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As filed with the Securities and Exchange Commission on March 17, 2009.
Registration Statement No. 333-
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM F-1
REGISTRATION STATEMENT
Under
the Securities Act of 1933
CHANGYOU.COM LIMITED
(Exact Name of Registrant as Specified in its Charter)
| Cayman Islands | 7379 | 98-0549988 | ||
| (State or Other Jurisdiction of Incorporation or Organization) | (Primary Standard Industrial Classification Code Number) | (I.R.S. Employer Identification No.) |
East Tower, Jing Yan Building
No. 29 Shijingshan Road, Shijingshan District
Beijing 100043
People’s Republic of China
(8610) 6272-7777
(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive office)
CT Corporation System
111 Eighth Avenue
New York, New York 10011
(212) 664-1666
(Name, address, including zip code, and telephone number, including area code, of agent for service)
Copies to:
| Timothy B. Bancroft, Esq. Goulston & Storrs, P.C. 400 Atlantic Avenue Boston, Massachusetts 02110 (617) 482-1776 | James C. Lin, Esq. Davis Polk & Wardwell 18th Floor, The Hong Kong Club Building 3A Chater Road, Hong Kong (852) 2533-3300 |
Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement becomes effective.
If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. ¨
If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ¨
If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ¨
If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ¨
If delivery of the prospectus is expect to be made pursuant to Rule 434, check the following box. ¨
CALCULATION OF REGISTRATION FEE
| Title of each class of securities to be registered(1) | Proposed maximum aggregate offering price(2)(3) | Amount of registration fee | ||||
| Class A ordinary shares, par value $0.01 per share | $ | 138,000,000 | $ | 7,701 | ||
| (1) | American depositary shares issuable upon deposit of the Class A ordinary shares registered hereby have been registered under a separate registration statement on Form F-6 filed with the Commission on , 2009 (Registration No. ). Each American depositary share represents two Class A ordinary shares. |
| (2) | Includes (i) 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 (ii) Class A ordinary shares that may be purchased by the underwriters pursuant to an over-allotment option. These Class A ordinary shares are not being registered for the purposes of sales outside of the United States. |
| (3) | Estimated solely for the purpose of determining the amount of registration fee in accordance with Rule 457(o) under the Securities Act of 1933. |
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 preliminary prospectus is not complete and may be changed. Neither we nor the selling shareholder may sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.
PROSPECTUS (SUBJECT TO COMPLETION)
DATED March 17, 2009
7,500,000
American Depositary Shares
CHANGYOU.COM LIMITED
Representing 15,000,000 Class A Ordinary Shares
This is the initial public offering of Changyou.com Limited, or Changyou. We are offering 3,750,000 American depositary shares, or ADSs, and the selling shareholder identified in this prospectus is offering 3,750,000 ADSs. Each ADS represents two Class A ordinary shares, par value $0.01 per share, of Changyou. We will not receive any proceeds from the ADSs sold by the selling shareholder.
Prior to this offering, there has been no public market for the ADSs or our ordinary shares. We anticipate that the initial public offering price of the ADSs will be between $14.00 and $16.00 per ADS. We have applied to have the ADSs listed on the NASDAQ Global Select Market under the symbol “CYOU.”
Investing in the ADSs involves risks. See “Risk Factors” beginning on page 15 of this prospectus.
| Per ADS | Total | |||||
| Public offering price | $ | $ | ||||
| Underwriting discounts and commissions | $ | $ | ||||
| Proceeds, before expenses, to Changyou | $ | $ | ||||
| Proceeds, before expenses, to the selling shareholder | $ | $ | ||||
The underwriters may also purchase up to an additional 1,125,000 ADSs from the selling shareholder at the public offering price, less the underwriting discounts and commissions, within 30 days from the date of this prospectus to cover over-allotments.
Neither the Securities and Exchange Commission nor any state securities regulator has approved or disapproved these securities or determined if this prospectus is truthful or complete. 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 or about , 2009.
| Credit Suisse | Merrill Lynch & Co. |
| Citi |
| Susquehanna Financial Group, LLLP |
The date of this prospectus is , 2009.
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| F-1 |
You should rely only on the information contained in this prospectus. Neither we nor the underwriters have authorized any other person, including the selling shareholder, to provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. Neither we nor the selling shareholder nor the underwriters are making an offer to sell these securities in any jurisdiction where the offer or sale is not permitted. You should assume that the information appearing in this prospectus is accurate only as of the date on the front cover of this prospectus. Our business, financial condition, results of operation and prospects may have changed since that date.
We have not taken any action to permit a public offering of the ADSs outside the United States or to permit the possession or distribution of this prospectus or any filed free writing prospectus outside the United States. Persons outside the United States who come into possession of this prospectus or any filed free writing prospectus must inform themselves about and observe any restrictions relating to the offering of the ADSs and the distribution of this prospectus or any filed free writing prospectus outside of the United States.
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You should read the following summary together with the entire prospectus, including the more detailed information regarding us, the ADSs being sold in this offering, and our financial statements and related notes appearing elsewhere in this prospectus.
Overview
We are a leading online game developer and operator in China as measured by the popularity of our game Tian Long Ba Bu, or TLBB. TLBB, which was launched in May 2007, was ranked by International Data Corporation, or IDC, for 2007 as the third most popular online game overall in China and the second most popular online game in China among locally-developed online games. We engage in the development, operation and licensing of our massively multi-player online role-playing games, or MMORPGs, which are interactive online games that may be played simultaneously by hundreds of thousands of game players. We currently operate two MMORPGs, TLBB, which we developed in-house, and Blade Online, or BO, which we licensed from a third party. For the three months ended December 31, 2008, we had approximately 1.8 million active paying accounts, which refers to the number of accounts from which game points are utilized for the purchase of virtual items at least once during a given period, for TLBB and approximately 159,000 active paying accounts for BO.
TLBB is a martial arts game with 2.5D graphics. In May 2007, the month of its launch, TLBB’s peak concurrent users surpassed 400,000, and its quarterly peak concurrent users for the fourth quarter of 2008 was approximately 738,000. In March 2009, its peak concurrent users exceeded 800,000. TLBB is adapted from the popular Chinese martial arts novel “Tian Long Ba Bu,” which means “Novel of Eight Demigods,” written by the famous writer Louis Cha. Millions of copies of his novels have been sold in numerous languages, and they have been adapted into various movies and television series. To leverage the success of TLBB, we licensed the game to third-party operators to operate the game in Taiwan, Hong Kong, Vietnam, Malaysia and Singapore.
We have three new MMORPGs in the pipeline, including the Duke of Mount Deer, or DMD, Immortal Faith, or IF, and the Legend of the Ancient World, or LAW. DMD, which we are developing in-house, is also based on a popular martial arts novel written by Louis Cha. We have licensed IF and LAW from third parties. We expect to begin open beta testing of IF and DMD in the second and fourth quarters of 2009, respectively, and of LAW in early 2010.
Sohu.com Inc., our controlling shareholder, has operated a leading Chinese Internet portal, Sohu.com, since 1998. Sohu had more than 250 million registered accounts as of December 31, 2008. We have benefited from Sohu’s strong brand recognition in China, large user base and pre-launch game review services. Sohu’s trusted brand name in China provides us with a broad marketing reach. By marketing across Sohu’s web domains and taking advantage of the Sohu Group’s single-user ID system that provides easy access to our games, we believe we have been able to tap into Sohu’s large user base to drive new users to our games. Sohu’s experienced game editors review and critique our games prior to launch, thereby improving the quality of our games. We intend to continue to leverage our relationships with Sohu in the development, marketing and operation of our games.
We operate our current games under the item-based revenue model, meaning game players can play our games for free, but may choose to pay for virtual items, which are non-physical items that game players can purchase and use within an MMORPG, such as gems, pets, fashion items, magic medicine, riding animals, hierograms, skill books and fireworks, to enhance the game-playing experience. Game players purchase prepaid game cards or game points, which are used to purchase virtual items. Most of our virtual items are priced between less than $0.01 and $2.20. However, unit prices of certain virtual items can be as high as approximately $180. We sell our prepaid game cards to approximately 100 regional distributors throughout China, who in turn sub-distribute them to numerous retail outlets, including Internet cafes and various websites, news stands, software stores, book stores and retail stores.
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We continually collect feedback from our game players through multiple channels. Our product development team and our game operations team work closely together, allowing us to translate game player feedback into game updates and expansion packs in a timely manner. We typically release expansion packs, which are software packages that contain significant upgrades and improvements to a game based on the existing game’s framework, every few months. These upgrades may include new game content such as storylines, characters, tasks, maps and virtual items. We also update TLBB on a weekly basis with interim enhancements. We believe that such expansion packs and regular updates improve the game-playing experience and help to maintain the interest level of TLBB’s players, thereby helping us to extend the lifespan of the game.
Our revenues grew from $42.1 million for the year ended December 31, 2007 to $201.8 million for the year ended December 31, 2008, and our net income grew from $5.3 million to $108.0 million during the same period. For the year ended December 31, 2008, 93.6% of our total revenues was attributable to TLBB.
Industry Background
According to the China Internet Network Information Center, or CNNIC, in June 2008 China surpassed the United States as the largest Internet market in the world. Within the Chinese Internet market, online games have been a fast growing segment and one of the most popular activities for Internet users.
