furthermore, while the economy of China has experienced significant growth in the past twenty years, growth has been uneven, both geographically and among various sectors of the economy. Any adverse change in the economic conditions in China, in policies of the PRC government or in laws and regulations in China, could have a material adverse effect on the overall economic growth of China and investment in the online game industry. Such developments could adversely affect our businesses, lead to reduction in demand for our services and adversely affect our competitive position.

The laws and regulations governing the online game industry in China are developing and subject to future changes. If we fail to obtain or maintain all applicable permits and approvals, our business and operations would be materially and adversely affected.

The online game industry in China is highly regulated by the PRC government. Various regulatory authorities of the PRC central government, such as the State Council, the MII, the GAPP, the Ministry of Culture

 

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and the Ministry of Public Security, are empowered to issue and implement regulations governing various aspects of the online game industry.

We are required to obtain applicable permits or approvals from different regulatory authorities in order to provide online games. For example, an Internet content provider, or ICP, such as PW Network, must obtain an ICP license in order to engage in any commercial ICP operations within China. An online game operator must also obtain a license from the Ministry of Culture and an Internet publishing license from the GAPP in order to distribute games through the Internet. We do not hold an Internet publishing license as the issuance of such licenses has been suspended by the GAPP. We cannot assure you that we will be able to obtain an Internet publishing license if and when the issuances of such licenses are resumed. The online games we currently offer are published by an unrelated publisher which holds an electronic publishing license. The term of our agreements with that publisher in connection with the publication of our online games, namely, Perfect World, Legend of Martial Arts, Perfect World II and Zhu Xian, will expire on April 29, 2009, September 5, 2009, November 2, 2009 and April 6, 2010, respectively. Upon expiration of each agreement, we will be required to either negotiate a renewal or new agreement with that publisher or enter into a new agreement with a different qualified publisher, and there is no assurance that we will be able to do so. In addition, the current PRC rules are not clear as to whether this practice is permissible, or whether any penalties shall be imposed on this practice. We have made verbal inquiries with the officials at the GAPP and been informed that the GAPP is aware of and does not object to such practice, where an online game operator publishes its online games through a holder of electronic publishing license, so long as the Internet publication of such online games has been filed with the GAPP. The Internet publication of all of our existing online games has been filed with the GAPP. If this practice is challenged by the GAPP or if we are unable to obtain a renewal or new agreement with a qualified publisher upon expiration of our existing agreements, or if we fail to maintain any of our permits or approvals, we may be subject to various penalties, including fines and the discontinuation or restriction of our operations. Any such disruption in our business operations would materially and adversely affect our financial condition and results of operations.

As the online game industry is at an early stage of development in China, new laws and regulations may be adopted from time to time to require additional licenses and permits other than those we currently have, and address new issues that arise. As a result, substantial uncertainties exist regarding the interpretation and implementation of current and any future PRC laws and regulations applicable to the online game industry. We cannot assure you that we will be able to timely obtain required licenses or any other new license required in the future, or at all. While we believe that we are in compliance with all applicable PRC laws and regulations currently in effect, we cannot assure you that we will not be found in violation of any current or future PRC laws and regulations.

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

The PRC government has adopted certain regulations governing Internet access and the distribution of news and other information over the Internet. Under these regulations, Internet content providers and Internet publishers are prohibited from posting or displaying over the Internet content that, among other things, violates PRC laws and regulations, impairs the national dignity of China, or is obscene, superstitious, fraudulent or defamatory. Meanwhile, when Internet content providers and Internet publishers find that information falling within the above scope is transmitted on their website or is stored in its electronic bulletin service system, they shall 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.

 

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In addition, the MII has published regulations that subject website operators to potential liability for content included on their websites and the actions of users and others using their websites, including liability for violations of PRC laws prohibiting the dissemination of content deemed to be socially destabilizing. The Ministry of Public Security has the authority to order any local Internet service provider, or ISP, to block any Internet website maintained outside China at its sole discretion. Periodically, the Ministry of Public Security has stopped the dissemination over the Internet of information which it believes to be socially destabilizing. The State Secrecy Bureau, which is directly responsible for the protection of State secrets of the PRC government, is authorized to block any website it deems to be leaking State secrets or failing to meet the relevant regulations relating to the protection of State secrets in the dissemination of online information.

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 a website 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 websites by our users, despite our attempt to monitor such content. To the extent that regulatory authorities find any portion of our content objectionable, they may require us to limit or eliminate the dissemination of such information or otherwise curtail the nature of such content in our online games and on our websites, and keep records and report to relevant authorities, which may reduce our player base, the amount of time our games are played or the purchases of in-game items. This would have a material adverse effect on our financial condition and results of operations. 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 online games and websites, including a suspension or shutdown of our operations.

If we are required to obtain prior approval of the China Securities Regulatory Commission, or CSRC, of the listing and trading of our ADSs on the Nasdaq Global Market, this offering could be delayed until we obtain the approval.

On August 8, 2006, six PRC regulatory agencies, including the Ministry of Commerce, the State Assets Supervision and Administration Commission, the State Administration for Taxation, the State Administration for Industry and Commerce, the CSRC and the State Administration of Foreign Exchange, or the SAFE, jointly issued the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, which became effective on September 8, 2006.

This regulation, among other things, includes provisions that purport to require that an offshore special purpose vehicle formed for purposes of overseas listing of equity interests in PRC companies and controlled directly or indirectly by 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.

On September 21, 2006, the CSRC published on its official website procedures regarding its approval of overseas listings by special purpose vehicles. The CSRC approval procedures require the filing of a number of documents with the CSRC and it would take several months to complete the approval process. The application of this new PRC regulation remains unclear with no consensus currently existing among leading PRC law firms regarding the scope of the applicability of the CSRC approval requirement.

Our PRC counsel, King & Wood, has advised us that, based on their understanding of the current PRC laws and regulations as well as the procedures announced on September 21, 2006:

 

   

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

 

   

In spite of the above, given that we have completed our restructuring before September 8, 2006, the effective date of the new regulation, and that our holding company, Perfect World Co., Ltd., was formed for the sole purpose of facilitating private equity investment, this regulation does not require an

 

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application to be submitted to the CSRC for its approval of the issuance and sale of the ADSs and the Class B ordinary shares, or the listing and trading of our ADSs on the Nasdaq Global Market; and

 

   

The issuance and sale of the ADSs and the Class B ordinary shares and the listing and trading of the ADSs on the Nasdaq Global Market do not conflict with or violate this new PRC regulation.

If the CSRC requires that we obtain its approval prior to the completion of this offering, this offering will be delayed until we obtain CSRC approval, which may take several months. If prior CSRC approval is required but not obtained, 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 in the PRC, limit our operating privileges in the PRC, delay or restrict the repatriation of the proceeds from this offering into the PRC, or take other actions that could have a material adverse effect on our business, financial condition, results of operations, reputation and prospects, as well as the trading price of our ADSs. 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 subsequently 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 and/or negative publicity regarding this CSRC approval requirement could have a material adverse effect on the trading price of our ADSs.

Recent PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident shareholders to personal liability and limit our ability to inject capital into our PRC subsidiary, limit our subsidiary’s ability to increase its registered capital, distribute profits to us, or otherwise adversely affect us.

On October 21, 2005, the SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-raising and Reverse Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or Notice 75, which became effective as of November 1, 2005. According to Notice 75, prior registration with the local SAFE branch is required for PRC residents to establish or to control an offshore company for the purposes of financing that offshore company with assets or equity interests in an onshore enterprise located in the PRC. An amendment to registration or filing with the local SAFE branch by such PRC resident is also required for the injection of equity interests or assets of an onshore enterprise in the offshore company or overseas funds raised by such offshore company, or any other material change involving a change in the capital of the offshore company. Moreover, Notice 75 applies retroactively. As a result, PRC residents who have established or acquired control of offshore companies that have made onshore investments in the PRC in the past were required to complete the relevant registration procedures with the local SAFE branch by March 31, 2006.

We have requested our shareholders who are PRC residents to make the necessary applications, filings and amendments as required under Notice 75 and other related rules. We attempt to comply, and attempt to ensure that our shareholders who are subject to these rules comply, with the relevant requirements. However, we cannot provide any assurances that all of our shareholders who are PRC residents will comply with our request to make or obtain any applicable registrations or comply with other requirements required by Notice 75 or other related rules. The failure or inability of our PRC resident shareholders to make any required registrations or comply with other requirements may subject such shareholders 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 or our VIE, limit our PRC subsidiary’s ability to pay dividends or otherwise distribute profits to us, or otherwise adversely affect us.

 

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

We are a holding company, and we conduct our business primarily through our subsidiary and affiliated entity incorporated in China. These entities are generally subject to laws and regulations applicable to foreign investment in China and, in particular, laws applicable to wholly-foreign owned enterprises. In addition, we depend on PW Network to honor its agreements with us.

Almost all of these agreements are governed by PRC law and disputes arising out of these agreements are expected to be decided by arbitration in China. The PRC legal system is based on written statutes. Prior court decisions may be cited for reference but have limited precedential value. Since 1979, PRC legislation and regulations have significantly enhanced the protections afforded to various forms of foreign investments in China. However, since 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 involve uncertainties, which may limit legal protections available to us. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention.

We rely on dividends paid by our subsidiary for our cash needs.

We rely on dividends paid by our Chinese subsidiary, PW Software, for our cash needs, including the funds necessary to pay dividends and other cash distributions, if any, to our shareholders, to service any debt we may incur and to pay our operating expenses. The payment of dividends by entities organized in China is subject to limitations. Regulations in the PRC currently permit payment of dividends only out of accumulated profits as determined in accordance with accounting standards and regulations in China. PW Software is also required to set aside at least 10% of its after-tax profit based on PRC accounting standards each year to its general reserves until the accumulative amount of such reserves reach 50% of its registered capital. These reserves are not distributable as cash dividends. PW Software is also required to allocate a portion of its after-tax profits, as determined by its board of directors, to its staff welfare and bonus funds, which may not be distributed to equity owners. In addition, if PW Software 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.

Under the current PRC tax law, dividend payments to foreign investors made by FIEs are exempt from PRC withholding tax. Pursuant to the new PRC enterprise income tax law to be effective on January 1, 2008, however, dividends payable by a FIE to its foreign investors will be subject to a 20% withholding tax, unless any such foreign investor’s jurisdiction of incorporation has a tax treaty with China that provides for a different withholding arrangement. The Cayman Islands, where we are incorporated, does not have such a tax treaty with China. Although the new tax law contemplates the possibility of exemptions from withholding taxes for China-sourced income of FIEs, the PRC tax authorities have not promulgated any related implementation rules and it remains unclear whether we would be able to obtain exemptions from PRC withholding taxes for dividends distributed to us by PW Software.

Fluctuation in the value of the Renminbi may have a material adverse effect on your investment.

The change in value of the Renminbi against the U.S. dollar and other currencies is affected by, among other things, changes in China’s political and economic conditions. On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the Renminbi to the U.S. dollar. Under the new policy, the Renminbi is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. This change in policy has resulted in an approximately 6.7% appreciation of the RMB against the U.S. dollar between July 21, 2005 and March 30, 2007. While the international reaction to the Renminbi revaluation has generally been positive, there remains significant international pressure on the PRC government to adopt an even more flexible currency policy, which could result in a further and more significant appreciation of the Renminbi against the U.S. dollar. As substantially all of our costs and expenses are denominated in Renminbi, the revaluation beginning in July 2005 and potential future revaluation has and could further increase our costs in

 

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U.S. dollar terms. For example, to the extent that we need to convert U.S. dollars we receive from this offering into Renminbi for our operations, appreciation of the Renminbi against the U.S. dollar would have an adverse effect on the Renminbi amount we receive from the conversion. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of making payments for dividends on our shares or ADSs or for other business purposes, appreciation of the U.S. dollar against the Renminbi would have a negative effect on the U.S. dollar amount available to us.

Restrictions on currency exchange may limit our ability to receive and use our revenues or financing effectively.

Substantially all of our revenues and expenses are denominated in Renminbi. If our revenues denominated in Renminbi increase or expenses denominated in Renminbi decrease in the future, we may need to convert a portion of our revenues into other currencies to meet our foreign currency obligations, including, among others, payment of dividends declared, if any, in respect of our ordinary shares or ADSs. Under China’s existing foreign exchange regulations, PW Software is able to pay dividends in foreign currencies, without prior approval from the SAFE, by complying with certain procedural requirements. However, we cannot assure you that the PRC government will not take further measures in the future to restrict access to foreign currencies for current account transactions.

Foreign exchange transactions by our subsidiary and affiliated entity in China under capital accounts continue to be subject to significant foreign exchange controls and require the approval of, or registration with, PRC governmental authorities. In particular, if our subsidiary and affiliated entity in China borrows foreign currency loans from us or other foreign lenders, these loans must be registered with the SAFE, and if we finance them by means of additional capital contributions using, for instance, proceeds from this offering, these capital contributions must be approved or registered by certain government authorities including the SAFE, the Ministry of Commerce or their local counterparts. These limitations could affect the ability of these entities to obtain foreign exchange through debt or equity financing, and could affect our business and financial condition.

Risks Related to Our ADSs 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.

Prior to this initial public offering, there has been no public market for our ordinary shares or ADSs. Our ADSs have been approved for listing on the Nasdaq Global Market. Our ordinary shares will not be listed or quoted for trading on any exchange. 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 the initial public offering. We cannot assure you that an active trading market for our ADSs will develop or that the market price of our ADSs will not decline below the initial public offering price.

The market price for our ADSs may be volatile.

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

 

   

actual or anticipated fluctuations in our quarterly operating results;

 

   

changes in financial estimates by securities research analysts;

 

   

conditions in the online game industry;

 

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changes in the economic performance or market valuations of other online game companies;

 

   

announcements by us or our competitors of new products or services, new revenue models, acquisitions, strategic partnerships, joint ventures or capital commitments;

 

   

addition or departure of key personnel;

 

   

fluctuations of exchange rates between the RMB and U.S. dollar or other foreign currencies;

 

   

potential litigation or administrative investigations;

 

   

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

 

   

general economic or political conditions in China.

In addition, the securities markets have from time to time experienced significant price and volume fluctuations that are not related to the operating performance of particular companies. These market fluctuations may also materially and adversely affect the market price of our ADSs.

You will experience immediate and substantial dilution in the net tangible book value of ADSs purchased.

The initial public offering price per ADSs will be substantially higher than the net tangible book value per ADS prior to the offering. Consequently, when you purchase ADSs in the offering at an assumed initial public offering price of US$13.00, you will incur immediate dilution of US$10.91 per ADS. See “Dilution.” In addition, you may experience further dilution to the extent that additional ordinary shares are issued upon exercise of outstanding options we may grant from time to time.

We may need additional capital and may sell additional ADSs or other equity securities or incur indebtedness, which could result in additional dilution to our shareholders or increase our debt service obligations.

We believe that our current cash and cash equivalents, anticipated cash flow from operations and the proceeds from this offering will be sufficient to meet our anticipated cash needs for at least the next 12 months. We may, however, require additional cash resources due to changed business conditions or other future developments, including any investments or acquisitions we may decide to pursue. If these resources are insufficient to satisfy our cash requirements, we may seek to sell additional equity or debt securities or obtain a credit facility. The sale of additional equity securities could result in additional dilution to 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. We cannot assure you that financing will be available in amounts or on terms acceptable to us, if at all.

Substantial future sales of our ADSs or ordinary shares in the public market, or the perception that these sales could occur, could cause the price of our ADSs to decline.

Additional sales of our ADSs or 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 91,309,730 Class A ordinary shares and 187,975,990 Class B ordinary shares outstanding. All ADSs sold in this offering will be freely transferable without restriction or additional registration under the Securities Act of 1933, 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 volume and other 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 lead 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.

 

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In addition, certain holders of our ordinary shares after the completion of this offering will, upon the expiration of the lock-up period, have the right to cause us to register the sale of those 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 Securities Act immediately upon the effectiveness of the registration. Sales of these registered shares in the public market could cause the price of our ADSs to decline.

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

Except as described in this prospectus and in the deposit agreement, holders of our ADSs will not be able to exercise voting rights attaching to the shares evidenced by our ADSs on an individual basis. Holders of our ADSs will appoint the depositary or its nominee as their representative to exercise the voting rights attaching to the shares represented by the ADSs. You may not receive voting materials in time to instruct the depositary to vote, and it is possible that you, or persons who hold their ADSs through brokers, dealers or other third parties, will not have the opportunity to exercise a right to vote.

You may not be able to participate in rights offerings and may experience dilution of your holdings as a result.

We may from time to time distribute rights to our shareholders, including rights to acquire our securities. Under the deposit agreement for the ADSs, the depositary will not offer those rights to ADS holders unless both the rights and the underlying securities to be distributed to ADS holders are either registered under the Securities Act of 1933, as amended, or exempt from registration under the Securities Act with respect to all holders of ADSs. We are under no obligation to file a registration statement with respect to any such rights or underlying securities or to endeavor to cause such a registration statement to be declared effective. In addition, we may not be able to take advantage of any exemptions from registration under the Securities Act. Accordingly, holders of our ADSs may be unable to participate in our rights offerings and may experience dilution in their holdings as a result.

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

Your ADSs represented by the ADRs are transferable on the books of the depositary. However, the depositary may close its transfer books at any time or from time to time when it deems expedient in connection with the performance of its duties. In addition, the depositary may refuse to deliver, transfer or register transfers of ADSs generally when our books or the books of the depositary are closed, or at any time if we or the depositary 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.

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

We are incorporated in the Cayman Islands, and conduct substantially all of our operations in China through our wholly-owned subsidiaries in China. Most of our officers and directors reside outside the United States and some or all of the assets of those persons are located outside of the United States. It may be difficult or impossible for you to bring an original action against us or against these individuals in a Cayman Islands or Chinese court in the event that you believe that your rights have been infringed under the U.S. federal securities laws or otherwise. Even if you are successful in bringing an action of this kind, the laws of the Cayman Islands and of China may render you unable to enforce a judgment against our assets or the assets of our directors and officers. You would also find it difficult to enforce a U.S. court judgment based on the civil liability provisions of the U.S. federal securities laws, in the United States, the Cayman Islands or China, against us or our officers and directors. For more information regarding the relevant laws of the Cayman Islands and China, see “Enforceability of Civil Liabilities.”

 

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Our corporate affairs are governed by our memorandum and articles of association and by the Companies Law (2007 Revision) and common law of the Cayman Islands. The rights of shareholders to take legal action against our directors and us, 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 precedents in the United States. In particular, the Cayman Islands has a less developed body of securities laws as compared to the United States, and provides significantly less protection to investors. In addition, Cayman Islands companies may not have standing to initiate a shareholder derivative action before the federal courts of the United States.

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

Our management will have considerable discretion as to the use of the net proceeds from this offering.

We have not allocated the majority of the net proceeds of this offering to any particular purpose. Rather, our management will have considerable discretion in the application of the net proceeds received by us. You will not have the opportunity, as part of your investment decision, to assess whether proceeds are being used appropriately. You must rely on the judgment of our management regarding the application of the net proceeds of this offering. The net proceeds may be used for corporate purposes that do not improve our efforts to maintain profitability or increase our ADS price. The net proceeds from this offering may be placed in investments that do not produce income or that lose value.

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 ending December 31, 2007 or for the foreseeable future. However, we must make a separate determination each year as to whether we are a PFIC (after the close of each taxable year). Accordingly, we cannot assure you that we will not be a PFIC for our current taxable year ending December 31, 2007 or any future taxable year. A non-U.S. corporation will be considered a PFIC for any taxable year if either (1) at least 75% of its gross income is passive income or (2) at least 50% of the value of its assets (based on an average of the quarterly values of the assets during the taxable year) is attributable to assets that produce or are held for the production of passive income. The market value of our assets may be determined in large part by the market price of our ADSs and ordinary shares, which is likely to fluctuate after this offering (and may fluctuate considerably given that market prices of technology companies have been especially volatile). If we were treated as a PFIC for any taxable year during which a U.S. person held an ADS or an ordinary share, certain adverse U.S. federal income tax consequences could apply to such U.S. person. See “Taxation—United States Federal Income Taxation—Passive Foreign Investment Company.”

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

As a public company, we will incur a significantly higher level of legal, accounting and other expenses than we did as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC and the Nasdaq Global Market, have required changes in corporate governance practices of public companies. We expect these new rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly. We are currently evaluating and monitoring developments with respect to these new rules, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.

 

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FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements that involve risks and uncertainties. All statements other than statements of historical facts are forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from those expressed or implied by the forward-looking statements.

You can identify these forward-looking statements by words or phrases such as “may,” “will,” “expect,” “anticipate,” “aim,” “estimate,” “intend,” “plan,” “believe,” “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:

 

   

our ability to maintain and strengthen our position as a leading online game developer and operator in China;

 

   

our expected development and launch of additional MMORPGs or other online games;

 

   

our various initiatives to implement our business strategies;

 

   

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

 

   

our planned use of proceeds;

 

   

the expected growth of and change in the online game industry in China; and

 

   

the Chinese government policies relating to the Internet and Internet content providers, including online game developers and operators.

You should read thoroughly this prospectus and the documents that we refer to in this prospectus with the understanding that our actual future results may be materially different from and worse than what we expect. We qualify all of our forward-looking statements by these cautionary statements. Other sections of this prospectus include additional factors which could adversely impact our business and financial performance. Moreover, we operate in an evolving environment. New risk factors and uncertainties emerge from time to time and it is not possible for our management to predict all risk factors and uncertainties, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

This prospectus also contains data related to the online game market in several countries, including China. This market data, including data from IDC, includes projections that are based on a number of assumptions. The online game market may not grow at the rates projected by the market data, or at all. The failure of the market to grow at the projected rates may materially and adversely affect our business and the market price of our ADSs. In addition, the rapidly changing nature of the online game market subjects any projections or 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 proves 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.

You should not rely upon forward-looking statements as predictions of future events. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

 

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USE OF PROCEEDS

We estimate that we will receive net proceeds from this offering of approximately US$106.2 million, after deducting underwriting discounts and commissions and the estimated offering expenses payable by us. These estimates are based upon an assumed initial offering price of US$13.00 per ADS, the midpoint of the range shown on the front cover page of this prospectus. We will not receive any of the proceeds from the sale of ADSs by the selling shareholders. A US$1.00 increase (decrease) in the assumed initial public offering price of US$13.00 per ADS would increase (decrease) our net proceeds from this offering by US$8.4 million, after deducting underwriting discounts and commissions and assuming no change to the number of ADSs offered by us as set forth on the cover page of this prospectus.

The primary purposes of this offering are to create a public market for our shares for the benefit of all shareholders, retain talented employees by providing them with equity incentives, and obtain additional capital. We intend to use approximately US$12 million of the net proceeds from this offering to expand our research and development efforts and use the remaining amount for other general corporate purposes, including capital expenditures and funding possible future acquisitions.

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

Pending use of the net proceeds, we intend to hold our net proceeds in short-term bank deposits or invest them in interest-bearing government securities.

 

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DIVIDEND POLICY

We have no present plan to declare and pay any dividends on our shares or ADSs in the near future. We currently intend to retain most, if not all, of our available funds and any future earnings to operate and expand our business.

