F-1 1 d634128df1.htm FORM F-1 Form F-1
Table of Contents

As filed with the Securities and Exchange Commission on April 18, 2014

Registration No. 333-            

 

 

 

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM F-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

Chukong Holdings Limited

(Exact name of Registrant as specified in its charter)

 

 

Not Applicable

(Translation of Registrant’s name into English)

 

 

 

Cayman Islands   7371   Not Applicable

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

3A-20, Focus Square,

6 Futong East Avenue, Beijing 100102

People’s Republic of China

+86 (10) 84783860

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

 

 

PunchBox USA Inc.

931 Hamilton Ave.

Menlo Park, CA 94025

+1 (650) 241 1793

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

 

 

Copies to:

 

Z. Julie Gao, Esq.

Will H. Cai, Esq.

Skadden, Arps, Slate, Meagher & Flom LLP

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

15 Queen’s Road Central

Hong Kong

(+852) 3740-4700

 

Chris Lin, Esq.

Simpson Thacher & Bartlett

ICBC Tower, 35/F

3 Garden Road, Central

Hong Kong

(+852) 2514-7600

 

 

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

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

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

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

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

 

 

CALCULATION OF REGISTRATION FEE

 

 

Title of each class of

securities to be registered

 

Proposed maximum
aggregate

offering price(1)

 

Amount of

registration fee

Class A ordinary shares, par value US$0.000002 per share(2)(3)

  US$150,000,000   US$19,320

 

 

(1) Estimated solely for the purpose of determining the amount of registration fee in accordance with Rule 457(o) under the Securities Act of 1933.
(2) Includes 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, and also includes Class A ordinary shares that are issuable upon exercise of the underwriters’ option to purchase additional shares. These Class A ordinary shares are not being registered for the purpose of sales outside the United States.
(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 and Exchange Commission, acting pursuant to such Section 8(a), may determine.

 

 

 


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The information in this prospectus is not complete and may be changed. We [and the selling shareholders] may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any state where the offer or sale is not permitted.

 

Subject to Completion

Preliminary Prospectus Dated                      , 2014

                     American Depositary Shares

 

LOGO

Chukong Holdings Limited

Representing              Class A Ordinary Shares

 

 

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

We are offering              ADSs. [The selling shareholders identified in this prospectus are offering an additional              ADSs.] Each ADS represents              of our Class A ordinary shares, par value US$0.000002 per share. [We will not receive any of the proceeds from the sale of the ADSs being sold by the selling shareholders.]

Prior to this offering, there has been no public market for our ADSs or our Class A ordinary shares. It is currently estimated that the initial public offering price per ADSs will be between US$             and US$            . We have applied to list the ADSs on the NASDAQ Global Market, under the symbol “            .”

We are an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012 and will therefore be subject to reduced reporting requirements.

See “Risk Factors” beginning on page 17 to read about factors you should consider before buying the ADSs.

 

 

 

     Per ADS      Total  

Initial public offering price

   US$                    US$                

Underwriting discount

   US$                    US$                

Proceeds, before expenses, to us

   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 the selling shareholders] at the initial public offering price less the underwriting discounts and commissions, within 30 days from the date of this prospectus.

Immediately prior to the completion of this offering, our outstanding share capital will consist of Class A ordinary shares and Class B ordinary shares. Holders of Class A ordinary shares and Class B ordinary shares have the same rights except for conversion and voting rights. Each Class A ordinary share is entitled to one vote, and each Class B ordinary share is entitled to 20 votes and is convertible into one Class A ordinary share at any time. Class A ordinary shares cannot be converted into Class B ordinary shares under any circumstances. Upon the completion of this offering, our existing shareholders will own an aggregate of              Class B ordinary shares, which will represent         % of the then total voting power of our outstanding shares, assuming the underwriters do not exercise their option to purchase additional ADSs. Holders of our Class A ordinary shares will own an aggregate of              Class A ordinary shares, which will represent         % of the then total voting power of our outstanding shares, assuming the underwriters do not exercise their option to purchase additional ADSs.

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

The underwriters expect to deliver the ADSs against payment in U.S. dollars in New York, New York on                     , 2014.

 

 

 

MORGAN STANLEY   DEUTSCHE BANK SECURITIES   CHINA RENAISSANCE

The date of this prospectus is                     , 2014


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TABLE OF CONTENTS

 

     Page  

Prospectus Summary

     1   

Risk Factors

     17   

Special Note Regarding Forward-Looking Statements

     62   

Use of Proceeds

     63   

Dividend Policy

     64   

Capitalization

     65   

Dilution

     67   

Exchange Rate Information

     69   

Enforceability of Civil Liabilities

     70   

Corporate History and Structure

     72   

Selected Consolidated Financial Data

     79   

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

     82   

Industry

     114   
     Page  

Business

     118   

Regulations

     136   

Management

     148   

Principal [and Selling] Shareholders

     156   

Related Party Transactions

     159   

Description of Share Capital

     160   

Description of American Depositary Shares

     167   

Shares Eligible for Future Sale

     178   

Taxation

     180   

Underwriting

     186   

Expenses Relating to This Offering

     194   

Legal Matters

     195   

Experts

     196   

Where You Can Find Additional Information

     197   

Index to Consolidated Financial Statements

     F-1   
 

 

 

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

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

Until                     , 2014 (the 25th day after the date of this prospectus), all dealers that buy, sell or trade ADSs, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the obligation of dealers to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions.

 

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PROSPECTUS SUMMARY

The following summary is qualified in its entirety by, and should be read in conjunction with, the more detailed information and financial statements appearing elsewhere in this prospectus. In addition to this summary, we urge you to read the entire prospectus carefully, especially the risks of investing in our ADSs discussed under “Risk Factors,” before deciding whether to buy our ADSs. In addition, we commissioned iResearch Consulting Group, or iResearch, a third-party market research firm, to prepare a report for the purpose of providing various industry and other information and illustrating our position in the mobile gaming industry in China. Information from the report prepared by iResearch appears in “Summary,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and other sections of this prospectus. We have taken such care as we consider reasonable in the reproduction and extraction of information from the iResearch Report and other third-party sources.

Overview

We operate an innovative mobile entertainment platform, offering a full suite of solutions and services to enable developers worldwide to efficiently develop, publish and monetize content and providing a highly engaging mobile entertainment experience to our users. We seek to create significant value to our business partners and users.

For mobile content developers, we enable them to develop popular content with high efficiency and publish and monetize their content with ease. Our suite of solutions and services consists of world-leading Cocos open-source engines, a content design toolkit and content publishing services, such as game operation, payment service, content localization, data analytics, technical support and advertising service. According to iResearch, the Cocos2d-x open-source game engine, which we develop and maintain, was the most adopted engine among the 100 top grossing games on both iOS and Android in 2013 in China, United States and Taiwan. As a result of the significant value we create for content developers, we have become a trusted publishing partner for leading mobile content developers in China. We published three out of the top four mobile games in China as measured by gross billing in 2013, according to iResearch.

For mobile users, we deliver an engaging mobile entertainment experience. We offer an extensive portfolio of in-house developed and licensed popular mobile games and other rich entertainment content, provide an interactive user system and deliver convenient payment options. We have experienced significant growth in our user base, as evidenced by increases in our average monthly active users, or MAUs, and average daily active users, or DAUs, for our games from 12.4 million and 1.7 million, respectively, in the fourth quarter of 2011, to 52.7 million and 9.1 million, respectively, in the fourth quarter of 2013.

In addition, we seek to create value to other participants in the mobile entertainment ecosystem, including mobile content distribution channels and mobile carriers by enriching their content offerings and monetizing their user base. According to iResearch, we were the largest mobile game revenue contributor to each of China Mobile, China Unicom and China Telecom in 2013, primarily through the fee sharing arrangements we had with these mobile carriers as payment channels for many of our self-developed games and licensed third-party games.

Our mission is to become a leading global mobile entertainment platform. We are pioneering a business model that provides significant long-term value to our business partners and users, fosters a healthy expansion of the mobile entertainment ecosystem and drives our own long-term growth and profitability.

Our platform is comprised of the following core components:

Mobile Content Development Solutions

As mobile content developers are the key for the mobile entertainment ecosystem, we are committed to investing in leading technologies and providing integrated solutions that enable developers to efficiently develop and deliver high-quality mobile entertainment content to users.

 

 

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We develop and maintain one of the most widely adopted open-source mobile game engines in the world, Cocos2d-x. To meet the evolving technological needs and rapidly-changing user preferences, we have further developed Cocos-HTML5 to support the development of HTML5-based mobile games. We are also developing another advanced version of Cocos engines to support the development of mobile 3D games. Together with Cocos2d-x, these advanced versions of Cocos engines offer developers a comprehensive range of open-source solutions that can meet their various development needs, free of charge. In addition, the robust architecture of the Cocos engines enables developers to easily render sensational visual effects, extending its application beyond mobile games. Since 2010, Cocos engines have been downloaded more than 700,000 times across the globe. As more developers use and contribute to the Cocos engines, these engines evolve faster and provide even better and more efficient solutions to the mobile entertainment community, thereby creating a virtuous cycle.

Powered by our Cocos engines, we also offer CocoStudio, a content development and design toolkit to streamline and simplify the creation of in-game user interfaces, graphics and sound effects. It allows game developers to improve their design efficiency and shorten the time to market. In addition, we provide payment channel integration solutions, proprietary data analytics and localization capabilities, which offer developers with insightful metrics to optimize their games, resulting in higher user engagement and monetization.

Furthermore, we strengthen our connections to the content developer community by organizing online forums and offline conventions. We believe our website, CocoaChina.com, is the largest online forum for iOS mobile content developers in China with approximately 310,000 registered members as of the date of this prospectus. CocoaChina Developers Convention, a semi-annual offline convention organized by us, has become one of the most important events in the mobile game industry in China, with thousands of participants from every segment of the mobile entertainment ecosystem.

Although we do not generate any significant revenue from providing mobile content development solutions, we believe our open-source business model can help us generate goodwill and other indirect benefits that outweigh the costs of maintaining and improving the content development solutions, especially in the long term.

Mobile Entertainment Content

We deliver a highly engaging mobile entertainment experience to our users by offering an extensive portfolio of in-house developed games, licensed games and other mobile entertainment content, as well as our fast-growing interactive user system, Coco.

Our game portfolio consisted of 98 mobile games in operation as of December 31, 2013, including 16 self-developed and 82 licensed games. We are recognized by iResearch as one of the leading independent mobile game developers in China. Our Fishing Joy series, including Fishing Joy I and Fishing Joy II, was among the top three mobile games in China in terms of gross billing in 2013, according to iResearch. Fishing Joy series attracted 327.4 million total activations since launch and engaged 37.6 million average MAUs and 7.0 million average DAUs in the quarter ended December 31, 2013.

We collaborate with global entertainment content leaders to introduce innovative and appealing content to users. For example, our Art, Technologies & Humanities Design Studio, or ATH Studio, and Disney Mobile jointly developed Where’s My XiYangYang, a game featuring characters from the XiYangYang franchise, a highly popular cartoon series in China. Where’s My XiYangYang became the number one top paid game on iOS App Store in China within one week after launch.

In addition to games, we have developed other mobile content, including educational and digital reading applications. For example, we developed Ocean Adventures, an educational application that teaches children to recognize sea creatures, and trains their color- and shape-recognition abilities. Ocean Adventures became the number two top paid iPad application in the iOS App Store in China and the number one top paid iPad application in the iOS App Store’s Kids category within one week after launch. We also developed Kung Fu Tang Poetry, an educational application that teaches Tang poetry to pre-school children in an engaging way.

 

 

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To enrich our user experience, we also offer Coco, our fast-growing interactive user system with in-game and cross-game social networking features, as well as integrated payment solutions. We believe that Coco paves the way to grow our user base as we integrate Coco into more popular games and cross promote more high-quality content through Coco. By growing and expanding our Coco user system, we expect to further enhance user experience and increase user stickiness, and thereby fuel our own growth.

Mobile Content Publishing and Monetization

We also operate an established publishing business and a robust advertising network, which create significant value for mobile content developers, content distribution channels and mobile carriers. We collaborate with leading global and regional content providers, including Konami, Gameloft, Fincon, Locojoy and Yinhan to publish their top-ranked games, such as Hello Hero ( LOGO ), Space Hunter ( LOGO ) and I am MT Online ( LOGO MT Online). We also operate a fast-growing international game publishing business. For example, we published Beauty of the Qin Dynasty (“ LOGO ”) in Korea in October 2013. By the end of the month, it had become the number one action game on the iOS App Store and the number four Arcade & Action game on Google Play in Korea.

As a large number of popular mobile games are developed with the Cocos engines and technical assistance from our engine maintenance team at the development stage, we have an early access to mobile content, which enables us to identify popular content with potential to succeed. In addition, we help mobile content providers connect with over 300 distribution channels, link with major payment channels, run targeted advertising campaigns and promotions, collect insightful business analytics and receive ongoing technical support. Our publishing expertise, coupled with our strong localization capabilities and our broad and efficient distribution network, including substantially all leading mobile content distribution channels in China, enables us to efficiently reach a large and high quality user base. We believe these make us a trusted partner for mobile content developers and help us license popular games from them with favorable terms at times. In turn, our high quality content helps us further strengthen the relationship with distribution channels, as well as garner the channels’ commitment to prioritize their resources in distributing and promoting our content, creating another virtuous cycle.

We generally pay a certain upfront fee or a minimum guarantee fee to third-party game developers, and then share the gross billing generated from those licensed games with such game developers pursuant to the agreed sharing percentage. Generally, approximately 30% to 50% of the net billing generated from our licensed games after deducting distribution and other expenses is distributed to third-party game developers, and approximately 50% to 70% is kept by us as the game publisher.

We operate a mobile advertising network to promote content developed by ourselves as well as third-party developers and help monetize user traffic. Leveraging our strong data analytics capability, we are able to analyze the user traffic on our platform and deliver advertisements in a targeted and precise manner. Our mobile advertising network provides effective marketing and additional monetization opportunities to developers, which in turn would contribute to our revenue growth.

We have achieved significant growth in our business since our inception in November 2010. Our revenues increased from RMB8.7 million in 2011 to RMB76.5 million in 2012 and to RMB554.8 million (US$91.6 million) in 2013. We had a net loss of RMB88.3 million (US$14.6 million) in 2013, compared to a net loss of RMB52.1 million and RMB28.9 million in 2012 and 2011, respectively.

Our Industry

The mobile game industry in China is experiencing rapid growth. According to iResearch, China has the largest mobile internet user population in the world, with 500 million users in 2013 and expected to reach

 

 

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745 million by the end of 2017, representing an annual compound growth rate, or CAGR, of 10.5%. Furthermore, a large number of these mobile internet users are mobile game players. According to iResearch, the number of mobile game players in China is expected to grow from 188 million in 2013 to 526 million in 2017, representing a CAGR of 29.3%. Driven by this large game player base, China’s mobile game market revenue is expected to grow from RMB14.9 billion in 2013 to RMB70.6 billion in 2017, representing a CAGR of 47.6%. The mobile game market is expected to grow much faster than the PC client-based game and webgame markets.

We believe that the mobile game industry in China is likely to continue its strong growth for the foreseeable future, due to the following factors:

 

    increasing penetration of mobile devices;

 

    better technology and infrastructure to support mobile devices;

 

    increasing mobile internet and mobile broadband penetration;

 

    growing trend for people to enjoy entertainment on their mobile devices; and

 

    increasing popularity of mobile games relative to other forms of mobile entertainment.

Around the world, the mobile game industry is also experiencing robust growth. According to iResearch, the number of global mobile internet users is expected to grow from 1.9 billion in 2013 to 3.0 billion in 2017, representing a CAGR of 12.1%. According to iResearch, the mobile game market in the U.S. is expected to grow from US$1.8 billion in 2013 to US$3.8 billion in 2017, representing a CAGR of 20.6%, while the same market in Korea is expected to reach US$1.2 billion by end of 2013, representing an annual growth rate of 65.2% from 2012.

Our Strategies

We intend to achieve our mission through the following key strategies:

 

    continue to strengthen our technological capabilities and optimize development solutions;

 

    continue to develop, license, and publish popular mobile entertainment content;

 

    expand our interactive user system;

 

    increase monetization opportunities;

 

    expand into the international markets; and

 

    pursue strategic acquisitions and partnerships.

Our Challenges

Our ability to realize our business objectives and execute our strategies is subject to risks and uncertainties, including, but not limited to, the following:

 

    our ability to accurately evaluate and assess our operating performance and future prospects in a new and rapidly changing industry;

 

    our ability to achieve and sustain profitability in the future;

 

    our ability to continue to develop and license popular games and diversify our game portfolio;

 

    our ability to maintain the popularity of our existing top games by successfully operating and improving them to satisfy the changing demands of game players;

 

    our ability to retain existing paying players, increase the amount that our players spend and attract new paying players efficiently;

 

 

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    our ability to maintain good relationships with third-party content providers and licensors, distribution channels, mobile carriers and other business partners;

 

    our ability to continue to expand the adoption of the Cocos engines and the content developer community; and

 

    our ability to compete successfully.

In addition, we are subject to risks and uncertainties related to our corporate structure and doing business in China, including, but not limited to:

 

    risks associated with our control of our variable interest entities, which is based upon contractual arrangements rather than equity ownership. If the PRC authorities determine that our contractual arrangements do not comply with applicable PRC laws and regulations, we could be subject to severe penalties. In addition, our contractual arrangements may not be as effective in providing operational control as direct ownership; and

 

    risks associated with potential conflicts of interests between the fiduciary duties owed by the equity owners of our variable interest entities to such entities and us under PRC and Cayman Islands laws, respectively, and the lack of an effective mechanism between these different jurisdictions to resolve these conflicts.

See “Risk Factors” and “Special Note Regarding Forward-Looking Statements” for a discussion of these and other risks and uncertainties associated with our business and investing in our ADSs.

Our Corporate History and Structure

We are a holding company incorporated in the Cayman Islands and conduct our business through our subsidiaries and our consolidated affiliated entities in China. We started our operations in April 2010 when our founders established Beijing Chukong Technology Co., Ltd., or Chukong Technology, in China. In order to facilitate foreign investment in our company, our holding company, Directouch Holdings Limited, was incorporated in the Cayman Islands in November 2010, and subsequently changed its name to Chukong Holdings Limited in January 2014. In December 2010, we established Directouch Management Limited, or Chukong HK, a wholly-owned subsidiary, in Hong Kong. Subsequently, Chukong HK established a wholly owned PRC subsidiary, Beijing Chukong Aipu Technology Co., Ltd., or Chukong Beijing, in April 2011. In October 2011, we established PunchBox USA Inc., or Chukong USA, a wholly-owned subsidiary in the United States. In August 2013, Chukong HK established Chukong Technology Korea, Inc., or Chukong Korea, a wholly owned subsidiary, in Korea.

 

 

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The following diagram illustrates our corporate structure, including our principal operating entities, as of the date of this prospectus:

 

LOGO

 

* Wholly foreign-owned entity.
Consists of (1) with respect to Beijing Wan’ai Internet Technology Co., Ltd. and Chukong Technology, Business Operations Agreement, Equity Interest Pledge Agreement, Power of Attorney, Exclusive Consulting and Services Agreement, Equity Disposal Agreement, Domain Names and Trademarks Pledge Agreement, Intellectual Property Licensing Agreement and Intellectual Property Transfer Agreement, as amended; (2) with respect to Tiansheng Chengye, Exclusive Business Cooperation Agreement, Equity Pledge Agreement, Exclusive Option Agreement, Loan Agreement and Power of Attorney. For details on the contractual arrangements, see “Our Corporate History and Structure—Our Contractual Arrangements.”
(1) The shareholders of Beijing Wan’ai Internet Technology Co., Ltd., or Beijing Wan’ai, are Haozhi Chen, Guanqun Liu and Fei Ma, holding 45%, 45% and 10% of the total equity interests in Beijing Wan’ai, respectively. Haozhi Chen is our chairman of the board of directors and chief executive officer, Guanqun Liu is our director and chief operating officer and Fei Ma is a shareholder of our company. Beijing Wan’ai currently does not conduct any business operations.
(2) The shareholders of Beijing Tiansheng Chengye Information Technology Co., Ltd., or Tiansheng Chengye, are Yan Jia and Yingtao Hou, each an employee of our company, and each holding 50% of the total equity interests in Tiansheng Chengye. Tiansheng Chengye holds a license for trans-regional value-added telecommunications businesses, or a trans-regional VATS License, and a license for using short message service access code. Tiansheng Chengye is currently engaged in software development. For the years ended December 31, 2011, 2012 and 2013, we generated nominal revenues from Tiansheng Chengye.
(3) The shareholders of Chukong Technology are Haozhi Chen, Guanqun Liu and Fei Ma, holding 45%, 45% and 10% of the total equity interests in Chukong Technology, respectively. Chukong Technology holds a value-added telecommunication license for internet information services, or the ICP License, a trans-regional VATS License, as well as an internet culture operation license. We conduct most of our businesses, including content development, content publishing and advertising, through Chukong Technology and its subsidiaries.

 

 

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Foreign ownership of mobile game businesses is subject to significant restrictions under current PRC laws and regulations. The PRC government regulates internet access, the distribution of online information and the conduct of mobile game through strict business licensing requirements and other government regulations. We are a Cayman Islands company and our PRC subsidiary, Chukong Beijing, is a wholly foreign-owned enterprise. As a result, Chukong Beijing is restricted from holding the licenses that are necessary for our mobile internet business in China. To comply with these restrictions, we conduct substantially all of our business through contractual arrangements with our variable interest entities and their respective shareholders. Chukong Technology, Tiansheng Chengye and their subsidiaries hold the licenses necessary to conduct our internet-related operations in China. Chukong Beijing is currently engaged in the business of software development, which is an encouraged foreign investment industry under the latest version of Guiding Catalog for Foreign Investment Industries.

Our wholly owned subsidiary, Chukong Beijing, has entered into a series of contractual arrangements with our variable interest entities and their respective shareholders, which enable us to:

 

    exercise effective control over our variable interest entities;

 

    receive substantially all of the economic benefits of our variable interest entities through service fees in consideration for the consulting services provided by Chukong Beijing; and

 

    have an exclusive option to purchase all of the equity interests in our variable interest entities to the extent permitted under PRC laws, regulations and legal procedures.

We do not have any equity interest in our variable interest entities. However, as a result of contractual arrangements, we are considered the primary beneficiary of our variable interest entities, and we deem them as our variable interest entities under U.S. GAAP. We have consolidated the financial results of our variable interest entities and their subsidiaries in our consolidated financial statements included in this prospectus in accordance with U.S. GAAP.

We face risks with respect to the contractual arrangements with our variable interest entities and their respective shareholders. If our variable interest entities or their respective shareholders fail to perform their obligations under the contractual arrangements, our ability to enforce the contractual arrangements that give us effective control over our variable interest entities may be limited. If we are unable to maintain effective control over our variable interest entities, we would not be able to continue to consolidate their financial results. For a detailed description of the regulatory environment that necessitates the adoption of our corporate structure, see “Regulation.” For a detailed description of the risks associated with our corporate structure, see “Risk Factors—Risks Related to Our Corporate Structure.”

Corporate Information

Our principal executive offices are located at 3A-20, Focus Square, 6 Futong East Avenue, Beijing 100102, the People’s Republic of China. Our telephone number at this address is +86 (10) 84783860. Our registered office in the Cayman Islands is located at the offices of Corporate Filing Services Ltd., P.O. Box 613, 3rd Floor, Harbour Centre, George Town, Grand Cayman KY1-1107, Cayman Islands. Our agent for service of process in the United States is PunchBox USA Inc. located at 931 Hamilton Ave., Menlo Park, CA 94025. Investors should contact us for any inquiries through the address and telephone number of our principal executive offices.

Our website is http://www.chukong-inc.com. The information contained on our website does not form a part of this prospectus.

Conventions Which Apply to This Prospectus

In this prospectus, except where the context otherwise requires, references to:

 

    “activation” refers to the download and installation of an application, which has been opened and connected to the internet for at least once;

 

 

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

 

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

 

    “Cocos engines” refers to Cocos2d-x engine, Cocos-HTML5, a version that supports 3D development and other versions we develop and maintain;

 

    “consolidated affiliated entities” refers to our variable interest entities and their subsidiaries;

 

    “DAUs” refers to daily active users, which is the number of players who access a particular game in a particular day. Under this metric, a player who accesses two different games on the same device on the same day is counted as one DAU; however, a player who plays the same game on two different devices on a day is counted as two DAUs. Average DAUs for a particular period is the average of the DAUs on each day during that period;

 

    “gross billing” refers to the total amount paid by game players for downloads or in-game purchases, excluding doubtful accounts;

 

    “MAUs” refers to monthly active users, which is the number of players who access a particular game in the relevant calendar month. Under this metric, a player who accesses two different games on the same device in the same month is counted as two MAUs; and a player who plays the same game on two different devices in a month is counted as two MAUs. Average MAUs for a particular period is the average of the MAUs in each month during that period;

 

    “preferred shares” refers to Series A, Series B, Series C and Series D preferred shares of Chukong, par value US$0.000002 per share;

 

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

 

    “shares” or “ordinary shares” refers to, prior to the completion of this offering, our ordinary shares, par value US$0.000002 per share and upon and after the completion of this offering, to our Class A and Class B ordinary shares, par value US$0.000002 per share;

 

    “variable interest entities” or “VIEs” refers to Chukong Technology, Beijing Wan’ai, and Tiansheng Chengye; and

 

    “we,” “us,” “our company,” “our,” or “Chukong” refers to Chukong Holdings Limited, a Cayman Islands company, its subsidiaries and consolidated affiliated entities.

Renminbi amounts shown in this prospectus are accompanied by translations into U.S. dollars solely for the convenience of the reader. In addition, certain PRC economic and market data shown in U.S. dollars in this prospectus have been translated from Renminbi amounts. Unless otherwise noted, all such translations from Renminbi to U.S. dollars in this prospectus were made at RMB6.0537 to US$1.0000, the noon buying rate for December 31, 2013 set forth in the H.10 statistical release of the Federal Reserve Board. We make no representation that the Renminbi or U.S. dollar amounts referred to in this prospectus could have been or could be converted into U.S. dollars or Renminbi, as the case may be, at any particular rate or at all. The PRC government restricts the conversion of Renminbi into foreign currency and foreign currency into Renminbi for certain types of transactions. On April 11, 2014, the noon buying rate set forth in the H.10 statistical release of the Federal Reserve Board was RMB6.2111 to US$1.0000.

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 applicable generally to public companies. These provisions include exemption from the auditor attestation

 

 

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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 the 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.

 

 

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The Offering

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

 

Offering price

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

ADSs offered by us

                ADSs

[ADSs offered by the selling shareholders

                ADSs]

[Total ADSs offered

                ADSs]

Ordinary shares outstanding immediately after this offering

                Class A ordinary shares (or              Class A ordinary shares if the underwriters exercise their option to purchase additional ADSs in full) and              Class B ordinary shares. Class B ordinary shares outstanding immediately after the completion of this offering will represent         % of our total outstanding shares and         % of the then total voting power (or         % of our total outstanding shares and         % of the then total voting power if the underwriters exercise their option to purchase additional ADSs in full).

ADSs outstanding immediately after this offering

                ADSs (or              ADSs if the underwriters exercise their option to purchase additional ADSs in full).

The ADSs

  

Each ADS represents              Class A ordinary shares.

The depositary will hold the Class A ordinary shares underlying your ADSs. You will have rights as provided in the deposit agreement. If we declare dividends on our Class A ordinary shares, the depositary will pay you the corresponding cash dividends and other distributions it receives on our Class A ordinary shares, after deducting its fees and expenses. You may turn in your ADSs to the depositary in exchange for Class A ordinary shares. The depositary will charge you fees for any exchange. We may amend or terminate the deposit agreement without your consent. If you continue to hold your ADSs, you agree to be bound by the deposit agreement as amended from time to time.

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

Option to purchase additional ADSs

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

 

 

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Use of proceeds

  

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

 

•     approximately US$             in engine development and mobile content development;

 

•     approximately US$             in sales and marketing activities, technology infrastructure, improvement of corporate facilities; and

 

•     the balance for other general corporate purposes.

 

See “Use of Proceeds” for additional information.

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

Lock-up

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

NASDAQ Global Market Symbol

   We have applied to have the ADSs listed on the NASDAQ Global Market under the symbol “            .” Our ADSs and ordinary shares will not be listed on any other stock exchange or traded on any other automated quotation system.

Depositary

  

[Directed share program

   At our request, the underwriters have reserved for sale, at the initial public offering price, up to              ADSs offered by this prospectus to our directors, officers, employees, business associates and related persons.]

Risk factors

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

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

 

    is based on              ordinary shares outstanding as of the date of this prospectus, assuming conversion of all outstanding preferred shares into 94,725,998 ordinary shares immediately prior to the completion of this offering; and

 

    excludes              ordinary shares reserved for future issuances under our 2011 Global Share Plan and 2013 Share Incentive Plan.

 

 

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Our Summary Consolidated Financial data

The following summary consolidated statements of operations and comprehensive loss data for the years ended December 31, 2011, 2012 and 2013, and summary consolidated balance sheet data as of December 31, 2011, 2012 and 2013, have been derived from our audited consolidated financial statements included elsewhere in this prospectus. Our consolidated financial statements are prepared and presented in accordance with U.S. GAAP.

Our historical results for any period are not necessarily indicative of results to be expected for any future period. You should read the following summary financial information in conjunction with the consolidated financial statements and related notes and the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

 

     For the Years Ended December 31,  
     2011      2012      2013  
     (RMB)      (RMB)      (RMB)      (US$)  
     (in thousands, except for share and share related data)  

Summary consolidated statements of operations and comprehensive loss data:

           

Revenues:

           

Mobile games

     7,143         69,506         546,612         90,294   

Online advertising

     1,540         7,027         8,153         1,347   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total revenues

     8,683         76,533         554,765         91,641   

Cost of revenues(1)(2)

     3,424         36,746         298,085         49,241   
  

 

 

    

 

 

    

 

 

    

 

 

 

Gross profit

     5,259         39,787         256,680         42,400   
  

 

 

    

 

 

    

 

 

    

 

 

 

Operating expenses:

           

Sales and marketing expenses(1)

     12,849         37,740         149,039         24,619   

Research and development expenses(1)(3)

     12,065         38,922         105,193         17,377   

General and administrative expenses(1)

     6,344         14,655         56,230         9,289   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total operating expenses

     31,258         91,317         310,462         51,285   
  

 

 

    

 

 

    

 

 

    

 

 

 

Loss from operations

     (25,999      (51,530      (53,782      (8,885
  

 

 

    

 

 

    

 

 

    

 

 

 

 

 

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     For the Years Ended December 31,  
     2011      2012      2013  
     (RMB)      (RMB)      (RMB)      (US$)  
     (in thousands, except for share and share related data)  

Other (expenses)/income:

           

Interest (expenses)/income, net

     (73      43         375         62   

Investment income/(loss)

             (389      (3,572      (590

Others, net

     462         (802      (608      (100

Gain from previously held equity interest related to step acquisition

             6,967                   

Beneficial conversion charges on convertible notes

     (359                        

Fair value changes in warrant liability

     (2,895      (6,413      (30,071      (4,967
  

 

 

    

 

 

    

 

 

    

 

 

 

Loss before tax

     (28,864      (52,124      (87,658      (14,480

Income tax (expenses)/benefits

             15         (648      (108
  

 

 

    

 

 

    

 

 

    

 

 

 

Net loss

     (28,864      (52,109      (88,306      (14,588

Accretions to preferred shares redemption value

     (6,091      (25,038      (114,983      (18,994

Deemed dividends to preferred shareholders

     (601                        

Net loss attributable to ordinary shareholders

     (35,556      (77,147      (203,289      (33,582
  

 

 

    

 

 

    

 

 

    

 

 

 

Net loss

     (28,864      (52,109      (88,306      (14,588

Foreign currency translation adjustment, net of nil tax

     (1,063      (1,041      (2,521      (416
  

 

 

    

 

 

    

 

 

    

 

 

 

Comprehensive loss

     (29,927      (53,150      (90,827      (15,004
  

 

 

    

 

 

    

 

 

    

 

 

 

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

     5,000,000         5,000,000         27,042,808         27,042,808   

Net loss per share attributable to ordinary shareholders—basic and diluted

     (7.11      (15.43      (7.52      (1.24

Unaudited pro forma net loss per share attributable to ordinary shareholder—basic and diluted(5)

           (0.84)         (0.14)   

Non-GAAP financial measures:(4)

           

Adjusted net loss

     (24,602      (50,824      (49,753      (8,220

Adjusted EBITDA

     (24,679      (47,429      (35,344      (5,839

Mobile game gross billing

     7,143         75,955         756,769         125,009   

 

Notes:    (1)   Share-based compensation expenses were allocated to cost of revenues and operating expenses as follows:

 

     For the Years Ended December 31,  
     2011      2012      2013  
     (RMB)      (RMB)      (RMB)      (USD)  
     (in thousands)  

Cost of revenues

                               

Sales and marketing expenses

     3         98         1,080         178   

Research and development expenses

     4         166         3,020         499   

General and administrative expenses

     1,001         1,575         4,382         724   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     1,008         1,839         8,482         1,401   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(2)   Includes content fees paid to related parties of RMB0, RMB505 thousand and RMB12.9 million for the years ended December 31, 2011, 2012 and 2013, respectively.
(3)   Includes technical service fees paid to related parties of RMB0, RMB2.3 million and RMB500 thousand for the years ended December 31, 2011, 2012 and 2013, respectively.

 

 

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(4)   See “—Non-GAAP Financial Measures.”
(5)   See “Notes to Consolidated Financial Statements—Note 23”

 

    As of December 31,  
    2011     2012     2013  
    (RMB)     (RMB)     (RMB)     (US$)     (RMB)  
                Actual     Actual     Pro forma(1)  
    (in thousands)  

Summary consolidated balance sheet data:

         

Cash and cash equivalents

    67,893        110,926        330,558        54,604        330,558   

Accounts receivable, net

    590        25,279        132,269        21,849        132,269   

Prepayment and other current assets

    2,794        4,497        65,589        10,835        65,589   

Total assets

    77,194        180,579        616,130        101,778        616,130   

Deferred revenues

           2,902        37,427        6,182        37,427   

Total liabilities

    10,143        52,502        229,768        37,955        229,768   

Total mezzanine equity

    101,190        235,736        691,349        114,204          

Total shareholders’ (deficit)/equity

    (34,139     (107,659     (304,987     (50,381     386,362   

Total liabilities, mezzanine equity and shareholders’ (deficit)/equity

    77,194        180,579        616,130        101,778        616,130   

 

Note:    (1)   The consolidated balance sheet data as of December 31, 2013 are adjusted on a pro forma basis to give effect to the automatic conversion of all of our outstanding preferred shares into 94,725,998 ordinary shares immediately prior to the completion of this offering.

Non-GAAP Financial Measures

In evaluating our business, we consider and use the following non-GAAP measures as supplemental measures to review and assess our operating performance: adjusted net loss, adjusted EBITDA and mobile game gross billing. The presentation of these non-GAAP financial measures is not intended to be considered in isolation or as a substitute for the financial information prepared and presented in accordance with U.S. GAAP.

We define adjusted net loss as net loss excluding share-based compensation expenses, fair value changes in warrant liability, beneficial conversion charges on convertible notes, and gain from previously held equity interest related to step acquisition. We define adjusted EBITDA as net income (loss) before net interest (expenses)/income, investment income/(loss), net others, depreciation and amortization and income tax expenses, share-based compensation expenses, beneficial conversion charges on convertible notes, fair value changes in warrant liability and gain from previously held equity interest related to step acquisition.

We also use mobile game gross billing as an important non-GAAP top-line metric to evaluate our operating performance, which represents the total amount paid by our mobile game players for downloads and in-game purchase, excluding doubtful accounts. The difference between our mobile game gross billing and revenues from mobile games is primarily due to our recognition of certain licensed game revenues on a net basis, and to a lesser extent, due to deferred revenues.

