Equity incentives and debt financing are handled by different people at different moments: the ESOP is designed when the first ten engineers join, the bank facility is negotiated when working capital runs short. Both, however, are claims on the same cap table, and the second one is priced against the first. Companies that treat them as separate workstreams usually discover the overlap in the lender’s due diligence list, at which point the option pool is already promised and the covenant is already drafted.
Sizing the pool before the first round
A Chinese AI company at seed stage typically reserves 10 to 15 per cent of fully diluted equity for employees, with hardware and model-training companies landing at the higher end because hiring is capital-intensive and cash-light. The number itself matters less than when it is created: a pool carved out before the round dilutes founders only, while a pool carved out after the round dilutes founders and the new investor, which is why investors push to have it created beforehand.
The arithmetic is worth doing explicitly. If founders hold 100 per cent and create a 15 per cent pool pre-money, they retain 85 per cent. If the same 15 per cent is created post-money alongside a 20 per cent investor, founders end up with roughly 68 per cent. On a RMB 300 million valuation the difference is tens of millions of RMB of founder value, decided by sequencing rather than negotiation skill.
Two further constraints shape the pool. First, the pool is a promise, not an issuance: options are granted from it over three to five years, and ungranted capacity is still counted in the fully diluted number used for pricing. Second, increases to the pool after the first round normally require investor consent, either under the charter or the shareholders’ agreement, so the capacity reserved at seed stage is effectively the budget for the next two hiring cycles.
Vesting, cliffs and what acceleration costs
The market standard in China is four-year vesting with a one-year cliff: nothing vests before the first anniversary, then 25 per cent vests at the cliff and the remainder monthly or quarterly. For AI companies the clause that matters more is acceleration. Single-trigger acceleration on a change of control lets a founder or key engineer vest everything on closing; double-trigger requires both a change of control and a termination without cause. Investors accept double-trigger almost routinely and resist single-trigger, because single-trigger transfers value from the acquirer’s retention budget to the employee at the moment the company is sold.
Repurchase rights deserve the same attention. A standard arrangement gives the company the right to repurchase unvested shares at cost on departure, and vested shares at a defined formula price. Where the formula is left blank, disputes follow: departing employees argue fair market value, the company argues nominal value, and the case is decided years later on documents that were never completed.
Tax deferral: the conditions, and the failure mode
For non-listed companies, Caishui [2016] No. 101 allows equity incentive income to be deferred until the shares are sold, taxed at 20 per cent as income from transfer of property rather than at progressive wage rates that reach 45 per cent. The conditions are cumulative, not alternative:
- the instrument is a stock option, restricted stock or equity award over the company’s own equity, and the company is a domestic resident enterprise;
- the company is not in a restricted industry catalogue;
- the grant was approved by the board and the shareholders’ meeting;
- for options, the holding period from grant is at least three years and at least one year after exercise, with no more than ten years between grant and exercise; for restricted stock, three years from grant and one year after vesting; for equity awards, three years from acquisition;
- the arrangement is filed with the competent tax authority.
The last item is where most companies fail. Filing is an administrative step that nobody owns, so it is skipped, and the deferral is lost by default rather than by decision. The consequence is not a penalty but a recharacterisation: the spread is treated as wages and salaries, subject to the comprehensive income scale, and the company as withholding agent carries the exposure. For a senior hire receiving equity worth several million RMB, the difference between 20 per cent and a 45 per cent marginal rate is the entire retention effect of the grant.
Listed companies operate under a separate regime: incentive income is not combined with comprehensive income for the year but taxed separately on the comprehensive income scale, and payment may be spread over up to 36 months from exercise subject to filing, with all tax settled before departure. The current extension of that policy runs to 31 December 2027.
Debt financing: what is actually available
Chinese AI companies rarely borrow against cash flow, because there is little of it. The instruments that do get used are narrower:
- Technology and innovation loans. Bank products tied to recognised high-tech enterprise status, often subsidised at the municipal or district level. Ticket sizes are modest, typically RMB 3 to 10 million, and pricing depends on the subsidy rather than the credit.
- Intellectual property pledges. Patents and software copyrights pledged as collateral. Valuation is the bottleneck: lenders discount heavily, accept only registered IP with clean chain of title, and require the IP to be unencumbered and not jointly owned with a university or a co-development partner.
- Convertible notes and bonds. Used between rounds, usually with a valuation cap and a discount. In China the instrument is often structured as a convertible bond with a shareholder agreement, because direct equity issuance before a valuation is agreed creates registration and tax complications.
- Government guidance funds and policy facilities. Equity or quasi-equity from state-guided funds, typically with localisation, registered-address and reporting conditions attached.
What lenders diligence is predictable: the cap table and all historical equity transfers, the ESOP and any promised but unissued grants, related-party transactions between founders and the company, IP ownership and encumbrances, social insurance and housing fund contributions for the whole workforce, and tax filings for the last three years. Two items on that list routinely kill facilities: social insurance paid on a minimum base rather than actual salary, and IP that is registered to a founder rather than the company.
Covenants follow the diligence. Expect restrictions on further indebtedness, on dividends, on changes to the cap table above a threshold, and on disposal of core IP. Founder personal guarantees remain common for smaller facilities, which is a decision about personal balance sheet rather than company credit.
Where the two collide
Three intersections are worth planning for in advance.
Pool increases against covenant limits. A debt facility that restricts equity issuances above a threshold can block the pool top-up a company needs to hire. The fix is a carve-out for employee grants in the covenant, negotiated at signing rather than after a hiring freeze.
ESOP promises against IP pledges. If IP is pledged, the company may be restricted from licensing or transferring it, which matters when an option exercise is settled by transferring rights in a subsidiary holding the IP. Structure the settlement before the pledge, not after.
Tax filings against financing timelines. The 101 filing must be completed before the tax authority processes the grant; a financing closing that compresses the timetable tends to push the filing past the deadline. Build the filing into the closing checklist, with a named owner.
A five-item checklist
- Reserve the pool before the first priced round, and write the consent threshold for future increases into the shareholders’ agreement.
- Complete the vesting and repurchase formula in the grant documents; leave no blanks.
- File the 101 deferral with the tax authority for every grant, and keep the filing receipt.
- Before approaching a lender, reconcile social insurance bases and move IP registrations into the company.
- Ask for employee-grant carve-outs in debt covenants at signing.
None of these is difficult individually. The cost comes from doing them in the wrong order.