F-1 1 d138068df1.htm FORM F-1 Form F-1
Table of Contents

As filed with the Securities and Exchange Commission on October 22, 2013

Registration No. 333-            

 

 

 

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM F-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

500.COM LIMITED

(Exact name of Registrant as specified in its charter)

Not Applicable

(Translation of Registrant’s name into English)

 

Cayman Islands   7990   Not Applicable

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

500.com Building

Shenxianling Sports Center

Longgang District

Shenzhen, 518115

People’s Republic of China

(86 755) 8633 0000

(Address, including zip code, and telephone number, including

area code, of Registrant’s principal executive offices)

 

 

Law Debenture Corporate Services Inc.

400 Madison Avenue, 4th Floor

New York, New York 10017

(212) 750-6474

(Name, address, including zip code, and telephone number,

including area code, of agent for service)

 

 

Copies to:

 

Chris K.H. Lin, Esq.
Simpson Thacher & Bartlett
35th Floor, ICBC Tower
3 Garden Road, Central
Hong Kong
(852) 2514-7600
 

Shuang Zhao, Esq.

Shearman & Sterling LLP

c/o 12th Floor Gloucester Tower, The Landmark

15 Queen’s Road Central, Central

Hong Kong

(852) 2978-8000

 

 

Approximate date of commencement of proposed sale to the public:

as soon as practicable after the effective date of this registration statement

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

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

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

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

 

 

CALCULATION OF REGISTRATION FEE

 

 

Title of each class of securities

to be registered

 

Proposed maximum

aggregate offering

price(1)(2)

 

Amount of

registration fee

Class A ordinary shares, par value US$0.00005 per share(3)

  US$150,000,000   US$19,320

 

 

 

(1) Includes (a)              Class A ordinary shares represented by American depositary shares that may be purchased by the underwriters pursuant to their option to purchase additional American depositary shares to cover over-allotments, and (b) Class A ordinary shares initially offered and sold outside the United States that may be resold from time to time in the United States either as part of their distribution or within 40 days after the later of the effective date of this registration statement and the date the shares are first bona fide offered to the public. These Class A ordinary shares are not being registered for the purpose of sales outside the United States.

 

(2) Estimated solely for the purpose of determining the amount of registration fee in accordance with Rule 457(o) under the Securities Act of 1933, as amended.

 

(3) American depositary shares issuable upon deposit of the Class A ordinary shares registered hereby will be registered under a separate registration statement on Form F-6 (Registration No. 333-        ). Each American depositary share represents             Class A ordinary shares.

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 Exchange Commission, acting pursuant to such Section 8(a), may determine.

 

 

 


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The information in this preliminary prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and is not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

Subject to Completion, Dated                     , 2013.

 

LOGO

500.com Limited

                     American Depositary Shares

Representing              Class A Ordinary Shares

 

 

This is the initial public offering of 500.com Limited. We are offering              American depositary shares, or ADSs, and the selling shareholders identified in this prospectus are offering an additional              ADSs. Each ADS represents              Class A ordinary shares, par value US$0.00005 per share of 500.com Limited. We will not receive any proceeds from the ADSs sold by the selling shareholders.

Our ordinary shares will be divided into Class A and Class B ordinary shares upon completion of this offering. Holders of Class A ordinary shares and Class B ordinary shares will have the same rights except for voting and conversion rights. Each Class A ordinary share will be entitled to one vote per share, and each Class B ordinary share will be entitled to 10 votes per share and will be convertible at any time into one Class A ordinary share. Class A ordinary shares will not be convertible into Class B ordinary shares under any circumstances. Ordinary shares held by our existing shareholders prior to this offering will be redesignated as our Class B ordinary shares upon completion of this offering. Assuming the underwriters do not exercise their over-allotment option to purchase additional ADSs, upon completion of this offering, holders of our Class B ordinary shares will hold              Class B ordinary shares, or             % of the combined total of our outstanding Class A and Class B ordinary shares (representing             % of the total voting rights) in our company. Our dual-class share structure involves certain risks. See the relevant risk factors in this prospectus for a detailed discussion of such risks.

Prior to this offering, there has been no public market for the ADSs or our ordinary shares. It is currently estimated that the public offering price per ADS will be between US$             and US$            . We have applied for listing of the ADSs on the New York Stock Exchange, or the NYSE, under the symbol “WBAI.”

We are an “emerging growth company” under the applicable U.S. federal securities laws and will be subject to reduced public company reporting requirements.

See “Risk Factors” beginning on page 13 to read about factors you should consider before buying the ADSs.

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

 

 

 

     Per ADS      Total  

Public offering price

   US$                    US$                

Underwriting discounts and commissions

   US$         US$     

Proceeds, before expenses, to 500.com Limited

   US$         US$     

Proceeds, before expenses, to the selling shareholders

   US$         US$     

The underwriters have an option to purchase up to an additional              ADSs from us and up to an additional              ADSs from the selling shareholders at the public offering price less the underwriting discounts and commissions.

 

 

The underwriters expect to deliver the ADSs against payment in U.S. dollars on or about                     , 2013.

 

 

 

Deutsche Bank Securities

 

 

 

Piper Jaffray

Prospectus dated                     , 2013.


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TABLE OF CONTENT

 

     Page  

PROSPECTUS SUMMARY

     1   

RISK FACTORS

     13   

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

     44   

USE OF PROCEEDS

     45   

DIVIDEND POLICY

     46   

CAPITALIZATION

     47   

DILUTION

     48   

EXCHANGE RATE INFORMATION

     50   

ENFORCEMENT OF CIVIL LIABILITIES

     51   

OUR HISTORY AND CORPORATE STRUCTURE

     53   

SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA

     58   

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

     61   

INDUSTRY BACKGROUND

     88   

OUR BUSINESS

     95   

REGULATIONS

     109   

MANAGEMENT

     119   

PRINCIPAL AND SELLING SHAREHOLDERS

     128   

RELATED PARTY TRANSACTIONS

     132   

DESCRIPTION OF SHARE CAPITAL

     134   

DESCRIPTION OF AMERICAN DEPOSITARY SHARES

     144   

SHARES ELIGIBLE FOR FUTURE SALE

     153   

TAXATION

     155   

UNDERWRITING

     163   

EXPENSES RELATED TO THIS OFFERING

     172   

LEGAL MATTERS

     173   

EXPERTS

     174   

WHERE YOU CAN FIND MORE INFORMATION

     175   

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

     F-1   

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

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

Through and including                     , 2013 (the 25th day after the date of this prospectus), all dealers effecting transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to a dealer’s obligation to deliver a prospectus when acting as an underwriter and with respect to an unsold allotment or subscription.


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PROSPECTUS SUMMARY

This summary highlights selected information contained in greater detail elsewhere in this prospectus. This summary may not contain all of the information that you should consider before investing in our ADSs. You should carefully read the entire prospectus, including “Risk Factors” and the financial statements, before making an investment decision. This summary and other sections of this prospectus contain information from a report, referred to in this prospectus as the iResearch Report, which we commissioned from iResearch Consulting Group, or iResearch, a third-party market research firm, to provide information on the industry in which we operate, including our market position in that industry.

Overview

We are a leading online sports lottery service provider in China with the largest market share in the six months ended June 30, 2013 and the second largest market share in 2012 in terms of purchase amount of sports lottery products, according to the iResearch Report. We act as an aggregator and processor of lottery purchase orders from our registered user accounts and currently derive substantially all of our revenues from service fees paid to us by provincial sports lottery administration centers for the purchase orders of sports lottery products that we direct to such centers. We offer a comprehensive and integrated suite of online lottery services, information, user tools and virtual community venues to our users. We were among the first companies to provide online lottery services in China, and we are one of the two entities that are authorized by the Ministry of Finance, or the MOF, to provide online lottery sales services on behalf of China Sports Lottery Administration Center, the government authority in charge of the issuance and sale of sports lottery products in China. Through continued and significant investments in the past 12 years, we have built a prominent brand, 500wan, which means “five million” in Chinese and is the typical amount of top prizes of most lottery products in China. We believe our brand is known in the industry and by our users for its credibility and reliability.

Historically, we provided online sales services for, and generated service fees from, both sports and welfare lottery products. From March to November 2012, we voluntarily suspended our online lottery sales services to substantially all of our customers, or the voluntary suspension, in response to a newly promulgated regulation which mandates, among other things, that online lottery sales services can only be provided by entities approved by the MOF. During this period, we continued to provide lottery sales services via our mobile applications to mobile users and via our online platform to a limited number of loyal customers as a means of customer maintenance. Approximately 78.5% of our service fees during the voluntary suspension period were generated from our mobile applications. We resumed online lottery sales services for sports lottery products in November 2012 after we obtained the relevant approval for such lottery products from the MOF. Simultaneously, we ceased to provide sales services for welfare lottery products.

Historically, we have one of the largest and fastest-growing user bases among online lottery service providers in China. We had 8.8 million, 13.8 million, 16.6 million and 18.4 million registered user accounts as of December 31, 2010, 2011 and 2012 and September 30, 2013, respectively. The activity level of our users was adversely affected by the voluntary suspension. We had 1.4 million, 1.9 million, 0.9 million and 0.8 million active accounts, meaning registered accounts which made at least one lottery purchase during the relevant period, in 2010, 2011 and 2012 and the nine months ended September 30, 2013, respectively. The purchase amount of our users was RMB1.8 billion, RMB2.5 billion, RMB1.7 billion (US$272.7 million) and RMB2.0 billion (US$322.8 million) in 2010, 2011 and 2012 and the nine months ended September 30, 2013, respectively. Since we resumed online lottery sales services for sports lottery products on November 12, 2012, our user activity level has been recovering steadily. Our number of active accounts was approximately 282,000, 297,000, 389,000 and 374,000 in the three months ended December 31, 2012, March 31, 2013, June 30, 2013 and September 30, 2013, respectively, representing a 6.0%, 5.3% and 31.0% increase and a 3.9% decrease from those in the respective preceding quarters. In comparison, we had approximately 635,000, 309,000 and 266,000 active accounts in the three months ended March 31, June 30 and September 30, 2012, respectively, representing a 13.6%, 51.3% and 13.9% decrease from those in the respective preceding quarters. The purchase amount per active account was

 

 

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RMB1,169, RMB1,818, RMB1,799 and RMB1,967 in the three months ended December 31, 2012, March 31, 2013, June 30 2013 and September 30, 2013, respectively, representing a 25.8% increase, a 55.5% increase, a 1.0% decrease and a 9.3% increase from those in the respective preceding quarters. In comparison, the purchase amount per active account was RMB1,143, RMB1,200 and RMB929 in the three months ended March 31, 2012, June 30, 2012 and September 30, 2012, respectively, representing a 4.2% increase, a 5.1% increase and a 22.6% decrease from those in the respective preceding quarters.

Our net revenues were RMB157.4 million, RMB232.3 million and RMB171.5 million (US$28.0 million) in 2010, 2011 and 2012, respectively, representing a 47.6% increase from 2010 to 2011 and a 26.2% decrease from 2011 to 2012, respectively. The majority of our service fees were generated from sports lottery products, which accounted for 76.9%, 78.7% and 86.0% of our total service fees in 2010, 2011 and 2012, respectively. The increases in percentages of revenue contribution from sports lottery products were results of our efforts to promote the sales of such products during the periods. Our net income was RMB38.3 million, RMB13.6 million and RMB4.2 million (US$0.7 million) in 2010, 2011 and 2012, respectively, representing a 64.5% decrease from 2010 to 2011 and a 68.7% decrease from 2011 to 2012. Our net income in 2011 and 2012 was adversely impacted by share-based compensation expenses of RMB50.2 million and RMB13.7 million (US$2.2 million), respectively. In addition, our net income in 2010, 2011 and 2012 was adversely impacted by deferred tax expenses relating to outside basis differences in our consolidated affiliated entities of RMB35.6 million, RMB21.5 million and RMB11.9 million (US$1.9 million), respectively. Our service fees increased by 49.3% from RMB142.1 million in the nine months ended September 30, 2012 to RMB212.2 million (US$34.7 million) in the nine months ended September 30, 2013. All of our service fees in the nine months ended September 30, 2013 were generated from sports lottery products. Our net revenues increased by 25.0% from RMB130.7 million in the nine months ended September 30, 2012 to RMB163.4 million (US$26.7 million) in the nine months ended September 30, 2013. Our net income increased by 96.2% from RMB10.5 million in the nine months ended September 30, 2012 to RMB20.6 million (US$3.4 million) in the nine months ended September 30, 2013.

Industry Background

The Chinese lottery market has experienced strong growth in recent years as a result of positive macro trends in China, such as robust economic growth, increases in disposable income and a more positive shift in public perception towards the lottery business. Total lottery sales in China amounted to RMB166.3 billion, RMB221.6 billion and RMB261.5 billion (US$42.7 million) in 2010, 2011 and 2012, respectively, representing a 33.3% and 18.0% increase in 2011 and 2012 from their respective preceding years, according to a report by the MOF. According to the iResearch Report, approximately 41.7%, 42.3% and 42.3% of the total sales of lottery products in China in 2010, 2011 and 2012 were attributable to sales of sports lottery products, respectively, and approximately 3.3%, 5.0% and 5.6% of total sales of lottery products in 2010, 2011 and 2012 in China were attributable to online lottery sales. According to the iResearch Report, although no accurate projection of the future growth of the Chinese lottery market can be guaranteed, the Chinese lottery market is expected to continue to grow in the near future due to the increasingly more transparent regulatory environment for the development of the lottery market in China and the continued growth of China’s GDP and individual disposable income. Total lottery sales in China is projected to be RMB308.0 billion, RMB374.3 billion and RMB450.3 billion in 2013, 2014 and 2015, respectively, representing a 17.8%, 21.5% and 20.3% increase in 2013, 2014 and 2015 from their respective preceding years, according to the iResearch Report. According to the iResearch Report, online sales amount for sports lottery products was approximately RMB2.3 billion, RMB4.7 billion and RMB6.2 billion (US$1.0 billion) in 2010, 2011 and 2012, respectively, representing a 104.3% and 31.9% increase in 2011 and 2012 from the respective preceding years. The iResearch Report projected online sales amount for sports lottery products to be RMB9.1 billion, RMB13.4 billion and RMB19.4 billion in 2013, 2014 and 2015, respectively, representing 46.8%, 47.3% and 44.8% increase from the respective preceding years.

 

 

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We believe that by leveraging our first mover advantage, we are well-positioned to capitalize on the growing online lottery market. We believe the growth of the online lottery market in China will be driven by:

 

   

growth of China’s gross domestic product, or GDP, and the increase of individual disposable income

 

   

government encouragement and more transparent regulatory environment

 

   

increasing public acceptance of the lottery industry

 

   

growth in the number of lottery purchasers

 

   

increasing Internet penetration in lottery distribution

Our Competitive Strengths

We believe the following competitive strengths have helped to make us a leading online lottery service provider in China:

 

   

a leading online lottery service platform in China with established and trusted brand

 

   

comprehensive and innovative services that enhance user experience

 

   

large and active user base

 

   

the only MOF-approved online lottery sales service provider with an operational track record and expertise

 

   

experienced and dedicated management team

Our Strategies

Our goal is to maintain and enhance our position as a leading online lottery service provider in China and to accelerate growth by building an integrated online service platform. To achieve our goal, we intend to leverage our competitive strengths and pursue the following strategies:

 

   

strengthen our brand name by concerted sales and marketing efforts

 

   

further enhance our specialized and sophisticated lottery purchase services

 

   

focus on the development of mobile services

 

   

enhance infrastructure and security system to ensure reliability and better user satisfaction

 

   

pursue strategic partnerships and acquisitions

Our Challenges

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

 

   

maintain our brand recognition and retain and expand our user base

 

   

maintain cooperation and strategic partnerships with provincial lottery administration centers

 

   

maintain and strengthen our position as a leading company in a competitive market

In addition, we also face risks and uncertainties relating to:

 

   

rules and regulations on online lottery sales service market in China which are relatively new and subject to interpretation, and their implementation involves uncertainties

 

   

suspension of our operation of online sales of sports lottery products if the operation of online sports lottery sales services by China Sports Lottery Administration Center fails to obtain further approval from the MOF

 

 

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We also face other risks and uncertainties that may materially affect our business, financial condition, results of operations and prospects. You should consider the risks discussed in “Risk Factors” and elsewhere in this prospectus before investing in our ADSs.

Our Corporate Structure

We began operations in the online lottery service industry in 2001 through one of our consolidated affiliated entities, Shenzhen E-Sun Network Co., Ltd., or E-Sun Network, in Shenzhen, China. In May 2006, E-Sun Network established its wholly owned subsidiary, Shenzhen E-Sun Sky Network Technology Co., Ltd., or E-Sun Sky Network, which became our major operating entity for our online lottery service business. To enable us to raise equity capital from investors outside of China, we set up a holding company structure by establishing our current Cayman Islands holding company, 500.com Limited, on April 20, 2007 under the name Fine Success Limited, which was changed to 500wan.com on May 9, 2011 and further changed to our current name on October 9, 2013. In June 2007, we established our wholly owned PRC subsidiary, E-Sun Sky Computer (Shenzhen) Co., Ltd., or E-Sun Sky Computer. We established two PRC consolidated affiliated entities in December 2008, Shenzhen Youlanguang Technology Co., Ltd., or Youlanguang Technology, and Shenzhen Guangtiandi Technology Co., Ltd., or Guangtiandi Technology. For more information on our corporate structure, including a detailed discussion of the consolidation of E-Sun Network and its wholly owned subsidiary, E-Sun Sky Network, Youlanguang Technology and Guangtiandi Technology, see “Our History and Corporate Structure.” In February and March 2011, we established Fine Brand Limited, a company registered in the British Virgin Islands, and 500wan HK Limited, a company registered in Hong Kong, as our wholly owned subsidiaries, respectively, and we transferred all the equity interests held by 500.com Limited in E-Sun Sky Computer to 500wan HK Limited in May 2011.

 

 

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The following diagram illustrates our corporate structure as of the date of this prospectus.

 

LOGO

 

(1) E-Sun Network is approximately 18.8% owned by Jiepin Fu, our director and beneficial owner, approximately 23.8% owned by Ping Yuan, our beneficial owner and wife of our founder, chairman and CEO, Man San Law, approximately 14.3% owned by He Li, brother of our director, Qi Li, 11.0% owned by Xue Li, sister of our director, Qi Li, approximately 14.9% owned by Ying Zou, our employee and beneficial owner, approximately 17.1% owned by Bo Zou, our beneficial owner and employee. All of these shareholders are parties to the contractual arrangements. Our online lottery services were primarily provided through E-Sun Sky Network, the wholly owned subsidiary of E-Sun Network.

 

(2) Youlanguang Technology is 50% owned by Jin Li and 50% owned by Jing Zhang, both of whom are our employees and parties to the contractual arrangements. Youlanguang Technology provides services relating to the management of our users’ registration information and accounts to E-Sun Sky Network.

 

(3) Guangtiandi Technology is 50% owned by Ying Wang and 50% owned by Liangdong Yuan, both of whom are our employees and parties to the contractual arrangements. Guangtiandi Technology provides services relating to the implementation of the technical interface with the provincial lottery administration centers and the printing of the lottery tickets to E-Sun Sky Network.

Our Corporate Information

Our principal executive offices are located at 500.com Building, Shenxianling Sports Center, Longgang District, Shenzhen, 518115, People’s Republic of China. Our telephone number at this address is +(86) 755 86330000 and our fax number is +(86) 755 83796070. Our registered office in the Cayman Islands is at 4th Floor, Willow House, P.O. Box 2804, Grand Cayman, KYI-1112, Cayman Islands. Our websites are www.500.com and www.500wan.com. The information contained on our websites does not constitute a part of this prospectus.

 

 

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Investor inquiries should be directed to us at the address and telephone number of our principal executive offices set forth above. Our agent for service of process in the U.S. is Law Debenture Corporate Services Inc.

Implications of Being an Emerging Growth Company

As a company with less than US$1.0 billion in revenue for our last fiscal year, we qualify as an “emerging growth company” pursuant to the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. An emerging growth company may take advantage of specified reduced reporting and other requirements that are otherwise generally applicable to public companies. These provisions include exemption from the auditor attestation requirement under Section 404 of the Sarbanes-Oxley Act of 2002, or Section 404, in the assessment of the emerging growth company’s internal control over financial reporting. The JOBS Act also provides that an emerging growth company does not need to comply with any new or revised financial accounting standards until such date that a private company is otherwise required to comply with such new or revised accounting standards. However, we have elected to “opt out” of this provision and, as a result, we will comply with new or revised accounting standards as required when they are adopted for public companies. This decision to opt out of the extended transition period under the JOBS Act is irrevocable.

We will remain an emerging growth company until the earliest of (a) the last day of our fiscal year during which we have total annual gross revenues of at least US$1.0 billion; (b) the last day of our fiscal year following the fifth anniversary of completion of this offering; (c) the date on which we have, during the previous three-year period, issued more than US$1.0 billion in non-convertible debt; or (d) the date on which we are deemed to be a “large accelerated filer” under the Securities Exchange Act of 1934, as amended, or the Exchange Act, which would occur if the market value of our ADSs that are held by non-affiliates exceeds US$700 million as of the last business day of our most recently completed second fiscal quarter. Once we cease to be an emerging growth company, we will not be entitled to the exemptions provided in the JOBS Act discussed above.

Conventions Which Apply to this Prospectus

In this prospectus, unless otherwise indicated or the context otherwise requires,

 

   

“we,” “us,” “our company,” and “our,” refer to 500.com Limited, its subsidiaries and consolidated affiliated entities;

 

   

“consolidated affiliated entities” refer to our variable interest entities, namely, E-Sun Network, Youlanguang Technology and Guangtiandi Technology, and where required by the context, E-Sun Sky Network, the wholly owned subsidiary of E-Sun Network.

 

   

“ordinary shares” refers to, prior to completion of this offering, our ordinary shares, par value US$0.00005 per share, and, after completion of this offering, our Class A and Class B ordinary shares, par value US$0.00005 per share;

 

   

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

 

   

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

 

   

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

 

   

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

Except as otherwise indicated, all information in this prospectus (i) assumes no exercises by the underwriters of their option to purchase additional ADSs, (ii) excludes ordinary shares issuable upon the exercise of outstanding options with respect to our ordinary shares under our 2011 share incentive plan and (iii) excludes ordinary shares reserved for future issuance under our 2011 share incentive plan. In addition, unless otherwise noted or required by the context, all ordinary share and per share information is adjusted to reflect the 1:20 share-split effected on April 26, 2011.

 

 

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Our reporting currency is the RMB. Unless otherwise stated, all translations of the RMB into U.S. dollars were made at RMB6.1200 to US$1.00, the noon buying rate on September 30, 2013, as set forth in the H.10 statistical release of the U.S. Federal Reserve Board. We make no representation that the RMB or U.S. dollar amounts referred to in this prospectus could have been or could be converted into U.S. dollars or RMB, as the case may be, at any particular rate or at all.

Recent Developments

Short-term loan

In October 2013, we entered into a US dollar denominated short-term loan agreement for a principal amount of RMB53.6 million (US$8.8 million) with Industrial and Commercial Bank of China, Paris Branch for general corporate purposes. The short-term loan is secured by HK dollar denominated bank deposits equivalent to RMB57.7 million (US$9.4 million) placed with Industrial and Commercial Bank of China, Shenzhen Branch in the PRC. The short-term loan bears interest at the rate of LIBOR plus 2.0% and is due within six months. The loan proceeds were used to pay the outstanding dividend amounts in full to certain of our shareholders.

Convertible note issued and sold to Sequoia

On October 21, 2013, pursuant to a convertible note purchase agreement, we issued a convertible note in an aggregate principal amount of US$20 million to Sequoia Capital 2010 CGF Holdco, Ltd., or Sequoia. The convertible note will be due on June 30, 2014 and bears interest at 10% per annum, or 13% per annum upon an event of default, in both cases uncompounded and computed on the basis of the actual number of days elapsed. The convertible note will be automatically converted into our Class B ordinary shares immediately upon completion of this offering. The conversion price per Class B ordinary share will be equal to 80% of the public offering price of our ADSs, adjusted to reflect our ADS-to-ordinary share ratio. Assuming a public offering price of US$             per ADS, the mid-point of the estimated range of the public offering price as set forth on the cover page of this prospectus, the convertible note would be automatically converted into              Class B ordinary shares upon completion of this offering. In the event of automatic conversion triggered by this offering, the convertible note will be deemed interest free between the date of issuance and the date of conversion.

Assuming that this offering occurs before December 31, 2013, in connection with the issuance and automatic conversion of the convertible note, we will recognize the amortization of the discount and issuance cost of the convertible note, change in the fair value of the embedded derivative in the aggregate amount of US$5.1 million through the consolidated statement of comprehensive income for the year and quarter ending December 31, 2013.

Concurrent private placement to Sequoia

Concurrently with, and subject to, completion of this offering, Sequoia has agreed to purchase from us our Class B ordinary shares, at a price equal to the public offering price of our ADSs in this offering, adjusted to reflect our ADS-to-ordinary share ratio, for a total purchase price of US$15 million in a concurrent private placement. Assuming a public offering price of US$             per ADS, the mid-point of the estimated range of the public offering price as set forth on the cover page of this prospectus, Sequoia will purchase              Class B ordinary shares in the concurrent private placement.

Option issuances to executive officers and employees

We issued options to purchase 2,660,000 ordinary shares to several executive directors and employees on October 22, 2013. The exercise price of each option is US$0.40 per share. Of these options, options to purchase 600,000 and 1.4 million ordinary shares will vest in six months and one year from the date of the issuance of the options, respectively; options to purchase 600,000 ordinary shares will vest in three annual equal installments.

We expect to recognize share-based compensation expenses in the amount of US$             per share based on the fair value of our company as of October 22, 2013 as determined with the assistance of our independent valuation firm. These expenses will be amortized according to these vesting schedules of these options commencing on the date of the issuance.

 

 

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THE OFFERING

 

Price per ADS

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

 

ADSs offered by us

            ADSs

 

ADSs offered by the selling shareholders

            ADSs, after the conversion of Class B ordinary shares into Class A ordinary shares on a 1:1 basis.

 

ADSs outstanding immediately after this offering

            ADSs (or             ADSs if the underwriters exercise in full the over-allotment option).