For some licensed games, our primary responsibilities are to publish them and provide payment solutions and game operating advice, and the game developers handle game operations and related matters. Therefore, we view the game developers to be our customers and consider ourselves the agent in the arrangements. Accordingly, we record mobile game revenues from these third-party licensed games, net of the predetermined revenue sharing with the game developers, as well as the revenue sharing with distribution channels and payment channels, upon the provision of service.

 

 

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With respect to the in-game purchases made by the player to gain an enhanced game-playing experience where we will provide continuous mobile game services, we recognize the revenues ratably over the estimated average playing period of the paying players, which result in deferred revenues.

We believe that the use of these non-GAAP measures facilitates investors’ assessment of our operating performance from period to period and from company to company by backing out potential differences caused by variations in items such as capital structures (affecting relative interest expenses), the book amortization of intangibles (affecting relative amortization expenses), the age and book value of property and equipment (affecting relative depreciation expenses) and other non-cash expenses (affecting share-based compensation expenses). We also present these non-GAAP measures because we believe these non-GAAP measures are frequently used by securities analysts, investors and other interested parties as measures of the financial performance of companies in our industry.

These non-GAAP financial measures are not defined under U.S. GAAP and are not presented in accordance with U.S. GAAP. These non-GAAP financial measures have limitations as analytical tools. Some of these limitations include, but are not limited to:

 

    they do not reflect changes in, or cash requirements for, our working capital needs;

 

    they do not reflect the interest expenses, or the cash requirements necessary to service interest or principal payments, on our debt;

 

    they do not reflect income taxes or the cash requirements for any tax payments;

 

    although depreciation and amortization are non-cash charges, the assets being depreciated and amortized often will have to be replaced in the future, and adjusted net loss and adjusted EBITDA do not reflect any cash requirements for such replacements;

 

    they do not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments;

 

    while share-based compensation is a component of cost of revenues and operating expenses, the impact to our consolidated financial statements compared to other companies can vary significantly due to such factors as assumed life of the options and assumed volatility of our ordinary shares;

 

    Mobile game gross billing includes the total proceeds from certain licensed games that we recognize revenue on a net basis and deferred revenues, excluding the doubtful accounts, which does not fully reflect our income, risks and obligations under these arrangements; and

 

    other companies may calculate differently than we do, limiting the usefulness of these non-GAAP measures as comparative measures.

 

 

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We compensate for these limitations by relying primarily on our U.S. GAAP results and using adjusted net loss and adjusted EBITDA only as supplemental measures. We have provided below reconciliations between adjusted net loss, adjusted EBITDA and net loss, the most directly comparable GAAP financial measures, for the periods presented:

 

     For the Years Ended
December 31,
 
     2011     2012     2013     2013  
     (RMB)     (RMB)     (RMB)     (US$)  
     (in thousands)  

Net loss

     (28,864     (52,109     (88,306     (14,588

Less: Share-based compensation expenses

     (1,008     (1,839     (8,482     (1,401

Fair value changes in warrant liability

     (2,895     (6,413     (30,071     (4,967

Beneficial conversion charges on convertible notes

     (359                     

Gain from previously held equity interest related to step acquisition

            6,967                 
  

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted net loss

     (24,602     (50,824     (49,753     (8,220
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

     (28,864     (52,109     (88,306)        (14,588

Less: Interest (expenses)/income, net

     (73     43        375        62   

Investment loss

            (389     (3,572     (590

Others, net

     462        (802     (608     (100

Income tax (expenses)/benefits

            15        (648     (108

Depreciation expenses

     (312     (2,179     (5,672     (937

Amortization expenses

            (83     (4,284     (708

Fair value changes in warrant liability

     (2,895     (6,413     (30,071     (4,967

Share-based compensation expenses

     (1,008     (1,839     (8,482     (1,401

Beneficial conversion charges on convertible notes

     (359                     

Gain from previously held equity interest related to step acquisition

            6,967                 
  

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted EBITDA

     (24,679     (47,429     (35,344     (5,839
  

 

 

   

 

 

   

 

 

   

 

 

 

The following table sets forth the reconciliations between our mobile game gross billing and revenues from mobile games:

 

     For the Year Ended December 31,  
     2011      2012      2013  
     RMB      RMB      RMB     US$  
     (in thousands)  

Mobile game gross billing

     7,143         75,955         756,769        125,009   

Less: revenue sharing(1)

             (5,284)         (173,092     (28,593

Less: deferred revenues

             (2,902)         (37,427     (6,182

Plus: other game related revenues(2)

             1,737         362        60   
  

 

 

    

 

 

    

 

 

   

 

 

 

Revenues from mobile games

     7,143         69,506         546,612        90,294   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

Note:    (1)   Includes content fees paid to game developers, distribution fees paid to distribution channels and commission fees paid to payment channels for the licensed game revenues that we recognize on a net basis.
    (2)   Mobile game development related revenues.

 

 

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RISK FACTORS

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

Risks Related to Our Business and Industry

We have a short operating history, which makes it difficult to evaluate our prospects and predict future financial results.

We began operations in 2010, and we have a short history operating in the emerging mobile entertainment market, which makes it difficult to effectively assess our future prospects. You should consider our business and prospects in light of the challenges we face, which include our ability to, among other things:

 

    successfully develop and launch new games and extend the lifespan of our existing games;

 

    license and publish successful games and other entertainment content;

 

    develop and maintain our open-source engines, developer solutions and developer forums;

 

    effectively and efficiently attract and retain a larger user base and increase user engagement and user spending;

 

    anticipate changes in the mobile entertainment industry and meet the changing demands of mobile developers and users;

 

    maintain and expand our distribution network and payment channels;

 

    compete successfully with other game engines, developers, publishers and platforms;

 

    hire, integrate and retain talent;

 

    successfully execute our growth strategies and expand our content offerings to more non-game entertainment;

 

    upgrade our technology and infrastructure to support increased traffic and expanded offerings of products and services; and

 

    maintain adequate control of our costs and expenses.

We may not be able to maintain a growth rate in our game development, game publishing or revenues in future periods similar to what we have done in the past. Accordingly, you should not rely on results of our operations for any prior periods as an indication of our future performance. It is also difficult to evaluate our prospects because we may not have sufficient experience to address the risks and difficulties frequently encountered by companies entering rapidly evolving markets, including the mobile entertainment market. We may not be able to successfully address these risks and difficulties, which could materially harm our business, financial condition and results of operations.

We have a history of net losses and may not achieve profitability in the future.

We have incurred net losses since we started our operations in 2010. Our net losses amounted to RMB28.9 million (US$4.8 million), RMB52.1 million (US$8.6 million) and RMB88.3 million (US$14.6 million) in 2011, 2012 and 2013, respectively. Our ability to become profitable depends on our ability to grow our business, increase our revenues and control our costs and operating expenses. Although we have experienced

 

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significant revenue growth since our inception, such growth may not be sustainable and we may continue to incur net losses in future periods. We expect the absolute amount of our cost of revenues and operating expenses to continue to increase as we expand our business, which will reduce our net income and may result in future losses. If our cost of revenues and operating expenses continue to increase without a commensurate increase in our revenues, our business, financial condition and results of operations will be materially and adversely affected.

We rely on a small number of games for a majority of our revenues. If our top games are no longer popular for any reason or if we are unable to continue releasing new popular games, our results of operations could be materially and adversely affected.

We currently rely on the Fishing Joy series for a significant portion of our revenues. In 2012 and 2013, revenues from our Fishing Joy series accounted for 61.8% and 73.4% of our revenues, respectively. We cannot guarantee that these games will sustain their current level of popularity. To prolong these games’ lifespan, we have to continually improve and update them with new features that appeal to existing players and attract new players. Despite our efforts to improve existing games, our game players may nevertheless lose interest in these games over time. If we fail to improve and update our games or release new popular games, or if our competitors introduce more popular games catering to our game player base, our games may lose popularity, which could materially decrease our revenues. In addition, introduction of new games targeting similar groups of players may attract players away from our existing games, which may have a material adverse effect on our business and results of operations.

Continuous enhancement and updating of games require significant resources, and such costs on average have increased. We may not be able to successfully enhance, expand or update our current games or it may not be commercially reasonable to do so. A decrease in popularity of our top games, or reduced spending on our games could have a material adverse effect on our business and results of operations.

Our business depends on our ability to continue to attract new players and retain existing players. If we fail to launch new games or release upgrades to attract new players and retain existing players, our business and prospects will be materially and adversely affected.

Our growth depends on our ability to continuously launch new games that achieve significant popularity. Our ability to continuously launch popular games and attract new players and retain existing players depends largely on our ability to anticipate and effectively respond to changing player interests and preferences, attract, retain and motivate talented game developers to develop and update games that are fun, interesting and compelling to play and on which players are willing to spend money. It is difficult to consistently anticipate player preferences or industry changes to market and promote new products and services, particularly as we develop new games in new genres or for new markets, including international markets. If our existing technology becomes unreliable and we are unable to successfully launch new games that attract and retain significant numbers of paying players and extend the lifespan of our existing games, our business, results of operations and prospects will be materially and adversely affected.

We must introduce new games that can generate additional revenues and diversify our revenue sources. We have at least seven self-developed games and at least 18 licensed games in the pipeline, which we expect to launch or publish before the end of 2014. We cannot assure you that we will be able to meet our timetable for new game launches. A number of factors, including technical difficulties and lack of sufficient game development resources, could result in delayed launching of our new games. In addition, we cannot assure you that our new games will attract a large number of players and be commercially successful, and you should not use existing games as an indication of the commercial success of future games. Some of our games may not be well-received during the testing phases and as a result we may decide not to launch them. There are many factors that may adversely affect the popularity of new games. For example, we may fail to anticipate and adapt to future technical trends, new business models and changed game player preferences and requirements, fail to effectively

 

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plan and organize marketing and promotional activities, or fail to differentiate our new games from our existing games. If the new games we introduce are not commercially successful, we may not be able to recover our related expenses, which can be significant.

In addition, our new games may attract game players away from our existing games. If this occurs, it will decrease the player base of our existing games, which could result in decreased revenues from our existing games. Game players of our existing games may also spend less money to purchase virtual items in our new games than they would have spent if they had continued playing our existing games, which could materially and adversely affect our revenues.

If we fail to attract new paying players and maintain or increase the existing players’ spending on our games, our business and results of operations may be materially and adversely affected.

A small percentage of players accounts for substantially all of our revenues. We allow players to play some of our games free of charge or pay to download our games. Only a small number of our players spend money while playing our games, mostly through purchase of virtual items. This requires us to design games that not only attract players to spend more time playing, but also encourage them to purchase such virtual items. The sale of virtual items requires us to track player tastes and preferences, especially in-game spending patterns. We may lose paying players in the ordinary course of business. In order to sustain our revenue levels, we must attract new paying players and increase purchases by our paying players. If we fail to grow the number of paying players, or if the rate at which we add paying players declines or if the average amount our paying players spend declines, our business and our financial results may be materially and adversely affected.

If we are unable to maintain business arrangements with third-party content providers or licensors, our business and prospects may be materially and adversely affected.

We license top ranked games across different genres from leading global and regional content providers. In addition, we collaborate with global entertainment content leaders, such as Disney Mobile, and leverage their established intellectual property to introduce innovative and appealing content to our users. We also consider popular webgames and client-based games and cooperate with the original developers to port them to mobile platforms.

We generated revenues of RMB19.4 million and RMB138.7 million (US$22.9 million) from licensed games in 2012 and 2013, respectively. We expect to continue to generate a significant amount of revenues from our game licensing business for the foreseeable future. Any deterioration in our ability to license top games or games with revenue generating potential in the future would have a material adverse effect on our business and results of operations. However, we cannot assure you that we will be able to continue to license from our current or future content providers or licensors on commercially reasonable terms. For example, with respect to some games that are licensed to us for publishing, we agreed to provide a performance-based deposit or minimum publishing revenue guarantee. If we are unable to achieve the preset minimum threshold, we would not be able to cover our upfront cost. In addition, our ability to publish more third-party games may be limited by our available liquidity and capital resources if we are required to pay higher up-front fees or minimum guarantee fees to third-party game developers.

Certain of our business arrangements with third-party content providers or licensors may not be renewed on the same terms, and our business would be harmed if the providers or licensors decide to, among other things, modify the terms and conditions of service or other policies, including fees they charge, or restrictions they impose, or establish more favorable relationships with one or more of our competitors. Any such changes in the future could significantly harm our business and prospects.

 

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We depend on third-party distribution channels to distribute our games, and our ability to work with them is critical for our business.

We publish our self-developed and licensed games through third-party distributors and pay commission fees to them. We have established a broad and diversified distribution network, covering more than 300 distribution channels as of December 31, 2013. Our distribution network includes various distribution channels in the Android market, the iOS App Store and the major mobile carriers in China. We have been able to maintain a good relationship with almost all of our distribution channels. However, if in the future we are unable to work with a large number of distribution channels or cannot work with them on reasonable terms, our business and results of operations may be materially and adversely affected.

We depend on mobile carriers for the collection of a significant portion of our revenues, such that any loss of or deterioration in our cooperation with mobile carriers, or the inaccuracy of the billing and collection systems of mobile carriers, may result in the loss of revenue and have material adverse effect on our cash flows.

We collect a significant portion of the payments from our users through the billing and collection systems of China’s three largest mobile carriers, namely China Mobile, China Unicom and China Telecom, who dominate the wireless telecommunication sector in China. We collect payments from these mobile carriers directly for our revenues from mobile games. In 2012 and 2013, 49.6% and 69.6%, respectively, of our mobile game gross billing were collected through these mobile carriers. Failure to timely collect our receivables from mobile carriers may adversely affect our cash flows.

The concentration of our sales through mobile carriers could lead to a short-term disruption in our sales if one or more of them were to reduce or cease offering our products. Such concentration also makes us more vulnerable to collection risks should one or more of these mobile carriers become unable or unwilling to share the proceeds they receive with us. Also, mobile carriers categorize content providers, including us, into different preference classes based on a series of criteria, including game performance, customer satisfaction, responsiveness and technical support, among others. We are currently regarded as a Grade A business partner by the mobile carriers and can therefore enjoy relatively favorable revenue sharing terms, and they allocate more resources in promoting our games. However, our operations and business could be harmed if our relationship with one or more of these mobile carriers deteriorates, or if one or more of the mobile carriers experience deterioration in their business or an increase in non-payment from users. In addition, we rely on these mobile carriers to distribute and promote certain of our games and changes in how they distribute or promote our games could have an adverse effect on our results of operations and financial condition.

Furthermore, we depend on mobile carriers to maintain accurate records of payments of sales proceeds by users and to collect such payments. We receive periodic statements from mobile carriers that indicate the aggregate amount of fees that were charged to users for purchases of our virtual items, but the periodic statements provided by the mobile carriers currently do not contain detailed revenue and billing information. In addition, we have only limited means to independently verify the information provided to us in this regard because we do not have access to the mobile carriers’ internal records. As a result, billing records provided in the periodic statements from mobile carriers may not be reconciled with our own internal records, and we are not able to definitively calculate and monitor player-by-player revenue, margins and other financial and operating information. Our business and results of operation could be adversely affected if these mobile carriers miscalculate the revenue generated from our services and our portion of that revenue.

Significant changes in the policies, guidelines or practice of mobile carriers or the PRC government with respect to mobile applications and other content may result in lower revenues or additional costs for us and materially and adversely affect our business operations, financial condition and results of operations.

We rely heavily on mobile carriers in China, directly and indirectly, to distribute our products to and collect payments from our users. The mobile telecommunication business in China is highly concentrated and major

 

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mobile carriers, such as China Mobile, may from time to time issue new policies or change their business practices, requesting or stating their preferences for certain actions to be taken by all mobile service providers using their networks. In addition, the PRC government may also implement new policies or change existing policies regulating the mobile telecommunication business. Such new policies or changes may cause our revenues to decrease or operating costs to increase. In January 2010, China Mobile began implementing an additional series of measures targeted at further improving the user experience from mobile handset embedded services. Under these measures, additional notices and confirmations to users are required when they purchase mobile applications and other content embedded in handsets. We cannot assure you that PRC mobile carriers or the PRC government will not introduce additional requirements with respect to the procedures for ordering monthly subscriptions or single-transaction downloads of our mobile games, notifications to users, the billing of users or other consumer-protection measures or adopt other policies that may require significant changes in the way we promote and sell our mobile games, any of which could have a material adverse effect on our financial condition and results of operations.

We may also be compelled to alter our arrangements with the mobile carriers in ways that adversely affect our business. Some mobile carriers have unilaterally changed its policies as applied to content providers in the past, and may do so again in the future. For example, one of the mobile carriers in China suspended its payment channel for all payments related to mobile entertainment for approximately six weeks in late 2013 while adjusting their own internal quality control procedures. We may not be able to adequately respond to negative developments in our contractual relationships with the mobile carriers in the future because we are not able to predict such unilateral policy changes.

We operate in a highly competitive industry and compete with many companies and other entertainment sources. If we are unable to compete successfully, our business prospects and results of operations may be materially and adversely affected.

The mobile entertainment industry in China is highly competitive. The industry is characterized by the frequent introduction of new products and services, short product life cycles, evolving industry standards, rapid adoption of technological and product advancements, as well as price sensitivity on the part of players. In China, we compete directly with other mobile game engines, developers and publishers. In particular, Cocos engines compete with other game engines, such as Unity 3D and Unreal. As a mobile content publisher, we compete with other publishers, such as Tencent and Shanda Games. As a mobile content provider, we compete with other content providers, especially with other mobile game developers, such as Zynga, EA, and Gree.

Some of our products are made available to users in countries outside of China through our cooperation with various application stores and mobile carriers. Our mobile game products offered internationally are also subject to intense competition. In addition, we face competition from other media formats and mobile applications and content, such as internet-based games, mobile music, mobile books and social network services. We cannot assure you that mobile entertainment will continue to be popular or that it will not be replaced by other forms of entertainment in the future.

Some of our existing and potential competitors have significantly greater financial, technological and marketing resources and stronger relationships with industry participants than we do. Some of our competitors or potential competitors, especially major international mobile game developers, have greater mobile game development experience and resources than we have. If there are new entrants in the market or intensified competition among existing competitors, we may have to provide more incentives to industry participants, which could adversely affect our profitability. If we fail to compete successfully, our market share could decrease and our results of operations could be materially and adversely affected.

 

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A lawsuit has been filed against us with respect to our Fishing Joy series and an adverse resolution of this lawsuit would materially and adversely affect our business, financial condition and results of operations.

In January 2014, we received a complaint filed by two China-based companies, alleging that our Fishing Joy series infringed their brand name, artworks copyrights and software copyrights. In addition to monetary relief of RMB97.0 million (US$16.0 million), including damages, fees and costs, the plaintiffs also requested the court to permanently enjoin us from operating the Fishing Joy series games. These plaintiffs are Guilin Ligang Network Technology Co., Ltd. and Guangzhou Sealy Electronic Technology Co., Ltd. For the years ended December 31, 2011, 2012 and 2013, we derived 74.1%, 61.8% and 73.4% of our total revenues from the Fishing Joy series, respectively. The plaintiffs are engaged in arcade game development and operation in China, while we are engaged in the mobile game business. On March 6, 2014, Guilin Municipal Intermediate People’s Court of Guangxi Zhuang Autonomous Region dismissed our motion to dismiss for lack of jurisdiction, and we appealed such decision on March 24, 2014 to the Higher People’s Court of the Guangxi Zhuang Autonomous Region. We do not expect to receive a ruling on the motion to dismiss in the near future, and it is difficult to predict when the final ruling on this lawsuit may be issued. While we believe that these claims of infringement asserted against us in the present litigation are without merit and intend to vigorously defend the action, we cannot assure you that this lawsuit ultimately will be resolved in our favor. An adverse ruling would have a material adverse effect on our business, financial condition and results of operations.

We are exposed to risks related to the open-source engines, developer toolkit and the mobile content developer forum.

We develop and maintain the Cocos2d-x game engine and other Cocos engines. We do not derive any direct economic benefits in providing these services. We plan to keep the Cocos engines open-source and freely accessible to the developer community because we believe in the spirit of sharing knowledge, and that the open-source model can bring us indirect benefits that outweigh the costs of maintaining and developing the engine, especially in the long term. However, our strategies may in the future prove to have been incorrect, and we may not have adequate intellectual property protection for certain innovations that later turn out to be material to our business.

In addition, one of the characteristics of open-source software is that anyone may modify and redistribute the existing open-source software and use it to compete with us. Such competition can develop without the degree of overhead and lead time required by traditional proprietary software companies. It is possible for competitors with greater resources than ours to develop their own open-source game engine, potentially reducing the demand for the Cocos engines. Alternatively, other companies could take the Cocos engines and adapt it for use in their own game engines and provide developers with better and more frequently updated engines, which would also decrease our influence among developers.

To date, we have not encountered any material legal or technical issues related to the open-source engines maintained by us, nor have we had any such issues relating to the free CocoStudio developer toolkit. However, we cannot assure you that any such issues will not arise in the future. For example, companies that incorporate open-source software into their products or services have, from time to time, faced claims relating to the ownership of open-source software. Therefore, we could be subject to suits by persons claiming ownership of the open-source engines. Any negative publicity resulting from these free services or legal or financial issues may affect the public perception of our brands and have a material adverse effect on our business and operations.

The success of an open-source engine depends on the quality, size and continuous expansion of the developer community and our own team.

In addition to our maintenance and ongoing development of the Cocos2d-x game engine and other Cocos engines and our support of the developer community, the success of the Cocos2d-x game engine and other Cocos

 

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engines depends upon the continued open-source contributions of third party programmers and corporations. If contributions to the Cocos2d-x game engine and other Cocos engines were to diminish, for example, due to the increased popularity in competing game engines, we would need to develop and enhance our engines with our own resources or abandon the project—in either case, potentially resulting in a material adverse effect on our business and operations.

If and when we undertake actions to protect and maintain ownership and control over our intellectual property, our standing in the open-source community could be adversely affected, which in turn could limit our ability to rely on this community as a resource to help develop and improve the Cocos2d-x game engine and other Cocos engines, which could adversely affect our business.

More generally, the terms of many open-source licenses have not been interpreted by U.S. or foreign courts, such that there is a risk that open-source software licenses could be construed in a manner that imposes unanticipated conditions or restrictions on users of open-source software, which could result in a decrease in the popularity of open-source software generally. Changes in the law that negatively impact the open-source community will also likely have a material adverse effect on our business and operations.

If we are unable to successfully localize our games for targeted markets, our business and results of operations may be materially and adversely affected.

Before each game is published, our operations team reviews the game to improve its monetization potential and to install software development kit, or SDK, and other technical and payment interfaces. For overseas content developers, our operations team works closely with them to localize their products, designing features that are tailored to local players’ preferences. If we are unable to accurately predict preferences and spending pattern of local players and successfully localize the games we publish, our business and results of operations may be materially and adversely affected.

If we are unable to manage our current growth and effectively implement our future growth strategies, our business and results of operations may be materially and adversely affected.

We continue to experience rapid growth in our headcount and operations, which will continue to place significant demands on our management and our operational, financial and technological infrastructure. To accommodate our potential growth, we anticipate that we may need to implement and maintain a variety of new and upgraded operational and financial systems, procedures and controls, and improve our accounting and other internal management systems, all of which require substantial management efforts. We will also need to continue to expand, train, manage and motivate our employees, and manage our relationships with our distributors, game players and third-party service providers. All of these endeavors will require substantial management efforts and skill and the incurrence of additional expenditure.

To further grow our business and explore market opportunities, we plan to aggregate more high-quality content on our platform and extend our offerings beyond games to more areas of interests, such as education, digital reading and music. We intend to expand Coco, our interactive user system by adding more social features and integrating payment solutions. In addition, we plan to diversify our revenue streams. We currently derive a small portion of our revenues from online advertisements, but we believe that in-game advertising presents an exciting opportunity and we plan to explore this market opportunity. Successful execution of our growth strategies requires sound business judgment of the market and future trends, in addition to strong execution capabilities and resources. If we are unable to manage the growth of our current operations and effectively implement our future growth strategies, our business and results of operations may be materially and adversely affected.

 

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If we fail to maintain and enhance our brand, our business, results of operations and prospects may be materially and adversely affected.

We believe that maintaining and enhancing our brand are of significant importance to the success of our business. A well-recognized brand can help to increase the number and the level of engagement of our players. In the long term, low brand recognition may also hinder our recruitment efforts and our ability to attract new talent. From time to time, we conduct marketing activities on the internet. We cannot assure you, however, that these activities will be successful or that we will be able to achieve the brand promotion effect we expect. In China, we market our services under the brand “ LOGO ” or “Chukong.”

Any negative publicity relating to our products or services, regardless of its veracity, could harm our brand and the perception of our brand in the market. If our brand is harmed, we may not be able to continue to attract a growing user base, which may materially and adversely affect our business, results of operations and financial condition.

We operate in a new and rapidly changing industry, which makes it difficult to evaluate our business and prospects.

The mobile entertainment industry is new and rapidly evolving. The growth of the mobile entertainment industry and the level of demand and market acceptance of our content are subject to a high degree of uncertainty. Our future operating results will depend on numerous factors affecting the mobile entertainment industry, many of which are beyond our control, including changes in player demographics, tastes and preferences, the availability and popularity of other forms of entertainment, and general economic conditions, particularly economic conditions adversely affecting discretionary consumer spending.

There is no assurance that mobile entertainment will continue to be popular in China or elsewhere. A decline in the popularity of mobile entertainment in general, or our mobile content in particular, may adversely affect our business and prospects. In addition, government authorities or industry organizations may adopt new standards that apply to game development. New technologies and new standards may require increases in expenditure for game development and operations, and we will need to adapt our business to cope with the changes and support these new services to be successful. If we fall behind in adopting new technologies or standards, our existing games may lose popularity, and our newly developed games may not be well received.

If we fail to operate and improve our games to satisfy the changing demands of players, our business and results of operations may be materially and adversely affected.

We depend on purchases and continued consumption of virtual items by players to generate revenues, which in turn depends on the continued attractiveness of our games. We continue to improve our games through regular updates as well as periodic major enhancements, and we make efforts to resolve any programming flaws or other operating issues in a timely manner. However, we cannot assure you that our efforts will be effective in satisfying player demands, retaining the attractiveness of our games, or eliminating program errors associated with our games. For example:

 

    our game updates and enhancements may contain program errors or other issues that adversely affect the playing experience;

 

    we may fail to timely respond to and/or resolve complaints from our players;

 

    we may fail to eliminate computer “bots,” which can disrupt our games’ smooth operation and reduce the attractiveness of our games;

 

    our game updates and enhancements may change the rules or aspects of our games that our players do not welcome, resulting in a reduction in the number of people paying our games; and

 

    we may fail to provide game updates and enhancements in a timely manner due to limits on our technologies and resources or other factors.

 

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Our failure to address the issues mentioned above could adversely affect the playing experience for our players, damage the reputation of our games, shorten the lifespan of our games, and eventually result in the loss of players and a decrease in our revenues.

Our business is subject to the risks associated with international operations.

Although most of our revenue in 2011, 2012 and 2013 was derived from our operations in China, international expansion is an important component of our growth strategy. We have established Chukong USA in October 2011 and Chukong Korea in August 2013. 11.8% of our total gross billing in 2013 was generated from our overseas market. Expanding our business internationally exposes us to a number of risks, including:

 

    fluctuations in currency exchange rates;

 

    our ability to select the appropriate geographical regions for international expansion;

 

    difficulty in identifying appropriate partners and establishing and maintaining good cooperative relationships with them;

 

    difficulty in understanding local markets and culture; and

 

    increased costs associated with doing business in foreign jurisdictions.

Our financial condition and operating results also could be significantly affected by these and other risks associated with international activities. Furthermore, we have implemented policies and procedures designed to facilitate compliance with laws and regulations in foreign jurisdictions applicable to us, but there can be no assurance that our employees, contractors, or agents will not violate such laws and regulations or our policies. Any such violations could individually or in the aggregate materially and adversely affect our financial condition or operating results.

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

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

Furthermore, maintaining our brand will depend in part on our ability to remain an active participant in the developer community and our ability to continue to provide high-quality open-source engines, including the Cocos2d-x game engine, which is developed by and requires contributions from third parties with whom we have no business relationship. To successfully release other versions of the Cocos engines, we must therefore assemble and test codes developed by disparate sources. Despite our efforts, errors and bugs have been and may continue to be found in the engines. If errors and bugs are discovered, we may not be able to successfully correct them in a timely manner, if at all. Any errors and failures in the Cocos2d-x game engine and other Cocos engines could result in a loss of market share of the engines and could damage our reputation. In addition, we may need to make significant expenditures of capital resources to reduce errors and failures.

 

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The value of our virtual items is highly dependent on how we manage the virtual economies in our games. If we fail to manage our game economies properly, our business may be materially and adversely affected.

Paying players purchase virtual items in our games because of the perceived value of these goods, which is dependent on the relative ease of obtaining the goods via non-paid means within the games. The perceived value of these virtual items can be impacted by an increase in the availability of free or discounted virtual currency or by various actions that we take in the games, including offering discounts for virtual items, giving away virtual items in promotions or providing easier non-paid means to obtain these goods. If we fail to manage our virtual economies properly, players may be less likely to purchase virtual items and our business may be materially and adversely affected.

If we are unable to accurately assess our operating performance through certain key performance indicators, our ability to form appropriate business growth strategies may be impaired and our business, results of operations and prospects may be materially and adversely affected.

We assess our operating performance using a set of key performance indicators, which include DAUs, MAUs and activations. Capturing accurate data is subject to various limitations, as is true with many internet companies. For example, we may need to collect certain data from mobile carriers or other third parties, which limits our ability to verify the reliability of such data, or we may not be able to collect any data from third parties at all. As an other example, historically, we did not have systematic in-house mechanism to track the number of paying users. Therefore we were not able to provide accurate quantified paying player information for the periods prior to the fourth quarter of 2013. We have made efforts to obtain relevant paying player information, including obtaining regular paying user information from the mobile carriers since the fourth quarter of 2013 for single-player games and installing SDKs to track paying user information for multi-player games. However, we cannot assure you that we can always have the cooperation of mobile carriers and the technologies to capture accurate paying user information. The key operating performance indicators we use may not always reflect our actual operating performance. Similarly, we may incorrectly assess our key operating performance indicators and in turn make incorrect operational and strategic decisions. Failure to capture accurate data or an incorrect assessment of this data may materially harm our business and operating results.

Concerns about our collection and use of personal data and other privacy-related matters could damage our reputation and deter game players from playing our games.

Concerns about our practices with regard to the collection, use or disclosure of personal information or other privacy-related matters, even if unfounded, could damage our reputation and operations. The PRC Constitution, the PRC Criminal Law and the General Principles of Civil Law of the PRC protect individual privacy in general. In particular, Amendment 7 to the PRC Criminal Law prohibits institutions, companies and their employees in the telecommunications and other industries from selling or otherwise illegally disclosing a citizen’s personal information obtained during the course of performing duties or providing services. Our internal policy also requires our employees to protect the personal data of our players, and employees who violate this policy are subject to disciplinary actions, including dismissal. While we strive to comply with all applicable data protection laws and regulations, as well as our own privacy policy, and we believe we are in compliance with the applicable PRC laws and regulations on data protection, any failure or perceived failure to comply may result in proceedings or actions against us by government entities or private individuals, which could have a material adverse effect on our business. Moreover, any failure or perceived failure to comply with applicable laws and regulations related to the collection, use, sharing or security of personal information or other privacy-related matters could result in a loss of confidence in us by our players, which could materially and adversely affect our business, financial condition and results of operations.

 

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Currently there is no law or regulation specifically governing virtual asset property rights and, therefore, it is not clear what liabilities, if any, mobile game operators may have relating to virtual assets.

In the course of playing mobile games, some virtual assets, such as special equipment, player experience grades and other features of our users’ game characters, are acquired and accumulated. Such virtual assets have monetary value and in some cases are sold among players for actual money. In practice, virtual assets can be lost for various reasons, often through unauthorized use of the game account of one user by other users and occasionally through data loss caused by delays in network services, system errors, network crashes or hacking activities. Currently, there is no PRC law or regulation specifically governing virtual asset property rights. As a result, there is uncertainty as to the legal owner of virtual assets, whether and how the ownership of virtual assets is protected by law, and whether we, as an operator of mobile games, would have any liability to game players or other interested parties (whether in contract, tort or otherwise) for loss of such virtual assets. In case of a loss of virtual assets, we may be sued by our game players and held liable for damages, which may negatively affect our reputation and business, financial condition and results of operations. We have not been involved in any virtual asset-related lawsuits to date.

Based on several judgments by PRC courts regarding the liabilities of mobile game operators for loss of virtual assets by game players, the courts have generally required the mobile game operators to return the virtual items or be liable for the loss and damage incurred.

We may need additional capital, and we may be unable to obtain such capital in a timely manner or on acceptable terms, if at all.

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

 

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

 

    general market conditions for capital raising activities by companies offering mobile products and services; and

 

    economic, political and other conditions in China and internationally.

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

Our strategy of acquiring and investing in complementary businesses, assets and technologies may result in operating difficulties, dilution to our investors and other negative consequences.

As part of our business strategy, we have successfully acquired, and intend to continue to selectively acquire and invest in, businesses, assets and technologies that complement our existing business, including (i) acquisitions of companies, businesses, intellectual property rights and other assets, (ii) minority investments in strategic partners, and (iii) investments in new interactive mobile game businesses. Acquisitions and investments involve uncertainties and risks, including:

 

    accurately evaluating the potential of acquisition targets and identifying acquisition targets with operations complementary to our existing operations;

 

    potential ongoing financial obligations and unforeseen or hidden liabilities;

 

    retaining key employees and maintaining the key business relationships with customers of the businesses we acquire;

 

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    failure to achieve the intended objectives, benefits or revenue enhancement;

 

    costs and difficulties of integrating acquired businesses and managing a larger business;

 

    the need to integrate an acquired company’s accounting, management information, human resource and other administrative systems to permit effective management and timely reporting;

 

    the possibility that, before the acquisition or investment, we will not discover important facts during due diligence that could have a material adverse impact on the value of the businesses we acquire or invest in;

 

    significant accounting charges resulting from the completion and integration of a sizeable acquisition and increased capital expenditures;

 

    the possibility that a change of control of a company we acquire triggers a termination of contractual or intellectual property rights important to the operation of its business; and

 

    diversion of resources and management attention.

Our failure to address these risks successfully may have a material adverse effect on our financial condition and results of operations. In addition, any such acquisition or investment may require a significant amount of capital investment, which would decrease the amount of cash available for working capital or capital expenditures. Furthermore, if we use our equity securities to pay for acquisitions, we may dilute the value of the ADSs and the underlying ordinary shares. Our shareholders may not have the opportunity to review, vote on or evaluate future acquisitions or investments. If we borrow funds to finance acquisitions, such debt instruments may contain restrictive covenants that could, among other things, restrict us from distributing dividends.

We depend upon talented employees, including our senior management and key employees, to grow and operate our business, and if we are unable to retain and motivate our employees and attract new talent, our business and prospects may be materially and adversely affected.

Our success depends on our continued ability to identify, hire, develop, motivate and retain talented employees. Our ability to operate efficiently depends upon contributions from all of our employees, and in particular upon our senior management team led by Mr. Haozhi Chen, our chief executive officer and Mr. Guanqun Liu, our chief operating officer. If we are unable to retain the services of our current senior management team or other key personnel, our business may be disrupted and our financial condition and results of operations may be materially and adversely affected.

In addition, we face significant competition for skilled personnel for all areas of our operation. Training new employees with no prior relevant experience could be time-consuming and requires significant resources. We may also need to increase employee remuneration to retain our key employees. If competition further intensifies, it may be more difficult for us to hire, motivate and retain highly skilled personnel. If we fail to attract additional skilled personnel or retain or motivate our existing personnel, we may be unable to grow and our business and prospects may be materially and adversely affected.