We are a holding company incorporated in the Cayman Islands. We rely on dividends from PW Software, our subsidiary in China. Current PRC regulations permit our subsidiaries to pay dividends to us only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. In addition, our subsidiary in China is required to set aside a certain amount of its accumulated after-tax profits each year, if any, to fund certain statutory reserves. These reserves may not be distributed as cash dividends. Further, if our subsidiary in China incurs debt on its own behalf, the instruments governing the debt may restrict its ability to pay dividends or make other payments to us.

Our board of directors has complete discretion as to whether to distribute dividends, subject to the approval of our shareholders. Even if our board of directors decides to pay dividends, the form, frequency and amount will depend upon our future operations and earnings, capital requirements and surplus, general financial condition, contractual restrictions and other factors that the board of directors may deem relevant. If we pay any dividends, we will pay our ADS holders to the same extent as holders of our ordinary shares, subject to the terms of the deposit agreement, including the fees and expenses payable thereunder. See “Description of American Depositary Shares.” Cash dividends on our ADSs and ordinary shares, if any, will be paid in U.S. dollars.

 

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CAPITALIZATION

The following table sets forth our capitalization as of March 31, 2007:

 

   

on an actual basis;

 

   

on an as adjusted basis to reflect the automatic conversion of all of our outstanding Series A convertible preferred shares into 64,000,000 Class B ordinary shares and 16,000,000 Class A ordinary shares automatically upon the closing of this offering, and the sale of 45,000,000 Class B ordinary shares in the form of ADSs by us in this offering at an assumed initial public offering price of US$13.00 per ADS, the midpoint of the estimated range of the initial public offering price shown on the front cover of this prospectus, after deducting the underwriting discounts and commissions and estimated offering expenses payable by us.

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

 

     As of March 31, 2007  
     Actual     As adjusted (1)  
     RMB     US$     RMB     US$  
     ( in thousands)  

Shareholders’ equity:

        

Ordinary shares,
US$0.0001 par value, 420,000,000 shares authorized; 154,285,720 Class A ordinary shares and nil Class B ordinary shares issued and outstanding on an actual basis, 91,309,730 Class A ordinary shares and 187,975,990 Class B ordinary shares issued and outstanding on an as adjusted basis

   123     16     222     29  

Series A convertible preferred shares,
US$0.0001 par value, 80,000,000 shares authorized, issued and outstanding on an actual basis, nil shares issued and outstanding on an as adjusted basis

   61,797     8,001     —       —    

Additional paid-in capital

   46,397     6,008     928,327     120,200  

Statutory reserves

   161     21     161     21  

Accumulated deficit

   (24,340 )   (3,152 )   (24,340 )   (3,152 )
                        

Total shareholders’ equity(2)

   84,138     10,894     904,370     117,098  
                        

Total capitalization(2)

   84,138     10,894     904,370     117,098  
                        

(1) The as adjusted information discussed above is illustrative only. Our additional paid-in capital, total shareholders’ equity and total capitalization following the completion of this offering are subject to adjustment based on the actual initial public offering price and other terms of this offering determined at pricing.

 

(2) 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$13.00 per ADS, the midpoint of the estimated range of the initial public offering price shown on the front cover of this prospectus, would increase (decrease) each of total shareholders’ equity and total capitalization by US$8.4 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 from the conversion of our Series A convertible preferred shares and the fact that the initial public offering price per ordinary share of our ADSs is substantially in excess of the book value per ordinary share attributable to the existing shareholders for our presently outstanding ordinary shares. Our net tangible book value as of March 31, 2007 was approximately RMB81.7 million (US$10.6 million), or RMB0.53 (US$0.07) per ordinary share, and US$0.34 per ADS. Net tangible book value represents the amount of our total consolidated tangible assets, less the amount of our total consolidated liabilities. Dilution is determined by subtracting net tangible book value per ordinary share, after giving effect to the conversion of all outstanding Series A convertible preferred shares into ordinary shares upon the completion of this offering and the additional proceeds we will receive from this offering, from the assumed initial public offering price per ordinary share, which is the midpoint of the estimated initial public offering price range set forth on the cover page of this prospectus and after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

Without taking into account any other changes in net tangible book value after March 31, 2007, other than to give effect to our sale of the ADSs offered in this offering at the assumed initial public offering price of US$13.00 per ADS, the midpoint of the estimated range of the initial public offering price shown on the front cover of this prospectus, after deduction of the underwriting discounts and commissions and estimated offering expenses payable by us and the conversion of all outstanding Series A convertible preferred shares into ordinary shares upon the completion of this offering, our adjusted net tangible book value as of March 31, 2007 would have been RMB901.9 million (US$116.8 million), or RMB3.23 (US$0.42) per outstanding ordinary share, including ordinary shares underlying our outstanding ADSs, and RMB16.15 (US$2.09) per ADS. This represents an immediate increase in net tangible book value of US$0.35 per ordinary share and US$1.75 per ADS, to the existing shareholders and an immediate dilution in net tangible book value of US$2.18 per ordinary share and US$10.91 per ADS, to investors purchasing ADSs in this offering.

The following table illustrates such dilution on a per ordinary share and per ADS basis:

 

Assumed initial public offering price per ordinary share

   US$ 2.60

Assumed initial public offering price per ADS

   US$ 13.00

Net tangible book value per ordinary share as of March 31, 2007

   US$ 0.07

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

   US$ 0.35

Adjusted net tangible book value per ordinary share after giving effect to the conversion of all outstanding preferred shares into ordinary shares upon the completion of this offering and the additional proceeds we will receive from this offering

   US$ 0.42
      

Dilution in net tangible book value per ordinary share to new investors in this offering

   US$ 2.18
      

Dilution in net tangible book value per ADS to new investors in this offering

   US$ 10.91
      

A US$1.00 increase (decrease) in the assumed initial public offering price of US$13.00 per ADS would increase (decrease) our adjusted net tangible book value after giving effect to the offering by RMB64.6 million (US$8.4 million), the adjusted net tangible book value per ordinary share and per ADS after giving effect to this offering by RMB0.23 (US$0.03) per ordinary share and RMB1.16 (US$0.15) per ADS and the dilution in adjusted net tangible book value per ordinary share and per ADS to new investors in this offering by RMB1.31 (US$0.17) per ordinary share and RMB6.57 (US$0.85) 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 estimated offering expenses payable by us.

 

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The following table summarizes, on an as adjusted basis, as of March 31, 2007, the differences between existing shareholders and the new investors with respect to the number of ordinary shares (in the form of ADSs or shares) purchased from us, the total consideration paid and the average price per ordinary share paid before deducting the underwriting discounts and commissions and estimated offering expenses payable by us. The total number of ordinary shares does not include ordinary shares underlying the ADSs issuable upon the exercise of the over-allotment option granted to the underwriters.

 

    

Ordinary shares

Purchased

   

Total

Consideration

    Average
Price Per
Ordinary
share
   Average
Price Per
ADS
     Number    Percent     Amount    Percent           

Existing shareholders

   234,285,720    84 %   US$ 7,016,429    6 %   US$ 0.03    US$ 0.15

New investors

   45,000,000    16 %   US$ 117,000,000    94 %   US$ 2.60    US$ 13.00
                                     

Total

   279,285,720    100 %   US$ 124,016,429    100 %   US$ 0.44    US$ 2.22
                             

A US$1.00 increase (decrease) in the assumed initial public offering price of US$13.00 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$9.0 million, US$9.0 million and US$0.16, 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 estimated offering expenses payable by us.

The discussion and tables above also assume no exercise of any outstanding stock options. As of July 11, 2007, there were 16,986,620 Class B ordinary shares issuable upon exercise of outstanding stock options at a weighted average exercise price of US$0.26 per share, and there were 15,158,380 Class B 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 exercised, there will be further dilution to new investors.

 

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EXCHANGE RATE INFORMATION

Our business is conducted in China and substantially all of our revenues are denominated in RMB. This prospectus contains translations of RMB amounts into U.S. dollars at specific rates solely for the convenience of the reader. The conversion of RMB into U.S. dollars in this prospectus is based on the noon buying rate in The City of New York for cable transfers of RMB as certified for customs purposes by the Federal Reserve Bank of New York. Unless otherwise noted, all translations from RMB to U.S. dollars and from U.S. dollars to RMB in this prospectus were made at a rate of RMB7.7232 to US$1.00, the noon buying rate in effect as of March 30, 2007. We make no representation that any RMB or U.S. dollar amounts could have been, or could be, converted into U.S. dollars or RMB, 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 RMB into foreign exchange and through restrictions on foreign trade. On July 20, 2007, the noon buying rate was RMB7.5727 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 that we used in this prospectus or will use in the preparation of our periodic reports or any other information to be provided to you. The source of these rates is the Federal Reserve Bank of New York.

 

Period

   Noon Buying Rate
   Period End    Average(1)    Low    High
     (RMB Per US$1.00)

2002

   8.2800    8.2770    8.2800    8.2669

2003

   8.2767    8.2772    8.2800    8.2765

2004

   8.2765    8.2768    8.2774    8.2764

2005

   8.0702    8.1940    8.2765    8.0702

2006

   7.8041    7.9579    8.0702    7.8041

2007

           

January

   7.7714    7.7876    7.8127    7.7705

February

   7.7410    7.7502    7.7632    7.7410

March

   7.7232    7.7369    7.7454    7.7232

April

   7.7090    7.7247    7.7345    7.7090

May

   7.6516    7.6773    7.7065    7.6463

June

   7.6120    7.6333    7.6680    7.6120

July (through July 20)

   7.5727    7.5803    7.6055    7.5580

(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 were incorporated in the Cayman Islands in order to enjoy the following benefits:

 

   

political and economic stability;

 

   

an effective judicial system;

 

   

a favorable tax system;

 

   

the absence of exchange control or currency restrictions; and

 

   

the availability of professional and support services.

However, certain disadvantages accompany incorporation in the Cayman Islands. These disadvantages include:

 

   

the Cayman Islands has a less developed body of securities laws as compared to the United States and these securities laws provide significantly less protection to investors; and

 

   

Cayman Islands companies may not have standing to sue before the federal courts of the United States.

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

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

We have appointed CT Corporation System, 111 Eighth Avenue, New York, NY 10011, as our agent upon whom process may be served in any action brought against us under the securities laws of the United States.

Maples and Calder, our counsel as to Cayman Islands law, and King & Wood, our counsel as to PRC law, have advised us, respectively, that there is uncertainty as to whether the courts of the Cayman Islands and China, respectively, would:

 

   

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

 

   

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

Maples and Calder has further advised us that a final and conclusive judgment in the federal or state courts of the United States under which a sum of money is payable, other than a sum payable in respect of taxes, fines, penalties or similar charges, may be subject to enforcement proceedings as a debt in the courts of the Cayman Islands under the common law doctrine of obligation.

King & Wood has further advised us that the recognition and enforcement of foreign judgments are provided for under PRC Civil Procedures Law. PRC courts may recognize and enforce foreign judgments in accordance with the requirements of PRC Civil Procedures Law based either on treaties between China and the country where the judgment is made or on reciprocity between jurisdictions. If there are neither treaties nor reciprocity arrangements between China and a foreign jurisdiction where a judgment is rendered, according to the PRC Civil Procedures Law, matters relating to the recognition and enforcement of a foreign judgment in China may be resolved through diplomatic channels. China does not have any treaties or other arrangements that provide for the reciprocal recognition and enforcement of foreign judgments with the United States or the Cayman Islands. As a result, it is generally difficult to recognize and enforce in China a judgment rendered by a court in either of these two jurisdictions.

 

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CORPORATE HISTORY AND STRUCTURE

Corporate History

We commenced operations through PW Network, a limited liability company established in China in 2004. To enable us to raise equity capital from international investors, our holding company, Perfect World, was incorporated under the laws of the Cayman Islands in June 2006. In August 2006, we formed PW Software, our wholly-owned subsidiary in China.

PRC laws currently restrict foreign ownership of the online game business. To comply with PRC laws, we conduct our online game operation and distribution businesses through PW Network. In September 2006, we entered into contractual agreements with PW Network and its equity owners, pursuant to which PW Network transferred certain fixed assets and employment relationships with certain personnel to us and we provide technical support and research and development services to PW Network. Through these contractual arrangements, we also have the ability to effectively control PW Network’s daily operations and financial affairs, appoint senior executives and decide on all matters subject to shareholders’ approval. As a result of these contractual arrangements, we are considered to be the primary beneficiary of PW Network and PW Network is a VIE of our company under U.S. GAAP. Accordingly, we consolidate PW Network’s results, assets and liabilities in our financial statements. PW Network is considered as our predecessor company. Since both we and PW Network are under common control, our consolidated financial statements reflect this reorganization as a transaction under common control and have been prepared as if the reorganized corporate structure had been in existence throughout all the periods presented. If PW Network and/or its equity owners breach the contractual arrangements with us, we may not be able to continue to effectively control PW Network’s operations and remain to be its primary beneficiary. For example, PW Network may distribute dividends to its equity owners who may decide not to remit these dividends to us in accordance with the existing contractual arrangements. In such case, 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. See “Risk Factors—Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could adversely affect us.”

In the opinion of King & Wood, our PRC counsel, (i) the ownership structure and the business and operation model of each of PW Software and PW Network are in compliance with all existing PRC laws and regulations, and (ii) each contract under PW Software’s contractual arrangements with PW Network and its shareholders is valid and binding, and will not result in any violation of PRC laws or regulations currently in effect.

 

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Corporate Structure

The following diagram illustrates our corporate structure.

LOGO

 

Ø Beneficial Interest

 

×---Ø Contractual arrangements including an Exclusive Technology Support and Service Agreement, a Development Cooperation Agreement, a Business Operation Agreement, a Call Option Agreement and an Equity Pledge Agreement.

 

×Ø Contractual arrangements including a Call Option Agreement, an Equity Pledge Agreement and a Power of Attorney.

 

* Beijing Shiji Xiangshu Technology Co., Ltd. is 88.03% owned by Mr. Michael Yufeng Chi, the founder, chairman and chief executive officer of our company and an ultimate owner of our ordinary shares, 6.38% owned by Mr. Tongyan Wang, who is a holder of our ordinary shares, and 5.59% owned by Mr. Di He, our vice president and chief technology officer and holder of our ordinary shares.

 

** Beijing Jiuzhou Tianyuan Investment Management Co., Ltd. is 60% owned by Mr. Huan Su and 35.72% owned by Mr. Furui Chen, both of whom are ultimate owners of our ordinary shares, and 4.28% owned by Mr. Di He, our vice president and chief technology officer and a holder of our ordinary shares. See “Principal and Selling Shareholders.”

Contractual Arrangements with PW Network and its Equity Owners

Under PRC laws, each of PW Software and PW Network 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 PW Software and PW Network, PW Network does not transfer any other funds generated from its operations to

 

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PW Software. PW Software’s relationships with PW Network and its equity owners are governed by the following contractual arrangements entered into in September 2006, as amended and restated in April 2007.

Exclusive Technology Support and Service Agreement. Under the exclusive technology support and service agreement between PW Software and PW Network, PW Software has the exclusive right to provide to PW Network technical support and services related to PW Network’s online game operations. PW Software owns the intellectual property rights developed by either PW Software or PW Network in the performance of this agreement. PW Network pays to PW Software quarterly service fees, the amount of which is determined by PW Software and PW Network based on the complexity, time spent, contents and value of the technical services provided by PW Software as well as the market price of similar services. This agreement is effective until March 9, 2024 or the early termination by PW Software or by either party due to the other party’s insolvency or similar circumstances.

Development Cooperation Agreement. Under the development cooperation agreement between PW Network and PW Software, PW Network exclusively engages PW Software to develop software for PW Network’s operation. PW Network owns the intellectual property rights developed by PW Software, but PW Software is entitled, free of charge, to use and license to third parties such intellectual property rights. PW Network pays to PW Software monthly service fees, the amount of which is determined by PW Software and PW Network based on the complexity, time spent, cost, contents and value of the development work done by PW Software as well as the market price of similar work. This agreement is effective until March 9, 2024 or the early termination by both parties thereto.

Business Operation Agreement. Under the business operation agreement among PW Software, PW Network and the shareholders of PW Network, PW Software provides guidance and advice on PW Network’s daily operations and financial management systems. The shareholders of PW Network must elect the candidates recommended by PW Software as PW Network’s directors, and procure the appointment of PW Network’s senior executives as per PW Software’s designation. Moreover, PW Network and its shareholders agree that without the prior consent of PW Software, PW Network will not engage in any transactions that could materially affect the assets, business, personnel, rights, liabilities or operations of PW Network, including incurrence or assumption of any indebtedness of more than RMB400,000, sale or purchase of any assets or rights, incurrence of any encumbrance on any of its assets or intellectual property rights in favor of a third party, amendment of its articles of association or business scope, or change of its normal operation procedures. The agreement also provides that if any of the agreements between PW Software and PW Network is terminated, PW Software is entitled to terminate all of the other agreements between itself and PW Network. This agreement is effective until March 9, 2024 or the early termination by PW Software.

Call Option Agreement. Under the call option agreement among the equity owners of PW Network, PW Network and PW Software, the equity owners of PW Network irrevocably granted PW Software or its designated person an exclusive option to purchase from PW Network’s equity owners, to the extent permitted under PRC law, all or part of the equity interests in PW Network for the higher of (i) RMB10,000 or (ii) the minimum amount of consideration permitted by the applicable law. PW Software or its designated person has sole discretion to decide when to exercise the option. This agreement is effective until March 9, 2024 or the early termination by all parties thereto.

Equity Pledge Agreement. Under the equity pledge agreement among the equity owners of PW Network, PW Network and PW Software, the equity owners of PW Network pledged all of their equity interests in PW Network to PW Software to guarantee PW Network’s performance of its obligations under the exclusive technology support and service agreement, the development cooperation agreement, the business operation agreement and the call option agreement. If PW Network or either of its equity owners breaches its respective contractual obligations, PW Software, as pledgee, will be entitled to certain rights, including the right to sell the pledged equity interests. The equity owners of PW Network agreed not to take any actions that would prejudice PW Software’s interest. This agreement is effective until March 9, 2024.

 

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Power of Attorney. Each equity owner of PW Network has executed a power of attorney to appoint PW Software as its attorney-in-fact to exercise all of its rights as equity owner of PW Network, including voting rights and the rights to transfer any or all of its equity interest in PW Network. The appointment of PW Software as attorney-in-fact will remain effective until the termination of the above business operation agreement or the dissolution of PW Software.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated statement of operations data for the period from March 10, 2004 (date of inception) to December 31, 2004 and for the years ended December 31, 2005 and 2006 and the consolidated balance sheet data as of December 31, 2005 and 2006 have been derived from our audited consolidated financial statements, which are included elsewhere in this prospectus. Our consolidated balance sheet data as of December 31, 2004 has been derived from our audited consolidated balance sheet which is not included in this prospectus. The selected consolidated statement of operations data for the three months ended March 31, 2006 and 2007 and the selected consolidated balance sheet data as of March 31, 2007 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. Our consolidated financial statements are prepared and presented in accordance with U.S. GAAP, and reflect our current corporate structure as if it had been in existence throughout the relevant periods. The historical results are not necessarily indicative of results to be expected in any future period. In addition, our unaudited results for the three months ended March 31, 2007 may not be indicative of our results for the full year ending December 31, 2007. You should read the following information in conjunction with our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

 

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For the Period
From March 10,
2004 (Date

of Inception) to
December 31,
2004

    For the Year Ended December 31,     For the Three Months Ended March 31,  
    2005     2006     2006     2007  
    RMB     RMB     RMB     US$     RMB     RMB     US$  
    (in thousands, except share, per share and per ADS data)  

Consolidated Statement of Operations Data

       

Revenues:

             

Online game operation revenues

  —       —       98,392     12,740     9,138     76,575     9,915  

Overseas licensing revenues

  —       —       1,014     131     —       10,579     1,370  
                                         

Total revenues

  —       —       99,406     12,871     9,138     87,154     11,285  

Cost of revenues

  —       —       (24,604 )   (3,186 )   (3,053 )   (19,196 )   (2,486 )

Gross profit

  —       —       74,802     9,685     6,085     67,958     8,799  

Operating expenses:

             

Research and development expenses

  (6,043 )   (15,151 )   (18,889 )   (2,446 )   (3,860 )   (6,951 )   (900 )

Sales and marketing expenses

  (176 )   (12,904 )   (37,496 )   (4,855 )   (5,248 )   (15,308 )   (1,982 )

General and administrative expenses

  (656 )   (1,508 )   (45,868 )   (5,939 )   (1,325 )   (3,737 )   (484 )
                                         

Total operating expenses

  (6,875 )   (29,563 )   (102,253 )   (13,240 )   (10,433 )   (25,996 )   (3,366 )
                                         

Operating (loss) income

  (6,875 )   (29,563 )   (27,451 )   (3,555 )   (4,348 )   41,962     5,433  
                                         

Other income (expense):

             

Interest income

  64     14     321     42     5     454     59  

Others, net

  (1 )   115     (612 )   (79 )   19     (355 )   (46 )

Income tax expense

  —       —       (203 )   (26 )   —       (2,049 )   (265 )
                                         

Net (loss) income

  (6,812 )   (29,434 )   (27,945 )   (3,618 )   (4,324 )   40,012     5,181  
                                         

Series A convertible preferred shares accretion

  —       —       (1,834 )   (238 )   —       —       —    

Cumulative unearned dividends of Series A convertible preferred shares

  —       —       (1,019 )   (132 )   —       (767 )   (99 )
                                         

Net (loss) income attributable to ordinary shareholders

  (6,812 )   (29,434 )   (30,798 )   (3,988 )   (4,324 )   39,245     5,082  
                                         

Net (loss) income per ordinary share:

             

Basic

  (0.05 )   (0.20 )   (0.21 )   (0.03 )   (0.03 )   0.25     0.03  

Diluted

  (0.05 )   (0.20 )   (0.21 )   (0.03 )   (0.03 )   0.16     0.02  

Net (loss) income per ADS:

             

Basic

  (0.23 )   (0.99 )   (1.02 )   (0.13 )   (0.15 )   1.27     0.16  

Diluted

  (0.23 )   (0.99 )   (1.02 )   (0.13 )   (0.15 )   0.82     0.11  

Weighted average number of ordinary shares used in per ordinary share calculations:

             

Basic

  148,571,430     148,571,430     150,403,134     150,403,134     148,571,430     154,285,720     154,285,720  

Diluted

  148,571,430     148,571,430     150,403,134     150,403,134     148,571,430     242,951,028     242,951,028  

 

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     For the Period
From March
10, 2004 (Date
of Inception) to
December 31,
2004
   For the Year Ended December 31,     For the Three
Months Ended
March 31,
 
            2005          2006     2006    2007  
     RMB    RMB    RMB     US$     RMB    RMB     US$  
     (in thousands)  

Share-based compensation expenses included in:

                 

Cost of revenues

   —      —      (9 )   (1 )   —      (27 )   (3 )

Research and development expenses

   —      —      (312 )   (40 )   —      (278 )   (36 )

Sales and marketing expenses

   —      —      (31 )   (4 )   —      (36 )   (5 )

General and administrative expenses(1)

   —      —      (37,828 )   (4,898 )   —      (158 )   (21 )

(1) Included a RMB30,300,487 (US$3,923,307) one-time share-based compensation charge in connection with a founder’s ordinary shares becoming subject to restrictions and the subsequent elimination of these restrictions and a RMB7,508,775 (US$972,236) one-time share-based compensation charge in connection with our issuance of Series A convertible preferred shares to a founding shareholder at par value in 2006.