 

Ordinary shares outstanding immediately prior to completion of this offering

             ordinary shares.

 

Ordinary shares upon completion of this offering

Our ordinary shares will be divided into Class A and Class B ordinary shares upon completion of this offering. Holders of Class A ordinary shares and Class B ordinary shares will have the same rights except for voting and conversion rights. Each Class A ordinary share will be entitled to one vote on all matters subject to shareholders’ vote, and each Class B ordinary share will be entitled to ten votes on all matters subject to shareholders’ vote. Each Class B ordinary share will be convertible into one Class A ordinary share at any time by the holder thereof. Class A ordinary shares will not be convertible into Class B ordinary shares under any circumstance.

 

Class A ordinary shares outstanding immediately after completion of this offering

            Class A ordinary shares (or              Class A ordinary shares if the underwriters exercise in full the over-allotment option).

 

Class B ordinary shares outstanding immediately after completion of this offering

            Class B ordinary shares, which include (i)              Class B ordinary shares redesignated from our ordinary shares outstanding immediately prior to completion of this offering, (ii)              Class B ordinary shares to be issued upon automatic conversion of the convertible note and (iii)              Class B ordinary shares to be issued in the concurrent private placement to Sequoia, in each case assuming a public offering price of US$             per ADS, the mid-point of the estimated range of the public offering price as set forth on the cover page of this prospectus.

 

Over-allotment option

We and the selling shareholders have granted to the underwriters an option, exercisable for 30 days from the date of this prospectus, to purchase up to an aggregate of              additional ADSs at the public offering price, less the underwriting discounts and commissions.

 

Reserved ADSs

At our request, the underwriters have reserved for sale, at the public offering price, up to an aggregate of 5% of the ADSs offered in this offering to some of our directors, officers, employees, business associates and related persons through a directed share program.

 

 

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Sequoia concurrent private placement

Concurrently with, and subject to, completion of this offering, Sequoia has agreed to purchase from us our Class B ordinary shares, at a price per share equal to the public offering price of our ADSs in this offering, adjusted to reflect our ADS-to-ordinary share ratio, for a total purchase price of US$15 million. Assuming a public offering price of US$             per ADS, the mid-point of the estimated range of the public offering price as set forth on the cover page of this prospectus, Sequoia would purchase              Class B ordinary shares. This private placement is being made pursuant to an exemption from registration under the U.S. Securities Act of 1933, as amended, or the Securities Act, in reliance upon Regulation S under the Securities Act. See “Underwriting.” Class B ordinary shares to be issued and sold to Sequoia in this concurrent private placement will be subject to a 180-day lock-up arrangement commencing on the date of this prospectus.

 

The ADSs

Each ADS represents             Class A ordinary shares. The ADSs will be evidenced by American depositary receipts, or ADRs.

 

  The depositary will be the holder of the Class A ordinary shares represented by the ADSs and you will have the rights of an ADR holder as provided in the deposit agreement dated             , 2013 among us, the depositary and holders and beneficial owners of ADSs from time to time.

 

  You may surrender your ADSs to the depositary in exchange for the Class A ordinary shares represented by your ADSs. The depositary will charge you a fee for such an exchange.

 

  We may amend or terminate the deposit agreement for any reason without your consent. Any amendment that imposes or increases fees or charges or which materially prejudices any substantial existing right you have as an ADS holder will not become effective as to outstanding ADSs until 30 days after notice of the amendment is given to ADS holders. If an amendment becomes effective, you will be bound by the deposit agreement as amended if you continue to hold your ADSs.

 

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

 

Use of proceeds

We estimate that we will receive net proceeds of approximately US$             million from this offering and the concurrent private placement to Sequoia, assuming a public offering price of US$              per ADS, the mid-point of the estimated range of the public offering price as set forth on the cover page of this prospectus, after deducting underwriting discounts and commissions and estimated offering expenses payable by us. We anticipate using the net proceeds of this offering and the concurrent private placement for continuing investment in our technology platform, research and

 

 

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development, and sales and marketing initiatives, including advertising. We expect to use any remaining amounts for general corporate purposes, including working capital needs, incremental costs associated with being a public company and potential acquisitions. See “Use of Proceeds” for more information.

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

 

Risk factors

See “Risk Factors” and other information included in this prospectus for a discussion of the risks relating to investing in our ADSs. You should carefully consider these risks before deciding to invest in our ADSs.

 

Listing

We have applied to list our ADSs on the NYSE. Our ordinary shares will not be listed on any exchange or quoted for trading on any over-the-counter trading system.

 

NYSE symbol

WBAI

 

Depositary

Deutsche Bank Trust Company Americas

 

Lock-up

We, our directors, executive officers, our existing shareholders and option holders, Sequoia and holders of exchangeable notes which are exchangeable into our ordinary shares have agreed with the underwriters not to sell, transfer or dispose of any ADSs, ordinary shares or similar securities for a period of 180 days after the date of this prospectus. See “Shares Eligible for Future Sale” and “Underwriting.”

 

 

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SUMMARY CONSOLIDATED FINANCIAL AND OPERATING DATA

The following summary consolidated financial data for the periods and as of the dates indicated are qualified by reference to, and should be read in conjunction with, our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” both of which are included elsewhere in this prospectus.

Our historical results do not necessarily indicate our results to be expected for any future period.

 

    Year ended December 31,     For the nine months ended
September 30,
 
    2010     2011     2012     2012     2013     2013  
    RMB     RMB     RMB     US$     RMB     RMB     US$  
    (in thousands, except for per share data)   
Consolidated Statement of Comprehensive Income Data:                                          

Net Revenues

    157,378        232,332        171,527        28,027        130,736        163,411        26,701   

Operating expenses:

             

Cost of services

    (22,052     (24,425     (18,476     (3,019     (13,922     (19,564     (3,197

Sales and marketing

    (14,252     (52,471     (45,794     (7,483     (36,322     (61,201     (10,000

General and administrative

    (34,255     (101,996     (57,784     (9,442     (39,899     (46,517     (7,601

Service development expenses

    (9,299     (19,566     (26,571     (4,342     (17,673     (18,924     (3,092

Write-off of deferred initial public offering expenses

                  (6,404     (1,046     (6,404              
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

    (79,858     (198,458     (155,029     (25,332     (114,220     (146,206     (23,890

Other operating income

    4,667        6,455        4,193        685        4,139        11,371        1,858   

Government grant

           1,778        2,242        366        2,203        139        23   

Other operating expenses

    (537     (296     (1,821     (298     (1,582     (2,647     (433
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating profit

    81,650        41,811        21,112        3,448        21,276        26,068        4,259   

Interest income

    102        243        1,132        185        813        251        41   

Interest expense

                                       (430     (70
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before income tax

    81,752        42,054        22,244        3,633        22,089        25,889        4,230   

Income tax expenses

    (43,463     (28,497     (18,001     (2,940     (11,631     (5,291     (865
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

    38,289        13,557        4,243        693        10,458        20,598        3,365   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other Comprehensive income (loss):

             

Foreign currency translation gain (loss)

    70        (224     58        9        6        1,296        212   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

    38,359        13,333        4,301        702        10,464        21,894        3,577   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Reconciliation of net income to net income attributable to ordinary shareholders:

             

Net income

    38,289        13,557        4,243        693        10,458        20,598        3,365   

Accretion of Series A contingently redeemable convertible preferred shares

    (190                                          

Repurchase of Series B and B-1 contingently redeemable convertible preferred shares

    24,392                                             
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income attributable to ordinary shareholders

    62,491        13,557        4,243        693        10,458        20,598        3,365   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Earnings per share:

             

Basic

    0.27        0.06        0.02               0.05        0.09        0.01   

Diluted

    0.16        0.06        0.02               0.04        0.08        0.01   

Dividend declared per ordinary share

    0.69               0.39        0.06                        

Pro forma earnings per share(1)

             

Basic

             

Diluted

             

Non-GAAP financial data(2)

             

Adjusted net income (non-GAAP)(3)

    73,852        85,193        29,866        4,880        27,928        29,508        4,821   

 

(1) As adjusted to give effect to the issuance of              Class A ordinary shares on January 1, 2012 and 2013 at the mid-point of the estimated range of public offering price of US$             per share to pay RMB85.8 million dividend declared in excess of net income of RMB4.2 million for the year ended December 31, 2012.
(2)

As a supplement to net income, we use the non-GAAP financial measure of adjusted net income which is U.S. GAAP net income as adjusted to exclude share-based compensation and deferred tax expense relating to outside basis differences in our consolidated affiliated entities. This non-GAAP financial measure is provided as additional information to help our investors compare business trends among different reporting periods on a consistent basis and to enhance investors’ overall understanding of our current financial performance and

 

 

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  prospects for the future. This non-GAAP financial measure should not be considered in addition to or as a substitute for or superior to U.S. GAAP net income. In addition, our definition of adjusted net income may be different from the definition of such term used by other companies, and therefore comparability may be limited.

 

(3) We present adjusted net income (non-GAAP) excluding share-based compensation and deferred tax expense relating to outside basis differences from our consolidated affiliated entities. The following table reconciles our adjusted net income (non-GAAP) in 2010, 2011, 2012 and the nine months ended September 30, 2012 and 2013 to the net income calculated and presented in accordance with U.S. GAAP.

 

     Year ended December 31,      Nine months
ended September 30,
 
     2010      2011      2012      2012      2013  
     RMB      RMB      RMB      US$     

RMB

    

RMB

    

US$

 
    

(in thousands)

 

Net income

     38,289         13,557         4,243         693         10,458         20,598         3,365   

Adjustment for share-based compensation

             50,154         13,704         2,239         11,000         3,021         494   

Adjustment for deferred tax expense relating to outside basis differences

     35,563         21,482         11,919         1,948         6,470         5,889         962   

Adjusted net income (non-GAAP)

     73,852         85,193         29,866         4,880         27,928         29,508         4,821   

 

     As of December 31,      As of
September 30,
 
     2011      2012      2013  
     RMB      RMB      US$     

RMB

    

US$

 
    

(in thousands)

 

Consolidated Balance Sheet Data:

              

Total current assets

     308,523         329,821         53,893         417,225         68,174   

Total assets

     337,258         379,343         61,984         465,063         75,990   

Total current liabilities

     182,437         282,016         46,081         338,163         55,255   

Total liabilities

     262,909         381,963         62,412         442,768         72,348   

Total long-term debt

                                       

Contingently redeemable convertible preferred shares

                                       

Total shareholders’ equity (deficit)

     74,349         (2,620      (428      22,295         3,642   

Total liabilities and shareholders’ equity

     337,258         379,343         61,984         465,063         75,990   

The following tables set forth our user information and their purchase amounts during the indicated periods:

 

     Year ended December 31,      Nine months
ended
September 30,
 
         2010         2011          2012          2013  
     (in thousands)  

Active Accounts(1):

             

Newly Registered Accounts(2)

    
   968
  
    1,287         430         489   

Existing Accounts(3)

    
   418
  
       606         518         295   
  

 

 

   

 

 

    

 

 

    

 

 

 

Total

    
1,386
  
    1,893         948         784   
  

 

 

   

 

 

    

 

 

    

 

 

 
     Year ended December 31,      Nine months
ended
September 30,
 
         2010         2011          2012          2013  
     RMB     RMB     

RMB

     US$     

RMB

    

US$

 
     (in thousands)  

Purchase Amount:

                

Newly Registered Accounts(2)

     830,857        1,026,761         374,005         60,939         619,303         101,193   

Existing Accounts(3)

     964,662        1,489,472         1,299,493         211,733         1,356,182         221,598   
  

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     1,795,519        2,516,233         1,673,498         272,672         1,975,485         322,791   
  

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Defined as registered accounts which made at least one purchase during the year or the period.
(2) Defined as accounts registered during the year or the period.
(3) Defined as accounts registered prior to the year or the period.

 

 

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RISK FACTORS

Investing in our ADSs involves a high degree of risk. You should carefully consider the following risk factors and all other information contained in this prospectus before purchasing our ADSs. If any of the following risks occurs, our business, financial condition or results of operations could be materially and adversely affected. In that case, the trading price of our ADSs could decline, and you may lose some or all of your investment.

Risks Related to Our Business and Industry

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

We believe that our reputation in the industry and among our users as a leading reliable and trustworthy online lottery service provider and our “500wan” brand is of significant importance to the success of our business. A well-recognized brand is critical to increasing our user base and, in turn, increasing our net revenues from service fees. Since the online lottery service market is highly competitive, our ability to remain the market leader in China depends largely on maintaining and enhancing our reputation and brand, which may be difficult and expensive.

We have developed our reputation and established a leading position by providing our users with what we believe are superior and trustworthy services. We have conducted, and may continue to conduct, various marketing and brand promotion activities. We cannot assure you, however, that these activities will be successful and achieve the brand promotion and activity enhancement goals we expected. In addition, any negative publicity in relation to our services or products, regardless of its veracity, could harm our brand image and, in turn, have adverse effects on our user loyalty and stickiness, or result in a reduction in the number of our users. For example, we are aware of certain complaints against our websites on a number of online forums with regard to purchase order processing and prize collections. From 2010 through September 30, 2013, we received 86 complaints with regard to order processing and prize collection, and paid a total amount of RMB32,125 to resolve such complaints. Among the 86 complaints, nine involved compensation amounts over RMB1,000, and the highest amount was RMB4,200. Even though the allegations made in such complaints were not factually proven or the amounts in issue were diminutive, such complaints can nonetheless have a detrimental effect on our reputation. If we fail to maintain and enhance our reputation and brand, or if we incur excessive expenses in our efforts to do so, our business, financial condition and results of operations may be materially and adversely affected.

The rules and regulations on online lottery sales service market in China are relatively new and subject to interpretation, and their implementation involves uncertainty.

On September 26, 2010, the MOF issued the Interim Measures for the Administration of Online Sales of Lottery, or the Interim Measures, which allows qualified service providers to provide online lottery sales services after obtaining the approval by and the operating permit from the MOF. On January 18, 2012, the MOF, the Ministry of Civil Affairs and the General Administration of Sports of China jointly promulgated the Implementing Rules of Regulation on Administration of Lottery, or the Implementing Rules, which set forth, among other things, detailed requirements and qualifications for the approvals to conduct online lottery sales. For a description of relevant PRC laws and regulations on online lottery services, see “Regulations—Regulation on Lottery Services Industry and Online Lottery Sales.” Applications were submitted to the MOF in connection with the qualifications and approvals of our online lottery sales services for both sports and welfare lottery products provided on our websites, in accordance with the new measures. In October 2012, we were notified by China Sports Lottery Administration Center that we were one of the two entities that had been approved by the MOF to conduct online sales of sports lottery products in China on behalf of China Sports Lottery Administration Center. However, since the operation of online sports lottery sales services by China Sports Lottery Administration Center itself is in a pilot phase and is subject to further approval by the MOF, our operation of online sales of sports lottery products may be subject to suspension if China Sports Lottery Administration Center fails to obtain

 

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such further approval from the MOF. We are currently awaiting approval from the MOF to provide sales services for welfare lottery products. As the relevant rules and regulations are relatively new and we are one of the first two entities that have ever been approved by the MOF to conduct online sales of sports lottery products in China, we face uncertainties in the implementation of such rules and regulations by the competent authorities. The competent authorities may establish certain management systems to supervise and monitor the online lottery sales, which systems may comprise a sales monitoring system, a back-office management system and an application service platform. The competent authorities may also ask the approved entities, like us, to adopt certain measures to meet specific regulatory requirements that may be adopted from time to time. For example, the competent authorities may monitor or adjust the categories of lottery products being sold online, and supervise the sales procedures and key data of our online lottery sales on a real-time basis, such as those relating to our customer account opening procedures, capital management, database information and risk controls. In addition, we may be required to enter into new lottery agency agreements with the relevant lottery administration center that could have different terms and conditions from those in our existing service agreements with the relevant sports lottery administration centers. As a result, we may have to amend our existing service agreements. Any unfavorable new regulatory requirements or amendments to the key terms of our existing service agreements could have a material adverse effect on our business, financial condition, results of operations and prospects.

We have 12 years of operating experience in providing online lottery sales services. From March to November 2012, we suspended our online lottery sales services to substantially all of our customers in response to the Urgent Notice with regard to the Implementation of the Implementing Rules of Regulation on Administration of Lottery promulgated by the General Administration of Sports of China on February 28, 2012, or the Urgent Notice. We continued to provide lottery sales services via our mobile applications to mobile users and via our online platform to a limited number of loyal customers and generated service fees from such services. The PRC regulations on lottery sales services via mobile applications and their interpretations are subject to uncertainty. Our PRC legal counsel has advised us, given that the MOF has approved us as an authorized entity to conduct online lottery sales on behalf of China Sports Lottery Administration Center, our operation of lottery sales services prior to November 2012, including sales through our mobile applications and online platform, did not and will not likely to have a material adverse effect on us. However, under the rules and regulations on online lottery sales, the relevant PRC authorities have broad discretion on the lottery sales that are conducted without the approval by the MOF, and have the authority to impose sanctions thereon, including without limitation, levying fines, confiscating illegal income or suspending the operations and other sanctions. We have not received any legal sanctions, but there is no assurance that the competent authorities would not impose any legal sanction. Any legal sanctions imposed on us by the competent authorities could have a material adverse effect on our business, financial condition, results of operations and prospects.

Our product portfolio depends on the offerings of the lottery administration centers and could change unfavorably for us as a result of decisions made by them.

The lottery products we service are issued and sold by national and provincial lottery administration centers. We do not have the right to issue lottery products and cannot prevent the discontinuation of lottery products currently being offered. If the national lottery administration centers decide to discontinue one or more lottery products or to replace them with other products, this could lead to a decline in our purchase orders and thus have an adverse effect on our financial position and results of operations. In addition, if we want to provide services on newly issued lottery products, we have to enter into service agreements with the lottery administration centers that issue or sell such new lottery products. We cannot assure you that such service agreements can be entered into on terms favorable to us, or at all. If our competitors are able to enter into service agreements to service popular newly issued lottery products while we cannot, it could have an adverse effect on our revenue and brand name.

Lottery products offered by provincial lottery administration centers may be discontinued or subject to restriction and regulations by the relevant national lottery administration centers. Due to the popularity of certain lottery products we service, those provincial lottery administration centers with which we do not have service

 

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agreements might choose to issue similar lottery products on more competitive terms. This may result in a decrease in the purchase orders of those lottery products we service and, in turn, result in a decrease in the revenue we are able to generate from those lottery products. We cannot assure you that we will be able to reach an agreement with a provincial lottery administration center to obtain the right to service its lottery products that compete with products we currently service. In addition, the relevant lottery authorities could mandate the change of the rules or prize scheme of our current lottery products or stop the issuance of those lottery products altogether due to social policy or other considerations, which could have an adverse effect on our results of operations.

We depend on our agreements with a few provincial lottery administration centers for our service fees and such agreements could be terminated, amended or fail to be renewed.

Substantially all of our revenues were generated from service fees paid to us by a few provincial lottery administration centers. We have entered into non-exclusive service agreements with these lottery centers for terms of one year or five years, and the lottery administration centers may choose to enter into similar arrangements with other service providers. We have long-term, mutually beneficial partnerships with a few provincial lottery administration centers, such as Jiangxi Sports Lottery Administration Center. Service fees received from our single largest lottery administration center partner, all of which were generated from sports lottery products, accounted for 57.6%, 56.7%, 65% and 78.3% of our net revenues in 2010, 2011, 2012 and the nine months ended September 30, 2013, respectively. The service fees received from the lottery administration centers represent revenues recognized before the reduction of incentives paid to users and the residual amount of lottery pool contributed by us to the lottery centers. We have a service agreement with Jiangxi Sports Lottery Administration Center that is effective until October 2017 and renewable upon expiration, but Jiangxi Sports Lottery Administration Center can terminate its agreement with us for various reasons or decide not to renew the agreement upon expiration. For example, the service agreement provides that the Jiangxi Sports Lottery Administration Center has the right to monitor our operations and unilaterally terminate the service agreement if we violate relevant laws and regulations. If any of the provincial sports lottery administration centers terminates or decides not to renew its agreement with us, or if the agreement is amended to our disfavor, this could have an adverse effect on our business, results of operations and prospects, and we could lose a substantial portion of our revenues.

We have a limited history of being profitable and our business model is subject to uncertainties, which makes it difficult to evaluate our business.

We launched our online lottery services in 2001 and became profitable in 2007. We have a limited history of being profitable from 2007 to 2012 and a relatively new business model in an emerging and rapidly evolving market. This makes it difficult for you to evaluate our business, financial performance and prospects, and our historical growth rate may not be indicative of our future performance. Although we achieved profitability in recent periods, we cannot assure you that we will be able to achieve similar results or growth in the future. We may not be able to achieve or sustain profitability on a quarterly or annual basis. You should consider our prospects in light of the risks and uncertainties that fast-growing companies in a rapidly evolving market may encounter.

In particular, our net revenues in 2012 were RMB171.5 million (US$28.0 million), a 26.2% decrease as compared to 2011, and we recorded net income of RMB4.2 million (US$0.7 million) in 2012, as compared to RMB13.6 million in 2011 primarily due to the adverse impact of voluntary suspension. We cannot assure you that our users’ purchasing activities for sports lottery products will return to previous levels and continue to grow at a comparable pace as compared to that of the period prior to the voluntary suspension.

A significant portion of our service fees from 2010 to 2012 were generated from the sales of welfare lottery products for which we currently do not offer sales services.

Service fees generated from welfare lottery products were RMB38.2 million, RMB52.5 million and RMB25.9 million in 2010, 2011 and 2012, respectively, accounting for 23.1%, 21.3% and 14.0% of our service

 

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fees generated from lottery products in the same periods, respectively. We ceased to offer sales services for welfare lottery products in November 2012. Consequently, we did not generate any service fees from welfare lottery products in the nine months ended September 30, 2013. We plan to resume our online sales services for welfare lottery products after we obtain the relevant approval for such products from the MOF. Chongqing Welfare Lottery Administration Center notified us that it submitted an application for qualification and approval for the online lottery sales services for welfare lottery products to China Welfare Lottery Issuance and Administration Center on November 15, 2010, and such application would be further submitted by China Welfare Lottery Issuance and Administration Center to the MOF for approval. As of the date of this prospectus, Chongqing Welfare Lottery Administration Center had not updated us on the status of the application for welfare lottery products. Since the relevant regulations do not set forth a specific time limit for the MOF to issue such approval, we cannot assure you that we would be able to obtain such approval in the near future, or at all.

We operate in an intensely competitive environment, which may lead to declining revenue growth or other circumstances that would negatively affect our results of operations.

We operate in the new and dynamically growing online market for lottery products. There is no guarantee that we can maintain our position as one of the market leaders. Going forward, we anticipate significant competition, primarily from other online lottery service providers that may obtain relevant approvals and licences to provide online lottery sales services in China. When the approval and licensing system for online lottery service providers is fully implemented in China in the future, we may face increased competition from companies that do not currently operate in the online lottery services industry. For example, if major portal websites obtain relevant approvals and licences to offer lottery sales services, they may be able to offer similar services at a lower cost or to a larger user group due to their larger operational scales and user bases, which will put us at a competitive disadvantage. We also face competition from traditional offline lottery agents. If we do not recognize market trends or user demand in a timely manner, we may lose our market share to our competitors, which would have a negative impact on our results of operations.

According to the iResearch Report, we were among the first group of online lottery service providers in China. Since our inception, we have been offering a number of innovative services on our websites, such as lottery pool purchase services and automatic tag-along purchase services. Lottery pool is the purchase mode most favored by our users. Due to the popularity of lottery pool purchase services, competing websites have started to offer similar services. Since there are no adequate measures to protect the exclusivity of online service innovations or business models, we cannot assure you that new or existing services offered by us will not be imitated by our competitors.

The lottery industry in China in general and the online lottery service industry in particular may not grow as quickly as expected, which may adversely affect our revenues and business prospects.

Our business and prospects depend on the continuing development and expansion of the lottery industry in China in general and the online lottery service industry in particular. Both China’s lottery industry and the online lottery service industry have experienced substantial growth in recent years in terms of both the number of people purchasing lottery products and revenue generated. We cannot assure you, however, that the lottery industry or the online lottery service industry in China will continue to grow as rapidly as it has in the past, or the current trend of a faster growth rate of the lottery market in comparison to the growth rates of China’s GDP and individual disposable income will continue in the future. Growth of China’s lottery industry and the online lottery services industry are affected by numerous factors, such as GDP growth, growth of individual disposable income, regulatory changes, public perception and receptiveness, users’ trust and confidence level in the online lottery market, users’ general online purchase experience, technological innovations, development of the Internet and Internet-based services, and the macroeconomic environment. If the lottery industry or online lottery service industry in China does not grow as quickly as expected or if we fail to benefit from such growth by failing to successfully implement our business strategies, our user base may decrease and our business and prospects may be adversely affected.

 

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We depend on the technology and advanced information system, which may fail or be subject to disruption.

We are dependent on our IT systems for handling purchase orders, and the efficiency and reliability of our systems are in turn dependent on the functionality and stability of the underlying technical infrastructure. The functionality of the servers used by us and the related hardware and software infrastructure are of considerable significance to our business, our reputation and our ability to attract business partners and users. Our IT systems may be damaged or interrupted by increases in usage, human errors, unauthorized access, destruction of hardware, power cuts not covered by backup facilities, system crashes, software problems, virus attacks, natural hazards or disasters, or similar disruptions or disruptive events. Furthermore, our current IT systems may be unable to support a significant increase in online traffic or increased number of users, whether as a result of organic or inorganic growth of the business. We have in place business continuity procedures, disaster recovery systems and security measures to protect against network or technical failures or disruptions. Despite such procedures, failures in computer processing and weakness in the existing software and hardware cannot be completely prevented or eliminated. Any failure of our IT system and infrastructure could lead to significant costs and disruptions that could reduce our revenues, harm our reputation and have a material adverse effect on our operations.

In addition, we rely on bandwidth providers, communications carriers, data centers and other third parties for key aspects of the process in providing services to our users. Any failure or interruption in the services and products provided by these third parties could limit our ability to operate certain of our businesses, which could in turn have a material adverse effect on our business and financial condition.

We may not be able to develop and launch new services or new technologies in a timely manner or at all, and new services or technologies we manage to develop or provide may not be successful.