According to IDC, China’s online game players reached 40.2 million in 2007, and generated revenues of $1.4 billion, representing a 61.5% increase over those in 2006. Online game revenues are expected to continue to grow to $3.4 billion in 2012 at a compound annual growth rate, or CAGR, of 19.9%. MMORPGs represent a dominant online game type in China, revenues from which accounted for 76.0% of China’s total online game revenues in 2007. Most of the revenues from online games are generated under the item-based revenue model as compared to the time-based revenue model.
In addition, China’s online games industry has other key characteristics, including:
| Ÿ | growing popularity of online games developed by Chinese game developers; |
| Ÿ | slow pace of upgrading personal computer hardware; |
| Ÿ | increasingly competitive market dynamics; and |
| Ÿ | rampant cheating programs and hacking activities. |
Our Competitive Strengths
We believe that the following competitive strengths enable us to compete effectively and to capitalize on the rapid growth in the online game market:
| Ÿ | leading market position in the China online game market; |
| Ÿ | strong capability to timely translate game player feedback into game enhancements to extend the lifespan of our games; |
| Ÿ | leading technology platform, which includes our uniform game development platform, advanced 2.5D graphics engine, effective anti-cheating and anti-hacking technologies, proprietary cross-networking technology and advanced data protection technology; |
| Ÿ | strong marketing and game development support from Sohu, our controlling shareholder and a leading Internet portal in China; and |
| Ÿ | experienced management team with local game development and operational expertise. |
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Our Challenges
Notwithstanding our competitive strengths, we expect to face various challenges, including those presented by:
| Ÿ | our limited operating history; |
| Ÿ | our reliance on TLBB, which has accounted for nearly all of our revenues to date; |
| Ÿ | our ability to develop successful games in the future and to create expansion packs to extend the lifespan of our current and future games; |
| Ÿ | our ability to attract and retain talent, particularly game developers and related technical personnel; |
| Ÿ | the growth of the online games market and continued market acceptance of our games and virtual items in China and elsewhere; |
| Ÿ | our ability to compete successfully; |
| Ÿ | our ability to protect our intellectual property rights; |
| Ÿ | uncertainties with respect to the PRC legal and regulatory environment; |
| Ÿ | the current severe worldwide economic downturn; and |
| Ÿ | restrictions under our Non-Competition Agreement with Sohu, which limit our ability to expand our online games business beyond MMORPGs in a manner that competes with Sohu’s business. |
Our Strategies
Our objective is to establish one of the most powerful online game brands in China. We intend to achieve this objective by pursuing the following strategies:
| Ÿ | leverage our success with TLBB and our game development platform to develop new MMORPGs; |
| Ÿ | continue to employ and improve our integrated game player feedback and game enhancement system; |
| Ÿ | expand and diversify our game offerings; |
| Ÿ | selectively expand into international markets; |
| Ÿ | focus on building human capital; and |
| Ÿ | pursue strategic acquisition and alliance opportunities. |
Our History and Corporate Structure
Our MMORPG business began operations as a business unit within the Sohu Group in 2003. In June 2003, the Sohu Group launched its first MMORPG, Knight Online, or KO, which was licensed from a Korean developer. KO had limited acceptance in the Chinese market, and its operation was discontinued in November 2006 when the license expired. In October 2004, the Sohu Group launched BO, its second MMORPG, which was licensed from a Beijing-based studio. In May 2007, the Sohu Group launched TLBB, its first in-house developed MMORPG.
In 2007, the Sohu Group reorganized its MMORPG business. As part of the reorganization, Changyou.com Limited, or Changyou, a Cayman Islands company and an indirect, wholly-owned subsidiary of Sohu.com Inc., was established in August 2007 to hold the MMORPG business of the Sohu Group. Subsequently,
| Ÿ | Changyou.com (HK) Limited, or Changyou HK, was incorporated in Hong Kong as a direct, wholly-owned subsidiary of Changyou to be our offshore intermediate holding company for our MMORPG operations in China; |
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| Ÿ | Beijing AmazGame Age Internet Technology Co., Ltd., or AmazGame, was incorporated in the PRC as a direct wholly-owned subsidiary of Changyou HK to undertake the technical support and product development functions of our MMORPG operations; and |
| Ÿ | Beijing Gamease Age Digital Technology Co., Ltd., or Gamease, was incorporated in the PRC as our variable interest entity, or VIE, to operate our MMORPG operations and to hold intellectual property and online game operating licenses and permits relating to our MMORPG operations. |
Gamease is jointly owned by Tao Wang, our Chief Executive Officer, and a Changyou employee, but is controlled by AmazGame through a series of contractual arrangements, and therefore its financial results are consolidated with ours. We operate all of our MMORPG operations through Gamease, our VIE, rather than a subsidiary, in order to comply with PRC laws and regulations restricting foreign ownership in the online game business in China. See “Our History and Corporate Structure” for a detailed discussion of our contractual arrangements with Gamease.
After the establishment of the above entities, Changyou, AmazGame and Gamease entered into various agreements with Sohu. Pursuant to these agreements, Sohu transferred to us, effective December 1, 2007, all of its assets and operations relating to its MMORPG business unit, and we assumed all the liabilities associated with the MMORPG business unit and paid net consideration of $9.9 million to Sohu.
In January 2009, we incorporated AmazGame Entertainment (US), Inc., through which we intend to operate our planned MMORPG business in the United States.
The following diagram illustrates our corporate structure as of the date of this prospectus(1):
| (1) | For risks relating to our current corporate structure, see “Risk Factors—Risks Related to Our Structure and Regulations.” |
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Our Relationship with Sohu
We were a business unit within the Sohu Group prior to our reorganization as a separate, indirect subsidiary of Sohu.com Inc. The Sohu Group began reporting results of its MMORPG operations as a separate business segment for the three months ended June 30, 2007. References in this prospectus to the operations of our business, financial condition, and results of operations with respect to periods prior to December 1, 2007 are to the Sohu Group’s MMORPG business unit. Prior to this offering, Sohu had provided us with tax, accounting, treasury, legal and human resources services, and had also provided us with the services of a number of its executives and employees. All of our current executive officers and most of our current employees formerly were employees of Sohu.
Upon the completion of this offering, Sohu will continue to be our controlling shareholder, with an indirect shareholding of 70.7% of the combined total of our outstanding Class A and Class B ordinary shares, and control of 81.5% of the voting power of the combined total of our outstanding Class A and Class B ordinary shares, assuming the underwriters’ over-allotment option is not exercised.
We have entered into agreements with Sohu with respect to various interim and ongoing relationships between us, including a Master Transaction Agreement, a Non-Competition Agreement, and a Marketing Services Agreement. These agreements contain provisions, among others, relating to the transfer of assets and assumption of liabilities of the MMORPG business, provide cross-indemnification of liabilities arising from each other’s business, mutually limit Sohu and us from competing in each other’s business, and also include a number of ongoing commercial relationships. See “Our Relationship with Sohu.”
We believe that we will realize benefits from our carve-out from Sohu, including:
| Ÿ | Sharper strategic focus. By having our own board of directors and management team, we expect to be able to make more focused strategic decisions and be in a better position to take advantage of strategic opportunities in the online game business. |
| Ÿ | Better incentives for employees and greater accountability. We will seek to motivate and retain our employees through the implementation of incentive compensation programs tied to the market performance of our ADSs and the financial results of our company. |
| Ÿ | Direct access to capital markets. As a separate, stand-alone company, we will have capital planning flexibility with direct access to the debt and equity capital markets and the opportunity to grow through acquisitions by using our shares as consideration. |
Our Corporate Information
Our principal executive offices are located at East Tower, Jing Yan Building, No. 29 Shijingshan Road, Shijingshan District, Beijing 100043, People’s Republic of China. Our telephone number at this address is (8610) 6272-7777. Our registered office in the Cayman Islands is located at Scotia Centre, 4th Floor, P.O. Box 2804, George Town, Grand Cayman, Cayman Islands, KY1-1112.
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Conventions that Apply to this Prospectus
Unless otherwise indicated, information in this prospectus assumes that the underwriters have not exercised their option to purchase additional ADSs to cover over-allotments and assumes that there has been no vesting of restricted share units granted to our executive officers and employees.
This prospectus contains translations of certain Renminbi, or RMB, the legal currency of China, amounts into U.S. dollars at the rate of RMB6.8225 to $1.00, the noon buying rate in effect on December 31, 2008, in New York City for cable transfers of Renminbi as certified for customs purposes by the Federal Reserve Bank of New York. We make no representation that the Renminbi or U.S. dollar amounts referred to in this prospectus could have been or can be converted into U.S. dollars or Renminbi, as the case may be, at any particular rate or at all. On March 13, 2009, the noon buying rate was RMB6.8380 to $1.00.