Limitations of system and internet infrastructure, network interruptions or loss of critical customer data caused by infrastructure failures may lead to player attrition and revenue reduction and harm our business and reputation.

Our business may be harmed if we are unable to upgrade our systems fast enough to accommodate future traffic levels, avoid obsolescence or successfully integrate any newly developed or acquired technology with our existing systems. Furthermore, our network capacity depends on the network servers and the communication bandwidth that we lease. Constraints in network capacity could cause unanticipated system disruptions and slower response time, affecting data transmission and game play. Thus, any failure to maintain the satisfactory performance, reliability, security and availability of our network and computer infrastructure may cause

 

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significant harm to our reputation and our ability to attract and maintain players. In addition, the internet infrastructure and fixed telecommunications networks in China are critical to the performance of our games and to player satisfaction. In particular, we rely on, and expect to continue to rely on, telecommunications infrastructure to provide data communications capacity for most of our games. In the event of any disruption or failure of the telecommunications infrastructure, we might not have access to alternative networks and services on a timely basis or on terms reasonable to us or at all. If a particular game is unavailable when players attempt to access it or navigation through a game is slower than they expect, players may stop playing the game and may be less likely to return to the game as often, if at all.

From time to time, our players in certain locations may be unable to access our mobile game services for a period of time ranging from several minutes to several hours, due to server interruptions, power blackouts, internet connection problems or other reasons. Any server interruptions, break-downs, design deficiencies, or system failures, including failures which may be attributable to events within or outside our control that result in a sustained shutdown of all or a material portion of our services or loss of critical customer data, could adversely impact our ability to service our players and lead to player attrition and revenue reduction.

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

We and our independent registered public accounting firm have identified material weaknesses in our internal control over financial reporting. If we fail to maintain an effective system of internal control over financial reporting, our ability to accurately and timely report our financial results or prevent fraud may be adversely affected, and investor confidence and the market price of our ADSs may be adversely impacted.

Prior to this offering, we were a private company with limited accounting personnel and other resources with which to address our internal controls and procedures. Our independent registered public accounting firm has not conducted an audit of our internal control over financial reporting. However, in connection with the audit of our consolidated financial statements as of and for the year ended December 31, 2013, we and our independent registered public accounting firm identified a “material weakness” in our internal control over financial reporting, as defined in the standards established by the Public Company Accounting Oversight Board of the United States, or PCAOB. Pursuant to PCAOB standards, 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 on a timely basis. The material weakness identified related to lack of sufficient financial reporting and accounting personnel with appropriate knowledge of U.S. GAAP and SEC reporting requirements to formalize key controls over financial reporting and to prepare consolidated financial statements and related disclosures. We have taken the following remedial measures to improve our internal control over financial reporting: (i) in August 2013, we hired a chief financial officer with more than 30 years’ experience in finance and accounting management both in the United States and China, who is also a certified public accountant in the state of Texas, U.S.; (ii) in October 2013, we hired a financial controller, who is a PRC certified public accountant with more than 15 years of work experience, including nine years’ career in one of the “big four” accounting firms; and (iii) we also hired one additional staff for our U.S. GAAP reporting team, with six years of “big four” accounting firm experience and allocated more staff resources to our U.S. GAAP reporting team during the reporting period in 2013; and (iv) in December 2013, we implemented a new financial software that improves visibility of data, journal entries and to formalize closing and reporting process controls.

We plan to take additional measures to improve our internal controls over financial reporting, including: (i) further expediting and streamlining the reporting process; (ii) developing a compliance process, including a comprehensive policy and procedure manual, to allow early detection, prevention and resolution of potential compliance issues; (iii) conducting regular and continuous U.S. GAAP accounting and financial reporting

 

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training programs for our accounting and financial reporting personnel, including sending our financial staff to attend external U.S. GAAP training courses; (iv) hiring more resources to strengthen the financial reporting function and to set up financial and system control framework; and (v) engaging an external consulting firm to assist us in developing processes and procedures to comply with Sarbanes-Oxley Act. However, the implementation of these measures may not fully address these deficiencies in our internal control over financial reporting, and we cannot conclude that they have been fully remedied. Our failure to correct these control deficiencies or our failure to discover and address any other control deficiencies could result in inaccuracies in our financial statements and could also impair our ability to comply with applicable financial reporting requirements and related regulatory filings on a timely basis. As a result, our business, financial condition, results of operations and prospects, as well as the trading price of our ADSs, may be materially and adversely affected. Moreover, ineffective internal control over financial reporting significantly hinders our ability to prevent fraud.

Furthermore, it is possible that, had our independent registered public accounting firm conducted an audit of our internal control over financial reporting, such firm might have identified additional material weaknesses and deficiencies. Upon completion of this offering, we will become subject to Section 404 of the Sarbanes-Oxley Act of 2002, or Section 404, which requires 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, 2015. In addition, once we cease to be an “emerging growth company” as such term is defined in the JOBS Act, our independent registered public accounting firm must attest to and report on the effectiveness of our internal control over financial reporting. Our management may conclude that our internal control over financial reporting is not effective. Moreover, even if our management concludes that our internal control over financial reporting is effective, our independent registered public accounting firm, after conducting its own independent testing, may issue a report that is qualified if it is not satisfied with our internal controls or the level at which our controls are documented, designed, operated or reviewed, or if it interprets the relevant requirements differently from us. In addition, after we become a public company, our reporting obligations may place a significant strain on our management, operational and financial resources and systems for the foreseeable future. We may be unable to timely complete our evaluation testing and any required remediation.

During the course of documenting and testing our internal control procedures, in order to satisfy the requirements of Section 404, we may identify other weaknesses and deficiencies in our internal control over financial reporting. In addition, if we fail to maintain the adequacy of our internal control over financial reporting, as these standards are modified, supplemented or amended from time to time, we may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with Section 404. If we fail to achieve and maintain an effective internal control environment, we could suffer material misstatements in our financial statements and fail to meet our reporting obligations, which would likely cause investors to lose confidence in our reported financial information. This could in turn limit our access to capital markets, harm our results of operations, and lead to a decline in the trading price of our ADSs. Additionally, ineffective internal control over financial reporting could expose us to increased risk of fraud or misuse of corporate assets and subject us to delisting from the stock exchange on which we list, regulatory investigations and civil or criminal sanctions. We may also be required to restate our financial statements from prior periods.

If we fail to protect our intellectual property rights, it could materially and adversely affect our business and results of operations.

We rely on a combination of trademark, copyright and trade secret protection laws in the PRC, as well as confidentiality agreements and procedures, to protect our intellectual property rights. Despite our precautions, third parties may obtain and use our intellectual property without our authorization, which includes trademarks related to our brand and games, registered domain names, copyrights in software and creative content, and trade secrets.

 

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Historically, the legal system and courts of the PRC have not protected intellectual property rights to the same extent as the legal system and courts of the United States. Companies operating in the PRC continue to face a significant risk of intellectual property infringement. Furthermore, the validity, application, enforceability and scope of protection of intellectual property rights for many internet-related activities are uncertain and still evolving in China and abroad, which may make it more difficult for us to protect our intellectual property, and could have a material adverse effect on our business, financial condition and the results of our operations.

We may be vulnerable to intellectual property infringement claims brought against us by others.

We rely on third-party intellectual property to operate our business to some extent, such as licenses to use certain software and copyrights. As we face increasing competition and as litigation becomes more common in China to resolve commercial disputes, we face increasing risk of being subject to intellectual property infringement claims. A successful infringement claim against us could result in monetary liability or a material disruption in the conduct of our business. We cannot be certain that our games, brand names and other intellectual property do not or will not infringe on valid patents, trademarks, copyrights or other intellectual property rights held by third parties. We may be subject to legal proceedings and claims from time to time relating to the intellectual property of third parties in the ordinary course of our business.

We may incur substantial expenses in defending against third-party infringement claims, regardless of their merits. As a result, due to diversion of management time, expenses required to defend against any claim and the potential liabilities associated with any lawsuit, any significant litigation could significantly harm our business, financial condition and results of operations. If we were found to have infringed on the intellectual property rights of a third party, we could be liable to that party for license fees, royalty payments, lost profits or other damages, and the owners of such intellectual property may be able to obtain injunctive relief to prevent us from using the technology, software or trademark in the future. If the amount of these payments were significant, if we were prevented from incorporating certain technology or software into our products or services, or if we were prevented from using our trademarks, our business could be significantly harmed.

Certain of our PRC Subsidiary and consolidated affiliated entities have not been in full compliance with applicable PRC social insurance and housing fund laws and regulations.

We are subject to various social insurance and housing fund laws and regulations in the PRC, under which we are required to pay our employees’ pension contributions, housing funds, medical insurance premiums and other welfare-oriented payments. Certain of our PRC subsidiaries and consolidated affiliated entities have not paid social insurance premiums and housing funds for some of their employees in full compliance with applicable PRC laws. We estimate that the cumulative amount of such underpaid social insurance premiums and housing fund contributions as of December 31, 2013 was RMB6.6 million and we have made a provision for such underpayment accordingly. However, we may still be subject to administrative penalties, such as fines, for our prior failure to fully pay the requisite social insurance premiums and/or housing fund contributions and if we do not comply with the social insurance and housing funds contribution requirements in the future, our business and reputation may be adversely affected.

A severe and prolonged global economic recession and related slowdown in the Chinese economy may adversely affect our business, results of operations and financial condition.

Any actual or perceived threat of a financial crisis in China or elsewhere in the world could have an indirect, but material and adverse, impact on our business and results of operations. Since we derive most of our revenues from China, any slowdown in the Chinese economy may have a negative impact on our business, operating results and financial condition in a number of ways. For example, our players may decrease in number or reduce their spending, and we may have difficulty expanding our customer base fast enough, or at all, to offset the impact of decreased spending by our existing players. Furthermore, the economic recession in other countries where our games are operated may reduce players’ levels of disposable income, perceived future earning

 

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capacities and willingness to spend, and may thus result in a decline in their spending on our games and a corresponding decrease in our revenues and profit. It is difficult to predict how the PRC economy may develop in the future and whether it will experience a financial or economic crisis in a manner and scale similar to what the United States and other developed countries have experienced. The PRC economy was negatively affected by the recent global financial crises and may be further negatively impacted by economic uncertainties in Europe and the United States, particularly the European debt crisis. Recently, there have been increasing concerns that the PRC economy is slowing, which weighs on enterprises in China, including us. In May 2012, the PRC central bank lowered the reserve-requirement ratio for PRC banks to encourage economic growth after certain data revealed a weakening economic momentum. In any event, a severe and prolonged global economic recession and the related slowdown in the Chinese economy may adversely affect our business, results of operations and financial condition.

Our business may be subject to seasonality, which could adversely affect our results of operations.

Our business generally experiences some effects of seasonal variations. For example, players tend to spend more time playing our games in the first and third quarters of each year, which typically encompass more public holidays and school breaks, during which school-aged users and working professionals have more time for digital entertainment. The second and fourth quarters are relatively slower for our business as there are fewer holidays during those quarters. However, we have experienced growth in revenues in 2013, especially in game publishing business, which may potentially offset the seasonality factor in the near term. Our short operating history and our rapid growth make it difficult for us to identify recurring seasonal trends in our business. Accordingly, you should not rely on quarter-to-quarter comparisons of our results of operations as an indication of our future performance.

We have limited business insurance coverage.

Insurance companies in China currently do not offer as extensive an array of insurance products as insurance companies do in countries with more developed economies. In line with general industry practice in China, we do not have any business liability or disruption insurance to cover our operations. Any occurrence of business disruption may result in our incurring substantial costs and the diversion of resources, which could have a material adverse effect on our results of operations and financial condition.

We face risks related to health epidemics and other natural disasters.

Our business could be adversely affected by the effects of H1N1 flu, avian flu, Severe Acute Respiratory Syndrome, or SARS, or other epidemics. China reported a number of cases of SARS in 2003, which resulted in the closure of many businesses by the PRC government to prevent transmission. In recent years, there have been reports of occurrences of avian flu in various parts of China, including a few confirmed human cases and deaths. In 2009, the global spread of H1N1 flu resulted in several confirmed infections and deaths in China. Our operations may be impacted by a number of health-related factors, including, among other things, quarantines or closures of our offices which could severely disrupt our operations, the sickness or death of our key officers and employees, and a general slowdown in the Chinese economy. Any of the foregoing events or other unforeseen consequences of public health problems could adversely affect our business and results of operations. We have no preventive measures or contingency plans to combat any future outbreak of H1N1 influenza, avian flu, SARS or any other epidemic.

We are also vulnerable to natural disasters and other calamities, such as fire, floods, typhoons, earthquakes, power blackouts, telecommunications failures, break-ins, wars, riots, terrorist acts or similar events or acts of God. Any of the foregoing events may give rise to server interruptions, breakdowns, system failures, technology platform failures or internet failures, which could cause the loss or corruption of data or malfunctions of software or hardware as well as adversely affect the availability of our games. In addition, a severe disaster could affect the operations or financial condition of our vendors, players and service providers, which could harm our results of operations.

 

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Risks Related to Our Corporate Structure

If PRC authorities determine that the agreements that establish the structure for operating our business in China do not comply with applicable PRC laws and regulations, we could be subject to severe penalties.

We are a Cayman Islands company and, as such, we are classified as a foreign enterprise under PRC laws, and our PRC subsidiary, Chukong Beijing, is a foreign-invested enterprise under PRC laws. Various regulations in China currently restrict or prevent foreign-invested entities from holding certain licenses required to provide mobile game operation services in China, including internet content provision, internet culture operation and internet publishing. In light of these restrictions, we rely on Chukong Technology and Tiansheng Chengye to hold and maintain the licenses necessary to operate mobile games in China.

Various regulations in China currently restrict or prevent foreign-invested entities from engaging in telecommunication services, including operating mobile games. The Circular on Strengthening the Administration of Foreign Investment in and Operation of Value-added Telecommunications Business issued by the Ministry of Industry and Information Technology, or MIIT, in July 2006, or the MIIT Circular, reiterates restrictions on foreign investment in telecommunications businesses. Under the MIIT Circular, a domestic company that holds a license to conduct value-added telecommunications businesses, or a VATS License, such as the internet content provider license, or the ICP License, in China, is prohibited from leasing, transferring or selling the license to foreign investors in any form, and from providing any assistance, including providing resources, sites or facilities, to foreign investors to conduct value-added telecommunications businesses illegally in China. Furthermore, trademarks and domain names that are used in a value-added telecommunications business must be owned by the local VATS License holder or its shareholder(s). The MIIT Circular further requires each VATS License holder to have appropriate facilities for its approved business operations and to maintain such facilities in the regions covered by its license. In addition, all value-added telecommunications service providers are required to maintain network and information security in accordance with the standards set forth under relevant PRC regulations. Both Chukong Technology and Tiansheng Chengye hold valid VATS Licenses for provision of information services through mobile networks, and Chukong Technology also owns an ICP License. Chukong Technology owns cocoachina.com, cocimg.com, appget.cn, newapp.cn and certain other domain names, and has been applying to register relevant trademarks, which are in compliance with the MIIT Circular. However, due to a lack of interpretative materials from the authorities, it is uncertain whether MIIT would consider our corporate structures and contractual arrangements as a kind of foreign investment in telecommunication services in China. Therefore, it is unclear what impact the MIIT Circular might have on us or the other Chinese internet companies that have adopted the same or similar corporate structures and contractual arrangements as ours.

On September 28, 2009, the General Administration of Press and Publication, or GAPP, together with the National Copyright Administration, and the National Office of Combating Pornography and Illegal Publications jointly issued the Notice Regarding the Consistent Implementation of the “Stipulations on ‘Three Provisions’ of the State Council and the Relevant Interpretations of the State Commission Office for Public Sector Reform and the Further Strengthening of the Administration of Pre-examination and Approval of Online Game and the Examination and Approval of Imported Online Game,” or the GAPP Notice. The GAPP Notice states that foreign investors are not permitted to invest in online game operation businesses in China through wholly foreign-owned entities, China-foreign equity joint ventures or cooperative joint ventures or to exercise control over or participate in the operation of online game businesses through indirect means, such as other joint venture companies or contractual or technical arrangements. It is not clear whether the regulatory authority of GAPP applies to the regulation of ownership structures of online game companies based in China. Other government agencies that have regulatory jurisdiction over the online game operations in China, such as the Ministry of Culture, or MOC, and MIIT, did not join GAPP in issuing the GAPP Notice. To date, GAPP has not issued any interpretation of the GAPP Notice. It is unclear how the GAPP Notice will be implemented and whether GAPP will deem our contractual arrangement to be such an “indirect means” for foreign investors to exercise control over or

 

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participate in the operation of a domestic online game business. If our contractual arrangement were deemed to be such an “indirect means” under the GAPP Notice, our contractual arrangement might be challenged by the GAPP authorities. Effective on March 22, 2013, GAPP and the State Administration of Radio, Film and Television merged into one entity, namely, the State General Administration of Press, Publication, Radio, Film and Television, or SAPPRFT, which oversees China’s press, publication, radio, film and TV sectors.

In August 2011, the Ministry of Commerce, or MOFCOM, promulgated the Rules of Ministry of Commerce on Implementation of Security Review System of Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or the MOFCOM Security Review Rules, to implement the Notice of the General Office of the State Council on Establishing the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or Circular No. 6, promulgated on February 3, 2011. The MOFCOM Security Review Rules came into effect on September 1, 2011 and replaced the Interim Provisions of the Ministry of Commerce on Matters Relating to the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors promulgated by MOFCOM in March 2011 by the State Council. Under these circulars and rules, a security review by MOFCOM is required for foreign investors’ mergers and acquisitions having “national defense and security” implications and mergers and acquisitions by which foreign investors may acquire “de facto control” of domestic enterprises having “national security” implications. In addition, when deciding whether a specific merger or acquisition of a domestic enterprise by foreign investors is subject to a security review, MOFCOM will look into the substantive and actual impact of the transaction. The MOFCOM Security Review Rules further prohibit foreign investors from bypassing the security review requirement by structuring transactions through proxies, trusts, indirect investments, leases, loans, control through contractual arrangements or offshore transactions. There is no explicit provision or official interpretation stating that our mobile game business or our online advertising business falls within the scope of transactions subject to security review, and there is no requirement for foreign investors in those merger and acquisition transactions already completed prior to the promulgation of Circular No. 6 to submit such transactions to MOFCOM for a security review. We do not believe we are required to submit our existing contractual arrangement to MOFCOM for a security review. However, as there is a lack of clear statutory interpretation regarding the implementation of the rules, there is no assurance that MOFCOM will have the same view as we do when applying these national security review-related circulars and rules.

Because of these restrictions, our operation of mobile game businesses in the PRC is conducted through contractual arrangements among Chukong Beijing, our variable interest entities and their respective shareholders. Our contractual arrangements enable us to receive substantially all of the economic benefits derived from, and exercise effective control over, our variable interest entities and consolidate their results of operations. For a detailed discussion of these contractual arrangements, see “Corporate History and Structure—Our Contractual Arrangements.”

Although we believe our contractual arrangements are in compliance with current PRC laws and regulations, we cannot assure you that the PRC government will agree that these contractual arrangements comply with existing PRC laws and regulations or with PRC laws and regulations that may be adopted in the future. PRC laws and regulations governing the validity of these contractual arrangements are uncertain and the relevant government authorities have broad discretion in interpreting these laws and regulations. In 2011, various media sources reported that the China Securities Regulatory Commission, or CSRC, had prepared a report proposing regulations requiring the pre-approval by a competent central government authority of offshore listings by China-based companies with variable interest entity structures, such as ours, that operate in industry sectors subject to foreign investment restrictions. However, it is unclear whether the CSRC officially issued or submitted such a report to a higher level government authority or what any such report provides, or whether any new PRC laws or regulations relating to variable interest entity structures would be adopted or what they would provide.

 

 

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If the corporate structure and contractual arrangements through which we conduct our business in China were found to be in violation of any existing or future PRC laws or regulations, or such arrangement is determined as illegal or invalid by the PRC court, arbitral tribunal or regulatory authorities, or if we fail to obtain or maintain any of the required permits or approvals under our contractual arrangements, the relevant regulatory authorities, including the SAPPRFT and the CSRC, would have broad discretion in dealing with such violations and imposing relevant actions, which actions could include:

 

    revoking or refusing to grant or renew the business and operating licenses required to conduct our operations in China;

 

    restricting or prohibiting transactions between our PRC subsidiaries and our variable interest entities;

 

    imposing fines or other requirements which we or our PRC subsidiaries or our variable interest entities may find difficult or impossible to comply with;

 

    requiring us and our PRC subsidiaries and/or our variable interest entities to alter our ownership structure or operations; and

 

    restricting or prohibiting the use of any proceeds from our public offering to finance our business and operations in China.

The imposition of any of these penalties could result in a material adverse effect on our ability to conduct our business in China, which may have a material adverse effect on our results of operations and financial condition. If any of our contractual arrangements through which we conduct our business are determined to violate any existing or future PRC laws and regulations, we may no longer be able to consolidate the financial results of our variable interest entities, through which substantially all of our operations are conducted, into our consolidated financial statements.

Our contractual arrangements with our variable interest entities and their respective shareholders may not be as effective in providing operational control as direct ownership. Any failure by our variable interest entities or their respective shareholders to perform their obligations under their contractual arrangements with us may have a material adverse effect on our business and financial condition.

We have relied and expect to continue to rely on contractual arrangements with our variable interest entities and their respective shareholders to operate a part of our business in China. For a description of these contractual arrangements, see “Corporate History and Structure—Our Contractual Arrangements.” These contractual arrangements may not be as effective in providing us with control over our variable interest entities as direct ownership. If we had direct ownership of our variable interest entities, we would be able to exercise our rights as a shareholder to effect changes in its board of directors, which in turn could effect changes at the management level, subject to any applicable fiduciary obligations.

Under the current contractual arrangements, we rely on the performance by our variable interest entities and their respective shareholders of their respective obligations under the contracts to exercise control over our variable interest entities. For example, our variable interest entities and their respective shareholders could breach their contractual arrangements with us by, among other things, failing to operate our business in an acceptable manner or taking other actions that are detrimental to our interests. Our variable interest 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 our variable interest entities or their respective shareholders fail to perform their obligations under the contractual arrangements with us, we may have to restructure our business operations, and/or incur substantial costs and resources to enforce our rights under the contracts and rely on legal remedies under PRC laws, including seeking specific performance or injunctive relief and claiming damages, which may not be effective. If the shareholders of our variable interest entities were to refuse to transfer their equity interests in these entities to us or our designee(s) when and if we request so, or if they were otherwise to act in bad faith toward us, then we may have to take legal actions to compel them to perform their contractual

 

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obligations, or they may bring claims against us to demand their economic interests and exercise other rights in our variable interest entities by virtue of the fact that they are direct or indirect equity holders of these entities. PRC laws and regulations governing the validity of our contractual arrangements are uncertain and PRC government authorities, including courts, have broad discretions in interpreting these laws and regulations. See “—If PRC authorities determine that the agreements that establish the structure for operating our business in China do not comply with applicable PRC laws and regulations, we could be subject to severe penalties” and “Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could have a material adverse effect on us.” In addition, the shareholders of our variable interest entities may not act in the best interests of our company or may not perform their obligations under these contracts.

All of the material agreements under our contractual arrangements are governed by PRC laws and provide for the resolution of disputes arising from or in connection with the agreements through arbitration in the PRC. Accordingly, these contracts would be interpreted in accordance with PRC laws and any disputes would be resolved in accordance with PRC legal procedures. The legal system in the PRC is not as developed as that of 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. Under PRC laws, rulings by arbitrators are final, parties cannot appeal the arbitration results in courts, and the prevailing parties may only enforce the arbitration awards in PRC courts through arbitration award recognition proceedings, which would incur additional expenses and may cause delay. In the event we are unable to enforce our contractual arrangements, we may not be able to exercise effective control over our variable interest entities, and our ability to conduct our business may be materially and adversely affected.

The shareholders of our consolidated affiliated companies may have potential conflicts of interest with us, which may materially and adversely affect our business and financial condition. We do not have any arrangements in place to address such potential conflicts.

Each shareholder of Chukong Technology and Beijing Wan’ai is a shareholder of our company. The equity interest held by each of these shareholders in our company is less than his interest in Chukong Technology and Beijing Wan’ai as a result of our introduction of private equity investors. In addition, such shareholders’ equity interest in our company will be further diluted as a result of this offering as well as any future offering of equity securities. As a result, conflicts of interest may arise as a result of such dual shareholding and governance structure.

The shareholders of Tiansheng Chengye are Mr. Yan Jia and Mr. Yingtao Hou. Neither of them is a shareholder of our company, but each of them has been granted options to purchase shares of our company. Each of Mr. Jia and Mr. Hou is a member of our senior management. In addition, each of Mr. Jia and Mr. Hou has executed an irrevocable power of attorney to appoint Chukong Beijing to vote on his behalf and exercise all of his other shareholder rights.

Although these individuals are contractually obligated, or obligated as a result of their fiduciary duties to our company, to act in good faith and in our best interest, they still have potential conflicts of interest with us. For example, occasions may arise when the fiduciary duties these individuals owe to us under Cayman Islands law conflict with the fiduciary duties they owe to our variable interest entities under PRC laws. Under Cayman Islands law, a director is not released from his or her fiduciary duties owed to us as a director of our company, and his or her obligation to discharge such duties is not affected by any other duties that such director owes or interests which such director may have, including as a director or shareholder of another company, such as Chukong Technology and Beijing Wan’ai. In exchange for entering into the initial contractual arrangements with us when we established the current corporate structure, the shareholders of Chukong Technology and Beijing Wan’ai received shares in our holding company in the Cayman Islands. Because the shareholders of Chukong Technology and Beijing Wan’ai are also shareholders of our holding company in the Cayman Islands, we believe they have incentives to act in the best interests of our company when conflicts of interest arise. None of the shareholders of Tiansheng Chengye is a shareholder of our company, but each of them has been granted options

 

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to purchase shares of our company, so we believe they have incentives to act in the best interests of our company when conflicts of interest arise. However, we cannot assure you that when conflicts of interest arise, any or all of these individuals will act in the best interests of our company or such conflicts will be resolved in our favor. In addition, these individuals may breach, cause Chukong Technology, Beijing Wan’ai and Tiansheng Chengye to breach or refuse to renew, the existing contractual arrangements with us. Currently, we do not have any arrangements to address potential conflicts of interest between these individuals and our company. We rely on these individuals to abide by the laws of the Cayman Islands and the PRC, which provide that directors owe a fiduciary duty to the company and require them to act in good faith and in the best interests of the company and not to use their positions for personal gains. There are, however, no specific regulations under the PRC or Cayman Islands laws with respect to potential conflicts of interest. If we cannot resolve any conflict of interest or dispute between ourselves and the shareholders of Chukong Technology, Beijing Wan’ai and Tiansheng Chengye, we would have to rely on legal proceedings, which could disrupt our business, distract management and subject us to substantial uncertainty as to the outcome of any such legal proceedings.

The shareholders of Chukong Technology, Beijing Wan’ai and Tiansheng Chengye may be involved in personal disputes with third parties or other incidents that may have an adverse effect on their respective equity interests in Chukong Technology, Beijing Wan’ai and Tiansheng Chengye and the validity or enforceability of our contractual arrangements with our variable interest entities and their respective shareholders. For example, in the event that any shareholder of Chukong Technology, Beijing Wan’ai and Tiansheng Chengye divorces his or her spouse, the spouse may claim that the equity interest of Chukong Technology, Beijing Wan’ai and Tiansheng Chengye held by such shareholder is part of their marital or community property and should be divided between such shareholder and the spouse. If such claim is supported by the court, the relevant equity interest may be obtained by the shareholder’s spouse or another third party who is not bound by our contractual arrangements, which could result in our losing effective control over our variable interest entities. Similarly, if any of the equity interests of Chukong Technology, Beijing Wan’ai and Tiansheng Chengye are inherited by a third party on whom the current contractual arrangements are not binding, we could lose our control over Chukong Technology, Beijing Wan’ai and Tiansheng Chengye or have to maintain such control at unpredictable cost, which could cause significant disruption to our business, operations and harm our financial condition and results of operations.

Although under our current contractual arrangements, (i) the spouses of each of the shareholders of Chukong Technology, Beijing Wan’ai and Tiansheng Chengye have executed spousal consent letters, under which they agree that they will not take any actions or raise any claims to interfere with the performance by their spouses of their obligations under these contractual arrangements, including claiming community property ownership on the equity interest, and they renounce any and all rights and interests related to the equity interests that they may be entitled to under applicable laws, and (ii) it is expressly provided that all these agreements and the rights and obligations thereunder shall be equally effective and binding on the heirs and successors of the contracting parties, we cannot assure you that these undertakings and arrangements will be complied with or effectively enforced. In the case any of them is breached or becomes unenforceable and leads to legal proceedings, it could disrupt our business, distract management and subject us to substantial uncertainty as to the outcome of any such legal proceedings.

We may lose the ability to use and enjoy assets held by our consolidated affiliated entities that are important to the operation of our business if our consolidated affiliated entities declare bankruptcy or become subject to dissolution or liquidation proceedings.

Our consolidated affiliated entities hold certain assets that are important to our business operations, such as the copyrights of our games. Although each of the exclusive equity option agreements among Chukong Beijing, our consolidate affiliated entities and their respective shareholders contains terms that specifically obligate the shareholders of our variable interest entities to ensure the valid existence of Chukong Technology, Beijing Wan’ai and Tiansheng Chengye and that all our variable interest entities may not be voluntarily liquidated without our prior consent, in the event the shareholders breach this obligation and voluntarily liquidate our

 

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variable interest entities, or if our variable interest entities declare bankruptcy, and all or part of their assets become subject to liens or rights of third-party creditors, we may be unable to continue some or all of our business operations, which could materially and adversely affect our business, financial condition and results of operations. Furthermore, if any of our variable interest entities undergoes a voluntary or involuntary liquidation proceeding, its shareholders or unrelated third-party creditors may claim rights to some or all of its assets, thereby hindering our ability to operate our business, which could materially and adversely affect our business, financial condition and results of operations.

Contractual arrangements with our variable interest entities and their respective shareholders may be subject to scrutiny by the PRC tax authorities and result in adverse tax consequences for us.

Under PRC laws and regulations, arrangements and transactions among related parties may be subject to audit or challenged by the PRC tax authorities within ten years after the taxable year in which the relevant transactions are conducted. We could face material and adverse tax consequences if the PRC tax authorities determine that the contractual arrangements among Chukong Beijing, our wholly owned subsidiary in China, our variable interest entities and their respective shareholders were not entered into on an arm’s length basis and consequently adjust our variable interest entities’ income in the form of a transfer pricing adjustment. A transfer pricing adjustment could, among other things, result in a reduction, for PRC tax purposes, of expense deductions recorded by our variable interest entities which could in turn increase their tax liabilities. In addition, the PRC tax authorities may impose late payment fees and other penalties upon our variable interest entities for unpaid taxes. Our consolidated net income may be materially and adversely affected if our variable interest entities’ tax liabilities increase or if they are subject to late payment fees, interests, or other penalties.

We may rely on dividends paid by our subsidiaries for our cash needs, and any limitation on the ability of our subsidiaries to make dividend payments to us, or any tax implications of making dividend payments to us, could limit our ability to pay dividends to holders of our ADSs and ordinary shares.

We are a holding company and conduct substantially all of our business through our operating subsidiaries and our consolidated affiliated entities, which are limited liability companies established in China. We may rely on dividends paid by our subsidiaries for our cash needs, including the funds necessary to pay dividends and other cash distributions to our shareholders, to service any debt we may incur and to pay our operating expenses.

Payment of dividends by entities organized in China is subject to certain limitations. In particular, regulations in China currently permit payment of dividends only out of accumulated profits as determined in accordance with PRC accounting standards and regulations. Each of our subsidiaries in China is also required to set aside at least 10% of its after-tax profit, if any, based on PRC accounting standards each year to its general reserves until the cumulative amount of such reserves reaches 50% of its registered capital and to allocate a portion of its after-tax profit to its staff welfare and bonus fund at the discretion of its board of directors. These reserves are not distributable as cash dividends. Our PRC subsidiaries and consolidated affiliated entities historically have not allocated any of their after-tax profits to staff welfare and bonus funds, but they may nevertheless decide to set aside such funds in the future. There is no maximum amount of after-tax profit that a company may contribute to such fund. Any direct or indirect limitation on the ability of our PRC subsidiaries to distribute dividends and other distributions to us could materially and adversely limit our ability to make investments or acquisitions at the holding company level, pay dividends or otherwise fund and conduct our business.

In addition, the PRC Enterprise Income Tax Law and its implementation rules provide that a withholding tax rate of 10% will be applicable to dividends paid by Chinese companies to non-PRC resident enterprises unless otherwise exempted or reduced pursuant to treaties or arrangements between the PRC central government and governments of other countries or regions where the non-PRC resident enterprises are recognized as tax residents. While the tax arrangement between the PRC and Hong Kong provides that dividends paid by a foreign-invested enterprise in the PRC to its offshore corporate shareholders that are considered Hong Kong tax

 

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residents will be subject to PRC withholding tax at the rate of 5% of the amount of the total dividends, this is limited to instances where the corporate shareholder has directly held 25% or more of the equity interests in the PRC foreign-invested company that is paying dividends for at least twelve (12) consecutive months immediately prior to receiving the dividends and has met certain other criteria prescribed by the relevant regulations. Entitlement to a lower tax rate on dividends pursuant to tax treaties or arrangements between the PRC central government and governments of other countries or regions is further subject to approval of the relevant tax authority.

Furthermore, the State Administration of Taxation, or SAT, promulgated the Notice on How to Understand and Determine the Beneficial Owners in Tax Treaty in October 2009, or Circular No. 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 No. 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. A conduit company normally refers to a company that is set up for the purpose of avoiding or reducing taxes or transferring or accumulating profits. We cannot assure you that we will be entitled to the benefits under the relevant tax treaties and arrangements, if any, for any dividends to be distributed by our subsidiaries to us. In particular, we cannot assure you that Chukong HK, our wholly owned subsidiary incorporated in Hong Kong, and also the direct equity owner of our PRC subsidiary, Chukong Beijing, will be entitled to the 5% reduced tax rate. If Chukong HK is subject to the 10% tax rate instead of the 5% tax rate for dividends paid to it, our financial condition will be negatively affected.

PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident beneficial owners to personal liability and limit our ability to acquire PRC companies or to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to distribute profits to us or otherwise materially and adversely affect us.

The State Administration of Foreign Exchange, or SAFE, issued the Notice on Relevant Issues Concerning Foreign Exchange Administration for PRC Residents to Engage in Financing and Round-trip Investment via Overseas Special Purpose Vehicles, or SAFE Circular No. 75, and a series of implementation rules and guidance, requiring PRC residents, including both legal persons and natural persons, to register with the relevant local branch of SAFE before establishing or acquiring control over any company outside of China, referred to as an offshore special purpose company, for the purpose of raising funds from overseas to acquire assets of, or equity interest in, PRC companies. In addition, any PRC resident that is a beneficial owner of an offshore special purpose company is required to amend his or her registration with the local branch of SAFE, with respect to that offshore special purpose company in connection with any increase or decrease in its capital, transfer of shares, merger, division, equity investment or creation of any security interest over any assets located in China. Any failure to comply with the above registration requirements could result in our PRC subsidiaries being prohibited from distributing their profits and proceeds from any reduction in capital, share transfer or liquidation to their offshore parent companies, offshore parent companies being restricted in their ability to contribute additional capital into their PRC subsidiaries and may also subject the relevant PRC subsidiaries and PRC residents to penalties under PRC foreign exchange administration regulations.