Our success in attracting new users and keeping existing users engaged depends on our ability to consistently develop and launch new and innovative services and technologies. Although we will continue to focus on research and development going forward, we cannot assure you that we will continue to be able to develop our technology to keep up-to-date with developments across the online lottery service industry and to launch new products or technologies in a timely manner or at all. New technologies and software are also less likely to be reliable, robust and resistant to viruses or failure. Given the fast growing online lottery service industry, we may not have enough time to fully test the new technologies and software we have developed before deploying them on our websites, which might cause service problems and negative user experience.

In particular, the number of people who access the Internet through non-PC devices such as mobile phones has increased in recent years. The software we have developed for these devices may not be widely adopted by users of such non-PC devices. The lower resolution, functionality and memory capacity associated with non-PC devices make the use of our services through such devices difficult. If we are unable to attract and retain a substantial number of non-PC device users to our services or if we are slow to develop services and technologies that are more compatible with non-PC devices relative to our competitors, we may fail to capture a significant share of new users or lose our existing users who switch to non-PC devices for their lottery purchase activities.

We could be subject to foreign laws and regulations applicable to lottery services, which could have important legal consequences for us.

We currently only conduct our operations in China, and will continue to do so in the future. We have blocked direct access to our websites and mobile applications from the United States through IP address filtering. We have implemented an identity verification procedure as part of the prize collection process. A user who has won a prize is required to provide his or her valid PRC identification card number and valid PRC bank account number to us for identity and age verification through a government designated entity before we transfer the prize money to such user’s online account registered at our websites and mobile applications. Despite such measures taken by us, it is conceivable that a user with a valid Chinese bank account and a Chinese identification card could place an order or collect a prize at our websites or mobile applications from a jurisdiction other than China and the United States, or that a user could devise a way to evade our blocking measures and access our websites and mobile applications from the United States. In addition, we have not been able to implement the

 

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same identity verification process over users registered with websites of third-party online service providers, which conduct their own identity verification processes, and these users may place purchase orders with us and collect prize money they win without providing their identity to us. As a result, we could be subject to foreign laws and regulations applicable to lottery services, which could have important legal consequences for us. The fact that our websites and mobile applications are accessible from a foreign jurisdiction could render our business operations subject to the laws and regulations of such jurisdiction, even though we do not have a physical presence in that jurisdiction. As a result, we could be required to obtain the requisite approval or license for lottery services in such jurisdiction, or could be deemed to have violated the prohibition against lottery services in that jurisdiction.

If we were found to have violated any applicable foreign laws and regulations applicable to lottery services, we could face civil or even criminal liabilities, such as injunctions, restrictive orders, damage awards or fines. Even if we successfully defend ourselves against such allegations, we could nevertheless incur considerable costs in such defense or suffer reputational damage due to the negative publicity associated with such allegations.

Our systems and controls to restrict access to our websites from persons located in the United States may not be adequate.

In the United States, some credit card companies have classified online purchase orders of U.S. state-issued lottery products as online gambling and thus denied such purchase orders, despite the fact that many such purchases are exempt from the Unlawful Internet Gambling Enforcement Act, or UIGEA, enacted in 2006. The UIGEA is silent on whether lottery products issued by non-U.S. state entities are exempt from the definition of online gambling. There are several other U.S. federal laws relevant to online gaming, including the Professional and Amateur Sports Protection Act, the Federal Interstate Wire Act, the Illegal Gambling Business Act, the Interstate Transportation of Wagering Paraphernalia Act and the Interstate and Foreign Travel or Transportation in Aid of Racketeering Enterprising Act. In addition, laws and regulations exist in various individual U.S. states that limit or prohibit online games of chance. Although the services we provide to our users are solely related to lottery products issued and sold by national and authorized provincial lottery administration centers in China, we cannot assure you that the United States Department of Justice or other federal or state regulatory authorities will not deem our business as being in violation of the UIGEA or any of the laws mentioned above if purchase orders are placed on our platform from users in the United States not successfully blocked by our system. Violations of such laws can lead to criminal and civil penalties, including substantial fines, injunctions, damage claims and jail terms for persons accountable.

As a precaution, we have implemented technological and other measures to prevent persons in the United States from accessing our websites and mobile applications. These measures could fail or otherwise be inadequate, either currently or as a result of future technological developments. This may result in allegations or accusations of our violations of the above-mentioned or other applicable laws or regulations of the United States, and actions brought against us based on such violations, which could have a material adverse effect on our operations, financial performance and prospects.

Our service agreements with certain third-party Internet companies may be amended or terminated.

We generate a portion of our net revenues pursuant to cooperation agreements with certain third-party Internet companies. We build and maintain embedded lottery purchase webpages for websites of these Internet companies which redirect user purchase orders to our websites. We pay these third-party Internet companies a predetermined fixed percentage of the total purchase amount generated by purchase orders redirected to us from their websites. In 2010, 2011, 2012 and the nine months ended September 30, 2013, such payments to certain Internet companies accounted for 6.5%, 6.2%, 4.7% and 5.6% of our net revenues, respectively. We also provide lottery information packages to the lottery information channels of some portal websites. The third-party Internet companies that we work with may request amendments to the material terms of our cooperation agreements in a manner that is unfavorable to us or decide to terminate such cooperation agreements. In particular, if any of these companies decide to start offering its own online lottery services after terminating its cooperation arrangement with us, users formerly redirected to our websites through websites of these companies may decide to use these companies’ services instead, which would have a negative impact on our net revenues.

 

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We are exposed to contractual claims by third parties arising from regulatory actions, which could damage our reputation and results of operations.

We have entered into various service, online payment and advertisement agreements with a number of third parties. Many of these agreements contain warranties, indemnities and termination provisions in which we have made representations and warranties to the counterparties as to the legitimacy of our operations and our compliance with relevant laws and regulations. If a claim or regulatory action is brought against our counterparties alleging that our historical business conduct breached such provisions on which our counterparties have relied, whether as a result of judicial proceedings or a change of law or otherwise, we may face material claims or regulatory actions and may owe damages to the relevant third parties. We may also remain liable for any outstanding fees payable to the counterparty of an agreement which has been terminated.

Any extended periods in the future without our users winning substantial prizes could result in losses in revenues and profits for us.

As of September 30, 2013, three prizes of over RMB10 million, 55 prizes of RMB5 million to RMB10 million, and 365 prizes of RMB1 million to RMB5 million had been awarded to users who purchased their lottery products using our online lottery service platform. Our users’ record of winnings is one of the factors contributing to our ability to attract new users and retain existing users. Winning of number-based lotteries arise purely by chance during the lottery draws. No assurance can be given that there will not be long periods in the future without any of our users winning a prize of significant amount, which could lead to a reduction in user activity and therefore a shortfall in our revenue and profit.

Our operations and services relating to sports lottery products depend on the scheduling and live broadcasting of major sports events.

Our operations and services relating to sports lotteries are affected by the scheduling and live broadcasting of the underlying sports events. In particular, a significant portion of our service fees are derived from results of international soccer games. Disruptions to the scheduling and broadcasting of those games may have a material impact on our results of operations. In some instances, the scheduling of major sports events occurs seasonally (for example, European soccer) or at regular but infrequent intervals (for example, the FIFA World Cup). The cancellation, postponement or curtailment of significant sports events, due to, among other things, adverse weather conditions, terrorist acts, other acts of war or hostility or the outbreak of infectious diseases, or cancellation of, disruption to, or postponement of the live broadcasting of such sports events, due to contractual disputes, technical or communication problems, or the insolvency of a major broadcaster, could materially adversely affect our operations and services relating to sports lotteries.

Future strategic acquisitions may have a material adverse effect on our business, reputation and results of operations.

Although we have no current acquisition plans, we may acquire additional assets, products, technologies or businesses that are complementary to our existing business if we are presented with appropriate opportunities. Future acquisitions and subsequent integration of newly acquired assets and businesses into our own would require significant attention from our management and could result in a diversion of resources from our existing business, which in turn could have an adverse effect on our business operations. Acquired assets or businesses may not generate the financial results we expect. In addition, acquisitions could result in the use of substantial amounts of cash, potentially dilutive issuances of equity securities, the occurrence of significant goodwill impairment charges, amortization expenses for other intangible assets and exposure to potential unknown liabilities of the acquired business. Moreover, the cost of identifying and consummating acquisitions may be significant. In addition to possible shareholders’ approval, we may also have to obtain approvals and licenses from the relevant government authorities in the PRC for the acquisitions and to comply with any applicable PRC laws and regulations, which could result in increased cost and delay.

 

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Negative publicity about our operations, or problems such as underage and compulsive lottery activities, fraud and corruption in sports matches may adversely affect our reputation and business.

Social responsibility policies are a key consideration in lottery laws and regulations. There are concerns as to the ability of online lottery service providers to effectively block minors from purchasing lottery products online and the possible increase in compulsive lottery activity due to the relative ease of making online lottery purchases. Publicity regarding such concerns could harm our brand and image. If the perception develops that online lottery operators or the lottery industry as a whole is failing to adequately protect minors and vulnerable lottery purchasers, we may face increased social resistance. Damage to the industry’s reputation could also lead to the withdrawal of support for the industry from the government or the tightening of regulations, which may have a material adverse effect on our business.

Negative publicity about potential fraud (including money laundering) and corruption in sports matches (including collusion and match-fixing), even if not directly or indirectly connected with us or our services, may adversely impact our reputation and the willingness of the public to participate in the purchase of sports lotteries. As a result, the number of potential users available to us could be adversely affected.

Undetected errors with regard to historical or real-time data in our information platform could adversely affect our user experience, which may materially and adversely affect our reputation and business.

As of September 30, 2013, our information database provided to our users real-time updated information on all 13 national lottery products and 55 provincial lottery products, as well as historical data, charts analytical tools and account management tools and functions. Although we intend to ensure the accuracy and reliability of all data in our information database, in a number of instances, users have complained on online forums of being misled by the wrong historical data and users have also alleged that the winning numbers posted by us differ from the actual winning numbers published by the relevant national or provincial lottery administration centers. Such complaints and allegations, whether with or without merit, may damage our reputation as a credible online lottery service provider and adversely affect user experience, which could materially and adversely affect our reputation and business.

We may fail to detect fraudulent activities of our users or employees.

Online transactions may be subject to sophisticated schemes or collusion to defraud or other illegal activities, and there is a risk that our platform may be used for those purposes either by our users or our employees. While we make continuing efforts to protect our business and our users from such illegal activities, including a user identity verifying system and pre-payment procedures to protect against fictitious transactions, the controls and procedures we have implemented may not be effective in all cases. Failure to protect our operations and our users from fraudulent activity either by other users or our employees could result in reputational damage to us and could materially and adversely affect our results of operations.

We rely on individual employees to handle prize collection using their personal bank accounts, which creates a risk of misappropriation of funds.

Under the current prize payout rules for national and provincial lottery products, prizes can only be claimed by natural persons who present the winning lottery tickets at the time of collection. Since we do not distribute physical tickets to individual users and need to collect prizes on behalf of the winning users, we rely on certain of our employees to maintain bank accounts opened in their individual names into which winning prizes are first deposited before they are transferred into the bank account of Shenzhen Youlanguang Technology Co., Ltd., or Youlanguang Technology, which then allocates the prize money to the winners’ accounts. We have adopted several measures to ensure that such individual accounts are under our strict control. See “Our Business—Purchase Order Processing and Prize Collection.” Although we have never had an incident where prize money deposited in an employee’s account was misappropriated, there is no assurance that misappropriations of prize money will not happen in the future, which could have an adverse effect on our reputation and financial results.

 

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Failure to adequately protect user account information could have a material adverse effect on us.

We process our users’ personal data (including name, address, age, bank details and lottery purchase history) as part of our business and therefore must comply with data protection laws in China. Data protection laws restrict our ability to collect and use personal information relating to our users and potential users. Notwithstanding our IT and data security and other systems, we may not be effective in detecting any intrusion or other security breaches, or safeguarding against sabotage, hackers, viruses and cyber crime. We are exposed to the risk that personal data could be wrongfully accessed and/or used, whether by employees, users or other third parties, or otherwise lost or disclosed or processed in breach of data protection laws. If we or any of the third party service providers whom we rely on fail to transmit users information and payment details online in a secure manner or if any such theft or loss of personal users data were to otherwise occur, it could subject us to liabilities under the data protection laws or result in the loss of the goodwill of our users.

We have no insurance coverage against product liability claims or business interruptions.

As the insurance industry in China is still in an early stage of development, insurance companies in China currently offer limited business insurance products. We do not have any product liability insurance or business interruption insurance. As we continue to increase the number of lottery products we service, we may be increasingly exposed to claims related to such lottery products. Any such claims, business disruption, or natural disaster could result in us incurring substantial costs and a diversion of our resources away from our business, which would have an adverse effect on our business and results of operations.

We plan to incur significant costs on a variety of marketing efforts designed to increase our net revenues and some marketing campaigns and methods may not be effective.

We have been and plan to continue to engage in a variety of different marketing efforts tailored to our targeted users to increase our user base and user activity level. For more details, see “Business—Sales, Marketing and Branding” and “Business—Our Strategies—Strengthen our brand name by concerted sales and marketing efforts.” Our marketing activities, which we expect to involve significant costs, may not be well received by users and may not result in increases in net revenues that we anticipate. Marketing approaches and tools in the online lottery market in China are evolving. This further requires us to enhance our marketing approaches and experiment with new marketing methods to keep pace with industry developments and user preferences. Failure to refine our existing marketing approaches or to introduce new effective marketing approaches in a cost-effective manner could reduce our market share, cause our net revenues to decline and negatively impact our profitability.

We might not be able to adequately protect our intellectual property rights.

We believe our trademarks, software, technology know-how and other intellectual property provide competitive advantages to us, which are important to our achievements to date and our future success. We have invested significant resources to develop our brand name, 500wan, which is an important asset to us. We cannot assure you that steps taken to protect our intellectual property rights will be sufficient to prevent infringement of our intellectual property rights. If we fail to adequately protect our intellectual property rights, including our rights in our trademarks and know-how, it could have a material adverse effect on our operations.

The validity, enforceability and scope of protection available under intellectual property laws with respect to the Internet industry in China are uncertain and evolving. Implementation and enforcement of PRC intellectual property-related laws have historically been deficient and ineffective. Accordingly, protection of intellectual property rights in China may not be as effective as in the United States or other western countries. Furthermore, policing unauthorized use of proprietary technology is difficult and expensive, and we may need to resort to litigation to enforce or defend our copyrights or other intellectual property rights or to determine the enforceability, scope and validity of our proprietary rights or those of others. Such litigation and any adverse determination thereof could result in substantial costs and diversion of resources and management attention away from our business.

 

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We may be subject to allegations or liabilities for infringement of third-party intellectual property rights based on the content available on our websites or information services we provide.

We provide our users with real-time and historical lottery-related news, data, analyses, real-time match scores and other content on our information platform. We obtain such content from a third-party professional sports information agency as well as publicly available sources. The user forum of our websites also hosts a significant amount of content generated by our users. We cannot assure you that we will not be subject to allegations, claims or lawsuits by third parties regarding the use of lottery or sports related information or any other content on our websites, which may infringe upon the intellectual property rights of such third parties. If such claims are found valid by the courts and we are ordered to remove the content from our websites, our information platform will become less attractive and our user experience and satisfaction will be adversely affected. Even if we successfully defend ourselves against such claims or allegations, we could nevertheless incur considerable costs in such defense or suffer reputational damage due to the negative publicity associated with such claims or allegations.

We rely on our senior management and key employees.

Our success is dependent upon the expertise and continued service of our senior management and other key personnel. Our founder, Chairman and Chief Executive Officer, Mr. Man San Law, has 12 years of experience in the lottery service industry. Mr. Law is a pioneer of the online lottery service market who has been at the forefront of developing innovative online products and solutions and has established relations with market participants in China. Most of our senior management team members have 12 years of experience in information technology or Internet related industries. They are crucial to our smooth operation and continued innovation. In addition, we rely on a limited number of specialized staff members in certain areas of our IT operations where we do not receive support from external service providers. Furthermore, our ability to expand our operations to accommodate our anticipated growth will also depend on our ability to attract and retain additional personnel such as qualified risk managers, finance, management, marketing, technical and other personnel. Competition for these employees is intense due to the limited number of qualified personnel. It may be difficult for us to manage our business and meet our objectives if we fail to attract and retain such personnel and our results of operations or financial condition may be adversely affected.

We are dependent on external service providers with respect to payment and settlement processing, and the provision of faulty services by these providers could lead to financial loss and damage to our reputation.

We are dependent on cooperation with external service providers with specialist knowledge and technology for processing lottery purchase orders. This includes, among other things, data and voice communication, procurement, installation, further development, maintenance and servicing of hardware and software, server housing and payment processing. It is possible that one or more of the external service providers do not perform the services, or that they do not perform them in a timely and accurate manner. It is therefore possible that, due to failures or omissions by the external service providers that we have engaged, we will not be in a position to perform our own services faultlessly or on time. This could lead to revenue losses, liability for damage, and substantial damage to our reputation.

We depend on payment processing for the success of our business.

We require our users to deposit funds in their registered accounts in advance of any lottery purchases. Users’ prize money are also deposited in and withdrawn from their respective accounts. Therefore, the provision of convenient, trusted and effective payment processing services to our users and potential users is critical to our business. If there is any deterioration or perceived deterioration in the quality of the payment processing services provided by us or any interruption to those services, or if our payment processing services are not performed in a timely manner, our users and potential users may be deterred from using our online lottery services, and we may be subject to user complaints and allegations concerning the mishandling of their funds, which may damage our reputation and have a material adverse effect on our business and results of operations.

 

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

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

 

   

seasonality of sports events on which sport lotteries are based;

 

   

change of lottery issuance schedules by the lottery issuance authorities;

 

   

changes in government policies or regulations, or their enforcement;

 

   

economic conditions in China and worldwide; and

 

   

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

Our operating results tend to be seasonal. For instance, we may have lower net revenues during the first quarter of each year primarily due to the Chinese New Year holidays in that quarter.

We could be subject to administrative penalties or business losses if our current user identity verifying system cannot sufficiently prevent us from taking purchase orders from underage users.

According to the Regulation on Administration of Lottery issued by the State Council which came into effect on July 1, 2009, a lottery service provider may be subject to administrative penalties from the local civil affairs authority or the sports administration authorities if it takes lottery purchase orders from underage users. The lottery administration centers have the right to terminate their service agreements with a service provider if it becomes subject to administrative penalties. It is still unclear which security mechanisms have to be introduced for online service providers to protect minors. Although we have adopted a user identity verifying system which allows us to filter out underage users, we cannot assure you that our current system is sufficient for us to identify all underage users. If the relevant authorities determine that we are in violation of any relevant regulations, we may be subject to administrative penalties and we may lose our service agreements with the lottery operation centers.

In addition, a registration process that is as simple as possible and takes only a short time to complete is an important factor in our ability to attract new users. Currently, the age verification step of our registration process is relatively simple. If it becomes apparent that this measure is inadequate, the registration process might have to be made more lengthy and difficult for more in-depth checks, such as requiring users to provide a copy of their Chinese ID card or other identification documents as part of the registration process, which could decrease the number of new registrations or lead to a decrease in users. This could have a material adverse effect on our financial condition and results of operations.

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

We will be subject to reporting obligations under U.S. securities laws after this offering. Our reporting obligations as a public company will place a significant strain on our management, operational and financial resources and systems for the foreseeable future. Prior to this offering, we have been a private company and have had limited accounting personnel and other resources with which to address our internal control over financial reporting. We and our independent registered public accounting firm, in connection with the preparation and

 

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external audit of our consolidated financial statements as of and for the fiscal year ended December 31, 2012, have identified certain material weaknesses and a control deficiency, each as defined in the U.S. Public Company Accounting Oversight Board Standard AU Section 325, Communications About Control Deficiencies in an Audit of Financial Statements, or AU325, in our internal control over financial reporting. As defined in AU325, a “material weakness” is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.

The material weaknesses identified related to (i) insufficient personnel with U.S. GAAP expertise in the preparation of the financial statements and related disclosures in accordance with U.S. GAAP and SEC reporting requirements; and (ii) lack of an effective independent oversight function to prevent and detect misstatements in financial statements. Neither we nor our independent registered public accounting firm undertook a comprehensive assessment of our internal control for purposes of identifying and reporting material weaknesses and other control deficiencies in our internal control over financial reporting as we and they may be required to do after we become a public company. In light of the number of material weaknesses and other control deficiencies that were identified as a result of the limited procedures performed, we believe it is possible that, had we performed a formal assessment of our internal control over financial reporting or had our independent registered public accounting firm performed an audit of our internal control over financial reporting, additional control deficiencies may have been identified.

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

Upon completion of this offering, we will become subject to the Sarbanes-Oxley Act of 2002. Section 404 of the Sarbanes-Oxley Act will require that we include a report from management on the effectiveness of our internal control over financial reporting in our annual report on Form 20-F beginning with our annual report for the fiscal year ending December 31, 2014. In addition, beginning at the same time, our independent registered public accounting firm may be required to report on the effectiveness of our internal control over financial reporting. If we fail to remedy the problems identified above, our management and our independent registered public accounting firm may conclude that our internal control over financial reporting is not effective. This could adversely impact the market price of our ADSs due to a loss of investor confidence in the reliability of our reporting processes. We will need to incur significant costs and use significant management and other resources in order to comply with Section 404 of the Sarbanes-Oxley Act.

Our grant of employee share options, restricted shares or other share-based compensation and any future grants could have an adverse effect on our net income.

U.S. GAAP prescribes how we account for share-based compensation and may have an adverse impact on our results of operations or the price of our ADSs. U.S. GAAP requires us to recognize share-based compensation as compensation expense in the consolidated statement of comprehensive income generally based on the fair value of equity awards on the date of the grant, with compensation expense recognized over the period in which the recipient is required to provide service in exchange for the equity award. The expenses associated with share-based compensation may reduce the attractiveness of issuing share options or restricted shares under our equity incentive plan. However, if we do not grant share options or restricted shares, or reduce the number of share options or restricted shares we grant, we may not be able to attract and retain key personnel. If we grant more share options or restricted shares to attract and retain key personnel, the expenses associated with share-based compensation may adversely affect our net income.

 

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Risks Related to Our Corporate Structure

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

Current PRC laws and regulations place certain restrictions on foreign ownership of companies that engage in the Internet and lottery businesses. We conduct our operations in China principally through contractual arrangements among our wholly owned PRC subsidiary, E-Sun Sky Computer, our consolidated affiliated entities in the PRC and their respective shareholders. Our online lottery services were primarily provided through E-Sun Sky Network, the wholly owned subsidiary of E-Sun Network. E-Sun Sky Network owns and manages our operating websites, namely, www.500wan.com and www.500.com. Guangtiandi Technology and Yonglanguang Technology were established to provide technical support to E-Sun Sky Network. Youlanguang Technology provides services to E-Sun Sky Network relating to the management of our users’ registration information and accounts, while Guangtiandi Technology provides services to E-Sun Sky Network relating to the implementation of the technical interface with the provincial lottery administration centers, the maintenance of our lottery ticket database, and the printing of lottery tickets when needed for the purpose of prize collection. Our contractual arrangements with E-Sun Network, Guangtiandi Technology, Youlanguang Technology and their respective shareholders (i) enable us to exercise effective control over these entities, and (ii) give us the obligation to absorb losses and the right to receive benefits of these entities, requiring us to treat them as our consolidated affiliated entities and to consolidate their operating results. For a detailed discussion of these contractual arrangements, see “Our History and Corporate Structure.”

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

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

Since PRC laws restrict foreign equity ownership in companies engaged in the Internet and lottery businesses in China, we rely on contractual arrangements with our consolidated affiliated entities and their respective shareholders to operate our business in China. If we had direct ownership of E-Sun Network, Guangtiandi Technology or Youlanguang Technology, we would be able to exercise our rights as a shareholder to effect changes in the board of directors of E-Sun Network, Guangtiandi Technology or Youlanguang Technology, which in turn could effectuate changes at the management level, subject to any applicable fiduciary obligations. However, under the current contractual arrangements that were executed on June 1, 2011 and amended on May 2, 2013, we rely on our consolidated affiliated entities and their respective shareholders’ performance of their contractual obligations to exercise effective control over our business in China. In addition, our contractual arrangements generally have a term of 10 years with an automatic extension for a number of years to be determined by E-Sun Sky Computer, which is subject to E-Sun Sky Computer’s unilateral termination right. In general, neither our consolidated affiliated entities nor their respective shareholders may terminate the

 

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contracts prior to the expiration date. However, the shareholders of E-Sun Network, Guangtiandi Technology or Youlanguang Technology may not act in the best interests of our company or may not perform their obligations under these contracts, including the obligation to renew these contracts when their initial term expires. Such risks exist throughout the period in which we intend to operate our business through the contractual arrangements with our consolidated affiliated entities and their respective shareholders. We may replace the shareholders of our consolidated affiliated entities at any time pursuant to our contractual arrangements with them and their shareholders. However, if any dispute relating to these contracts remains unresolved, we will have to enforce our rights under these contracts through the operations of PRC law, arbitration and courts and therefore will be subject to uncertainties in the PRC legal system. See “—Any failure by our consolidated affiliated entities or their respective shareholders to perform their obligations under our contractual arrangements with them may have a material adverse effect on our business.” Therefore, these contractual arrangements may not be as effective as direct ownership in providing us with control over these consolidated affiliated entities.

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

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

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

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

Under applicable PRC tax laws and regulations, arrangements and transactions among related parties may be subject to audit or scrutiny by the PRC tax authorities within 10 years after the taxable year when the arrangements or transactions are conducted. We could face material and adverse tax consequences if the PRC tax authorities were to determine that the contractual arrangements among E-Sun Sky Computer, our wholly owned subsidiary in China, our consolidated affiliated entities in China and their respective shareholders were not entered into on an arm’s-length basis and therefore constituted unfavorable transfer pricing arrangements. Unfavorable transfer pricing arrangements could, among other things, result in an upward adjustment on taxation. In addition, the PRC tax authorities may impose interest on late payments on our consolidated affiliated entities for the adjusted but unpaid taxes. Our results of operations may be materially and adversely affected if our consolidated affiliated entities’ tax liabilities increase significantly or if they are required to pay interest on late payments.