As used in this prospectus,
| Ÿ | “Changyou” refers to Changyou.com Limited, a Cayman Islands company, and unless the context requires otherwise, includes its subsidiaries and variable interest entity; |
| Ÿ | “China” or “PRC” refers to the People’s Republic of China, and for the purpose of this prospectus, excludes Hong Kong, Macau and Taiwan; |
| Ÿ | “Sohu.com Inc.” refers to our ultimate parent and controlling shareholder, whose shares of common stock are listed on the NASDAQ Global Select Market under the symbol “SOHU”; |
| Ÿ | “Sohu” refers to Sohu.com Inc. and its subsidiaries and consolidated variable interest entities and, unless the context requires otherwise, excludes Changyou.com Limited and its subsidiaries and variable interest entity; |
| Ÿ | “Sohu Group” refers to Sohu.com Inc. and its subsidiaries and consolidated variable interest entities and, unless the context requires otherwise, includes Changyou.com Limited and its subsidiaries and variable interest entity; and |
| Ÿ | “we,” “us,” “our company” and “our” refer to Changyou.com Limited, and unless the context requires otherwise, include its subsidiaries and variable interest entity; when required by the context, references to “we,” “us,” “our company” and “our” include the MMORPG business unit of the Sohu Group for periods prior to December 1, 2007. |
Unless indicated otherwise, the information included in this prospectus regarding our outstanding ordinary shares gives effect to the following as if they all had occurred as of January 1, 2005:
| (i) | the issuance on August 6, 2007 of 50,000 of our ordinary shares, par value $1.00 per share, constituting all of our authorized ordinary shares, to Sohu.com Limited, a subsidiary of Sohu.com Inc.; |
| (ii) | the transfer on February 29, 2008 from Sohu.com Limited to Sohu.com (Game) Limited, an indirect subsidiary of Sohu.com Inc., of 50,000 of our ordinary shares; |
| (iii) | the subdivision on May 29, 2008 of the 50,000 ordinary shares held by Sohu.com (Game) Limited into 5,000,000 ordinary shares, par value $0.01 per share; |
| (iv) | the increase on May 29, 2008 of our authorized ordinary shares from 5,000,000 to 10,000,000 ordinary shares, par value $0.01 per share; |
| (v) | the issuance on June 1, 2008 of an additional 3,500,000 of our ordinary shares to Sohu.com (Game) Limited; |
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| (vi) | the transfer on December 31, 2008 by Sohu.com (Game) Limited to us of 8,500,000 of our ordinary shares; the cancellation of such 8,500,000 ordinary shares; the increase of our authorized ordinary shares from 10,000,000 to 109,774,000 ordinary shares, par value $0.01 per share, with the designation of 100,000,000 of such shares as Class A ordinary shares and 9,774,000 of such shares as Class B ordinary shares; and the issuance of 8,000,000 Class B ordinary shares to Sohu.com (Game) Limited; |
| (vii) | the increase on March 16, 2009 of our authorized ordinary shares from 109,774,000 to 297,740,000 ordinary shares, par value $0.01 per share, with 200,000,000 of such shares designated as Class A ordinary shares and 97,740,000 of such shares designated as Class B ordinary shares; and |
| (viii) | a ten-for-one split of outstanding Class B ordinary shares effected on March 16, 2009 by way of a bonus share issuance of nine Class B ordinary shares for each Class B ordinary share then outstanding, nine Class B restricted shares for each Class B restricted share then outstanding and a corresponding adjustment in the number of Class A ordinary shares and Class B ordinary shares issuable upon vesting of Class A and Class B restricted share units then outstanding. |
The information included in this prospectus regarding our outstanding ordinary shares also includes as outstanding, as of their January 2, 2008 grant date, 7,000,000 Class B ordinary shares and 8,000,000 Class B restricted shares (the amount of such shares giving effect to the ten-for-one split referred to above) that were issued, out of ordinary shares held by Sohu.com (Game) Limited, on January 15, 2009 to Prominence Investments Ltd., a British Virgin Islands company beneficially owned by Tao Wang, our Chief Executive Officer.
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The Offering
| Offering price | We currently estimate that the initial public offering price will be between $14.00 and $16.00 per ADS. |
ADSs offered:
| By us | 3,750,000 ADSs |
| By the selling shareholder | 3,750,000 ADSs |
| The ADSs | Each ADS represents two Class A ordinary shares, par value $0.01 per share. The ADSs will be evidenced by American Depositary Receipts, or ADRs. The depositary will hold the shares underlying your ADSs. You will have rights as provided in the Deposit Agreement described in the section of this prospectus entitled “Description of American Depositary Shares.” If we declare dividends on our ordinary shares, the depositary will pay you the 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 such exchange. We may amend or terminate the Deposit Agreement without your consent. If you continue to hold your ADSs, you will be bound by the Deposit Agreement as amended. |
To understand the terms of the ADSs, you should carefully read the section of this prospectus entitled “Description of American Depositary Shares.” We also encourage you to read the Deposit Agreement, which is an exhibit to the registration statement that includes this prospectus.
| ADSs outstanding immediately after the offering | 7,500,000 ADSs |
| Ordinary shares | Holders of Class A ordinary shares and holders of Class B ordinary shares have the same rights, with the exception of voting and conversion rights. Each Class A ordinary share is entitled to one vote on all matters subject to a shareholder vote, and each Class B ordinary share is entitled to ten votes on all matters subject to a shareholder vote. Each Class B ordinary share is convertible into one Class A ordinary share at any time at the election of the holder. Class A ordinary shares are not convertible into Class B ordinary shares under any circumstances. No Class B ordinary shares may be transferred by a holder to any person or entity which is not an affiliate of the holder. |
| Class A ordinary shares outstanding immediately after the offering (including Class A ordinary shares represented by ADSs) | 15,000,000 Class A ordinary shares |
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| Class B ordinary shares outstanding immediately after the offering | 87,500,000 Class B ordinary shares |
| Use of proceeds | The net proceeds to us from this offering are expected to be approximately $48.3 million, assuming an initial public offering price per ADS of $15.00, which is the mid-point of the estimated public offering price range. |
The primary purposes of this offering are to create a public market for our shares for the benefit of all shareholders, retain talented employees by providing them with equity incentives and obtain additional capital. We intend to use the net proceeds from this offering for general corporate purposes, including capital expenditures and funding possible future acquisitions.
We will not receive any of the proceeds from the sale of ADSs by the selling shareholder.
| Over-allotment option | Sohu.com (Game) Limited, the selling shareholder, has granted to the underwriters an option, which is exercisable within 30 days from the date of this prospectus, to purchase up to an aggregate of 1,125,000 additional ADSs. |
| Lock-up | We and all of our directors, executive officers and existing shareholders have agreed with the underwriters, subject to certain exceptions, not to sell, transfer or dispose of, directly or indirectly, any of our ADSs or ordinary shares or securities convertible into or exercisable or exchangeable for our ADSs or ordinary shares, other than the ADSs offered and sold in this offering, for a period of 180 days following the date of this prospectus. See “Underwriting” for additional information. |
| Risk factors | See “Risk Factors” and other information included in this prospectus for a discussion of factors you should carefully consider before deciding to invest in the ADSs. |
| Dividend | We intend to declare, prior to the completion of this offering, a cash dividend of $96.8 million payable solely to Sohu.com (Game) Limited. Purchasers of ADSs in this offering will not participate in the dividend. |
| Depositary | Bank of New York Mellon |
| NASDAQ symbol | “CYOU” |
| Listing | We have applied to have our ADSs listed on the NASDAQ Global Select Market under the symbol “CYOU.” Our ADSs and shares will not be listed on any other stock exchange or traded on any other automated quotation system. |
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| Payment and settlement | The ADSs are expected to be delivered against payment on , 2009. They will be deposited with a custodian for, and registered in the name of a nominee of, The Depository Trust Company, or DTC, in New York, New York. Initially, beneficial interests in the ADSs will be shown on, and transfers of these beneficial interest will be effected through, records maintained by DTC and its direct and indirect participants. |
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Summary Consolidated Financial and Operating Data
The following summary consolidated statements of operations and cash flow data for the years ended December 31, 2006, 2007 and 2008 and the summary consolidated balance sheet data as of December 31, 2006, 2007 and 2008 have been derived from our audited consolidated financial statements included elsewhere in this prospectus. You should read the summary consolidated financial data in conjunction with those financial statements and the accompanying notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Our consolidated financial statements are prepared and presented in accordance with United States generally accepted accounting principles, or U.S. GAAP.
Prior to Sohu’s transfer to our PRC subsidiary and VIE of all of the assets and operations of the Sohu Group’s MMORPG business unit effective December 1, 2007, the operations of our MMORPGs were carried out by various companies owned or controlled by Sohu.com Inc. For periods both before and after December 1, 2007, our consolidated financial statements include the assets, liabilities, revenues, expenses and changes in shareholders’ equity and cash flows that were directly attributable to our MMORPG business whether held or incurred by Sohu or by Changyou. In cases involving assets and liabilities not specifically identifiable to any particular operation of the Sohu Group, only those assets and liabilities transferred or expected to be transferred to Changyou are included in our consolidated balance sheets. With respect to costs of operations of the MMORPG business, an allocation of certain general corporate expenses of Sohu which were not directly related to the MMORPG operations and an allocation of certain advertising and other expenses provided by Sohu to Changyou were also included. These allocations are based on a variety of factors depending upon the nature of the expenses being allocated, including revenue, the number of employees and the number of servers. Our statements of operations also include the sales and marketing expenses and other costs charged from Sohu. The transactions are measured at the amount of consideration established and agreed to by the related parties.
Our consolidated financial statements have been prepared as if the current corporate structure had been in existence throughout the periods presented.
Our management believes that the assumptions underlying our financial statements and the above allocations are reasonable. Our financial statements, however, may not necessarily reflect our results of operations, financial position and cash flows as if we had operated as a separate, stand-alone company during the periods presented. You should not view our historical results as an indicator of our future performance.