The following table presents a summary of our consolidated balance sheet data as of December 31, 2004, 2005, 2006, and March 31, 2007:

 

     As of December 31,    As of March 31,
     2004    2005     2006    2007
     RMB    RMB     RMB    US$    RMB    US$
     (in thousands)

Consolidated Balance Sheet Data:

                

Cash and cash equivalents

   2,871    4,272     101,357    13,124    159,263    20,621

Total assets

   9,577    8,489     127,530    16,512    190,408    24,654

Advance from customers

   —      6,613     20,449    2,648    24,942    3,230

Deferred revenues

   —      —       32,976    4,270    60,540    7,839

Total liabilities

   1,389    29,735     84,030    10,880    106,270    13,760

Series A convertible preferred shares

   —      —       61,797    8,001    61,797    8,001

Ordinary shares

   —      —       123    16    123    16

Additional paid-in capital

   15,000    15,000     45,898    5,942    46,397    6,008

Total shareholders’ equity

   8,188    (21,246 )   43,500    5,632    84,138    10,894

Total liabilities and shareholders’ equity

   9,577    8,489     127,530    16,512    190,408    24,654

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the section entitled “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements that involve risks, uncertainties and assumptions. 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 game developer and operator in China as measured by the popularity of our games in China in 2006, according to a report published by IDC. We primarily develop 3D online games based on our proprietary Angelica 3D game engine and game development platform. Our strong technology and creative game design capabilities, combined with our extensive local knowledge and experience, enable us to frequently and rapidly introduce popular games designed to cater to changing customer preferences and market trends in China.

In 2006, we launched our first three self-developed 3D MMORPGs, namely, Perfect World, Legend of Martial Arts and Perfect World II. In the first quarter of 2007, our games recorded approximately 237,000 average concurrent users in China. We launched a new self-developed 3D MMORPG, Zhu Xian, in late May 2007 and expect to launch two additional 3D MMORPGs and a casual game in 2007 and early 2008. We plan to develop more online games with a variety of themes, cultural characteristics and features that appeal to different segments of the online game player community.

We use a time-based revenue model for our first game, Perfect World, under which we charge players based on the time they spend playing the game. We use an item-based revenue model for Legend of Martial Arts, Perfect World II and Zhu Xian, under which players can play the games for free, but they are charged for purchases of in-game items, such as performance-enhancing items, clothing, accessories and pets. In 2006 and the first quarter of 2007, 46.9% and 86.5%, respectively, of our online game operation revenues were generated through this item-based model. We will continue to explore new and innovative business models to maximize our revenues and profit. We distribute our physical and virtual prepaid game cards to players in China through a variety of channels, consisting primarily of a network of 27 third-party distributors of our physical cards and one national distributor of our virtual cards. We also sell online points through our proprietary E-sales system and our own website. Although most of our revenues are generated in China, we have licensed Perfect World II and Legend of Martial Arts to leading game operators in 11 and seven countries and regions, respectively, including Japan and Taiwan, and we plan to license our games to more countries and regions. We have grown significantly since our inception, and generated revenues of RMB99.4 million (US$12.9 million) and RMB87.2 million (US$11.3 million) in 2006 and the first quarter of 2007, respectively. We incurred net losses from our inception in 2004 through the end of 2006. Our net loss of RMB27.9 million (US$3.6 million) in 2006 included one-time share-based compensation charges in the amount of RMB37.8 million (US$4.9 million) incurred in the year. We achieved net income of RMB40.0 million (US$5.2 million) in the first quarter of 2007.

Factors Affecting Our Results of Operations

We have benefited from general conditions typically affecting the online game industry in China, including the overall economic growth, which has resulted in increases in disposable income and discretionary consumer spending; the increasing use of the Internet with the growth of PC and broadband penetration; the growing popularity of online games in comparison with other forms of entertainment; and favorable demographic trends, particularly the growth of the population in the age groups more inclined to play online games.

Our operating results are more directly affected by company-specific factors, including the number of online games available in the market, the popularity of our games and in-game items compared with those of our

 

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competitors, the pricing of our games and in-game items, the speed at which we develop and launch new online games and related in-game items, the growth of our overseas licensing revenues, and our cost of developing, operating and marketing online games. Our future growth will depend significantly upon our ability to continually and successfully develop, market and operate additional online games that are attractive to players, to increase monetization of our existing and future games and to expand our international licensing.

Revenues

In 2006, we launched our first three games and generated revenues of RMB99.4 million (US$12.9 million). For the first quarter of 2007, we generated revenues of RMB87.2 million (US$11.3 million). We expect that our revenues will further increase in the near future, driven by our launch of additional games, increasing monetization of our games, and expansion of our overseas licensing. Our online game operation revenues are net of sales discounts and rebates to our distributors, which historically have averaged approximately 16.4% of the face value of our prepaid game cards sold to our distributors. The following table sets forth the revenues generated from our online game operations in China and overseas licensing, both in absolute amount and as a percentage of total revenues for the periods indicated.

 

    

For the Year Ended

December 31, 2006

   For the Three Months Ended
March 31, 2007
         RMB            US$            %            RMB            US$            %    
     (in thousands except percentages)

Revenues:

                 

Online game operation

   98,392    12,740    99.0    76,575    9,915    87.9

Overseas licensing

   1,014    131    1.0    10,579    1,370    12.1
                             

Total revenues

   99,406    12,871    100.0    87,154    11,285    100.0
                             

Online Game Operation Revenues

In 2006 and the first quarter of 2007, substantially all of our revenues were generated from our online game operations in China. We launched our first game, Perfect World, in January 2006, using the time-based revenue model, and 53.1%, or RMB52.3 million (US$6.8 million), of our online game operation revenues in 2006 were derived from this game. With respect to games operated under the time-based model, the revenue growth will depend primarily on the increase in the number of players and their playtime. We expect that our revenues generated from games operated under the time-based model will decrease as a percentage of our online game operation revenues as we began using the item-based model only in September 2006 and plan to continue to use this model for our new games.

We launched our second and third games, Legend of Martial Arts and Perfect World II, in late September and the end of November 2006, respectively, using the item-based revenue model. In 2006, 43.8%, or RMB43.1 million (US$5.6 million), and 3.1%, or RMB3.0 million (US$0.4 million), of our online game operation revenues were derived from Legend of Martial Arts and Perfect World II, respectively.

We also adopt the item-based revenue model for our fourth game, Zhu Xian, which was launched in late May 2007, and we plan to adopt the item-based revenue model for all of our new games that will be launched in 2007 and early 2008. With respect to games using the item-based revenue model, the revenue growth will depend primarily on the increase in the number of players and the average spending of players. We expect that revenues derived from our games operated under the item-based model will continue to increase as a percentage of our total revenues in the foreseeable future.

We target to launch two new MMORPGs and a casual game in 2007 and early 2008. We believe that our proprietary 3D game engine, powerful game development platform and creative game design will facilitate our

 

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successful development of games that cater to changing customer preferences and market trends in China. Furthermore, our creative utilization of extensive local knowledge and experience and strong and consistent operations will help increase the monetization of our existing and future games. We intend to continue to develop new games, including MMORPGs, casual games and a 3D online virtual community, to expand our game portfolio and replace our existing games as they reach the end of their useful economic lives. We expect that the percentage of our online game operation revenues derived from particular games to change from period to period over the life span of each individual game.

Overseas Licensing Revenues

In 2006 and the first quarter of 2007, we recorded revenues of RMB1.0 million (US$0.1 million) and RMB10.6 million (US$1.4 million), respectively, for the license fees and usage-based royalties we earned from overseas licensees of our online games. As of the date of this prospectus, we have licensed Perfect World II and Legend of Martial Arts to leading game operators in 11 and seven countries and regions, respectively, including Japan and Taiwan, and expect to recognize more overseas licensing revenues in 2007, as compared with 2006. All of these licensed games are operated under the item-based revenue model by the respective operators.

Under our license agreements with overseas licensees, we are generally entitled to receive from the licensees an initial license fee and ongoing usage-based royalties. The usage-based royalties are generally determined based on the amount of money charged to players’ accounts in a given country or region. We plan to further expand the geographical reach of our games by licensing Perfect World II and other games we develop in the future to leading online game operators in additional countries and regions, including Southeast Asia, the U.S., Europe and South America. We expect that license fees and usage-based royalties earned from overseas licensees will increase in the future.

Revenue Collections

Online game operations. We collect our online game operation revenues through sales of (i) physical and virtual prepaid game cards, which record entitlements to certain numbers of our online points, and (ii) online points, which entitle players to play our games for a specified period of time or to purchase our in-game items. We generally sell physical prepaid game cards through an offline network of third-party distributors, which in turn distribute our cards to retailers, including Internet cafés, newsstands and bookstores. Our virtual prepaid game cards are sold via third-party online distributors and audio response phone and mobile operators who bundle the collection of fees for our games with the fees for their services to users. We sell online points via online payment platform service providers or our E-sales system. Through our E-sales system, we electronically sell online points to distributors and our distributors electronically sell the online points in their accounts to the accounts of their sub-distributors, retailers or players.

In most cases, we receive cash payments from distributors upon or before delivering our prepaid game cards to them. In other cases, the online payment platform service providers or other third parties generally pay us within several days after they collect the payments or after our monthly settlement with them. As a result, we generally do not have substantial accounts receivable relating to our online game operation revenues.

We offer a discount equal to 14% of the face value of our game cards to most of our third-party distributors. As a result, the net cash proceeds we receive from most of our distributors represent 86% of the face value of the game cards sold to them. We also offer a volume rebate equal to 3% of the face value of our game cards to our major distributors if they have achieved a pre-set sales target. The rebate is provided to these major distributors in the form of free game cards. To date, all of these major distributors have been able to achieve the pre-set sales target. Therefore, we estimate that the average total discount rate we have offered historically to all of our distributors is approximately 16.4% of the face value of our game cards.

Overseas licensing. Under our license agreements with overseas licensees, we are generally entitled to receive, from the licensees, an initial license fee and ongoing usage-based royalties. The ongoing usage-based

 

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royalties are generally determined based on the amount of money charged to players’ accounts in a given country or region. We generally receive ongoing usage-based royalties on a monthly basis. We generally receive our initial license fees in installments, usually in several days after the signing of the license agreements, closed beta testing, open beta testing and commercial launch of our games, respectively.

Revenue Recognition

Online game operations. To use the online points on a prepaid game card, a player must “activate” the card by using an access code and password to transfer the online points on the card to such player’s personal game account. Players can directly charge the online points they purchased into their accounts. Under both the time-based and the item-based revenue models, the net proceeds we receive from sales of online points to players are recorded as deferred revenues, while the net proceeds we receive from sales of online points to parties other than players and sales of prepaid game cards are initially recorded as advances from customers. As we do not have the control and generally do not know the ultimate selling price of the prepaid game cards or online points sold by third-party distributors, we record the net proceeds collected from distributors as advances from customers. Upon activation of the game cards or charge of the online points, these advances from customers are immediately transferred to deferred revenues. As of December 31, 2006 and March 31, 2007, our advances from customers amounted to RMB20.4 million (US$2.6 million) and RMB24.9 million (US$3.2 million), respectively, and our deferred revenues amounted to RMB30.4 million (US$3.9 million) and RMB51.7 million (US$6.7 million), respectively. As our player base and overall sales volume grows, we expect that advances from customers and deferred revenues will increase correspondingly.

The timing of recognizing deferred revenues as revenues depends on whether the game is using the time-based model or the item-based model. For our games that use the time-based model, we recognize revenues when the activated prepaid game cards or the charged online points representing the playing time are actually used by the players to play our games. For our games that use the item-based model, we recognize revenues over the life of the purchased in-game items or as these items are consumed. See “—Critical Accounting Policies—Revenue Recognition.”

Overseas licensing. For the initial license fees received under our overseas license agreements, we recognize revenues ratably over the license period, when we are obligated to provide post-sales services such as technical support and provision of updates or upgrades to the licensed games. As of December 31, 2006 and March 31, 2007, our deferred revenues associated with unrecognized initial license fees received amounted to RMB2.6 million (US$0.3 million) and RMB8.8 million (US$1.1 million), respectively. With respect to the ongoing usage-based royalties, we recognize revenues when the usage-based royalties are earned according to the license agreements, and the collection of such royalties is probable.

Cost of Revenues

Our cost of revenues consists primarily of server and bandwidth leasing fees, salary and benefits expenses related to the operation of our online games, and other direct costs of providing online game services. Our cost of revenues includes the amount of VAT to which we are actually subject in China after deducting the amount of VAT refunds we are entitled to receive. Other direct costs of providing online game services primarily comprise depreciation and amortization expenses of computer equipment and copyrights, rental cost for the premises used in relation to the operation of our online games and manufacturing costs of physical game cards. We expect that our cost of revenues will increase as our revenues increase.

Server and Bandwidth Leasing Fees

Server and bandwidth leasing fees accounted for 59.3% and 68.6% of our cost of revenues in 2006 and the first quarter of 2007, respectively. We rent communication bandwidth to connect our game operating networks to the Internet and interchange data traffic to and from our networks and our users. Our bandwidth needs are considerable given the large number of concurrent users of our games and because our games are highly interactive between online users, requiring considerable amounts of data to be exchanged at high frequencies. We

 

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currently lease a significant amount of connectivity bandwidth and approximately 78% of our servers from third parties. We expect our payments for server and bandwidth leasing fees will increase in the future as we launch new games, broaden our geographic reach, add features to advance our network security and data traffic management systems and address additional growth in our player base. Moreover, to ensure that we have sufficient network capacity to meet the needs of our players at all times, we generally increase our server capacity in line with the rate of increase in our peak concurrent users.

Salary and Benefits Expenses

Salary and benefits expenses accounted for 13.8% and 9.5% of our cost of revenues in 2006 and the first quarter of 2007, respectively. Salary and benefits expenses included in our cost of revenues primarily relate to employees involved in the operation of our online games, including network operation and customer service. Salary and benefits expenses primarily include employee wages and social welfare benefits, such as medical insurance, housing subsidies, unemployment insurance and pension benefits.

VAT

The amount of net VAT included in our cost of revenues for the year ended December 31, 2006 and the first quarter of 2007 was RMB2.5 million (US$0.3 million) and RMB2.0 million (US$0.3 million), respectively, accounting for 10.3% and 10.2% of our cost of revenues in 2006 and the first quarter of 2007, respectively. It was determined and approved by the tax authority that our online game revenues are subject to 17% VAT and that we are entitled to a 14% VAT refund immediately upon filing the VAT returns. Effectively, we are only subject to 3% VAT. The VAT refund is recorded as a reduction of cost of revenues.

Operating Expenses

Our operating expenses consist of research and development expenses, sales and marketing expenses, and general and administrative expenses, each of which include share-based compensation. Without taking into account share-based compensation expenses, we expect that our operating expenses will further increase in the future as we further expand our game portfolio and enhance our research and development and sales and marketing activities.

Research and Development Expenses

Research and development expenses accounted for 18.5% and 26.7% of our operating expenses in 2006 and the first quarter of 2007, respectively. Our research and development expenses consist primarily of salary and benefits expenses of personnel engaged in the research and development of our game engine, game development platform and online games, and rental cost for the premises used in our development of online game products. We expect that our research and development expenses will increase in the future, as we plan to increase research and development expenditures to develop more MMORPGs and other online games, including casual online games and a 3D virtual community, and upgrade our proprietary Angelica 3D game engine and game development platform.

Sales and Marketing Expenses

Sales and marketing expenses accounted for 36.7% and 58.9% of our operating expenses in 2006 and the first quarter of 2007, respectively. Our sales and marketing expenses consist primarily of expenses for the promotion, advertisement and sponsorship of media events, and salary and benefits of our sales and marketing personnel. Our advertising expenses include advertising payments to various game magazines and online game sites and other advertising service providers. We incurred more sales and marketing expenses in 2006 and the first quarter of 2007, as compared to prior years, as we launched our first three games in January, September and November 2006. Even though we did not launch any game in 2005, we incurred sales and marketing expenses in 2005 primarily relating to our marketing and promotion activities in preparation for the launch of our first game,

 

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Perfect World, in January 2006. We plan to intensify our marketing and promotional efforts and thus increase our sales and marketing expenses when we launch new games in the future.

General and Administrative Expenses

General and administrative expenses accounted for 44.8% and 14.4% of our operating expenses in 2006 and the first quarter of 2007, respectively. Of our general and administrative expenses in 2006, RMB37.8 million (US$4.9 million), or 37.0% of our total operating expenses in 2006, were one-time share-based compensation charges in connection with the ordinary shares held by our founder, chairman and chief executive officer, Mr. Michael Yufeng Chi, becoming subject to restrictions and the subsequent elimination of these restrictions and our issuance of Series A convertible preferred shares to one of our founding shareholders controlled by Mr. Chi at par value in 2006.

Other than the above one-time share-based compensation charge, our general and administrative expenses consist primarily of salary and benefits for general management, finance and administrative personnel and professional service fees for services rendered in connection with our reorganization, audit and tax consultation. We expect that our general and administrative expenses, excluding the one-time share-based compensation charge in connection with our founder’s ordinary shares subject to restrictions and the elimination of such restrictions, will increase after the completion of this offering due to, among other things, the additional expenses for compliance with legal, accounting and other requirements associated with being a public company.

Share-based Compensation Expenses

In 2006, our board of directors and shareholders adopted a share incentive plan and supplemented and amended the plan in January and June 2007, respectively. Up to 32,145,000 Class B ordinary shares have been reserved under the plan for future issuances upon exercise of the options and other equity incentives granted under the plan. See “Management—Share Incentive Plan.” As of March 31, 2007, there are outstanding options to purchase a total of 14,091,620 Class B ordinary shares and as a result, we recorded share-based compensation expenses in 2006 and the first quarter of 2007 in connection with the options granted. In 2006, we also recorded share-based compensation expenses in connection with (i) a founder’s ordinary shares becoming subject to restrictions and the subsequent elimination of such restrictions, (ii) restricted shares awarded by two principal shareholders to an employee, and (iii) our issuance of Series A preferred shares to a founding shareholder at par value. The amounts of these share-based compensation charges are set forth below:

 

     For the Year Ended
December 31, 2006
   For the Three Months Ended
March 31, 2007
             RMB                    US$                    RMB                    US$        
    

(in thousands)

Share-based compensation expenses:

           

Founder’s shares

   30,300    3,923    —      —  

Series A convertible preferred share issued to a founding shareholder

   7,509    972    —      —  

Restricted shares awarded to an employee

   216    28    183    24

Options granted to employees

   155    20    316    41

As of March 31, 2007, the unamortized compensation expenses in connection with our outstanding options were RMB10.1 million (US$1.3 million), and the unamortized compensation expenses in connection with restricted shares awarded to an employee were RMB2.6 million (US$0.3 million). These amounts do not include share-based compensation expenses with respect to our options granted after March 31, 2007.

Taxation

Under the current laws of the Cayman Islands, we are not subject to tax on income or capital gains. In addition, payment of dividends by us is not subject to withholding tax in the Cayman Islands.

 

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PRC Enterprise Income Tax, or EIT

PRC EIT is generally assessed at the rate of 33% of taxable income. Under current PRC rules and policies, an enterprise qualified both as a “software enterprise” and a “high and new technology enterprise” is entitled to a preferential EIT rate of 15% and is further entitled to a two-year EIT exemption for the first two years during which it has cumulative taxable income, and a 50% reduction of its applicable EIT rate for the succeeding three years. In addition, an enterprise qualified as a “high and new technology enterprise” located in the Beijing New Industry Development Pilot Zone is entitled to a preferential EIT rate of 15% and is further entitled to a three-year EIT exemption from either its first year of operation or, if it is incorporated in the second half of a calendar year, its second year of operation if so selected, and a 50% reduction of its applicable EIT rate for the succeeding three years.

PW Network is currently qualified both as a “software enterprise” and a “high and new technology enterprise” in China and enjoying preferential tax treatments as a result of this status. PW Network did not have any cumulative taxable income during the period from March 10, 2004 (date of inception) to December 2004 and for the years ended December 31, 2005 and 2006.

PW Software is currently qualified as a “high and new technology enterprise” located in the Beijing New Industry Development Pilot Zone and enjoying preferential tax treatments as a result of this status. PW Software was incorporated in the second half of 2006, and has elected to enjoy its preferential tax treatment from 2007 as permitted by PRC tax rules. Therefore, PW Software is expected to be exempted from EIT from 2007 to 2009 and to be subject to a 7.5% EIT rate from 2010 to 2012. However, PW Software and PW Network’s qualifications are subject to an annual or biennial assessment by the relevant government authority in China.

On March 16, 2007, the National People’s Congress of China enacted a new enterprise income tax law, under which FIEs and domestic companies would be subject to EIT at a uniform rate of 25%. Preferential tax treatments will continue to be granted to entities that are classified as “high and new technology enterprises strongly supported by the State” or conduct business in encouraged sectors, whether FIEs or domestic companies. The new tax law will become effective on January 1, 2008. Under the new tax law, enterprises that were established and already enjoyed preferential tax treatments before March 16, 2007 will continue to enjoy them (i) in the case of preferential tax rates, for a period of five years from January 1, 2008, or (ii) in the case of preferential tax exemption or reduction for a specified term, until the expiration of such term. Therefore, PW Network and PW Software will continue to be entitled to the preferential tax treatments currently enjoyed by them during such transition period. The new tax law, however, does not define “high and new technology enterprises strongly supported by the State,” nor does it specify which encouraged sectors will be eligible for preferential tax treatments. Because the detailed implementing rules for the new tax law have not yet been promulgated, we cannot assure you that PW Network or PW Software will be classified as a “high and new technology enterprises strongly supported by the State” or an enterprise that conducts business in encouraged sectors, and continue to be entitled to the preferential EIT rate of 15% after the transition period expires.

PRC VAT and Business Tax

We operate and distribute our online games via PW Network in China. As determined and approved by the relevant tax authority, the sales proceeds that PW Network collects from our online game operations are subject to VAT, which is at a rate of 17% of such proceeds. Pursuant to relevant tax rules, prior to the end of 2010, PW Network is entitled to a refund of the portion of VAT that exceeds 3% of its sales proceeds.

Taxpayers providing taxable services in China are required to pay a business tax at a statutory tax rate of 5% of their revenues. According to an applicable governmental policy, revenues generated from PW Software’s software development and relevant technology consulting services, being a technology development business, are exempt from the business tax. However, PW Software’s revenues generated by the provision of technology consultancy services which are independent of its software development services and other consultancy services are subject to the business tax.