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

We provide no incentives to the shareholders of our consolidated affiliated entities for the purpose of encouraging them to act in our best interests in their capacity as the shareholders of our consolidated affiliated entities. We may replace any of the shareholders of our consolidated affiliated entities at any time pursuant to the amended and restated equity option agreements. In addition, each of the shareholders of our consolidated affiliated entities has executed a power of attorney to appoint E-Sun Sky Computer or any person designated by E-Sun Sky Computer to vote on their behalf and exercise full voting rights as shareholders of the consolidated

 

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affiliated entities. We cannot assure you that when conflicts arise, the shareholders of our consolidated affiliated entities will act in the best interests of our company or that conflicts will be resolved in our favor. If we cannot resolve any conflicts of interest or disputes between us and the shareholders of our consolidated affiliated entities, we would have to rely on legal proceedings, which may be expensive, time-consuming and disruptive to our operations. There is also substantial uncertainty as to the outcome of any such legal proceedings.

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

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

Under PRC laws and regulations, E-Sun Sky Computer, as a wholly foreign-owned enterprise in the PRC, may pay dividends only out of its accumulated profits as determined in accordance with PRC accounting standards and regulations. In addition, a wholly foreign-owned enterprise such as E-Sun Sky Computer is required to set aside at least 10% of its accumulated after-tax profits each year, if any, to fund a statutory reserve fund, until the aggregate amount of such a fund reaches 50% of its registered capital. At its discretion, it may allocate a portion of its after-tax profits based on PRC accounting standards to staff welfare and bonus funds. These reserve funds and staff welfare and bonus funds are not distributable as cash dividends. Any limitation on the ability of E-Sun Sky Computer to pay dividends or make other distributions to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our business, pay dividends, or otherwise fund and conduct our business.

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

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

 

   

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

 

   

loans by us to our PRC subsidiaries, each of which is a foreign-invested enterprise, to finance their activities cannot exceed the statutory limit, which is the difference between the registered capital and the amount of total investment as approved by the Ministry of Commerce or its local counterparts, and must be registered with the PRC State Administration of Foreign Exchange, or SAFE, or its local branches; and

 

   

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

 

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On August 29, 2008, SAFE promulgated the Circular on the Relevant Operating Issues Concerning the Improvement of the Administration of the Payment and Settlement of Foreign Currency Capital of Foreign Invested Enterprises, or SAFE Circular 142, regulating the conversion by a foreign-invested enterprise of foreign currency registered capital into Renminbi by restricting how the converted Renminbi may be used. SAFE Circular 142 provides that the Renminbi capital converted from foreign currency registered capital of a foreign-invested enterprise may only be used for purposes within the business scope approved by the applicable governmental authority and may not be used for equity investments within the PRC, unless it is provided for otherwise. In addition, SAFE strengthened its oversight of the flow and use of the Renminbi capital converted from foreign currency registered capital of a foreign-invested company. The use of such Renminbi capital may not be altered without SAFE approval, and such Renminbi capital may not in any case be used to repay Renminbi loans if the proceeds of such loans have not been used. Violations of SAFE Circular 142 could result in severe monetary or other penalties. We expect that if we convert the net proceeds we receive from this offering into Renminbi pursuant to SAFE Circular 142, our use of Renminbi funds will be for purposes within the approved business scope of our PRC subsidiary. Such business scope includes “technical services,” which we believe permits our PRC subsidiary to purchase or lease servers and other equipment for their own technical data and research and to provide operational support to our consolidated affiliated entities. However, we may not be able to use such Renminbi funds to make equity investments in the PRC through our PRC subsidiary. Furthermore, SAFE promulgated a circular on November 9, 2010, or Circular 59, which requires the authenticity of settlement of net proceeds from offshore offerings to be closely examined and the net proceeds to be settled in the manner described in the offering documents. SAFE further promulgated the Circular on Further Clarification and Regulation of the Issues Concerning the Administration of Certain Capital Account Foreign Exchange Businesses, or Circular 45, on November 9, 2011, which expressly prohibits foreign-invested enterprises from using the registered capital settled in Renminbi converted from foreign currencies to grant loans through entrustment arrangements with a bank, repay inter-company loans or repay bank loans that have been transferred to a third party. Circular 142, Circular 59 and Circular 45 may significantly limit our ability to transfer the net proceeds from an offering to our PRC subsidiaries and convert the net proceeds into Renminbi, which may adversely affect our liquidity and our ability to fund and expand our business in the PRC.

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

Risks Related to Doing Business in China

The complexities, uncertainties and rapid changes in PRC regulation of Internet business and companies require significant resources for compliance.

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

 

   

There are uncertainties relating to the regulation of the Internet business in China, including evolving licensing practices. This means that permits, licenses or operations at some of our companies may be

 

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subject to challenge, or we may fail to obtain permits or licenses that may be deemed necessary for our operations or we may not be able to obtain or renew certain permits or licenses. The major permits and licenses that could be involved include, without limitation, the Permit for Operation of Value-Added Telecom Services, or VAS license, issued by the Ministry of Industry and Information Technology, or the MIIT. Pursuant to the VAS license issued to E-Sun Sky Network by Telecommunication Management Bureau of Guangdong Province in February 2013, E-Sun Sky Network is permitted to provide internet information services within Guangdong Province. The license is effective until September 2017. We need to renew each of the licenses upon its expiration, and apply for permits and alteration of the license in advance of any change to the license holder regarding its shareholding structure, controlling shareholders, merger and acquisition, business scope and etc, and apply for alteration of the license for any change to the name, legal representative of the license holder. However, we cannot assure you that each of the licenses will be successfully and timely renewed, or that the license will continue to cover all aspects of our online lottery service business upon its renewal. If we fail to maintain any of these required licenses or approvals, we may be subject to various penalties, including fines and the discontinuation of or restriction on our operations. Any such disruption in our operations may have a material and adverse effect on our results of operations.

 

   

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

 

   

We only have contractual control over our operating websites, namely, www.500wan.com and www.500.com. We do not directly own our websites due to the restriction of foreign investment in businesses providing value-added telecom services in China, including Internet content provision services. If the authorities challenge our corporate structure or rights to our websites, it could significantly disrupt our business, subject us to sanctions, compromise enforceability of related contractual arrangements, or have other adverse effects on us.

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

In addition, new laws and regulations governing the use of the Internet could be issued at the national or provincial level, or existing regulations could be interpreted more strictly. No assurance can be given that business on the Internet in general or our online services in particular will not be adversely impacted by further regulations. Technical limitations on Internet use can also be developed or implemented. For example, restrictions can be implemented on personal Internet use in the workplace in general or access to our site in particular. This could lead to a reduction of user activities or a loss of users which in turn could have a material adverse effect on our financial condition and results of operations.

The approval of the China Securities Regulatory Commission, or the CSRC, may be required in connection with this offering. Any requirement to obtain prior CSRC approval could delay, or create uncertainties regarding, this offering, and our failure to obtain this approval, if required, could have a material adverse effect on our business, results of operations, reputation and trading price of our ADSs.

On August 8, 2006, six PRC regulatory authorities, including the CSRC, jointly promulgated the 2006 M&A Rules, which were later amended on June 22, 2009. According to the 2006 M&A Rules, an offshore

 

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special purpose vehicle, or SPV, refers to an overseas company controlled directly or indirectly by domestic companies or individuals for purposes of overseas listing of equity interests in domestic companies (defined as enterprises in the PRC other than foreign-invested enterprises). If an SPV purchases, for the purpose of overseas listing, the equity interests of any PRC company that are held by PRC companies or individuals controlling such SPV, then the overseas listing by the SPV must be approved by the CSRC. The application of the 2006 M&A Rules remains unclear, with no consensus currently existing among PRC law firms regarding the scope of CSRC jurisdiction. The CSRC currently has not issued any definitive rule concerning whether offerings like this offering are subject to the 2006 M&A Rules.

Our PRC counsel has advised that the 2006 M&A Rules do not require us to obtain prior CSRC approval for the listing and trading of our ADSs on the NYSE, given that:

 

   

the CSRC approval requirement applies to SPVs that acquired equity interests of any PRC company that are held by PRC companies or individuals controlling such SPV and seek overseas listing; and

 

   

our PRC operating subsidiary was incorporated as a wholly foreign-owned enterprise by means of direct investment rather than by merger or acquisition by our company of the equity interest or assets of any “domestic company” as defined under the 2006 M&A Rules, and no provision in the 2006 M&A Rules classifies the contractual arrangements between our company, our PRC subsidiary and any of our consolidated affiliated entities, including, among others, the Equity Interests Pledge Agreements and the Irrevocable Power of Attorney, either by each agreement itself or taken as a whole, as a type of acquisition transaction falling under the 2006 M&A Rules.

However, if the CSRC subsequently determines that its prior approval is required, we may face regulatory action or other sanctions from the CSRC or other PRC regulatory agencies. These regulatory agencies may impose fines and penalties on our operations, limit our operating privileges, delay or restrict our remittance of the proceeds from this offering into China, 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 may also 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 such settlement and delivery may not occur.

We cannot predict when the CSRC may promulgate additional rules or other guidance, if at all. If implementing rules or guidance are issued prior to completion of this offering and consequently we conclude that we are required to obtain CSRC approval, this offering will be delayed until we obtain CSRC approval, which may take several months or longer. Moreover, implementing rules or guidance, to the extent issued, may fail to resolve current ambiguities under the 2006 M&A Rules. Uncertainties or negative publicity regarding the 2006 M&A Rules could have a material adverse effect on the trading price of our ADSs.

Governmental control of currency conversion may affect the value of your investment.

The PRC government imposes controls on the convertibility of the Renminbi into foreign currencies and, in certain cases, the remittance of foreign currency out of China. We receive all of our service fees in Renminbi. Under our current corporate structure, our income is primarily derived from dividend payments from our PRC subsidiary. Shortages in the availability of foreign currency may restrict the ability of our PRC subsidiary to remit sufficient foreign currency to pay dividends or other payments to us, or otherwise satisfy their foreign currency-denominated obligations. Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and expenditures from trade related transactions, can be made in foreign currencies without prior approval from SAFE by complying with certain procedural requirements. However, approval from SAFE or its local branch is required where Renminbi is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment of loans denominated in foreign currencies. The PRC government may also at its discretion restrict access to foreign currencies for current account transactions in the future. If the foreign exchange control system prevents us from obtaining sufficient foreign currency to satisfy our currency demands, we may not be able to pay dividends in foreign currencies to our shareholders, including holders of our ADSs.

 

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Fluctuations in exchange rates of the Renminbi could materially affect our reported results of operations.

The exchange rates between the Renminbi and the U.S. dollar and other foreign currencies is affected by, among other things, changes in China’s political and economic conditions. In July 2005, the PRC government changed its policy of pegging the value of the Renminbi to the U.S. dollar, and the Renminbi was permitted to fluctuate within a band against a basket of certain foreign currencies. As a result, the Renminbi appreciated more than 20% against the U.S. dollar over the following three years. During the period between July 2008 and June 2010, the Renminbi has traded stably within a narrow range against the U.S. dollar. Since June 2010, the Renminbi has started to slowly appreciate further against the U.S. dollar. See “Exchange Rate Information.” However, the People’s Bank of China regularly intervenes in the foreign exchange market to limit fluctuations in Renminbi exchange rates and achieve policy goals.

As we may rely on dividends and other fees paid to us by our subsidiaries and affiliated consolidated entities in China, any significant revaluation of the Renminbi may materially and adversely affect our cash flows, net revenues, earnings and financial position, and the value of, and any dividends payable on, our ADSs in U.S. dollars. To the extent that we need to convert U.S. dollars received from our initial public offering into Renminbi for our operations, an appreciation of the Renminbi against the U.S. dollar would have an adverse effect on the Renminbi amount we would 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 ordinary 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.

Our operations may be adversely affected by changes in China’s political, economic and social conditions.

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

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

While the Chinese economy has experienced significant growth over the past decade, growth has been uneven, both geographically and among various sectors of the economy. The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures may benefit the overall Chinese economy, but may have a negative effect on us. For example, our financial condition and results of operations may be adversely affected by government control over capital investments or changes in tax regulations. In the past the Chinese government has implemented certain measures, including interest rate increases, to control the pace of economic growth. These measures may cause decreased economic activity in China, which may adversely affect our business and operating results. Any significant increase in China’s inflation rate could increase our costs and have a negative impact on our operating margins. In addition, any sudden changes to China’s political system or the occurrence of widespread social unrest could have negative effects on our business and results of operations.

 

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Under the EIT Law, we may be classified as a “resident enterprise” of China. Such classification would likely result in unfavorable tax consequences to us and our non-PRC shareholders.

Under the new enterprise income tax law, or the EIT Law, and its implementation rules, or the Implementation Rules, both of which became effective on January 1, 2008, an enterprise established outside of the PRC with “de facto management bodies” within the PRC is considered a resident enterprise and is subject to enterprise income tax, or EIT, at the rate of 25% on its global income. The Implementation Rules define the term “de facto management bodies” as “establishments that carry out substantial and overall management and control over the manufacturing and business operations, personnel, accounting, properties, etc. of an enterprise.” The State Administration of Taxation issued the Notice Regarding the Determination of Chinese-Controlled Offshore Incorporated Enterprises as PRC Tax Resident Enterprises on the Basis of De Facto Management Bodies, or Circular 82, on April 22, 2009. Circular 82 provides that a foreign enterprise controlled by a PRC company or a PRC company group will be classified as a “resident enterprise” with its “de facto management bodies” located within China if the following criteria are satisfied: (i) the place where the senior management and core management departments that are in charge of its daily operations perform their duties is mainly located in the PRC; (ii) its financial and human resources decisions are made by or are subject to approval by persons or bodies in the PRC; (iii) its major assets, accounting books, company seals, and minutes and files of its board and shareholders’ meetings are located or kept in the PRC; and (iv) more than half of the enterprise’s directors or senior management with voting rights frequently reside in the PRC. Although Circular 82 only applies to offshore enterprises controlled by PRC enterprises, not those invested in by PRC individuals, like our company, the determining criteria set forth in Circular 82 may reflect the State Administration of Taxation’s general position on how the “de facto management body” test should be applied in determining the tax resident status of offshore enterprises, regardless of whether they are controlled by PRC enterprises or controlled by or invested in by PRC individuals. We do not believe that any of 500.com Limited, Fine Brand Limited or 500wan HK Limited meets all of the criteria above. Although we conduct our business principally through contractual arrangements among our wholly owned PRC subsidiary and our consolidated affiliated entities in the PRC, and decisions relating to our financial and human resource matters are made by personnel of our wholly owned PRC subsidiary and our consolidated affiliated entities in the PRC, each of 500.com Limited, Fine Brand Limited or 500wan HK Limited is a company incorporated outside the PRC. As holding companies, these three entities’ key assets and records, including the resolutions of their respective board of directors and the resolutions of their respective shareholders, are located and maintained outside the PRC. While we do not believe we would be considered a resident enterprise, if the PRC authorities were to subsequently determine that we should be so treated, a 25% EIT on our global income could significantly increase our tax burden and materially and adversely affect our financial condition and results of operations.

Pursuant to the EIT Law, dividends generated after January 1, 2008 and payable by a foreign-invested enterprise in China to its foreign investors will be subject to a 10% withholding tax, unless any such foreign investor’s jurisdiction of incorporation has a tax treaty with China that provides for a different withholding arrangement and provided that relevant tax authorities approved the foreign investors as the beneficial owners of such dividends under applicable tax regulations. We are a Cayman Islands holding company and substantially all of our income may come from dividends from our PRC subsidiary, E-Sun Sky Computer, through our Hong Kong holding company. The Cayman Islands do not have such a tax treaty with China. According to the Mainland and Hong Kong Special Administrative Region Arrangement on Avoiding Double Taxation or Evasion of Taxation on Income between China and Hong Kong entered into in August 2006, or the Double Tax Avoidance Arrangement, and other applicable PRC laws, if a Hong Kong resident enterprise is determined by the relevant PRC tax authority to have satisfied the relevant conditions and requirements under the Double Tax Avoidance Arrangement and other applicable laws, the 10% withholding tax on the dividends the Hong Kong resident enterprise receives from a PRC resident enterprise may be reduced to 5%. To the extent these dividends are subject to withholding tax, the amount of funds available to us to meet our cash requirements, including the payment of dividends to our shareholders and ADS holders, will be reduced.

In addition, because there remains uncertainty regarding the interpretation and implementation of the EIT Law and the Implementation Rules, it is uncertain whether, if we are regarded as a PRC resident enterprise,

 

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any dividends to be distributed by us to our non-PRC shareholders and ADS holders would be subject to any PRC withholding tax. If we are required under the EIT Law to withhold PRC income tax on our dividends payable to our non-PRC corporate shareholders and ADS holders, your investment in our ADSs or ordinary shares may be materially and adversely affected.

Furthermore, the State Administration of Taxation promulgated the Notice on How to Understand and Determine the Beneficial Owners in Tax Agreement in October 2009, or Circular 601, which provides guidance for determining whether a resident of a contracting state is the “beneficial owner” of an item of income under China’s tax treaties and tax arrangements. According to Circular 601, a beneficial owner generally must be engaged in substantive business activities. An agent or conduit company will not be regarded as a beneficial owner and, therefore, will not qualify for treaty benefits. The conduit company normally refers to a company that is set up for the purpose of avoiding or reducing taxes or transferring or accumulating profits. If we are not considered a resident enterprise, we cannot assure you that any dividends distributed to our Hong Kong holding company will be eligible for a reduced withholding tax rate under the applicable treaty. In addition, we cannot assure you that any dividends to be distributed by us to our non-PRC shareholders and ADS holders whose jurisdiction of incorporation has a tax treaty with China providing for a different withholding arrangement will be entitled to the benefits under the relevant withholding arrangement if we are considered a resident enterprise.

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

Pursuant to the Notice on Strengthening Administration of Enterprise Income Tax for Share Transfers by Non-PRC Resident Enterprises, or SAT Circular 698, issued by the State Administration of Taxation, or the SAT, on December 10, 2009 with retroactive effect from January 1, 2008, where a non-resident enterprise transfers the equity interests of a PRC resident enterprise indirectly via disposing the equity interests of an overseas holding company, or an Indirect Transfer, and such overseas holding company is located in a tax jurisdiction that (i) has an effective tax of rate less than 12.5% or (ii) does not tax foreign income of its residents, the non-resident enterprise, being the transferor, shall report to the relevant tax authority of the PRC resident enterprise such Indirect Transfer. Using a “substance over form” principle, the PRC tax authority may disregard the existence of the overseas holding company if it lacks a reasonable commercial purpose and was established for the purpose of reducing, avoiding or deferring PRC tax. As a result, gains derived from such Indirect Transfer may be subject to PRC withholding tax at a rate of up to 10%. SAT Circular 698 also provides that, where a non-PRC resident enterprise transfers its equity interests in a PRC resident enterprise to its related parties at a price lower than the fair market value, the relevant tax authority has the power to make a reasonable adjustment to the taxable income of the transaction.

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

 

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The PRC legal system embodies uncertainties which could limit the legal protections available to you and us.

As our main operating entities and a substantial majority of our assets are located in China, PRC laws and the PRC legal system in general may have a significant impact on our business operations. Although China’s legal system has developed over the last several decades, PRC laws, regulations and legal requirements remain underdeveloped relative to the United States. Moreover, PRC laws and regulations change frequently and their interpretation and enforcement involve uncertainties. For example, the interpretation or enforcement of PRC laws and regulations may be subject to government rules or policies, some of which are not published on a timely basis or at all. In addition, the relative inexperience of China’s judiciary in some cases may create uncertainty as to the outcome of litigation. These uncertainties could limit our ability to enforce our legal or contractual rights or otherwise adversely affect our business and operations. Furthermore, due to the existence of unpublished rules and policies, and since newly issued PRC laws and regulations may have retroactive effect, we may not be aware of our violation of certain PRC laws, regulations, policies or rules until after the fact.

A failure by our shareholders or beneficial owners who are PRC citizens or residents in China to comply with certain PRC foreign exchange regulations could restrict our ability to distribute profits, restrict our overseas and cross-border investment activities or subject us to liability under PRC laws, which could adversely affect our business and financial condition.

In October 2005, SAFE, issued the Notice on Relevant Issues Concerning Foreign Exchange Administration for PRC Residents Engaging in Financing and Roundtrip Investments via Overseas Special Purpose Vehicles, or SAFE Circular 75. SAFE Circular 75 states that PRC citizens or residents must register with the relevant local SAFE branch or central SAFE in connection with their establishment or control of an offshore entity established for the purpose of overseas equity financing involving a roundtrip investment, whereby the offshore entity acquires or controls onshore assets or equity interests held by the PRC citizens or residents. In addition, such PRC citizens or residents must amend their SAFE registrations when the offshore special purpose company undergoes material events relating to increases or decreases in investment amount, transfers or exchanges of shares, mergers or divisions, long-term equity or debt investments, external guarantees, or other material events that do not involve roundtrip investments. Since May 2007, SAFE has issued guidance to its local branches regarding the operational procedures for such registration, which provides more specific and stringent requirements on the registration relating to SAFE Circular 75.

We are committed to complying, and to ensuring that our shareholders and beneficial owners who are PRC citizens or residents comply, with SAFE Circular 75 requirements. We have requested our beneficial owners who are PRC residents to complete the registration under SAFE Circular 75, if applicable. As of the date of this prospectus, our beneficial shareholders Ping Yuan, Jiepin Fu, Bo Zou, Ying Zou, He Li, Xue Li and Man San Law have completed their SAFE Circular 75 registrations with the Shenzhen branch of SAFE and they are expected to update and amend such registrations to reflect the development of our company, including reservation of ordinary shares under our 2011 share incentive plan, the redemption and issuance of our ordinary shares in 2012, Xiaojun Xu ceasing to be our beneficial shareholder, the issuance and sales of the convertible note and exchangeable notes, the concurrent private placement to Sequoia, recent change of our company name and this offering. However, we may not be fully informed of the identities of all our beneficial owners who are PRC citizens or residents, and we cannot compel our beneficial owners to comply with SAFE Circular 75 requirements. As a result, we cannot assure you that all of our shareholders or beneficial owners who are PRC citizens or residents have complied with, and will in the future make or obtain any applicable registrations or approvals required by, SAFE Circular 75 or other related regulations. Failure by such shareholders or beneficial owners to comply with SAFE Circular 75, or failure by us to amend the foreign exchange registrations of our PRC subsidiary, could subject us to fines or legal sanctions, restrict our overseas or cross-border investment activities, limit our subsidiaries’ ability to make distributions or pay dividends or affect our ownership structure, which could adversely affect our business and prospects.

 

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A failure to comply with PRC regulations regarding the registration of shares and share options held by our employees who are PRC citizens may subject such employees or us to fines and legal or administrative sanctions.

On February 15, 2012, SAFE promulgated the Notices on Issues concerning the Foreign Exchange Administration for Domestic Individuals Participating in Share Incentive Plans of Overseas Publicly-Listed Companies, or the Share Option Rules, which replaced the Application Procedures of Foreign Exchange Administration for Domestic Individuals Participating in Employee Share Ownership Plans or Share Option Plans of Overseas Publicly-Listed Companies issued by SAFE on March 28, 2007. Under the Share Option Rules and other relevant rules and regulations, PRC residents who participate in share incentive plan in an overseas publicly-listed company are required to register with SAFE or its local branches and complete certain other procedures. Participants of a share incentive plan who are PRC residents must retain a qualified PRC agent, which could be a PRC subsidiary of such overseas publicly listed company or another qualified institution selected by such PRC subsidiary, to conduct the SAFE registration and other procedures with respect to the share incentive plan on behalf of its participants. Such participants must also retain an overseas entrusted institution to handle matters in connection with their exercise of share options, the purchase and sale of corresponding shares or interests and fund transfers. In addition, the PRC agent is required to amend the SAFE registration with respect to the share incentive plan if there is any material change to the share incentive plan, the PRC agent or the overseas entrusted institution or other material changes. See “Regulations—Regulations on Foreign Exchange.”

Our auditor, like other independent registered public accounting firms operating in China, is not permitted to be subject to inspection by Public Company Accounting Oversight Board, and as such, investors may be deprived of the benefits of such inspection.

Our independent registered public accounting firm issued the audit report included in this prospectus and will issue audit reports filed with the SEC in the future. Generally, an auditor of companies that are traded publicly in the United States is registered with the Public Company Accounting Oversight Board (United States), or PCAOB, and is required by the laws of the United States to undergo regular inspections by PCAOB to assess its compliance with the laws of the United States and professional standards. However, as our auditor is located in China, a jurisdiction where PCAOB is currently unable to conduct inspections without the approval of the PRC authorities, our auditor, like other independent registered public accounting firms operating in China, is currently not inspected by PCAOB.

Inspections of other firms outside of China conducted by PCAOB have identified deficiencies in those firms’ audit procedures and quality control procedures. The inability of PCAOB to conduct inspections of independent registered public accounting firms operating in China makes it more difficult to evaluate the effectiveness of our auditor’s audit procedures or quality control procedures. As a result, investors may be deprived of the benefits of PCAOB inspections.

We may be adversely affected by the outcome of the administrative proceedings brought by the SEC against five accounting firms in China.

The SEC has brought administrative proceedings against five accounting firms in China, alleging that the accounting firms refused to produce audit papers and other documents related to certain China-based companies that were under investigation by the SEC for potential accounting fraud. The independent registered public accounting firm that will issue the audit reports included in this prospectus and our future annual reports to be filed with the SEC is one of the five accounting firms named in the SEC’s proceedings, and we may be adversely affected by the outcome of the proceedings.

The PCAOB announced on May 24, 2013 that it had entered into a Memorandum of Understanding on Enforcement Cooperation, or the MOU, with CSRC and the Ministry of Finance of China. The MOU establishes a cooperative framework between the parties for the production and exchange of audit documents relevant to investigations in the US and the PRC. The PCAOB continues to engage in discussions with the CSRC and Ministry of Finance of China to permit joint inspections in China of audit firms that are registered with the PCAOB and audit China based companies that trade on U.S. exchanges.