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Summary Consolidated Statements of Operations Data
| For the Year Ended December 31, | |||||||||
| 2006 | 2007 | 2008 | |||||||
| ($ in thousands) | |||||||||
| Revenues: | |||||||||
| Game operations revenues | 8,525 | 41,751 | 194,607 | ||||||
| Overseas licensing revenues | — | 345 | 7,238 | ||||||
| Total revenues | 8,525 | 42,096 | 201,845 | ||||||
| Cost of revenues(1) | 3,895 | 7,317 | 14,633 | ||||||
| Gross profit | 4,630 | 34,779 | 187,212 | ||||||
| Operating expenses: | |||||||||
| Product development(1) | 1,957 | 6,738 | 23,862 | ||||||
| Sales and marketing(1) | 1,798 | 19,851 | 38,917 | ||||||
| General and administrative(1) | 876 | 2,992 | 9,053 | ||||||
| Total operating expenses | 4,631 | 29,581 | 71,832 | ||||||
| Operating (loss) profit | (1 | ) | 5,198 | 115,380 | |||||
| Investment income from an associate | 151 | 9 | — | ||||||
| Gain on disposal of investment in an associate | — | 561 | — | ||||||
| Interest expense | — | (61 | ) | (245 | ) | ||||
| Interest income and foreign currency exchange gain | 20 | 44 | 1,235 | ||||||
| Other expense | — | — | (278 | ) | |||||
| Income before income tax expense | 170 | 5,751 | 116,092 | ||||||
| Income tax expense | 161 | 452 | 8,106 | ||||||
| Net income | 9 | 5,299 | 107,986 | ||||||
| (1) | Share-based compensation expenses are included in the following financial statements line items: |
| For the Year Ended December 31, | ||||||
| 2006 | 2007 | 2008 | ||||
| ($ in thousands) | ||||||
| Cost of revenues | 74 | 38 | 14 | |||
| Product development | 263 | 170 | 4,919 | |||
| Sales and marketing | — | 10 | 10 | |||
| General and administrative | 52 | 225 | 404 | |||
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Summary Consolidated Balance Sheet Data
| As of December 31, | As of December 31, 2008 | |||||||||
| 2006 | 2007 | Actual | Pro Forma as Adjusted(1)(2) | |||||||
| ($ in thousands) | ||||||||||
| Cash and bank deposits | 1,547 | 15,419 | 134,439 | 183,641 | ||||||
| Total current assets | 1,575 | 24,386 | 166,180 | 214,465 | ||||||
| Total assets | 3,950 | 30,126 | 176,656 | 224,941 | ||||||
| Receipts in advance and deferred revenue | 1,036 | 8,173 | 20,703 | 20,703 | ||||||
| Dividend payable | — | — | — | 96,800 | ||||||
| Total current liabilities | 1,948 | 39,868 | 71,962 | (3) | 168,762 | |||||
| Total shareholders’ equity (deficit) | 2,002 | (9,742 | ) | 104,694 | 56,179 | |||||
| Total liabilities and shareholders’ equity | 3,950 | 30,126 | 176,656 | 224,941 | ||||||
| (1) | Our consolidated balance sheet data is presented on a pro forma as adjusted basis to give effect to (i) our intended declaration prior to the completion of this offering of a cash dividend in the amount of $96.8 million payable to Sohu.com (Game) Limited and (ii) the issuance and sale of 3,750,000 ADSs, representing 7,500,000 Class A ordinary shares, by us in this offering, assuming an initial public offering price of $15.00 per ADS, the mid-point of the estimated range of the initial public offering price, after deducting estimated underwriting discounts and commissions and estimated aggregate offering expenses payable by us and assuming no other change to the number of ADSs sold by us as set forth on the cover page of this prospectus. |
| (2) | The payment of the dividend referred to in footnote (1) above is subject to receipt of PRC government approvals for our indirect subsidiary in China to pay a dividend to us through our Hong Kong subsidiary, Changyou HK. Until the dividend is paid, the amount of the dividend we intend to declare will be reflected in our current liabilities. Upon our payment of the dividend to Sohu.com (Game) Limited and the PRC withholding tax described in footnote (3) below, the amount of our cash and bank deposits will be reduced by $101.8 million, and our total current liabilities will be reduced by the same amount. |
| (3) | Includes PRC withholding tax of $5.0 million in connection with the declaration by AmazGame of a dividend in the amount of $101.8 million to Changyou HK. Changyou HK intends to declare as a cash dividend the net amount of $96.8 million that it receives from AmazGame to us, which amount we intend to declare as a cash dividend to Sohu.com (Game) Limited as described in footnote (1) above. |
Summary Consolidated Statements of Cash Flows Data
| For the Year Ended December 31, | |||||||||
| 2006 | 2007 | 2008 | |||||||
| ($ in thousands) | |||||||||
| Net cash provided by operating activities | 1,648 | 35,512 | 133,916 | ||||||
| Net cash used in investing activities(1) | (733 | ) | (3,115 | ) | (7,806 | ) | |||
| Net cash provided by (used in) financing activities | 329 | (18,426 | ) | (7,305 | ) | ||||
| Effect of exchange rate changes on cash and cash equivalents | (219 | ) | (99 | ) | 215 | ||||
| Net increase in cash and cash equivalents | 1,025 | 13,872 | 119,020 | ||||||
| Cash and cash equivalents at beginning of the year | 522 | 1,547 | 15,419 | ||||||
| Cash and cash equivalents at end of the year | 1,547 | 15,419 | 134,439 | ||||||
| (1) | Consists mainly of capital expenditures and proceeds from the disposal of interests in an associate. |
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Summary Operating Data
As used in the tables below and elsewhere in this prospectus:
The average concurrent users of any of our games for a given period is determined as follows: we first determine the number of users logged on to the game at ten-minute intervals and average that data over the course of a day to derive the daily average; the daily average data are then averaged over the period to derive the average concurrent users over the period.
Active paying accounts for a given period refers to the number of accounts from which game points are utilized at least once during the period.
Average revenue per active paying account of any of our games for a given period is our online game operations revenues for a game during the period divided by the active paying accounts of the game during the period.
Our calculation of average concurrent users, active paying accounts and average revenue per active paying account may not be comparable to similarly-named measures presented by other online game companies.
The following table sets forth our game operations revenues from TLBB in China and the related operating data:
| For the Three Months Ended | ||||||||||||||
| Jun. 30, 2007 | Sep. 30, 2007 | Dec. 31, 2007 | Mar. 31, 2008 | Jun. 30, 2008 | Sep. 30, 2008 | Dec. 31, 2008 | ||||||||
| TLBB Operations Revenues | 2,256 | 10,794 | 21,757 | 38,493 | 43,350 | 48,278 | 51,540 | |||||||
| Peak Concurrent Users | 405 | 408 | 531 | 592 | 699 | 690 | 738 | |||||||
| Average Concurrent Users | 181 | 216 | 278 | 306 | 380 | 387 | 411 | |||||||
| Quarterly Active Paying Accounts | 209 | 690 | 1,096 | 1,387 | 1,684 | 1,860 | 1,822 | |||||||
| Quarterly Average Revenue per Active Paying Account | 82 | 118 | 147 | 199 | 179 | 178 | 193 | |||||||
The following table sets forth our game operations revenues from BO in China and the related operating data:
| For the Three Months Ended | ||||||||||||||||
| Mar. 31, 2007 | Jun. 30, 2007 | Sep. 30, 2007 | Dec. 31, 2007 | Mar. 31, 2008 | Jun. 30, 2008 | Sep. 30, 2008 | Dec. 31, 2008 | |||||||||
| BO Operations Revenues | 1,608 | 1,569 | 1,783 | 1,975 | 2,081 | 2,380 | 3,615 | 4,870 | ||||||||
| Peak Concurrent Users | 63 | 60 | 64 | 68 | 69 | 74 | 82 | 95 | ||||||||
| Average Concurrent Users | 42 | 42 | 42 | 47 | 46 | 46 | 51 | 55 | ||||||||
| Quarterly Active Paying Accounts | 217 | 138 | 143 | 147 | 127 | 123 | 146 | 159 | ||||||||
| Quarterly Average Revenue per Active Paying Account (in RMB) | 58 | 87 | 94 | 100 | 116 | 135 | 169 | 209 | ||||||||
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Investment in our ADSs involves significant risks. You should carefully consider the risks described below before you decide to buy our ADSs. If any of the possible adverse events discussed below actually occurs, our business, prospects, financial condition and results of operations could be materially and adversely affected, the trading price of our ADSs could decline and you could lose all or part of your investment.
Risks Related to Our Business and Our Industry
Our limited operating history makes evaluating our business and prospects difficult.
We were incorporated on August 6, 2007 in the Cayman Islands as an indirect wholly-owned subsidiary of Sohu.com Inc. On December 1, 2007, Sohu transferred all of its MMORPG business to us. We have launched three MMORPGs, including KO in June 2003, BO in October 2004 and TLBB in May 2007, all of which were launched when we were still a business unit of the Sohu Group. KO and BO are licensed games. We terminated the operation of KO in November 2006 when its license expired. We developed TLBB in-house. TLBB generated a substantial majority of our revenues for the years ended December 31, 2007 and 2008. We expect to begin open beta testing of three new MMORPGs, including IF, a licensed game, and DMD, an in-house developed game, in the second and fourth quarters of 2009, respectively, and of LAW, a licensed game, in early 2010. Our limited operating history may not provide a meaningful basis for you to evaluate our business and prospects. Furthermore, we have been a business unit within the Sohu Group prior to our reorganization and have had no experience running our business as a separate, stand-alone company. Our business strategy has not been proven over time and we cannot be certain that we will be able to successfully expand our MMORPG business. In addition, you should not place undue reliance on our financial statements included in this prospectus, as such financial statements may not be representative of our financial condition and results of operations if we were a separate, stand-alone company.