 

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Withholding Taxes

PW Network and/or PW Software are subject to withholding taxes on the license fees and usage-based royalties received from our licensees in various jurisdictions outside of China. Upon approval by the relevant PRC tax authorities, the amount of withholding taxes that our licensees pay on behalf of PW Network or PW Software in foreign jurisdictions may be treated as a foreign tax credit which may be used to offset their respective EITs otherwise payable in China. However, as PW Network and PW Software are currently entitled to an exemption from EIT, neither of them is entitled to such foreign tax credit during the period of EIT exemption. RMB0.2 million (US$26 thousand) and RMB2.0 million (US$0.3 million) were recognized as income tax expense related to withholding taxes for the year ended December 31, 2006 and for the three months ended March 31, 2007, respectively.

Critical Accounting Policies

We prepare financial statements in accordance with U.S. GAAP, which requires us to make judgments, estimates and assumptions that affect (i) the reported amounts of our assets and liabilities, (ii) the disclosure of our contingent assets and liabilities at the end of each fiscal period and (iii) the reported amounts of revenues and expenses during each fiscal period. We continually evaluate these estimates based on our own historical experience, knowledge and assessment of current business and other conditions, and our expectations regarding the future based on available information and reasonable assumptions, which together form our basis for making judgments about matters that are not readily apparent from other sources. Since the use of estimates is an integral component of the financial reporting process, our actual results could differ from those estimates. Some of our accounting policies require a higher degree of judgment than others in their application.

When reviewing our financial statements, you should consider (i) our selection of critical accounting policies, (ii) the judgment and other uncertainties affecting the application of such policies and (iii) the sensitivity of reported results to changes in conditions and assumptions. We believe the following accounting policies involve the most significant judgments and estimates used in the preparation of our financial statements.

Revenue Recognition

Online game operation revenues. Substantially all of our revenues are earned through providing online game services to players. We have been providing online game services to our players pursuant to revenue models: a time-based revenue model and an item-based revenue model. For online games using the time-based model, we charge players based on the time they spend playing our games. Under the item-based model, the basic game play functions are free of charge, and we charge users for purchases of in-game items.

Under both the time-based and the item-based revenue models, net proceeds received from sales of online points to players are recorded as deferred revenues, while net proceeds received from sales of online points to parties other than players and sales of prepaid game cards are initially recorded as advances from customers. As we do not control and generally do not know the ultimate selling price of the prepaid game cards or online points sold by the distributors, net proceeds from distributors are recorded as advances from customers. Upon activation of the game cards or charge of the online points, these advances from customers are immediately transferred to deferred revenues.

Revenue recognition policies adopted for time-based and item-based models are as follows:

Time-based revenue model. We recognize revenues when the online points representing the playing time are actually used by the players to play our games.

Item-based revenue model. Under this model, the players can access our games free of charge, but may utilize their activated prepaid game cards or online points charged to their accounts to purchase the following categories of in-game items: (1) consumable items with expiration time, such as facial expressions and fireworks; or (2) permanent ownership items, such as mine stones, materials, clothing and riding pets.

 

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Revenues in relation to consumable items are recognized when they have been consumed or expired (i.e., the actual lives of the in-game items), as our services in connection with such these items have been fully rendered to our players as of that time. Revenues in relation to permanent ownership items are recognized over their estimated lives. We will provide continuous online game services in connection with these permanent ownership items until they are no longer used by our players (i.e., the estimated lives of the in-game items). We have considered the average period that players typically play our games and other player behavior patterns to arrive at our best estimates for the lives of these in-game items, which, in some cases, may be as long as the estimated life of the related game. However, given the relatively short operation history of our online games, our estimate of the period that players typically play our games may not accurately depict such period and hence the lives of the in-game items. While we believe our estimates to be reasonable in view of actual player information available, we may revise such estimates in the future as we continue to gain operating history and data and refine our estimation process and results accordingly.

According to our published expiration policy, prepaid game cards will expire on the expiration date printed thereon, which is generally two years after the date of card production. The proceeds from the expired game cards that have never been activated are recognized as other income upon expiration of the cards.

Online points within a player’s personal online game account will not expire as long as the personal game account remains active, i.e. being logged in at least once by the player. We published a policy on January 17, 2007, under which we will suspend and close a player’s personal game account if it has been inactive for a period of 180 consecutive days. The unused online points in an inactive personal game account are recognized as revenues when the player is no longer entitled to access our online games, or when the likelihood that we would provide further online game service to such player is remote.

As of the date of this prospectus, we do not have any expired prepaid game cards, or any activated and unused prepaid game cards or charged and unused online points in an inactive account.

It was determined and approved by the PRC tax authority that our online game revenues are subject to 17% VAT and that prior to the end of 2010, we are entitled to a 14% VAT refund immediately upon filing the VAT returns. Effectively, we are only subject to 3% VAT. We have adopted the gross presentation for VAT pursuant to EITF 06-3, “How taxes collected from customers and remitted to governmental authorities should be presented in the income statements,” i.e., VAT is included in revenues and cost of revenues. The VAT refund is recorded as a reduction of cost of revenues. The amount of net VAT included in our cost of revenues for the year ended December 31, 2006 was RMB2.5 million (US$0.3 million).

Alternatively, we could adopt the net presentation allowed under EITF 06-3 and present our revenue net of the 17% VAT while recording the 14% VAT refund as other operating income. However, we believe that the gross presentation better reflects our results of operations, as we consider our VAT obligation and VAT refund entitlement as one integrated preferential VAT policy and we are only obligated to pay net 3% VAT under this preferential VAT policy.

Overseas licensing revenues. We have entered into licensing arrangements with overseas licensees to operate our game products in other countries and regions including Japan and Taiwan. Our revenues from the sales of software licenses to overseas licensees often include a combination of licenses to use the software, provision of training and post contract services, or PCS. During the license period, we are required to provide the licensees with updates or upgrades to the licensed games every three to six months. Because there is no vendor-specific objective evidence of fair value of the PCS upon the commercial launch of the game, the initial license fees from the licensing arrangements are recognized as revenue ratably over the license period for which the PCS are to be provided in accordance with Statement of Position 97-2, Software Revenue Recognition.

According to the license agreements, we are also entitled to ongoing usage-based royalties determined based on the amount of money charged to players’ accounts in a given country or region. The usage-based royalties are recognized when they are earned, provided that the collectibility is probable.

 

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Consolidation of Variable Interest Entity

PRC laws and regulations currently prohibit or restrict foreign invested companies from providing Internet content services, which include operating online games. In order to comply with these foreign ownership restrictions, we operate our online game business in China through PW Network. We have entered into a series of contractual arrangements with PW Network and its equity owners. As a result of these contractual arrangements as described in note (2) to the consolidated financial statements, we have the ability to effectively control PW Network and we are considered the primary beneficiary of PW Network and accordingly PW Network is a VIE of our company under U.S. GAAP and we consolidate its results in our consolidated financial statements. We have consulted our PRC legal counsel in assessing our ability to control PW Network through these contractual arrangements. Any changes in PRC laws and regulations that affect our ability to control PW Network might preclude us from consolidating PW Network in the future.

Software Development Costs

We account for software development costs in accordance with Statement of Financial Accounting Standards, or SFAS, No. 86 “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed” as described in note 3(g) in our consolidated financial statements as all of our self-developed online games are marketed and licensed to game players and overseas licensees, respectively. Costs incurred in the development of online games prior to the establishment of technological feasibility are expensed when incurred and are included in product development expenses. Once a game has reached technological feasibility, all subsequent online game product development costs are capitalized until the product is available for marketing. Technological feasibility requires significant judgment and is evaluated on a product-by-product basis, but typically includes both technical design and game design documentation and only occurs when the online game has a proven ability to operate in the online game environment in the market. After the online game is released, the capitalized product development costs are amortized as a component of cost of services over the estimated life of the game.

With respect to our existing online games, due to the fact that the period between the date of technological feasibility and the game release date is very short and the development costs incurred during this period were insignificant, all online game development costs have been expensed when incurred.

Long-Lived Assets—Property, Equipment and Intangible Assets

Property, equipment and intangible assets are stated at historical cost less accumulated depreciation and amortization. Depreciation of property and equipment is computed using a straight-line method over the estimated useful lives of the assets, generally from five to six years. Amortization of intangible assets is computed using a straight-line method over the estimated useful lines of the assets, which are generally three years. Judgment is required to determine the estimated useful lives of assets, especially for servers, including determining how long existing equipment can function and when new technologies will be introduced at cost-effective price points to replace existing equipment. Changes in these estimates and assumptions could materially impact our financial position and results of operations.

We assess impairment for long-lived assets whenever events or changes in circumstances indicate that the applicable net book value of these assets may not be recoverable. Recoverability of the long-lived assets is assessed by comparing the net book value of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. During the period from March 10, 2004 (date of inception) to December 31, 2004 and for the years ended December 31, 2005 and 2006, we did not record any impairment charges. If different judgments or estimates had been utilized, material differences could have resulted in the amount and timing of any impairment charge and the related depreciation and amortization charges.

Operating Leases

Leases where substantially all the rewards and risks of ownership of assets remain with the lessor are accounted for as operating leases. We have signed lease arrangements for most of the servers we are currently

 

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using and assessed these arrangements to be operating leases because (1) the lease does not transfer the ownership to us by the end of the lease term, (2) the lease does not contain any bargain purchase option, (3) the lease term is less than 75% of the estimated economic life of the servers and (4) the present value of the minimum lease payments at the beginning of the lease term is less than 90% of the fair value to the lessor less any investment credit retained by the lessor. Payments made under operating leases are charged to the statements of operations on a straight-line basis over the lease periods as specified in the lease agreements. Judgment is required to determine the estimated economic lives or the fair values of the servers. Changes in these estimates and assumptions could materially impact our financial position and results of operations.

Share-Based Compensation Expenses

We have accounted for share-based compensation in accordance with SFAS No.123 (revised 2004) “Share-Based Payment” (“SFAS 123R”). Under the fair value recognition provisions of SFAS 123R, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as an expense on a straight-line basis, net of estimated forfeitures, over the requisite service period, which is generally the vesting period.

Share incentive plan

We have a share incentive plan, which allows for the granting of stock options to certain senior executives, management, employees and directors.

We have granted options to purchase an aggregate of 17,329,620 Class B ordinary shares to some of our senior executives and employees. We engaged American Appraisal China Limited, an independent appraiser, to assess the fair value of our ordinary shares and stock options on the grant dates.

We use the Black-Scholes option pricing model to determine the fair value of share options. The determination of the fair value of share-based compensation awards on the date of grant using an option-pricing model is affected by our share price as well as assumptions regarding a number of complex and subjective variables, including our expected share price volatility over the term of the awards, actual and projected employee share option exercise behavior, risk-free interest rates and expected dividends. When estimating the fair value of our ordinary shares, both internal and external sources of information are reviewed. As we have historically been a private company, the sources utilized to determine the fair value of the underlying shares at the date of measurement are subjective in nature. For our September and December 2006 option grants, the estimated fair value of our ordinary shares was based on, among other factors, our (1) financial condition as of the date of grant, (2) operating history and (3) financial and operating prospects at that time with reference to our issuance of Series A convertible preferred shares in September 2006. Furthermore, we are required to estimate forfeitures at the time of grant and record share-based compensation expenses only for those awards that are expected to vest. If actual forfeitures differ from these estimates, we may need to revise those estimates used in subsequent periods.

If factors change and we employ different assumptions for estimating share-based compensation expense in future periods or if we decide to use a different valuation model, our share-based compensation in future periods may differ significantly from what we have recorded in prior periods and could materially affect our operating income, net income and net income per share.

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, which are characteristics not present in our option grants. Existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair value of our share-based compensation. Consequently, there is a risk that our estimates of the fair values of our share-based compensation awards on the grant dates may be significantly different from the actual values realized upon the exercise, expiration, early termination or forfeiture of those share-based payments in the future. Certain share-based compensation awards, such as employee share options,

 

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may expire worthless or otherwise result in zero intrinsic value as compared to the fair value originally estimated on the grant date and reported in our financial statements. Alternatively, values that are significantly higher than fair values originally estimated on the grant date and reported in our financial statements may be realized from these instruments. There is currently no market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor is there a means to compare and adjust the estimates to actual values.

The guidance provided in SFAS 123R and Staff Accounting Bulletin No. 107 is relatively new. The application of these principles may be subject to further interpretation and refinement over time. There are significant differences among valuation models and there is a possibility that we will adopt different valuation models in the future. This may result in a lack of consistency in future periods and materially affect the fair value estimates of share-based compensation awards. It may also result in a lack of comparability with other companies that use different models, methods and assumptions.

Restricted shares granted to an employee

In September 2006, Perfect Human Holding Company Limited and Prosperous World Company Limited transferred to Mr. Di He, one of our executives, 4,591,350 and 2,337,220 Class A ordinary shares, respectively. These ordinary shares were granted to Mr. Di He for his contributions of certain management and technological expertise since the inception of the Company. These ordinary shares are subject to transfer restrictions with a vesting period of four years from the grant date and were valued at their estimated fair value on the date of the award. We recorded share-based compensation expenses in respect of these restricted shares awarded in accordance with SFAS 123R. Under the fair value recognition provisions of SFAS 123R, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expenses on a straight-line basis, net of estimated forfeitures, over the requisite service period, which is generally the vesting period.

Series A convertible preferred shares issued to a founding shareholder

In September 2006, in conjunction with our plan to issue a total of 80,000,000 Series A convertible preferred shares to SAIF, we issued and sold 70,000,000 Series A convertible preferred shares to SAIF directly at a price of US$0.1 per share, and issued 10,000,000 Series A convertible preferred shares to the two founding shareholders of our company at par value of US$0.0001 per share, who in turn sold these shares to SAIF at a price of US$0.1 per share. We structured the above transactions in order to allow our founding shareholders to monetize part of their earlier investment in our company. One of our founding shareholders is owned by our chairman and chief executive officer, Mr. Michael Yufeng Chi. Accordingly, we accounted for the issuance of the 5,000,000 Series A convertible preferred shares to the founding shareholder controlled by Mr. Chi as share-based compensation under SFAS 123R, and recorded a related share-based compensation charge. Such charge was computed based on the difference between the fair value of Series A convertible preferred shares of US$0.19 per share at that time and the issuance price paid by such founding shareholder to us.

Founder’s shares

In accordance with a shareholders agreement entered into in September 2006, 75% of the 92,397,140 ordinary shares ultimately owned by Mr. Michael Yufeng Chi, our founder, chairman and chief executive officer would become subject to monthly vesting thereafter in thirty-six equal monthly installments. We accounted for this arrangement similar to a reverse stock split, followed by the grant of restricted stock awards subject to service vesting conditions. Accordingly, compensation cost is measured based on the fair value of the ordinary shares at the grant date and recognized over the requisite service period.

According to the amendment to the above shareholders agreement in December 2006, all parties agreed that the abovementioned ordinary shares were no longer subject to vesting. Consequently, we recognize all remaining compensation cost for unvested founder shares at that time when the vesting was accelerated.

 

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Change of Rights of Series A Convertible Preferred shares

SAIF, the holder of our Series A convertible preferred shares, waived its rights with regard to the contingent conversion for performance-based adjustment, redemption and liquidation preferences in December 2006.

The changes to the rights were made because we found out from a subsequent valuation exercise performed by an independent appraiser that the Series A convertible preferred shares were inadvertently issued at a significant discount as compared with the estimated fair value of the shares, and there were significant values associated with the rights being waived, which were not given accounting recognition at issuance as the convertible preferred shares were recorded at the amount of cash consideration received. Accordingly, we consider the waiver of these rights to be a modification of the terms of the Series A convertible preferred shares, which normally would result in a transfer of wealth to the common shareholders, computed as the difference between the fair value of the Series A convertible preferred shares immediately before and after the modifications. However, due to the original issuance of the Series A convertible preferred shares at an amount significant lower than their then fair value, the fair value of the Series A convertible preferred shares immediately after the modification still exceeded the accreted carrying value of the shares. As such, we consider it appropriate that no accounting recognition be given to the modification, except as described below.

Prior to the modification, due to the redemption features of the Series A convertible preferred shares, the Series A convertible preferred shares were accounted for as mandatorily redeemable preferred stock in accordance with SEC’s Accounting Series Release No. 268 – “Presentation in Financial Statements of Redeemable Preferred Stock” (ASR 268), as interpreted by EITF Topic D-98 “Classification and Measurement of Redeemable Securities,” and were accreted to its redemption value and recorded outside of permanent equity. After the modification, the accreted carrying value of the shares was reclassified into permanent equity and the accretion ceased due to the waiving of the redemption rights by the holder of the Series A convertible preferred shares.

Earnings Per Share

In accordance with SFAS No. 128, “Computation of Earnings Per Share,” or SFAS No. 128, and EITF Issue 03-6, “Participating Securities and the Two-Class Method under FASB Statement No.128”, basic earnings per share are computed by dividing net income attributable to holders of ordinary shares by the weighted average number of ordinary shares outstanding during the year using the two-class method. Under the two-class method, net income is allocated between ordinary shares and other participating securities based on their participating rights.

The holder of our Series A convertible preferred shares had the right to redeem the Series A convertible preferred shares at a redemption price equal to 150% of the original issuance price, and is also entitled to receive cumulative dividends at the rate of 5% of the original issuance price per annum when and if declared by our board of directors. The redemption right was waived in December 2006. The carrying value of the Series A convertible preferred shares was accreted from the original issuance price to the redemption value on a straight line basis over the redemption period, up to the date the redemption right was waived. In accordance with SFAS No. 128, we deducted the accretion and cumulative dividends from net loss before arriving at net loss attributable to holders of ordinary shares when computing the earnings per share.

Income Taxes

We account for income taxes under the provisions of SFAS No.109, “Accounting for Income Taxes”, with the required disclosures as described in note 3(n) and note 14 to our consolidated financial statements. Under this method, deferred income taxes are recognized for the tax consequences of temporary differences by applying enacted statutory rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes. The effect on deferred taxes of a change in tax rates is recognized in the

 

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statement of operations in the period of change. A valuation allowance is provided to reduce the amount of deferred tax assets if it is considered more likely than not that all or a portion of the deferred tax assets will not be realized. Accordingly, we will record valuation allowances to reduce our deferred tax assets when we believe it is more likely than not that we will not be able to utilize the deferred tax asset amounts based on our estimates of future taxable income and prudent and feasible tax planning strategies. Management must make assumptions, judgments and estimates to determine our current provision for income taxes and our deferred tax assets and liabilities and any valuation allowance to be recorded against a deferred tax asset. Our judgments, assumptions and estimates relative to current provision for income tax take into account current tax laws, our interpretation of current tax laws and possible outcomes of current and future audits conducted by foreign and domestic tax authorities. Changes in tax law and our interpretation of tax laws and the resolution of current and future tax audits could significantly impact the amounts provided for income taxes in our consolidated financial statements. Our assumptions, judgments and estimates relative to the value of a deferred tax asset take into account predictions of the amount and category of future taxable income, such as income from operations. Actual operating results and the underlying amount and category of income in future years could render our current assumptions, judgments and estimates of recoverable net deferred taxes inaccurate. Any of the assumptions, judgments and estimates mentioned above could cause our actual income tax obligations to differ from our estimates, and thus materially impact our financial position and results of operations.

When we sell our online game operation licenses to certain overseas licensees through PW Network or PW Software, approximately 10% to 20% of the overseas licensing revenues are withheld and paid by the overseas licensees to the local tax authorities as the income tax on our behalf. Upon approval by the relevant PRC tax authorities, the amount of withholding taxes that our licensees pay on behalf of PW Network or PW Software in foreign jurisdictions may be treated as a foreign tax credit which may be used to offset their respective EITs otherwise payable in China. During the period that PW Network or PW Software is entitled to exemption from the PRC EIT, it does not need to pay PRC EIT with respect to such overseas licensing income, and the paid foreign income taxes cannot be used to set off our PRC EIT in the future. Accordingly, we recognized the foreign income tax of approximately RMB0.2 million (US$26 thousand) and RMB2.0 million (US$0.3 million) in our consolidated financial statements as income tax expense in 2006 and the first quarter of 2007, respectively. If, however, events were to occur in the future which are not currently contemplated or there is any change in the relevant PRC tax laws and regulations or the PRC tax authority’s judgment, as a result of which we may be allowed to set off these foreign income tax payments against our future income tax, an adjustment would result by way of a reversal of the income tax expense in the period in which such determination was made.

Foreign Currency Translation

Our reporting currency is RMB. Our holding company’s functional currency was RMB before January 1, 2007 and changed to U.S. dollar starting from January 1, 2007, when it started to enter into transactions that were denominated in U.S. dollars and received cash in U.S. dollars in these transactions. The functional currency of PW Software and PW Network is RMB. An entity’s functional currency is the currency of the primary economic environment in which the entity operates. Management must use judgment in determining an entity’s functional currency, assessing economic factors including cash flow, sales price, sales and marketing expenses, financing and inter-company transactions and arrangements.

We are incorporated in the Cayman Islands. Prior to 2007, our holding company did not participate in any operating activities. Hence, RMB was considered as the functional currency of our holding company as it held substantial investment in China. In 2007, our holding company started to enter into transactions that were denominated in U.S. dollars and received cash in U.S. dollars in these transactions. As such, we have evaluated which currency, the RMB or the U.S. dollar, was best suited to be used as the functional currency of our holding company. On the basis of this evaluation, management determined that the functional currency of our holding company should be changed from RMB to U.S. dollar. The change was adopted retroactively beginning January 1, 2007 in accordance with SFAS No. 52. No restatement of comparative amounts was made for the change in functional currency. This change in functional currency does not have a material impact on our financial

 

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statements. Exchange gains and losses resulting from transactions recorded by our holding company denominated in a currency other than U.S. dollar are included in the consolidated statements of operations. The financial statements of our holding company are translated from its functional currency into RMB. Assets and liabilities denominated in foreign currencies are translated into RMB using the applicable exchange rates quoted by the People’s Bank of China at the balance sheet dates. Transactions denominated in currencies other than RMB are translated into RMB at the exchange rate quoted by the People’s Bank of China prevailing at the dates of the transactions. The resulting translation adjustments are recorded in “Accumulated Other Comprehensive Income or Loss” in the consolidated statements of shareholders’ equity.

All of PW Software and PW Network’s operations are carried out in China and most of their revenues and expenses are collected and expensed in RMB. Therefore, their functional currency is RMB. Transactions recorded by PW Software and PW Network denominated in currencies other than RMB are translated into RMB at the exchange rate quoted by the People’s Bank of China prevailing at the dates of the transactions. Gains and losses resulting from foreign currency transactions are included in the consolidated statements of operations. Monetary assets and liabilities denominated in foreign currencies are translated into RMB using the applicable exchange rates quoted by the People’s Bank of China at the balance sheet dates. All such exchange gains and losses are included in the consolidated statements of operations.

If our operational strategies change in the future, there may be changes in our functional currency.