We have requested PRC residents who we know hold direct or indirect interests in our company to make necessary applications, filings and amendments as required under SAFE Circular No. 75 and other related rules. All of our founders who are subject to SAFE Circular No. 75 have completed the necessary registrations with the local SAFE branch as required by SAFE Circular No. 75 in relation to our previous financings. However, we cannot assure you that such amendment registrations will be duly completed with the local SAFE branch in a timely manner, or at all. In addition, we may not be informed of the identities of all of the PRC residents holding direct or indirect interests in our company, and we cannot provide any assurance that these PRC residents will obtain all necessary registrations or comply with other requirements under SAFE Circular No. 75 or other related rules. Any failure or inability by such individuals to comply with SAFE regulations may subject us to fines or legal sanctions, such as restrictions on our cross-border investment activities or our direct PRC subsidiary’s

 

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ability to distribute dividends to, or obtain foreign-exchange-denominated loans from, our company or prevent us from making distributions or paying dividends. As a result, our business operations and our ability to make distributions to you could be materially and adversely affected.

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

PRC laws and regulations establish more complex procedures for some acquisitions of Chinese companies by foreign investors, which could make it more difficult for us to pursue growth through acquisitions in China.

PRC laws and regulations, such as the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or the M&A Rules, the Anti-Monopoly Law and the MOFCOM Security Review Rules, establish additional procedures and requirements that are expected to make merger and acquisition activities in China by foreign investors more time-consuming and complex, by including requirements in some instances that MOFCOM be notified in advance of any change-of-control transaction in which a foreign investor takes control of a PRC domestic enterprise, or that the approval from MOFCOM be obtained in circumstances where overseas companies established or controlled by PRC enterprises or residents acquire affiliated domestic companies. PRC laws and regulations also require certain merger and acquisition transactions to be subject to merger control review or security review. The MOFCOM Security Review Rules, effective from September 1, 2011, further provide that, when deciding whether a specific merger or acquisition of a domestic enterprise by foreign investors is subject to the security review by MOFCOM, the principle of substance over form should be applied and foreign investors are prohibited from bypassing the security review requirement by structuring transactions through proxies, trusts, indirect investments, leases, loans, control through contractual arrangements or offshore transactions. If the business of any target company that we plan to acquire falls into the ambit of a security review by MOFCOM, we may not be able to successfully acquire such company either by equity or asset acquisition, capital contribution or through any contractual arrangement. We may grow our business in part by acquiring other companies operating in our industry. Complying with the requirements of the relevant regulations to complete such transactions could be time-consuming, and any required approval processes, including approval from MOFCOM, may delay or inhibit our ability to complete such transactions, which could affect our ability to expand our business or maintain our market share.

Risks Related to Doing Business in China

Our business may be adversely affected by public opinion and governmental policies in China as well as in other jurisdictions where we operate our mobile games.

Currently, most of our game players in China are young people, many of whom are students. Due to the exciting and appealing features of online games as a form of entertainment, many teenagers in China frequently play online games. This may result in these teenagers spending less time on or neglecting other activities, including education, vocational training, sports, and proper rest, which in term could result in adverse public reaction and stricter government regulation. For example, the PRC government has promulgated anti-fatigue-related regulations to limit the amount of time minors can play online games. See “—Our mobile game operations may be adversely affected by implementation of new anti-fatigue-related regulations.”

 

 

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Adverse public opinion could discourage players from playing our games, and could result in government regulations that impose additional limitations on the operations of online games as well as on players’ access to online games. For example, in January 2011, MIIT and seven other PRC central government authorities jointly issued the circular entitled Implementation Scheme Regarding Online Game Parental Guardianship Project for Minors, or the Parental Guardianship Project Circular, under which online game operators are required to adopt various measures to maintain a system to communicate with the parents or other guardians of minors playing their online games and are required to monitor the gaming activities of minors and suspend the accounts of minors if so requested by their parents or guardians. We believe stricter government regulations, such as regulations limiting the issuance of virtual currency by online game operators or the amount of virtual currency that can be purchased by an individual player, or extending anti-fatigue-related regulations to adults, may be implemented in the future. Such adverse public opinion and tightened government regulations could materially and adversely affect our business prospects and our ability to maintain or increase revenues.

Moreover, similar adverse public reaction may arise, and similar government policies may be adopted, in other jurisdictions where we operate our games, which could materially and adversely affect our revenues.

Our mobile game operations may be adversely affected by implementation of new anti-fatigue-related regulations.

The PRC government may decide to adopt more stringent policies to monitor the online game industry as a result of adverse public reaction to perceived addiction to online games, particularly by minors. This will not affect our single-player games, but our online mobile games may be subject to these policies. On April 15, 2007, eight PRC government authorities, including GAPP, the Ministry of Education and MIIT, jointly issued a notice, or the Anti-Fatigue Notice, requiring all Chinese online game operators to adopt an “anti-fatigue system” in an effort to curb addiction to online games by minors. Under the anti-fatigue system, three hours or less of continuous play is defined to be “healthy,” three to five hours is defined to be “fatiguing,” and five hours or more is defined to be “unhealthy.” Game operators are required to reduce the value of game benefits for minor players by half when those players reach the “fatigue” level, and to zero when they reach the “unhealthy” level. In addition, online game players in China are now required to register their identity card numbers before they can play an online game. The anti-fatigue system allows game operators to identify which players are minors. These restrictions could limit our ability to increase our business among minors. Furthermore, if these restrictions were expanded to apply to adult players in the future, our business could be materially and adversely affected.

On July 1, 2011, eight PRC government authorities, including GAPP, the Ministry of Education, MIIT and five others, jointly promulgated a further notice to strengthen the implementation of the anti-fatigue system and real-name registration, entitled the Notice on Initializing the Verification of Real-name Registration for Anti-Fatigue System on Online Games, or the Real-name Registration Notice, which took effect on October 1, 2011. The Real-name Registration Notice’s main focus is to prevent minors from using an adult’s ID to play internet games. Accordingly, the notice provides more stringent punishment for online game operators for not implementing the anti-fatigue and real name registration measures properly and effectively. The most severe punishment contemplated by the Real-name Registration Notice requires the termination of the operation of the online game if it is found to be in violation of the Anti-Fatigue Notice, the Parental Guardianship Project Circular, or the Real-name Registration Notice. The Real-name Registration Notice further increases our operational risks, as we will be required to spend more resources on real-name verification and anti-fatigue systems, which will lead to an increase in operation costs. In addition, the amount of time that minors will be able to spend playing online games such as ours will be further limited, which can be expected to lead to a reduction in our revenues. Furthermore, if we are found to be in violation of the Real-name Registration Notice, we may be required to suspend or discontinue our online game operations.

Strengthened supervision of the online game industry may adversely affect our mobile game operations.

We may face stricter supervision in the future regarding the operation of our online games by several PRC governmental departments with oversight on the online game industry in China, including SAPPRFT and MOC.

 

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For example, the GAPP Notice states that SAPPRFT is the governmental department with authority to examine and pre-approve online games, and that each online game operator must obtain an internet publishing license in order to provide online game services. As of the date of this prospectus, we are in the process of applying for such an internet publishing license. While we are in the process of applying for such an internet publishing license, we are in cooperation with traditional publishing houses, who hold such internet publishing licenses, to publish our online games. Under the GAPP Notice, each online game is also required to be approved by SAPPRFT prior to the commencement of its operations in China. As of the date of this prospectus, we are still in the process of applying with the SAPPRFT for the approvals of all of our games. While we understand that the government authorities have not actively enforced this requirement or assessed any penalties for the failure to receive SAPPRFT approval for each game, we cannot assure you that the government authorities will not begin to enforce this requirement or assess penalties in the future. Under the GAPP Notice, in the event of any failure to meet the above-mentioned requirements, an operator may face severe monetary penalties or be forced to cease operations, any of which would have a material adverse effect on our business and results of operations.

On June 3, 2010, MOC issued the Interim Measures for Online Games Administration, or the Online Game Measures, which became effective on August 1, 2010 and are intended to further strengthen MOC’s supervision of the online game industry. Specifically, the Online Game Measures reiterate that MOC has the authority to review the content of all online games except online game publications that have been pre-approved by SAPPRFT. However, the Online Game Measures do not clearly specify what constitutes “online game publications.” Furthermore, the Online Game Measures require all operators of online games, issuers of virtual currencies and providers of virtual currency trading services obtain Internet Culture Operation Licenses. Chukong Technology has obtained such an Internet Culture Operation License. In addition, the Online Game Measures provide that all domestic online games must be filed with MOC, and all imported online games must be approved by the MOC. If a substantial change (for example, any significant modification to a game’s storyline, language, tasks or trading system) is made to an existing online game, it will be subject to a new content review.

Our mobile game business may be adversely affected by the Online Game Measures. The Online Game Measures do not set forth any specific procedure for the required filing or content review and therefore may cause delays when we try to file or apply for content review with MOC. In addition, the Online Game Measures do not resolve certain inconsistencies and ambiguities resulting from pronouncements included in previous notices issued by SAPPRFT and MOC. Because there is ambiguity in the scope of the authority and the roles and responsibilities of various different governmental departments, such as MOC and SAPPRFT, with oversight on the online game industry, we may face stricter scrutiny of the operation of our online mobile games. If we do not comply with the regulations of any relevant PRC governmental department regarding the online game industry, we may be subject to various penalties, such as a fine, confiscation of proceeds received during the non-compliance period or revocation of our Internet Culture Operation License, and our online game business may be adversely affected.

Adverse changes in political and economic policies of the PRC government could have a material adverse effect on our business.

Substantially all of our assets and business operations are located in China. Accordingly, our business, financial condition, results of operations and prospects are affected significantly by economic, political and legal developments in China. The economy in China differs from the economies of most developed countries in many respects, including:

 

    degree of government involvement;

 

    level of development;

 

    rate of economic growth;

 

    control of foreign exchange rates and currency conversion;

 

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    access to financing; and

 

    allocation of resources.

Although China has been transitioning from a planned economy to a more market-oriented economy since the 1970s, the PRC government continues to exercise significant control over China’s economy through resource allocation, foreign exchange control, monetary policies and administrative regulations of certain industries and entities. The continued control of these assets and other aspects of the national economy by the government could affect our access to key resources and materially and adversely affect our business. While the Chinese economy has grown significantly in the past 30 years, the growth has been uneven geographically, among various sectors of the economy and during different periods. We cannot assure you that the Chinese economy will continue to grow, that any growth will be steady and uniform or that any slowdown will not have a negative effect on our business.

Uncertainties with respect to the PRC legal system could have a material adverse effect on us.

The PRC legal system is a civil law system based on written statutes. Unlike the common law system, prior court decisions in a civil law system may be cited for reference but have limited precedential value. Since 1979, PRC legislation and regulations have significantly enhanced the protections afforded to various forms of foreign investments in China. However, since these laws and regulations are relatively new and the PRC legal system continues to rapidly evolve, interpretations of many laws, regulations and rules are not always consistent, and enforcement of these laws, regulations and rules involves uncertainties, which may limit the availability of certain legal protections.

In addition, the PRC administrative and court authorities have significant discretions in interpreting and implementing or enforcing statutory rules and contractual terms, and it may be more difficult to predict the outcome of administrative and court proceedings and the level of legal protection we may enjoy in the PRC than under some more developed legal systems. These uncertainties may affect our judgment on the relevance of legal requirements and our decisions on the measures and actions to be taken to fully comply therewith, and may affect our ability to enforce our contractual or tort rights. Such uncertainties may therefore increase our operating expenses and costs and materially and adversely affect our business and results of operations.

Contract drafting, interpretation and enforcement in China involve significant uncertainty.

We have entered into numerous contracts governed by PRC laws, many of which are material to our business. As compared with contracts in the United States, contracts governed by PRC laws tend to contain less detail and are not as comprehensive in defining contracting parties’ rights and obligations. As a result, contracts in China are more vulnerable to disputes and legal challenges. In addition, contract interpretation and enforcement in China are not as developed as in the United States, and the result of any contractual dispute resolution is subject to significant uncertainties. Therefore, we cannot assure you that we will not be subject to disputes under our material contracts, and if such disputes arise, we cannot assure you that we will prevail. Due to the materiality of certain contracts to our business, any dispute involving such contracts, even without merit, may materially and adversely affect our reputation and our business operations, and may cause the price of our ADSs to decline.

Any requirement to obtain prior approval from the China Securities Regulatory Commission, or the CSRC, could delay this offering and a failure to obtain this approval, if required, could have a material adverse effect on our business, operating results, reputation and the trading price of our ADSs.

On August 8, 2006, six PRC regulatory agencies, namely, the Ministry of Commerce, the State Assets Supervision and Administration Commission, SAT, the State Administration for Industry and Commerce, the CSRC and SAFE, jointly adopted the M&A Rules, which became effective on September 8, 2006, and were amended on June 22, 2009. The M&A Rules purport to require, among other things, offshore special purpose

 

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vehicles, or SPVs, formed for the purpose of seeking a public listing on an overseas stock exchange through acquisitions of PRC domestic companies or assets and controlled by PRC companies or individuals, to obtain the approval of the CSRC prior to publicly listing their securities on an overseas stock exchange.

While the application of the M&A Rules remains unclear, we believe, based on the advice of our PRC legal counsel, Han Kun Law Offices, that CSRC’s approval is not required for this offering or our holding of the equity interests in Chukong Beijing given the fact that (i) Chukong Beijing was incorporated as a wholly foreign-owned enterprise by means of direct investment, rather than by merger with, or acquisition of equity interests or assets of, a PRC domestic company owned by PRC companies or individuals as defined in the M&A Rules that are our beneficial owners, and (ii) no provision in the M&A Rules clearly classifies contractual arrangements as a type of transaction subject to the M&A Rules. We established Chukong Beijing as a wholly foreign-owned enterprise in China in April 2011 through direct investment by Chukong HK, rather than through merger or acquisition of a PRC domestic enterprise as defined under the M&A Rules. Therefore, we do not believe the M&A Rules apply to our holding of the equity interests in Chukong Beijing. We also believe, based on the advice of our PRC legal counsel, governmental approvals under the M&A Rules were not required for our historical corporate restructuring and acquisitions. However, our PRC legal counsel has further advised us that there remains some uncertainty as to how the M&A Rules will be interpreted or implemented in the context of an overseas offering and the opinions summarized above are subject to any new laws, rules and regulations or detailed implementations and interpretations of competent government authorities in any form relating to the M&A Rules. We cannot assure you that the relevant PRC government agencies, including the CSRC, would reach the same conclusion as our PRC legal counsel. If the CSRC or other PRC regulatory agencies subsequently determine that we need to obtain the CSRC’s approval for this offering, we may face sanctions by the CSRC or other PRC regulatory agencies. In such an event, these regulatory agencies may impose fines and penalties on our operations in the PRC, limit our operating privileges in the PRC, delay or restrict the repatriation of proceeds from this offering into the PRC, or take other actions that could have a material adverse effect on our business, financial condition, results of operations, and prospects, as well as the trading price of our ADSs. The CSRC or other PRC regulatory agencies may also take actions requiring us to halt this offering before the settlement and delivery of the ADSs offered by this prospectus.

PRC regulation of loans and direct investment by offshore holding companies to PRC entities may limit the use of the proceeds we receive from this offering for our expansion or operations.

In utilizing the proceeds we receive from this offering in the manner described in “Use of Proceeds,” as an offshore holding company with PRC subsidiaries, we may (i) make additional capital contributions to our direct PRC subsidiary, (ii) establish new direct PRC subsidiaries and make capital contributions to these new direct PRC subsidiaries, (iii) make loans to our PRC subsidiaries or our 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 direct subsidiaries in China, whether existing or newly established, must be approved by the PRC Ministry of Commerce or its local bureaus;

 

    loans by us to our direct subsidiary in China, which is a foreign-invested enterprise, to finance its activities cannot exceed statutory limits and must be registered with SAFE or its local bureaus; 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 bureaus.

In addition, on August 29, 2008, SAFE promulgated SAFE Circular No. 142, a notice regulating the conversion by a foreign-invested company of its capital contribution in foreign currency into Renminbi. It requires that the capital in Renminbi converted from foreign currency-denominated capital of a foreign-invested enterprise may only be used for purposes within the business scope approved by the relevant government authority and may not be used to make equity investments in China, unless specifically provided otherwise. Moreover, the approved use of such Renminbi funds may not be changed without approval from SAFE.

 

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Renminbi funds converted from foreign exchange may not be used to repay loans in Renminbi if the proceeds of such loans have not yet been used. Any violation of SAFE Circular No. 142 may result in severe penalties, including substantial fines. We expect that if we convert the net proceeds from this offering into Renminbi pursuant to SAFE Circular No. 142, our use of such Renminbi funds will be for purposes within the approved business scope of our direct PRC subsidiary. However, we may not be able to use such Renminbi funds to make equity investments in the PRC through our direct PRC subsidiary. Furthermore, SAFE promulgated SAFE Circular No. 59 in November 2010, which tightens the regulations over settlement of net proceeds from overseas offerings like this offering and requires that the settlement of net proceeds must be consistent with the description in the prospectus for the offering. SAFE further promulgated SAFE Circular No. 45 in November 2011, which, among other things, restricts a foreign-invested enterprise from using RMB converted from its registered capital to provide entrusted loans or repay loans between non-financial enterprises. These circulars may significantly limit our ability to transfer the net proceeds from this offering to our consolidated affiliated entities through our subsidiaries in China, and we may not be able to convert the net proceeds into Renminbi to invest in or acquire any other PRC companies or establish other consolidated affiliated entities in China.

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

We may be adversely affected by the complexity, uncertainties and changes in PRC regulation on internet businesses and companies.

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

 

    The evolving PRC regulatory system for the internet industry may lead to the establishment of new regulatory agencies. Further, new laws, regulations or policies may be promulgated or announced that will regulate internet activities, including mobile game businesses. If these new laws, regulations or policies 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 and our business operations could be disrupted.

 

    There are uncertainties relating to the regulation of the internet industry in China, including evolving licensing requirements. This means that permits, licenses or operations of some of our companies may be subject to challenge, or we may fail to obtain or renew permits or licenses that applicable regulators may deem necessary for our operations. If we fail to maintain or obtain the required permits or licenses, we may be subject to various penalties, including fines and discontinuation of, or restriction on, our operations. Any such penalty may disrupt our business operations and may have a material adverse effect on our results of operations.

 

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

If current or future laws, rules or regulations regarding internet-related activities are interpreted in such a way as to render our ownership structure and/or business operations illegal or non-compliant, our business could be severely impaired and we could be subject to severe penalties.

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

The Chinese internet industry, including the operation of mobile games, is highly regulated by the PRC government. Various regulatory authorities of the PRC central government, such as the State Council, MIIT, the State Administration for Industry and Commerce, or SAIC, MOC, SAPPRFT, and the Ministry of Public Security, are empowered to promulgate and implement regulations governing various aspects of the internet and the mobile game industry.

We are required to obtain applicable permits or approvals from different regulatory authorities in order to provide mobile game services. For example, a value-added telecommunications services provider must obtain a VATS License for approved scope of business. An internet content provider, or ICP, must obtain an ICP License from MIIT or its local offices in order to engage in any commercial ICP operations within China. An mobile game operator must also obtain an internet culture operation license from MOC, and an internet publishing license from SAPPRFT, in order to operate and distribute games through the internet. As of the date of this prospectus, both Chukong Technology and Tiansheng Chengye hold valid VATS Licenses for information services through mobile networks, and Chukong Technology holds a valid ICP License and a valid internet culture operation license. We are also in the process of applying for an internet publishing license. As the mobile game industry is at its early stage of development in China, new laws and regulations may be adopted from time to time to require additional licenses and permits other than those we currently have. While we believe that we comply in all material respects with all applicable PRC laws and regulations currently in effect, we cannot assure you that we will be able to obtain timely, or at all, required licenses or any other new license required in the future. We also cannot assure you that we will not be found in violation of any current or future PRC laws and regulations.

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

China has enacted laws and regulations governing internet access and the distribution of news and other content, as well as products and services, through the internet. The PRC government prohibits information that it believes to be in violations of PRC laws from being distributed through the internet. MIIT, SAPPRFT and MOC have promulgated regulations that prohibit games from being distributed through the internet if the games contain content that is found to, among other things, propagate obscenity, gambling or violence, instigate crimes, undermine public morality or the cultural traditions of China, or compromise state security or secrets. In addition, certain PRC social organizations have recently discussed the possibility of implementing a rating system for mobile games. The effect that such a system could have on our business is unclear. If any games we offer were deemed to have violated any such content restrictions, we would not be able to obtain the necessary government approval for us to continue such offerings and/or could be subject to penalties, including confiscation of income, fines, suspension of business and revocation of our licenses for operating mobile games, which would materially

 

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and adversely affect our business, financial condition and results of operations. We may also be subject to potential liability for certain unlawful actions of our users or for content we distribute that is deemed inappropriate. We may be required to delete content that violates PRC laws and report content that we suspect may violate PRC laws, which may reduce our player base, the amount of time our games are played or the purchases of virtual items in our games. It may be difficult to determine the type of content that may result in liability for us, and if we are found to be liable, we may be prevented from operating our games or offering other services in China.

We may be subject to the PRC government’s ongoing crackdown on internet pornographic content.

The Chinese government has stringent regulations on online pornographic content and has launched several crackdowns on internet pornography in past years. On December 4, 2009, MIIT and other three government authorities jointly issued the Incentives Measures for Reporting of Pornographic, Obscene and Vulgar Messages on the internet and Mobile Media, or the Anti-Pornography Notice, to further crack down on online pornography. Pursuant to this Anti-Pornography Notice, rewards of up to RMB10,000 may be given to internet users who report websites that feature pornographic content and a committee has been established by MIIT to review such reports to determine an appropriate reward.

We attempt to delete from our applications, forums, channels and communities all contents which might be deemed to be pornographic or vulgar under the Anti-Pornography Notice. In addition, we have strengthened our internal censorship and supervision of links and contents uploaded by users. We have not, to date, received any violation notice from or been subject to any penalties imposed by PRC government agencies in this regard. However, there is no assurance that content in our applications, forums, channels and communities will not be found to be pornographic or vulgar by PRC government agencies in the future. In the event that we are accused by the government of disseminating pornographic or vulgar content, our reputation could be adversely affected.

There are currently no laws or regulations in the PRC governing property rights of virtual assets and therefore it is not clear what liabilities, if any, we may have relating to the loss of virtual assets by our players.

In the course of playing our games, some virtual assets, such as player experience and skills, are acquired and accumulated. Such virtual assets can be highly valued by players. In practice, virtual assets can be lost for various reasons, such as data loss caused by network delays or breakdowns, or by hacking activities. There are currently no PRC laws and regulations governing property rights of virtual assets. As a result, it is unclear who the legal owner of any particular virtual asset is and whether the ownership of virtual assets (if any) is protected by law. In addition, it is unclear under PRC laws whether an operator of mobile games such as us would have any liability (whether in contract, tort or otherwise) for loss of such virtual assets by players. Based on several judgments regarding the liabilities of game operators for loss of virtual assets by players, the courts have generally required the game operators to provide well-developed security systems to protect such virtual assets owned by players. In the event of a loss of virtual assets, we may be sued by players and may be held liable for damages.

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

The conversion of Renminbi into foreign currencies, including U.S. dollars, is based on rates set by the People’s Bank of China. The PRC government allowed the Renminbi to appreciate by more than 20% against the U.S. dollar between July 2005 and July 2008. Between July 2008 and June 2010, this appreciation halted and the exchange rate between the Renminbi and the U.S. dollar remained within a narrow band. Since June 2010, the PRC government has allowed the Renminbi to appreciate slowly against the U.S. dollar again. The Renminbi has appreciated more than 10% against the U.S. dollar since June 2010. It is difficult to predict how market forces or PRC or U.S. government policy may impact the exchange rate between the Renminbi and the U.S. dollar in the future.

 

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There remains significant international pressure on the Chinese government to substantially liberalize its currency policy, which could result in further appreciation in the value of the RMB against the U.S. dollar. Substantially all of our revenues and expenses are denominated in Renminbi. At the Cayman Islands holding company level, we may rely on dividends paid to us by our subsidiaries and fees paid to us by our variable interest entities in China. Any significant revaluation of the Renminbi may materially affect our cash flows, net revenues, earnings and financial position as a whole, and the value of, and any dividends payable on, our shares and/or ADSs in U.S. dollars. To the extent that we need to convert U.S. dollars into RMB for capital expenditures and working capital and other business purposes, appreciation of the RMB against the U.S. dollar would have an adverse effect on the RMB amount we would receive from the conversion. Conversely, if we decide to convert RMB into U.S. dollars for the purpose of making payments for dividends on our ordinary shares or ADSs, strategic acquisitions or investments or other business purposes, appreciation of the U.S. dollar against the RMB would have a negative effect on the U.S. dollar amount we would receive from such conversion.

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

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 currency out of China. Under our current corporate structure, the income of our Cayman Islands holding company is primarily derived from the earnings of our PRC subsidiaries. Revenues of our PRC subsidiaries are all denominated in Renminbi. Shortages in the availability of foreign currency may restrict the ability of our PRC subsidiaries to remit sufficient foreign currency to pay dividends or make 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, for any PRC company, dividends can be declared and paid only out of its retained earnings under PRC laws. Furthermore, 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. Specifically, under the existing exchange restrictions, without a prior approval of SAFE, cash generated from the operations of our subsidiaries in China may be used to pay dividends by our PRC subsidiaries to our company and to pay employees of our PRC subsidiaries who are located outside China in a currency other than the Renminbi. With a prior approval from SAFE, cash generated from the operations of our PRC subsidiary and our variable interest entities may be used to pay off debt in a currency other than the Renminbi owed by our subsidiary and our variable interest entities to entities outside China, and make other capital expenditures outside China in a currency other than the Renminbi. The PRC government may also at its discretion restrict access in the future to foreign currencies for current account transactions. 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.

Failure to comply with the registration requirements for employee share option plans may subject our PRC equity incentive plan participants or us to fines and other legal or administrative sanctions.

On February 15, 2012, SAFE promulgated the Notice on Foreign Exchange Administration of PRC Residents Participating in Share Incentive Plans of Offshore Listed Companies, or SAFE Circular No. 7, to replace the previous Operating Procedures for Administration of Domestic Individuals Participating in the

 

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Employee Stock Ownership Plan or Stock Option Plan of Offshore Listed Companies. SAFE Circular No. 7 regulates foreign exchange matters associated with employee stock option incentives or similar incentives permitted under applicable laws and regulations granted to PRC residents by companies whose shares are listed on offshore stock exchanges. Pursuant to SAFE Circular No. 7, all PRC residents participating in share incentive plans of offshore listed companies shall, through their employers, jointly retain qualified PRC agents to register with local SAFE branches. PRC residents include PRC nationals or foreign citizens having been consecutively residing in PRC for not less than one year, acting as directors, supervisors, senior management personnel or other employees of PRC entities affiliated with such offshore listed company. A qualified PRC agent may be a PRC entity involved in the share incentive plan or a PRC institution eligible for asset trusteeship, which is lawfully selected to handle various foreign exchange matters related to share incentive plans and applies annually for a quota for conversion and/or payment of foreign currencies in connection with the domestic individuals’ exercise of their employee stock options. The foreign exchange proceeds received by PRC residents from sale of shares under share incentive plans granted by offshore listed companies must be remitted to bank accounts in China opened by their employers or PRC agents.

Further, a Notice Concerning Individual Income Tax on Earnings from Employee Stock Options, jointly issued by the Ministry of Finance and SAT, provides that domestic companies that implement employee share option programs must file the employee share option plans and other relevant documents with local tax authorities having jurisdiction over the companies before implementing such plans, and must file share option exercise notices and other relevant documents with local tax authorities before exercise by their employees of any share options, and clarify whether the shares issuable under the employee share options referenced in the notices are shares of publicly-listed companies.

Following the completion of this offering, we intend to register with the local SAFE bureau on behalf of our employees who have been granted shares or share options under our share/option incentive plan and follow other procedures set forth in SAFE Circular No. 7 and other applicable regulations. These registrations and filings are a matter of foreign exchange control and tax procedure and the grant of share incentive awards to employees is not subject to the government’s discretionary approval. We and our PRC employees who participate in our share option plans will be subject to these regulations when this offering is completed. If we or any of our PRC option holders fail to comply with these regulations, we or the relevant PRC option holders may be subject to fines and other legal or administrative sanctions.

If the chops of our subsidiary and consolidated affiliated entities in China are not kept safely, are stolen or are used by unauthorized persons or for unauthorized purposes, our business and operations could be materially and adversely affected.

In China, a company chop or seal legally represents the authority of and authorization by the company towards third parties even when unaccompanied by any signature of authorized persons. Under PRC laws, legal documents for corporate transactions, including contracts and leases that our business relies on, are executed using “corporate chops,” which are instruments that contain either the official seal of the signing entity and the signature of a legal representative of the entity whose designation is registered and filed with the State Administration of Industry and Commerce or its local counterparts.

Our PRC subsidiary and consolidated affiliated entities generally execute legal documents with their corporate chops. One or more of our corporate chops may be used to, among other things, execute commercial sale or purchase contracts, procurement contracts and office leases, open bank accounts, issue checks and invoices. We believe that we have sufficient control in place over access to and use of the chops. Our company chops, or chops, are kept securely at our finance department under the direction of the chief executive officer at the headquarters level or held securely by personnel designated and approved by the general manager at the level of subsidiaries or consolidated affiliated entities. Use of chops requires proper approvals in accordance with our internal control procedures. The custodian at the finance department also maintains a log to keep detailed record of each use of the chops. Moreover, the finance department is always locked after office hours and only authorized persons have access to its keys.

 

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However, we cannot assure you that unauthorized access to or use of those chops can be totally prevented. Our designated employees who hold the corporate chops could abuse their authority by, for example, binding us to contracts against our interests or intentions, which could result in economic harm, disruption of our operations, legal disputes or other damages to us. If the party contracting with us did not act in good faith under the circumstances, we might be able to nullify such contracts through legal proceedings. However, such corporate or legal action could incur significant costs and involve significant time and resources, while distracting management from our operations.

If an employee misuses a chop in an attempt to obtain control over our PRC subsidiary and one or more of our consolidated affiliated entities, we would need to take legal action to seek the return of the chop(s), apply for a new chop(s) with the relevant authorities or otherwise seek legal redress for the violation of such employee’s duties. During any period where we might lose effective control of the corporate activities of one or more of our PRC subsidiary and consolidated affiliated entities as a result of such misuse or misappropriation, the business activities of the affected entities could be disrupted and we could lose the economic benefits of those aspects of our business. To the extent those chops are stolen or are used by unauthorized persons or for unauthorized purposes, the corporate governance of these entities could be severely and adversely compromised and the operations of these entities could be significantly and adversely impacted.

The audit report included in this prospectus is prepared by an auditor who is not inspected by the Public Company Accounting Oversight Board and, as such, you are deprived of the benefits of such inspection.

Auditors of companies that are registered with the U.S. Securities and Exchange Commission and traded publicly in the United States, including our independent registered public accounting firm, must be registered with the U.S. Public Company Accounting Oversight Board (United States), or PCAOB, and are required by the laws of the United States to undergo regular inspections by the PCAOB to assess their compliance with the laws of the United States and professional standards. Because our auditor is located in the Peoples’ Republic of China, a jurisdiction where the PCAOB is currently unable to conduct inspections without the approval of the PRC authorities, our auditor is not currently inspected by the PCAOB. In May 2013, PCAOB announced that it had entered into a Memorandum of Understanding on Enforcement Cooperation with the CSRC and the PRC Ministry of Finance, which establishes a cooperative framework between the parties for the production and exchange of audit documents relevant to investigations undertaken by PCAOB, the CSRC or the PRC Ministry of Finance in the United States and the PRC, respectively. PCAOB continues to be in discussions with the CSRC and the PRC Ministry of Finance to permit joint inspections in the PRC of audit firms that are registered with PCAOB and audit Chinese companies that trade on U.S. exchanges.

This lack of PCAOB inspections in China prevents the PCAOB from regularly evaluating audits and quality control procedures of any auditors operating in China, including our auditor. As a result, investors may be deprived of the benefits of PCAOB inspections. The inability of the PCAOB to conduct inspections of auditors in China makes it more difficult to evaluate the effectiveness of our auditor’s audit procedures or quality control procedures as compared to auditors outside of China that are subject to PCAOB inspections. Investors may lose confidence in our reported financial information and procedures and the quality of our financial statements.

The outcome of the administrative proceedings brought by the SEC against the “big four” PRC-based accounting firms, including our independent registered public accounting firm, could result in financial statements being determined to not be in compliance with the requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act.

In December 2012, the SEC instituted administrative proceedings under Rule 102(e)(1)(iii) of the SEC’s Rules of Practice against the “big four” PRC-based accounting firms, including our independent registered public accounting firm, alleging that these firms had violated U.S. securities laws and the SEC’s rules and regulations thereunder by failing to provide to the SEC the firms’ work papers related to their audits of certain PRC-based companies that are publicly traded in the United States. Rule 102(e)(1)(iii) authorizes the SEC to deny any person, temporarily or permanently, the ability to practice before the SEC if found by the SEC, after notice and

 

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opportunity for a hearing, to have willfully violated any such laws or rules and regulations. On January 22, 2014, the administrative law judge presiding over the matter reached an initial decision that the firms had each violated the SEC’s rules of practice by failing to produce the audit work papers and related documents directly to the SEC. The initial decision further determined that each of the firms should be censured and barred from practicing before the SEC for a period of six months. The “big four” PRC-based accounting firms recently appealed the initial administrative law decision to the SEC. The initial administrative law decision will not take effect until and unless it is endorsed by the SEC. The “big four” PRC-based accounting firms can then further appeal the final decision of the SEC through the federal appellate courts. While we cannot predict the outcome of the SEC’s review nor that of any subsequent appeal process, if the “big four” PRC-based accounting firms, including our independent registered public accounting firm, were denied, temporarily or permanently, the ability to practice before the SEC, and we are unable to timely find another registered public accounting firm which can audit and issue a report on our financial statements, our financial statements could be determined to not be in compliance with the requirements for financial statements in connection with this offering under the Securities Act of 1933, as amended, or the Securities Act, or those of public companies registered under the Exchange Act after our completion of this offering. Such a determination could ultimately lead to the delay or abandonment of this offering, or, after the completion of this offering, delisting of our ADSs from NASDAQ or deregistration from the SEC, or both, which would substantially reduce or effectively terminate the trading of our ADSs in the United States.

The business license of our direct PRC subsidiary does not specifically authorize equity investments and, as a result, we are prohibited from using Renminbi converted from foreign currency-denominated capital to establish new subsidiaries or to invest in other companies in China.

On August 29, 2008, SAFE promulgated SAFE Circular No. 142, a notice regulating the conversion by a foreign-invested company of foreign currency-denominated capital into Renminbi and restricting the use of capital in Renminbi converted from foreign currencies. SAFE Circular No. 142 provides that a foreign-invested company is only permitted to use Renminbi converted from foreign currency-denominated capital for purposes within the business scope specified on its business license, as approved by the applicable governmental authorities. Our direct PRC subsidiary has used Renminbi converted from foreign currency-denominated capital to research and develop software, network technology and provide technical consulting services, all of which are within the approved business scope specified on our direct PRC subsidiary’s business license. Currently, the approved business scope of our direct PRC subsidiary, which is a foreign-invested enterprise, does not include equity investments.

As a result, although we may finance our direct PRC subsidiary through shareholder loans or capital contributions after obtaining approval from, and completing registration with, the applicable PRC governmental authorities, such capital can only be used for approved business purposes specified on the business license of our direct PRC subsidiary, and our direct PRC subsidiary is not permitted to use such funds to make any equity investment in the PRC by means of establishing new subsidiaries or acquiring an equity interest in other entities in China. Any violation of SAFE Circular No. 142 may result in severe penalties, including substantial fines. This limitation could adversely affect the ability of our direct PRC subsidiary to expand its business operations and may impact our planned use of proceeds. For example, we may not be able to use our proceeds for strategic investments or acquisitions in the PRC, though we are not currently negotiating any such investment or acquisition.

Our global income and the dividends we may receive from our PRC subsidiaries may be subject to PRC taxes under the PRC Enterprise Income Tax Law, which could have a material adverse effect on our results of operations, and non-PRC shareholders may be subject to PRC tax on dividends and gains which may reduce returns on their investments in our shares or ADSs.