You should also consider additional risks and uncertainties that may be experienced by early stage companies operating in a rapidly developing and evolving industry. Some of these risks and uncertainties relate to our ability to:
| Ÿ | develop or license new MMORPGs that are appealing to game players and meet our expected timetable for launches of new games; |
| Ÿ | raise our brand recognition and game player loyalty; and |
| Ÿ | successfully adapt to an evolving business model. |
We may not be successful in addressing the risks listed above, which may materially and adversely affect our business prospects.
We are not likely to sustain our recent growth rate.
Our revenues have grown significantly in a relatively short period of time, in particular after our launch of TLBB in May 2007. The peak concurrent users of TLBB reached approximately 400,000 within the first month of its launch in May 2007, and its quarterly peak concurrent users were approximately 738,000 in the fourth quarter of 2008. TLBB was ranked by IDC as the third most popular online game overall in China in 2007. Primarily due to the commercial success of TLBB, our revenues grew from $1.6 million for the three months ended March 31, 2007 before the launch of TLBB to $58.4 million for the three months ended December 31, 2008, representing an increase of 35.5 times over seven quarters, and our net income grew from a net loss of $1.4 million for the three months ended March 31, 2007 to net income of $29.1 million for the three months ended December 31, 2008. We are not likely to sustain similar growth rate in revenues or net income in future periods due to a number of factors, including, among others, the greater difficulty of growing at sustained rates from a
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larger revenue base, the uncertain level of popularity of our future games, the potential need to expend greater amounts in order to develop or acquire new games, and the potential increases in our costs and expenses as a separate, stand-alone public company. For example, for the three months ended December 31, 2008, our revenues grew 6.9% over the three months ended September 30, 2008, which is significantly lower than the revenue growth rate of the previous several quarters, as TLBB has entered into a more mature stage. Accordingly, you should not rely on the results of any prior period as an indication of our future financial and operating performance.
We may be adversely affected by the slowdown of China’s economy caused in part by the recent global crisis in the financial services and credit markets.
We rely on the spending of our game players for our revenues, which may in turn depend on the players’ level of disposable income, perceived future earnings capabilities and willingness to spend. The growth of China’s economy experienced a slowdown after the second quarter of 2007, when the quarterly growth rate of China’s gross domestic product reached 11.9%. A number of factors have contributed to this slowdown, including appreciation of the Renminbi, which has adversely affected China’s exports, and tightening macroeconomic measures and monetary policies adopted by the PRC government aimed at preventing overheating of China’s economy and controlling China’s high level of inflation. The slowdown was further exacerbated by the recent global crisis in the financial services and credit markets, which in recent months has resulted in extreme volatility and dislocation of the global capital markets. In the fourth quarter of 2008, the growth rate of China’s gross domestic product decreased to 6.8%, and the closing of the Shanghai Stock Exchange Composite Index dropped from a high of 6,092 reached on October 16, 2007 to 2,129 on March 13, 2009.
It is uncertain how long the global crisis in the financial services and credit markets will continue and how much adverse impact it will have on the global economy in general and the economies in China and other jurisdictions where we license our games in particular. If our game players reduce their spending on playing MMORPGs due to such uncertain economic conditions, our business may be adversely affected.
We currently depend on TLBB for a substantial majority of our revenues. Any decrease in TLBB’s popularity may materially and adversely affect our results of operations.
We currently rely on our in-house developed MMORPG, TLBB, for a substantial majority of our revenues. Including revenues from game operations and overseas licensing, revenues generated from TLBB accounted for 93.6% of our total revenues for the year ended December 31, 2008. We launched TLBB in May 2007, and we cannot guarantee how long TLBB will continue to sustain its current level of popularity. To prolong this game’s lifespan, we need to continually improve and update it on a timely basis with new features that appeal to existing game players and attract new game players, and to market these new features. Despite our efforts to improve TLBB, our game players may nevertheless lose interest in the game over time. See “—We may not be successful in operating and improving our games to satisfy the changing demands of game players.” If we fail to improve and update TLBB on a timely basis, or if our competitors introduce more popular games catering to our game player base, which could include games adapted from other novels written by Louis Cha, TLBB may lose its popularity, which could materially decrease our revenues.
Furthermore, if there are any interruptions in TLBB’s operations due to unexpected server interruptions, network failures or other factors, game players may be prevented or deterred from making purchases of virtual items, which may also result in significant decreases in our revenues.
We expect to rely on MMORPGs as our only source of revenue. Any adverse trend affecting MMORPGs may materially and adversely affect our business.
We entered into a Non-Competition Agreement with Sohu which prohibits us from engaging in certain businesses that Sohu is currently conducting or is contemplating conducting, including the development and
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operation of online games other than MMORPGs, during the non-competition period. See “Our Relationship with Sohu—Our relationship with Sohu following the Offering.” As a result, during such non-competition period, we will not be able to diversify our business into businesses Sohu is currently conducting or contemplating to conduct, even if such business presents growth opportunities for us. Therefore, we expect to rely on MMORPGs as our only source of revenue, and may face competition from other online games, including those developed and/or operated by Sohu.
We may not be successful in operating and improving our games to satisfy the changing demands of game players.
We depend on purchase and continual consumption of virtual items by our game players to generate revenues, which in turn depends on the continued attractiveness of our games to the game players and their satisfactory game-playing experience. We provide support for our games and collect game players’ feedback on their game-playing experience in order to resolve any programming flaws or other game operational issues in a timely manner. We also use software and systems to monitor game players’ preferences in order to develop and improve game features and virtual items in a way that is attractive to our game players. We continue to improve our games through regular updates as well as periodic major enhancements using expansion packs. However, we cannot assure you that our efforts will be effective in eliminating program errors associated with our games, satisfying game player demands, or retaining the continued attractiveness of our games. For example:
| Ÿ | we may fail to provide game updates and expansion packs in a timely manner due to technologies, resources or other factors; |
| Ÿ | our game updates and expansion packs may contain program errors, and their installation may create other unforeseen issues that adversely affect the game-playing experience; |
| Ÿ | we may fail to timely respond and/or resolve complaints from our game players; and |
| Ÿ | our game updates and expansion packs may change rules or other aspects of our games that our game players do not welcome, resulting in reduction of peak concurrent users and/or average concurrent users of our games. |
Our failure to address the above-mentioned issues could adversely affect the game-playing experience of our game players, damage the reputation of our games, shorten the lifespan of our games, and eventually result in the loss of game players and a decrease in our revenues.
Furthermore, for the games that we license from third parties, we may not have access to the game source codes during the initial period of the license or at all. Without the source codes, we have to rely on the licensors to provide updates and enhancements during the initial period, giving us less control over the quality and timeliness of updates and enhancements. If our game players are not satisfied with the level of services they receive, they may choose to not play the games, leading to a decrease in our revenues.
We may fail to launch new games according to our timetable, and our new games may not be commercially successful, or may attract game players away from our existing games.
We must introduce new games that can generate additional revenue and diversify our revenue source in order to remain competitive. We have three games in the pipeline, DMD, IF and LAW. We expect to begin open beta testing of IF and DMD in the second and fourth quarters of 2009, respectively, and of LAW in early 2010. We are developing DMD in-house and we have licensed IF and LAW from local third-party developers. We will not generate any revenue from a game until it enters open beta testing. However, we cannot assure you that we will be able to meet our timetable for new game launches. A number of factors, including technical difficulties, lack of sufficient game development personnel and other resources, and adverse developments in our relationship with the licensors of our new licensed games could result in delayed launching of our new games. In addition, we
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cannot assure you that our new games will be as well received in the market as TLBB, and you should not use TLBB as an indication of the commercial success of our future games. There are many factors that may adversely affect the popularity of our 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 plan and organize marketing and promotion 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 product development costs, which can be significant.
In addition, our new games may attract game players away from our existing games. In particular, DMD is an MMORPG based on a novel written by Louis Cha, the same author of “Tian Long Ba Bu,” based on which we developed TLBB. We cannot assure you that our TLBB game players will not be attracted to play DMD instead of TLBB after DMD’s launch. If this occurred, it would decrease our existing games’ player bases, which could in turn make these games less attractive to other game players, resulting 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 total revenues.
Our business may not succeed in a highly competitive market.
Competition in the online game market in China is becoming increasingly intense. For example, according to IDC, there were more than 140 game developers and 281 game titles in 2007. There were four online game companies, Perfect World Co., Ltd., Giant Interactive Group Inc., Kingsoft Corporation Limited and NetDragon Websoft Inc., that successfully listed their shares on NASDAQ, the New York Stock Exchange or the Hong Kong Stock Exchange in the second half of 2007 alone, adding to the previously listed public companies focusing on the online game market in China, such as NetEase.com, Inc., Shanda Interactive Entertainment Limited, Tencent Holdings Limited and The9 Limited, most of which focus on MMORPGs. Moreover, there are many venture-backed private companies focusing on online game development, and MMORPG development in particular, further intensifying the competition. Recently, many of our competitors have been aggressively hiring talent for game development, increasing spending on marketing for games and bidding for licenses of games. Increased competition in the online game market may make it difficult for us to retain our existing employees and attract new employees, and to sustain our growth rate. Furthermore, we also face intense competition for cost-effective marketing resources for online games, such as online game-related websites, which could drive up our marketing costs and decrease the effectiveness of our marketing campaigns.
We have a history of net losses, which might occur again in the future.
We incurred net losses from the inception of our business until the third quarter of 2007. We cannot assure you that we can remain profitable or avoid net losses in the future or that there will not be any earnings or revenue declines for any future quarterly or other periods. We expect that our operating expenses will increase as we grow our business, including significantly increasing our headcount and expending substantial resources for product development and marketing, and as we operate as a separate, stand-alone company. As a result, any decrease or delay in generating revenues could result in material operating losses.