Internal Control Over Financial Reporting

We and our auditors, an independent registered public accounting firm, in connection with the preparation and external audit of our consolidated financial statements for the period from March 10, 2004 (date of inception) to December 31, 2004 and for the years ended December 31, 2005 and 2006, noted a material weakness and a significant deficiency in our internal control over financial reporting. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected. A significant deficiency is a control deficiency, or combination of control deficiencies, that adversely affects a company’s ability to initiate, authorize, record, process or report external financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the company’s annual or interim financial statements that is more than inconsequential will not be prevented or detected. The material weakness observed is our lack of sufficient competent staff to perform period end reporting procedures, to address complex U.S. GAAP accounting issues, and to prepare and review financial statements and related disclosures under U.S. GAAP. This material weakness resulted in material audit adjustments and corrections to our financial statements. The significant deficiency observed is that we lacked adequate control over program development and program change within our revenue billing and recognition systems. As a result, it would be possible for erroneous code to be distributed to the revenue billing and recognition systems, which could negatively impact management’s ability to properly initiate and record basic transactional data that are relied upon in generating revenue figures.

Following the identification of the material weakness and the significant deficiency, we undertook certain remedial steps to address them. In March 2007, we appointed a new chief financial officer, who has extensive financial reporting experience, to lead our company’s accounting and financial reporting department. We also hired additional accounting staff, including a financial controller with U.S. GAAP expertise and an internal audit manager, and trained our new and existing accounting staff. However, the implementation of these measures may not fully address the material weakness and significant deficiency in our internal control over financial reporting, and we cannot yet conclude that they have been fully remedied.

We plan to take additional initiatives to improve our internal control over financial reporting and disclosure controls. These initiatives will include (i) establishing an audit committee to oversee the accounting and financial reporting processes as well as external and internal audits of our company, (ii) hiring additional qualified

 

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professionals with relevant experience for our finance and accounting department, (iii) providing additional accounting and financial reporting training for our existing personnel, (iv) improving our revenue billing and recognition systems by introducing additional programs and procedures, and (v) increasing the level of interaction among our management, audit committee, independent auditors and other external advisors. However, the process of designing and implementing an effective financial reporting system is a continuous effort that requires us to anticipate and react to changes in our business and the economic and regulatory environments and to expend significant resources to maintain a financial reporting system that is adequate to satisfy our reporting obligations. See “Risk Factors—Risks Related to Our Business—During the course of the preparation and external audit of our consolidated financial statements for the period ended December 31, 2004 and the years ended December 31, 2005 and 2006, we and our independent registered public accounting firm noted a material weakness and a significant deficiency in our internal control over financial reporting; if we fail to maintain an effective system of internal control over financial reporting, we may be unable to accurately report our financial results or prevent fraud, and investor confidence and the market price of our ADSs may, therefore, be adversely impacted.”

 

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Selected Quarterly Results of Operations

The following table presents our selected unaudited quarterly results of operations for the five quarters in the period from January 1, 2006 to March 31, 2007. The information should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this prospectus. We have prepared the unaudited consolidated quarterly financial information on the same basis as our audited consolidated financial statements. This unaudited consolidated financial information includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair representation of our financial position and operating results for the quarters presented. Our quarterly operating results have fluctuated and may continue to fluctuate from period to period. We believe that the quarter-to-quarter comparison of our operating results should not be relied upon as being indicative of our results for any future quarters or for a full year.

 

 

     For the Three Months Ended  
     March 31,
2006
    June 30,
2006
    September
30, 2006
    December
31, 2006
    March 31,
2007
 
     (in RMB thousands, except share, per share, per ADS and operating data)  

Consolidated Statement of Operations Data:

          

Revenues:

          

Online game operation revenues

   9,138     15,914     13,585     59,755     76,575  

Overseas licensing revenues

   —       —       —       1,014     10,579  
                              

Total revenues

   9,138     15,914     13,585     60,769     87,154  

Cost of revenues(1):

   (3,053 )   (3,912 )   (4,233 )   (13,406 )   (19,196 )
                              

Gross profit

   6,085     12,002     9,352     47,363     67,958  

Operating expenses(1):

          

Research and development expenses

   (3,860 )   (4,389 )   (4,816 )   (5,824 )   (6,951 )

Sales and marketing expenses

   (5,248 )   (3,864 )   (9,122 )   (19,262 )   (15,308 )

General and administrative expenses

   (1,325 )   (1,473 )   (10,337 )   (32,733 )   (3,737 )
                              

Total operating expenses

   (10,433 )   (9,726 )   (24,275 )   (57,819 )   (25,996 )
                              

Operating (loss) income

   (4,348 )   2,276     (14,923 )   (10,456 )   41,962  
                              

Other income (expense):

          

Interest income

   5     12     182     122     454  

Others, net

   19     2     (119 )   (514 )   (355 )

Income tax expense

   —       —       —       (203 )   (2,049 )
                              

Net (loss) income

   (4,324 )   2,290     (14,860 )   (11,051 )   40,012  
                              

Accretion of Series A Preferred Shares

   —       —       (509 )   (1,325 )   —    
                              

Cumulative unearned dividends of Series A Preferred Shares

   —       —       (227 )   (792 )   (767 )
                              

Net (loss) income attributable to ordinary shareholders

   (4,324 )   2,290     (15,596 )   (13,168 )   39,245  
                              

Net (loss) income per ordinary share:

          

Basic

   (0.03 )   0.02     (0.10 )   (0.09 )   0.25  

Diluted

   (0.03 )   0.02     (0.10 )   (0.09 )   0.16  

Net (loss) income per ADS:

          

Basic

   (0.15 )   0.08     (0.52 )   (0.43 )   1.27  

Diluted

   (0.15 )   0.08     (0.52 )   (0.43 )   0.82  

Weighted average number of ordinary shares used in per ordinary share calculations:

          

Basic

   148,571,430     148,571,430     150,124,226     154,285,720     154,285,720  

Diluted

   148,571,430     148,571,430     150,124,226     154,285,720     242,951,028  

Selected Operating Data:

          

ACU(2) (in thousands)

   39     44     118     246     237  

APC(3) (in thousands)

   —       —       26     602     695  

ARPU(4) (RMB)

   —       —       11.8     76.1     95.3  

 

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     For the Three Months Ended  
     March 31,
2006
    June 30,
2006
    September
30, 2006
    December
31, 2006
   

March 31,

2007

 

Consolidated Statement of Operations Data

          

Revenues:

          

Online game operation revenues

   100.0 %   100.0 %   100.0 %   98.3 %   87.9 %

Overseas licensing revenues

   —       —       —       1.7     12.1  
                              

Total revenues

   100.0     100.0     100.0     100.0     100.0  

Cost of revenues(1):

   (33.4 )   (24.6 )   (31.2 )   (22.1 )   (22.0 )

Gross profit

   66.6     75.4     68.8     77.9     78.0  

Operating expenses(1):

          

Research and development expenses

   (42.3 )   (27.5 )   (35.4 )   (9.5 )   (8.0 )

Sales and marketing expenses

   (57.4 )   (24.3 )   (67.1 )   (31.7 )   (17.5 )

General and administrative expenses

   (14.5 )   (9.3 )   (76.1 )   (53.9 )   (4.3 )
                              

Total operating expenses

   (114.2 )   (61.1 )   (178.6 )   (95.1 )   (29.8 )
                              

Operating (loss) income

   (47.6 )   14.3     (109.8 )   (17.2 )   48.2  
                              

Other income (expense):

          

Interest income

   0.1     0.1     1.3     0.2     0.5  

Others, net

   0.2     —       (0.9 )   (0.9 )   (0.4 )
                              

Income tax expense

     —       —       (0.3 )   (2.4 )

Net (loss) income

   (47.3 )   14.4     (109.4 )   (18.2 )   45.9  
                              

Accretion of Series A Preferred Shares

   —       —       (3.7 )   (2.2 )   —    
                              

Cumulative unearned dividends of Series A Preferred Shares

   —       —       (1.7 )   (1.3 )   (0.9 )
                              

Net (loss) income attributable to ordinary shareholders

   (47.3 )%   14.4 %   (114.8 )%   (21.7 )%   45.0 %
                              

(1) Share-based compensation expenses are included in our operating costs and expenses as follows:

 

     For the Three Months Ended  
     March 31,
2006
   June 30,
2006
   September 30,
2006
   

December 31,

2006

    March 31,
2007
 
     RMB    %    RMB    %    RMB     %     RMB     %     RMB     %  
     (in thousands except percentages)  

Allocation of share-based compensation expenses

                        

Cost of revenues

   —      —      —      —      (0.4 )   —       (9 )   —       (27 )   (5.4 )

Research and development expenses

   —      —      —      —      (44 )   (0.5 )   (267 )   (0.9 )   (278 )   (55.7 )

Selling and marketing expenses

   —      —      —      —      (5 )   (0.1 )   (26 )   (0.1 )   (36 )   (7.2 )

General and administrative expenses

   —      —      —      —      (8,204 )*   (99.4 )   (29,624 )**   (99.0 )   (158 )   (31.7 )

* Included share-based compensation expenses of RMB0.7 million (US$0.1 million) in connection with a founder’s ordinary shares becoming subject to restrictions in the third quarter of 2006 and share-based compensation expenses of RMB7.5 million (US$1.0 million) in connection with issuance of Series A convertible preferred shares to a founding shareholder at par value in the third quarter of 2006.
** Included share-based compensation expenses of RMB29.6 million (US$3.8 million) in connection with a founder’s ordinary shares becoming subject to restrictions in the third quarter of 2006 and the subsequent elimination of these restrictions in the fourth quarter of 2006.
(2) Consist of aggregate data from our online game operations in China with respect to all of our games.
(3) Consist of aggregate data from our online game operations in China with respect to all of our games that use the item-based revenue model.
(4) Consist of aggregate data from our online game operations in China with respect to all of our games that use the item-based revenue model. Our total online game operation revenues derived from operating in China our online games using the item-based revenue model which are used to calculate ARPU are RMB0.3 million (US$39 thousand), RMB45.8 million (US$5.9 million) and RMB66.3 million (US$8.6 million) for the quarters ended September 30, 2006, December 31, 2006 and March 31, 2007, respectively.

Quarter Ended March 31, 2007 Compared to Quarter Ended December 31, 2006

Revenues. For the quarter ended March 31, 2007, our revenues were RMB87.2 million (US$11.3 million), a 43.4% increase from RMB60.8 million (US$7.9 million) for the previous quarter. This increase was primarily

attributable to an increase in our revenues from our operations of two new MMORPGs, namely Legend of

 

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Martial Arts and Perfect World II, and to an increase in our overseas licensing revenues as Perfect World II was launched in Taiwan in late December 2006 and as we began to recognize licensing revenues from our licensees in Vietnam, Malaysia and Singapore. In the first quarter of 2007, our games recorded approximately 237,000 average concurrent users in China, a slight decrease from approximately 246,000 average concurrent users in the previous quarter. ARPU of our games in the first quarter of 2007 was RMB95.3, a 25.2% increase from RMB76.1 in the previous quarter.

Cost of Revenues. For the quarter ended March 31, 2007, our cost of revenues was RMB19.2 million (US$2.5 million), a 43.2% increase from RMB13.4 million (US$1.7 million) for the previous quarter. This increase was primarily due to an increase in our servers and bandwidth leasing fees to support the expansion of our operations.

Gross Profit. Our gross profit increased by 43.5% from RMB47.4 million (US$6.1 million) for the last quarter of 2006 to RMB68.0 million (US$8.8 million) for the quarter ended March 31, 2007, primarily driven by the increase in our revenues. Our gross margin increased slightly to 78.0% in the first quarter of 2007 from 77.9% in the last quarter of 2006.

Operating Expenses. For the quarter ended March 31, 2007, our operating expenses were RMB26.0 million (US$3.4 million), a 55.0% decrease from RMB57.8 million (US$7.5 million) for the quarter ended December 31, 2006. This decrease was primarily attributable to a RMB29.6 million (US$3.8 million) one-time share-based compensation charge incurred in the fourth quarter of 2006, included in our general and administrative expenses, in connection with a founder’s ordinary shares becoming subject to restrictions in the third quarter of 2006 and the subsequent elimination of these restrictions in the fourth quarter of 2006. The decrease was also due to a decrease of our sales and marketing expenses in the first quarter of 2007, which was higher in the quarter ended December 31, 2006 when we launched our third MMORPG, Perfect World II, at the end of November 2006, partly offset by an increase in our research and development expenses as we hired more research and development personnel.

Income Tax Expense. We incurred income tax expense of RMB2.0 million (US$0.3 million) in the quarter ended March 31, 2007, primarily due to the withholding taxes we incurred on the license fees and royalties earned from our overseas licensees in the quarter. Our income tax expense for the fourth quarter of 2006 was RMB0.2 million (US$26 thousand) as we started licensing Perfect World II to overseas licensees only in December 2006.

Net (Loss) Income. As a result of the foregoing, we had a net income of RMB40.0 million (US$5.2 million) for the quarter ended March 31, 2007, compared to a net loss of RMB11.1 million (US$1.4 million) for the quarter ended December 31, 2006.

Quarter Ended December 31, 2006 Compared to Quarter Ended September 30, 2006

Revenues. For the quarter ended December 31, 2006, our revenues were RMB60.8 million (US$7.9 million), a 347.3% increase from RMB13.6 million (US$1.8 million) for the previous quarter. This increase was primarily attributable to the revenue contribution of our two new MMORPGs, namely Legend of Martial Arts and Perfect World II, launched in late September 2006 and at the end of November 2006, respectively. In the fourth quarter of 2006, average concurrent users of our games in China increased to approximately 246,000 from approximately 118,000 in the previous quarter. ARPU of our games in the fourth quarter of 2006 was RMB76.1, a substantial increase from RMB11.8 in the previous quarter. The increase in the fourth quarter revenues was also due to overseas licensing revenues that we began to recognize in the fourth quarter of 2006.

Cost of Revenues. For the quarter ended December 31, 2006, our cost of revenues was RMB13.4 million (US$1.7 million), a 216.7% increase from RMB4.2 million (US$0.5 million) for the previous quarter. This increase was primarily due to an increase in our servers and bandwidth leasing fees, particularly in connection with our launch of two new MMORPGs in late September and at the end of November 2006, respectively.

 

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Gross Profit. Our gross profit increased by 406.4% from RMB9.4 million (US$1.2 million) for the third quarter of 2006 to RMB47.4 million (US$6.1 million) for the last quarter of 2006. Our gross margin increased to 77.9% in the fourth quarter of 2006 from 68.8% in the third quarter of 2006, primarily because we achieved greater economies of scale after launching and operating two additional MMORPGs.

Operating Expenses. For the quarter ended December 31, 2006, our operating expenses were RMB57.8 million (US$7.5 million), a 138.2% increase from RMB24.3 million (US$3.1 million) for the previous quarter. This increase was primarily attributable to a RMB29.6 million (US$3.8 million) one-time share-based compensation charge, included in our general and administrative expenses, in connection with a founder’s ordinary shares becoming subject to restrictions in the third quarter of 2006 and the subsequent elimination of these restrictions in the fourth quarter of 2006. The increase was also due to an increase in our sales and marketing expenses primarily as a result of promotion of our two new games.

Net Loss. As a result of the foregoing, we had a net loss of RMB11.1 million (US$1.4 million) for the quarter ended December 31, 2006, compared to a net loss of RMB14.9 million (US$1.9 million) for the quarter ended September 30, 2006.

Quarter Ended September 30, 2006 Compared to Quarter Ended June 30, 2006

Revenues. For the quarter ended September 30, 2006, our revenues were RMB13.6 million (US$1.8 million), a 14.6% decrease from RMB15.9 million (US$2.1 million) for the quarter ended June 30, 2006. This decrease was primarily attributable to the summer holidays during the third quarter of 2006, when many students spent less time playing online games. This decrease was also due to the FIFA world cup tournament held in June and July 2006, which we believe resulted in a reduction in playing time of our players. Average concurrent users of our games in China increased to approximately 118,000 in the third quarter of 2006, from approximately 44,000 in the previous quarter.

Cost of Revenues. For the quarter ended September 30, 2006, our cost of revenues was RMB4.2 million (US$0.5 million), a 8.2% increase from RMB3.9 million (US$0.5 million) for the quarter ended June 30, 2006. This increase was primarily attributable to an increase in our servers and bandwidth leasing fees and salary and benefits expenses in connection with the expansion of our operations.

Gross Profit. Our gross profit decreased by 22.1% to RMB9.4 million (US$1.2 million) for the quarter ended September 30, 2006 from RMB12.0 million (US$1.6 million) for the quarter ended June 30, 2006. Our gross margin decreased to 68.8% for the quarter ended September 30, 2006 from 75.4% for the quarter ended June 30, 2006, primarily due to the decrease in our revenues as a result of the summer holidays and the world cup tournament.

Operating Expenses. For the quarter ended September 30, 2006, our operating expenses were RMB24.3 million (US$3.1 million), a 149.6% increase from our operating expenses of RMB9.7 million (US$1.3 million) for the quarter ended June 30, 2006. This increase was primarily attributable to (i) an increase of our sales and marketing expenses primarily as a result of promotion of our second MMORPG launched in September 2006 and our third MMORPG to be launched in November 2006, and (ii) an increase in our general and administrative expenses due to share-based compensation expenses of RMB7.5 million (US$1.0 million) in connection with our issuance of Series A convertible preferred shares to a founding shareholder at par value in September 2006.

Net (Loss) Income. As a result of the foregoing, we had a net loss of RMB14.9 million (US$1.9 million) for the quarter ended September 30, 2006, compared to a net income of RMB2.3 million (US$0.3 million) for the quarter ended June 30, 2006.

Quarter Ended June 30, 2006 Compared to Quarter Ended March 31, 2006

Revenues. For the quarter ended June 30, 2006, our revenues were RMB15.9 million (US$2.1 million), a 74.2% increase from RMB9.1 million (US$1.2 million) for the quarter ended March 31, 2006. This increase was

 

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primarily attributable to the increasing popularity of our first game, Perfect World, during the quarter ended June 30, 2006 after the game was launched in January 2006. Average concurrent users of our games in China in the second quarter of 2006 increased to approximately 44,000, from approximately 39,000 in the previous quarter.

Cost of Revenues. For the quarter ended June 30, 2006, our cost of revenues was RMB3.9 million (US$0.5 million), a 28.2% increase from RMB3.1 million (US$0.4 million) for the quarter ended March 31, 2006. This increase was primarily attributable to an increase in our servers and bandwidth leasing fees to support the expansion of our operations.

Gross Profit. Our gross profit increased by 97.2% to RMB12.0 million (US$1.6 million) for the quarter ended June 30, 2006 from RMB6.1 million (US$0.8 million) for the quarter ended March 31, 2006. Our gross margin increased to 75.4% for the quarter ended June 30, 2006 from 66.6% for the quarter ended March 31, 2006, primarily as a result of the increase in our revenues outpacing the increase in our cost of revenues due to economies of scale.

Operating Expenses. For the quarter ended June 30, 2006, our operating expenses were RMB9.7 million (US$1.3 million), a 6.8% decrease from RMB10.4 million (US$1.4 million) for the quarter ended March 31, 2006. This decrease was primarily attributable to a decrease of our sales and marketing expenses, which was higher in the quarter ended March 31, 2006 when we launched our first game in January 2006, partly offset by increases in our research and development expenses and general and administrative expenses.

Net (Loss) Income. As a result of the foregoing, we had a net income of RMB2.3 million (US$0.3 million) for the quarter ended June 30, 2006, compared to a net loss of RMB4.3 million (US$0.6 million) for the quarter ended March 31, 2006.

 

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Results of Operations

The following table sets forth a summary, for the periods indicated, of our consolidated results of operations and each item expressed as a percentage of our total revenues. Our business has grown significantly since we commenced operations in March 2004. Period-to-period comparisons of our operating results should not be relied upon as indicative of future performance. See “Risk Factors—Risks Related to Our Business—We have a limited operating history and the long-term potential of our online games is unproven, which makes it difficult to evaluate our business and prospects.”

 

   

For the Period

From March 10, 2004

(Date of Inception)

to December 31, 2004

   

For the Year Ended December 31,

   

For the Three Months Ended March 31,

 
      2005     2006     2006     2007  
        RMB             RMB             RMB             US$             %             RMB             RMB             US$             %      
    (in thousands, except percentages)  

Revenues:

                 

Online game operation revenues

  —       —       98,392     12,740     99.0     9,138     76,575     9,915     87.9 %

Overseas licensing revenues

  —       —       1,014     131     1.0     —       10,579     1,370     12.1  
                                                     

Total revenues

  —       —       99,406     12,871     100.0     9,138     87,154     11,285     100.0  
                                                     

Cost of revenues

  —       —       (24,604 )   (3,186 )   (24.8 )   (3,053 )   (19,196 )   (2,486 )   (22.0 )
                                                     

Gross profit

  —       —       74,802     9,685     75.2     6,085     67,958     8,799     78.0  

Operating expenses:

                 

Research and development expenses

  (6,043 )   (15,151 )   (18,889 )   (2,446 )   (19.0 )   (3,860 )   (6,951 )   (900 )   (8.0 )

Sales and marketing expenses

  (176 )   (12,904 )   (37,496 )   (4,855 )   (37.7 )   (5,248 )   (15,308 )   (1,982 )   (17.5 )

General and administrative expenses

  (656 )   (1,508 )   (45,868 )   (5,939 )   (46.1 )   (1,325 )   (3,737 )   (484 )   (4.3 )
                                                     

Total operating expenses

  (6,875 )   (29,563 )   (102,253 )   (13,240 )   (102.8 )   (10,433 )   (25,996 )   (3,366 )   (29.8 )
                                                     

Operating (loss) income

  (6,875 )   (29,563 )   (27,451 )   (3,555 )   (27.6 )   (4,348 )   41,962     5,433     48.2  
                                                     

Interest income

  64     14     321     42     0.3     5     454     59     0.5  

Others, net

  (1 )   115     (612 )   (79 )   (0.6 )   19     (355 )   (46 )   (0.4 )

Income tax expense

  —       —       (203 )   (26 )   (0.2 )   —       (2,049 )   (265 )   (2.4 )
                                                     

Net (loss) income

  (6,812 )   (29,434 )   (27,945 )   (3,618 )   (28.1 )   (4,324 )   40,012     5,181     45.9  
                                                     

Accretion of Series A convertible preferred shares

  —       —       (1,834 )   (238 )   (1.8 )   —       —       —       —    

Cumulative unearned dividends of Series A convertible preferred shares

  —       —       (1,019 )   (132 )   (1.0 )   —       (767 )   (99 )   (0.9 )
                                                     

Net (loss) income attributable to ordinary shareholders

  (6,812 )   (29,434 )   (30,798 )   (3,988 )   (30.9 )   (4,324 )   39,245     5,082     45.0 %
                                                     

 

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Three Months Ended March 31, 2007 Compared to Three Months Ended March 31, 2006

Revenues. For the three months ended March 31, 2007, we generated revenues of RMB87.2 million (US$11.3 million), a substantial increase from RMB9.1 million for the three months ended March 31, 2006. This increase was primarily due to a substantial increase in our revenues from our operations of two new MMORPGs, namely Legend of Martial Arts and Perfect World II, launched in late September 2006 and at the end of November 2006, respectively. For the three months ended March 31, 2007, we generated revenues of RMB76.6 million (US$9.9 million) from our online game operations, compared to RMB9.1 million for the three months ended December 31, 2006. The increase in our revenues was also due to overseas licensing revenues that we began to recognize in the last quarter of 2006. For the three months ended March 31, 2007, we generated revenues of RMB10.6 million (US$1.4 million) from licensing our Perfect World II game to operators in Taiwan, Vietnam, Malaysia and Singapore.