However, the SEC administrative proceedings are ongoing and it is unclear what impact, if any, the MOU will have on the SEC proceedings. If the SEC prevails in the proceedings, our independent registered public

 

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accounting firm and the other four accounting firms in China that were named in the proceedings may be barred from practicing before the SEC and hence unable to continue serving as auditors for China-based companies listed in the U.S. If none of the China-based auditors are able to continue serving as auditors for China-based companies listed in the U.S., we will not be able to meet the reporting requirements under the Exchange Act following the listing of our ADSs in the U.S., which may ultimately result in our deregistration by the SEC and delisting from the NYSE.

Risks Related to Our ADSs and This Offering

An active trading market for our ordinary shares or our ADSs may not develop and the trading price of our ADSs may fluctuate significantly.

Prior to this offering, there has been no public market for our ADSs or our ordinary shares represented by the ADSs. If an active public market for our ADSs does not develop after this offering, the market price and liquidity of our ADSs may be adversely affected. We have applied to list our ADSs on the NYSE. A liquid public market for our ADSs may not develop. The public offering price for our ADSs will be determined by negotiation between us and the underwriters based upon several factors, including prevailing market conditions, our historical performance, estimates of our business potential and earnings prospects, and the market valuations of similar companies. The price at which the ADSs are traded after this offering may decline below the public offering price, meaning that you may experience a decrease in the value of your ADSs regardless of our operating performance or prospects. In the past, following periods of volatility in the market price of a company’s securities, shareholders have often instituted securities class action litigation against that company. If we were involved in a class action suit, it could divert the attention of senior management, and, if adversely determined, could have a material adverse effect on our results of operations.

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

If our existing shareholders sell, indicate an intention to sell, or are perceived to intend to sell, substantial amounts of our ordinary shares in the public market after the 180-day contractual lock-up period and the lapse of other legal restrictions on resale discussed in this prospectus, the trading price of our ordinary shares could decline. Upon closing of this offering and the concurrent private placement to Sequoia, we will have              outstanding ordinary shares. All ADSs sold in this offering will be freely tradable, without restriction, in the public market. The representatives of the underwriters may, in their sole discretion, permit any party subject to lock-up agreements to sell shares prior to the expiration of the lock-up agreements. After the lock-up agreements pertaining to this offering expire (180 days or more from the date of this prospectus), all of our outstanding shares will be eligible for sale in the public market, but they will be subject to volume limitations under Rule 144 under the Securities Act. In addition, ordinary shares subject to outstanding options under our share incentive plan will become eligible for sale in the public market to the extent permitted by the provisions of various vesting agreements, the lock-up agreements and Rules 144 and 701 under the Securities Act. If these additional shares are sold, or if it is perceived that they will be sold in the public market, the trading price of our ordinary shares could decline.

Because the public offering price is substantially higher than our pro forma net tangible book value per ADS, you will incur immediate and substantial dilution.

If you purchase ADSs in this offering, you will pay more for your ADSs than the amount paid by existing shareholders for their ordinary shares on a per ADS basis. As a result, you will experience immediate and substantial dilution of US$         per ADS (assuming (i) the automatic conversion of the convertible note issued to Sequoia into Class B ordinary shares immediately upon completion of this offering, based on a conversion price of US$         per ordinary share, which, pursuant to the convertible note, equals to 80% of the public offering price of our ADS adjusted to reflect our ADS-to-ordinary share ratio and based on an assumed public offering price of US$         per ADS, the mid-point of the estimated public offering price range shown on the front cover of this prospectus, (ii) the issuance and sale of Class B ordinary shares to Sequoia in connection with the concurrent private placement at an assumed public offering price of US$         per ADS, the mid-point of the estimated range of the public offering price shown on the front cover of this prospectus, and (iii) no exercise of outstanding options to acquire Class A ordinary shares or the underwriters’ option to acquire additional ADSs),

 

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representing the difference between our pro forma net tangible book value per ADS as of                     , 2013, after giving effect to this offering and the assumed public offering price of US$         per ADS (the mid-point of the estimated range of the public offering price shown on the front cover of this prospectus). In addition, you may experience further dilution to the extent that our Class A ordinary shares are issued upon the exercise of outstanding share options. Substantially all of the Class A ordinary shares issuable upon the exercise of currently outstanding share options will be issued at a purchase price on a per ADS basis that is less than the public offering price per ADS in this offering.

Future issuance of share options or restricted shares may have a diluting effect on existing and future shareholders.

The grant and exercise of share options or restricted shares to be issued in the future will likely result in a dilution of the value of our ordinary shares for all shareholders. We established a 2011 Share Incentive Plan under which we are able to issue up to 12% of our issued and outstanding ordinary shares from time to time. We subsequently adjusted the exercise prices of certain options granted in June 2012. For more details, see “Management—Share Incentive Plan.” We may in the future issue additional share options and other share-based awards under the plan, which may dilute the interest of the existing and future shareholders. See “Management—Share Incentive Plan.” Moreover, we may seek authorization to increase the number of shares subject to our 2011 Share Incentive Plan, or sell additional securities and/or rights to purchase such securities at any time in the future. Dilution of the value of the ordinary shares will likely result from such sales, which in turn could adversely affect the market price of our ordinary shares and ADSs.

We may become a passive foreign investment company, or PFIC, which could result in adverse United States tax consequences to United States investors.

Based on our financial statements and the projected composition of our income and valuation of our assets, including goodwill, we do not expect to be a passive foreign investment company, or PFIC, for 2013, and we do not expect to become one in the future, although there can be no assurance in this regard. The determination of whether or not we are a PFIC is made on an annual basis and will depend on the composition of our income and assets from time to time. Specifically, for any taxable year we will be classified as a PFIC for United States federal income tax purposes if either (i) 75% or more of our gross income in that taxable year is passive income or (ii) the average percentage of our assets (which includes cash) by value in that taxable year which produce or are held for the production of passive income is at least 50%. The calculation of the value of our assets will be based, in part, on the quarterly market value of our ADSs, which is subject to change. See “Taxation—Material United States Federal Income Tax Considerations—Passive Foreign Investment Company.”

In addition, there is uncertainty as to the treatment of our corporate structure and ownership of our consolidated affiliated entities for United States federal income tax purposes. If it is determined that we do not own the stock of our consolidated affiliated entities for United States federal income tax purposes (for instance, because the relevant PRC authorities do not respect these arrangements), we would likely be treated as a PFIC.

If we are a PFIC for any taxable year during which you hold our ADSs or ordinary shares, such characterization could result in adverse United States federal income tax consequences to you if you are a United States Holder, as defined under “Taxation—Material United States Federal Income Tax Considerations.” For example, if we are or become a PFIC, you may become subject to increased tax liabilities under United States federal income tax laws and regulations, and will become subject to burdensome reporting requirements. See “Taxation—Material United States Federal Income Tax Considerations—Passive Foreign Investment Company.” We cannot assure you that we will not be a PFIC for 2013 or any future taxable year.

You may not be able to participate in rights offerings and may experience dilution of your holdings in relation to any such offerings.

We may, from time to time, distribute rights to our shareholders, including rights to acquire securities. Under the deposit agreement, the depositary will not distribute rights to holders of ADSs unless the distribution

 

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and sale of rights and the securities to which these rights relate are either exempt from registration under the Securities Act with respect to all holders of ADSs, or are registered under the provisions of the Securities Act. The depositary may, but is not required to, attempt to sell these undistributed rights to third parties, and may allow the rights to lapse. We may be unable to establish an exemption from registration under the Securities Act, and we are under no obligation to file a registration statement with respect to these rights or underlying securities or to endeavor to have a registration statement declared effective. Accordingly, holders of ADSs may be unable to participate in our rights offerings and may experience dilution of their holdings as a result.

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

The trading price of our ADSs may be volatile, which could result in substantial losses to investors.

The trading price of our ADSs may be volatile and could fluctuate widely in response to factors relating to our business as well as external factors beyond our control. Factors such as variations in our financial results, announcements of new business initiatives by us or by our competitors, recruitment or departure of key personnel, changes in the estimates of our financial results or changes in the recommendations of any securities analysts electing to follow our securities or the securities of our competitors could cause the market price for our ADSs to change substantially. At the same time, securities markets may from time to time experience significant price and volume fluctuations that are not related to the operating performance of particular companies. For example, in late 2008 and early 2009, the securities markets in the United States, China and other jurisdictions experienced the largest decline in share prices since September 2001. These market fluctuations may also have a material adverse effect on the market price of our ordinary shares.

In addition, the performance and fluctuation of the market prices of other companies with business operations located mainly in China that have listed their securities in the United States may affect the volatility in the price of and trading volumes for our ADSs. In recent years, a number of PRC companies have listed their securities, or are in the process of preparing for listing their securities, on U.S. stock markets. Some of these companies have experienced significant volatility, including significant price declines in connection with their initial public offerings. The trading performances of these PRC companies’ securities at the time of or after their offerings may affect the overall investor sentiment towards PRC companies listed in the United States and consequently may impact the trading performance of our ADSs. These broad market and industry factors may significantly affect the market price and volatility of our ADSs, regardless of our actual operating performance. Any of these factors may result in large and sudden changes in the trading volume and price for our ADSs.

Holders of our Class B ordinary shares will control the outcome of shareholder actions in our company.

Under our amended and restated memorandum and articles of association, our ordinary shares will be divided into Class A ordinary shares and Class B ordinary shares upon completion of this offering. Holders of Class A ordinary shares will be entitled to one vote per share, while holders of Class B ordinary shares will be entitled to 10 votes per share. We will issue Class A ordinary shares represented by our ADSs in this offering. Assuming the underwriters do not exercise their over-allotment option to purchase additional ADSs, upon completion of this offering and the concurrent private placement to Sequoia, holders of our Class B ordinary shares will hold              Class B ordinary shares, or             % of the combined total outstanding ordinary shares (representing             % of the total voting rights) in our company, which include (i) Class B ordinary shares redesignated from our ordinary shares outstanding prior to completion of this offering, (ii) Class B ordinary shares to be automatically converted from the convertible note and (iii) Class B ordinary shares to be issued and sold by us to Sequoia in connection with the concurrent private placement, in both cases assuming a public

 

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offering price of US$ per ADS, the mid-point of the estimated range of the public offering price as set forth on the cover page of this prospectus. Their shareholding, in particular the greater voting rights of the Class B ordinary shares, gives Class B ordinary shareholders the power to control any actions that require shareholder approval under Cayman Islands law, our amended and restated memorandum and articles of association and the NYSE requirements, including the election and removal of any member of our board of directors, mergers, consolidations and other business combinations, changes to our amended and restated memorandum and articles of association, the number of shares available for issuance under share incentive plans and the issuance of significant amounts of our ordinary shares in private placements. Due to the disparate voting rights attached to the two classes of our ordinary shares, holders of our Class B ordinary shares could have sufficient voting rights to determine the outcome of all matters requiring shareholder approval even if it should, at some point in the future, hold considerably less than a majority of the combined total of our outstanding Class A and Class B ordinary shares.

As a result of their ownership of Class B ordinary shares, the voting power of holders of our Class B ordinary shares may cause transactions to occur that might not be beneficial to you as a holder of ADSs and may prevent transactions that would be beneficial to you. For example, their voting power may prevent a transaction involving a change of control of us, including transactions in which you as a holder of our ADSs might otherwise receive a premium for your securities over the then-current market price. Similarly, they may approve a merger or consolidation of our company that may result in you receiving a stake (either in the form of shares, debt obligations or other securities) in the surviving or new consolidated company, which may not operate our current business model and dissenter rights may not be available to you in such an event. See “Description of Share Capital—Differences in Corporate Law—Mergers and Similar Arrangements” for a detailed discussion of the merger and consolidation provisions under Cayman Islands law. In addition, holders of our Class B ordinary shares are not prohibited from selling a controlling interest in us to a third party and may do so without your approval. If they sell a controlling interest in us to a third party or otherwise undergo a change of control, any acquiror or successor will be entitled to exercise the voting control and may do so in a manner that could vary significantly from that of our current holders of Class B ordinary shares.

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

Our amended and restated memorandum and articles of association provide for a dual-class 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 one vote per share, while holders of Class B ordinary shares are entitled to 10 votes per share. We will issue Class A ordinary shares represented by our ADSs in this offering. Our existing shareholders, Sequoia and Blue Ivy Investment Limited, if Sequoia and Blue Ivy Investment Limited exercise their options to exchange certain exchangeable notes into our Class B ordinary shares held by certain of our current shareholders upon completion of this offering, will together hold              Class B ordinary shares upon completion of this offering, each of which is convertible into one Class A ordinary share at any time by the holder thereof. Class A ordinary shares are not convertible into Class B ordinary shares under any circumstances.

Due to the disparate voting rights attached to these two classes, our existing shareholders will have significant voting rights over matters requiring shareholder approval, including the election and removal of directors and certain corporate transactions, such as mergers, consolidations and other business combinations. This concentrated control could discourage others from pursuing any potential merger, takeover or other change of control transactions that holders of Class A ordinary shares and ADSs may view as beneficial.

Anti-takeover provisions in our charter documents may discourage a third party from acquiring us, which could limit our shareholders’ opportunities to sell their shares at a premium.

We have adopted an amended and restated memorandum and articles of association that will become effective upon completion of this offering. Our amended and restated memorandum and articles of association will include provisions that could limit the ability of others to acquire control of us, modify our structure or cause us to engage in change-of-control transactions. For example, our board of directors will have the authority,

 

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without further action by our shareholders, to issue preferred shares in one or more series and to fix the powers and rights of these shares, including dividend rights, conversion rights, voting rights, terms of redemption and liquidation preferences, any or all of which may be greater than the rights associated with our ordinary shares. Preferred shares could thus be issued quickly with terms calculated to delay or prevent a change in control or make removal of management more difficult. In addition, if our board of directors issues preferred shares, the market price of our ordinary shares may fall and the voting and other rights of the holders of our ordinary shares may be adversely affected. These provisions could have the effect of depriving our shareholders of an opportunity to sell their shares at a premium over prevailing market prices by discouraging third parties from seeking to obtain control of us in a tender offer or similar transaction.

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

Our corporate affairs are governed by our amended and restated memorandum and articles of association, the Cayman Islands Companies Law and the common law of the Cayman Islands. The rights of shareholders to take action against the directors, actions by noncontrolling shareholders and the fiduciary responsibilities of our directors to us under Cayman Islands law are to a large extent governed by the common law of the Cayman Islands. The common law of the Cayman Islands is derived in part from comparatively limited judicial precedent in the Cayman Islands as well as from English common law, which has persuasive, but not binding, authority on a court in the Cayman Islands. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as they would be under statutes or judicial precedent in some jurisdictions in the United States. In particular, the Cayman Islands has a less developed body of securities laws than the United States and provides significantly less protection to investors. In addition, some U.S. states, such as Delaware, have more fully developed and judicially interpreted bodies of corporate law than the Cayman Islands.

There is no statutory recognition in the Cayman Islands of judgments obtained in the United States, although a judgment obtained in the United States will be recognised and enforced in the courts of the Cayman Islands at common law, without any re-examination of the merits of the underlying dispute, by an action commenced on the foreign judgment debt in the Grand Court of the Cayman Islands, provided such judgment (a) is given by a foreign court of competent jurisdiction; (b) imposes on the judgment debtor a liability to pay a liquidated sum for which the judgment has been given; (c) is final; (d) is not in respect of taxes, a fine or a penalty; and (e) was not obtained in a manner and is not of a kind the enforcement of which is contrary to natural justice or the public policy of the Cayman Islands. You should also read “Description of Share Capital—Differences in Corporate Law” for some of the differences between the corporate and securities laws in the Cayman Islands and the United States.

You will have limited ability to bring an action against us or against our directors and officers, or to enforce a judgment against us or them, because we are incorporated in the Cayman Islands, because we conduct our operations exclusively in China and most of our directors and officers reside outside the United States.

We are incorporated in the Cayman Islands and conduct our operations exclusively in China. All of our assets are located outside the United States. Most of our directors and officers reside outside the United States and a substantial portion of the assets of those persons are located outside of the United States. As a result, it may be difficult or impossible for you to bring an action against us or against these individuals in the Cayman Islands or in China in the event that you believe that your rights have been infringed under the applicable 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. In addition, there is uncertainty as to whether the courts of the Cayman Islands or the PRC would recognize or enforce judgments of U.S. courts against us or such persons predicated upon the civil liability provisions of the securities laws of the United States or any state, and it is uncertain whether such Cayman Islands or PRC courts

 

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would be competent to hear original actions brought in the Cayman Islands or the PRC against us or such persons predicated upon the securities laws of the United States or any state. For more information regarding the relevant laws of the Cayman Islands and China, see “Enforcement of Civil Liabilities.”

Shareholders of Cayman Islands exempted companies such as ourselves have no general rights under Cayman Islands law to inspect corporate records and accounts or to obtain copies of lists of shareholders of these companies. Our directors have discretion under our amended and restated articles of association to determine whether or not, and under what conditions, our corporate records may be inspected by our shareholders, but are not obliged to make them available to our shareholders. This may make it more difficult for you to obtain the information needed to establish any facts necessary for a shareholder motion or to solicit proxies from other shareholders in connection with a proxy contest.

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

Your ability to protect your rights as shareholders through the U.S. federal courts may be limited because we are incorporated under Cayman Islands law.

Cayman Islands companies may not have standing to initiate a derivative action in a federal court of the United States. As a result, your ability to protect your interests if you are harmed in a manner that would otherwise enable you to sue in a United States federal court may be limited to direct shareholder lawsuits.

We have considerable discretion in the application of the net proceeds from this offering and we may use these proceeds in ways with which you may not agree.

Our management will have considerable discretion in the application of these proceeds received by us. You will not have the opportunity, as part of your investment decision, to assess whether the 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 or other purposes with which you do not agree or that do not improve our profitability or increase our ADS price. The net proceeds from this offering may also be placed in investments that do not produce income or that lose value.

The voting rights of holders of ADSs are limited in several significant ways by the terms of the deposit agreement.

Holders of our ADSs may only exercise their voting rights with respect to the underlying ordinary shares in accordance with the provisions of the deposit agreement. Upon receipt of voting instructions from a holder of ADSs in the manner set forth in the deposit agreement, the depositary will endeavor to vote the underlying ordinary shares in accordance with these instructions. Under our amended and restated memorandum and articles of association and Cayman Islands law, the minimum notice period required for convening a general meeting is five days. When a general meeting is convened, you may not receive sufficient notice of a shareholders’ meeting to permit you to withdraw your ordinary shares to allow you to cast your vote with respect to any specific matter at the meeting. In addition, the depositary and its agents may not be able to send voting instructions to you or carry out your voting instructions in a timely manner. We will make all reasonable efforts to cause the depositary to extend voting rights to you in a timely manner, but we cannot assure you that you will receive the voting materials in time to ensure that you can instruct the depositary to vote your shares. Furthermore, the depositary and its agents will not be responsible for any failure to carry out any instructions to vote, for the manner in which any vote is cast or for the effect of any such vote. As a result, you may not be able to exercise your right to vote and you may lack recourse if your ordinary shares are not voted as you requested.

 

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The depositary of our ADSs will, except in limited circumstances, grant to us a discretionary proxy to vote the ordinary shares underlying your ADSs if you do not vote at shareholders’ meetings, which could adversely affect your interests and the ability of our shareholders as a group to influence the management of our company.

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

The effect of this discretionary proxy is that you cannot prevent our ordinary shares underlying your ADSs from being voted, absent the situations described above, and it may make it more difficult for holders of ADSs to influence the management of our company. Holders of our ordinary shares are not subject to this discretionary proxy.

You may not receive distributions on our ordinary shares or any value for them if it is unlawful or impractical for us to make them available to you.

The depositary of our ADSs has agreed to pay you the cash dividends or other distributions it or the custodian for our ADSs receives on our ordinary shares or other deposited securities after deducting its fees and expenses. You will receive these distributions in proportion to the number of our ordinary shares your ADSs represent. However, the depositary is not responsible if it is unlawful or impractical to make a distribution available to any holders of ADSs. For example, it would be unlawful to make a distribution to a holder of ADSs if it consists of securities that require registration under the Securities Act but that are not properly registered or distributed pursuant to an applicable exemption from registration. The depositary is not responsible for making a distribution available to any holders of ADSs if any government approval or registration is required for such distribution. We have no obligation to take any other action to permit the distribution of our ADSs, ordinary shares, rights or anything else to holders of our ADSs. This means that you may not receive the distributions we make on our ordinary shares or any value for them if it is unlawful or impractical for us to make them available to you. These restrictions may have a material and adverse effect on the value of your ADSs.

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

Your ADSs, represented by ADRs, are transferable on the books of the depositary. However, the depositary may close its books at any time or from time to time when it deems expedient in connection with the performance of its duties. The depositary may close its books from time to time for a number of reasons, including in connection with corporate events such as a rights offering, during which time the depositary needs to maintain an exact number of ADS holders on its books for a specified period. The depositary may also close its books in emergencies, and on weekends and public holidays. The depositary may refuse to deliver, transfer or register transfers of our ADSs generally when our books or the books of the depositary are closed, or at any time if we think or the depositary thinks it is necessary or advisable to do so in connection with the performance of its duty under the deposit agreement, including due to any requirement of law or any government or governmental body, or under any provision of the deposit agreement.

We are an emerging growth company within the meaning of the Securities Act and may take advantage of certain reduced reporting requirements.

We are an “emerging growth company,” as defined in the JOBS Act, and we may take advantage of certain exemptions from various requirements applicable to other public companies that are not emerging growth

 

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companies including, most significantly, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-oxley act of 2012 for so long as we are an emerging growth company. As a result, if we elect not to comply with such auditor attestation requirements, our investors may not have access to certain information they may deem important.

The JOBS Act also provides that an emerging growth company does not need to comply with any new or revised financial accounting standards until such date that a private company is otherwise required to comply with such new or revised accounting standards. However, we have elected to “opt out” of this provision and, as a result, we will comply with new or revised accounting standards as required when they are adopted for public companies. This decision to opt out of the extended transition period under the JOBS Act is irrevocable.

We will incur increased costs as a result of being a public company, particularly after we cease to qualify as an “emerging growth company”.

Upon completion of this offering, we will become a public company and expect to incur significant legal, accounting and other expenses that we did not incur as a private company. The Sarbanes-Oxley Act of 2002, as well as rules subsequently implemented by the SEC, and NYSE, impose various requirements on the corporate governance practices of public companies.

We expect these rules and regulations to increase our legal and financial compliance costs and to make some corporate activities more time-consuming and costly. After we are no longer an “emerging growth company,” we expect to incur significant expenses and devote substantial management effort toward ensuring compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 and the other rules and regulations of the SEC. For example, as a result of becoming a public company, we will need to increase the number of independent directors and adopt policies regarding internal controls and disclosure controls and procedures. We also expect that operating as a public company will make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. In addition, we will incur additional costs associated with our public company reporting requirements. It may also be more difficult for us to find qualified persons to serve on our board of directors or as executive officers. We are currently evaluating and monitoring developments with respect to these rules and regulations, and we cannot predict or estimate with any degree of certainty the amount of additional costs we may incur or the timing of such costs.

In the past, shareholders of a public company often brought securities class action suits against the company following periods of instability in the market price of that company’s securities. If we were involved in a class action suit, it could divert a significant amount of our management’s attention and other resources from our business and operations, which could harm our results of operations and require us to incur significant expenses to defend the suit. Any such class action suit, whether or not successful, could harm our reputation and restrict our ability to raise capital in the future. In addition, if a claim is successfully made against us, we may be required to pay significant damages, which could have a material adverse effect on our financial condition and results of operations.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements that involve risks and uncertainties, including statements based on our current expectations, assumptions, estimates and projections about us and our industry. The forward-looking statements are contained principally in the sections entitled “Prospectus Summary,” “Risk Factors,” “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Our Business.” In some cases, these forward-looking statements can be identified by words or phrases such as “may,” “will,” “expect,” “anticipate,” “aim,” “estimate,” “intend,” “plan,” “believe,” “potential,” “continue,” “is/are likely to” or other similar expressions. The forward-looking statements included in this prospectus relate to, among others:

 

   

our goals and strategies;

 

   

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

 

   

the expected growth of the online lottery market in China;

 

   

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

 

   

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

 

   

potential regulatory changes;

 

   

competition in our industry in China;

 

   

our planned use of proceeds; and

 

   

fluctuations in general economic and business conditions in China.

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

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

 

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USE OF PROCEEDS

We estimate that we will receive net proceeds of approximately US$         consisting of (i) US$             from this offering after deducting underwriting discounts and commissions and the estimated offering expenses payable by us in connection with this offering and based upon an assumed public offering price of US$        per ADS (the mid-point of the estimated public offering price range shown on the front cover of this prospectus) and (ii) US$             from the concurrent private placement to Sequoia. A US$1.00 increase (decrease) in the assumed public offering price of US$             per ADS would increase (decrease) the net proceeds to us from this offering and the concurrent private placement to Sequoia by US$        , after deducting the estimated underwriting discounts and commissions and estimated aggregate offering expenses payable by us in connection with this offering and assuming (i) no change to the number of ADSs offered by us as set forth on the cover page of this prospectus, and (ii) the completion of the concurrent private placement to Sequoia. We will not receive any of the proceeds from the sale of ADSs by the selling shareholders.

We anticipate using the net proceeds of this offering and the concurrent private placement to Sequoia for the following purposes:

 

   

approximately US$         million for continuing investment in our technology platform;

 

   

approximately US$         million for research and development;

 

   

approximately US$         million for sales and marketing initiatives including advertising; and

 

   

the balance for other general corporate purposes, including working capital needs, incremental costs associated with being a public company, and potential acquisitions (although we are not currently negotiating any such acquisitions).

In addition, the purposes of this offering also include the retention of employees by providing them with equity incentives and the creation of a public market for our ordinary shares represented by the ADSs for the benefit of our shareholders.

The foregoing represents our intentions as of the date of this prospectus with respect to the use and allocation of the net proceeds of this offering and the concurrent private placement to Sequoia based upon our present plans and business conditions, but our management will have significant flexibility and discretion in applying the net proceeds of the offering and the concurrent private placement to Sequoia. The occurrence of unforeseen events or changed business conditions may result in application of the proceeds of this offering and the concurrent private placement to Sequoia in a manner other than as described in this prospectus.