Under the PRC Enterprise Income Tax Law, an enterprise established outside of the PRC with “de facto management bodies” within the PRC is considered a “resident enterprise,” meaning it can be treated in a manner similar to a PRC enterprise for enterprise income tax purposes, i.e., it is required to pay enterprise income tax on

 

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income derived from sources inside and outside China, although the dividends paid to one resident enterprise from another may qualify as “tax-exempt income.” The implementation rules of the PRC Enterprise Income Tax Law define a “de facto management body” as a body that has substantial and overall management and control over the production and business operations, personnel and human resources, finances and properties of an enterprise, and provide that if the foreign enterprise is deemed to be a PRC resident enterprise, dividends and other income received by its non-PRC resident enterprise shareholders from the deemed PRC resident enterprise will be considered PRC-source income and subject to a 10% PRC withholding tax, which may be reduced depending on provisions in any double taxation agreement between the PRC and the relevant country. A circular issued by SAT on April 22, 2009, or the Circular, specifies that certain foreign enterprises controlled by a PRC company or a PRC company group will be classified as PRC “resident enterprises” if the following requirements are satisfied: (i) the senior management personnel and core management departments in charge of its daily production operations and management are located mainly in the PRC; (ii) its financial and human resources decisions are subject to determination or 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) at least half of the enterprise’s directors with voting rights or senior management reside in the PRC. Although the Circular only applies to offshore enterprises controlled by PRC enterprises or PRC enterprise groups and not those controlled by PRC individuals or by foreign individuals or enterprises, the criteria set forth in the Circular may reflect SAT’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 PRC individuals.

We do not believe that Chukong Holdings Limited meets all of the criteria described above. Chukong Holdings Limited is a company incorporated outside the PRC, and it keeps its key assets and records, including resolutions of its board of directors and resolutions of its shareholders, outside of the PRC. In addition, we are not aware of any offshore holding companies with a similar corporate structure as ours ever having been deemed to be PRC “resident enterprises” by the PRC tax authorities. Therefore, we believe that Chukong Holdings Limited should not be treated as a “resident enterprise” for PRC tax purposes. However, as the tax resident status of an enterprise is subject to determination by the PRC tax authorities and uncertainties remain with respect to the interpretation of the term “de facto management body” when applied to our offshore entities, we may be considered a resident enterprise and may therefore be subject to PRC enterprise income tax at 25% on our global income.

If we are considered a resident enterprise and earn income other than dividends from our PRC subsidiary, a 25% enterprise income tax on our global income could significantly increase our tax burden and materially and adversely affect our cash flows and profitability. Moreover, the “resident enterprise” classification could result in a situation in which a 10% withholding tax is imposed on dividends we pay to our non-PRC resident enterprise shareholders, and a 10% PRC tax is imposed on gains derived by our non-PRC resident enterprise shareholders from transferring our ordinary shares or ADSs, unless the holder is eligible for a reduced rate under an applicable treaty.

It is unclear whether our non-PRC individual shareholders would be subject to any PRC tax on dividends or gains received by such non-PRC individual shareholders in the event we are determined to be a PRC resident enterprise. If any PRC tax were to apply to such dividends or gains received by such non-PRC individual shareholders, it would generally apply at a rate of 20%, unless a reduced rate is available under an applicable tax treaty. It is also unclear whether non-PRC shareholders of Chukong Holdings Limited would be able to claim the benefits of any tax treaties between their tax residence countries and the PRC in the event that Chukong Holdings Limited is treated as a PRC resident enterprise. This could have the effect of increasing our and our shareholders’ effective income tax rates and may require us to deduct withholding tax from any dividends we pay to our non-PRC shareholders. In addition to the uncertainty regarding how the “resident enterprise” classification may apply, it is also possible that the rules may change in the future, possibly with retroactive effect.

 

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If we are required under the PRC Enterprise Income Tax Law to withhold PRC income tax on our dividends payable to our non-PRC enterprise or non-PRC individual shareholders and ADS holders or our shareholders and ADS holders are subject to PRC tax on gains derived from transferring our ordinary shares or ADSs, their investment in our ordinary shares or ADSs may be materially and adversely affected.

We face uncertainties with respect to application of the Circular on Strengthening the Administration of Enterprise Income Tax for Share Transfer by Non-PRC Resident Enterprises.

Pursuant to the Circular on Strengthening the Administration of Enterprise Income Tax for Share Transfers by Non-PRC Resident Enterprises, or SAT Circular No. 698, issued by SAT, in December 2009, with retroactive effect from January 1, 2008, where a non-resident enterprise transfers the equity interests of a PRC resident enterprise indirectly by disposition of the equity interests of an overseas holding company, or an Indirect Transfer, and such overseas holding company is located in a tax jurisdiction that: (i) has an effective tax rate of less than 12.5% or (ii) does not impose income tax on foreign income of its residents, the non-resident enterprise, being the transferor, shall report this Indirect Transfer to the competent tax authority of the PRC resident enterprise. Applying 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 an Indirect Transfer may be subject to PRC withholding tax at a rate of up to 10%. SAT Circular No. 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.

On March 28, 2011, SAT released the SAT Public Notice (2011) No. 24, or SAT Public Notice 24, to clarify several issues related to SAT Circular No. 698. SAT Public Notice 24 became effective on April 1, 2011. According to SAT Public Notice 24, the term “effective tax” refers to the effective tax on the gain derived from a disposition of any equity interests of an overseas holding company; and the term “does not impose income tax” refers to cases where the gain derived from such a disposition of equity interests of an overseas holding company is not subject to income tax in the country or jurisdiction where the overseas holding company is a resident.

There is uncertainty as to the application of SAT Circular No. 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 the PRC. Moreover, the relevant authority has not yet promulgated any formal provisions or made any formal declaration as to the process and format for reporting an Indirect Transfer to the competent tax authority of the relevant PRC resident enterprise. In addition, there are not any formal declarations concerning how to determine whether a foreign investor has adopted an arrangement for the purpose of reducing, avoiding or deferring PRC tax. SAT Circular No. 698 may be determined by the tax authorities to be applicable to our private equity financing transactions where non-resident investors were involved, if any of such transactions were determined by the tax authorities to lack reasonable commercial purpose. As a result, we and our non-resident investors may become at risk of being taxed under SAT Circular No. 698 and may be required to expend valuable resources to comply with SAT Circular No. 698 or to establish that we and our non-resident enterprise investors should not be taxed under SAT Circular No. 698, which may have a material adverse effect on our financial condition and results of operations or such non-resident investors’ investments in us.

Failure to obtain any preferential tax treatments or the discontinuation, reduction or delay of any of the preferential tax treatments that may be available to us in the future could materially and adversely affect our business, financial condition and results of operations.

Under the PRC Enterprise Income Tax Law effective from January 1, 2008, foreign-invested companies such as Chukong Beijing, and domestic companies such as our consolidated affiliated entities, are subject to a unified income tax rate of 25%. Various favorable income tax rates are, however, available to qualified enterprises in certain encouraged sectors of the economy. Companies that qualify as software enterprises are

 

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exempt from PRC income tax for two years and subject to a preferred income tax rate of 12.5% for the following three years, starting from the first profit making year. All of Chukong Beijing, Chukong Technology and Xiamen Yaji are software enterprises, and are eligible for such preferential tax treatment commencing from each of their first profit-making year.

However, if any of our PRC subsidiaries and consolidated affiliated entities that qualified for preferential tax treatment fails to continue to qualify in a subsequent year, our income tax expenses would increase, which may have a material adverse effect on our net income and results of operations.

Risks Related to Our ADSs and This Offering

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

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

The initial public offering price for our ADSs will be determined by negotiations between us and our underwriters and may bear no relationship to the market price for our ADSs after this initial public offering. We cannot assure you that an active trading market for our ADSs will develop or that the market price of our ADSs will not decline below the initial public offering price.

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 companies including, most significantly, not being required to comply with the auditor attestation requirements of Section 404 for so long as we are an emerging growth company until the fifth anniversary from the date of our initial listing. 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.

The trading prices of our ADSs are likely to be volatile, which could result in substantial losses to investors.

The trading prices of our ADSs are likely to be volatile and could fluctuate widely due to factors beyond our control. This may happen because of broad market and industry factors, like 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. In recent months, the widespread negative publicity of alleged fraudulent accounting practices and poor corporate governance of certain U.S. public companies with operations in China were believed to have negatively affected investors’ perception and sentiment towards companies with connection with China, which significantly and negatively affected the trading prices of some companies’ securities listed in the U.S. Once we become a public company, any similar negative publicity or sentiment may affect the performances of our American depositary shares. A number of PRC companies have listed or are in the

 

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process of listing their securities on U.S. stock markets. The securities of some of these companies have experienced significant volatility, including price declines in connection with their initial public offerings. The trading performances of these PRC companies’ securities after their offerings may affect the attitudes of investors toward PRC companies listed in the United States in general and consequently may impact the trading performance of our ADSs, regardless of our actual operating performance.

In addition to market and industry factors, the price and trading volume for our ADSs may be highly volatile for factors specific to our own operations, including the following:

 

    the financial projections that we may choose to provide to the public, any changes in those projections or our failure for any reason to meet those projections;

 

    variations in our net sales, earnings and cash flow;

 

    announcements of new investments, acquisitions, strategic partnerships, or joint ventures;

 

    announcements of new services and expansions by us or our competitors;

 

    changes in financial estimates by securities analysts;

 

    additions or departures of key personnel;

 

    release of lock-up or other transfer restrictions on our outstanding equity securities or sales of additional equity securities;

 

    detrimental negative publicity about us, our competitors or our industry; and

 

    potential litigation or regulatory investigations or other proceedings involving us.

Any of these factors may result in large and sudden changes in the volume and price at which our ADSs will trade.

If securities or industry analysts publish negative reports about our business, the price and trading volume of our securities could decline.

The trading market for our securities depends, in part, on the research reports and ratings that securities or industry analysts or ratings agencies publish about us, our business and the mobile entertainment market in China in general. We do not have any control over these analysts or agencies. If one or more of the analysts or agencies who cover us downgrades us or our securities, the price of our securities may decline. If one or more of these analysts ceases coverage of our company or fails to regularly publish reports on us, we could lose visibility in the financial markets, which could cause the price of our securities or trading volume to decline.

We may invest or spend the proceeds of this offering in ways with which you may not agree or in ways which may not yield a return.

The net proceeds from this offering may be used for our geographic expansion, product development and upgrading of our information technology system, and otherwise for general corporate purposes, including working capital. We may also use a portion of the net proceeds for strategic investments and potential acquisition opportunities, although we are not currently negotiating any material investment or acquisition. Our management will have considerable discretion in the application of the net proceeds, and you will not have the opportunity, as part of your investing decision, to assess whether the proceeds are being used appropriately. The net proceeds may be used for corporate purposes that do not increase our operating results or market value. Until the net proceeds are used, they may be placed in investments that do not produce significant income or that may lose value.

 

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

If you purchase ADSs in this offering, you will pay more for your ADSs than the amount paid by our existing shareholders for their ordinary shares on a per ADS basis. As a result, you will experience immediate and substantial dilution of approximately US$             per ADS (assuming no exercise by the underwriters of their option to acquire additional ADSs), representing the difference between the assumed initial public offering price of US$             per ADS, the midpoint of the range shown on the front cover page of this prospectus, and our net tangible book value per ADS as of                     , after giving effect to this offering. In addition, you may experience further dilution to the extent that our ordinary shares are issued upon exercise of share options vested. See “Dilution” for a more complete description of how the value of your investment in our ADSs will be diluted upon completion of this offering.

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

Our ordinary shares will be divided into Class A ordinary shares and Class B ordinary shares immediately prior to the 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 20 votes per share. We will issue Class A ordinary shares represented by our ADSs in this offering. All of our ordinary shares and preferred shares issued and outstanding before the completion of this offering will be re-designated or automatically converted into Class B ordinary shares, while all of the ordinary shares to be issued in or after the completion of this offering will be Class A ordinary shares. We intend to maintain the dual-class voting structure after the completion of this offering. Each Class B ordinary share is convertible into one Class A ordinary share at any time by the holder thereof. Class A ordinary shares are not convertible into Class B ordinary shares under any circumstances. Upon any transfer of Class B ordinary shares by a holder thereof to any person or entity which is not an affiliate of such holder, such Class B ordinary shares shall be automatically and immediately converted into the equal number of Class A ordinary shares. An affiliate of a specified person or entity generally refers to one who, directly or indirectly, either controls, is controlled by or is under common control with, the specified person or entity, and in the case of a natural person, includes such person’s spouse, parents, children, siblings, mother-in-law and father-in-law and brothers and sisters-in-law, a trust for the benefit of any of the foregoing, a company, partnership or any natural person or entity wholly or jointly owned by any of the foregoing.

Due to the disparate voting powers attached to these two classes of ordinary shares, our pre-IPO shareholders will collectively own approximately         % of the voting power of our outstanding shares immediately after this offering and will have decisive influence over matters requiring shareholders’ approval, including election of directors and significant corporate transactions, such as a merger or sale of our company or our assets. This concentrated control will limit your ability to influence corporate matters and could discourage others from pursuing any potential merger, takeover or other change of control transactions that holders of Class A ordinary shares and ADSs may view as beneficial.

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

Sales of our ADSs or ordinary shares in the public market after this offering, or the perception that these sales could occur, could cause the market price of our ADSs to decline. Upon completion of this offering, we will have ordinary shares outstanding, including ordinary shares represented by ADSs. All ADSs sold in this offering will be freely transferable without restriction or additional registration under the U.S. Securities Act of 1933, as amended, or the Securities Act. The remaining ordinary shares outstanding after this offering will be available for sale upon the expiration of the 180-day lock-up period beginning from the date of this prospectus and, in the case of the ordinary shares that certain option holders will receive when they exercise their share options, subject to

 

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volume and other restrictions as applicable under Rule 144 and Rule 701 under the Securities Act. Any or all of these shares (other than those held by certain option holders) may be released prior to expiration of the lock-up period at the discretion of the underwriters. To the extent shares are released before the expiration of the lock-up period and these shares are sold into the market, the market price of our ADSs could decline.

In addition, certain of our shareholders have the right to cause us to register the sale of their shares under the Securities Act upon the occurrence of certain circumstances. See “Description of Share Capital—Registration Rights.” Registration of these shares under the Securities Act would result in these shares becoming freely tradable without restriction under the Securities Act immediately upon the effectiveness of the registration of these shares. Sales of these registered shares in the public market could cause the price of our ADSs to decline.

We are controlled by a small number of our existing shareholders, whose interests may differ from other shareholders, and our board of directors has the power to discourage a change of control.

After our preferred shares are automatically converted into ordinary shares upon the completion of this offering, assuming that the underwriters do not exercise their over-allotment option, our executive officers and directors, together with our existing private equity investors, will beneficially own approximately             ordinary shares, or approximately                      of our outstanding ordinary shares. Due to the disparate voting powers associated with our two classes of ordinary shares, the shares they beneficially own represent approximately             % of the aggregate voting power of our company immediately after this offering. Accordingly, our executive officers and directors, together with our existing shareholders, could have significant influence in determining the outcome of any corporate transaction or other matter submitted to the shareholders for approval, including mergers, consolidations and the sale of all or substantially all of our assets, election of directors and other significant corporate actions. In cases where their interests are aligned and they vote together, these shareholders will also have the power to prevent or cause a change in control. Without the consent of some or all of these shareholders, we may be prevented from entering into transactions that could be beneficial to us. In addition, our directors and officers could violate their fiduciary duties by diverting business opportunities from us to themselves or others. The interests of our largest shareholders may differ from the interests of our other shareholders. The concentration in ownership of our ordinary shares may cause a material decline in the value of our ADSs.

Our post-offering articles of association contain anti-takeover provisions that could discourage a third party from acquiring us, which could limit our shareholders’ opportunity to sell their shares, including ordinary shares represented by our ADSs, at a premium.

Our post-offering articles of association, which will become effective immediately upon the completion of this offering, contain provisions that limit the ability of others to acquire control of our company or cause us to engage in change-of-control transactions. 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 our company in a tender offer or a similar transaction. For example, our board of directors has the authority to, without further action by our shareholders, issue preference shares. These preference shares may have better voting rights than our ordinary shares, in the form of ADSs or otherwise, and could be issued quickly with terms calculated to delay or prevent a change in control of our company or make removal of management more difficult. If our board of directors decides to issue preference shares, the price of our ADSs may fall and the voting rights of the holders of our ordinary shares and ADSs may be diluted.

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

Holders of our ADSs do not have the same rights as our shareholders and may only exercise the voting rights with respect to the underlying Class A ordinary shares in accordance with the provisions of the deposit agreement. Under our post-offering memorandum and articles of association, the minimum notice period required to convene a general meeting is                     days. To allow ADS holders to act through the depositary to exercise their rights, we typically provide                      days’ notice. When a general meeting is convened, you may not receive sufficient notice of a shareholders’ meeting to permit you to withdraw your Class A ordinary shares to allow you to cast your vote with respect to any specific matter. In addition, the depositary and its agents

 

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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 ADSs. 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, where such failure or other actions result from reasons beyond their control. As a result, you may not be able to exercise your right to vote and you may lack recourse if your ADSs are not voted as you requested. In addition, in your capacity as an ADS holder, you will not be able to call a shareholders’ meeting unless you withdraw your ordinary shares by canceling your ADSs.

You may not receive distributions on our ordinary shares or any value for them if such distribution is illegal or if any required government approval cannot be obtained in order to make such distribution available to you.

The depositary of our ADSs has agreed to pay to you the cash dividends or other distributions it or the custodian receives on ordinary shares or other deposited securities underlying our ADSs, 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 is not responsible if it decides that it is unlawful, inequitable 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 the underlying securities require registration under the Securities Act but have not been properly registered or distributed under an applicable exemption from registration. The depositary may also determine that it is not feasible to distribute certain property through the mail. Additionally, the value of certain distributions may be less than the cost of mailing them. In these cases, the depositary may determine not to distribute such property. We have no obligation to register under U.S. securities laws any ADSs, ordinary shares, rights or other securities received through such distributions. We also have no obligation to take any other action to permit the distribution of ADSs, ordinary shares, rights or anything else to holders of ADSs. This means that you may not receive distributions we make on our ordinary shares or any value for them if it is illegal or impractical for us or the depositary to make them available to you. These restrictions may cause a material decline in the value of our ADSs.

We do not expect to pay dividends in the foreseeable future and you may have to rely on price appreciation of our ADSs for any return on your investment.

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

Our board of directors has complete discretion as to whether to distribute dividends. Even if our board of directors decides to declare and pay dividends, the timing, amount and form of future dividends, if any, will depend on, among other things, our future results of operations and cash flows, our capital requirements and surplus, the amount of distributions, if any, received by us from our subsidiaries, our financial condition, contractual restrictions and other factors deemed relevant by our board of directors. Accordingly, the return on your investment in our ADSs will likely depend entirely upon any future price appreciation of our ADSs. There is no guarantee that our ADSs will appreciate in value or even maintain the price at which you purchased the ADSs. You may not realize a return on your investment in our ADSs and you may even lose your entire investment in our ADSs.

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

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

 

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or the books of the depositary are closed, or at any time if we or the depositary deems it advisable to do so because of any requirement of law or of any government or governmental body, or under any provision of the deposit agreement, or for any other reason.

Your right to participate in any future rights offerings may be limited, which may cause dilution to your holdings.

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

We may be classified as a passive foreign investment company for United States federal income tax purposes, which could result in adverse United States federal income tax consequences to United States investors in our ADSs or ordinary shares.

Depending upon the value of our assets, which may be determined based, in part, on the market value of our ordinary shares and ADSs, and the nature of our assets and income over time, we could be treated as a passive foreign investment company, or a PFIC. Under United States federal income tax law, we will be treated as a PFIC for any taxable year if either (i) 75% or more of our gross income for the taxable year is passive income or (ii) 50% or more of the value of our assets (determined on the basis of a quarterly average) is attributable to assets that produce or are held for the production of passive income. Based on our current and projected income and assets, including the proceeds from this offering, and projections as to the value of our assets, based in part on the market value of our ADSs following this offering, we do not expect to be treated as a PFIC for the current taxable year or in the foreseeable future. While we do not anticipate being a PFIC, changes in the nature of our income or assets or the value of our assets may cause us to become a PFIC for the current or any subsequent taxable year.

Although the law in this regard is not entirely clear, we treat our consolidated affiliated entities as being owned by us for United States federal income tax purposes, because we control their management decisions and we are entitled to substantially all of the economic benefits associated with these entities, and, as a result, we consolidate their results of operations into our consolidated U.S. GAAP financial statements. If the corporate structure and contractual arrangements through which we conduct our business in China were found to be in violation of any existing or future PRC laws or regulations, we would be subject to severe penalties and we may also not be able to consolidate the results of operations of our consolidated affiliated entities into our consolidated U.S. GAAP financial statements. As a result, we may not be treated as the owner of our consolidated affiliated entities for United States federal income tax purposes. If it were determined that we are not the owner of our consolidated affiliated entities for United States federal income tax purposes, we may be treated as a PFIC for the current and any subsequent taxable years. Because of the uncertainties in the application of the relevant rules and because PFIC status is a factual determination made annually after the close of each taxable year on the basis of the composition of our income and the value of our active versus passive assets, there can be no assurance that we will not be a PFIC for the current or any future taxable year. The overall level of our passive assets will be affected by how, and how quickly, we spend our liquid assets and the cash raised in this offering. Under circumstances where revenues from activities that produce passive income significantly increase relative to our revenues from activities that produce non-passive income or where we determine not to deploy significant amounts of cash for active purposes, our risk of being classified as a PFIC may substantially increase.

 

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If we were to be or be treated as a PFIC, a U.S. Holder (as defined in “Taxation—United States Federal Income Tax Considerations—General”) may incur significantly increased United States income tax on gain recognized on the sale or other disposition of our ADSs or ordinary shares and on the receipt of any distribution on our ADSs or ordinary shares to the extent such gain or distribution is treated as an “excess distribution” under United States federal income tax rules. Each U.S. Holder is urged to consult its tax advisor concerning the United States federal income tax consequences of purchasing, holding and disposing of our ADSs or ordinary shares if we are or become treated as a PFIC, including the possibility of making a mark-to-market election and the unavailability of the election to treat us as a qualified electing fund. For more information, see “Taxation—United States Federal Income Tax Considerations—Passive Foreign Investment Company Considerations.”

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

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

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

You may experience difficulties in effecting service of legal process, enforcing foreign judgments or bringing original actions in China based on United States or other foreign laws against us, our management or the experts named in this prospectus.

We are a Cayman Islands company and substantially all of our assets are located outside of the United States. Substantially all of our current operations are conducted in the PRC. In addition, all of our directors and officers reside outside the United States. As a result, it may be difficult for you to effect service of process within the United States or elsewhere outside China upon these persons. It may also be difficult for you to enforce in PRC or Cayman Islands courts judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us and our officers and directors, most of whom are not residents in the United States and the substantial majority of whose assets are located outside of the United States. It may be difficult or impossible for you to bring an action against us in the Cayman Islands if you believe your rights under the U.S. securities laws have been infringed. 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 would hear original actions brought in the Cayman Islands or the PRC against us or such persons predicated upon the securities laws of the United States or any state. See “Enforceability of Civil Liabilities.”

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

 

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well as rules subsequently implemented by the SEC, impose various requirements on the corporate governance practices of public companies. Section 404 requires that we include a management report on our internal control over financial reporting in our annual report on Form 20-F beginning with the fiscal year ending December 31, 2015. In addition, once we cease to be an “emerging growth company” as such term is defined in the JOBS Act, our independent registered public accounting firm must attest to and report on the effectiveness of our internal control over financial reporting. We expect these rules and regulations applicable to public companies to increase our accounting, legal and financial compliance costs and to make certain corporate activities more time-consuming and costly. Our management will be required to devote substantial time and attention to our public company reporting obligations and other compliance matters. We are currently evaluating and monitoring developments with respect to these rules and regulations, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs. Our reporting and other compliance obligations as a public company may place a significant strain on our management, operational and financial resources and systems for the foreseeable future.

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.

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

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

 

    we have failed to timely provide the depositary with notice of the 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; or

 

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

We will be a foreign private issuer and, as a result, we will not be subject to U.S. proxy rules and will be subject to Exchange Act reporting obligations that, to some extent, are more lenient and less frequent than those of a U.S. issuer.

Upon consummation of this offering, we will report under the Exchange Act, as a foreign private issuer. Because we qualify as a foreign private issuer under the Exchange Act, we will be exempt from certain provisions of the Exchange Act that are applicable to U.S. public companies, including (i) the sections of the Exchange Act regulating the solicitation of proxies, consents or authorizations in respect of a security registered under the Exchange Act, (ii) the sections of the Exchange Act requiring insiders to file public reports of their stock ownership and trading activities and liability for insiders who profit from trades made in a short period of time, and (iii) the rules under the Exchange Act requiring the filing with the SEC of quarterly reports on Form 10-Q containing unaudited financial and other specified information, or current reports on Form 8-K, upon the occurrence of specified significant events.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

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

You can identify these forward-looking statements by words or phrases such as “may,” “will,” “expect,” “anticipate,” “aim,” “estimate,” “intend,” “plan,” “believe,” “likely to” or other similar expressions. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. These forward-looking statements include, but are not limited to, statements about:

 

    our goals and strategies;

 

    our expected development, launch and market acceptance of new games;

 

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

 

    our ability to retain and grow our user base and distribution network;

 

    the expected growth of, and trends in, the mobile entertainment markets in China;

 

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

 

    competition in our industry in China;

 

    our ability to maintain the network infrastructure necessary to operate our mobile applications;

 

    relevant government policies and regulations relating to our corporate structure, business and industry; and

 

    our ability to protect our users’ information and adequately address privacy concerns.

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

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

This prospectus also contains statistical data and estimates that we obtained from industry publications and reports generated by government agencies and third-party providers of market intelligence. These industry publications and reports generally indicate that the information contained therein was obtained from sources believed to be reliable, but do not guarantee the accuracy and completeness of such information. Although we believe that the publications and reports are reliable, we have not independently verified the data.

 

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USE OF PROCEEDS

We estimate that we will receive net proceeds from this offering of approximately US$             million, or approximately US$             million if the underwriters exercise in full their option to purchase additional ADSs, after deducting underwriting discounts and commissions and the estimated offering expenses payable by us. These estimates are based upon an assumed initial offering price of US$             per ADS, the mid-point of the range shown on the front cover page of this prospectus. [We will not receive any of the proceeds from the sale of ADSs by the selling shareholders.] A US$1.00 change in the assumed initial public offering price of US$             per ADS would, in the case of an increase, increase and, in the case of a decrease, decrease the net proceeds of this offering by US$             million, or approximately US$             million if the underwriters exercise their option to purchase additional ADSs in full, assuming the sale of              ADSs at US$             per ADS, the mid-point of the range shown on the front cover page of this prospectus and after deducting underwriting discounts and commissions and the estimated offering expenses payable by us.

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

 

    approximately US$             in engine development and mobile content development;

 

    approximately US$             in sales and marketing activities, technology infrastructure, improvement of corporate facilities; and

 

    the balance for other general corporate purposes, including the acquisition of, or investment in, technologies, solutions or businesses that complement our business, although we have no present commitments or agreements to enter into any acquisitions or investments.

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

Pending any use as described above, we plan to invest the net proceeds in short-term financial instruments or demand deposits.

Under PRC laws and regulations, we are permitted to utilize the proceeds from this offering to fund our PRC subsidiaries only through loans or capital contributions, subject to applicable government registration and approval requirements. We cannot assure you that we will be able to meet these requirements on a timely basis, if at all. See “Risk Factors—Risks Relating to Doing Business in China—PRC regulation of loans and direct investment by offshore holding companies to PRC entities may limit the use of the proceeds we receive from this offering for our expansion or operations.”

 

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DIVIDEND POLICY

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

We are a holding company incorporated in the Cayman Islands. We rely principally on dividends from our PRC subsidiaries for our cash requirements, including any payment of dividends to our shareholders. PRC regulations may restrict the ability of our PRC subsidiaries to pay dividends to us. See “PRC Regulation—Regulations on Dividend Distribution.”

Our board of directors has discretion as to whether to distribute dividends, subject to applicable laws. Even if our board of directors decides to pay dividends, the form, frequency and amount will depend on our future operations and earnings, capital requirements and surplus, general financial condition, contractual restrictions and other factors that our 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.

 

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CAPITALIZATION

The following table sets forth our capitalization as of December 31, 2013:

 

    on an actual basis;

 

    on a pro forma basis to reflect the automatic conversion of all of our issued and outstanding preferred shares into an aggregate of 94,725,998 ordinary shares immediately upon the completion of this offering; and

 

    on a pro forma as adjusted basis to reflect (i) the automatic conversion of all of our issued and outstanding preferred shares into 94,725,998 ordinary shares immediately upon the completion of this offering, and (ii) the sale of              ordinary shares in the form of ADSs by us in this offering at an assumed initial public offering price of US$             per ADS, the mid-point of the estimated range of the initial public offering price shown on the front cover of this prospectus, after deducting the underwriting discounts and commissions and estimated offering expenses payable by us.

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

 

     As of December 31, 2013
     Actual     Pro forma     Pro forma
as adjusted(1)
     RMB     RMB     US$
     (in thousands)

Preferred shares

      

Series A preferred shares (US$0.000002 par value; 17,857,150 shares authorized, 17,857,150 shares issued and outstanding on an actual basis; none outstanding on a pro forma or pro forma as adjusted basis)

     67,176            

Series B preferred shares (US$0.000002 par value; 31,959,597 shares authorized, 31,959,597 shares issued and outstanding on an actual basis; none outstanding on a pro forma or pro forma as adjusted basis)

     153,940            

Series C preferred shares (US$0.000002 par value; 28,735,413 shares authorized, 28,735,413 shares issued and outstanding on an actual basis; none outstanding on a pro forma or pro forma as adjusted basis)

     160,924            

Series D Preferred Shares (US$0.000002 par value, 16,173,838 shares authorized, 16,173,838 shares issued and outstanding on an actual basis; none outstanding on a pro forma or pro forma as adjusted basis)

     309,309            

Shareholders’ equity/(deficit)

      

Ordinary shares (US$0.000002 par value; 405,274,002 shares authorized, 50,000,000 shares issued and outstanding on an actual basis; 144,725,998 outstanding on a pro forma basis;              outstanding on a pro forma as adjusted basis)

     1        2     

Additional paid-in capital(2)

            691,348     

Accumulated other comprehensive loss

     (4,625     (4,625  

Accumulated deficit

     (300,363     (300,363  

Total shareholders’ (deficit)/equity(2)

     (304,987     386,362     
  

 

 

   

 

 

   

 

Total capitalization(2)

     386,362        386,362     
  

 

 

   

 

 

   

 

 

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

 

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(2)   Assuming the issuance and sale of              ADS, representing              Class A ordinary shares, by us in this offering at an assumed initial public offering price of US$              per ADS, the mid-point of the estimated range of the initial public offering price shown on the front cover of this prospectus, after deducting the underwriting discounts and commissions, estimated offering expenses payable by us. As a result, an increase in the cash and cash equivalents by approximately RMB             million would increase the total par value of our ordinary shares by approximately RMB             and the additional paid-in capital by approximately RMB             million. There is no change to any other item in the pro forma as adjusted column above. A US$1.00 increase (decrease) in the assumed initial public offering price of US$             per ADS would increase (decrease) each of our cash and cash equivalents, total assets and total shareholders’ equity (deficit) by RMB             million (US$             million).

 

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DILUTION

Our net tangible book value as of December 31, 2013 was approximately US$             per ordinary share and US$            per ADS. Net tangible book value per ordinary share represents the amount of total tangible assets, minus the amount of total liabilities, divided by the total number of ordinary shares outstanding. Dilution is determined by subtracting net tangible book value per ordinary share from the assumed public offering price per ordinary share. Because our Class A ordinary shares and Class B ordinary shares have the same dividend and other rights, except for voting and conversion rights, the dilution is presented here based on all ordinary shares, including Class A ordinary shares and Class B ordinary shares.

Without taking into account any other changes in such net tangible book value after December 31, 2013, other than to give effect to (1) the conversion of all of our preferred shares into ordinary shares, which will occur automatically upon the completion of this offering, and (2) our issuance and sale of              ADSs in this offering, at an assumed initial public offering price of US$             per ADS, the mid-point of the estimated public offering price range, and after deduction of underwriting discounts and commissions and estimated offering expenses payable by us (assuming the over-allotment option is not exercised), our pro forma net tangible book value at December 31, 2013 would have been US$             per outstanding ordinary share, including ordinary shares underlying our outstanding ADSs, or US$             per ADS. This represents an immediate increase in net tangible book value of US$             per ordinary share, or US$             per ADS, to existing shareholders and an immediate dilution in net tangible book value of US$             per ordinary share, or US$             per ADS, to purchasers of ADSs in this offering.

The following table illustrates the dilution on a per ordinary share basis assuming that the initial public offering price per ordinary share is US$ and all ADSs are exchanged for ordinary shares:

 

Assumed initial public offering price per ordinary share

   US$                

Net tangible book value per ordinary share

   US$                

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

   US$                

Pro forma net tangible book value per ordinary share as adjusted to give effect to the automatic conversion of all of our outstanding preferred shares and this offering as of December 31, 2013

   US$                

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

   US$                

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

   US$                

A US$1.00 change in the assumed public offering price of US$             per ADS would, in the case of an increase, increase and, in the case of a decrease, decrease our pro forma net tangible book value after giving effect to the offering by US$             million, the pro forma net tangible book value per ordinary share and per ADS after giving effect to this offering by US$             per ordinary share and US$             per ADS and the dilution in pro forma net tangible book value per ordinary share and per ADS to new investors in this offering by US$             per ordinary share and US$             per ADS, assuming no change to the number of ADSs offered by us as set forth on the cover page of this prospectus, and after deducting underwriting discounts and commissions and estimated offering expenses. The pro forma information discussed above is illustrative only. Our net tangible book value following the completion of this offering is subject to adjustment based on the actual initial public offering price of our ADSs and other terms of this offering determined at pricing.

 

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The following table summarizes, on a pro forma basis as of December 31, 2013, the differences between the shareholders as of December 31, 2013 and the new investors with respect to the number of ordinary shares purchased from us, the total consideration paid and the average price per ordinary share paid at an assumed initial public offering price of US$             per ADS before deducting estimated underwriting discounts and commissions and estimated offering expenses.

 

     Ordinary shares
purchased
   Total consideration    Average
price per
ordinary
share
   Average
price per
ADS
     Number    Percent    Amount    Percent          

Existing shareholders

                 

New investors

                 
  

 

  

 

  

 

  

 

  

 

  

 

Total

                 
  

 

  

 

  

 

  

 

  

 

  

 

A US$1.00 change in the assumed public offering price of US$             per ADS would, in the case of an increase, increase and, in the case of a decrease, decrease total consideration paid by new investors, total consideration paid by all shareholders, average price per ordinary share and average price per ADS paid by all shareholders by US$            , US$            , US$             and US$            , respectively, assuming the sale of              ADSs at US$            , the mid-point of the range set forth on the cover page of this prospectus, and after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

The discussion and tables above also assume no              exercise of any outstanding share options outstanding as of the date of this prospectus. As of             , 2014, there were ordinary shares issuable upon exercise of outstanding share options, options to purchase              Class A ordinary shares had been exercised for which we will issue              Class A ordinary shares to the option holders after the expiration of the 180-day lock-up period, and there were or more              Class A ordinary shares available for future issuance upon the exercise of future grants under our 2011 Global Share Plan and 2013 Share Incentive Plan. To the extent that any of these options are exercised, there will be further dilution to new investors.