Cost of Revenues. For the three months ended March 31, 2007, our cost of revenues amounted to RMB19.2 million (US$2.5 million), or 22.0% of our revenues. This represented a substantial increase from RMB3.1 million, or 33.4% of our revenues, for the three months ended March 31, 2006. This increase was primarily due to a substantial increase in our servers and bandwidth leasing fees, particularly in connection with our two new games. For the three months ended March 31, 2007, servers and bandwidth leasing fees amounted to RMB13.2 million (US$1.7 million), or 15.1% of our revenues, compared to RMB1.8 million, or 19.3% of our revenues, for the three months ended March 31, 2006.

Gross Profit. Our gross profit increased substantially from RMB6.1 million for the three months ended March 31, 2006 to RMB68.0 million (US$8.8 million) for the three months ended March 31, 2007. Our gross margin increased to 78.0% for the three months ended March 31, 2007 from 66.6% for the three months ended March 31, 2006, primarily because we achieved greater economies of scale after launching and operating two additional games.

Operating Expenses. For the three months ended March 31, 2007, our operating expenses were RMB26.0 million (US$3.4 million), a 149.2% increase from RMB10.4 million for the three months ended March 31, 2006. This increase was primarily attributable to a substantial increase in our sales and marketing expenses relating to the promotion of our two new games in the first quarter of 2007.

Research and development expenses. For the three months ended March 31, 2007, our research and development expenses increased by 80.1% to RMB7.0 million (US$0.9 million) from RMB3.9 million for the three months ended March 31, 2006. The increase was primarily attributable to an increase in salary and benefits expenses from RMB3.1 million for the three months ended March 31, 2006 to RMB5.8 million (US$0.7 million) for the three months ended March 31, 2007, as we hired additional research and development personnel, from 116 as of March 31, 2006 to 208 as of March 31, 2007.

Sales and marketing expenses. For the three months ended March 31, 2007, our sales and marketing expenses increased by 191.7% to RMB15.3 million (US$2.0 million) from RMB5.2 million for the three months ended March 31, 2006. The increase was primarily attributable to our introduction of more marketing activities, particularly advertising payments to various game magazines and online game sites to promote our two new games. Our expenses of marketing activities increased from RMB3.8 million for the three months ended March 31, 2006 to RMB12.7 million (US$1.6 million) for the three months ended March 31, 2007.

General and administrative expenses. For the three months ended March 31, 2007, our general and administrative expenses increased by 182.1% to RMB3.7 million (US$0.5 million) from RMB1.3 million for the three months ended March 31, 2006. The increase was primarily attributable to an increase in expenses we incurred for professional advisors, from RMB1.1 million for the three months ended March 31, 2006 to RMB2.3 million (US$0.3 million) for the three months ended March 31, 2007. The increase was also due to an increase in salary and benefits expenses for administrative personnel from RMB0.2 million for the three months ended

 

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March 31, 2006 to RMB0.8 million (US$0.1 million) for the three months ended March 31, 2007, as we hired additional general and administrative personnel, from 6 as of March 31, 2006 to 21 as of March 31, 2007.

Income Tax Expense. We incurred income tax expense of RMB2.0 million (US$0.3 million) in the three months ended March 31, 2007, primarily due to the withholding taxes we incurred on the license fees and royalties earned from our overseas licensees in the period. We did not have such tax expense in the three months ended March 31, 2006.

Net (Loss) Income. As a result of the foregoing, we had a net income of RMB40.0 million (US$ 5.2 million) for the three months ended March 31, 2007, compared to a net loss of RMB4.3 million for the three months ended March 31, 2006.

Year Ended December 31, 2006 Compared to Year Ended December 31, 2005

Revenues. We generated revenues of RMB99.4 million (US$12.9 million) in 2006, of which RMB98.4 million (US$12.8 million) was generated from our online game operations. We launched our first three MMORPGs, namely Perfect World, Legend of Martial Arts and Perfect World II in January, September and the end of November 2006, respectively. We recorded RMB52.3 million (US$6.8 million), RMB43.1 million (US$5.6 million) and RMB3.0 million (US$0.4 million) in revenues from the operation of our games, Perfect World, Legend of Martial Arts and Perfect World II, respectively, in 2006. We also generated overseas licensing revenues of RMB1.0 million (US$0.1 million) in 2006.

We were in the process of developing our game engine, game development platform and our first MMORPG, Perfect World, in 2005. Accordingly, we did not generate any revenues in 2005.

Cost of Revenues. Our cost of revenues amounted to RMB24.6 million (US$3.2 million), or 24.8% of our revenues, in 2006. Server and bandwidth leasing fees amounted to RMB14.6 million (US$1.9 million), or 14.7% of our revenues, in 2006. Salary and benefits expenses amounted to RMB3.4 million (US$0.4 million), or 3.4% of our revenues, in 2006, and depreciation of computer equipment and amortization of copyrights amounted to RMB0.7 million (US$0.1 million), or 0.7% of our revenues, in 2006. As of December 31, 2006, we had 147 employees involved in the operation of our online games, including network operation and customer service. Our cost of revenues in 2006 also included VAT in the amount of RMB2.5 million (US$0.3 million), representing the amount that we actually paid in 2006 after deducting the amount of VAT refunds we were entitled to receive.

Gross Profit. In 2006, our gross profit amounted to RMB74.8 million (US$9.7 million), and our gross margin was 75.2%.

Operating Expenses. Our operating expenses increased substantially to RMB102.3 million (US$13.2 million) in 2006 from RMB29.6 million in 2005. The increase in our operating expenses was due primarily to a one-time non-cash share-based compensation charge in connection with a founder’s ordinary shares becoming subject to restrictions and the subsequent elimination of such restrictions, a one-time non-cash share-based compensation in connection with our issuance of Series A convertible preferred shares to a founding shareholder at par value, and a significant increase in sales and marketing expenses in connection with the launch of our first three games in 2006.

Research and development expenses. Our research and development expenses increased by 24.7% to RMB18.9 million (US$2.4 million) in 2006 from RMB15.2 million in 2005. We incurred more research and development expenses in 2006 as we hired additional research and development personnel, from 105 as of December 31, 2005 to 172 as of December 31, 2006, which resulted in the increase in salaries and benefits of our research and development personnel from RMB11.8 million in 2005 to RMB15.7 million (US$2.0 million) in 2006. The increase in our research and development expenses was also due to increased expenditures in the research and development of our game engine, game development platform and new online games. As we did not operate any online games in 2005, our server and bandwidth leasing fees in the amount of RMB1.2 million were

 

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classified into our research and development expenses. Beginning in 2006, all server and bandwidth leasing fees have been classified into our cost of revenues in 2006.

Sales and marketing expenses. Our sales and marketing expenses increased by 190.6% to RMB37.5 million (US$4.9 million) in 2006 from RMB12.9 million in 2005. The significant increase in our sales and marketing expenses was primarily due to our introduction of more marketing and promotion activities, particularly advertising payments to various game magazines and online game sites, in connection with the launch of our first three games in 2006. The increase was also attributable to the increases in salaries and benefits for sales and marketing personnel from RMB3.3 million in 2005 to RMB5.0 million (US$0.6 million) in 2006 as we hired more sales and marketing personnel in connection with the expansion of our game operations, from 50 as of December 31, 2005 to 95 as of December 31, 2006. Even though we did not launch any game in 2005, we incurred sales and marketing expenses in 2005 primarily relating to our marketing and promotion activities in preparation for the launch of our first game, Perfect World, in January 2006.

General and administrative expenses. General and administrative expenses increased significantly to RMB45.9 million (US$5.9 million) in 2006 from RMB1.5 million in 2005. The increase in our general and administrative expenses was due primarily to a one-time share-based compensation charge in the amount of RMB30.3 million (US$3.9 million) in connection with a founder’s ordinary shares becoming subject to restrictions and the elimination of such restrictions. In connection with our Series A convertible preferred shares private placement in September 2006, we and our shareholders entered into a shareholders agreement, under which 75% of the ordinary shares held by our founder, chairman and chief executive officer, Mr. Michael Yufeng Chi, were subjected to a 36-month vesting period. We originally recognized compensation expenses over the requisite vesting period based on the fair value of the ordinary shares. The shareholders agreement was subsequently amended in December 2006 to eliminate the vesting restrictions on the ordinary shares held by Mr. Chi. As a result, all remaining compensation cost for the unvested shares were recognized at that time when the vesting was accelerated. In addition, the increase in our general and administrative expenses was attributable to a one time share-based compensation charge in the amount of RMB7.5 million (US$1.0 million) in connection with our issuance of Series A convertible preferred shares to a founding shareholder controlled by Mr. Chi at par value. The increase in our general and administrative expenses was also due to an increase in audit and other professional fees in connection with our private placement, and to a lesser extent, due to increases in salaries and benefits for our administrative personnel from RMB0.3 million in 2005 to RMB1.4 million (US$0.2 million) in 2006 as we hired more administrative personnel in connection with the expansion of our business, from 4 as of December 31, 2005 to 16 as of December 31, 2006.

Net Loss. As a result of the cumulative effect of the foregoing factors, we had a net loss of RMB27.9 million (US$3.6 million) in 2006, compared to a net loss of RMB29.4 million in 2005.

Year Ended December 31, 2005 Compared to the Period From March 10, 2004 (Date of Inception) to December 31, 2004

Revenues. Our predecessor company, PW Network was founded in March 2004. For the period from our inception to December 31, 2005, we were in the process of developing our game engine, game development platform and our first MMORPG, Perfect World. Accordingly, we did not generate any revenues in 2004 and 2005.

Operating Expenses. Our operating expenses increased substantially to RMB29.6 million in 2005 from RMB6.9 million for the period from March 10, 2004 (date of inception) to December 31, 2004. The increase in our operating expenses was due primarily to a significant increase in sales and marketing expenses, and to a lesser extent, due to the increases in our research and development expenses and general and administrative expenses.

Research and development expenses. Our research and development expenses increased by 150.7% to RMB15.2 million in 2005 from RMB6.0 million for the period from March 10, 2004 (date of inception) to

 

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December 31, 2004. We incurred more research and development expenses in 2005 as we hired additional research and development personnel, from 64 as of December 31, 2004 to 105 as of December 31, 2005, which resulted in the increase in salaries and benefits of our research and development personnel from RMB5.1 million in 2004 to RMB11.8 million in 2005. The increase in our research and development expenses was also due to increased expenditures in the research and development of our game engine, game development platform and online games, and our incurrence of server and bandwidth leasing fees, which were classified into our research and development expenses in 2005.

Sales and marketing expenses. Our sales and marketing expenses increased substantially to RMB12.9 million in 2005 from RMB0.2 million for the period from March 10, 2004 (date of inception) to December 31, 2004. The significant increase in our sales and marketing expenses was primarily due to (i) our marketing and promotion activities, particularly advertising payments to various game magazines and online game sites in preparation of the launch of our first game, Perfect World, in January 2006, and (ii) increases in salaries and benefits for sales and marketing personnel from RMB0.1 million in 2004 to RMB3.3 million in 2005, as we hired more sales and marketing personnel, from 10 as of December 31, 2004 to 50 as of December 31, 2005, and the average salary of sales and marketing personnel increased.

General and administrative expenses. General and administrative expenses increased by 129.9% to RMB1.5 million in 2005 from RMB0.7 million for the period from March 10, 2004 (date of inception) to December 31, 2004. The increase in our general and administrative expenses was due primarily to increases in salaries and benefits for our administrative and finance personnel from RMB14 thousand in 2004 to RMB0.3 million in 2005 as we hired more administrative personnel in connection with the expansion of our business and the average salary of administrative personnel increased.

Net Loss. As a result of the cumulative effect of the foregoing factors, we had a net loss of RMB29.4 million in 2005, compared to a net loss of RMB6.8 million in 2004.

Liquidity and Capital Resources

Cash Flows and Working Capital

To date, we have financed our operations primarily through cash flows from equity contributions by our shareholders, cash flows from operations beginning in 2006 and loans from related parties. We received RMB15.0 million proceeds from our issuance and sale of ordinary shares in 2004 and RMB54.5 million (US$7.1 million) from our issuance and sale of Series A convertible preferred shares in 2006. We also received loans in a total amount of RMB15.5 million from certain shareholders in 2005 and 2006.

As we were in a start-up phase in 2004 and 2005 and did not generate any revenues until 2006, our principal use of cash through 2006 was to fund our research and development and other expenses. Historically, our related parties provided loans for us to meet some of our temporary liquidity needs. We had fully repaid such loans by the end of 2006. As of March 31, 2007, we had RMB159.3 million (US$20.6 million) in cash and cash equivalents. Our current cash and cash equivalents primarily consist of cash on hand and demand deposits with original maturities of three months or less that are placed with banks and other financial institutions. We do not expect to experience an increase in our net working capital requirements in the foreseeable future due to our current liquidity and expected positive operating cash flow as we generally receive cash payments from distributors upon delivery of our prepaid game cards to them and therefore do not have significant accounts receivable.

 

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The following table sets forth a summary of our cash flows for the periods indicated:

 

     For the Period From
March 10, 2004
(Date of Inception)
to December 31, 2004
    For the Year Ended December 31,     For the Three Months Ended
March 31,
 
       2005     2006     2006     2007  
     RMB         RMB             RMB             US$             RMB             RMB             US$      
     (in thousands)                                      

Net cash (used in) provided by operating activities

   (11,487 )   (8,054 )   66,950     8,669     (2,119 )   62,776     8,128  

Net cash used in investing activities

   (642 )   (2,545 )   (11,577 )   (1,499 )   (113 )   (4,650 )   (602 )

Net cash provided by financing activities

   15,000     12,000     42,511     5,504     1,000     127     16  

Net increase in cash and cash equivalents

   2,871     1,401     97,884     12,674     (1,232 )   58,253     7,542  

Effect of exchange rate changes on cash

   —       —       (799 )   (103 )   —       (347 )   (45 )

Cash and cash equivalents at the beginning of the year

   —       2,871     4,272     553     4,272     101,357     13,124  

Cash and cash equivalents at the end of the year

   2,871     4,272     101,357     13,124     3,040     159,263     20,621  

Operating Activities

Net cash provided by operating activities in the first quarter of 2007 was RMB62.8 million (US$8.1 million), which was primarily attributable to the following factors: (i) a net income of RMB40.0 million (US$5.2 million), (ii) an increase in deferred revenues of RMB27.6 million (US$3.6 million), and (iii) an increase in advances from customers of RMB5.5 million (US$0.7 million), all as a result of our launch of two new games in September and November 2006. Our net income was also due to the increase in our overseas licensing revenues. As our player base and overall sales volume grow, we expect that advances from customers and deferred revenues will increase correspondingly and continue to be a significant factor affecting our operating cash flow.

Net cash provided by operating activities in 2006 was RMB67.0 million (US$8.7 million), while net cash used in operating activities in 2005 and 2004 was RMB8.1 million and RMB11.5 million, respectively. Net cash provided by operating activities in 2006 was primarily attributable to the following factors: (i) increases in deferred revenues of RMB33.0 million (US$4.3 million) and advances from customers of RMB14.7 million (US$1.9 million) as a result of our launch of our first three games in 2006, and (ii) an add-back of the non-cash share-based compensation expenses, in the amount of RMB38.2 million (US$4.9 million). The increase in operating cash flow was partially offset by a net loss of RMB27.9 million (US$3.6 million).

Net cash used in operating activities in 2005 was primarily attributable to a net loss of RMB29.4 million, partly offset by (i) an increase in advances from customers of RMB6.6 million as we received payment from distributors immediately before our launch of our first game in January 2006, (ii) a decrease in amount due from related parties of RMB5.9 million, (iii) an increase in salary and welfare payable of RMB3.4 million, (iv) an increase in amount due to related parties of RMB2.3 million, and (v) an increase in accrued liabilities of RMB2.4 million.

Net cash used in operating activities in 2004 was primarily attributable to a net loss of RMB6.8 million and an increase in amount due from related parties of RMB5.9 million.

 

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Investing Activities

Net cash used in investing activities in the first quarter of 2007 was RMB4.7 million (US$0.6 million), which primarily related to purchases of servers, computer equipment and other equipment to support our expanded operations.

Net cash used in investing activities in 2006 was RMB11.6 million (US$1.5 million), compared to RMB2.5 million and RMB0.6 million in 2005 and 2004, respectively. Net cash used in investing activities in 2006 primarily related to (i) purchases of servers, computer equipment and other equipment in the amount of RMB8.5 million (US$1.1 million) to support our expanded operations; and (ii) obtaining licenses of copyrights on which the contents of our online games are based and obtaining a license of a database software in the amount of approximately RMB3.1 million (US$0.4 million). Net cash used in investing activities in 2005 and 2004 was primarily attributable to purchases of servers, computer equipment and other equipment. We expect to purchase additional servers and other computer equipment to support the anticipated growth of our operations in the near future.

Financing Activities

Net cash provided by financing activities in the first quarter of 2007 was RMB0.1 million (US$16 thousand), which was primarily attributable to our shareholders’ payment of receivables.

Net cash provided by financing activities in 2006 was RMB42.5 million (US$5.5 million), as compared to RMB12.0 million and RMB15.0 million in 2005 and 2004, respectively. Net cash provided by financing activities in 2006 was primarily attributable to the net proceeds from the sale of our Series A convertible preferred shares in the amount of RMB54.5 million (US$7.1 million) in September 2006, partly offset by repayment of loans from related parties in the amount of RMB13.0 million (US$1.7 million). In addition, in 2006, we issued 10,000,000 shares of our Series A convertible preferred shares to two founding shareholders for nominal consideration, and these shareholders immediately sold all of these shares at a price of US$0.1 per share. One of the founding shareholders is controlled by Mr. Michael Yufeng Chi, our founder, chairman and chief executive officer. With respect to the shares issued to such shareholder, we recorded a one-time share-based compensation charge. See “—Share-based Compensation Expenses.” With respect to shares issued to the other shareholder, whose shareholders have never had any employment or business relationship with us, the transaction has been accounted for as a return of capital to this shareholder in the amount of RMB4.0 million (US$0.5 million). This transaction is reflected in our consolidated statement of cash flows for the year ended December 31, 2006 as a non-cash financing activity. See note 11 to our consolidated financial statements included in this prospectus. Net cash provided by financing activities in 2005 was primarily attributable to loans from related parties. Net cash provided by financing activities in 2004 consists of proceeds received from subscriptions for our share capital by our founders.

Capital Expenditures

We incurred capital expenditures of RMB0.6 million, RMB2.5 million and RMB11.6 million (US$1.5 million) in 2004, 2005 and 2006, respectively. Our capital expenditures have been used primarily to purchase servers and other computer equipment for the operation of our online games and to obtain licenses of copyrights of the TV drama series “ LOGO,” on which our game Legend of Martial Arts is based, and the Internet novel “Zhu Xian,” based on which we are developing a game with the same name.

We incurred capital expenditures of RMB4.6 million (US$0.6 million) in the first quarter of 2007. We estimate that our capital expenditures in 2007 will be used primarily to purchase computer equipment for the further expansion of our operations and to obtain licenses of copyrights required for our new games. We believe that our current cash and cash equivalents, anticipated cash flow from operations and net proceeds from this offering will be sufficient to meet our anticipated cash needs, including our cash needs for working capital and capital expenditures, for at least the next 12 months. We may, however, require additional cash due to changing business conditions or

 

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other future developments, including any investments or acquisitions we may decide to pursue. If our existing cash is insufficient to meet our requirements, we may seek to sell additional equity securities, debt securities or borrow from lending institutions.

Contractual Obligations and Commercial Commitments

The following table sets forth our contractual obligations and commercial commitments as of March 31, 2007:

 

     Payment Due by Period
   Total    Less than
1 Year
   1-3 Years    3-5 Years   

More than 5

Years

     (in RMB thousands)

Operating lease obligations

   70,976    39,315    31,661    —      —  

Total

   70,976    39,315    31,661    —      —  

Other than the obligations set forth above, we did not have any long-term debt obligations, operating lease obligations, purchase obligations or other long-term liabilities as of March 31, 2007.

Off-balance Sheet Commitments and Arrangements

We have not entered into any financial guarantees or other commitments to guarantee the payment obligations of third parties, except for PW Network’s guarantee of the obligations of an unrelated party, Beijing Aoshi Lianheng Technology Co., Ltd., or Beijing Aoshi, for an aggregate rental fee of RMB1.8 million (US$0.2 million) under a server lease agreement for the benefit of the lessor, Shanghai Mengchi Network Technology Co., Ltd. PW Network provided the guarantee with respect to the rental payment as the servers rented by Beijing Aoshi were subleased to PW Network. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder’s equity, or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or that engages in leasing, hedging or research and development services with us.

Inflation

Since our inception, inflation in China has not materially impacted our results of operations. According to the National Bureau of Statistics of China, the change of consumer price index in China was 3.9%, 1.8% and 1.5% in 2004, 2005 and 2006, respectively.

Market Risks

Foreign Exchange Risk

Substantially all of our revenues and expenses are denominated in RMB. Our exposure to foreign exchange risk primarily relates to cash and cash equivalents denominated in U.S. dollars as a result of our past issuances of preferred shares through a private placement and proceeds from this offering. In 2007, we will generate more revenues in foreign currency from licensing our games to overseas licensees. Therefore, fluctuations in currency exchange rates could have an impact on our financial condition due to a mismatch among various foreign currency-denominated sales and costs. Fluctuations in exchange rates, particularly between the U.S. dollar and Renminbi, affect our gross and net profit margins and could result in foreign exchange and operating losses. Although in general, our exposure to foreign exchange risks should be limited, the value of your investment in our ADSs will be affected by the foreign exchange rate between U.S. dollars and RMB because the value of our business is effectively denominated in RMB, while the ADSs will be traded in U.S. dollars. We recorded a net foreign currency loss of approximately RMB0.8 million (US$0.1 million) in 2006 principally due to a foreign

 

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currency loss on the U.S. dollar proceeds from the issuance of our Series A preferred shares resulting from the RMB appreciation. We may experience additional foreign exchange losses in the future to the extent we hold the proceeds of this offering in U.S. dollars.

The value of the RMB against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in China’s political and economic conditions. The conversion of RMB into foreign currencies, including U.S. dollars, has been based on rates set by the People’s Bank of China. On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the RMB to the U.S. dollar. Under the new policy, the RMB is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. This change in policy has resulted in an approximately 6.7% appreciation of the RMB against the U.S. dollar by March 30, 2007. There remains significant international pressure on the PRC government to adopt an even more flexible currency policy, which could result in a further and more significant appreciation of the RMB against the U.S. dollar. To the extent that we need to convert U.S. dollars we receive from this offering into RMB for our operations, appreciation of the RMB against the U.S. dollar would have an adverse effect on the RMB amount we receive from the conversion. We have not used any forward contracts or currency borrowings to hedge our exposure to foreign currency exchange risk.