To the extent that the net proceeds we receive from this offering and the concurrent private placement to Sequoia are not immediately applied for the above purposes, we intend to invest our net proceeds in short-term, interest-bearing debt instruments or bank deposits. These investments may have a material adverse effect on the United States federal income tax consequences of your investment in our ADSs. It is possible that we may become a PFIC for United States federal income tax purposes, which could result in negative tax consequences for you. These consequences are described in more detail in “Risk Factors—Risks Related to Our ADSs and This Offering—We may become a passive foreign investment company, or PFIC, which could result in adverse United States tax consequences to United States investors” and “Taxation—Material United States Federal Income Tax Considerations—Passive Foreign Investment Company.”

In utilizing the proceeds of this offering and the concurrent private placement to Sequoia, we, as an offshore holding company, are permitted under PRC laws and regulations to provide funding to our PRC subsidiary through loans or capital contributions and to our consolidated affiliated entities through loans. Subject to satisfaction of applicable government registration and approval requirements, we may extend inter-company loans to our PRC subsidiary or our consolidated affiliated entities or make additional capital contributions to our PRC subsidiary to fund their capital expenditures or working capital. We cannot assure you that we will be able to obtain these government registrations or approvals on a timely basis, if at all. See “Risk Factors—Risks Related to China—PRC regulation of loans to, and direct investment in, PRC entities by offshore holding companies and governmental control of currency conversion may limit our use of the proceeds we receive from this offering to fund our expansion or operations.”

 

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DIVIDEND POLICY

In 2010, we declared dividends of RMB159.9 million (US$26.1 million) to our shareholders. On December 6, 2012, we declared dividends of RMB90.0 million (US$14.7 million) to our shareholders. As of September 30, 2013, RMB94.5 million (US$15.4 million) of these dividends remained unpaid, which was repaid in full as of the date of this prospectus. See “Related Party Transactions—Related Party Loans and Other Payments” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.” Purchasers of ADSs in this offering are not eligible to receive any portion of these previously declared and outstanding dividends.

We currently intend to retain all available funds and any future earnings to finance our business and to fund growth and expansion of our business and, therefore, do not expect to pay any cash dividends on our ordinary shares, including those represented by ADSs, in the foreseeable future. We currently have no specific intention to issue share dividends in the future.

Any future determination to pay dividends will be made at the discretion of our board of directors and may be based on a number of factors, including 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 ordinary shares, if any, will be paid in U.S. dollars.

We are a holding company incorporated in the Cayman Islands. In order for us to distribute any dividends to our shareholders and ADS holders, we will rely on dividends distributed by our PRC subsidiary. Certain payments from our PRC subsidiary to us are subject to PRC taxes, such as withholding income tax. In addition, regulations in the PRC currently permit payment of dividends of a PRC company only out of accumulated distributable after-tax profits as determined in accordance with its articles of association and the accounting standards and regulations in China. Our PRC subsidiary is required to set aside at least 10% of its after-tax profit based on PRC accounting standards every year to a statutory reserve fund until the aggregate amount of such reserve fund reaches 50% of the registered capital of such subsidiary. Such statutory reserve fund is not distributable as loans, advances or cash dividends. The reserve fund can only be used for specific purposes and are not transferable to the company’s parent in the form of loans, advances or dividends. See “Risk Factors—We may rely principally on dividends and other distributions on equity paid by our PRC subsidiary to fund any cash and financing requirements we may have. Any limitation on the ability of our PRC subsidiary to pay dividends to us could have a material adverse effect on our ability to conduct our business.”

 

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CAPITALIZATION

The following table sets forth our capitalization as of September 30, 2013 presented on:

 

   

an actual basis; and

 

   

as adjusted basis to give effect to (i) the redesignation of all of our outstanding ordinary shares immediately prior to this offering into Class B ordinary shares upon completion of this offering, (ii) the issuance and sales of US$20 million convertible note to Sequoia in October 2013, (iii) the automatic conversion of the convertible note issued and sold to Sequoia into Class B ordinary shares upon completion of this offering, based on a conversion price of US$             per ordinary share, which, pursuant to the convertible note, equals to 80% of the public offering price of our ADSs adjusted to reflect our ADS-to-ordinary share ratio and based on an assumed public offering price of US$             per ADS, the mid-point of the estimated public offering price range shown on the front cover of this prospectus, (iv) the issuance and sale of              Class B ordinary shares to Sequoia in a concurrent private placement at an assumed public offering price of US$             per ADS on a per ordinary share basis, the mid-point of the estimated range of the public offering price shown on the front cover of this prospectus, and (v) the issuance and sale of the Class A ordinary shares in the form of              ADSs offered hereby at an assumed public offering price of US$        per ADS, the mid-point of the estimated public offering price range shown on the front cover of this prospectus, after deducting underwriting discounts and commissions and estimated offering expenses payable by us in connection with this offering and assuming no exercise of the underwriters’ over-allotment option and no other change to the number of ADSs sold by us as set forth on the cover page of this prospectus.

The as adjusted information below is illustrative only and our capitalization following the closing of this offering is subject to adjustment based on the public offering price of our ADSs and other terms of this offering determined at pricing. You should read this table in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this prospectus.

 

    As of September 30, 2013  
    Actual     As adjusted  
    RMB     US$     RMB     US$  
    (in thousands)  

Convertible note

                           

Shareholders’ equity:

       

Ordinary shares, US$0.00005 par value per share, 931,878,540 shares authorized; 228,768,220 shares issued and outstanding

    84        14                 

Class A ordinary shares, par value US$0.00005 per share, 700,000,000 shares authorized;              shares issued and outstanding

                 

Class B ordinary shares, par value US$0.00005 per share, 300,000,000 shares authorized;              shares issued and outstanding

                 

Additional paid-in capital(1)

    258,802        42,288       

Accumulated other comprehensive income

    17,284        2,824       

Accumulated deficit

    (253,875     (41,484    
 

 

 

   

 

 

   

 

 

   

 

 

 

Total shareholders’ equity

    22,295        3,642       
 

 

 

   

 

 

   

 

 

   

 

 

 

Total capitalization(1)

    22,295        3,642       
 

 

 

   

 

 

   

 

 

   

 

 

 

 

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

 

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DILUTION

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

Our net tangible book value as of September 30, 2013 was US$3.1 million, or US$0.01 per ordinary share, and US$             per ADS. Net tangible book value per ordinary share is determined by dividing our net tangible book value by the number of outstanding ordinary shares. Our net tangible book value is determined by subtracting the value of our acquired net intangible assets, deferred initial public offering costs and total liabilities from our total assets. Dilution is determined by subtracting net tangible book value per ordinary share from the assumed public offering price per ordinary share.

Without taking into account any other changes in such net tangible book value after September 30, 2013, other than to give effect to (i) the redesignation of all of our outstanding ordinary shares immediately prior to this offering into Class B ordinary shares upon completion of this offering, (ii) the issuance and sales of US$20 million convertible note to Sequoia in October 2013, (iii) the automatic conversion of the convertible note issued and sold to Sequoia into Class B ordinary shares upon completion of this offering, based on a conversion price of US$             per ordinary share, which, pursuant to the convertible note, equals to 80% of the public offering price of our ADSs adjusted to reflect our ADS-to-ordinary share ratio and based on an assumed public offering price of US$             per ADS, the mid-point of the estimated public offering price range shown on the front cover of this prospectus, (iv) the issuance and sale of              Class B ordinary shares to Sequoia in connection with a concurrent private placement at an assumed public offering price of US$             per ADS on a per ordinary share basis, the mid-point of the estimated range of the public offering price shown on the front cover of this prospectus, and (v) the issuance and sale of the          ADSs offered in this offering at an assumed public offering price of US$         per ADS, the mid-point of the estimated public offering price range as set forth on the cover of this prospectus, with estimated net proceeds of US$         million after deducting underwriting discounts and commissions and estimated offering expenses in connection with this offering, our pro forma net tangible book value as of September 30, 2013 would have been US$         million, US$         per outstanding ordinary share, including ordinary shares represented by our outstanding ADSs, and US$         per ADS. This represents an immediate increase in pro forma net tangible book value of US$         per ordinary share, or US$         per ADS, to existing shareholders and an immediate dilution in pro forma net tangible book value of US$         per ordinary share, or US$         per ADS, to new investors in this offering. The following table illustrates such per ordinary share dilution:

 

Assumed public offering price per Class A ordinary share

   US$                

Net tangible book value per ordinary share as of September 30, 2013

   US$ 0.01   

Increase in net tangible book value attributable to the sales and conversion of convertible note into ordinary shares

   US$                

Increase in net tangible book value attributable to price paid by Sequoia for the issuance of              ordinary shares to Sequoia at the midpoint of the estimated range of the public offering price of US$        per ADS with net proceeds of US$14.9 million after deducting debt issuance cost

   US$                

Increase in net tangible book value per ordinary share attributable to price paid by new investors

   US$                

Pro forma net tangible book value per ordinary share after the offering

   US$                

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

   US$     

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

   US$     

A US$1.00 increase (decrease) in the assumed public offering price of US$         per ADS would increase (decrease) our pro forma net tangible book value after giving effect to the offering by US$         million, the pro

 

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forma net tangible book value per ordinary share and per ADS after giving effect to this offering, the concurrent private placement and the automatic conversion by US$         per ordinary share and US$         per ADS and the dilution in pro forma net tangible book value per ordinary share and per ADS to new investors in this offering by US$         per Class A ordinary share and US$         per ADS, assuming (i) no change to the number of ADSs offered by us as set forth on the cover page of this prospectus, (ii) the issuance of Class B ordinary shares by us to Sequoia in connection with the conversion of the convertible note and the concurrent private placement, and after deducting underwriting discounts and commissions and estimated offering expenses of the offering. The pro forma information discussed above is illustrative only. Our net tangible book value following the closing of this offering is subject to adjustment based on the actual public offering price of our ADSs and other terms of this offering determined at pricing.

The following table summarizes on a pro forma basis the differences as of September 30, 2013 between the existing shareholders and the new investors with respect to the number of ordinary shares represented by ADSs purchased from us, the total consideration paid and the average price per ordinary share paid before deducting underwriting discounts and commissions and estimated offering expenses of this offering. The information in the following table is illustrative only and the total consideration paid and the average price per ordinary share equivalent and per ADS equivalent is subject to adjustment based on the actual public offering price of our ADSs and other terms of this offering determined at pricing.

 

    

 

Ordinary Shares Purchased

    Total Consideration     Average
Price per
Ordinary
Share
Equivalent
     Average
Price per
ADS
Equivalent
 
      Number    Percent     Amount      Percent       

Existing shareholders

                   US$                                 US$                    US$                

New investors

                   US$                      US$         US$     
  

 

  

 

 

   

 

 

    

 

 

      

Total

        100.0   US$           100.0     
  

 

  

 

 

   

 

 

    

 

 

      

A US$1.00 increase (decrease) in the assumed public offering price of US$         per ADS would increase (decrease) total consideration paid by new investors, total consideration paid by all shareholders and the average price per ADS paid by all shareholders by US$         million, US$         million and US$        , respectively, assuming (i) no change in the number of ADSs sold by us as set forth on the cover page of this prospectus, (ii) the issuance of Class B ordinary shares by us to Sequoia in connection with the conversion of the convertible note and the concurrent private placement and without deducting underwriting discounts and commissions and estimated offering expenses of this offering.

 

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EXCHANGE RATE INFORMATION

Substantially all of our operations are conducted in China and all of our service fees are denominated in Renminbi. This prospectus contains translations of Renminbi amounts into U.S. dollars at specific rates solely for the convenience of the reader. Unless otherwise stated, all translations of the RMB into U.S. dollars were made at RMB6.1200 to US$1.00, the noon buying rate on September 30, 2013, as set forth in the H.10 statistical release of the U.S. Federal Reserve Board. We make no representation that the RMB or U.S. dollar amounts referred to in this prospectus could have been or could be converted into U.S. dollars or RMB, as the case may be, at any particular rate or at all. The PRC government imposes control over its foreign currency reserves in part through direct regulation of the conversion of Renminbi into foreign exchange and through restrictions on foreign trade. On October 18, the noon buying rate was RMB6.0966 to US$1.00.

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

 

     Exchange Rate  

Period

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

2008

     6.8225         6.9193         7.2946         6.7800   

2009

     6.8259         6.8295         6.8470         6.8176   

2010

     6.6000         6.7603         6.8330         6.6000   

2011

     6.2939         6.4630         6.6364         6.2939   

2012

     6.2301         6.2990         6.3879         6.2221   

2013

           

April

     6.1647         6.1861         6.2078         6.1647   

May

     6.1340         6.1416        
6.1665
  
     6.1213   

June

    
6.1374
  
    
6.1342
  
    
6.1488
  
    
6.1248
  

July

    
6.1284
  
    
6.1343
  
    
6.1408
  
    
6.1284
  

August

    
6.1193
  
    
6.1213
  
    
6.1302
  
    
6.1145
  

September

     6.1200         6.1198         6.1213         6.1178   

October (through October 18)

     6.0966         6.1134         6.1209         6.0980   

 

Source: Federal Reserve Statistical Release

 

(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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ENFORCEMENT OF CIVIL LIABILITIES

We are registered under the laws of the Cayman Islands as an exempted company with limited liability. We are registered in the Cayman Islands to take advantage of certain benefits associated with being a Cayman Islands exempted company, such as political and economic stability, an effective judicial system, a favorable tax system, the absence of foreign exchange control or currency restrictions and the availability of professional and support services. The court system in the Cayman Islands is effective because litigation practice and procedure are based on English law principles of civil procedure. The Grand Court of the Cayman Islands is presided over by the Chief Justice and Grand Court judges permanently residing in the islands. Appeals lie from the Grand Court to the Cayman Islands Court of Appeal, which sits in the Grand Cayman, and from there to the Judicial Committee of the Privy Council in England. However, the Cayman Islands has a less developed body of securities laws as compared to the United States and provides protections for investors to a significantly lesser extent. In addition, Cayman Islands companies may not have standing to sue before the federal courts of the United States.

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

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

Maples and Calder, our counsel as to Cayman Islands law, and Han Kun Law Offices, our counsel as to PRC law, have advised us that there is uncertainty as to whether the courts of the Cayman Islands or the PRC would, respectively, (1) recognize or enforce judgments of United States courts obtained against us or our directors or officers predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States, or (2) entertain original actions brought in the Cayman Islands or the PRC against us or our directors or officers predicated upon the securities laws of the United States or any state in the United States.

Maples and Calder 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 fiscal or revenue obligations and which was neither obtained in a manner nor is of a kind enforcement of which is contrary to natural justice or the public policy of the Cayman Islands, may be subject to enforcement proceedings as a debt in the courts of the Cayman Islands. However, the Cayman Islands courts are unlikely to enforce a punitive judgment of a United States court predicated upon the liabilities provision of the federal securities laws in the United States without retrial on the merits if such judgment gives rise to obligations to make payments that may be regarded as fines, penalties or similar charges. Neither the United States or the PRC has a treaty with the Cayman Islands providing for reciprocal recognition and enforcement of civil and commercial judgments of courts of the United States or the PRC, respectively.

Han Kun Law Offices has advised us that the recognition and enforcement of foreign judgments are provided for under the PRC Civil Procedure Law. PRC courts may recognize and enforce foreign judgments in accordance with the requirements of the PRC Civil Procedure Law based either on treaties between China and the country where the judgment is made or on principles of reciprocity between jurisdictions. China does not have any treaties or other form of reciprocity with the United States that provide for the reciprocal recognition and enforcement of foreign judgments. In addition, according to the PRC Civil Procedures Law, courts in the PRC will not enforce a foreign judgment against us or our directors and officers if they decide that the judgment

 

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violates the basic principles of PRC law or national sovereignty, security or public interest. As a result, it is uncertain whether and on what basis a PRC court would enforce a judgment rendered by a court in the United States. Furthermore, it will be difficult for the United States shareholders to originate actions against us in China based upon PRC laws due to our identity as a company incorporated under the laws of the Cayman Islands. It is also difficult for United States shareholders, by virtue only of holding our ADSs or ordinary shares, to establish a connection to the PRC as required by the PRC Civil Procedures Law in order for a PRC court to have jurisdiction.

 

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OUR HISTORY AND CORPORATE STRUCTURE

Our History

We began operations in the online lottery service industry in 2001 through one of our consolidated affiliated entities, E-Sun Network, in Shenzhen, China. In May 2006, E-Sun Network established its wholly owned subsidiary, E-Sun Sky Network, which became our major operation entity for our online lottery services business. To enable us to raise equity capital from investors outside of China, we set up a holding company structure by establishing our current Cayman Islands holding company, 500.com Limited, on April 20, 2007 under the name Fine Success Limited, which was changed to 500wan.com Limited on May 9, 2011 and further changed to our current name on October 9, 2013. In June 2007, we established our wholly owned PRC subsidiary, E-Sun Sky Computer. We established two PRC consolidated affiliated entities in December 2008, Youlanguang Technology, and Guangtiandi Technology. In February and March 2011, we established Fine Brand Limited, a company registered in the British Virgin Islands, and 500wan HK Limited, a company registered in Hong Kong, respectively, as our wholly owned subsidiaries. We transferred all the equity interests held by 500.com Limited in E-Sun Sky Computer to 500wan HK Limited in May 2011.

The following diagram illustrates our corporate structure as of the date of this prospectus. See “—Our Subsidiaries and Consolidated Affiliated Entities” for more information on the operations of our corporate entities.

 

LOGO

 

(1) E-Sun Network is approximately 18.8% owned by Jiepin Fu, our director and beneficial owner, approximately 23.8% owned by Ping Yuan, our beneficial owner and wife of our founder, chairman and CEO, Man San Law, approximately 14.3% owned by He Li, brother of our director, Qi Li, 11.0% owned by Xue Li, sister of our director, Qi Li, approximately 14.9% owned by Ying Zou, our employee and beneficial owner, approximately 17.1% owned by Bo Zou, our beneficial owner and employee. All shareholders of E-Sun Network are parties to the contractual arrangements. Our online lottery services were primarily provided through E-Sun Sky Network, the wholly owned subsidiary of E-Sun Network.

 

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(2) Youlanguang Technology is 50% owned by Jin Li and 50% owned by Jing Zhang, both of whom are our employees and parties to the contractual arrangements. Youlanguang Technology provide services to E-Sun Sky Network relating to the management of our users’ registration information and accounts.

 

(3) Guangtiandi Technology is 50% owned by Ying Wang and 50% owned by Liangdong Yuan, both of whom are our employees and parties to the contractual arrangements described below. Guangtiandi Technology provides services to E-Sun Sky Network relating to the implementation of the technical interface with the provincial lottery administration centers and the printing of the lottery tickets.

Our Subsidiaries and Consolidated Affiliated Entities

As of the date of this prospectus, we conduct our operations through the following subsidiaries and consolidated affiliated entities:

Non-PRC Subsidiaries

 

   

Fine Brand Limited, our wholly owned subsidiary incorporated in the British Virgin Islands, was established on February 9, 2011.

 

   

500wan HK Limited, a wholly owned subsidiary of Fine Brand Limited, was incorporated in Hong Kong on March 8, 2011.

PRC Subsidiary and Consolidated Affiliated Entities

We currently conduct substantially all of our operations through our PRC subsidiary and our consolidated affiliated entities:

 

   

E-Sun Sky Computer, our wholly owned subsidiary in the PRC, established on June 18, 2007, provides technical and business support as well as consulting services to our consolidated affiliated entities, including platform and software support and technical services to E-Sun Sky Network, the operating company of our online lottery service platform.

 

   

E-Sun Network, our consolidated affiliated entity, established on December 7, 1999, is the holding company of E-Sun Sky Network, the main operating company of our online lottery service business.

 

   

E-Sun Sky Network, a wholly owned subsidiary of E-Sun Network, established on May 22, 2006, is the main operating company for our online lottery service business. E-Sun Sky Network primarily provides online lottery services through our online operation platforms, including our operating websites, namely, www.500wan.com and www.500.com. Through cooperation with the relevant lottery administration centers, E-Sun Sky Network provides online lottery sales services, develops online lottery markets and constructs online distribution channels and network for sports lottery products.

 

   

Youlanguang Technology, our consolidated affiliated entity, established on December 16, 2008, is the management service provider of our online lottery service platform. Youlanguang Technology used to provide services to E-Sun Sky Network in user account registration and information management as well as lottery prize collection and account management. We may adjust the services provided by Youlanguang Technology according to the development of our business.

 

   

Guangtiandi Technology, our consolidated affiliated entity, established on December 16, 2008, provides technical support to our online lottery service platform, including services to E-Sun Sky Network relating to the construction of ticket printing system, and the implementation and management of the technical interface with the relevant lottery administration centers.

Our PRC subsidiary and our consolidated affiliated entities have entered into a series of contractual arrangements. See “—Contractual Arrangements with Our Consolidated Affiliated Entities.”

Contractual Arrangements with Our Consolidated Affiliated Entities

PRC laws and regulations currently restrict foreign ownership in companies providing value-added telecommunications services and do not allow foreign investments in the lottery industry. Because we are a

 

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Cayman Islands company, we are classified as a foreign enterprise under PRC laws and regulations and our wholly owned PRC subsidiary, E-Sun Sky Computer, is a foreign-invested enterprise. To comply with PRC laws and regulations, we conduct our operations in China through a series of contractual arrangements with our consolidated affiliated entities and their respective shareholders.

In September 2007, our PRC subsidiary, E-Sun Sky Computer entered into a set of control agreements with E-Sun Sky Network and its shareholders, which include the Exclusive Technology Consultation and Service Agreement, the Business Operation Agreement, the Equity Interest Disposal Agreement, the Equity Pledge Agreement and the Power of Attorney, or the control agreements. The control agreements, including the Business Operation Agreement, the Equity Interest Disposal Agreement and the Equity Pledge Agreement, were further amended in January 2010 and December 2010, respectively.

Following the establishment of Youlanguang Technology and Guangtiandi Technology in December 2008, E-Sun Computer entered into an identical set of control agreements with each of Youlanguang Technology and Guangtiandi Technology and their respective shareholders. The control agreements between E-Sun Sky Computer and Youlanguang Technology and its shareholders, including the Business Operation Agreement, the Equity Interest Disposal Agreement and the Equity Pledge Agreement, were further amended in August 2009 and September 2010. The control agreements between E-Sun Sky Computer and Guangtiandi Technology and its shareholders, including the Business Operation Agreement, the Equity Interest Disposal Agreement and the Equity Pledge Agreement, were amended in August 2009.

We have been relying and expect to continue to rely on our consolidated affiliated entities to operate our online lottery service business in China as long as PRC laws and regulations do not allow us to directly operate such business in China. We revised our contractual arrangements with the consolidated affiliated entities and their respective shareholders on June 1, 2011, and further amended our contractual arrangements with E-Sun Network and Guangtiandi Technology on May 2, 2013. These revised contractual arrangements continue to enable us to:

 

   

exercise effective control over E-Sun Network, Youlanguang Technology, and Guangtiandi Technology;

 

   

receive substantially all of the economic benefits and assume substantially all the losses of E-Sun Network, E-Sun Sky Network, Youlanguang Technology, and Guangtiandi Technology in consideration for the services provided by E-Sun Sky Computer, our PRC subsidiary;

 

   

have an exclusive option to purchase all of the equity interest in E-Sun Network, Youlanguang Technology, and Guangtiandi Technology to the extent permitted under PRC law; and

 

   

provide appropriate funds to the consolidated affiliated entities through E-Sun Sky Computer for major losses resulting from their business and operations if any are incurred.

Accordingly, under U.S. GAAP, we consolidate E-Sun Network, Youlanguang Technology, and Guangtiandi Technology as our “variable interest entities” in our consolidated financial statements.

Our contractual arrangements with our consolidated affiliated entities and their shareholders are described in further detail as follows:

Agreements that Transfer Economic Benefits to Us

Exclusive Business Cooperation Agreements.    The exclusive business cooperation agreements are entered into by E-Sun Sky Computer and each of our consolidated affiliated entities. Pursuant to these exclusive business cooperation agreements, E-Sun Sky Computer provides technical services, business consultations, marketing consultancy, product research and development to the affiliated consolidated entities, in exchange for a service fee. The service fee is payable at such time as agreed between E-Sun Sky Computer and the relevant consolidated affiliated entity and approved by the board of such consolidated affiliated entity. The term of each exclusive business cooperation agreement is 10 years from the effective date.

 

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Agreements that Provide Us with Effective Control

Exclusive Option Agreement.    The exclusive option agreements are entered into by E-Sun Sky Computer and the consolidated affiliated entities and each of their respective shareholders. Pursuant to these exclusive option agreements, the shareholders irrevocably granted E-Sun Sky Computer or its designated representative exclusive options to purchase, to the extent permitted under PRC law, all or part of their equity interest in the consolidated affiliated entities. E-Sun Sky Computer or its designated representative has sole discretion as to when to exercise these options, whether in part or in full. These agreements are for terms of 10 years and are renewable at E-Sun Sky Computer’s discretion.

In November 2012, E-Sun Sky Computer, the consolidated affiliated entities (excluding E-Sun Sky Network) and each of their respective shareholders entered into certain supplementary agreements to exclusive option agreements, pursuant to which the shareholders shall, in the manner permitted by PRC laws, transfer all the capital and assets (including but not limited to dividends, bonuses or any other rights and interests) they gain from the consolidated affiliated entities to E-Sun Sky Computer unconditionally per its request.

Equity Interests Pledge Agreements.    The equity interests pledge agreements are entered into by E-Sun Sky Computer and the consolidated affiliated entities and each of their respective shareholders. Pursuant to these equity interests pledge agreements, the shareholders have pledged their respective equity interests in the relevant consolidated affiliated entity to E-Sun Sky Computer to secure the obligations of such consolidated affiliated entity under its exclusive business cooperation agreement with E-Sun Sky Computer. In addition, except for the performance of the exclusive option agreement executed by them, the shareholders have agreed not to transfer, place or permit the existence of any security interest or other encumbrance on their respective equity interest, without the prior written consent of E-Sun Sky Computer.

Irrevocable Power of Attorney.    Each shareholder of the consolidated affiliated entities executed an irrevocable power of attorney appointing E-Sun Sky Computer as his or her representative to attend shareholders’ meetings of the consolidated affiliated entities and to vote on his or her behalf on all matters requiring shareholder approval, including but not limited to, the sale, transfer, pledge, or disposition of his or her shareholding in the consolidated affiliated entities. E-Sun Sky Computer is entitled to re-authorize or assign the rights granted to it under the power of attorney to any other person or entity at its own discretion. The power of attorney remains valid and irrevocable from the date of its execution, so long as each shareholder remains the shareholder of the consolidated affiliated entities.