 

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EXCHANGE RATE INFORMATION

Our reporting currency is the Renminbi because our business is primarily conducted in China and substantially all of our revenues are denominated in Renminbi. This prospectus contains translations of Renminbi amounts into U.S. dollars at specific rates solely for the convenience of the reader. The conversion of Renminbi into U.S. dollars in this prospectus is based on the rate certified for customs purposes by the Federal Reserve Bank of New York. Unless otherwise noted, all translations from Renminbi to U.S. dollars and from U.S. dollars to Renminbi in this prospectus were made at a rate of RMB6.0537 to US$1.00, the rate in effect as of December 31, 2013. We make no representation that any RMB or U.S. dollar amounts could have been, or could be, converted into U.S. dollars or RMB, as the case may be, at any particular rate, the rates stated herein, or at all. The PRC government imposes control over its foreign currency reserves in part through direct regulation of the conversion of RMB into foreign currencies and through restrictions on international trade. On April 11, 2014, the certified exchange rate was RMB6.2111 to US$1.00.

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

 

     Exchange Rate  

Period

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

2009

     6.8259         6.8295         6.8470         6.8176   

2010

     6.6000         6.7603         6.8330         6.6000   

2011

     6.2939         6.4475         6.6364         6.2939   

2012

     6.2301         6.2990         6.3879         6.2221   

2013

     6.0537         6.1412         6.2438         6.0537   

2013

           

October

     6.0943         6.1032         6.1209         6.0815   

November

     6.0922         6.0929         6.0993         6.0903   

December

     6.0537         6.0738         6.0927         6.0537   

2014

           

January

     6.0590         6.0509         6.0600         6.0402   

February

     6.1448         6.0816         6.1448         6.0591   

March

     6.2164         6.1729         6.2273         6.1183   

April (through April 11, 2014)

     6.2111         6.2073         6.2123         6.1966   

 

Source: Federal Reserve Statistical Release

(1) Annual averages were calculated by using the average of the exchange rates on the last day of each month during the relevant year. Monthly averages are calculated by using the average of the daily rates during the relevant month.

 

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ENFORCEABILITY OF CIVIL LIABILITIES

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

 

    political and economic stability;

 

    a relatively effective judicial system;

 

    a favorable tax system;

 

    the absence of exchange control or currency restrictions; and

 

    the availability of professional and support services.

However, certain disadvantages accompany incorporation in the Cayman Islands. These disadvantages include, but are not limited to, the following:

 

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

 

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

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

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

We have appointed PunchBox USA Inc., located at 931 Hamilton Ave., Menlo Park, CA 94025 as our agent upon whom process may be served in any action brought against us under the securities laws of the United States.

Travers Thorp Alberga, our counsel as to Cayman Islands law, and Han Kun Law Offices, our counsel as to PRC law, have advised us, respectively, that there is uncertainty as to whether the courts of the Cayman Islands and China, respectively, would:

 

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

 

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

Travers Thorp Alberga has informed us that it is uncertain whether the courts of the Cayman Islands will allow shareholders of our company to originate actions in the Cayman Islands based upon securities laws of the United States. In addition, there is uncertainty with regard to Cayman Islands law related to whether a judgment obtained from the U.S. courts under civil liability provisions of U.S. securities laws will be determined by the courts of the Cayman Islands as penal or punitive in nature. If such a determination is made, the courts of the Cayman Islands will not recognize or enforce the judgment against a Cayman Islands company, such as our company. As the courts of the Cayman Islands have yet to rule on making such a determination in relation to judgments obtained from U.S. courts under civil liability provisions of U.S. securities laws, it is uncertain whether such judgments would be enforceable in the Cayman Islands.

Travers Thorp Alberga has further advised us that the courts of the Cayman Islands would recognize as a valid judgment a final and conclusive judgment in personam obtained in the federal or state courts in the United

 

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States under which a sum of money is payable (other than a sum of money payable in respect of multiple damages, taxes or other charges of a like nature or in respect of a fine or other penalty) or, in certain circumstances, an in personam judgment for non-monetary relief, and would give a judgment based thereon provided that: (a) such courts had proper jurisdiction over the parties subject to such judgment; (b) such courts did not contravene the rules of natural justice of the Cayman Islands; (c) such judgment was not obtained by fraud; (d) the enforcement of the judgment would not be contrary to the public policy of the Cayman Islands; (e) no new admissible evidence relevant to the action is submitted prior to the rendering of the judgment by the courts of the Cayman Islands; and (f) there is due compliance with the correct procedures under the laws of the Cayman Islands.

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

 

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CORPORATE HISTORY AND STRUCTURE

We are a holding company incorporated in the Cayman Islands and conduct our business through our subsidiaries and our consolidated affiliated entities in China. We started our operations in April 2010 when our founders established Beijing Chukong Technology Co., Ltd., or Chukong Technology, in China. In order to facilitate foreign investment in our company, our holding company, Directouch Holdings Limited, was incorporated in the Cayman Islands in November 2010, and subsequently changed its name to Chukong Holdings Limited in January 2014. In December 2010, we established Directouch Management Limited, or Chukong HK, a wholly owned subsidiary, in Hong Kong. Subsequently, Chukong HK established a wholly-owned PRC subsidiary, Beijing Chukong Aipu Technology Co., Ltd., or Chukong Beijing, in April 2011. In October 2011, we established PunchBox USA Inc., or Chukong USA, a wholly-owned subsidiary in the United States. In August 2013, Chukong HK established Chukong Technology Korea, Inc., or Chukong Korea, a wholly owned subsidiary, in Korea.

The following diagram illustrates our corporate structure, including our principal operating entities, as of the date of this prospectus:

 

LOGO

 

* Wholly foreign-owned entity.
Consists of (1) with respect to Beijing Wan’ai Internet Technology Co., Ltd. and Chukong Technology, Business Operations Agreement, Equity Interest Pledge Agreement, Power of Attorney, Exclusive Consulting and Services Agreement, Equity Disposal Agreement, Domain Names and Trademarks Pledge Agreement, Intellectual Property Licensing Agreement and Intellectual Property Transfer Agreement, as amended, and (2) with respect to Tiansheng Chengye, Exclusive Business Cooperation Agreement, Equity Pledge Agreement, Exclusive Option Agreement, Loan Agreement and Power of Attorney. For details on the contractual arrangements, see “Our Corporate History and Structure—Our Contractual Arrangements.”

 

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(1) The shareholders of Beijing Wan’ai are Haozhi Chen, Guanqun Liu and Fei Ma, holding 45%, 45% and 10% of the total equity interests in Beijing Wan’ai, respectively. Haozhi Chen is our chairman of the board of directors and chief executive officer, Guanqun Liu is our director and chief operating officer and Fei Ma is a shareholder of our company. Beijing Wan’ai currently does not conduct any business operations.
(2) The shareholders of Tiansheng Chengye are Yan Jia and Yingtao Hou, each an employee of our company, and each holding 50% of the total equity interests in Tiansheng Chengye. Tiansheng Chengye holds a license for trans-regional value-added telecommunications businesses, or a trans-regional VATS License, and a license for using short message service access code. Tiansheng Chengye is currently engaged in software development. For the years ended December 31, 2011, 2012 and 2013, we generated nominal revenues from Tiansheng Chengye.
(3) The shareholders of Chukong Technology include Haozhi Chen, Guanqun Liu and Fei Ma, holding 45%, 45% and 10% of the total equity interests in Chukong Technology, respectively. Chukong Technology holds a value-added telecommunication license for internet information services, or the ICP License, a trans-regional VATS License, as well as an internet culture operation license. We conduct most of our businesses, including content development, content publishing and advertising, through Chukong Technology and its subsidiaries.

Foreign ownership of mobile game businesses is subject to significant restrictions under current PRC laws and regulations. The PRC government regulates internet access, the distribution of online information and the conduct of mobile games through strict business licensing requirements and other government regulations. We are a Cayman Islands company and our PRC subsidiary, Chukong Beijing, is a wholly foreign-owned enterprise. As a result, Chukong Beijing is restricted from holding the licenses that are necessary for our mobile internet business in China. To comply with these restrictions, we conduct substantially all our business through contractual arrangements with our variable interest entities and their respective shareholders. Chukong Technology, Tiansheng Chengye and their subsidiaries hold the licenses necessary to conduct our internet-related operations in China. Chukong Beijing is currently engaged in the business of software development, which is an encouraged foreign investment industry under the current of Guiding Catalog for Foreign Investment Industries.

Our wholly owned subsidiary, Chukong Beijing, have entered into a series of contractual arrangements with our variable interest entities and their respective shareholders, which enable us to:

 

    exercise effective control over our variable interest entities;

 

    receive substantially all of the economic benefits of our variable interest entities through service fees in consideration for the consulting services provided by Chukong Beijing; and

 

    have an exclusive option to purchase all of the equity interests in our variable interest entities to the extent permitted under PRC laws, regulations and legal procedures.

We do not have any equity interest in our variable interest entities. However, as a result of contractual arrangements, we are considered the primary beneficiary of our variable interest entities, and we treat them as our variable interest entities under U.S. GAAP. We have consolidated the financial results of our variable interest entities and their subsidiaries in our consolidated financial statements included in this prospectus in accordance with U.S. GAAP.

We face risks with respect to the contractual arrangements with our variable interest entities and their respective shareholders. If our variable interest entities or their respective shareholders fail to perform their obligations under the contractual arrangements, our ability to enforce the contractual arrangements that give us effective control over our variable interest entities may be limited. If we are unable to maintain effective control over our variable interest entities, we would not be able to continue to consolidate their financial results. For a detailed description of the regulatory environment that necessitates the adoption of our corporate structure, see “Regulation.” For a detailed description of the risks associated with our corporate structure, see “Risk Factors—Risks Related to Our Corporate Structure.”

Our Contractual Arrangements

The following is a summary of the material provisions of the agreements entered into by our wholly owned PRC subsidiary, Chukong Beijing, with our variable interest entities and the shareholders of our variable interest entities. For more complete information, you should read these agreements in their entirety. Directions on how to obtain copies of these agreements are provided in this prospectus under “Where You Can Find Additional Information.”

 

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Our Contractual Arrangements with Chukong Technology and Beijing Wan’ai

Exclusive Consulting and Services Agreement. Under the Exclusive Consulting and Services Agreement between Chukong Beijing and Chukong Technology, Chukong Beijing has the exclusive right to provide, among other things, technical support, consulting services and other services to Chukong Technology, and Chukong Technology agrees to accept all the consultation and services provided by Chukong Beijing. Without Chukong Beijing’s prior written consent, Chukong Technology is prohibited from engaging any third party to provide any of the services under this agreement. In addition, Chukong Beijing shall be entitled to any and all the intellectual property rights arising out of or created in connection with the performance of this agreement. The consideration of the services provided by Chukong Beijing to Chukong Technology under this agreement shall be equal to 10% of the total revenue of Chukong Technology each month, which shall be calculated and payable on a quarterly basis and is subject to adjustment based on the complexity, time spent, cost, contents and value of the development work done by Chukong Beijing as well as the market price of similar work. Since Chukong Beijing has effective control over Chukong Technology through the Power of Attorney, the Equity Interest Pledge Agreement and the Equity Disposal Agreement, Chukong Beijing has the right to adjust the service fees at its sole discretion. Unless Chukong Beijing terminates this agreement in advance, it shall remain effective until expiration of the business term of Chukong Beijing, and if the business term of Chukong Beijing is renewed, the term of this agreement shall be automatically extended to the expiration date of such renewed business term of Chukong Beijing or upon request from Chukong Beijing.

Business Operations Agreement. Under the Business Operations Agreement among Chukong Beijing, Chukong Technology and the shareholders of Chukong Technology, without the prior written consent of Chukong Beijing or its designated party, Chukong Technology shall not conduct any transaction that may substantially affect the assets, business, operation or interest of Chukong Technology. Chukong Technology and its shareholders shall also follow Chukong Beijing’s instructions on management of Chukong Technology’s daily operation, finance and employee matters and appoint the nominee(s) designated by Chukong Beijing as the director(s) and senior management members of Chukong Technology. In the event that any agreements between Chukong Beijing and Chukong Technology terminates, Chukong Beijing has the sole discretion to determine whether to continue any other agreements with Chukong Technology. In addition, the shareholders of Beijing Technology shall issue a power of attorney in the form as attached to this agreement to authorize Chukong Beijing as their attorney and to exercise their shareholders’ right (see the summary of Power of Attorney in this section for more details). Unless Chukong Beijing terminates this agreement in advance, it shall remain effective until expiration of the business term of Chukong Beijing, and if the business term of Chukong Beijing is renewed, the term of this agreement shall be automatically extended to the expiration date of such renewed business term of Chukong Beijing or upon request from Chukong Beijing.

Power of Attorney. Pursuant to the power of attorney, the shareholders of Chukong Technology each irrevocably appointed Chukong Beijing as the attorney-in-fact to act on their behalf on all matters pertaining to Chukong Technology and to exercise all of their rights as a shareholder of Chukong Technology, including but not limited to convene, attend and vote on their behalf at shareholders’ meetings, designate and appoint directors and senior management members. Chukong Beijing may authorize or assign its rights under this appointment to a person as approved by its board of directors at its sole discretion. Each power of attorney will remain in force with the same effective term of the Business Operations Agreement. In addition, the term of each power of attorney shall be renewed at the request of Chukong Beijing upon expiration.

Equity Interest Pledge Agreement. Under the equity interest pledge agreement among Chukong Beijing and each of the shareholders of Chukong Technology, the shareholders pledged all of their equity interests in Chukong Technology to Chukong Beijing to guarantee Chukong Technology’s and its shareholders’ payment obligations under and liabilities arising from ineffectiveness of the Exclusive Business Consulting and Services Agreement, Business Operations Agreement, Equity Interest Disposal Agreement and Intellectual Properties Licensing Agreement, including, but not limited to, the payments due to Chukong Beijing for services provided and the license of intellectual properties. If Chukong Technology or any of Chukong Technology’s shareholders

 

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breaches its contractual obligations under the above agreements, Chukong Beijing, as the pledgee, will be entitled to certain rights and entitlements, including receiving proceeds from the auction or sale of whole or part of the pledged equity interests of Chukong Technology in accordance with legal procedures. During the term of the pledge, the shareholders of Chukong Technology shall cause Chukong Technology not to distribute any dividends and if they receive any dividends generated by the pledged equity interests, they shall transfer such received amounts to an account designated by Chukong Beijing according to the instruction of Chukong Beijing. If Beijing Technology or its shareholders fail to pay any due amount under the Exclusive Business Consulting and Services Agreement, Business Operations Agreement, Equity Interest Disposal Agreement or Intellectual Properties Licensing Agreement or fail to fulfill any other obligations thereunder and such failure is not cured within ten days after Chukong Beijing’s breach notice, Chukong Beijing, as the pledgee, will be entitled to dispose of the pledged equity interests in accordance with PRC laws and regulations. The pledge will become effective on the date when the pledge of equity interests contemplated in this agreement are registered with the relevant local administration for industry and commerce and will remain binding until Chukong Technology receives written confirmation from Chukong Beijing that Chukong Technology and its shareholders has fully performed all their obligations under the Exclusive Business Consulting and Services Agreement, Business Operations Agreement, Equity Interest Disposal Agreement and Intellectual Properties Licensing Agreement. We registered our equity interest pledge agreement regarding Chukong Technology with local administration of industry and commerce, or AIC, in April 2011.

Equity Disposal Agreement. Under the Equity Disposal Agreement among Chukong Beijing, Chukong Technology and each of the shareholders of Chukong Technology, each of the shareholders irrevocably granted Chukong Beijing or its designated representative(s) an exclusive option to purchase, to the extent permitted under PRC law, all or part of his, her or its equity interests in Chukong Technology at the consideration equal to the lessor of RMB 1 or the lowest price as permitted by PRC laws. In addition, any consideration paid by Chukong Beijing to the shareholders of Chukong Technology in exercising the option shall be transferred to Chukong Beijing or its designated person. Chukong Beijing or its designated representative(s) have sole discretion as to when to exercise such options, either in part or in full. Without Chukong Beijing’s written consent, the shareholders of Chukong Technology shall not transfer, pledge, or otherwise dispose any equity interests in Chukong Technology until Chukong Beijing or its designated party acquires all the equity interest or assets of Chukong Technology. Unless Chukong Beijing terminates this agreement in advance, it shall remain effective until expiration of the business term of Chukong Beijing, and if the business term of Chukong Beijing is renewed, the term of this agreement shall be automatically extended to the expiration date of such renewed business term of Chukong Beijing or upon request from Chukong Beijing. At the moment, we cannot exercise the exclusive option to purchase the current shareholders’ equity interests in Chukong Technology due to the PRC regulatory restrictions on foreign ownership in the value-added telecommunications services. We intend to exercise such option once China opens up these industries to foreign investment.

Intellectual Property Transfer Agreement. Under the Intellectual Property Transfer Agreement between Chukong Beijing and Chukong Technology, Chukong Technology transfers any and all the intellectual properties that are owned or are to be owned by it to Chukong Beijing, except for the trademarks and domain names. The total consideration paid to Chukong Technology under this agreement is RMB4.0 million. Without the prior written consent of Chukong Beijing, Chukong Technology shall not use its transferred intellectual properties under this agreement in any jurisdiction. On November 29, 2013, Chukong Technology and Chukong Beijing entered into an amendment to this intellectual property transfer agreement to further specify certain software that shall be transferred from Chukong Technology to Chukong Beijing.

Intellectual Property Licensing Agreement. Under the Intellectual Property Licensing Agreement between Chukong Beijing and Chukong Technology, Chukong Beijing grants Chukong Technology a non-exclusive, non-transferable and non-sub-licensable license to use the transferred intellectual properties under the intellectual property transfer agreement within PRC. The loyalty is equal to 10% of the total revenue of Chukong Technology every year, which shall be due and payable prior to December 31 each year and may be waived by Beijing Chukong at its discretion. Unless Chukong Beijing terminates this agreement in advance, it shall remain

 

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effective until expiration of the business term of Chukong Beijing, and if the business term of Chukong Beijing is renewed, the term of this agreement shall be automatically extended to the expiration date of such renewed business term of Chukong Beijing or upon request from Chukong Beijing. In addition, Chukong Technology may not terminate this agreement while Chukong Beijing is entitled to do so with a 30-day advance notice to Chukong Technology and its shareholders.

Domain Names and Trademarks Pledge Agreement. Under the Domain Names and Trademarks Pledge Agreement between Chukong Beijing and Chukong Technology, Chukong Technology pledged certain of its domain names and trademarks to Chukong Beijing, to guarantee Chukong Technology’s and its shareholders’ payment obligations under and liabilities arising from ineffectiveness of the Exclusive Business Consulting and Services Agreement, Business Operations Agreement, Equity Interest Disposal Agreement and Intellectual Properties Licensing Agreement including, but not limited to, the payments due to Chukong Beijing for services provided. If Chukong Technology or any of its shareholders breaches his/her/its contractual obligations under the contractual arrangements, Chukong Beijing, as the pledgee, will be entitled to dispose of the pledged domain names and trademarks in accordance with PRC laws and regulations. The pledge of trademarks will become effective on the date when the pledge is registered with the State Administration for Industry and Commerce and the pledge of domain names will become effective upon the execution of this agreement. Both pledges will remain effective until Chukong Technology receives written confirmation from Chukong Beijing that Chukong Technology has fully performed all its obligations under the Exclusive Business Consulting and Services Agreement, Business Operations Agreement, Equity Interest Disposal Agreement and Intellectual Properties Licensing Agreement.

Chukong Beijing, Beijing Wan’ai and the shareholders of Beijing Wan’ai also entered into an Exclusive Consulting and Services Agreement, a Business Operations Agreement, a Power of Attorney, an Equity Interest Pledge Agreement, an Equity Disposal Agreement, an Intellectual Property Transfer Agreement, an Intellectual Property Licensing Agreement, and a Domain Names and Trademarks Pledge Agreement, each substantially identical in all material respects to the agreements entered into by and among Chukong Beijing, Chukong Technology and the shareholders of Chukong Technology mentioned above, except as to the parties thereto and certain details. For example, the consideration under the intellectual properties transfer agreement regarding Beijing Wan’ai was RMB1. In addition, we registered our equity interest pledge agreement regarding Beijing Wan’ai with the local AIC in May 2011.

Our Contractual Arrangements with Tiansheng Chengye

Exclusive Business Cooperation Agreement. Under the exclusive business cooperation agreement between Chukong Beijing and Tiansheng Chengye, Chukong Beijing has the exclusive right to provide, among other things, technical support, consulting services and other services to Tiansheng Chengye and Tiansheng Chengye agrees to accept all the consultation and services provided by Chukong Beijing. Without Chukong Beijing’s prior written consent, Tiansheng Chengye is prohibited from engaging any third party to provide any of the services under this agreement. In addition, Chukong Beijing exclusively owns all intellectual property rights arising out of or created during the performance of this agreement. Tiansheng Chengye agrees to pay a monthly service fee to Chukong Beijing at an amount determined solely by Chukong Beijing after taking into account factors including the complexity and difficulty of the services provided, the time consumed, the seniority of the Chukong Beijing employees providing services to Tiansheng Chengye, the value of services provided, the market price of comparable services and the operating conditions of Tiansheng Chengye. This agreement will remain effective unless Chukong Beijing terminates the agreement in writing or a competent governmental authority rejects the renewal applications by either Tiansheng Chengye or Chukong Beijing to renew its respective business license upon expiration. Tiansheng Chengye is not permitted to terminate this agreement in any event unless required by applicable laws.

Powers of Attorney. Pursuant to the powers of attorney, the shareholders of Tiansheng Chengye each irrevocably appointed Chukong Beijing as the attorney-in-fact to act on their behalf on all matters pertaining to Tiansheng Chengye and to exercise all of their rights as a shareholder of Tiansheng Chengye, including but not

 

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limited to attend shareholders’ meetings, vote on their behalf on all matters of Tiansheng Chengye requiring shareholders’ approval under PRC laws and regulations and the articles of association of Tiansheng Chengye, designate and appoint directors and senior management members. Chukong Beijing may authorize or assign its rights under this appointment to any other person or entity at its sole discretion without prior notice to the shareholders of Tiansheng Chengye. Each power of attorney will remain in force until the shareholder ceases to hold any equity interest in Tiansheng Chengye.

Equity Interest Pledge Agreements. Under the equity interest pledge agreements between Chukong Beijing, Tiansheng Chengye and the shareholders of Tiansheng Chengye, the shareholders pledged all of their equity interests in Tiansheng Chengye to Chukong Beijing to guarantee Tiansheng Chengye’s and Tiansheng Chengye’s shareholders’ performance of their obligations under the contractual arrangements including, but not limited to, the payments due to Chukong Beijing for services provided. If Tiansheng Chengye or any of Tiansheng Chengye’s shareholders breaches its contractual obligations under the contractual arrangements, Chukong Beijing, as the pledgee, will be entitled to certain rights and entitlements, including receiving proceeds from the auction or sale of whole or part of the pledged equity interests of Tiansheng Chengye in accordance with legal procedures. Chukong Beijing has the right to receive dividends generated by the pledged equity interests during the term of the pledge. The pledge will become effective on the date when the pledge of equity interests contemplated in these agreements are registered with the relevant local administration for industry and commerce and will remain binding until Tiansheng Chengye and its shareholders discharges all their obligations under the contractual arrangements. We registered these equity interest pledge agreements with local AIC in January 2014.

Exclusive Option Agreements. Under the exclusive option agreements between Chukong Beijing, each of the shareholders of Tiansheng Chengye and Tiansheng Chengye, each of the shareholders irrevocably granted Chukong Beijing or its designated representative(s) an exclusive option to purchase, to the extent permitted under PRC law, all or part of his, her or its equity interests in Tiansheng Chengye. In addition, Chukong Beijing has the option to acquire all the equity interests of Tiansheng Chengye for a specified price equal to the loan provided by Chukong Beijing to the individual shareholders. If the lowest price permitted under PRC law is higher than the above price, the lowest price permitted under PRC law shall apply. Chukong Beijing or its designated representative(s) have sole discretion as to when to exercise such options, either in part or in full. Without Chukong Beijing’s prior written consent, Tiansheng Chengye’s shareholders shall not sell, transfer, pledge, or otherwise dispose of any equity interests in Tiansheng Chengye. These agreements will remain effective until all equity interests held in Tiansheng Chengye by Tiansheng Chengye’s shareholders are transferred or assigned to Chukong Beijing or Chukong Beijing’s designated representatives.

Loan Agreements. Pursuant to the loan agreements between Chukong Beijing and each individual shareholder of Tiansheng Chengye, Chukong Beijing provided interest-free loans with an aggregate amount of approximately RMB10.0 million (US$1.6 million) to the individual shareholders of Tiansheng Chengye for the sole purpose of acquiring equity interest of Tiansheng Chengye. The loans can be repaid by transferring the individual shareholders’ equity interest in Tiansheng Chengye to Chukong Beijing or its designated person pursuant to Exclusive Option Agreements. The term of each loan agreement is ten years from the date of the agreement and can be extended with the written consent of both parties before expiration.

In the opinion of our PRC legal counsel, Han Kun Law Offices, the ownership structure and the contractual arrangements among Chukong Beijing, our variable interest entities and their respective shareholders, comply with current PRC laws and regulations in effect.

We have been advised by our PRC legal counsel, however, that there are substantial uncertainties regarding the interpretation and application of current and future PRC laws, regulations and rules. Accordingly, the PRC regulatory authorities may in the future take a view that is contrary to the above opinion of our PRC legal counsel. We have been further advised by our PRC legal counsel that if the PRC government finds that the

 

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agreements that establish the structure for operating our PRC mobile game businesses do not comply with relevant PRC government restrictions on foreign investment in mobile game and related services, we could be subject to severe penalties, including being prohibited from continuing operations. See “Risk Factors—Risks Related to Our Corporate Structure—If PRC authorities determine that the agreements that establish the structure for operating our business in China do not comply with applicable PRC laws and regulations, we could be subject to severe penalties.” and “Risk Factors—Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could have a material adverse effect on us.”

 

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SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated statements of operations and comprehensive loss data for the years ended December 31, 2011, 2012 and 2013, and selected consolidated balance sheet data as of December 31, 2011, 2012 and 2013, have been derived from our audited consolidated financial statements included elsewhere in this prospectus. Our consolidated financial statements are prepared and presented in accordance with U.S. GAAP.

Our historical results for any period are not necessarily indicative of results to be expected for any future period. You should read the following selected financial information in conjunction with the consolidated financial statements and related notes and the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

 

     For the Years Ended December 31,  
     2011      2012      2013  
     (RMB)      (RMB)      (RMB)      (US$)  
     (in thousands, except for share and share related data)  

Selected data of consolidated statements of operations and comprehensive loss:

           

Revenues:

           

Mobile games

     7,143         69,506         546,612         90,294   

Online advertising

     1,540         7,027         8,153         1,347   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total revenues

     8,683         76,533         554,765         91,641   

Cost of revenues(1)(2)

     3,424         36,746         298,085         49,241   
  

 

 

    

 

 

    

 

 

    

 

 

 

Gross profit

     5,259         39,787         256,680         42,400   
  

 

 

    

 

 

    

 

 

    

 

 

 

Operating expenses:

           

Sales and marketing expenses(1)

     12,849         37,740         149,039         24,619   

Research and development expenses(1)(3)

     12,065         38,922         105,193         17,377   

General and administrative expenses(1)

     6,344         14,655         56,230         9,289   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total operating expenses

     31,258         91,317         310,462         51,285   
  

 

 

    

 

 

    

 

 

    

 

 

 

Loss from operations

     (25,999      (51,530      (53,782      (8,885
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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     For the Years Ended December 31,  
     2011      2012      2013  
     (RMB)      (RMB)      (RMB)      (US$)  
     (in thousands, except for share and share related data)  

Other (expenses)/income:

           

Interest (expenses)/income, net

     (73      43         375         62   

Investment income/(loss)

             (389      (3,572      (590

Others, net

     462         (802      (608      (100

Gain from previously held equity interest related to step acquisition

             6,967                   

Beneficial conversion charges on convertible notes

     (359                        

Fair value changes in warrant liability

     (2,895      (6,413      (30,071      (4,967
  

 

 

    

 

 

    

 

 

    

 

 

 

Loss before tax

     (28,864      (52,124      (87,658      (14,480

Income tax (expenses)/benefits

             15         (648      (108
  

 

 

    

 

 

    

 

 

    

 

 

 

Net loss

     (28,864      (52,109      (88,306      (14,588
  

 

 

    

 

 

    

 

 

    

 

 

 

Accretions to preferred shares redemption value

     (6,091      (25,038      (114,983      (18,994

Deemed dividends to preferred shareholders

     (601                        

Net loss attributable to ordinary shareholders

     (35,556      (77,147      (203,289      (33,582

Net loss

     (28,864      (52,109      (88,306      (14,588

Foreign currency translation adjustment, net of nil tax

     (1,063      (1,041      (2,521      (416
  

 

 

    

 

 

    

 

 

    

 

 

 

Comprehensive loss

     (29,927      (53,150      (90,827      (15,004
  

 

 

    

 

 

    

 

 

    

 

 

 

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

     5,000,000         5,000,000         27,042,808         27,042,808   

Net loss per share attributable to ordinary shareholders—basic and diluted

     (7.11      (15.43      (7.52      (1.24

Unaudited pro forma net loss per share attributable to ordinary stockholders—basic and diluted(4)

           (0.84      (0.14

Non-GAAP financial measures:(5)

           

Adjusted net loss

     (24,602      (50,824      (49,753      (8,220

Adjusted EBITDA

     (24,679      (47,429      (35,344      (5,839

Mobile game gross billing

     7,143         75,955         756,769         125,009   

 

Note:    (1)   Share-based compensation expenses were allocated in cost of revenues and operating expenses as follows:

 

     For the Years Ended December 31,  
     2011      2012      2013  
     (RMB)      (RMB)      (RMB)      (USD)  
     (in thousands)  

Cost of revenues

                               

Sales and marketing expenses

     3         98         1,080         178   

Research and development expenses

     4         166         3,020         499   

General and administrative expenses

     1,001         1,575         4,382         724   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     1,008         1,839         8,482         1,401   
  

 

 

    

 

 

    

 

 

    

 

 

 
(2)   Includes content fees paid to related parties of RMB0, RMB505 thousand and RMB12.9 million for the years ended December 31, 2011, 2012 and 2013, respectively.
(3)   Includes technical service fees paid to related parties of RMB0, RMB2.3 million and RMB500 thousand for the years ended December 31, 2011, 2012 and 2013, respectively.
(4)   See “Notes to Consolidated Financial Statements—Note 23.”
(5)   See “Prospectus Summary—Summary Consolidated Financial Data—Non-GAAP Financial Measures.”

 

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    As of December 31,  
    2011     2012     2013  
    (RMB)     (RMB)     (RMB)     (US$)  
    (in thousands)  

Selected consolidated balance sheet data:

       

Cash and cash equivalents

    67,893        110,926        330,558        54,604   

Accounts receivable, net

    590        25,279        132,269        21,849   

Prepayment and other current assets

    2,794        4,497        65,589        10,835   

Total assets

    77,194        180,579        616,130        101,778   

Deferred revenues

           2,902        37,427        6,182   

Total liabilities

    10,143        52,502        229,768        37,955   

Total mezzanine equity

    101,190        235,736        691,349        114,204   

Total shareholders’ (deficit)/equity

    (34,139     (107,659     (304,987     (50,381

Total liabilities, mezzanine equity and shareholders’ (deficit)/equity

    77,194        180,579        616,130        101,778   

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the section entitled “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements that involve risks 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 the section entitled “Risk Factors” and elsewhere in this prospectus.

Overview

We operate an innovative mobile entertainment platform, offering a full suite of solutions and services to enable developers worldwide to efficiently develop, publish and monetize content and providing a highly engaging mobile entertainment experience to our users. We seek to create significant value to our business partners and users.

For mobile content developers, we enable them to develop popular content with high efficiency and publish and monetize their content with ease. Our suite of solutions and services consists of world-leading Cocos open-source engines, a content design toolkit and content publishing services, such as game operation, payment service, content localization, data analytics, technical support and advertising service. According to iResearch, the Cocos2d-x open-source game engine, which we develop and maintain, was the most adopted engine among the 100 Top Grossing games on both iOS and Android in 2013 in China, United States and Taiwan. As a result of the significant value we create for content developers, we have become a trusted publishing partner for leading mobile content developers in China. We published three out of the top four mobile games in China as measured by gross billing in 2013, according to iResearch.

For mobile users, we deliver an engaging mobile entertainment experience. We offer an extensive portfolio of in-house developed and licensed popular mobile games and other rich entertainment content, provide an interactive user system and deliver convenient payment options. We have experienced significant growth in our user base, as evidenced by increases in our average MAUs and DAUs for our games from 12.4 million and 1.7 million, respectively, in the fourth quarter of 2011, to 52.7 million and 9.1 million, respectively, in the fourth quarter of 2013.

In addition, we seek to create value to other participants in the mobile entertainment ecosystem, including mobile content distribution channels and mobile carriers by enriching their content offerings and monetizing their user base. According to iResearch, we were the largest mobile game revenue contributor to each of China Mobile, China Unicom and China Telecom in 2013, primarily through the fee sharing arrangements we had with these mobile carriers as payment channels for many of our self-developed games and licensed third-party games.

We have achieved significant growth in our business in a short period of time. Our revenues increased from RMB8.7 million in 2011 to RMB76.5 million in 2012 and to RMB554.8 million (US$91.6 million) in 2013. We had a net loss of RMB88.3 million (US$14.6 million) in 2013, compared to a net loss of RMB52.1 million and RMB28.9 million in 2012 and 2011, respectively.

Major Factors Affecting Our Results of Operations

Our results of operations are affected by general conditions typically influencing the mobile entertainment industry in China, including the overall economic growth, the increase in smartphone and high-speed mobile internet penetration and high-speed mobile internet penetration, as well as the increasing popularity of entertainment on mobile devices. Our results of operations are also affected by PRC regulations and industry

 

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policies related to mobile entertainment and related operations. Although we have generally benefited from the PRC government’s policies to encourage economic growth, we are also affected by the complexity, uncertainties and changes in PRC regulations governing various aspects of our operations. For a detailed description of the PRC regulations applicable to us, see “Regulation.”

While our business is influenced by factors affecting the general mobile entertainment market in China, we believe our results of operations are more directly affected by the following company-specific factors.

Our Ability to Successfully Develop and Launch New Games

Our revenue growth has been driven primarily by the popularity of our self-developed games, especially the Fishing Joy series. The Fishing Joy series contributed 74.1%, 61.8% and 73.4% of our total revenues in 2011, 2012 and 2013, respectively. To continue to develop popular games, we need to accurately anticipate and effectively respond to game players’ changing interests and preferences. We plan to develop and launch seven self-developed games by the end of 2014, which cover multiple genres to cater to different game players’ demands. If the new games we introduce are not commercially successful, we may not be able to recover our related expenses and our business and growth prospects will be materially and adversely affected.

Our Ability to License and Publish Successful Games

We derive a portion of revenues from licensing and publishing top ranked games from leading global and regional content providers. Our game publishing business from licensed games contributed 25.3% and 25.0% of our total revenues in 2012 and 2013, respectively. The success of our publishing business depends on our ability to identify suitable games with the potential to attract players and with good monetization potentials, our ability to secure the rights to license and publish the identified games at attractive terms, preferably with exclusive publishing rights, as well as our ability to successfully modify such games for specific distribution channels and markets. In 2013, we published 82 licensed third-party mobile games with exclusive publishing rights to 71 games. We have entered into agreements to publish at least 18 additional licensed games by the end of 2014. We expect that revenues from our game publishing business will significantly increase in 2014 from the 2013 level.