Interest Rate Risk

Our exposure to interest rate risk primarily relates to interest income generated by excess cash invested in demand deposits with original maturities of three months or less. We have not used any derivative financial instruments to manage our interest rate risk exposure. We have not been exposed nor do we anticipate being exposed to material risks due to changes in interest rates. However, our future interest income may be different from expectations due to changes in market interest rates.

Recent Accounting Pronouncements

Standards Implemented

In September 2006, the SEC issued Staff Accounting Bulletin (SAB) No. 108, codified as SAB Topic 1.N, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB No. 108 describes the approach that should be used to quantify the materiality of a misstatement and provides guidance for correcting prior-year errors. We early adopted SAB No. 108 in the third quarter of 2006 and, accordingly, follow SAB No. 108 requirements when quantifying financial statement misstatements. The adoption of SAB No. 108 did not require any adjustments to our consolidated financial statements.

In the first quarter of 2006, we adopted SFAS No. 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 changed the requirements for the accounting for and reporting of a voluntary change in accounting principle. The adoption of this statement did not affect our consolidated financial statements in fiscal year 2006. Its effects on future periods will depend on the nature and significance of any future accounting changes subject to this statement.

We have early adopted the provisions of EITF 06-3 in 2006 and presented value-added taxes on a gross basis. In June 2006, the FASB ratified the consensus reached by the EITF on Issue No. 06-3, How Taxes Collected from Customers and Remitted to Government Authorities Should Be Presented in the Income Statement (“EITF 06-3”). EITF 06-3 includes any tax assessed by a government authority that is directly imposed on a revenue-producing transaction between a seller and a customer and may include, but is not limited to, sales, use, value added and some excise taxes. EITF 06-3 concludes that the presentation of taxes on either a gross basis (included in revenues and costs) or on a net basis (excluded from revenues) is an accounting policy decision that should be disclosed. In addition, for any such taxes that are reported on a gross basis, a company is required to disclose the amounts of such taxes in its interim and annual financial statements for each period for which an income statement is presented, if the amounts are significant. Please see Note 3(i) in our financial statements for the required disclosures.

 

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Recently Issued Accounting Standards

In September 2006, the FASB issued FAS 157, Fair Value Measurements. FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. FAS 157 applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurements attribute. Accordingly, this statement does not require any new fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We are in the process of assessing the impact of the adoption of FAS157 on our financial position or results of operations.

In July 2006, the FASB issued FASB Interpretation No. 48 (“FIN No. 48”), Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109, which clarifies the accounting for uncertain tax positions recognized in an enterprise’s financial statements. FIN No. 48 prescribes a two-step process for the evaluation of a tax position. First, a determination of whether a tax position shall be recognized is made using a “more-likely-than-not” threshold that the tax position will be sustained upon examination by the appropriate taxing authority. If a tax position meets the “more-likely-than-not” recognition threshold, then it is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. We are in the process of assessing the impact of the adoption on our financial position or results of operations.

 

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BUSINESS

Overview

We are a leading online game developer and operator in China as measured by the popularity of our games in China in 2006, according to a report published by IDC. We primarily develop 3D online games based on our proprietary Angelica 3D game engine and game development platform. Our strong technology and creative game design capabilities, combined with our extensive local knowledge and experience, enable us to frequently and rapidly introduce popular games designed to cater to changing customer preferences and market trends in China. In 2006, we launched our first three self-developed 3D MMORPGs, namely, Perfect World, Legend of Martial Arts and Perfect World II. In the first quarter of 2007, these games recorded approximately 237,000 average concurrent users in China. We launched a new self-developed 3D MMORPG, Zhu Xian, in May 2007.

Our core technology capabilities consist of our proprietary 3D game engine, game development platform and real-time anti-cheating expertise, all developed and built by our experienced development team. In particular, our game engine enables us to create superior 3D graphics with impressive visual effects and provides the technical foundation for realizing innovative features in the game environment. Our game development platform is built on modularized functions which allow us to shorten the development cycle of our 3D MMORPGs to approximately six months for our recent games and to update our games frequently with new features.

We have achieved an impressive game development track record. Our Perfect World and Legend of Martial Arts games were the two most popular domestically developed 3D online games in China in 2006 according to IDC. Perfect World was a winner of the “Best 3D Online Games” award, and Legend of Martial Arts was a winner of the “Best Self-Developed Online Games” award, in China in 2006 at the China Digital Entertainment Exposition and Conference, or ChinaJoy, a leading Chinese online game industry convention. Legend of Martial Arts was awarded as the “Most Favorite Brand Game among College Students” from the Education Management Center of the Ministry of Education in 2006. We expect to launch two additional 3D MMORPGs and a casual game in 2007 and early 2008. We plan to develop more online games with a variety of themes, cultural characteristics and features that appeal to different segments of the online game player community.

We use a time-based revenue model for our first game, Perfect World, under which we charge players based on the time they spend playing the game. We use an item-based revenue model for Legend of Martial Arts, Perfect World II and Zhu Xian, under which players can play the games for free, but they are charged for purchases of in-game items, such as performance-enhancing items, clothing, accessories and pets. In 2006 and the first quarter of 2007, 46.9% and 86.5%, respectively, of our online game operation revenues were generated through this item-based model. We will continue to explore new and innovative business models to maximize our revenues and profit. We distribute our physical and virtual prepaid game cards to players in China through a variety of channels, consisting primarily of a network of 27 third-party distributors of our physical cards and one national distributor of our virtual cards. We also sell online points through our proprietary E-sales system and our own website. Although most of our revenues are generated in China, we have licensed our games, Perfect World II and Legend of Martial Arts, to leading game operators in 11 and seven countries and regions, respectively, including Japan and Taiwan, and we plan to license our games to more countries and regions. We have grown significantly since our inception, and generated revenues of RMB99.4 million (US$12.9 million) and RMB87.2 million (US$11.3 million) in 2006 and the first quarter of 2007, respectively. We incurred net losses from our inception in 2004 through the end of 2006. Our net loss of RMB27.9 million (US$3.6 million) in 2006 included one-time share-based compensation charges in the amount of RMB37.8 million (US$4.9 million) incurred in the year. We achieved net income of RMB40.0 million (US$5.2 million) in the first quarter of 2007.

 

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Industry Background

Overview. Online games are electronic games played over the Internet via network servers and game data stored on the servers. There are currently two major categories of online games:

MMORPGs. MMORPGs allow for thousands of users to play in an evolving virtual world at the same time over the Internet. Players’ computers generally need to have game-specific software installed to enable access to specific game servers. In a typical MMORPG, players adopt specific characters within the game to develop personalized experiences, skills and game attributes, which can be carried over into higher game levels. Because MMORPGs are relatively sophisticated and require a significant amount of time to become proficient and ultimately master, players tend to spend significant time playing and have a high degree of loyalty to the game. MMORPGs do not typically have a game ending. Instead, there are numerous stories with unlimited scenarios and game situations that may be presented depending on the actions of a particular player and the actions of fellow players playing within the same game environment.

Casual Games. Casual games are relatively easy to play and are typically concluded within a short period of time. Popular game genres include sports games such as car racing and basketball, social games such as dancing games, card games such as solitaire, hearts and poker, chess, trivia games such as puzzles and parlor games such as blackjack and checkers. Players can typically download the user-end software from the game website directly. The games are usually played free of charge and, when compared to MMORPGs, tend to draw a broader group of players, with diversified age groups and a more equal gender mix.

Online Game Market in the Asia-Pacific Region. The Asia-Pacific online game market is expected to continue its growth, fueled by the development in several countries in the region, particularly China. The following chart shows IDC’s forecast of trends in the online game markets of several countries and regions in the Asia-Pacific region.

Forecast of Major Online Game Markets in Asia

    

Online game revenues

(in millions of US$)

   Paying online game users
(in thousands)
   Paying online
game user
penetration (%
of Internet
users)
     2006    2011    CAGR
06-11
   2006    2011    CAGR
06-11
   2006    2011

China

   815.5    3046.1    30.2%    17,030    39,457    18.3%    13.2%    20.1%

Hong Kong

   35.9    58.9    10.4%    553    789    7.4%    9.3%    11.1%

Indonesia

   3.3    10.9    27.1%    100    411    32.6%    0.9%    1.4%

Korea

   740.5    1167.2    9.5%    5,769    8,286    7.5%    14.1%    18.7%

Malaysia

   14.0    50.2    29.1%    223    654    24.0%    1.4%    3.4%

Philippines

   19.5    32.6    10.8%    826    1,984    19.1%    4.2%    6.6%

Singapore

   7.9    15.4    14.2%    129    235    12.7%    3.6%    5.0%

Taiwan

   234.1    379.2    10.1%    3,174    4,823    8.7%    18.2%    22.7%

Thailand

   31.4    64.3    15.4%    958    1,817    13.7%    7.9%    9.7%

Data Source: IDC Asia/Pacific Online Gaming Market Data Table, May 2007

Growth of Online Game Market in China. China is a key online game market in the Asia-Pacific region and has substantial growth potential. According to IDC, China’s online game revenues were US$816 million in 2006, representing a 73.5% increase over 2005. IDC predicts that China’s online game revenues will reach US$3.0 billion by 2011, representing a CAGR, of 30.2% from 2006 to 2011.

 

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The following table sets forth IDC’s forecast of Internet users and the online game market in China for the period from 2006 to 2011.

China Internet and Online Game Industry Forecast

 

     2006    2007    2008    2009    2010    2011    CAGR
(2006-
2011)

Internet users (in millions)

   128.7    150.1    167.5    180.1    189.8    196.4    8.8%

Online game players (in millions)

   32.7    39.6    47.3    55.4    63.4    69.9    16.4%

Paying online game players (in millions)

   17.0    21.1    25.6    30.5    35.3    39.5    18.3%

Paying online game player penetration (% of online game users)

   52.2    53.2    54.1    55.0    55.8    56.5    —  

Online game revenues (in millions of US$)

   815.5    1,229.4    1,663.3    2,199.5    2,620.9    3,046.1    30.2%

Data Source: IDC, Greater China Online Gaming 2007-2011 Forecast and Analysis, March 2007

Many factors have supported and we believe are likely to continue to drive the growth in the online game market in China:

 

   

Increasing Internet, Broadband and PC Penetration. The development of the Internet and broadband penetration provides a solid base for the online game industry in China. According to IDC, the Chinese Internet population is expected to increase from 128.7 million users in 2006 to 196.4 million users in 2011, representing a CAGR of 8.8%. In addition, broadband penetration increased as subscribers reached 48.7 million in 2006, a 29.0% increase over 2005, and is expected to grow at a CAGR of 10.1% over the next five years to 78.9 million by 2011. According to Euromonitor International, a leading industry research firm, PC penetration in China is expected to increase from 62.0 per every 1,000 persons in 2005 to 154.6 per every 1,000 persons in 2010, representing a CAGR of 20.0%.

 

   

Attractive form of entertainment and limited number of other forms of entertainment. With the growing use of the Internet, online games and other Internet-based entertainment are becoming increasingly popular with the younger generations in China. Online games, especially MMORPGs, enable players to participate interactively in the games and compete against each other on a massive scale, thereby offering players a sense of fulfillment in a community setting. Frequent online and offline activities organized by game operators and Internet cafés also help to build a community of game players. Online games are a way for many young players to express their emotions, create virtual personalities and are important social outlets for many players. These factors, combined with the lack of more appealing entertainment options in China, make online games an attractive form of entertainment in China, especially for people between the ages of 16 and 35. According to IDC, in 2006, approximately 7.9% of online game players in China were minors under the age of eighteen.

 

   

Low entry cost and convenience of play for users. Games of console systems, such as those made by Sony, Nintendo and Microsoft, typically require a significant one-time payment for the hardware equipment and software needed to play a game. In contrast, the entry cost for online games is relatively low and online game software is typically free to download onto a computer. While more advanced computers are still expensive in relation to Chinese per capita income, widespread Internet cafés throughout China provide players with easy and low-cost access to online games, and thus expand the geographic and demographic reach of online games in China. According to IDC, in 2006, approximately 41.7% of Chinese online game players accessed games at Internet cafés, where only a small fee for using the café is charged in addition to the game charges. In addition, many online games are designed with relatively basic hardware requirements, minimizing the cost barriers for some entry-level players.

 

   

High degree of user loyalty. Many online games, especially MMORPGs, require a significant amount of players’ time and commitment to develop the skills required to progress. The online game environment also allows players to have personalized, customizable and interactive experiences, including love, romance and friendship. In addition, the frequent introduction of new characters, game

 

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levels and other features creates a game environment that remains dynamic and appealing to players. The combination of these factors enhance players’ loyalty to the games.

Major Characteristics of the Online Game Market in China. The online game market in China currently has the following key characteristics:

 

   

Migration to 3D games. There has been a noticeable trend towards development and operation of 3D online games in China. Compared with 2D games, 3D settings and characters provide a more realistic representation of real-life objects and can depict more complex activities and movement. 3D games with enhanced graphics are more attractive to players, in particular MMORPG players.

 

   

Increasing acceptance of the item-based revenue model. The item-based revenue model is gaining wider market acceptance. While many of the older games use the traditional time-based model, many of the newer games are being introduced with the item-based model. Internet users are more likely to be attracted to playing item-based games since there is no initial charge to play the game. The model also presents players with a personalized and differentiated service portfolio and increases the ability of online game companies to generate higher revenues per customer. According to IDC, in 2006, more than 60% of online game revenues in China were generated from the item-based model, compared to a very low percentage in 2005.

 

   

Slow pace in upgrading PC hardware. Although PC and other hardware manufacturers constantly introduce more advanced hardware to the market, Internet cafés and individuals in China tend to replace computers at a much slower rate than game players in the United States and other developed countries. Therefore, many game players in China play online games using computers and hardware that may be generations behind the most sophisticated hardware. As a result, online games that are designed with flexible hardware requirements can reach a larger pool of potential players in China.

 

   

Rampant cheating programs and hacking in many games. Unauthorized character enhancements and other hacking or cheating activities are common in China. These activities not only impair the individual player’s property and affect the game experience, but also damage the game developer’s and operator’s reputation and credibility to maintain a fair and reliable game environment. According IDC, unauthorized character enhancements were viewed as one of the top factors causing players to stop playing an online game.

 

   

Continued growth of domestic online games. Domestically developed online games have shown strong competitive advantages in China. According to IDC, in 2006, revenues generated from domestically developed online games reached RMB4.2 billion (US$0.5 billion), accounting for 64.8% of the total online game revenues in China.

 

   

Growing popularity of casual games. Casual games have become more popular due to their relative benefits compared to MMORPGs, including providing less-experienced online game players with a means to become familiar with both online game playing and the online game culture without making substantial commitments of time and resources, and better suitability for play at home due to the shorter duration of casual games and reduced demand for a player’s full attention for prolonged periods. According to IDC, China’s casual game revenues reached US$153 million in 2006, an approximately 100% increase from the 2005 revenues. IDC predicts that China’s casual game revenues will grow at a CAGR of 48.0% from 2006 to 2011, and will reach US$1.1 billion by 2011.

Our Strengths

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

Leading Market Position in 3D Online Games in China. We are a leading online game developer and operator in China as measured by the popularity of our self-developed and operated online games, according to IDC. Anticipating the substantial market growth of 3D online games in China, we have focused on the development of our proprietary Angelica 3D game engine and 3D online games. Our focus on 3D technologies, combined with our powerful game development platform and game design capability, has allowed us to develop

 

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award-winning MMORPGs in-house without the need to rely on licensing games from third-party game developers. Our Perfect World and Legend of Martial Arts games were recognized by IDC as the two most popular domestically developed 3D online games in China in 2006. Perfect World was a winner of the “Best 3D Online Games” award, and Legend of Martial Arts was a winner of the “Best Self-Developed Online Games” award, in China in 2006 by ChinaJoy. We believe that we have maintained a loyal game player community, which provides an established audience to market our future products and services.

Powerful Technology Capabilities. The key features of our technology capabilities include:

 

   

State-of-the-art 3D game engine. Our proprietary Angelica 3D game engine enables us to create superior 3D graphics with impressive visual effects, realistically representing real-life characters and items in captivating scenes. The game engine provides the technical foundation to realize innovative game features in the game environment, such as enabling characters to fly freely, and enabling our game players to customize and personalize content and characters. It supports complicated algorithms and computation processes to ensure a consistently challenging and exciting game experience. Our Angelica 3D game engine also streamlines online data transmission, game operations and user control and supports up to 160 concurrent users playing on the same scene.

 

   

Powerful game development platform. Our game development platform has been designed with modularized functions to allow our game designers and graphic artists to quickly enhance the game play, design and settings without getting bogged down by complex and technical computer programming language. This significantly shortens our game development cycle and allows us to quickly update game content and features after game launch to further boost our in-game item sales and enhance user experience. Our game development platform builds in multiple-language capability, which supports our timely expansion into international markets by making the localization process more convenient for us and our international licensees. As of the date of this prospectus, we have licensed Perfect World II and Legend of Martial Arts to leading game operators in 11 and seven countries and regions, respectively, including Japan and Taiwan.

 

   

Flexible hardware requirements. Recognizing that many game players in China do not have access to state-of-the-art hardware, our Angelica 3D game engine is designed to be flexible, not only to deliver an advanced online game experience to users with high-end hardware, but also to present an effective game experience for users playing on computers that may be a few generations behind. We believe that the relatively flexible configuration requirements provide us access to a broad range of players in China.

 

   

Anti-cheating expertise. Our advanced technology, especially the built-in detection mechanisms of our games, procures the real-time detection and resolution of unauthorized character enhancements and other attacks from cheating activities, which have been seen in online games in China and in other parts of the Asia-Pacific region.

Creative Utilization of Extensive Local Knowledge and Experience. We utilize our deep understanding of the local culture, entertainment industry and customer preferences and behavior to design, market and distribute our games.

 

   

Innovative utilization of pop culture products. We consistently review pop culture products on the Internet and other forms of media and among our player community to generate game concepts that are in tune with Chinese game players’ interests and the most up-to-date market trends. For example, Legend of Martial Arts was designed based on a highly popular TV drama series. We developed our fourth MMORPG based on Zhu Xian, a popular Internet novel, which was ranked among the top five Internet novels for 2005 and 2006 according to the click statistics of Baidu.com, Inc. We believe that our systematic game design generation based on our insight into the local market facilitates the introduction of new games and a higher likelihood of success upon commercial launch.

 

   

Marketing activities and game features using popular local entertainment and fashion elements. We understand the entertainment-oriented Internet culture in China and incorporate entertainment and

 

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fashion elements into our marketing activities and into our games. For example, we hired Shui Mu Nian Hua ( LOGO), a popular Chinese folk-rock band, to record the theme song for our game, Perfect World. We also use celebrities for this and other games, including Crystal Liu ( LOGO), a popular TV star in China, who has been appointed as our “Miss Perfect” to promote our game, Perfect World, and Richie Jen ( LOGO), a well-known pop singer, who has been appointed as an ambassador for our game, Zhu Xian, and has recorded the theme song for that game. We strive for an interplay between game play, marketing and entertainment, which we believe is illustrated by the theme song for “Perfect World” being ranked among the top five most popular songs by several national charts in China.

 

   

Deep understanding of player preferences. To enhance our understanding of player preferences, we have recruited online game players to work at our game design department. We closely analyze and rapidly respond to changing player preferences by frequently updating our existing games. We also introduce event-related game features, such as offering special holiday edition items. Understanding the importance of a fair game environment to players, our dedicated technical team constantly monitors and deals with the latest developments in hacking and cheating activities. Our knowledge of hackers’ habits help to protect our games from these activities and to ensure players’ confidence in the reliability of our games. We also incorporate consumer behavior and preferences into our game ecosystem, which optimizes the balance of power to ensure overall fairness and provides incentives for players to spend on in-game items.

Strong and Consistent Operations. We believe that our strong and consistent operations distinguish us from our competitors. Our operations primarily consist of the following aspects:

 

   

Efficient technology infrastructure. We operate our games through an efficient hardware and software infrastructure with a large network capacity, consisting of over 1,400 owned and leased servers. Our streamlined server groups support a large number of concurrent users. For example, a standard server group for our Legend of Martial Arts game allows for up to 15,000 concurrent users.

 

   

Effective sales and marketing force. We have a dedicated product management team for each of our games, responsible for marketing activities, managing player community and setting operational plans. We also have local promotion personnel in approximately 20 cities that cooperate with our distributors to periodically organize a variety of promotional activities, such as Internet café gatherings, player clubs and college marketing teams.

 

   

Nationwide distribution network. We distribute our physical and virtual prepaid game cards through a variety of channels. Our offline distribution network for physical game cards includes 27 provincial distributors across China, with access to approximately 3,400 retail outlets, including Internet cafés, newsstands and bookstores. Our virtual game cards are distributed via an online distributor and third-party audio response phone and mobile services providers. We also sell our online points through our website and our proprietary E-sales system, which simplifies the sales process and logistics and allows us to centrally monitor transfers by the distributors.

 

   

High-quality customer service. We strive to provide high-quality customer service to offer our game players an enjoyable game playing and overall user experience. Our customer service consists of around-the-clock call centers and in-game masters that provide instant responses to players’ inquiries and requests. We manage our user membership through our comprehensive Perfect Pass system, which is user-friendly, quick and secure, and provides customers easy access to their individual profile and payment history.

Experienced Management Team and Game Development Personnel. We have an experienced management team with strong execution capabilities and technology expertise. Mr. Michael Yufeng Chi, our founder, chairman and chief executive officer, has approximately ten years of entrepreneurial experience in successfully establishing and managing software enterprises in China. Mr. Kelvin Wing Kee Lau, our chief financial officer, has approximately seventeen years of experience in accounting and financial reporting. Mr. Qi Zhu, our vice president in charge of operations, has over eight years of marketing and operation experience in

 

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Internet and computer related industries. Several core members of our game development team, including Mr. Di He, our vice president and chief technology officer, and Mr. Qing Li, our vice president and chief design officer, have worked together for approximately nine years, and possess an established track record in successfully developing 3D online and PC games. The collective experience and history of cooperation among these core members have contributed to our rapid and high-quality game development and is critical to our success.

Strategy

Our goal is to become one of the leading online game companies in the world. Our primary growth strategies include:

Further Expand and Diversify Our Game Portfolio. We plan to continue to develop and launch new games on a regular basis by further intensifying our development efforts and leveraging our proprietary 3D game engine and powerful game development platform. In addition to our four MMORPGs currently on the market, we are developing two new MMORPGs and a new casual game that we target to launch in 2007 and early 2008. We also intend to develop more online games based on various styles of storylines and designs and to source creative designs overseas that could be developed into potential hit games in China. We will also consider expanding into other game formats, such as 3D online virtual community. Our target in the long run is to establish a comprehensive game portfolio catering to all of the major market segments and player demographics.

Enhance User Experience to Increase Monetization of Our Games. We will continue to focus on building a community of loyal game players to maintain and increase loyalty to our games, thus lengthening user playtime and the life span of our games, and increasing in-game purchases. We will seek to increase customer demand for our in-game items by optimizing the visual effects of our in-game items and engaging consultants to help us design and provide a variety of new clothing, accessories and other items that may be appealing to players, including limited edition special items that can be sold at premium prices. We also intend to track our players’ purchase habits and trends through detailed analysis of the extensive data we collect via our integrated membership system and through other channels, and use this information to improve the content and display of our in-game items. To boost and maintain player purchases, we will continue to offer event-related in-game items, introduce attractive seasonal sales activities, and launch holiday promotion activities around public holidays. We also plan to commercialize certain in-game features under development, such as enabling game players to design in-game items themselves.