Guangzhou Shu Lian Information Investment Co., Ltd. and Xiaojun Xu, two former shareholders of E-Sun Network, jointly entered into a share transfer agreement with Bo Zou on November 15, 2012, pursuant to which Guangzhou Shu Lian Information Investment Co., Ltd. and Xiaojun Xu transfer all the equity interest they respectively held in E-Sun Network to Bo Zou. E-Sun Network completed registration with relevant branch of SAIC for the aforementioned share transfer on December 5, 2012. Shijie Zhang, a former shareholders of Guangtiandi Technology, entered into a share transfer agreement with Liangdong Yuan on October 31, 2012, pursuant to which Shijie Zhang transfers all the equity interest he held in Guangtiandi Technology to Liangdong Yuan. Guangtiandi Technology completed registration with relevant branch of SAIC for the aforementioned share transfer on March 27, 2013. Accordingly, we updated certain control agreements on May 2, 2013 entered into by and among E-Sun Sky Computer, E-Sun Network and Bo Zou, including the Equity Interests Pledge Agreement, the Exclusive Option Agreement, and its supplementary agreement to replace those entered into by and among E-Sun Sky Computer, E-Sun Network, Guangzhou Shu Lian Information Investment Co., Ltd. and Xiaojun Xu respectively. We also updated the Irrevocable Power of Attorney executed by Bo Zou on May 2, 2013 to replace those executed by Guangzhou Shu Lian Information Investment Co., Ltd. and Xiaojun Xu respectively. In addition, we superseded agreements entered into by and among E-Sun Sky Computer, Guangtiandi Technology and Shijie Zhang, including the Equity Interests Pledge Agreement, the Exclusive Option Agreement and its supplementary agreement with agreements entered into by and among E-Sun Sky Computer, Guangtiandi Technology and Liangdong Yuan respectively on May 2, 2013. We also superseded the Irrevocable Power of Attorney executed by Shijie Zhang with the Irrevocable Power of Attorney executed by Liangdong Yuan on May 2, 2013. Moreover, in May 2013, Bo Zou executed a confirmation letter, under which

 

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he agrees to succeed to and assume any and all the rights and obligations of Xiaojun Xu and Guangzhou Shu Lian Information Investment Co., Ltd. under the aforementioned supplementary agreements immediately after the share transfer among Bo Zou, Xiaojun Xu and Guangzhou Shu Lian Information Investment Co., Ltd. completed and Bo Zou was registered as E-Sun Network’s shareholder. On the same date, Liangdong Yuan executed an identical confirmation letter, pursuant to which Liangdong Yuan agrees to succeed to and assume any and all the rights and obligations of Shijie Zhang under the aforementioned supplementary agreements immediately after the share transfer between Liangdong Yuan and Shijie Zhang completed and Liangdong Yuan was registered as Guangtiandi Technology’s shareholder.

We have been advised by our PRC legal counsel, Han Kun Law Offices, that the structure for operating our business in China (including our corporate structure and our contractual arrangements with our consolidated affiliated entities) complies, and immediately after completion of this offering will continue to comply, with all applicable PRC laws, rules and regulations, and does not violate any applicable PRC laws, rules or regulations. However, there are uncertainties regarding the interpretation and application of PRC laws, rules and regulations that are relevant to our business operations. Accordingly, there can be no assurance that the PRC regulatory authorities will not take a view that is contrary to the opinion of our PRC legal counsel. Our PRC legal counsel has further advised us that if a PRC government authority determines that our corporate structure, the contractual arrangements or the reorganization to establish our current corporate structure violates any applicable PRC laws, rules or regulations, the contractual arrangements may become invalid or unenforceable, and we could be subject to severe penalties and required to obtain additional governmental approvals from the PRC regulatory authorities. See “Risk Factors—Risks Related to Our Corporate Structure—If the PRC government finds that the agreements that establish the structure for operating our businesses in China do not comply with PRC governmental restrictions on foreign investment in the Internet and the lottery business, or if these regulations or the interpretation of existing regulations change in the future, we could be subject to severe penalties or be forced to relinquish our interests in those operations” and “Risk Factors—Risks Related to Doing Business in China—The approval of the China Securities Regulatory Commission, or the CSRC, may be required in connection with this offering. Any requirement to obtain prior CSRC approval could delay, or create uncertainties regarding, this offering, and our failure to obtain this approval, if required, could have a material adverse effect on our business, results of operations, reputation and trading price of our ADSs.”

 

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SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA

The following selected consolidated financial data for the periods and as of the dates indicated are qualified by reference to, and should be read 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.

Our selected consolidated financial data presented below for the years ended December 31, 2010, 2011 and 2012 and the selected consolidated balance sheet data as of December 31, 2011 and 2012 have been derived from our audited consolidated financial statements included elsewhere in this prospectus. Our selected consolidated financial data for the year ended December 31, 2009 and the selected consolidated balance sheet data as of December 31, 2009 and 2010 have been derived from our audited consolidated financial statements which are not included in this prospectus. Our audited consolidated financial statements are prepared in accordance with U.S. GAAP and have been audited by Ernst & Young Hua Ming LLP, an independent registered public accounting firm.

Our selected consolidated financial data for the nine months ended September 30, 2012 and 2013 and the selected consolidated balance sheet data as of September 30, 2013 have been derived from our unaudited interim condensed consolidated financial statements included elsewhere in this prospectus. We have prepared the unaudited interim condensed 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.

 

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     Year ended December 31,     For the nine months ended
September 30,
 
     2009     2010     2011     2012     2012     2013     2013  
     RMB     RMB     RMB          RMB               US$          RMB     RMB     US$  

Consolidated Statement of Comprehensive Income Data

                
     (in thousands, except for per share data)  

Net Revenues

     82,595        157,378        232,332        171,527        28,027        130,736        163,411        26,701   

Operating expenses:

                

Cost of services

     (15,969     (22,052     (24,425     (18,476     (3,019     (13,922     (19,564     (3,197

Sales and marketing

     (3,661     (14,252     (52,471     (45,794     (7,483     (36,322     (61,201     (10,000

General and administrative

     (20,780     (34,255     (101,996     (57,784     (9,442     (39,899     (46,517     (7,601

Service development expenses

     (6,757     (9,299     (19,566     (26,571     (4,342     (17,673     (18,924     (3,092

Write-off of deferred initial public offering expenses

                          (6,404     (1,046     (6,404              
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     (47,167     (79,858     (198,458     (155,029     (25,332     (114,220     (146,206     (23,890

Other operating income

     2,999        4,667        6,455        4,193        685        4,139        11,371        1,858   

Government grant

                   1,778        2,242        366        2,203        139        23   

Other operating expenses

     (2     (537     (296     (1,821     (298     (1,582     (2,647     (433
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating profit

     38,425        81,650        41,811        21,112        3,448        21,276        26,068        4,259   

Interest income

     259        102        243        1,132        185        813        251        41   

Interest expense

                                               (430     (70
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before income tax

     38,684        81,752        42,054        22,244        3,633        22,089        25,889        4,230   

Income tax expenses

     (13,177     (43,463     (28,497     (18,001     (2,940     (11,631     (5,291     (865
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     25,507        38,289        13,557        4,243        693        10,458        20,598        3,365   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other Comprehensive income (loss):

                

Foreign currency translation gain (loss)

     164        70        (224     58        9        6        1,296        212   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

     25,671        38,359        13,333        4,301        702        10,464        21,894        3,577   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Reconciliation of net income to net income attributable to ordinary shareholders:

                

Net income

     25,507        38,289        13,557        4,243        693        10,458        20,598        3,365   

Accretion of Series A contingently redeemable convertible preferred shares

     (11,420     (190                                          

Repurchase of Series B and B-1 contingently redeemable convertible preferred shares

            24,392                                             
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income attributable to ordinary shareholders

     14,087        62,491        13,557        4,243        693        10,458        20,598        3,365   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Earnings per share:

                

Basic

     0.06        0.27        0.06        0.02               0.05        0.09        0.01   

Diluted

     0.06        0.16        0.06        0.02               0.04        0.08        0.01   

Dividend declared per ordinary share

            0.69               0.39        0.06                        

Pro forma earnings per share(1)

                

Basic

                

Diluted

                

Non-GAAP financial data(2)

                

Adjusted net income (non-GAAP)(3)

     34,474        73,852        85,193        29,866        4,880        27,928        29,508        4,821   

 

(1) As adjusted to give effect to the issuance of              Class A ordinary shares on January 1, 2012 and 2013 at the mid-point of the estimated range of the public offering price of US$             per share to pay RMB85.8 million dividend declared in excess of net income of RMB4.2 million for the year ended December 31, 2012.

 

(2) As a supplement to net income, we use the non-GAAP financial measure of adjusted net income which is U.S. GAAP net income as adjusted to exclude share-based compensation and deferred tax expense relating to outside basis differences in our consolidated affiliated entities. This non-GAAP financial measure is provided as additional information to help our investors compare business trends among different reporting periods on a consistent basis and to enhance investors’ overall understanding of our current financial performance and prospects for the future. This non-GAAP financial measure should not be considered in addition to or as a substitute for or superior to U.S. GAAP net income. In addition, our definition of adjusted net income may be different from the definition of such term used by other companies, and therefore comparability may be limited.

 

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(3) We present adjusted net income (non-GAAP) excluding share-based compensation and deferred tax expense relating to outside basis difference from our consolidated affiliated entities. The following table reconciled our adjusted net income (non-GAAP) in 2009, 2010, 2011 and 2012 and the nine months ended September 30, 2012 and 2013 to the net income calculated and presented in accordance with U.S. GAAP.

 

     Year ended December 31,      Nine months
ended September 30,
 
     2009      2010      2011      2012      2012      2013  
     RMB      RMB      RMB      RMB      US$      RMB      RMB      US$  
     (in thousands)  

Net income

     25,507         38,289         13,557         4,243         693         10,458         20,598         3,365   

Adjustment for share-based compensation

                     50,154         13,704         2,239         11,000         3,021         494   

Adjustment for deferred tax expense relating to outside basis differences

     8,967         35,563         21,482         11,919         1,948         6,470         5,889         962   

Adjusted net income (non-GAAP)

     34,474         73,852         85,193         29,866         4,880         27,928         29,508         4,821   

 

     As of December 31,      As of
September 30,
 
     2009      2010      2011      2012      2013  
     RMB      RMB      RMB      RMB      US$      RMB      US$  
    

(in thousands)

 

Consolidated Balance Sheet Data:

                    

Total current assets

     178,980         206,534         308,523         329,821         53,893         417,225         68,174   

Total assets

     190,703         224,251         337,258         379,343         61,984         465,063         75,990   

Total current liabilities

     37,272         155,520         182,437         282,016         46,081         338,163         55,255   

Total liabilities

     58,418         213,389         262,909         381,963         62,412         442,768         72,348   

Contingently redeemable convertible preferred shares

     186,059                                                   

Total shareholders’ equity (deficit)

     (53,774      10,862         74,349         (2,620      (428      22,295         3,642   

Total liabilities and shareholders’ equity

     190,703         224,251         337,258         379,343         61,984         465,063         75,990   

The following tables set forth our user information and their purchase amounts during the indicated periods:

 

     Year ended December 31,      Nine months
ended
September 30,
 
         2009             2010         2011          2012          2013  
    

(in thousands)

 

Active Accounts(1):

               

Newly Registered Accounts(2)

     525           968        1,287         430         489   

Existing Accounts(3)

     156           418           606         518         295   
  

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Total

     681        1,386        1,893         948         784   
  

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 
      Year ended December 31,      Nine months
ended
September 30,
 
         2009             2010         2011          2012          2013  
     RMB     RMB     RMB     

RMB

     US$     

RMB

    

US$

 
     (in thousands)  

Purchase Amount:

                  

Newly Registered Accounts(2)

     490,325        830,857        1,026,761         374,005         60,939         619,303         101,193   

Existing Accounts(3)

     467,105        964,662        1,489,472         1,299,493         211,733         1,356,182         221,598   
  

 

 

   

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     957,430        1,795,519        2,516,233         1,673,498         272,672         1,975,485         322,791   
  

 

 

   

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Defined as registered accounts which made at least one purchase during the year or the period.

 

(2) Defined as accounts registered during the year or the period.

 

(3) Defined as accounts registered prior to the year or the period.

 

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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 sections entitled “Summary Consolidated Financial and Operating Data” and “Selected Consolidated Financial and Operating Data” and our audited consolidated financial statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and elsewhere in this prospectus.

Overview

We are a leading online sports lottery service provider in China, with the largest market share in the six months ended June 30, 2013 and the second largest market share in 2012 in terms of purchase amount of sports lottery products in the six months ended June 30, 2013, according to the iResearch Report. We act as an aggregator and processor of lottery purchase orders from our registered user accounts and currently derive substantially all of our revenues from service fees paid to us by provincial sports lottery administration centers for the purchase orders of sports lottery products that we direct to such centers. We offer a comprehensive and integrated suite of online lottery services, information, user tools and virtual community venues to our users. We were among the first companies to provide online lottery services in China, and we are one of the two entities that are authorized by the MOF to provide online lottery sales services on behalf of China Sports Lottery Administration Center, the government authority in charge of the issuance and sale of sports lottery products in China.

Prior to 2013, we provided online sales services for, and generated service fees from, both sports and welfare lottery product. During the voluntary suspension from March to November 2012, we continued to provide lottery sales services via our mobile applications and online platform via our mobile applications to mobile users and via our online platform to a limited number of loyal customers as a means of customer maintenance. Approximately 78.5% of our service fees during the voluntary suspension period were generated from our mobile applications. We resumed online lottery sales services for sports lottery products in November 2012 after we obtained the relevant approval for such lottery products from the MOF. Simultaneously, we ceased to provide sales services for welfare lottery products.

Our net revenues were RMB157.4 million, RMB232.3 million and RMB171.5 million (US$28.0 million) in 2010, 2011 and 2012, respectively, representing a 47.6% increase from 2010 to 2011 and a 26.2% decrease from 2011 to 2012, respectively. The majority of our service fees were generated from sports lottery products, which accounted for 76.9%, 78.7% and 86.0% of our total service fees in 2010, 2011 and 2012, respectively. The increases in percentages of revenue contribution from sports lottery products were results of our efforts to promote the sales of such products during the periods. Our net income was RMB38.3 million, RMB13.6 million and RMB4.2 million (US$0.7 million) in 2010, 2011 and 2012, respectively, representing a 64.5% decrease from 2010 to 2011 and a 69.1% decrease from 2011 to 2012. Our net income in 2011 and 2012 was adversely impacted by share-based compensation expenses of RMB50.2 million and RMB13.7 million (US$2.2 million), respectively. In addition, our net income in 2010, 2011 and 2012 was adversely impacted by deferred tax expenses relating to outside basis differences in our consolidated affiliated entities of RMB35.6 million and RMB21.5 million and RMB11.9 million (US$1.9 million), respectively. Our service fees increased by 49.3% from RMB142.1 million in the nine months ended September 30, 2012 to RMB212.2 million (US$34.7 million) in the nine months ended September 30, 2013. All of our service fees in the nine months ended September 30, 2013 were generated from sports lottery products. Our net revenues increased by 25.0% from RMB130.7 million in the nine months ended September 30, 2012 to RMB163.4 million (US$26.7 million) in the nine months ended September 30, 2013. Our net income increased by 96.2% from RMB10.5 million in the nine months ended September 30, 2012 to RMB20.6 million (US$3.4 million) in the nine months ended September 30, 2013.

 

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Factors Affecting Our Results of Operations

There are a number of factors that affect our results of operations, including:

 

   

continued growth in China’s economy and in the PRC lottery market in general

 

   

growth in China’s Internet, e-commerce and online lottery industry

 

   

number of registered and active accounts

 

   

our ability to implement our strategies and enter into and maintain service agreements with provincial lottery administration centers

 

   

PRC regulations affecting the Internet and online lottery industries

Continued growth in China’s economy and in the PRC lottery market in general

We conduct all of our business and operations in China. Accordingly, our results of operations have been, and are expected to continue to be, affected by the general performance of China’s economy. Since the inception of our business, we have benefited significantly from overall economic growth in China. The lottery market in China has experienced higher growth rates compared with the growth rates of China’s economy in recent years. According to the National Bureau of Statistics of China, from 2000 to 2012, China’s GDP grew from RMB9.9 trillion to RMB51.9 trillion (US$8.5 trillion), while in the same period the total lottery sales amount grew from RMB18 billion to RMB261.5 billion (US$42.6 billion) according to the MOF, representing a growth of more than 10 times. Although there is no assurance that the lottery market in China will continue to grow faster than China’s GDP, as a leading online lottery service provider, our financial results have been, and are expected to continue to be, affected by the performance of the lottery market in China. In addition, introduction of new lottery products by lottery administration centers will enable us to provide new services to our users and as a result increase our revenue.

Growth in China’s Internet, e-commerce and online lottery industry

We are an online service provider. As such, our results of operations are heavily dependent on the successful and continued development of China’s Internet, e-commerce and online lottery sectors. According to the iResearch Report, the Internet users in China grew from 457.3 million in 2010 to 513.1 million in 2011. The Internet has emerged as an increasingly attractive and cost-effective lottery distribution channel in China, especially as the number of Internet users, disposable income and network infrastructure in China has increased. According to the iResearch Report, the percentage of online lottery purchasers to the number of Internet users also grew from 1.1% in 2010 to 2.7% in 2012. As a result of increasing Internet penetration and usage in China, we anticipate demand for online lottery services in China will continue to grow. In addition, the continued development and improvement of the online payment system will also benefit the growth of the online lottery industry.

Number of registered and active accounts

Our online lottery services depend on our ability to maintain and expand our highly engaged user base. Active accounts as of the year end are registered accounts which had at least one purchase order during the year. The growth of number of active accounts is driven by our ability to continue to, among other things, enhance recognition of our brand, increase types of lottery products we service and offer high-quality services to our users. From 2010 to 2011, the number of our registered accounts and active accounts have increased significantly. Our user active level in 2012 was adversely affected by the voluntary suspension. We had 8.8 million, 13.8 million, 16.6 million and 18.4 million total registered accounts as of December 31, 2010, 2011 and 2012 and September 30, 2013, respectively. Among total registered accounts, 1.4 million, 1.9 million, 0.9 million and 0.8 million were active accounts in 2010, 2011 and 2012 and the nine months ended September 30, 2013, respectively. Since we resumed online sales services for sports lottery products in November 2012, we have experienced a recovery of our user activity level. The purchase amount of our users

 

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was RMB540.0 million, RMB699.9 million and RMB735.6 million in the three months ended March 31, 2013, June 30, 2013 and September 30, 2013, respectively, representing a 63.8%, 29.6% and 5.1% increase from their respective preceding quarters. Our number of active accounts was approximately 297,000, 389,000 and 374,000 in the three months ended March 31, 2013, June 30, 2013 and September 30, 2013, respectively, representing a 6.0% and 5.3% increase and a 3.9% decrease from their respective preceding quarters. As the Chinese online lottery industry continues to grow, we expect further expansion of our user base in the near future.

Our ability to implement our strategies and maintain service agreements with provincial lottery administration centers

We currently derive substantially all our net revenues from service fees paid to us by the provincial lottery administration centers for orders we direct to such centers. We have established mutually beneficial partnerships with provincial lottery administration centers, such as Jiangxi Sports Lottery Administration Center with which we have ongoing service agreement that is effective until 2017. We have been strengthening our partnerships with provincial lottery administration centers in recent years to implement our strategy to promote sales of sports match lottery products, as this particular type of lottery products are most suitable to be purchased online. The chances of winning of sports match lottery products depend on results of the respective sports matches and as a result have greater information and knowledge requirements of lottery purchasers than other types of lottery products whose chances of winning are purely based on mathematic odds. We promote sales of sports match lottery products in a number of ways. Firstly, we provide comprehensive information on soccer and basketball matches on our websites which helps our users to make informed purchase decision. Secondly, our pool purchase service offers inexperienced users a chance to follow more experienced users in choosing sports match lottery products to enhance their chances of winning. Thirdly, our online user platform offers our users a forum to discuss sports matches and fosters a sense of community. As a result, service fees generated from sports match lottery products accounted for 53.4%, 57.3%, 70.2% and 85.1% of total service fees generated from lottery products in 2010, 2011 and 2012 and the nine months ended September 30, 2013, respectively.

PRC regulations affecting the Internet and online lottery industries

The PRC government regulates the Internet and online lottery industries in China extensively. PRC laws, rules and regulations cover virtually every aspect of these industries, including entry into the industries, the scope of permissible business activities and foreign investment in the industries. The PRC government also exerts considerable direct and indirect influence over these industries by imposing industry policies and other economic measures. Many of these regulations have recently been implemented and are expected to be refined and adjusted over time. It also regulates Internet access and the distribution of news, information or other content, as well as provision of products and services, through the Internet.

The PRC laws governing the online sales of lotteries are relatively new. On September 26, 2010, the MOF issued the Interim Measures for the Administration of the Internet Sales of Lottery, which is the first comprehensive regulation governing the sales of lotteries through the Internet. This regulation allows qualified service providers to provide online lottery services once approved by the MOF. On January 18, 2012, the MOF, the Ministry of Civil Affairs and the General Administration of Sports of China jointly promulgated the Implementing Rules of Regulation on Administration of Lottery which set forth, among other things, detailed requirements and qualifications for entities to obtain approval to conduct online lottery sales. From March to November 2012, we voluntarily suspended our online lottery sales services to substantially all of our customers in response to the Urgent Notice, which resulted in a decrease in our net revenues in 2012 as compared to 2011. We obtained the relevant approval to conduct online sales services for sports lottery products from the MOF in November 2012. Since the relevant rules and regulations are relatively new, our results of operations may be affected by their interpretation and implementation in the future.

Net Revenues

Our net revenues were RMB157.4 million, RMB232.3 million and RMB171.5 million (US$28.0 million) in 2010, 2011 and 2012, respectively, representing a 47.6% increase from 2010 to 2011 and a 26.2% decrease from

 

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2011 to 2012, respectively. Our net revenues were RMB130.7 million and RMB163.4 million (US$26.7 million) in the nine months ended September 30, 2012 and 2013, respectively, representing a 25.0% increase over the corresponding periods. We currently derive substantially all of our net revenues from service fees paid to us by the provincial lottery administration centers for orders we direct to such centers. The remaining of our net revenues were derived from service fees paid to us by third party aggregators for orders we direct to such aggregators, who in turn direct such orders to provincial lottery administration centers. The table below sets forth our net revenues in aggregate and derived from service fees paid to us by provincial lottery administration centers and from service fees paid to us by third-party aggregators for the periods indicated:

 

     Year ended December 31,     Nine months ended
September 30,
 
     2010     2011     2012     2012     2013  
     RMB     RMB     RMB     US$     RMB     RMB     US$  
     (in thousands)  

Provincial lottery administration centers

     155,771        221,216        169,444        27,687        130,142        201,962        33,000   

Third party aggregators

     9,786        25,110        15,107        2,468        11,927        10,248        1,675   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total service fees

     165,557        246,326        184,551        30,155        142,069        212,210        34,675   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Deductibles(1)

     (8,179     (13,994     (13,024     (2,128     (11,333     (48,799     (7,974
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net revenues

     157,378        232,332        171,527        28,027        130,736        163,411        26,701   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) The table below sets forth the breakdowns of the deductibles for the periods indicated:

 

     Year ended December 31,      Nine months ended
September 30,
 
     2010      2011      2012      2012      2013  
     RMB      RMB      RMB      US$      RMB      RMB      US$  
    

(in thousands)

 

Residual payments to complete lottery pool purchases

     6,441         9,526         3,111         508         2,893         9,703         1,585   

Super VIP incentive

     1,738         4,468         1,667         272         1,594         16,616         2,715   

Promotional incentives granted to users

                     8,246         1,348         6,846         22,480         3,674   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     8,179         13,994         13,024         2,128         11,333         48,799         7,974   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The following table sets forth our net revenues by lottery type for the periods indicated:

 

    Year ended December 31,     Nine months ended September 30,  
    2010     2011     2012     2012     2013  
    RMB     %     RMB     %     RMB     US$     %     RMB     %     RMB     US$     %  
   

(in thousands, except for percentages)

 

Sports Lottery

    127,382        76.9        193,874        78.7        158,683        25,928        86.0        119,469        84.1        212,210        34,675        100   

Welfare Lottery

    38,175        23.1        52,452        21.3        25,868        4,227        14.0        22,600        15.9                        
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total service fees

    165,557        100        246,326        100        184,551        30,155        100        142,069        100        212,210        34,675        100   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Deductibles

    (8,179       (13,994       (13,024     (2,128       (11,333       (48,799     (7,974  
 

 

 

     

 

 

     

 

 

   

 

 

     

 

 

     

 

 

   

 

 

   

Net revenues

    157,378          232,332          171,527        28,027          130,736          163,411        26,701     
 

 

 

     

 

 

     

 

 

   

 

 

     

 

 

     

 

 

   

 

 

   

Service fees generated from sports lottery products accounted for 76.9%, 78.7%, 86.0% and 100% of total service fees generated from lottery products in 2010, 2011, 2012 and the nine months ended September 30, 2013, respectively. The increases in percentage of revenue contribution from sports lottery products from 2010 to 2012 were results of our efforts to promote the sales of sports match lottery products during the periods. After we ceased to provide sales services for welfare lottery products in November 2012, all our service fees were generated from sports lottery products.

Lottery products can also be divided into three types as set forth by the MOF, namely, sports match lottery, Lotto (including high frequency lottery) and instant lottery. Both sports lottery administration centers and welfare lottery administration centers issue Lotto and instant lottery products, while only sports lottery administration

 

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centers issue sports match lottery products. We do not provide services for any instant lottery products as they are currently only sold through traditional channels. The table below sets forth the breakdown of our net revenues by lottery type for the periods indicated. We list high frequency lottery products as a separate revenue category because of its relatively significant proportion of our net revenues.