Our operating results for a particular period could fall below our expectations or the expectations of investors or research analysts, resulting in a decrease in the price of our ADSs.
Our operating results may vary significantly from period to period as a result of factors beyond our control, such as the recent slowdown in China’s economic growth caused in part by the recent severe global crisis in the financial services and credit markets, and may be difficult to predict for any given period. Our past results may not be indicative of our future performance and our quarterly results may not be indicative of our full year results. If our operating results for any period fall below our expectations or the expectations of investors or research analysts, the price of our ADSs is likely to decrease.
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We generate all of our revenues under the item-based revenue model, which has a short history of commercial application and presents risks related to consumer preferences and regulatory restrictions.
When we first launched BO in October 2004, it generated revenue under the time-based revenue model. Currently, we operate both of our games, TLBB and BO, under the item-based revenue model. Under this revenue model, our game players are free to play the games for an unlimited amount of time, but are charged for the purchases of certain virtual items. We currently expect that a substantial majority of our revenues, including revenues from all of our current pipeline games, will continually be generated under the item-based revenue model. The item-based revenue model requires us to design games that not only attract game players to spend more time playing, but also encourages them to purchase virtual items. The sale of virtual items requires us to track closely consumer tastes and preferences, especially as to in-game consumption patterns. If we fail to design virtual items so as to incentivize game players to purchase them, we may not be able to effectively translate our game player base and their playing time into revenues. Although the item-based revenue model is currently a prevalent revenue model for MMORPGs in China, it does not have a long history of proven commercial application. In addition, the item-based revenue model may cause additional concerns with PRC regulators who have been implementing regulations designed to reduce the amount of time that Chinese youths spend on online games and intended to limit the total amount of virtual currency issued by online game operators and the amount of purchase by individual game player. A revenue model that does not charge for time may be viewed by the PRC regulators as inconsistent with this goal. We cannot assure you that the item-based revenue model will continue to be commercially successful, or that we will not in the future need to change our revenue model back to the time-based revenue model or to a new revenue model. Any change in revenue model could result in disruption of our game operations and decrease in the number of our game players.
We rely on data recorded in our billing systems for revenue recognition and tracking of game players’ consumption patterns of virtual items. If our billing systems fail to operate effectively, it will not only affect the completeness and accuracy of our revenue recognition, but also our ability to design and improve virtual items that appeal to game players.
Our game operations revenues are collected through the sale of our prepaid game cards or online direct sale of game points. However, we do not recognize revenues when our prepaid game card or game points are sold. Rather, our revenues are recognized when the virtual items purchased by our game players are consumed. For consumable virtual items, including those with a predetermined expiration time, revenues are recognized as they are consumed, and for perpetual virtual items, revenues are recognized over their estimated lives. We rely on our billing systems to capture the purchase and consumption of the virtual items by our game players. If our billing systems fail to accurately record the purchase and consumption information of the virtual items, we may not be able to accurately recognize our revenues. In addition, various factors affect the estimated lives of perpetual virtual items, such as the average period that game players typically play our games and other game player behavior patterns, the acceptance and popularity of expansion packs, promotional events launched and market conditions, and we rely on our billing systems to capture such historical game player behavior patterns and other information. If such information is not accurately recorded, or if we do not have sufficient information due to our short operating history of TLBB, we will not be able to accurately estimate the lives of the perpetual virtual items, which will also affect our ability to accurately recognize our revenues from such perpetual virtual items. Therefore, if our billing systems were damaged by system failure, network interruption, or virus infection, or attacked by a hacker, the integrity of data would be compromised, which could materially and adversely affect our revenue recognition and the completeness and accuracy of our recognized revenues, resulting in possible restatement of our financial statements and loss of investors’ confidence in us.
In addition, we rely on our billing systems to record game player purchase and consumption patterns, based on which we improve our existing virtual items and design new virtual items. For example, we intend to increase development efforts on the number and variety of virtual items that our game players like to purchase, and we may also adjust prices accordingly. If our billing systems fail to record data accurately, our ability to
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improve existing virtual items or design new virtual items that are appealing to our game players may be adversely affected, which could in turn materially and adversely affect our revenues.
Rapid technological changes may increase our game development costs.
The online game industry is evolving rapidly, so we need to anticipate new technologies and evaluate their possible market acceptance. In addition, government authorities or industry organizations may adopt new standards that apply to game development. Any new technologies and new standards may require increases in expenditures for MMORPG 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 in the marketplace. As a result, our business prospects and results of operations could be materially and adversely affected.
Our business may be materially harmed if our MMORPGs are not featured in a sufficient number of Internet cafes in China.
A substantial number of game players access our games through Internet cafes in China. Due to limited hardware capacity, Internet cafes generally feature a limited number of games on their computers. We thus compete with a growing number of other online game operators to ensure that our games are featured on these computers. This competition may intensify in China due to a recent nationwide suspension of approval for the establishment of new Internet cafes in 2007. See “Regulation—Internet Cafe Regulation.” We take steps to ensure that our games are featured in a sufficient number of Internet cafes, including maintaining good relationships with Internet cafe operators, requiring our distributors to maintain a sales presence in a large number of Internet cafes, conducting periodical promotional activities in select Internet cafes, and other general sales and marketing efforts. If we fail to maintain good relationships with Internet cafe operators, or if we and/or our distributors fail to successfully persuade Internet cafes to feature our MMORPGs, our revenues may be materially and adversely affected.
Our marketing and promotion have benefited significantly from our association with Sohu. Any negative development in Sohu’s market position or brand recognition may materially and adversely affect our marketing efforts and the popularity of our games.
We were a business unit under Sohu and expect to continue to be part of the Sohu Group after the offering, as Sohu is expected to remain our controlling shareholder. We have benefited significantly from Sohu in marketing our games. For example, we have benefited from Sohu’s large user base by marketing and advertising across Sohu’s domains and using the Sohu Group’s single-user ID system, which provides Sohu’s registered users easy access to our games. We also benefit from Sohu’s strong brand recognition in China, which has provided us credibility and a broad marketing reach.
If Sohu loses its market position, the effectiveness of our marketing efforts through our association with Sohu may be materially and adversely affected. In addition, any negative publicity associated with Sohu.com or its affiliated websites will likely have an adverse impact on the effectiveness of our marketing on those sites as well as our reputation and our brand.
We may be exposed to infringement or misappropriation claims by third parties, which, if determined adversely to us, could subject us to significant liabilities and other costs.
Our success depends largely on our ability to use and develop our technology and know-how without infringing the intellectual property rights of third parties. We cannot assure you that third parties will not assert intellectual property claims against us. We are subject to additional risks if entities licensing to us intellectual property, including, for example, game source codes, do not have adequate rights in any such licensed materials.
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The validity and scope of claims relating to the intellectual property of game development and technology involve complex scientific, legal and factual questions and analysis and, therefore, tend to be uncertain. If third parties assert copyright or patent infringement or violation of other intellectual property rights against us, we have to defend ourselves in litigation or administrative proceedings, which can be both costly and time consuming and may significantly divert the efforts and resources of our technical and management personnel. An adverse determination in any such litigation or proceedings to which we may become a party could subject us to significant liability to third parties, require us to seek licenses from third parties, to pay ongoing royalties, or to redesign our games or subject us to injunctions prohibiting the development and operation of our games.
We may need to incur significant expenses to enforce our proprietary rights, and if we are unable to protect such rights, our competitive position could be harmed.
We regard our proprietary software, domain names, trade names, copyrights, trademarks, trade secrets and other intellectual property as critical to our success. In particular, we have spent a significant amount of time and resources in developing TLBB and our ability to protect our proprietary rights in connection with TLBB is critical for the success of this game and our overall financial performance. We have registered a number of software in China for copyright protection, including our TLBB software, and we have taken various measures to protect our source codes, including confidentiality agreements and segregation of source codes, so that only our Chief Technology Officer has access to the entire source codes for any of our games. We have registered two trademarks in Taiwan relating to TLBB. We have also applied for registration of 225 trademarks in the PRC and additional trademarks in Taiwan, which relate to our name and our MMORPGs. See “Business—Intellectual Property and Proprietary Rights.” However, we may not succeed in obtaining trademarks that we have applied for, including any trademarks relating to our game TLBB. Any failure to register trademarks may limit our ability to protect our rights under relevant trademark laws, and we may even need to change the name or the relevant trademark in certain cases, which may adversely affect our branding and marketing efforts.
In addition, we cannot assure you that our measures will be sufficient to protect our proprietary information and intellectual property. Intellectual property rights and confidentiality protection in China may not be as effective as in the United States or other developed countries. Policing unauthorized use of proprietary technology is difficult and expensive. Any steps we have taken to prevent the misappropriation of our proprietary technology may be inadequate. The validity, enforceability and scope of protection of intellectual property in Internet-related industries are uncertain and still evolving. In particular, the laws and enforcement procedures in the PRC are uncertain and do not protect intellectual property rights in this area to the same extent as do the laws and enforcement procedures in the United States and other developed countries.
Despite our efforts to protect our intellectual property, we cannot assure you that other online game developers will not copy our ideas and designs, or other third parties will not infringe our intellectual property rights. For example, certain third parties have misappropriated the source codes of previous versions of TLBB and have set up unauthorized servers in China and elsewhere to operate TLBB to compete with us. As a result, we have taken measures to enforce our intellectual property rights. However, we cannot assure you that such measures will be successful in eliminating these unauthorized servers. The existence of unauthorized servers may attract game players away from our games and may result in decreases in our revenues. Litigation relating to intellectual property rights may result in substantial costs to us and diversion of resources and management attention away from our business, and may not be successful. In addition, as our ideas and designs are not protected by patents, other online game developers may independently develop ideas and designs that compete with us.