Our Ability to Attract and Retain a Large Player Base, Increase Player Spending and Extend the Lifespan of our Games

We depend on the consumption of virtual items by players downloads of our games, as well as sales of advertising spaces in our games to generate revenues. Therefore, enlarging our player base and increasing the average amount our paying players spend are critical to our business. To attract more players, we need to continue to optimize our games and devote resources to market and promote our games. To encourage players’ in-game purchases, we need to design appealing features and virtual items that enhance the game-playing experience. This requires us to closely track player tastes and preferences, especially in-game spending trends. Historically, we did not have systematic in-house mechanism to track certain data, such as the number of paying users. Therefore we were not able to provide accurate quantified paying player information for the periods prior to the fourth quarter of 2013. We have made efforts to obtain relevant paying player information, including obtaining regular paying user information from the mobile carriers since the fourth quarter of 2013 for single-player games and installing SDKs to track paying user information for multi-player games. We also provide our players with easy and efficient payment methods, which enhances their gaming experience, and at the same time improves our monetization. In order to prolong the lifespan of our games, we need to continue to optimize and update them with new features to improve the stickiness of our existing players and attract new players. If we are able to attract and retain a large player base, increase average player spending and extend the lifespan of our games, we will be able to continue to grow our revenues and improve our overall financial performance.

Our Ability to Effectively Manage Our Costs and Expenses

Our ability to achieve and increase profitability depends on how effectively we manage our costs and expenses.

 

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Our cost of revenues as a percentage of our total revenues was 39.4%, 48.0% and 53.7% in 2011, 2012 and 2013, respectively. A significant component of our cost of revenues is the commission fees we pay to the mobile carriers, which accounted for 0%, 18.4% and 22.3% of our revenues in 2011, 2012 and 2013, respectively. Another key component of our cost of revenues is the distribution fees we pay to the distribution channels, which accounted for 24.9%, 14.0% and 19.0% of our revenues in 2011, 2012 and 2013, respectively. We believe the commission fees and distribution fees will continue to increase as our business continues to grow.

Our operating expenses include sales and marketing expenses, research and development expenses and general and administrative expenses. We expect that our sales and marketing expenses and research and development expenses will increase as we devote significant financial resources to develop and market new games, to maintain, upgrade and optimize our game engines and technologies and to maintain their popularity in the market. We also expect that our general and administrative expenses in absolute amount will increase in 2014 as we incur additional costs in connection with the growth of our business and operating as a public company. However, such increase is likely to be partially offset by our increasing economies of scale and improving operational efficiency.

Our Ability to Compete Successfully

The mobile entertainment industry is highly competitive. In China, we compete directly with other mobile entertainment content developers, publishers and platforms. Given the relatively low entry barriers for new mobile entertainment developers and publishers, we expect more companies to enter the mobile entertainment industry in China and a wider range of mobile games and other entertainment content to be introduced to the Chinese market. As a result, the number of our players, the growth rate of our player base, and the amount our paying players are willing to spend in our games and other entertainment content may decline. Therefore, our revenues may be materially affected.

The proliferation of the number of mobile entertainment companies has also placed significant pressure on our company, especially expenses related to recruiting and retaining game development and management talent. We may also need to increase employee remuneration to retain our skilled game developers. If competition further intensifies, it may become more difficult for us to hire, motivate and retain highly skilled personnel.

Critical Accounting Policies, Judgments and Estimates

We prepare our financial statements in conformity with U.S. GAAP, which requires us to make judgments, estimates and assumptions. 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 is an integral component of the financial reporting process, actual results could differ from our expectations as a result of changes in our estimates.

An accounting policy is considered 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. The selection of critical accounting policies, the judgments and other uncertainties affecting application of those policies, and the sensitivity of reported results to changes in conditions and assumptions are factors that should be considered when reviewing our consolidated financial statements. We believe that the following accounting policies involve a higher degree of judgment and complexity in their application and require us to make significant accounting estimates. The following descriptions of critical accounting policies, judgments and estimates should be read in conjunction with our consolidated financial statements and other disclosures included in this prospectus.

 

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Revenue recognition

We generate revenues from mobile games and online advertising. Mobile games are played on iOS or Android based smartphones and tablets. Online advertising revenues are primarily generated from our advertising services.

Mobile games

We publish our self-developed and licensed mobile games to the end users through distribution channels, such as the iOS App Store, 360 Mobile Assistant, 91Wireless, SnapPea and UCWeb, all of which are referred to as distribution channels in this prospectus. Through these distribution channels, users can download our games, pay to unlock the in-game features or acquire game points which can be used to purchase in-game virtual items.

We evaluate revenue recognition based on the criteria set forth in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 605, Revenue Recognition and ASC 985-605, Software: Revenue Recognition. We recognize revenues from mobile games when (1) persuasive evidence of an arrangement exists, (2) the service has been delivered, (3) the fee is fixed or determinable, and (4) the collection of the resulting receivable is probable. We classify the mobile game revenues as single-player game revenues and multi-player game revenues.

(1) Single player games

We generate single player game revenues from the sale of self-developed and licensed single player games through distribution channels. We operate the majority of the single player games under a free-to-play model. Revenues from pay-per-installation games were immaterial, which are recognized upon the installation by players.

Under the free-to-play model, the players can download the game to their mobile devices free of charge, with all functionalities of the game being fully delivered to their devices upon such a download. Players can then play the games on their devices without internet connection. At players’ discretion, in-game purchase is available via various payment channels to enhance players’ game experience, such as unlocking an in-game premium feature. In-game purchases are not refundable. The fulfillment of in-game purchase requires connection to the internet. However, once the players confirm their purchase requests, the purchased feature is automatically unlocked in the downloaded game through electronic command executed by the payment channel. Future play and use of the purchased features does not require online connectivity or any involvement from us. We do not host online servers in order for game players to play the game or utilize the purchased features.

For the games where we are acting as the principal in selling the single player games to customers (see “—Principal Agent Consideration” within this section), we have determined that all revenue recognition criteria are met upon players’ confirmation of the purchase request and the unlocking of the purchased features. Therefore, we recognize revenues from sales of single player games upon the purchase of in-game features by the game players.

For the games where we are acting as the agent, see the last paragraph of (3)a within this section.

(2) Multi-player games

We generate multi-player game revenues from the sale of game points that can be redeemed in the game for virtual items of self-developed and licensed multi-player games on smartphones and tablets. We primarily operate multi-player games under a free-to-play model.

Under the free-to-play model, players can download games free of charge from distribution channels. Playing of the multi-player games requires real time connection to online game servers, where all user information is stored, including user accounts, game playing contents, player’s in-game purchase data. Game players cannot play the game on their devices locally without connecting to the internet. The application

 

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downloaded on players’ device is similar to a portal to access the online game server. Game servers for multi-player mobile game services are hosted either by us or the game developers. At players’ discretion, they may purchase game points via various payment channels to enhance their game-playing experience. Game points in the players’ accounts are not refundable once charged.

For the games where we are acting as the principal in providing multi-player mobile game services to customers (see “—Principal Agent Consideration” within this section), we have determined that an implied obligation exists to the players who purchased game points to gain an enhanced game-playing experience over the estimated average playing period of these paying players, or estimated player pay life, and accordingly, recognize the revenues ratably over the estimated player pay life, starting from the point in time when game points are delivered to the players’ accounts, and all other revenue recognition criteria are met.

For the games where we are acting as the agent, see the last paragraph of (3)a within this section.

The estimated player pay life represents the average playing period of all paying players between the first time the players charge game points into their accounts and the last date these paying players would play the game. In determining the last date the paying players would play the game, as of the assessment date, we categorize the paying players into two groups, active and inactive paying players:

a. Inactive paying players

We considered a paying player to be inactive once he or she has reached a period of inactivity for which it is probable (defined as at least 80%) that a player will not return to a specific game. We believed that using an 80% threshold for the likelihood that a player will not return to a game is a reasonable estimate that achieves the magnitude of “probable” under the threshold described in ASC 450 Contingencies. We have consistently applied this threshold to the analysis.

To determine the period of inactivity for which it is probable that a player will not return to a specific game, all historical paying players’ log-on data of that game, at least a six month period of data, is analyzed. We looked back from the assessment date by 30 days, 45 days, 60 days and so forth, to see if any given player who had paid at least once since the launch of the game had logged on during the selected period. We believe the percentage of paying players that did not log on during the given period represents the probability that the players will not return to the game and the period during which such probability exceeds the 80% threshold benchmarks the game’s inactive period. Based on the results of the assessment, we classified the paying players who meet the inactive criteria as inactive paying players and calculated the average playing period of all inactive players by averaging the period between the first time the players charge game points into their accounts and the last date these paying players played the game.

b. Active paying players

Active paying players are those who at least logged on once during the estimated inactive period. We estimated that these active paying players will continue to remain active from the assessment date. An active paying player’s playing period is the period between the first time the player charge game points into his/her account and the assessment date plus the future period the player will remain active in the game, which is estimated by the Group by analyzing historical mobile game operation data, including the average player pay life of inactive paying players as well as paying players’ behavior in the game and by making reference to the common practice in the industry. The average playing period of all active players is calculated by averaging the playing period of all active players for a specific game.

The estimated player pay life of all paying players is calculated from the average of playing period of all active players and inactive players, weighted by the amount of game points charged by each paying player.

We track each of the paying players’ purchase and log on history for each significant game to estimate the average playing period of the game. If a new game is launched and only a limited period of paying player data is

 

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available, then we consider other qualitative factors, such as the playing patterns for paying players for other games with similar characteristics. Based on the assessment performed, we estimate the average player pay life of our multi-player games to be ranging from 120 to 180 days during the periods presented. The current estimated player pay life of 180 days is based on the reassessment performed in the fourth quarter of 2013 using our most recent game operating data from one game that has sufficient historical operating data. We applied the same estimated player pay life to other games due to the lack of sufficient historical operating data, as well as the similarity in game characteristics, such as game genre and playing method, and in playing patterns of paying players such as targeted players and purchasing frequency. While we believe our estimates to be reasonable based on available game player information, we may revise such estimates in the future as the games’ operation periods change, sufficient individual game data becomes available, or there is indication that the similarities in characteristics and playing patterns of paying players of the games change. Any adjustments arising from changes in the estimates of player pay life is applied prospectively on the basis that such changes are caused by new information indicating a change in game player behavior patterns. Any changes in our estimates of player pay life may result in revenues being recognized on a basis different from prior periods and may cause our operating results to fluctuate.

(3) Principal Agent Consideration

In accordance with ASC 605-45, Revenue Recognition: Principal Agent Considerations, we evaluate agreements with distribution channels, payment channels (mobile carriers and third-party payment systems), game developers and game players, in order to determine whether or not we act as the principal or as an agent in the arrangement, which it considers in determining if relevant revenues should be reported gross or net. The assessment is respectively performed for our self-developed mobile games, and mobile games licensed from third party developers.

a. Third party licensed games

We operate some mobile games licensed from third-party developers. Revenues from games developed by third parties are shared between us and the game developers based on a predetermined percentage for each game. These revenue-sharing contracts typically last one to two years.

Pursuant to the licensing contracts signed between us and the third-party developers, our responsibilities in operating the licensed games vary game-by-game. The determination of whether to record these revenues using gross or net method is based on an assessment of various factors, including but not limited to whether we (i) are the primary obligor in the arrangement, (ii) have latitude in establishing the selling price, (iii) change the product or perform part of the service, and (iv) have involvement in the determination of product and service specifications.

For the game license arrangements under which we take primary responsibilities of game operation, including determining distribution and payment channels, providing customer services, hosting game servers, if needed, and controlling game and services specifications and pricing, we considered ourselves the principal in these arrangements. Accordingly, we record mobile game revenues from these third-party licensed games on a gross basis. Commission fees paid to distribution channels and payment channels and content fees paid to third party game developers are recorded as cost of revenues.

For the game license arrangements under which our responsibilities are limited to publishing, providing payment solutions and game operating advices, we view the game developers to be our customers and consider ourselves the agent in the arrangements. Accordingly, we record mobile game revenues from these third-party licensed games, net of fees paid to third parties, upon the provision of service.

b. Self-developed games

Revenues derived from self-developed games are recorded on a gross basis as we act as a principal to fulfill all obligations related to the mobile games. Commission fees paid to distribution channels and payment channels are recorded as cost of revenues.

 

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Online advertising

Online advertising revenues are primarily generated from sales of different forms of advertising services. We enter into cost-per-click (“CPC”), cost-per-activation (“CPA”) and cost-per-mille (“CPM”) arrangements for promoting applications, under which we bill our customers based on the volume of end users who click the advertisement (for “CPC” arrangements), who click and activate the application (for “CPA” arrangements) and based on the number of times the advertisement display (for “CPM” arrangements). Revenue is recognized based on the volume delivered at the pre-agreed unit price. We also enter into pay-for-time contracts, under which we bill our customers based on the period of time to display the advertisements. Revenue is recognized ratably over the period the advertisement is displayed.

Cash payments received in advance of our performance of advertising services are recorded as “Customer advances” on the Consolidated Balance Sheets.

Consolidation

Our consolidated financial statements have been prepared in accordance with U.S. GAAP. The consolidated financial statements include the financial statements of our company, subsidiaries, variable interest entities (“VIE”) and VIEs’ subsidiaries for which we or our subsidiary is the ultimate primary beneficiary. All transactions and balances among our company, subsidiaries, the VIEs and VIEs’ subsidiaries have been eliminated upon consolidation.

A Subsidiary is an entity in which our company, directly or indirectly, controls more than one half of the voting power; or has the power to govern the financial and operating policies, to appoint or remove the majority of the members of the board of directors, or to cast a majority of votes at the meeting of directors.

A VIE is an entity in which our company, or subsidiary, through contractual arrangements, bears the risks of, and enjoys the rewards normally associated with, ownership of the entity, and therefore we or our subsidiary is the primary beneficiary of the entity. In determining whether our company or one of our subsidiaries is the primary beneficiary, we considered whether we have the power to direct activities that are significant to the VIE’s economic performance, and also our obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.

Foreign ownership of mobile game businesses is subject to significant restrictions under current PRC laws and regulations. The PRC government regulates internet access, the distribution of online information and the conduct of mobile games through strict business licensing requirements and other government regulations. We are a Cayman Islands company and our PRC subsidiary, Chukong Beijing, is a wholly foreign-owned enterprise. As a result, Chukong Beijing is restricted from holding the licenses that are necessary for our mobile internet business in China. To comply with these restrictions, we conduct our business partly through a series of contractual arrangements with our consolidated VIEs, including Chukong Technology, Wan’ai and Tiansheng Chengye, and their respective shareholders, which enable us to:

 

    exercise effective control over our consolidated VIEs;

 

    receive substantially all of the economic benefits of our consolidated VIEs through service fees in consideration for the consulting services provided by Chukong Beijing; and

 

    have an exclusive option to purchase all of the equity interests in our consolidated VIEs to the extent permitted under PRC laws, regulations and legal procedures at a nominal price.

We do not have any equity interest in our consolidated VIEs. However, as a result of contractual arrangements, we are considered the primary beneficiary of these VIEs, and have consolidated the financial results of these VIEs and their subsidiaries in our consolidated financial statements included in this prospectus in accordance with U.S. GAAP.

 

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We face risks with respect to the contractual arrangements with our consolidated VIEs and their respective shareholders. If our consolidated VIEs or their respective shareholders fail to perform their obligations under the contractual arrangements, our ability to enforce the contractual arrangements that give us effective control over our consolidated VIEs may be limited. If we are unable to maintain effective control over our consolidated VIEs, we would not be able to continue to consolidate their financial results. For a detailed description of the regulatory environment that necessitates the adoption of our corporate structure, see “Regulation.” For a detailed description of the risks associated with our corporate structure, see “Risk Factors—Risks Related to Our Corporate Structure.”

Share-Based Compensation

All share-based awards to employees and founders, including share options and ordinary shares awards are measured at the grant date based on the fair value of the awards. Share-based compensation, net of forfeitures, is recognized as expense on a straight-line basis over the requisite service period, which is the vesting period. We used the binominal option pricing model to determine the fair value of share options and account for share-based compensation expenses using an estimated forfeiture rate at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from initial estimates. Share-based compensation expense was recorded net of estimated forfeitures such that expense was recorded only for those share-based awards that are expected to vest.

Share options

We adopted a stock incentive plan, or the 2011 Plan, in April 2011. The maximum number of shares in respect of which share awards may be granted under the 2011 Plan is 7,142,850. The 2011 plan will terminate automatically 10 years after its adoption, unless terminated earlier by our shareholders’ approval.

We approved another share incentive plan, or the 2013 Plan, in June 2013, under which 3,400,000 shares of ordinary shares were newly reserved for future issuance. In addition, any shares subject to stock options granted under the 2011 plan and outstanding on the date of adoption of the 2013 Plan expire or for any reason are cancelled or terminated will be available for grant and issuance under the 2013 Plan. The 2013 Plan will terminate automatically 10 years after its adoption, unless terminated earlier by our shareholders’ approval. In October 2013, our shareholders approved an amendment to the 2013 Plan that reserved additional 4,852,151 shares of ordinary shares.

A summary of our share option activities is presented below (share and per share information is presented to give retroactive effect to the share splits that we have conducted so far).

 

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

December 21, 2011(1)

     2,894,868         0.147         0.081         0.142           

December 21, 2011(1)

     1,085,575         0.147         0.071         0.142           

December 21, 2012(1)

     1,165,952         0.100         0.304         0.391         0.291   

December 21, 2012(1)

     1,925,048         0.100         0.302         0.391         0.291   

July 6, 2013(1)

     1,018,541         0.240         0.598         0.791         0.551   

July 6, 2013(1)

     2,410,283         0.240         0.586         0.791         0.551   

October 21, 2013(1)

     550,000         0.77         0.938         1.345         0.407   

October 21, 2013(1)

     90,000         0.77         0.825         1.345         0.520   

October 21, 2013(1)

     1,492,700         0.77         0.871         1.345         0.474   

 

Note:    (1)   Options with different vesting schedules and terms result in different fair values on the same issue date.

 

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We estimated the fair value of share options using the binominal option-pricing model with the assistance from an independent valuation firm. We are ultimately responsible for the determination of all amounts related to share-based compensation recorded in the financial statements. The fair value of each option grant was estimated on the date of grant with the following assumptions.

 

     December 21, 2011     December 21, 2012     July 6, 2013     October 21, 2013  

Expected volatility(1)

     55     58     58     62

Risk-free interest rate (per annum)(2)

     2.0     1.8     2.6     2.6

Exercise multiple(3)

     2.20-2.80        2.20-2.80        2.20        2.20-2.80   

Expected dividend yield(4)

     0.00     0.00     0.00     0.00

Expected term (in years)(5)

     10        10        10        10   

Expected forfeiture rate (post-vesting)(6)

     0.0%-10.0     0.0%-10.0     10.0     0.0%-10.0

 

Note:    (1)   We estimated expected volatility based on the annualized standard deviation of the daily return embedded in historical share prices of comparable companies with a time horizon close to the expected expiry of the term.
(2)   We estimated risk-free interest rate based on the yield to maturity of U.S. Treasury bonds with a maturity similar to the expected expiry of the term.
(3)   The exercise multiple is estimated as the ratio of fair value of underlying shares over the exercise price as at the time the option is exercised, based on a consideration of research study regarding exercise pattern based on historical statistical data.
(4)   Expected dividend yield, we have never declared or paid any cash dividends on our capital stock, and we do not anticipate any dividend payments on our ordinary shares in the foreseeable future.
(5)   Expected term is the contract life of the option.
(6)   Expected forfeiture rate (post-vesting): Estimated based on historical employee turnover rate after each option grant.

Restricted shares

In October 2013, we awarded 550,000 restricted shares under the 2013 Plan to an executive officer. The restricted shares were subject to transfer restrictions and to be vested over four years, one fourth of which shall vest upon the first anniversary of the date of grant and the remaining shall vest monthly thereafter in 36 equal monthly installments. In addition, the restricted shares are subject to repurchase by the Company at the fair market value of the shares at the date of repurchase.

Founders’ shares

In April 2011, Mr. Haozhi Chen, our founder, chairman and chief executive officer, and Mr. Guanqun Liu, our founder, director and chief operating officer, entered into an arrangement with our investor in conjunction with the issuance of Series A preferred shares, whereby all of their 45,000,000 ordinary shares became subject to transfer restrictions. In addition, such founders’ shares are subject to repurchase by us upon termination of their employment. The repurchase price is the par value of the ordinary shares. The founders’ shares were to be vested over four years, fifty percent of which shall vest and become exercisable upon the second anniversary of the date of grant and the remaining shall vest monthly thereafter in 24 equal monthly installments. In October 2013, our Board of Directors approved the acceleration of vesting schedule of the founders’ shares. As a result, all founders’ shares held by the two founders became fully-vested immediately and unrecognized compensation expenses amounting to RMB2.1 million were immediately recognized.

We accounted for these awards as employee share-based compensation awards using fair value of the ordinary shares on the grant date. The compensation expense is recognized on a straight-line basis over the requisite service period.

Determining the fair value of our ordinary shares required us to make complex and subjective judgments, assumptions and estimates, which involved inherent uncertainty. Had our management used different assumptions and estimates, the resulting fair value of our ordinary shares and the resulting share-based compensation expenses could have been different.

 

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Fair Value of Our Ordinary Shares

We are a private company with no quoted market prices for our ordinary shares. We have therefore needed to make estimates of the fair value of our ordinary shares at various dates for the purposes of (a) determining the fair value of our ordinary shares at the date of issuance of convertible instruments as one of the inputs into determining the intrinsic value of the beneficial conversion feature, if any; (b) determining the fair value of our ordinary shares at the date of the grant of a share-based compensation award to our employees and founders as one of the inputs into determining the grant date fair value of the award; and (c) determining the fair value of our Series A preferred shares warrants as of the issuance date and re-measurement dates as one of the inputs.

The following table sets forth the fair value of our ordinary shares estimated at different times with the assistance from an independent valuation firm.

 

Date

   Equity
Value
(US$’000)
    Fair Value
Per Share
(US$)
    DLOM     Discount
Rate
    Type of
Valuation
    

Purpose of

the Valuations

                                    (see above)

April 13, 2011

     2,600        0.02        24.0     38.0     Retrospective       (a), (b), (c)

August 18, 2011

     25,500        0.12        22.0     30.0     Retrospective       (a), (b)

December 21, 2011

     28,800        0.14        20.0     27.0     Retrospective       (b)

December 31, 2011

     28,800        0.14        20.0     27.0     Retrospective       (c)

August 28, 2012

     51,100        0.25        17.0     25.0     Retrospective       (a)

December 21, 2012

     87,800        0.39        17.0     25.0     Retrospective       (b)

December 31, 2012

     87,800        0.39        17.0     25.0     Retrospective       (c)

July 6, 2013

     145,800        0.79        14.0     20.5     Retrospective       (b)

September 30, 2013

     227,800        1.33        12.0     19.0     Retrospective       (c)

October 21, 2013

     282,300        1.35        12.0     19.0     Retrospective       (b)

December 31, 2013

     328,100        1.65        11.0     18.5     Retrospective       (c)

In determining the fair value of our ordinary shares, we relied in part on a valuation report retrospectively prepared by an independent valuer based on data we provided. The valuation report provided us with guidelines in determining the fair value, but the determination was made by our management. We obtained a retrospective valuation instead of a contemporaneous valuation by an unrelated valuation specialist because, prior to December 2013, our financial and limited human resources were principally focused on our product development efforts. We applied the income approach/ discounted cash flow, or DCF, analysis based on our projected cash flow using management’s best estimate as of the valuation date. The determination of the fair value of our ordinary shares requires complex and subjective judgments to be made regarding our projected financial and operating results, our unique business risks, the liquidity of our shares and our operating history and prospects at the time of valuation. The comparability of our peer companies’ financial metrics and the relevance of the market approach were also considered low since our target market and stage of development are different from those of the publicly-listed companies in the same industry. In view of the above, we determined that the income approach is the most appropriate method to derive the fair values of our ordinary shares. In addition, we took into consideration the guidance prescribed by the American Institute of Certified Public Accountants (AICPA) Audit and Accounting Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, or the Practice Aid.

The determination of the fair value of our ordinary shares requires complex and subjective judgments to be made regarding our projected financial and operating results, our unique business risks, the liquidity of our shares and our operating history and prospects at the time of valuation.

 

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The major assumptions used in calculating the fair value of ordinary shares include:

 

    Weighted average cost of capital, or WACC: WACCs of 38.0% to 18.5% were used for dates as of April 13, 2011 to December 31, 2013, respectively. The WACCs were determined based on a consideration of the factors including risk-free rate, comparative industry risk, equity risk premium, company size and non-systematic risk factors.

 

    Comparable companies: In deriving the WACCs, which are used as the discount rates under the income approach, five overseas-listed companies in China mobile games industry and five publicly traded companies in the global mobile games industry were selected for reference as our guideline companies.

 

    Discount for lack of marketability, or DLOM: DLOM was quantified by Finnerty’s (2012) Average-Strike Put Option model. This option pricing method is one of the methods commonly used in estimating DLOM as it can take into consideration factors like the length of holding period restriction and the estimated volatility of our shares. The farther the valuation date is from an expected liquidity event, the higher the put option value and thus the higher the implied DLOM. The lower DLOM is used for the valuation, the higher is the determined fair value of the ordinary shares. DLOM remained in the range of 24.0% to 11.0% in the period from April 13, 2011 to December 31, 2013.

The income approach involves applying appropriate discount rates to estimated cash flows that are based on earnings forecasts. Our revenues and earnings growth rates, as well as major milestones that we have achieved, contributed significantly to the increase in the fair value of our ordinary shares from US$0.02 (after adjustment for later 1:50 share split) as of April 13, 2011 to US$1.65 as of December 31, 2013. However, these fair values are inherently uncertain and highly subjective. The assumptions used in deriving the fair values are consistent with our business plan. These assumptions include: no material changes in the existing political, legal and economic conditions in China; our ability to retain competent management, key personnel and staff to support our ongoing operations; and no material deviation in market conditions from economic forecasts. These assumptions are inherently uncertain. The risks associated with achieving our forecasts were assessed in selecting the appropriate discount rates, which ranged from 38.0% to 18.5%.

 

    The option-pricing method was used to allocate enterprise value to preferred and ordinary shares, taking into account the guidance prescribed by the Practice Aid.

 

    The option-pricing method involves making estimates of the anticipated timing of a potential liquidity event, such as a sale of our company or an initial public offering, and estimates of the volatility of our equity securities. The anticipated timing is based on the plans of our board of directors and management. Estimating the volatility of the share price of a privately held company is complex because there is no readily available market for the shares. We estimated the volatility of our shares based on the historical volatilities of comparable publicly traded companies engaged in similar lines of business. Had we used different estimates of volatility, the allocations between preference and ordinary shares would have been different.

The determined fair value of the ordinary shares increased from US$0.02 (after adjustment for later 1:50 share split) per share as of April 13, 2011 to US$0.14 per share as of December 31, 2011. We believe the change in the fair value of ordinary shares is primarily attributable to the following:

 

    our game Fishing Joy I was launched in 2011 and quickly won popularity, hence we experienced rapid growth in revenues in 2011;

 

    the funding through the issuance of Series A preferred shares in April 2011 and subsequent Series B preferred shares in August 2011 provided the financial resources required for accelerating the growth of our business;

 

   

as our launched games were successful, the technological risk and commercial risk of our business decreased; with the funding from two rounds of preferred shares financing, we were in a better position

 

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to withstand unexpected economic changes; accordingly, the discount rate used for valuation of our company’s shares decreased from 38.0% for the April 13, 2011 valuation to 27.0% for the December 31, 2011 valuation; and

 

    DLOM used for valuation decreased from 24.0% for the April 13, 2011 valuation to 20.0% for the December 31, 2011 valuation.

The determined fair value of the ordinary shares increased from US$0.14 per share as of December 31, 2011 to US$0.39 per share as of December 31, 2012. We believe the change in the fair value of ordinary shares is primarily attributable to the following:

 

    our game Fishing Joy I won tremendous success in 2012 and we experienced rapid growth in revenues from approximately RMB8.7 million in 2011 to RMB76.5 million in 2012;

 

    we completed Series C preferred shares financing in August 2012, which signified the recognition of our business model by and the confidence of the investment community on our business;

 

    the growth of our business and the completion of Series C preferred shares financing reduced the perceived risk of realizing the financial forecast going forward and thus, the discount rate used for valuation of our company’s shares decreased from 27.0% for the December 31, 2011 valuation to 25.0% for the December 31, 2012 valuation; and

 

    DLOM used for valuation decreased from 20.0% for the December 31, 2011 valuation to 17.0% for the December 31, 2012 valuation.

The determined fair value of the ordinary shares increased from US$0.39 per share as of December 31, 2012 to US$1.65 per share as of December 31, 2013. We believe the change in the fair value of ordinary shares is primarily attributable to the following:

 

    we experienced rapid growth in net revenues that our net revenue increased from RMB76.5 million in 2012 to RMB554.8 million in 2013;

 

    we completed a Series D preferred shares financing in October 2013, which attested the recognition of our business model by the investment community and the investors’ confidence on our business. The funding through the issuance of Series D preferred shares provided the financial resources required for accelerating the growth of our business;

 

    due to the increased marketability of our common equity as a result of this pending offering, DLOM decreased from 17.0% for the December 31, 2012 valuation to 11.0% for the December 31, 2013 valuation; and

 

    the actual performance in the 2013 reduced the perceived risk of realizing the financial forecast going forward and thus, the discount rate used for valuation of our company’s shares decreased from 25% for the December 31, 2012 valuation to 18.5% for the December 31, 2013 valuation.

Fair value of our Preferred Shares

In addition to our ordinary shares, we have also determined the fair value of the preferred shares with the assistance of an independent valuation firm, the result of which is used to determine the amount of redemption values as well as the fair value of our Series A preferred shares warrants. Consistent with ordinary shares discussed above, the determination of the fair value of our preferred shares requires complex and subjective judgments to be made regarding our projected financial and operating results, our unique business risks, the liquidity of these shares and our operating history and prospects at the time of valuation.

 

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Warrants

In connection with the issuance of our Series A preferred shares, we issued Series A warrants to Series A preferred shares investors. The Series A warrants were determined to be free standing financial instruments required to be measured at fair value since the underlying instruments, the Series A preferred shares, are redeemable instruments and therefore the warrants held by the holder is required to be classified as a liability and was initially recognized at the fair value. The Series A warrants were exercised on December 23, 2013.

The following table sets forth certain information regarding the Series A warrants on the dates indicated:

 

Date of Valuation

   No. of Warrants      Fair Value per Warrant      Type of Valuation  

April 13, 2011

     3,571,450       US$ 0.03           Retrospective   

December 31, 2011

     3,571,450       US$ 0.157         Retrospective   

December 31, 2012

     3,571,450       US$ 0.441         Retrospective   

December 23, 2013*

     3,571,450       US$ 1.803         Retrospective   

 

* On December 23, 2013, the holder of our Series A Warrants exercised the warrants to purchase 3,571,450 shares of Series A Preferred Shares.

In determining the value of the Series A warrants, we have used the binomial option-pricing model. Under this pricing model, certain assumptions, including the risk-free interest rate, the contractual term of the Series A warrants, the expected dividends of our equity securities, and the expected volatility of our equity securities for the contractual term of the Series A warrants are required in order to determine the fair value of the Series A warrants. Changes in these assumptions could significantly affect the fair value of the Series A warrants and, therefore, the amount we recognize in our consolidated financial statements. The key assumptions used in valuation of the warrants are summarized in the following table:

 

     As of
April 13,
2011
    As of
December 31,
2011
    As of
December 31,
2012
    As of
December 23,
2013
 

Risk-free rate of return

     1.3     0.3     0.2     0.1

Remaining contractual life of the warrants (years)

     3.0        2.3        1.3        0.3   

Volatility

     56     53     51     55

Expected dividend yield

                            

With respect to the valuation of the Series A warrants, the risk-free rate of return is based on the yield curve of U.S. Treasury bonds as of the valuation dates; the contractual term of the Series A warrants was estimated based on expiration date of the warrants; expected volatility is estimated on daily stock prices of guideline companies; and the expected dividend yield is based on our target paid-out ratio.

The fair value per Series A warrant changed from US$0.03 (after adjustment for 1:50 share split) as of April 13, 2011 to US$1.80 as of December 31, 2013. This was due in large part to the increase in fair value of Series A preferred shares from US$0.08 (after adjustment for 1:50 share split) per share to US$1.90 per share. The main reason for the increase in fair value of the Series A warrants is due to the increase in the fair value of the Series A preferred shares, and the reasons for increase in fair value of the Series A preferred shares are the same as the reasons for the increase in fair value of our ordinary shares as explained under the section “Fair Value of Our Ordinary Shares” above.

Prepaid Licensor Royalties

Our royalty expenses consist of fees that we pay to content owners for the use of their intellectual property, primarily developed games. Royalty-based obligations are either paid in advance and capitalized on the balance sheet as prepaid royalties or accrued as incurred and subsequently paid. These royalty-based obligations are

 

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expensed to cost of revenues at the greater of the revenues derived from the relevant game multiplied by the applicable contractual rate or an effective royalty rate based on expected game revenues.

On quarterly basis, we evaluate the realization of our prepaid royalties to determine amounts that we deem unlikely to be realized through mobile games. We use estimates of revenues, cash flows and net margins to evaluate the future realization of prepaid royalties. This evaluation considers multiple factors, including the term of the agreement, forecasted demand, game life cycle status, game development plans, and current and anticipated sales levels, as well as other qualitative factors such as the success of similar games and similar genres on mobile devices for us and our competitors. To the extent that this evaluation indicates that the remaining prepaid royalty payments are not recoverable, we record an impairment charge to cost of revenues in the period that impairment is indicated. We recorded impairment charges to cost of revenues of RMB0, RMB2.5 million and RMB8.7 million (US$1.4 million) during the years ended December 31, 2011, 2012 and 2013, respectively.

Impairment of long-lived assets

The carrying amounts of long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of assets to future undiscounted net cash flows expected to be generated by the assets. Such assets are considered to be impaired if the sum of the expected undiscounted cash flow is less than the carrying amount of the assets. The impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. We recorded no impairment charges related to the long-lived assets in 2011 and 2012; impairment charges related to certain licensed game software recognized for the year ended December 31, 2013 were RMB3.6 million (US$0.6 million).

Goodwill

Goodwill represents the excess of the purchase price over the fair value of the identifiable assets and liabilities acquired in a business combination.

Goodwill is not depreciated or amortized but is tested for impairment on an annual basis as of December 31, and in between annual tests when an event occurs or circumstances change that could indicate that the asset might be impaired. In accordance with the FASB guidance on “Testing of Goodwill for Impairment,” a company first has the option to assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If the company decides, as a result of its qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is mandatory. Otherwise, no further testing is required. The quantitative impairment test consists of a comparison of the fair value of each reporting unit with its carrying amount, including goodwill. If the carrying amount of each reporting unit exceeds its fair value, an impairment charge equal to the difference between the implied fair value of the reporting unit’s goodwill and the carrying amount of goodwill will be recorded. Application of a goodwill impairment test requires significant management judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. The judgment in estimating the fair value of reporting units includes estimating future cash flows, determining appropriate discount rates and making other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for each reporting unit. No impairment of goodwill was recognized for years ended December 31, 2011, 2012 and 2013.

 

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Major Components of Our Results of Operations

Revenues

The following table sets forth our revenues derived from mobile games and online advertising, both in absolute amounts and as a percentage of our total revenues, for the periods indicated.

 

    For the Year Ended December 31,  
    2011     2012     2013  
    RMB     %     RMB     %     RMB     US$     %  
    (in thousands)  

Revenues:

             

Mobile games

    7,143        82.3     69,506        90.8     546,612        90,294        98.5

Online advertising

    1,540        17.7     7,027        9.2     8,153        1,347        1.5
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

    8,683        100.0     76,533        100.0     554,765        91,641        100.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Mobile Game Revenues

Revenues from our mobile games were RMB7.1 million, RMB69.5 million and RMB546.6 million (US$90.3 million) in 2011, 2012 and 2013, respectively, accounting for 82.3%, 90.8% and 98.5% of our total revenues in the respective periods.