Increase Our Focus on International Expansion. We aim to expand our international operations to capture opportunities overseas. We plan to further expand the geographical presence of our games by licensing Perfect World II, Legend of Martial Arts and other games in the future to leading online game operators in additional countries and regions, including Southeast Asia, the United States, Europe and South America. We will seek to create games with themes that cater to specific overseas markets or cut across geographical boundaries and also work with leading foreign online game companies to localize our content for the specific tastes and preferences of the local markets that we wish to enter. By cooperating with the leading online game companies in each country or region, we will seek to improve our overseas distribution network and increase our market penetration. We also plan to offer cross-border in-game events, such as in-game battles between players from different countries, which we believe will help build up our international game player community and expand our international player base.

Strengthen Leading-edge Technology through Continuous Research and Development. We believe that our proprietary Angelica 3D game engine, game development platform, anti-cheating mechanisms and other advanced technologies that we use differentiate us from many of our Chinese competitors. We intend to continue to focus on and devote substantial resources to our research and development efforts. We plan to further expand the size and capabilities of our development team by recruiting additional talented program developers, game designers and graphics artists. We will continually improve and upgrade our Angelica 3D game engine, game development platform and anti-cheating technology to keep pace with the latest technical advancements and offer

 

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more attractive features in our games. We plan to consistently introduce new game features and improve operations infrastructure to meet evolving customer tastes and expectations. We currently focus on the development of the technology for game players to have more control over the design and creation of in-game content and graphics. We also plan to expand our testing team and create a testing center dedicated to evaluating the technological performance of our games.

Pursue Strategic Acquisitions, Partnerships and Alliances. We intend to selectively acquire complementary online game businesses, particularly game development studios in China, to broaden our game formats, expand our development team and obtain access to other valuable resources. To strengthen our market position in China, we also intend to establish relationships with key players in other industry sectors that may complement our business and broaden our player base. For example, we may partner with leading Chinese media outlets to promote our games. We believe our extensive game operating experience, established player base, deep understanding of Chinese culture and the preferences of Chinese players, existing technology infrastructure and cost-effective development capability offer attractive cooperation opportunities to leading international game companies that seek to enter the Chinese market. We may consider strategically partnering with leading international game developers to identify game designs with market potential, and engaging in joint development to localize popular foreign games for the Chinese market. We also intend to work with leading foreign game developers to introduce selective foreign games into China to leverage our strong operational platform and increase our revenues and profit.

Our Games

Since our inception in March 2004, we have developed, operated and distributed four 3D MMORPGs, Perfect World, Legend of Martial Arts, Perfect World II and Zhu Xian. All of our games are developed by using our Angelica 3D game engine and offer “anytime play,” meaning users can play the games 24 hours a day, seven days a week. In addition, players’ game characters develop skills and experience, which, along with enhanced game features that can be accumulated or bought, can be carried over into higher game levels as the stories and games progress. The games are ultimately never won or lost, but instead provide a virtually infinite number of different game scenarios and situations depending on the choices of the player and others playing the game.

Our games also offer significant opportunities for social interaction in cyberspace. Life-like features in some of our games include marriages among online characters and martial arts apprenticeships, which are historical associations formed by martial arts masters according to Chinese legends. In addition, characters in our games may visually express feelings by their actions or by using emotive icons that appear within a character’s dialogue box. We believe that these features significantly expand the interface for player interaction, allow players to express their own personalities or virtual personalities through their virtual characters and create a certain level of social reality in the game.

Although each game character may be unique, groups of players may, and often must, form teams or alliances to achieve certain collective game objectives, such as battles and missions. Our games also incorporate instant messaging systems and chat rooms, which allow players to communicate and interact with each other in real-time groups or in one-on-one discussions. The bulletin boards in our games allow players to post notes or inquiries and respond to other players’ notes or inquires.

 

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The following table summarizes the minimum hardware configuration requirements and date of commercial launch of each of the MMORPGs that we are currently operating. Our games are designed to be flexible to present an effective game experience even for players who may not have state-of-the-art hardware.

 

Game

  

Date of Commercial
Launch

  

Minimum Hardware Configuration

Requirements

Perfect World

   January 2006    Celeron 800 Mhz CPU, 256 MB RAM, 32 MB 3D Accelerator display card and 2.5 GB hard drive

Legend of Martial Arts

   September 2006    Pentium III 600 Mhz CPU, 256 MB RAM, TNT DX8.0 display card and 1 GB hard drive

Perfect World II

   November 2006    Celeron 800 Mhz CPU, 256 MB RAM, 32 MB 3D Accelerator display card and 2.5 GB hard drive

Zhu Xian

   May 2007    Celeron 800 Mhz CPU, 256 MB RAM, TNT DX8.0 display card and 700 MB hard drive

Perfect World. Perfect World is an adventure and fantasy game with traditional Chinese settings. Players can take on various roles, including swordsmen, magicians, archers, priests and magical creatures. Characters develop skills over time, use magical weapons and team up with other players to fight against monsters and various creatures and to conquer and govern territories.

Players can design and customize the appearance and characteristics of their characters and roles. This includes customization of skin color, facial features and expressions, body types and hair styles. The player can model the game character after her own image or the image of a star or create a new image. Perfect World also offers a variety of features that are innovative in China, such as day-and-night shifting and weather effects and changes. The game allows characters to fly freely and move in a continuous and changing terrain and environment seamlessly without having to wait for scenery changes as is often the case in many other online games.

Perfect World offers sophisticated 3D graphics that realistically represent real-life characters and items moving in captivating scenes. The game can be displayed on a 16:9 widescreen to provide a movie-like visual effect. The in-game online radio broadcasts live game commentary and enables players to select the background music. In addition to the intense fighting scenes and game play and sense of adventure offered by the game, players can build virtual homelands and customize the background settings, including creating mountains and rivers in the game environment.

We launched Perfect World in January 2006. We adopted a time-based revenue model for this game, i.e., charging players based on the time they spend playing the game. We conducted the open beta testing of Perfect World from November 2005 to January 2006, during which period we allowed our registered users to play without charge in open market conditions to test performance consistency and stability of operation systems.

Perfect World received several awards in 2006, including recognition as the most popular domestically developed 3D online game in China in 2006 according to IDC, one of the “Best 3D Online Games” and the “Top 10 Most Popular Online Games” in China, awarded by ChinaJoy, the “Most Popular Domestically-Developed Online Game,” awarded by the second game players survey organized by Interactive Games, an industry publication, the “Best Original Online Game,” awarded by Home PC and Games, an industry publication, and the “Best Domestically-Developed Online Game,” awarded by the annual conference of the China e-Game Industrial Association.

Legend of Martial Arts. We developed Legend of Martial Arts based on a popular TV drama series with the same Chinese name, “ LOGO.” Legend of Martial Arts is an adventure story of Chinese swordsmen set in an ancient kingdom. It is designed to provide a more light-hearted and less intense game environment than Perfect World. The game attempts to capture the look and feel that has made the TV series a hit with the Chinese public.

 

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In addition, although based on the original TV series, we have enriched the game content by creating stories developed specifically for the game. We engage a team of writers, including the playwright of the TV series. The game characters develop skills over time, gain experience and collect other game features and items upon completion of various story–related missions.

In addition to employing many of the customization features found in Perfect World, Legend of Martial Arts has contained several features designed to provide players a flavor of traditional oriental culture. These include an apprentice system, which is formed by martial arts masters according to Chinese legends, and a nick name/title system, which assigns interesting nick names and titles to players based on their respective game experience. The game has also added a marriage system, whereby game characters can get married to other game characters to add a sense of social reality to the experience.

Legend of Martial Arts is the first game for which we adopted an item-based revenue model. Unlike the time-based revenue model that we currently use in Perfect World, users can play the basic functions of Legend of Martial Arts free of charge for as long as they want. Players are charged when they purchase in-game items, such as performance-enhancing items, clothing, accessories and pets. This allows players to further express their own or virtual personalities and enhance the game experience. We also provide online auction services for players’ to trade their in-game items with other players.

We have designed this game to encourage player purchases. This requires us to maintain and improve the attractiveness of in-game items and respond even more quickly to user trends in game play, fashion and overall lifestyle. Players can purchase a variety of fashionable and personalized virtual clothes, including traditional Chinese wedding dresses for characters’ in-game marriages. The game also provides a range of choices among virtual riding animals, such as horses, leopards, tigers, polar bears and dinosaurs. To maintain and boost our sales, we offer new in-game items periodically, in particular around public holidays. We also continually improve the screen display of these items to attract player purchases.

We launched the Legend of Martial Arts game in September 2006, when we sold in-game items during the open beta testing. Legend of Martial Arts has received several awards, including recognition as the second most popular domestically developed 3D online game in China in 2006 according to IDC, the “Most Favorite Brand Game among College Students” from the Education Management Information Center of the Ministry of Education in 2006, and one of the “Best Self-Developed Online Games” and “Most Anticipated Online Games by Game Players” awarded by ChinaJoy in 2006, and “Most Anticipated Online Games by Game Player” awarded by the annual conference of the China e-Game Industrial Association in 2006.

Perfect World II. We launched our third MMORPG, Perfect World II, in November 2006. The storyline of Perfect World II is set in a similar content and graphic background as Perfect World.

Like Legend of Martial Arts, Perfect World II also uses an item-based revenue model. Compared to Perfect World, we further improved the playing methods and game environment. We provided more user-friendly guidance on the classification and ranking of in-game weapons, and players can purchase virtual raw materials to manufacture their weapons. We also optimized the visual effects of our in-game items to enhance the attraction to players and transaction volumes. As Perfect World II offers more appealing play experience and operates under a different model compared to Perfect World, we have noted that some users play these two games concurrently, particularly those players who have already achieved advanced game attributes in Perfect World and try to enjoy a more personalized experience.

Perfect World II is the first game we licensed to overseas game operators. We plan to introduce cross-border in-game events, such as in-game battles between players from different countries, which we believe will help build up our international game player community and expand our international player base.

 

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Zhu Xian. We launched Zhu Xian in late May 2007. Zhu Xian ( LOGO) was developed based on a popular Internet novel with the same name. The Internet novel was ranked the No. 1 most read Internet novel in 2005 and was among the top five most read Internet novels in 2006 according to the click statistics of Baidu.com, Inc. The basic story concept of Zhu Xian is a martial arts focused adventure set in a fantasy world. The game players are able to experience the various fantastic scenes and plots that have made the Internet novel popular, such as martial arts training, use of magical weapons, upgrading of special capabilities and contests to obtain magical treasure, from the perspectives of the novel characters that they choose to play. We also add a time dimension, so that the player can enter into any game scenario based on the time parameter that they select without having to wait for the plot development like a novel reader. We believe that this feature diversifies the game content and increases players’ interests in the game environment.

Online Games Under Development. We are in the process of developing two additional 3D MMORPGs, including Chi Bi, and a casual game, Hot Dance Party, all to be launched in 2007 and early 2008. We plan to adopt the item-based revenue model for these games. We are also developing a 3D online virtual community, Second World.

Chi Bi. Chi Bi ( LOGO) is a war story developed based on the well-known Chinese history over the ancient Three Kingdoms period. This game will be designed to include various in-game weapons and large-scale map of the game environment in a historical cultural setting. We expect to launch Chi Bi in the fourth quarter of 2007.

Hot Dance Party. We are developing Hot Dance Party, our first casual game. This game will allow players to enjoy dancing game play in a captivating 3D game environment with a variety of background music choices. Furthermore, we plan to incorporate certain community features into this game. Game characters can build their own homes in the game environment. We expect to launch Hot Dance Party in the fourth quarter of 2007.

Second World. We are developing a 3D online virtual community to be named Second World. This virtual online community will comprise user-created characters and content, ranging from various styles of houses to shopping malls, cinemas, office buildings and fortresses, modeled after real-life items or created by players based on their own imagination. A user of Second World will be represented by his “avatar,” a virtual identity expressed through a human-like image and used to interact with other avatars in a virtual environment.

Our Proprietary Technologies

3D Game Engine

Anticipating the potential growth of 3D online games in China and recognizing the importance of possessing our own game engine, we have focused on the development of our proprietary Angelica 3D game engine. Our Angelica 3D game engine enables us to create superior 3D graphics with impressive visual effects, realistically representing real-life characters moving in captivating scenes. Our Angelica 3D game engine employs the latest technology to realize 3D features, including shadow mapping, light reflection and refraction on water surfaces. It also enables characters to fly freely in the game environment, to embrace and thus enhance interaction between players, and enables our game players to create, customize and personalize virtual content and characters.

The Angelica 3D game engine is designed to be flexible to allow for effective game play on both high-end and lower-end computers. Many of the international game operators that license games to China use game engines that require players to have the newest and most advanced computers to play the game or enjoy the game experience. We believe these engines may not be suitable to the hardware environment in China, because a large number of game players in China play online games using hardware that may be generations behind the most advanced computers. In comparison, the games developed on our Angelica 3D game engine are compatible with a variety of hardware platforms by simplifying certain computation requirements for low-end hardware. This allows us to access a broad range of players in China.

 

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The logic part of the Angelica 3D game engine provides the framework for the continuous evolution of the game story and game episodes. Under the logic engine, all game elements including characters, weapons, skills, game plots and scenes, are defined as abstract parameters and assigned with relative probabilities. Based on the complicated algorithms, formulas and computation processes supported by the logic engine, our program developers optimize and maintain the systematic balance and evolution of the various game elements to create a consistently challenging and exciting game experience and a game environment that is perceived as fair by the players.

The network part of the Angelica 3D game engine provides a platform to streamline the online data transmission, game operation and user control. Our network engine is able to support up to 160 concurrent players on the same scene, thus facilitating in-game events, such as battles on a massive scale.

Our Angelica 3D game engine can support the development of a range of styles of games under various game environments. We have employed this engine to develop all of our existing MMORPGs and are using it in connection with the development of our two new MMORPGs and our casual game.

Game Development Platform

Our game development platform has been designed with modularized functions to allow our game designers and graphic artists to quickly enhance and expand on the game play, design and settings without getting bogged down by technical computer programming language. Designers and graphic artists can program by going through a series of user-friendly menus. This significantly shortens our game development process and allows us to quickly add content and features to our games even after their commercial launch. Furthermore, as the same program development team supports the programming of each of our games via the same development platform, any programming improvement originated from one game can be readily introduced to other games. We believe that our game development platform provides us with a solid foundation to rapidly and frequently develop and introduce new games and to update our existing games.

Anti-cheating Technology

Our game engine also provides the technological foundation for the real-time detection and resolution of unauthorized character enhancements and other attacks from hacking and cheating activities. Our games have built-in detection mechanisms, which include a verification process between the user end hardware and our operation servers and the instant detection of cheating activities. We believe this is important to ensure players’ confidence in the fairness and reliability of our games, in particular given the propensity of hacking and cheating activities in online games in China and in other parts of the Asia Pacific region.

Game Development

We believe that rapid and high-quality game development is critical to our success. Our game development team consists of our programming department, design department and graphics department. As of June 25, 2007, we had 274 game development personnel. Several core members of our development team have worked together for nearly a decade.

Unlike many of our competitors that operate MMORPGs licensed from foreign game developers, we have in-house capabilities that allow us to develop games rapidly and in response to constantly changing market demands and trends. Our game development cycle from initial design concept to commercial launch has decreased to approximately six months for our most recent MMORPGs.

Our systematic game development process includes the following key steps:

 

   

Concept generation. Our design department takes the lead in generating game development ideas based on the latest trends in player preferences. We recruit game players into our design team to closely track

 

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the hot topics among our players and on the Internet. We also encourage all of our employees to provide creative ideas and concepts for game development.

 

   

Detailed proposal. Upon management’s approval of the new game concept, the design department will prepare a detailed proposal that sets preliminary storylines and game characters, estimates of costs and target markets.

 

   

Development plan. After the completion of the technical review of the proposal, a project team consisting of our programming staff, design staff and graphics artists work together to set the technical criteria for the game development, and then formulate a game development plan with development milestones.

 

   

Design, style and story concepts. Based on the game development plan, our graphics artists will determine the style of the new game and design game characters, our game designers will develop the game story and define game environments, and our program developers will develop both the server-end software and the user-end software modules.

 

   

Internal reviews. Mid-term management reviews will take place upon the completion of each milestone of the development plan. Concurrently, our testing department tests the accuracy and completeness of the development, and our marketing department initiates marketing campaigns according to the development milestones.

 

   

Closed beta testing and open beta testing. We conduct closed beta testing to work out technical issues and eliminate technical problems. Thereafter, we conduct open beta testing to test the operation of new games under open market conditions and introduce new games to players.

Our games are realized through coordination among teams of program developers, game designers and graphic artists. Our in-house development team also supports our frequent game upgrades and updates to accommodate the latest user tastes and preferences and evolving market trends. We also try to design each of our games to cater to distinct market segments to grow our overall player base rather than merely shifting players from one game to another. Furthermore, our games are developed with built-in multiple-language capability to support our timely expansion into international markets through a convenient localization process.

Membership Management and Payment System

Perfect Pass is our integrated membership management system. It is designed to provide our customers with an integrated user-friendly platform to log in, pay and purchase any products and services that we offer. To play our online games, a customer must register an account with our Perfect Pass system. Once registered, the customer may log into our network, select and activate the desired games that the customer wishes to play, and then charge his account with prepaid game card or online points that enable the customer to play for a specified period of time or purchase in-game items. Each customer needs to maintain only one Perfect Pass account, which provides information regarding the customer’s available prepaid online points, profile and payment history of the last three months. As of March 31, 2007, we had over 30 million registered accounts, including over 11 million active accounts. An account is deemed active if a player has logged in such account at least once over the last three months.

A customer can purchase the prepaid game cards through our various distribution channels both online and offline. Each prepaid game card contains a unique access code and password that enables a player to add online points to his account. Our prepaid game cards are offered in a variety of denominations to provide players with flexibility, and each prepaid game card may be used to play any of our online games. To avoid third parties’ misuse of our customers’ accounts, we offer a series of security measures by linking the account with our customer’s mobile phones, such as the lock-up of account and lock-up of IP addresses via short message instructions.

 

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Pricing and Distribution

Pricing. We have two different pricing models: (1) time-based, which we have adopted for Perfect World; and (2) item-based, which we have adopted for Legend of Martial Arts, Perfect World II and Zhu Xian. Under the time-based model, players pay for game playing time. The pricing was determined near the end of the open beta testing period based on several factors, including the prices of other comparable games, the technological and other features of the game, and the targeted marketing position of the game. Under the item-based model, players can play the basic functions of the game free of charge for as long as they want. We generate revenues when players purchase in-game items such as performance-enhancing items, clothing, accessories and pets that enhance the game play. We determine the price of each in-game item before its introduction, generally based on an analysis of a series of benchmarks, such as the price of similar items offered in other online games, the market price of the real-life item represented by the in-game item, and pricing of other popular forms of entertainment. We have generally maintained stable pricing for our games and in-game items.

Distribution. We established our distribution network by leveraging our managing team’s extensive connections accumulated from their previous software distribution experience. We distribute our physical and virtual prepaid game cards and online points through various channels.

Physical card distribution. We generally sell physical cards through a network of third-party distributors. We have entered into agreements with 27 distributors across China. These distributors resell the cards to sub-distributors who, in turn, distribute the cards directly to approximately 3,400 Internet cafés, newsstands, bookstores and other retail outlets throughout China.

Online point distribution. We sell our online points through the following channels:

 

   

Online payment platforms: We sell our online points directly to players for charging their accounts via our own website without any discount. Payments for purchases are processed by banks and other third- party online payment platform service providers. These online payment platform service providers receive transaction fees, which reduce the net payment we receive from them.

 

   

E-sales system: Each of our E-sales regional distributors has a sales account in our E-sales system. Upon receipt of their payment, we allocate to the distributor a number of online points and record on the central E-sales computer system operated and monitored by us. The distributors can electronically transfer the online points in their sales accounts to the accounts of their sub-distributors, retailers or players on our central E-sales computer system. This system of electronic sales simplifies logistics by eliminating the need for, and the cost of, physical game cards, and allows us to centrally monitor transfers by the distributors.

Virtual card distribution. Our virtual prepaid game cards are sold via various platforms as follows:

 

   

National distributor: Currently, we distribute our virtual cards primarily through a national distributor.

 

   

Telecommunication operators: Our virtual cards are also sold through audio response phone, mobile and broadband services provided by telecommunication operators in approximately 20 and 30 cities, respectively, in China. These telecommunication operators bundle the collection of fees for our games with the fees for their services to users.

Overseas Licensing

As of the date of this prospectus, we had licensed Perfect World II and Legend of Martial Arts to operators in 11 and seven countries and regions, respectively. Under our license agreements, we allow our overseas licensees to exclusively operate, promote, service and distribute our games in specified territories. In return, we are generally entitled to an initial license fee and ongoing royalties, the latter of which is generally determined based on the amount of money charged to players’ accounts in a specific country or region. The licensees are

 

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responsible for the sales and marketing of our games in the specified territories, including setting the price of our games and virtual items, and usually there are minimum requirements on promotion expenditures. The licensees are also generally in charge of maintenance of the network infrastructure and customer service. We are responsible for the technical support for the operation of our games, including providing technical tools for the localization of our games. We generally agree to provide our licensees with updates or upgrades to the licensed games every three to six months. We also usually assist the licensee in preventing, detecting and resolving hacking and cheating activities.

We plan to further license Perfect World II, Legend of Martial Arts and other games to leading online game operators in additional countries and regions to expand the geographical presence of our games, including Southeast Asia, the United States, Europe and South America. Both of Perfect World II and Legend of Martial Arts use an item-based revenue model. Our games offer differentiated in-game items in different territories, e.g., kimonos offered in Japan. The licensees determine the pricing of in-game items based on the local market conditions as well as our input.

The following table lists certain information with respect to the licenses that we have entered into for Perfect World II.

 

Country/Region

  

Licensee

   Date of license
agreement
   Date/Estimate Date
of commercial
launch
 

Expiry date

Taiwan, Hong Kong
and Macau
   Soft-World International
Corporation
   June 15, 2006    December 2006   December 2009

Japan

   C&C Media Co., Ltd.    July 29, 2006    April 2007   April 2012

Vietnam

   Quang Minh DEC    August 25,
2006
   February 2007   February 2010

Malaysia and Singapore

   Cubinet Interactive Sdn Bhd    December 28,
2006
   March 2007   March 2012

Korea

   CJ Internet Corporation    December 12,
2006
   September 2007
(expected)
  Sixty months from commercial launch

The Philippines

   Level Up! Inc.    December 12,
2006
   September 2007
(expected)
  Five years from commercial launch

Brazil

   Level Up! Interactive S.A.    December 14,
2006
   December 2007
(expected)
  Five years from commercial launch

Thailand

   Cubinet Interactive Sdn Bhd    Ju