We may fail to maintain a stable and efficient physical distribution network for our prepaid game cards.
Online payment systems in China are in a developmental stage and are not as widely available to or accepted by consumers in China as they are in the United States. We rely heavily on a physical distribution network composed of third-party distributors to cover a network of retail outlets across China for the sales of our
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prepaid game cards to our game players. As a result, our revenues could be adversely affected by the under-performance of our distributors, such as the failure to meet minimum sales or penetration targets or the failure to establish an extensive retail network. Prior to January 1, 2009, we generally signed six-month agreements, and commencing January 1, 2009, we only sign one-year agreements with our distributors. We cannot assure you that we will continue to maintain favorable relationships with them. In addition, our distributors may violate our distribution agreements. Such violations may include, among other things, their:
| Ÿ | failure to maintain minimum price levels for our prepaid game cards in accordance with our distribution agreements; |
| Ÿ | failure to properly promote our MMORPGs in local Internet cafes and other important outlets, or cooperate with our sales and marketing team’s efforts in their designated territories; and |
| Ÿ | selling our prepaid game cards outside their designated territories. |
In the past, some of our distributors have failed to carry out their obligations in accordance with the distribution agreements, which resulted in our termination of our distribution relationship with them. If we decide to penalize, suspend or terminate our distributors for acting in violation of our distribution agreements, or if the distributors fail to address material violations committed by any of their retail outlets in a timely manner, our ability to effectively sell our prepaid game cards in any given territory could be negatively impacted, which could materially and adversely affect our revenues.
We could be liable for breaches of security of our and third-parties’ online payment platforms, and sales made through those channels might have a negative impact on our revenues.
Currently, we rely on Sohu’s online payment platform, or the PEAK system, to directly sell a substantial portion of virtual prepaid game cards and game points to our game players. We also sell our virtual prepaid game cards through other third-party online payment platforms. In all these online transactions, secured transmission of confidential information, such as customers’ credit card numbers and expiration dates, personal information and billing addresses, over public networks is essential to maintain consumer confidence. In addition, we expect that an increasing amount of our sales will be conducted over the Internet as a result of the growing use of online payment systems. As a result, the associated online crime will likely increase as well. We cannot assure you that our current security measures and those of the third parties with whom we transact business are adequate. We must be prepared to increase our security measures and efforts so that our game players have confidence in the reliability of the online payment systems that we use, which will require additional costs and expenses and may still not be completely safe. In addition, we do not have control over the security measures of our third-party online payment vendors. Security breaches of the online payment systems that we use could expose us to litigation and possible liability for failing to secure confidential customer information and could harm our reputation, ability to attract customers and ability to encourage customers to purchase virtual items.
We are dependent upon our existing management, our key development personnel and qualified technical personnel, and our business may be severely disrupted if we lose their services.
Our future success depends substantially on the continued services of our executive officers and our key development personnel, such as our Chief Executive Officer, Tao Wang, who has been instrumental in the development of TLBB, our Chief Technology Officer, Xiaojian Hong, and our Chief Operating Officer, Dewen Chen. If one or more of our executive officers and key development personnel were unable or unwilling to continue in their present positions, we might not be able to replace them easily or at all. In addition, if any of our executive officers or key employees joins a competitor or forms a competing company, we may lose know-how, key professionals and staff members as well as suppliers. These executive officers and key employees could develop and operate games that could compete with and take game players away from our existing and future games. Each of our executive officers and key personnel has entered into an employment agreement with us, which contains non-competition provisions. However, if any dispute arises between our executive officers, key
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employees and us, these non-competition provisions may not be enforceable in China. If any of these were to happen, our competitive position and business prospects may be materially and adversely affected.
We are rapidly expanding our business and need to hire a significant number of new employees. If we are unable to attract a sufficient number of qualified new employees or retain our existing employees, our business prospects may be materially and adversely affected.
As we are in the early stages of our development and our business is growing rapidly, we plan to double the number of employees by the end of 2009 as we grow our business and revenues to achieve our strategic objectives, including senior-level executives, experienced project managers and game development personnel. However, our industry in China is characterized by high demand and intense competition for talent, particularly for game developers and related technical personnel, and we may not be able to attract a sufficient number of qualified new employees or retain existing employees to meet the growth of our business, in which case our growth strategy and our business prospects could be materially and adversely affected.
Our business could suffer if we do not successfully manage our current and future growth.
We have experienced a period of rapid growth and expansion that has placed, and will continue to place, strain on our management personnel, systems and resources. To accommodate our growth pursuant to our strategies, we anticipate that we will need to implement a variety of new and upgraded operational and financial systems, including online payment systems and related security systems, procedures and controls, and the improvement of our accounting and other internal management systems, all of which require substantial management efforts and financial resources. We will also need to continue to expand, train, manage and motivate our workforce, and manage our relationships with our distributors, third-party service providers and game player base. All of these endeavors will require substantial management effort and skills and the incurrence of additional expenditures. We cannot assure you that we will be able to efficiently or effectively implement our growth strategies and manage the growth of our operations, and any failure to do so may limit our future growth and hamper our business strategy.
We incur additional costs and face significant risks when we license our games outside of China and seek to expand our operations to select markets, such as the United States. If we fail to manage these risks, our growth and business prospects could be materially and adversely affected.
We currently license TLBB to third-party operators to operate the game in Taiwan, Hong Kong, Vietnam, Malaysia and Singapore. Pursuant to our strategy, we plan to continue to license TLBB and other future games in these and other overseas markets. We also intend to expand our operations to select markets, such as MMORPG operations in the United States. Identifying appropriate overseas markets, negotiating with potential third-party licensees and managing our relationships with our licensees all require substantial management effort and skills and the incurrence of additional expenditures. Licensing games overseas also requires translation of our games to the local language of the overseas market in which we plan to license, and may require customization as well, both of which require additional costs and expenses. Furthermore, there are additional risks in connection with the licensing of our games overseas, including:
| Ÿ | difficulties in identifying and maintaining good relationships with licensees who are knowledgeable about, and can effectively distribute and operate our games in, overseas markets; |
| Ÿ | difficulties and costs relating to compliance with the different legal requirements and commercial terms in the overseas markets in which we license our games, such as game export regulatory procedures, taxes and other restrictions and expenses; |
| Ÿ | difficulties in maintaining the reputation of our company and our games, given that our games are operated by licensees in the overseas markets pursuant to their own standards; |
| Ÿ | changes in the political, regulatory or economic conditions in a foreign country or region, or public policies toward online games; |
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| Ÿ | fluctuations in currency exchange rate; |
| Ÿ | difficulties in verifying revenues generated from our games by our licensees for purposes of determining the royalties to us; |
| Ÿ | difficulties in protecting our intellectual property outside of China; |
| Ÿ | exposure to different regulatory systems governing the protection of intellectual property and the regulation of online games, the Internet and the export of technology; |
| Ÿ | the risk that the regulatory authorities in foreign countries or regions may impose withholding taxes, or place restriction on repatriation of our profits; and |
| Ÿ | inherent difficulties and delays in contract enforcement and collection of receivables through the use of foreign legal systems. |
If we are unable to mange these risks effectively, our ability to license our games overseas may be impaired, which may materially and adversely affect our future growth, financial condition and results of operations.
Potential future acquisitions and/or strategic alliances may have an adverse effect on our ability to manage our business.
We may acquire technologies, businesses or assets that are complementary to our business and/or enter into strategic alliances in order to leverage our position in the Chinese MMORPG market. Future acquisitions or strategic alliances would expose us to potential risks, including risks associated with the integration of new technologies, businesses and personnel, unforeseen or hidden liabilities, the diversion of management attention and resources from our existing business, and the inability to generate sufficient revenues to offset the costs and expenses of acquisitions or strategic alliances. Any difficulties encountered in the acquisition and strategic alliance process may have an adverse effect on our ability to manage our business.
We do not have business insurance coverage.
The insurance industry in China is still at an early stage of development. Insurance companies in China offer limited business insurance products, or offer them at a high price. As a result, we do not have any business liability, loss of data or disruption insurance coverage for our operations in China. Any business disruption, litigation or natural disaster might result in our incurring substantial costs and the diversion of our resources.
There are uncertainties regarding the future growth of the online game industry in China.
The online game industry, from which we derive all of our revenues, is a relatively new and evolving industry. The growth of the online game industry and the level of demand and market acceptance of our games are subject to a high degree of uncertainty. Our future operating results will depend on numerous factors affecting the online game industry, many of which are beyond our control, including:
| Ÿ | the growth of personal computer, Internet and broadband users and penetration in China and other markets in which we offer our games, and the rate of any such growth; |
| Ÿ | whether the online game industry, particularly in China and the rest of the Asia-Pacific region, continues to grow and the rate of any such growth; |
| Ÿ | general economic conditions in China, particularly economic conditions adversely affecting discretionary consumer spending, such as the slowdown in China’s economic growth partly caused by the recent global crisis in the financial services and credit markets; |
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| Ÿ | the availability and popularity of other forms of entertainment, particularly games of console systems, which are already popular in developed countries and may gain popularity in China; and |
| Ÿ | changes in consumer demographics and public tastes and preferences. |
There is no assurance that online games, in particular MMORPGs, will continue to be popular in China or elsewhere. A decline in the popularity of online games in general, or the MMORPGs that we operate, will likely adversely affect our business and prospects.