Revenues from our mobile games are primarily driven by our ability to successfully launch new games and effectively monetize both self-developed and licensed games. Revenues generated from our self-developed games represented 82.3%, 63.2% and 73.5% of our total revenues in 2011, 2012 and 2013, respectively. Revenues generated from licensed games represented 0%, 25.3% and 25.0% of our total revenues in 2011, 2012 and 2013, respectively.

We also use mobile game gross billing as an important non-GAAP top-line metric to evaluate our operating performance relating to our mobile games, which represents the total amount paid by our players, excluding doubtful accounts. The following table sets forth our mobile game gross billing for the periods indicated, as well as the reconciliation of mobile game gross billing to revenues from mobile games:

 

     For the Year Ended December 31,  
     2011      2012     2013  
     RMB      RMB     RMB     US$  
    

(in thousands)

 

Mobile game gross billing

     7,143         75,955        756,769        125,009   

Less: revenue sharing(1)

             (5,284     (173,092     (28,593

Less: deferred revenues

             (2,902     (37,427     (6,182

Plus: other game related revenues(2)

             1,737        362        60   
  

 

 

    

 

 

   

 

 

   

 

 

 

Revenues from mobile games

     7,143         69,506        546,612        90,294   
  

 

 

    

 

 

   

 

 

   

 

 

 

 

Note:    (1)   Include content fees paid to game developers, distribution fees paid to distribution channels and commission fees paid to payment channels for the licensed game revenues that we recognize on a net basis.
    (2)   Mobile game development related revenues.

See also “Prospectus Summary—Summary Consolidated Financial Data—Non-GAAP Financial Measures.” The difference between mobile game gross billing and mobile game revenues is primarily due to our revenue recognition of certain licensed games on a net basis, and to a less extent, due to deferred revenues and other game related revenues. For some licensed games, our key responsibilities are to publish them and provide payment solutions and game operating advices, and the game developers will then handle the game operations and related

 

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matters. Therefore, we view the game developers to be our customers and consider ourselves as the agent in the arrangement. Accordingly, we record mobile game revenues from these third-party licensed games, net of the predetermined revenue sharing with the game developers, as well as the revenue shared with distribution channels and payment channels, upon the provision of service. In addition, with respect to the in-game purchases made by the player to gain an enhanced game-playing experience where we will provide continuous mobile game services, we recognize the revenues ratably over the estimated average playing period of the paying players, which result in deferred revenues.

Online Advertising Revenues

We derive advertising revenues primarily from sales of different forms of advertisements. Our online advertising revenues were RMB1.5 million, RMB7.0 million and RMB8.2 million (US$1.3 million) in 2011, 2012 and 2013, respectively. With the growth of our player base and the expansion of fast mobile internet network in China, we plan to strengthen our online advertising endeavors and grow our advertising revenues.

Cost of Revenues

Our cost of revenues primarily consists of (i) distribution fees paid to distribution channels for distributing mobile games, (ii) commission fees paid to payment channels for processing game players payments, (iii) content fees paid to third-party game developers for licensing their games, and (iv) rental, depreciation and amortization and other costs. For third-party licensed games where we act as a publishing agent, we record revenues net of pre-determined revenue sharing with game developers, payment channels and distribution channels, which therefore are not recorded as cost of revenues.

In 2011, 2012 and 2013, our cost of revenues was RMB3.4 million, RMB36.7 million and RMB298.1 million (US$49.2 million), respectively, accounting for 39.4%, 48.0% and 53.7% of our total revenues for the respective periods. We expect that our cost of revenues to continue to increase in absolute amount as we develop and publish more games in the future.

Commission Fees

Commission fees represent fees paid to payment channels for processing payments. Commission fees as a percentage of our total revenue was 0%, 18.4% and 22.3% in 2011, 2012 and 2013, respectively. We expect that going forward, commission fees will continue to increase in absolute amount as we publish more self-developed and licensed games.

Distribution Fees

Distribution fees represent our payments to distribution channels to distribute our self-developed and licensed games. Distribution fees as a percentage of our total revenue was 24.9%, 14.0% and 19.0% in 2011, 2012 and 2013, respectively. We expect that going forward, distribution fees will continue to increase in absolute amount due to the increasing importance of distribution channels in the mobile game business in China and the corresponding increase of their bargaining powers.

Content Fees

Content fees represent the license fees and royalties paid to third-party game developers for licensing their games and the content fees paid to third parties for using their intellectual properties. Content fees as a percentage of our total revenue was 0%, 5.4% and 3.3% in 2011, 2012 and 2013, respectively. We expect that going forward, content fees will increase in absolute amount as we publish more licensed games.

 

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Operating Expenses

Our operating expenses comprise of selling and marketing expenses, research and development expenses and general and administrative expenses. The following table sets forth the components of our operating expenses for the respective periods presented.

 

     For the Year Ended December 31,  
     2011      2012      2013  
     RMB      RMB      RMB      US$  
     (in thousands)  

Operating expenses:

           

Selling and marketing expenses

     12,849         37,740         149,039         24,619   

Research and development expenses

     12,065         38,922         105,193         17,377   

General and administrative expenses

     6,344         14,655         56,230         9,289   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total operating expenses

     31,258         91,317         310,462         51,285   
  

 

 

    

 

 

    

 

 

    

 

 

 

Selling and Marketing Expenses

Our selling and marketing expenses were RMB12.8 million, RMB37.7 million and RMB149.0 million (US$24.6 million) in 2011, 2012 and 2013, respectively, accounting for 148.0%, 49.3% and 26.9% of our total revenues for the respective periods.

Our selling and marketing expenses primarily consist of expenses we incurred in placing online advertisements, search engine marketing, as well as TV and subway advertisements in order to promote our games and enhance the recognition of our corporate brand. We expect that our selling and marketing expenses will continue to increase in absolute amount as we continue to promote our games and enhance our brand awareness. In addition, to optimize the monetization potential for each game, we manage our selling and marketing expenses according to our game launch schedule, which may affect our profitability from time to time.

Research and Development Expenses

Our research and development expenses were RMB12.1 million, RMB38.9 million and RMB105.2 million (US$17.4 million) in 2011, 2012 and 2013, respectively, accounting for 138.9%, 50.9% and 19.0% of our total revenues for the respective periods.

Our research and development expenses include payroll expenses, rental, share-based compensation, depreciation, and outsourced technical service fees associated with game, engine and platform development. In particular, the number of our employees engaged in research and development increased from 82 as of December 31, 2011 to 206 as of December 31, 2012, and to 444 as of December 31, 2013. We expect our research and development expenses will continue to increase in absolute amount as we continue to strengthen our research and development function, but such increase will be partially offset by our increasing economies of scale.

General and Administrative Expenses

Our general and administrative expenses were RMB6.3 million, RMB14.7 million and RMB56.2 million (US$9.3 million) in 2011, 2012 and 2013, respectively, accounting for 73.1%, 19.1% and 10.1% of our total revenues for the respective periods.

Our general and administrative expenses primarily include salaries and benefits for our general management staff and staff not specifically dedicated to game operations or game development, share-based compensation applicable to such staff, depreciation and amortization, professional fees and other expenses. In particular, the number of our employees engaged in general and administrative function increased from 10 as of December 31,

 

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2011 to 30 as of December 31, 2012, and to 91 as of December 31, 2013. We expect that our general and administrative expenses to continue to increase in absolute amount.

Share-Based Compensation Expenses

Our cost of revenues and our operating expenses include share-based compensation expenses. Share-based compensation expenses are recorded in the financial statement line-item corresponding to the nature of services provided by the grantees. The following table sets forth the allocation of our share-based compensation expenses both in absolute amounts and as a percentage of our total revenues.

 

     For the Year Ended
December 31,
 
     2011     2012     2013  
     RMB      %     RMB      %     RMB      US$      %  
     (in thousands)  

Allocation of share-based compensation expenses:

                  

Cost of revenues

                                                     

Selling and marketing

     3         0.0     98         0.1     1,080         178         0.2

Research and development

     4         0.0     166         0.2     3,020         499         0.5

General and administrative

     1,001         11.5     1,575         2.1     4,382         724         0.8
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total share-based compensation expense

     1,008         11.6     1,839         2.4     8,482         1,401         1.5
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Internal Control over Financial Reporting

Prior to this offering, we were a private company with limited accounting personnel and other resources with which to address our internal controls and procedures. Our independent registered public accounting firm has not conducted an audit of our internal control over financial reporting. However, in connection with the audit of our consolidated financial statements as of and for the year ended December 31, 2013, we and our independent registered public accounting firm identified a “material weakness” in our internal control over financial reporting as defined in the standards established by PCAOB. Pursuant to PCAOB standards, 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 on a timely basis. The material weakness identified related to lack of sufficient financial reporting and accounting personnel with appropriate knowledge of U.S. GAAP and SEC reporting requirements to formalize key controls over financial reporting and to prepare consolidated financial statements and related disclosures. We have taken the following remedial measures to improve our internal control over financial reporting: (i) in August 2013, we hired a chief financial officer with more than 30 years’ experience in finance and accounting management both in the United States and China, who is also a certified public accountant in the state of Texas, U.S.; (ii) in October 2013, we hired a financial controller, who is a PRC certified public accountant with more than 15 years of work experience, including nine years of work experience with one of the “big four” accounting firms; and (iii) we also hired one additional staff for our U.S. GAAP reporting team, with six years of “big four” accounting firm experience and allocated more staff resources to our U.S. GAAP reporting team during the reporting period in 2013; and (iv) in December 2013, we implemented a new financial software that improves visibility of data, journal entries and to formalize closing and reporting process controls.

We plan to take additional measures to improve our internal controls over financial reporting, including: (i) further expediting and streamlining the reporting process; (ii) developing compliance process, including a comprehensive policy and procedure manual, to allow early detection, prevention and resolution of potential compliance issues; (iii) conducting regular and continuous U.S. GAAP accounting and financial reporting training programs for our accounting and financial reporting personnel, including sending our financial staff to attend external U.S. GAAP training courses; (iv) hiring more resources to strengthen the financial reporting

 

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function and to set up financial and system control framework; and (v) engaging an external consulting firm to assist us in developing processes and procedures to comply with Sarbanes-Oxley Act. However, the implementation of these measures may not fully address these deficiencies in our internal control over financial reporting, and we cannot conclude that they have been fully remedied. Our failure to correct these control deficiencies or our failure to discover and address any other control deficiencies could result in inaccuracies in our financial statements and could also impair our ability to comply with applicable financial reporting requirements and related regulatory filings on a timely basis. As a result, our business, financial condition, results of operations and prospects, as well as the trading price of our ADSs, may be materially and adversely affected. Moreover, ineffective internal control over financial reporting significantly hinders our ability to prevent fraud.

Furthermore, it is possible that, had our independent registered public accounting firm conducted an audit of our internal control over financial reporting, such firm might have identified additional material weaknesses and deficiencies. Upon completion of this offering, we will become subject to Section 404 of the Sarbanes-Oxley Act of 2002, or Section 404, which requires 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, 2015. In addition, once we cease to be an “emerging growth company” as such term is defined in the JOBS Act, our independent registered public accounting firm must attest to and report on the effectiveness of our internal control over financial reporting. Our management may conclude that our internal control over financial reporting is not effective. Moreover, even if our management concludes that our internal control over financial reporting is effective, our independent registered public accounting firm, after conducting its own independent testing, may issue a report that is qualified if it is not satisfied with our internal controls or the level at which our controls are documented, designed, operated or reviewed, or if it interprets the relevant requirements differently from us. In addition, after we become a public company, our reporting obligations may place a significant strain on our management, operational and financial resources and systems for the foreseeable future. We may not be able to complete our evaluation testing and any required remediation in a timely manner.

During the course of documenting and testing our internal control procedures, in order to satisfy the requirements of Section 404, we may identify other weaknesses and deficiencies in our internal control over financial reporting. In addition, if we fail to maintain the adequacy of our internal control over financial reporting, as these standards are modified, supplemented or amended from time to time, we may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with Section 404. If we fail to achieve and maintain an effective internal control environment, we could suffer material misstatements in our financial statements and fail to meet our reporting obligations, which would likely cause investors to lose confidence in our reported financial information. This could in turn limit our access to capital markets, harm our results of operations, and lead to a decline in the trading price of our ADSs. Additionally, ineffective internal control over financial reporting could expose us to increased risk of fraud or misuse of corporate assets and subject us to delisting from the stock exchange on which we list, regulatory investigations and civil or criminal sanctions. We may also be required to restate our financial statements from prior periods. See “Risk Factors—Risks Related to Our Business and Industry—We and our independent registered public accounting firm have identified material weaknesses in our internal control over financial reporting. If we fail to maintain an effective system of internal control over financial reporting, our ability to accurately and timely report our financial results or prevent fraud may be adversely affected, and investor confidence and the market price of our ADSs may be adversely impacted.”

Taxation

Cayman Islands

We have been incorporated under the laws of the Cayman Islands as an exempted company with limited liability and, as such, plan to obtain an undertaking from the Governor of the Cayman Islands that no law enacted in the Cayman Islands during the period of 20 years from the date of the undertaking, imposing any tax to be levied on profits, income, gains or appreciation shall apply to us or our operations and no such tax or any tax in

 

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the nature of estate duty or inheritance tax shall be payable (directly or by way of withholding) on ordinary shares, debentures or other obligations of ours. There are no exchange control regulations or currency restrictions in the Cayman Islands.

United States

PunchBox USA Inc. is generally subject to corporate income tax rates ranging from 15% to 35% at the federal level and, in some instances, is also subject to tax at the state level. PunchBox USA Inc. has incurred net accumulated operating losses for income tax purpose.

Hong Kong

Entities incorporated in Hong Kong are subject to Hong Kong profit tax at a rate of 16.5% since January 1, 2010. The operations in Hong Kong have incurred net accumulated operating losses for income tax purposes.

PRC

Our subsidiaries and our consolidated affiliated entities that are incorporated in China are subject to a value-added tax on revenues generated from providing services and related surcharges by various local tax authorities. Prior to January 1, 2012, pursuant to Provisional Regulation of China on Business Tax and its implementing rules, any entity or individual rendering services in the territory of PRC was generally subject to a business tax at the rate of 5% on the revenues generated from provision of such services. Our PRC subsidiary and consolidated affiliated entities were subject to business tax at the rate of 5% for the mobile game and online advertising services. Since January 1, 2012, the PRC Ministry of Finance and the State Administration of Taxation have been implementing a Business Tax to Value-Added Tax Transformation Pilot Program, or the Pilot Program, which imposes VAT in lieu of business tax for certain industries in Shanghai. On August 1, 2013, all regions in China have launched the pilot program. VAT is or will be applicable at a rate of 6% in lieu of business tax for the mobile game and online advertising services rendered by our PRC subsidiary and consolidated affiliated entities after the Pilot Program is implemented in their respective region. VAT payable on goods sold or taxable services provided by a general VAT taxpayer for a taxable period is the net balance of the output VAT for the period after crediting the input VAT for the period. Hence, the amount of VAT payable does not result directly from output VAT generated from goods sold or taxable services provided. Our value-added/business tax and related surcharges are primarily levied based on revenues at rates ranging from 3.4% to 6.7%, depending upon which legal entity generates the revenues, and are recorded as cost of revenues. Value-added/business tax and related surcharges of RMB0.4 million, RMB2.3 million and RMB21.0 million (US$3.5 million) were included in our cost of revenues for the years ended December 31, 2011, 2012 and 2013, respectively.

The EIT Law also provides that an enterprise established under the laws of a foreign country or region but whose “de facto management body” is located in the PRC be treated as a resident enterprise for PRC tax purposes and consequently be subject to the PRC income tax at the rate of 25% for its global income. The implementing rules of the EIT Law merely define the location of the “de facto management body” as “the place where the exercising, in substance, of the overall management and control of the production and business operation, personnel, accounting, properties, etc., of a non-PRC company is located.” Based on a review of surrounding facts and circumstances, Chukong does not believe that it is likely that its operations outside of the PRC should be considered a resident enterprise for PRC tax purposes.

The EIT Law also imposes a withholding income tax of 10% on dividends distributed by an FIE to its immediate holding company outside of China, if such immediate holding company is considered as a non-resident enterprise without any establishment or place within China or if the received dividends have no connection with the establishment or place of such immediate holding company within China, unless such immediate holding company’s jurisdiction of incorporation has a tax treaty with China that provides for a different withholding arrangement. The Cayman Islands, where our Company is incorporated, does not have such

 

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tax treaty with China. According to the arrangement between Mainland China and Hong Kong Special Administrative Region on the Avoidance of Double Taxation and Prevention of Fiscal Evasion in August 2006, dividends paid by an FIE in China to its immediate holding company in Hong Kong will be subject to withholding tax at a rate of no more than 5% (if the foreign investor owns directly at least 25% of the shares of the FIE).

Results of Operations

The following table sets forth, for the periods indicated, certain consolidated statements of operations data. Our business has experienced rapid growth over a short period of time. We expect our growth to continue as we grow our user base and explore a more effective monetization model. However, due to our limited operating history, our historical growth rate may not be indicative of our future performance. Therefore, you should not rely on the following period-to-period comparison of our results of operation as indicative of future performance.

 

     For the Year Ended December 31,  
     2011     2012     2013  
     RMB     RMB     (RMB)     (US$)  
     (in thousands)  

Revenues:

        

Mobile games

     7,143        69,506        546,612        90,294   

Online advertising

     1,540        7,027        8,153        1,347   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

     8,683        76,533        554,765        91,641   

Cost of revenues

     3,424        36,746        298,085        49,241   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     5,259        39,787        256,680        42,400   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating expenses:

        

Sales and marketing expenses

     12,849        37,740        149,039        24,619   

Research and development expenses

     12,065        38,922        105,193        17,377   

General and administrative expenses

     6,344        14,655        56,230        9,289   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     31,258        91,317        310,462        51,285   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating loss

     (25,999     (51,530     (53,782     (8,885

Loss before income taxes

     (28,864     (52,124     (87,658     (14,480

Income tax (expenses)/benefits

            15        (648     (108
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

     (28,864     (52,109     (88,306     (14,588

Year Ended December 31, 2013 Compared to Year Ended December 31, 2012

Revenues. Our total revenues increased from RMB76.5 million in 2012 to RMB554.8 million (US$91.6 million) in 2013 primarily due to an increase in revenues from mobile games.

 

    Mobile games revenues. Revenues generated from mobile games increased from RMB69.5 million in 2012 to RMB546.6 million (US$90.3 million) in 2013, due to an increase in revenues from both self-developed games and licensed games. Revenues generated from our self-developed games increased from RMB48.4 million in 2012 to RMB407.7 million (US$67.3 million) in 2013. This increase was primarily due to the success of our Fishing Joy Series games. Revenues generated from licensed games increased from RMB19.4 million in 2012 to RMB138.7 million (US$22.9 million) in 2013. This increase was primarily because we published more high-quality licensed games, such as I am MT Online and Space Hunter.

 

    Online advertising revenues. Revenues generated from online advertising increased from RMB7.0 million in 2012 to RMB8.2 million (US$1.3 million) in 2013, due to our increased ability to monetize our large user base by selling advertising space to other advertisers.

 

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Cost of Revenues. Our cost of revenues increased from RMB36.7 million in 2012 to RMB298.1 million (US$49.2 million) in 2013. Our cost of revenues as a percentage of revenues increased from 48.0% in the 2012 to 53.7% in 2013. This increase was primarily due to increases in our distribution fees, commission fees and content fees for game revenues that were recognized on a gross basis.

 

    Commission fees. Commission fees increased from RMB14.1 million in 2012 to RMB123.6 million (US$20.4 million) in 2013, primarily because we used more payment channels to process payments from game players. The increase was also due to the fact that more payments were processed through carriers, and mobile carriers charged higher commission fees.

 

    Distribution fees. Distribution fees increased from RMB10.7 million in 2012 to RMB105.3 million (US$17.4 million) in 2013, primarily because increased revenue sharing with distribution channels for games that were distributed through application stores.

 

    Content fees. Content fees increased from RMB4.1 million in 2012 to RMB18.3 million (US$3.0 million) in 2013, primarily because we generated more revenues from licensed games that were recognized on a gross basis.

Gross Profit. Our gross profit increased from RMB39.8 million in 2012 to RMB256.7 million (US$42.4 million) in 2013. Our gross margin decreased from 52.0% in 2012 to 46.3% in 2013 because we used more Android channels to distribute our games, which charge higher distribution fees than the iOS platform, and mobile carriers to process payments from users, which increased our commission fees.

Operating Expenses. Our operating expenses increased by 240.1% from RMB91.3 million in 2012 to RMB310.5 million (US$51.3 million) in 2013. This increase was due to increases in our research and development expenses, sales and marketing expenses and general and administrative expenses.

 

    Sales and Marketing Expenses. Our sales and marketing expenses increased from RMB37.7 million in 2012 to RMB149.0 million (US$24.6 million) in 2013, primarily due to an increase in advertisement and promotional expenses of RMB81.1 million and an increase in staff expense of RMB19.1 million as a result of our efforts to promote our games and our corporate brand.

 

    Research and Development Expenses. Our research and development expenses increased from RMB38.9 million in 2012 to RMB105.2 million (US$17.4 million) in 2013, primarily due to an increase in staff expense of RMB55.5 million as the number of our employees engaged in research and development increased from 206 as of December 31, 2012 to 444 as of December 31, 2013, an increase in technical services expenses of RMB2.1 million, and an increase in share-based compensation expense of RMB2.9 million as we strengthened our research and development function, including maintaining the open-source engines.

 

    General and Administrative Expenses. Our general and administrative expenses increased from RMB14.7 million in 2012 to RMB56.2 million (US$9.3 million) in 2013, primarily due to an increase in staff expense of RMB16.0 million as the number of our employees engaged in general and administrative function increased from 30 as of December 31, 2012 to 91 as of December 31, 2013, an increase in professional fees of RMB8.0 million, and an increase in travel and meeting expense of RMB3.1 million.

Net Loss. As a result of the above, we recorded a net loss of RMB52.1 million in 2012 and a net loss of RMB88.3 million (US$14.6 million) in 2013, respectively.

 

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Year Ended December 31, 2012 Compared to Year Ended December 31, 2011

Revenues. Our revenues increased from RMB8.7 million in 2011 to RMB76.5 million in 2012 as a result of an increase of revenues generated from mobile games as well as an increase of our online advertising revenues.

 

    Mobile games revenues. Revenues generated from mobile games increased from RMB7.1 million in 2011 to RMB69.5 million in 2012 due to increase in revenues from both self-developed and licensed games. Revenues generated from our self-developed games increased from RMB7.1 million in 2011 to RMB48.4 million in 2012 due to the success of our Fishing Joy series. Revenues generated from licensed games increased from nil in 2011 to RMB19.4 million in 2012, accounting for nil and 25.3% of our total revenues for the respective periods as we began publishing licensed games.

 

    Online advertising revenues. Revenues generated from online advertising increased from RMB1.5 million in 2011 to RMB7.0 million in 2012 due to our increased ability to monetize our large user base by selling advertising space to other advertisers.

Cost of Revenues. Our cost of revenues increased from RMB3.4 million in 2011 to RMB36.7 million in 2012. This increase was primarily due to significant increases in commission fees, distribution fees and content fees for game revenues that were recognized on a gross basis.

 

    Distribution fees. Distribution fees increased from RMB2.2 million in 2011 to RMB10.7 million in 2012, primarily because of increased revenue sharing with distribution channels.

 

    Commission fees. Commission fees increased from nil in 2011 to RMB14.1 million in 2012 as we started to use payment channels for processing payments from game players in line with our revenue growth.

 

    Content fees. Content fees increased from RMB0 in 2011 to RMB4.1 million in 2012, primarily because we started to publish licensed games in 2012.

Gross Profit. Our gross profit increased from RMB5.3 million in 2011 to RMB39.8 million in 2012. Our gross margin decreased from 60.6% in 2011 to 52.0% in 2012, primarily due to an increase in cost of revenues as a result of an increase in payment efficiency as we used mobile carriers to process more payments from game players and the growth of our publishing business where revenues were recognized on a gross basis.

Operating Expenses. Our operating expenses increased by 191.7% from RMB31.3 million in 2011 to RMB91.3 million in 2012. This increase was due to increases in our research and development expenses, sales and marketing expenses and general and administrative expenses as our business grew.

 

    Sales and Marketing Expenses. Our sales and marketing expenses increased from RMB12.8 million in 2011 to RMB37.7 million in 2012, primarily due to an increase in staff expenses of RMB13.8 million, an increase in advertisement and promotion expenses of RMB7.2 million, and an increase in rental expenses of RMB1.6 million.

 

    Research and Development Expenses. Our research and development expenses increased from RMB12.0 million in 2011 to RMB38.9 million in 2012, primarily due to an increase in staff expenses of RMB18.9 million as the number of our employees engaged in research and development increased from 82 as of December 31, 2011 to 206 as of December 31, 2012, and to a lesser extent, due to an increase in technical service expenses of RMB3.9 million and an increase in rental expenses of RMB1.3 million. The increase in our research and development expenses was a result of our experts to develop new games and upgrade our engines.

 

    General and Administrative Expenses. Our general and administrative expenses increased by 131.0% from RMB6.3 million in 2011 to RMB14.7 million in 2012, primarily due to an increase in staff expenses of RMB5.1 million as the number of our employees engaged in general and administrative function increased from 10 as of December 31, 2011 to 30 as of December 31, 2012, an increase in professional fees of RMB1.1 million and an increase in share-based compensation of RMB0.6 million.

 

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Net Loss. As a result of the above, we recorded a net loss of RMB28.9 million in 2011 and RMB52.1 million in 2012, respectively.

Selected Quarterly Results of Operations

The following table sets forth our unaudited consolidated selected quarterly results of operations for the quarters ended March 31, June 30, September 30 and December 31, 2013. This financial information has been prepared on the same basis as the audited consolidated financial statements included in this prospectus and, in the opinion of management, include all adjustments, consisting only of normal recurring adjustments, necessary for the fair statement of the consolidated results of operations for these periods. You should read the following table in conjunction with our audited consolidated financial statements and related notes included elsewhere in this prospectus. The operating results for any quarter are not necessarily indicative of the operating results for any future period or for a full year. For factors that may cause our revenue and operating results to vary or fluctuate, please see “Risk Factors—Risks Related to Our Business.”

 

     For the Three Months Ended  
     March 31,
2013
    June 30,
2013
    September 30,
2013
    December 31,
2013
 

Selected unaudited consolidated statements of operations and comprehensive loss data:

        

Revenues:

        

Mobile games

     104,116        120,210        161,148        161,138   

Online advertising

     947        958        2,723        3,525   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

     105,063        121,168        163,871        164,663   

Cost of revenues(1)

     56,209        62,923        93,784        85,169   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     48,854        58,245        70,087        79,494   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating expenses:

        

Sales and marketing expenses(1)

     14,828        20,126        46,424        67,661   

Research and development expenses(1)

     20,684        27,737        27,152        29,620   

General and administrative expenses(1)

     7,564        10,701        13,698        24,267   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     43,076        58,564        87,274        121,548   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income/(Loss) from operations

     5,778        (319     (17,187     (42,054
  

 

 

   

 

 

   

 

 

   

 

 

 

Other (expenses)/income:

        

Interest (expenses)/income, net

     80        50        43        202   

Investment income/(loss)

     (800     (1,265     (834     (673

Others, net

     (136     (289     (95     (88

Fair value changes in warrant liability

     (3,729     (6,211     (13,146     (6,985
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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     For the Three Months Ended  
     March 31,
2013
    June 30,
2013
    September 30,
2013
    December 31,
2013
 

Income/(Loss) before tax

     1,193        (8,034     (31,219     (49,598

Income tax (expenses)/benefits

     45        (61     28        (660
  

 

 

   

 

 

   

 

 

   

 

 

 

Net Income/(loss)

     1,238        (8,095     (31,191     (50,258

Foreign currency translation adjustment, net of nil tax

     (202     (650     183        (1,852
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive loss

     1,036        (8,745     (31,008     (52,110
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income/(loss)

     1,238        (8,095     (31,191     (50,258

Accretions to preference shares redemption value

     (14,514     (21,321     (34,369     (44,779

Net loss attributable to ordinary shareholders

     (13,276     (29,416     (65,560     (95,037

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

     5,000,000        25,223,214        30,872,962        46,576,087   

Net loss per share attributable to ordinary shareholders—basic and diluted

     (2.66     (1.17     (2.12     (2.04

Non-GAAP financial measures:(2)

        

Adjusted net income/(loss)

     5,662        (420     (15,595     (39,400

Adjusted EBITDA

     7,464        2,498        (11,140     (34,166

Mobile game gross billing

     118,940        159,849        214,454        263,526   

 

Notes:    (1) Share-based compensation expenses were allocated to cost of revenues and operating expenses as follows:

 

     For the Three Months Ended  
     March 31,
2013
     June 30,
2013
     September 30,
2013
     December 31,
2013
 

Cost of revenues

                               

Sales and marketing expenses

     25         24         669         362   

Research and development expenses

     279         1,054         1,030         657   

General and administrative expenses

     391         386         751         2,854   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     695         1,464         2,450         3,873   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

  (2) See “—Non-GAAP Financial Measures.”

 

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We have provided below reconciliations between adjusted net loss, adjusted EBITDA and net loss, the most directly comparable GAAP financial measures, for the periods presented:

 

     For the Three Months Ended  
     March 31,
2013
    June 30,
2013
    September 30,
2013
    December 31,
2013
 
     (in thousands)  

Net income/(loss)

     1,238        (8,095     (31,191     (50,258

Less: Share-based compensation expenses

     (695     (1,464     (2,450     (3,873

Fair value changes in warrant liability

     (3,729     (6,211     (13,146     (6,985

Beneficial conversion charges on convertible notes

                            

Gain from previously held equity interest related to step acquisition

                            
  

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted net income/(loss)

     5,662        (420     (15,595     (39,400
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income/(loss)

     1,238        (8,095     (31,191     (50,258

Less: Interest (expenses)/income, net

     80        50        43        202   

Investment loss

     (800     (1,265     (834     (673

Others, net

     (136     (289     (95     (88

Income tax (expenses)/benefits

     45        (61     28        (660

Depreciation and amortization expenses

     (991     (1,353     (3,597     (4,015

Fair value changes in warrant liability

     (3,729     (6,211     (13,146     (6,985

Share-based compensation expenses

     (695     (1,464     (2,450     (3,873

Beneficial conversion charges on convertible notes

                            

Gain from previously held equity interest related to step acquisition

                            
  

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted EBITDA

     7,464        2,498        (11,140     (34,166
  

 

 

   

 

 

   

 

 

   

 

 

 

Our business generally experiences some effects of seasonal variations. For example, players tend to spend more time playing our games in the first and third quarters of each year, which typically encompass more public holidays and school breaks, during which school-aged users and working professionals have more time for digital entertainment. The second and fourth quarters are relatively slower for our business as there are fewer holidays during those quarters. In addition, our quarterly results may be affected by events out of our ordinary course of business. For example, one of the mobile carriers in China suspended its payment channel for all payments related to mobile entertainment for approximately six weeks in late 2013 while adjusting their own internal quality control procedures, which has contributed to a slowdown in the growth of our quarterly revenues in the fourth quarter of 2013. We recorded relatively higher expenses in the fourth quarter of 2013 as we strengthened our efforts to promote our games and corporate brand and increased our headcount to support our rapid business growth. However, we have experienced growth in revenues in 2013, especially in game publishing business, which may potentially offset the seasonality or other factors in the near term. Our short operating history and our rapid growth make it difficult for us to identify recurring seasonal trends in our business. We have made efforts to track our paying users information and will provide such information since the fourth quarter of 2013. For the fourth quarter of 2013, we had 2.8 million paying users. Accordingly, you should not rely on quarter-to-quarter comparisons of our results of operations as an indication of our future performance.

Liquidity and Capital Resources

To date, we have financed our operations primarily through cash generated from our operating activities and the proceeds from the private placement of our preference shares. Our principal uses of cash have been for operating activities, primarily cost of revenues research and development, sales and marketing, general and

 

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administrative expenses and investing activities, primarily acquiring property, equipment, intangible assets and equity investments. As of December 31, 2013, we had RMB330.6 million (US$54.6 million) in cash and cash equivalents and no borrowings.

The table below sets forth our cash and cash equivalents as of the dates indicated:

 

     As of December 31,  
     2011      2012      2013  
     (in thousands)  

Cash located outside of the PRC

        

—in US dollars

     US$588         US$8,991         US$34,297   

—in Korean Won

                    

 

KRW1,944,444

(US$1,843)

  

  

—in RMB

    
 
RMB60,535
 
  
  
    
RMB36,274
  
    

 

RMB38,985

(US$6,440)

  

  

Cash located in the PRC (all denominated in RMB and subject to currency conversion control):

        

held by WFOE

    
RMB2,894
  
    
RMB11,088
  
    

 

RMB44,901

(US$7,417)

  

  

—held by VIEs and VIEs’ subsidiaries

    
RMB762
  
    
RMB7,048
  
    

 

RMB26,407

(US$4,362)

  

  

Total Cash and cash equivalents

    
 
RMB67,893
 
  
  
    
 
RMB110,926
 
  
  
    

 

RMB330,558

(US$54,604)

  

  

  

 

 

    

 

 

    

 

 

 

We believe that our current and anticipated cash flows from operations will be sufficient to meet our anticipated cash needs, including our cash needs for at least the next 12 months. We may require additional cash due to unanticipated business conditions or other future developments, including any investments or acquisitions we may decide to pursue. If our existing cash is insufficient to meet our requirements, we may sell additional equity securities, debt securities or borrow from banks. The proceeds of this offering are planned to be used to fund our PRC businesses (primarily through our direct PRC wholly owned subsidiary). The funding mechanisms available to us are subject to PRC regulations and approvals. In particular, the PRC government, through SAFE, has put in place various registration and approval requirements governing capital injections to foreign-invested enterprises, including provisions that limit foreign loans to the difference between the investment amount and the registered capital of a foreign-invested enterprise. Chukong Beijing’s approved investment amount is US$81 million and its registered capital is US$27 million. These statutory limits, or punitive actions taken by the relevant PRC regulatory authorities as a result of a failure to strictly abide by any regulations and required approvals, could materially impair our liquidity by curtailing our ability to finance our PRC businesses with the proceeds of this offering. See “Risk Factors—Risks Related to Doing Business in China—PRC regulation of loans and direct investment by offshore holding companies to PRC entities may limit the use of the proceeds we receive from this offering for our expansion or operations.”

The PRC government imposes certain controls on the conversion of the Renminbi into foreign currencies and the remittance thereof outside of the PRC. To the extent that (i) loans are arranged between our non-PRC entities and our PRC entities or (ii) we declare and pay dividends from our PRC entities to our non-PRC entities in the future, such cash flows may be limited, or may not be able to be processed on a timely basis, due to SAFE regulations or restrictions on the availability of foreign currencies. Such restrictions could have a material adverse effect on our liquidity and our ability to settle intercompany transactions or fund dividend payments to ordinary shareholders or ADS holders. See “Risk Factors—Risks Related to Doing Business in China—Governmental control of currency conversion may affect the value of your investment.”

On August 8, 2006, six PRC regulatory agencies, namely, the Ministry of Commerce, the State Assets Supervision and Administration Commission, SAT, the State Administration for Industry and Commerce, the CSRC and SAFE, jointly adopted the M&A Rules, which became effective on September 8, 2006, and were

 

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amended on June 22, 2009. The M&A Rules purport to require, among other things, offshore special purpose vehicles, or SPVs, formed for the purpose of seeking a public listing on an overseas stock exchange through acquisitions of PRC domestic companies or assets and controlled by PRC companies or individuals, to obtain the approval of the CSRC prior to publicly listing their securities on an overseas stock exchange. While we currently believe that the M&A Rules do not apply to, and the CSRC’s approval is not required for, this offering, we cannot assure you that the relevant regulatory agencies, including the CSRC, would reach the same conclusion. To the extent this offering continues and is consummated, and it is later concluded by the CSRC or any related agencies that approval should have been obtained, they would have broad discretion to impose a variety of punitive actions on us, which could have material adverse effects on our liquidity, such as de