 

    Year ended December 31,     Nine months ended September 30,  
    2010     2011     2012     2012     2013  
    RMB     %     RMB     %     RMB     US$     %     RMB     %     RMB     US$     %  
    (in thousand, except for percentages)        

Sports match lottery

    88,381        53.4        141,116        57.3        129,562        21,170        70.2        96,600        68.0        180,580        29,507        85.1   

Lotto*

    39,099        23.6        58,260        23.7        35,629        5,822        19.3        29,785        21.0        8,336        1,362        3.9   

High frequency lottery

    38,077        23.0        46,950        19.0        19,360        3,163        10.5        15,684        11.0        23,294        3,806        11.0   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total service fees

    165,557        100        246,326        100        184,551        30,155        100       
142,069
  
    100        212,210        34,675        100   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Deductibles

    (8,179       (13,994       (13,024     (2,128       (11,333       (48,799     (7,974  
 

 

 

     

 

 

     

 

 

   

 

 

     

 

 

     

 

 

   

 

 

   

Net Revenues

    157,378          232,332          171,527        28,027          130,736          163,411        26,701     
 

 

 

     

 

 

     

 

 

   

 

 

     

 

 

     

 

 

   

 

 

   

 

* excluding high frequency lottery

We derived the majority of our service fees from sports match lottery products, which accounted for 53.4%, 57.3%, 70.2% and 85.1% of total service fees generated from lottery products in 2010, 2011, 2012 and the nine months ended September 30, 2013, respectively. We expect sales from the three types of lottery products to grow in the next few years, due to the continued growth of the online lottery market as well as introductions of new types of lottery products by lottery administration centers. In particular, we expect the growth of service fees generated from sports match lottery products to increase the fastest among the three types of lottery products, due to our continued efforts to promote sales of such lottery products. For more details, see “—Factors Affecting Our Results of Operations—Our ability to implement our strategies and maintain service agreements with provincial lottery administration centers.”

Operating Expenses

The table below sets forth our operating expenses by amount and as a percentage of our net revenues for the periods indicated:

 

    Year ended December 31,     Nine months ended September 30,  
    2010     2011     2012     2012     2013  
    RMB     %     RMB     %     RMB     US$     %     RMB     %     RMB     US$     %  
   

(in thousands, except for percentages)

 

Operating Expenses:

                       

Cost of services

    22,052        14.0        24,425        10.5        18,476        3,019        10.8        13,922        10.7        19,564        3,197        12.0   

Sales and marketing

    14,252        9.1        52,471        22.6        45,794        7,483        26.7        36,322        27.8        61,201        10,000        37.4   

General and administrative

    34,255        21.8        101,996 (1)      43.9        57,784 (2)      9,442        33.7        39,899        30.5        46,517        7,601        28.5   

Service development expenses

    9,299        5.9        19,566        8.4        26,571        4,342        15.5        17,673        13.5        18,924        3,092        11.6   

Write-off of deferred initial public offering expense

                                6,404        1,046        3.7        6,404        4.9                        
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

    79,858        50.8        198,458        85.4        155,029        25,332        90.4        114,220        87.4        146,206        23,890        89.5   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) including share-based compensation expenses of RMB47.4 million and the audit fees of RMB8.9 million for professional services rendered by our principal auditor related to this offering.
(2) including share-based compensation expenses of RMB10.9 million (US$1.8 million).

Our operating expenses consist primarily of cost of services, sales and marketing expenses, general and administrative expenses and service development expenses.

 

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Cost of Services

Our cost of services is primarily related to the online lottery services we provide, and is largely directly linked to the level of our net revenues. Our cost of services as a percentage of our net revenues was 14.0%, 10.5% and 10.8% in 2010, 2011 and 2012, and 10.7% and 12.0% in the nine months ended September 30, 2012 and 2013, respectively. The increase in percentage from the nine months ended September 30, 2012 to 2013 was primarily due to the increase in account handling expenses. As our business continues to recover and grow, we expect the absolute amount of our cost of service will continue to increase but we expect the cost of service as a percentage of our net revenues to gradually stabilize.

Our cost of services primarily consists of:

 

   

business tax, which consists of business taxes, surcharges and cultural development fees that are levied on our online lottery services, was RMB5.3 million, RMB7.6 million and RMB5.5 million (US$0.9 million) in 2010, 2011 and 2012, and RMB4.4 million (US$0.7 million) and RMB5.7 million in the nine months ended September 30, 2012 and 2013, respectively, representing 3.4%, 3.3%, 3.2%, 3.4% and 3.5% of our net revenues in the corresponding periods;

 

   

account handling expenses, which consist primarily of transaction fees payable to banks and third-party payment processors for cash transfers between our users’ accounts on our websites and their accounts with banks or third-party payment processors, were RMB4.5 million, RMB5.2 million and RMB2.4 million (US$0.4 million) in 2010, 2011 and 2012, and RMB1.9 million and RMB4.6 million (US$0.7 million) in the nine months ended September 30, 2012 and 2013, respectively, representing 2.9%, 2.2%, 1.4%, 1.5% and 2.8% of our net revenues in the corresponding periods;

 

   

salary and benefit expenses for our lottery ticket processing staff were RMB2.6 million, RMB3.4 million and RMB3.1 million (US$0.5 million) in 2010, 2011 and 2012, and RMB2.1 million and RMB2.4 million (US$0.4 million) in the nine months ended September 30, 2012 and 2013, respectively, representing 1.6%, 1.5%, 1.8%, 1.6% and 1.5% of our net revenues in the corresponding periods; and

 

   

server leasing and maintenance expenses, which consist primarily of leasing expense of servers and other equipment used in providing online services, were RMB2.8 million, RMB4.8 million and RMB4.7 million (US$0.8 million) in 2010, 2011 and 2012, and RMB3.5 million and RMB4.5 million (US$0.7 million) in the nine months ended September 30, 2012 and 2013, respectively, representing 1.8%, 2.1%, 2.7%, 2.6% and 2.7% of our net revenues in the corresponding periods.

Sales and marketing expenses

Our sales and marketing expenses as a percentage of our net revenues were 9.1%, 22.6% and 26.7% in 2010, 2011 and 2012, and 27.8% and 37.4% in the nine months ended September 30, 2012 and 2013, respectively. The increase in percentage from the nine months ended September 30, 2012 to 2013 was primarily due to our increased sales and marketing efforts in 2013. Going forward, we expect our sales and marketing expenses to continue to increase as we grow our business. In particular, we decided to focus on marketing and promotion of our brand in 2013 in order to recover and grow our user base and user activity level following the voluntary suspension.

Our sales and marketing expenses consist primarily of:

 

   

commissions to third-party Internet companies, which are the portion of service fees we pay to third-party Internet companies for purchase orders placed on our websites by users redirected from their websites. The amount of such commissions paid to third-party Internet companies for each redirected order depends on an agreed-upon allocation ratio. The commissions to third-party Internet companies were RMB10.2 million, RMB14.5 million and RMB8.1 million (US$1.3 million) in 2010, 2011 and 2012, and RMB6.7 million and RMB9.1 million (US$1.5 million) in the nine months ended September 30, 2012 and 2013, respectively, representing 6.5%, 6.2%, 4.7%, 5.1% and 5.6% of our net revenues in the corresponding periods;

 

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salary and benefit expenses for sales and marketing staff, which were RMB1.4 million, RMB3.6 million and RMB4.2 million (US$0.7 million) in 2010, 2011 and 2012, and RMB3.0 million and RMB2.7 million (US$0.4 million) in the nine months ended September 30, 2012 and 2013, respectively, representing 0.9%, 1.6%, 2.5%, 2.3% and 1.7% of our net revenues in the corresponding periods;

 

   

advertising expenses, which consist primarily of expenses associated with advertisements we placed on third-party websites, were RMB2.3 million, RMB20.8 million and RMB12.1 million (US$2.0 million) in 2010, 2011 and 2012, and RMB11.6 million and RMB19.2 million (US$3.1 million) in the nine months ended September 30, 2012 and 2013, respectively, representing 1.5%, 9.0%, 7.1%, 8.8% and 11.7% of our net revenues in the corresponding periods; and

 

   

promotional event expenses, which primarily consist of expenses associated with various promotional events including our sponsorship for the CFA 500.com Star Project and Hangzhou Greentown Soccer Club, were nil, RMB5.3 million, RMB13.7 million (US$2.2 million) in 2010, 2011 and 2012, and RMB10.0 million and RMB13.5 million (US$2.1 million) in the nine months ended September 30, 2012 and 2013, respectively, representing nil, 2.3%, 8.0%, 7.7% and 8.3% of our net revenues in the corresponding periods.

General and administrative expenses

Our general and administrative expenses as a percentage of our net revenues were 21.8%, 43.9% and 33.7% in 2010, 2011 and 2012, and 30.5% and 28.5% in the nine months ended September 30, 2012 and 2013, respectively. General and administrative expenses in 2011 consisted mainly of share-based compensation expenses we incurred for shares and share options we issued to our directors, employees and consultants on April 8, 2011, for the purpose of retaining them and motivating them to serve our Company in their best efforts. For the number of options granted to our directors, employees and consultants, see note 14 to the Audited Consolidated Financial Statements. We expect that our general and administrative expenses will continue to increase as we incur additional costs in growing our business and after becoming a publicly traded company, including share-based compensation expenses for management, depreciation of new property, plant and equipment purchased and costs to enhance our internal control, but we expect general and administrative expense as a percentage of our net revenues to gradually decrease.

Our general and administrative expenses consist primarily of:

 

   

salary and benefit expenses for our management and general administrative staff, which were RMB16.1 million, RMB21.3 million and RMB23.3 million (US$3.8 million) in 2010, 2011 and 2012, and RMB15.9 million and RMB19.2 million (US$3.1 million) in the nine months ended September 30, 2012 and 2013, respectively, representing 10.2%, 9.2%, 13.6%, 12.2% and 11.7% of our net revenues in the corresponding periods;

 

   

office expenses, which consist primarily of office rental and other office administrative expenses, were RMB7.4 million, RMB13.6 million and RMB10.7 million (US$1.7 million) in 2010, 2011 and 2012, and RMB8.0 million and RMB10.1 million (US$1.5 million) in the nine months ended September 30, 2012 and 2013, respectively, representing 4.7%, 5.8%, 6.2%, 6.1% and 6.5% of our net revenues in the corresponding periods;

 

   

travel, communication and other business expenses, which consist primarily of expenses associated with business travels, were RMB5.4 million, RMB5.7 million and RMB6.0 million (US$1.0 million) in 2010, 2011 and 2012, and RMB4.0 million and RMB6.8 million (US$1.1 million) in the nine months ended September 30, 2012 and 2013, respectively, representing 3.4%, 2.4%, 3.5%, 3.1% and 4.2% of our net revenues in the corresponding periods;

 

   

third-party professional service fees, which consist primarily of professional service fees paid to third-party professionals, were RMB3.2 million, RMB11.1 million and RMB2.4 million (US$0.4 million) in 2010, 2011 and 2012, and RMB0.6 million and RMB1.5 million (US$0.3 million) in the nine months ended September 30, 2012 and 2013, respectively, representing 2.0%, 4.8%, 1.4%, 0.5% and 0.9% of our net revenues in the corresponding periods; and

 

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share-based compensation expenses, which were RMB47.4 million and RMB10.9 million (US$1.8 million) in 2011 and 2012 and RMB8.8 million and RMB2.1 million (US$0.3 million) in the nine months ended September 30, 2012 and 2013, representing 20.4%, 6.4%, 6.7% and 1.3% of our net revenues in the corresponding periods. We did not incur any share-based compensation expenses in 2010.

Service development expenses

Our service development expenses are primarily related to our research and development activities. Service development expenses as a percentage of our net revenues were 5.9%, 8.4% and 15.5% in 2010, 2011 and 2012, and 13.5% and 11.6% in the nine months ended September 30, 2012 and 2013, respectively.

Our service development expenses consist primarily of salary and benefit expenses for our research and development staff, which were RMB7.2 million, RMB15.5 million and RMB19.2 million (US$3.1 million) in 2010, 2011 and 2012, and RMB12.7 million and RMB14.2 million (US$2.3 million) in the nine months ended September 30, 2012 and 2013, respectively, representing 4.6%, 6.7%, 11.2%, 9.7% and 8.7% of our net revenues in the corresponding periods.

Other Operating Income

Our other operating income consists primarily of pool purchase prize amounts to which we are entitled from pool purchase prize distributions in respect of residual payments we make to complete lottery pool purchases. Our other operating income was RMB4.7 million, RMB6.5 million and RMB4.2 million (US$0.7 million) in 2010, 2011 and 2012, and RMB4.1 million and RMB11.4 million (US$1.9 million) in the nine months ended September 30, 2012 and 2013, respectively.

Government Grant

In 2011, 2012 and the nine months ended September 30, 2013, we obtained grants from Shenzhen local government in an aggregate amount of RMB1.8 million, RMB2.2 million, and RMB0.1 million (US$16,000), respectively, including grants to key local Internet businesses, project development, and a reimbursement for expense incurred in connection with the proposed listing. We might obtain similar grants from time to time in the future, but there is no assurance that we will continue to obtain such grants on a regular basis.

Income Tax

Cayman Islands

Under the current laws of the Cayman Islands, we are not subject to tax on income or capital gains. In addition, upon payments of dividends by us to our shareholders, no Cayman Islands withholding tax will be imposed.

China

The EIT Law became effective on January 1, 2008. The EIT Law applies a uniform 25% enterprise income tax, or EIT, rate to both foreign invested enterprises and domestic enterprises. Accordingly, E-Sun Sky Computer, Youlanguang Technology and Guangtiandi Technology were subject to an EIT rate of 25% in 2010, 2011 and 2012 and the nine months ended September 30, 2013, respectively.

The EIT Law provides a transition period from its effective date for the enterprises which were established before the promulgation date of the EIT Law and which were entitled to a preferential tax treatment such as a reduced tax rate or a tax holiday. According to the transitional rule, certain categories of enterprises, including the enterprises located in Shenzhen Special Economic Zone which previously enjoyed a preferential EIT rate of 15%, are eligible for a five-year transition period during which the EIT rate will be gradually increased to the uniform rate of 25%. Therefore, E-Sun Network was subject to transitional EIT rates of 22%, 24%, 25% and 25% in 2010, 2011 and 2012, and the nine months ended September 30, 2013, respectively.

E-Sun Sky Network qualifies as a “software enterprise” and was granted exemption from EIT for its first two years of operations and a reduction in half for the succeeding three years commencing from the first profit-making year. 2006 was the first year of EIT exemption for E-Sun Sky Network. In addition, E-Sun Sky Network

 

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is subject to the transition rule discussed above. As a result, E-Sun Sky Network was subject to EIT at rates of 11%, 24% and 25% in 2010, 2011 and 2012, respectively. In February 2011, E-Sun Sky Network obtained the certificate of “Key Software Enterprise” and therefore was granted a preferential income tax rate of 10% for the year ended December 31, 2010. In October 2011, E-Sun Sky Network obtained the certificate of “High-tech Enterprise” and was granted a preferential income tax rate of 15% for the three years commencing from 2011. In April 2013, E-Sun Sky Network was qualified as a “national key software enterprise” and was entitled to a preferential income tax rate of 10% for the years ended December 31, 2011 and 2012.

In March 2011, E-Sun Sky Computer became qualified as a “software enterprise” and was granted exemption from EIT for its first two years of operations commencing from its first profit-making year and a reduction in EIT rate by half for the succeeding three years.

Our tax expenses include a deferred tax expense relating to outside basis differences in our consolidated affiliated entities. This deferred tax expense relating to outside basis differences was RMB35.6 million and RMB21.5 million and RMB11.9 million (US$1.9 million) in 2010, 2011 and 2012, and RMB6.5 million and RMB5.9 million (US$1.0 million) in the nine months ended September 30, 2012 and 2013, respectively. The deferred tax expense relating to outside basis differences arises from (i) aggregate undistributed earnings and share capital of the consolidated affiliated entities that are available for distribution to E-Sun Sky Computer, a PRC tax resident company, and (ii) aggregate undistributed earnings of our PRC subsidiary, E-Sun Sky Computer, that are available for distribution to the Company, a non-PRC tax resident company. The decrease in the income tax expense from 2010 to 2012 is mainly due to the decrease in the deferred tax liabilities arising from aggregate undistributed earnings of the consolidated affiliated entities that are available for distribution to E-Sun Sky Computer. The decrease in the income tax expense in the nine months ended September 30, 2013 as compared to the nine months ended September 30, 2012 is mainly due to the change of income tax rate of E-Sun Sky Network from 15% to 10%. The effect of the change in tax rate of RMB6.4 million (US$1.0 million) was recognized as a discrete event in the current period accordingly.

For 2011 and 2012, we recognized an income tax expense of RMB28.5 million and an income tax expense of RMB18.0 million (US$2.9 million), respectively. As of December 31, 2011, the aggregate undistributed earnings of the foreign subsidiaries that were available for distribution to the Company were considered to be indefinitely reinvested and accordingly, no provision was made for income taxes that would be payable upon the distribution of those amounts to us. Determination of the amount of unrecognized deferred tax liabilities related to these earnings was not practicable. For the year ended December 31, 2012, our management reassessed the adequacy of working capital and determined that the foreign earnings are no longer indefinitely reinvested. As a result, we recorded a deferred tax liability related to the aggregate undistributed earnings of the foreign subsidiaries. As of September 30, 2013, we have recognized RMB10.7 million (US$1.8 million) as an accrual for unrecognized tax positions and related interest and penalties.

Critical Accounting Policies

We prepare our financial statements in conformity with U.S. GAAP, which requires us to make judgments, estimates and assumptions that affect the reported amounts of our assets and liabilities, disclosure of contingent assets and liabilities on the date of each set of financial statements and the reported amounts of revenues and expenses during each financial reporting period. We continually evaluate these estimates and assumptions based on the most recently available information, our own historical experience and various other assumptions that we believe to be reasonable under the circumstances. Since the use of estimates and assumptions is an integral component of the financial reporting process, actual results could differ from those estimates and assumptions.

An accounting policy is considered to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time such estimate is made, and if different accounting estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically could materially impact the consolidated financial statements. We believe the following critical accounting policies reflect the more significant estimates and assumptions used in the preparation of our consolidated financial statements. The following descriptions of critical accounting policies, judgments and

 

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estimates should be read in conjunction with our consolidated financial statements and other disclosures included elsewhere in this prospectus.

Revenue Recognition

Our revenues are derived principally from online lottery purchase services. We recognize revenues only when (i) there is persuasive evidence of an arrangement exists; (ii) the service has been rendered; (iii) the fees are fixed or determinable; and (iv) collectability is reasonably assured. Specifically, we recognize revenues based on the following revenue recognition principles:

Online lottery purchase services

We earn service fees for online lottery purchase services and revenues that are generated from processing lottery purchase orders from our registered users which we refer to as “service fees.” The registered users enter into certain terms and conditions when they first open their accounts with us. Lottery purchase orders are placed by users through our websites. Then we process these orders with the lottery administration centers. Prior to processing orders, users prepay all purchase amounts. Service fees that we receive from the lottery centers are based on pre-determined and negotiated service fee rates and the total amount of the processed orders. Pursuant to ASC 605-45, Principal Agent Considerations, we record service fees on a net basis because we are not the primary obligor in the arrangement, but instead we act as an agent in providing such purchase services.

Contingent service fee

We are entitled to receive additional service fees from lottery centers when the total amounts of our purchase orders reach an agreed threshold, which we refer to as “contingent service fees.” As we are the agent in providing lottery purchase services, when the agreed thresholds are reached, any contingent service fees received are recorded as net revenues. A monthly reconciliation is performed by us to determine whether such thresholds are reached. Once the agreed threshold is reached, the contingent service fee is then fixed and not subject to any adjustments.

Super VIP incentives

Certain qualified registered users, or Super VIPs, are entitled to receive incentives from us based on actual purchase amount of each transaction. As we do not receive an additional service or benefit from the Super VIP other than service fee earned from lottery administration centers by us from the transaction, the incentives are recognized as a reduction of revenue at each year end in accordance with ASC 605-50, Customer Payments and Incentives.

Lottery pool purchase service

A user may start a lottery pool on our websites. As we contribute the residual amount to the lottery pool in order to complete the lottery pool and earn service fees from the purchase made by the lottery pool, we recognize the lottery fees that we pay to the lottery centers in respect of residual amounts of lottery pools as a reduction in revenue. As our principal activity is to provide lottery purchase services to our users, we recognize the residual amount of the lottery pool we receive after distribution of the prizes as other income upon the announcement of lottery results.

Income Taxes

We follow the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the period in which the differences are expected to reverse. We record a valuation allowance to offset deferred tax assets if, based on the weight of available evidence, it is more likely than not that some portion, or all, of the deferred tax assets will not be realized. Our analyses of future taxable income are subject to a wide range of variables, many of which involve estimates.

 

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Uncertainty regarding future events and changes in tax regulation could materially alter our valuation of deferred tax liabilities and assets. If we determine that we would not be able to realize all or part of our deferred tax assets in the future, we would increase our valuation allowance and make a corresponding change to our earnings for the period in which we make such determination. If we later determine that we are more likely than not to realize our deferred tax assets, we would reverse the applicable portion of the previously provided valuation allowance. On January 1, 2007, we adopted ASC 740-10, Income taxes: Overall, to account for uncertainties in income taxes. There was no cumulative effect of the adoption of ASC 740-10 to beginning retained earnings. Interest and penalties arising from underpayment of income taxes are computed in accordance with the related PRC tax law. The amount of interest expense is computed by applying the applicable statutory rate of interest to the difference between the tax position recognized and the amount previously taken or expected to be taken in a tax return. Interest and penalties recognized in accordance with ASC 740-10 is classified in the consolidated statements of comprehensive income as income tax expense.

In accordance with the provisions of ASC 740-10, we recognize the impact of a tax position if a tax return position or future tax position is “more likely than not” to prevail based on the facts and technical merits of the position. Tax positions that meet the “more likely than not” recognition threshold are measured at the largest amount of tax benefit that has a greater than a fifty percent likelihood of being realized upon settlement. Our estimated liability for unrecognized tax benefits which is included in “long-term payables” is periodically assessed for adequacy and may be affected by changing interpretations of laws, rulings by tax authorities, changes and developments with respect to tax audits, and expiration of the statute of limitations. The outcome for a particular audit cannot be determined with certainty prior to the conclusion of the audit and, in some cases, appeal or litigation process. The actual benefits ultimately realized may differ from our estimates. As each audit is concluded, adjustments, if any, are recorded in our financial statements. Additionally, in future periods, changes in facts, circumstances, and new information may require us to adjust the recognition and measurement estimates with regard to individual tax positions. Changes in recognition and measurement estimates are recognized in the period in which the changes occur. In certain situations, the PRC tax authorities may challenge positions adopted in our income tax filings. In accounting for uncertain tax positions in the financial statements presented, we have made estimates based on assumptions with respect to the expectations of the outcome of the tax position we have taken. If those expectations were to change, our financial position and results of operations could be materially affected.

Share-based compensation

On March 28, 2011, our shareholders and board of directors approved the 2011 Share Incentive Plan (the “Plan”). The Plan provides for the grant of options, restricted shares and other share-based awards. All options granted under the Plan shall have their exercise prices denominated in U.S. dollars, which is the functional currency of the Company. The board of directors has authorized under the Plan the issuance of up to 12% of our issued and outstanding Class A ordinary shares from time to time, on an as-exercised and fully diluted basis, upon exercise of awards granted under the Plan. The maximum term of any issued stock option is 10 years from the grant date.

On April 8, 2011, we granted 13,864,000 stock options to a director and certain employees with an exercise price of US$0.40. For these awards, 5,506,600 options will be vested upon the first anniversary of the grant date, 5,225,800 options will be vested upon the second anniversary of the grant date, 1,565,800 options will be vested upon the third anniversary of the grant date, and 1,565,800 options will be vested upon the fourth anniversary of the grant date. On the same day, we granted 5,003,980 stock options to another director with an exercise price of US$0.40 per share, and all were vested on the grant date. On the same day, we granted 12,600,000 stock options to certain consultants with an exercise price of US$0.40 per share, and all were vested on the grant date.

Share options granted to employees and the directors are accounted for under ASC 718, Share-Based Payment. In accordance with ASC 718, we determine whether a share option should be classified and accounted for as a liability award or an equity award. All grants of share options to employees and the director classified as

 

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equity awards are recognized in the financial statements based on their grant date fair values. There were no liability awards granted during any of the periods stated herein. We recognize compensation expenses using the straight-line method for share options granted with graded vesting based on service conditions. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in the subsequent period if actual forfeitures differ from initial estimates. Forfeiture rate is estimated based on historical and future expectation of employee turnover rate and is adjusted to reflect future change in circumstances and facts, if any. Share-based compensation expense is recorded net of estimated forfeitures such that expense was recorded only for those share-based awards that are expected to vest. To the extent we revise this estimate in the future, the share-based payments could be materially impacted in the period of revision, as well as in subsequent periods.

We record share-based compensation expense for awards granted to consultants in exchange for services at fair value in accordance with the provisions of ASC 505-50, Equity based payment to non-employees. As the share options granted to non-employees were fully vested on the grant date, the related compensation expense was fully recognized in the consolidated statement of comprehensive income on the grant date.

On June 8, 2012 (the “modification date”), the Board of Directors modified the exercise price of both vested and unvested options that were previously granted to 88 employees from US$0.4 to US$0.2. The modification was intended to provide additional incentives for these employees.

In accordance with ASC 718-20, Compensation—Stock Compensation, the effects of a modification resulted in incremental compensation cost of US$0.7 million, which was measured as the excess of the fair value of the modified award of US$3.5 million over the fair value of the original award of US$2.8 million at the modification date.

We, with the assistance of an independent valuation firm, determined the fair values of the share-based compensation options recognized in the consolidated financial statements. The binomial option pricing model is applied in determining the estimated fair value of the options granted to employees and non-employees.

The binomial model requires the input of highly subjective assumptions, including the expected stock price volatility and the sub-optimal early exercise factor. For expected volatilities, we have made reference to historical volatilities of several comparable companies. The sub-optimal early exercise factor was estimated based on the vesting and contractual terms of the awards and management’s expectation of exercise behavior of the grantees. The risk-free rate for periods within the contractual life of the options is based on market yield of U.S. Treasury Bond in effect at the time of grant. The assumptions used to estimate the fair value of the stock options granted are as follows:

 

     For the year
ended
December 31,
 
       2011         2012    

Expected volatility

     50.34     50.11

Risk-free interest rate