The successful operation of our business and implementation of our growth strategies, including our ability to accommodate additional game players in the future, depend upon the performance and reliability of the Internet infrastructure and fixed telecommunications networks in China.
Although private Internet service providers currently exist in China, almost all access to the Internet is maintained through state-owned telecommunications operators under the administrative control and regulatory supervision of the Ministry of Industry and Information Technology, or MIIT (formerly the Ministry of Information Industry). We rely on this infrastructure to provide data communications capacity primarily through local telecommunications lines. Although the government has announced plans to develop aggressively the national information infrastructure, we cannot assure you that this infrastructure will be developed as planned or at all. In addition, we will have no access to alternative networks and services, on a timely basis if at all, in the event of any infrastructure disruption or failure. The Internet infrastructure in China may not support the demands necessary for the continued growth in Internet usage.
The limited use of personal computers in China and the relatively high cost of Internet access in relation to per capita gross domestic product may limit the development of the Internet in China and impede our growth.
The penetration rate for personal computers in China is significantly lower than it is in the United States and other developed countries. Furthermore, the cost of Internet access is still relatively high as compared to other developed countries. The limited use of personal computers in China and the relatively high cost of Internet access may limit the growth of our business. See “—The successful operation of our business and implementation of our growth strategies, including our ability to accommodate additional game players in the future, depend upon the performance and reliability of the Internet infrastructure and fixed telecommunications networks in China.” In addition, there may be increases in Internet access fees or telecommunication fees in China. If that happens, the number of our game players may decrease and the growth of our game player base may be materially impacted.
We face risks related to health epidemics and other natural disasters.
Our business could be adversely affected by the effects of avian flu, SARS or other epidemics or outbreaks. China reported a number of cases of SARS in 2003, which resulted in the closure by the PRC government of many businesses in May and June of 2003 to prevent the transmission of SARS. 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. Any prolonged recurrence of avian flu, SARS or other adverse public health developments in China may have a material adverse effect on our business operations. These could include illness and loss of our management and key employees, as well as temporary closure of our offices and related other businesses, such as server operations, upon which we rely. Such loss of management and key employees or closures would severely disrupt our business operations. We have not adopted any written preventive measures or contingency plans to combat any future outbreak of avian flu, SARS or any other epidemic. In addition, other major natural disasters may also adversely affect our business by, for example, causing disruptions of the Internet network or otherwise affecting access to our games. For example, after the Sichuan earthquake in May 2008, we suspended our MMORPG operations during a three-day national mourning period.
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Risks Related to Our Structure and Regulations
If the PRC government determines that the VIE structure for operating our business does not comply with PRC government restrictions on foreign investment in the online game industry, we could face severe penalties.
Various regulations in China currently restrict or prevent foreign-invested entities from engaging in telecommunication services, including operating online games. Because of these restrictions, our MMORPG operations in the PRC are conducted through our VIE, Gamease, a PRC company that is owned by our Chief Executive Officer and a Changyou employee, both of whom are PRC citizens, but which is effectively controlled by our subsidiary, AmazGame, through a series of contractual arrangements. For details of these contractual arrangements, see “Our History and Corporate Structure.”
A circular issued by MIIT in July 2006, or the MIIT circular, reiterated the regulations on foreign investment in telecommunications businesses. Under this circular, a domestic company that holds a license for the provision of Internet information service, or an ICP license, or a license to conduct any value-added telecommunications business 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, the relevant trademarks and domain names that are used in the value-added telecommunications business must be owned by the local ICP license holder. The circular further requires each ICP license holder to have the necessary facilities for its approved business operations and to maintain such facilities in the regions covered by its license. In addition, all value-added telecommunications service providers are required to maintain network and information security in accordance with the standards set forth under relevant PRC regulations. Due to a lack of interpretative materials from the regulators, it is uncertain whether MIIT would consider our corporate structures and contractual arrangements as a kind of foreign investment in telecommunication services. Therefore, it is unclear what impact this circular will have on us or the other Chinese Internet companies that have adopted the same or similar corporate structures and contractual arrangements as ours.
In the opinion of our PRC counsel, Commerce & Finance Law Offices, (i) the ownership structure and the business and operation model of each of AmazGame and Gamease are in compliance with all existing PRC laws and regulations, and (ii) each contract that AmazGame entered into with Gamease and its shareholders is valid and binding, and will not result in any violation of PRC laws or regulations currently in effect. However, there are substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including the MIIT circular discussed above. Accordingly, we cannot assure you that the PRC regulatory authorities will ultimately take a view that is consistent with the opinion of our PRC counsel.
If we are found to be in violation of any existing or future PRC laws or regulations, including the MIIT circular, the relevant regulatory authorities would have broad discretion in dealing with such violation, including levying fines, confiscating our income, revoking Gamease’s or AmazGame’s business or operating licenses, requiring us to restructure the relevant ownership structure or operations, and requiring us to discontinue all or any portion of our game operations. Any of these actions could cause significant disruption to our business operations.
AmazGame’s contractual arrangements with Gamease and its shareholders may not be as effective in providing control over Gamease as direct ownership of Gamease and the shareholders of Gamease may have potential conflicts of interest with us.
We have no ownership interest in Gamease and we conduct substantially all of our operations and generate substantially all of our revenues through contractual arrangements that our subsidiary, AmazGame, had
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entered into with Gamease and its shareholders, and such contractual arrangements are designed to provide us with effective control over Gamease. See “Our History and Corporate Structure” for a description of these contractual arrangements. We depend on Gamease to hold and maintain certain licenses necessary for our game business. Gamease also owns all of the necessary intellectual property, facilities and other assets relating to the operation of our games, and employs personnel for our game operations and distribution.
Although in the opinion of our PRC counsel, Commerce & Finance Law Offices, each of these contractual arrangements is valid, binding and enforceable, and will not result in any violation of PRC laws or regulations currently in effect, they may not be as effective in providing us with control over Gamease as direct ownership. If we had direct ownership of Gamease, we would be able to exercise our rights as a shareholder to effect changes in the board of directors of Gamease, which in turn could effect changes, subject to any applicable fiduciary obligations, at the management level. Due to our VIE structure, we have to rely on contractual rights to effect control and management of Gamease, which exposes us to the risk of potential breach of contract by the shareholders of Gamease. In addition, as Gamease is jointly owned by its shareholders, it may be difficult for us to change our corporate structure if such shareholders refuse to cooperate with us.
The shareholders of Gamease may breach, or cause Gamease to breach, the contracts for a number of reasons. For example, their interests as shareholders of Gamease and the interests of our company may conflict and we may fail to resolve such conflicts; the shareholders may believe that breaching the contracts will lead to greater economic benefit for them; or the shareholders may otherwise act in bad faith. If any of the foregoing were to happen, we may have to rely on legal or arbitral proceedings to enforce our contractual rights, including specific performance or injunctive relief, and claiming damages. Such arbitral and legal proceedings may cost us substantial financial and other resources, and result in disruption of our business, and we cannot assure you that the outcome will be in our favor.
In addition, as all of these contractual arrangements are governed by PRC law and provide for the resolution of disputes through either arbitration or litigation in the PRC, they would be interpreted in accordance with PRC law and any disputes would be resolved in accordance with PRC legal procedures. The legal environment in the PRC is not as developed as in other jurisdictions, such as the United States. As a result, uncertainties in the PRC legal system could further limit our ability to enforce these contractual arrangements. Furthermore, these contracts may not be enforceable in China if PRC government authorities or courts take a view that such contracts contravene PRC laws and regulations or are otherwise not enforceable for public policy reasons. In the event we are unable to enforce these contractual arrangements, we may not be able to exert effective control over Gamease, and our ability to conduct our business may be materially and adversely affected.
AmazGame and Gamease’s contractual arrangements may result in adverse tax consequences to us.
Under PRC laws and regulations, arrangements and transactions among related parties may be subject to audit or challenge by the PRC tax authorities. We could face material adverse tax consequences if the PRC tax authorities determine that AmazGame and Gamease’s contractual arrangements were not made on an arm’s length basis and adjust our income and expenses for PRC tax purposes in the form of a transfer pricing adjustment. A transfer pricing adjustment could result in a reduction, for PRC tax purposes, of adjustments recorded by Gamease, which could adversely affect us by (i) increasing Gamease’s tax liability without reducing AmazGame’s tax liability, which could further result in interest being levied to us for underpaid taxes; or (ii) limiting the ability of AmazGame and Gamease to maintain preferential tax treatments and other financial incentives.
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All of our revenues are generated through Gamease, our VIE, and we rely on payments made by Gamease to AmazGame, our subsidiary, pursuant to contractual arrangements to transfer any such revenues to AmazGame. Any restriction on such payments and any increase in the amount of PRC taxes applicable to such payments may materially and adversely affect our business and our ability to pay dividends to our shareholders and ADS holders.
We conduct substantially all of our operations through Gamease, our VIE, which generates all of our revenues. As Gamease is not owned by our subsidiaries, it is not able to make dividend payments to our subsidiaries. Instead, AmazGame, our subsidiary in China, entered into a number of contracts with Gamease, including a Business Operation Agreement, a Technology Support and Utilization Agreement, and a Services and Maintenance Agreement, pursuant to which Gamease pays AmazGame for certain services that AmazGame provides to Gamease. However, depending on the nature of services provided, certain of these payments are subject to PRC taxes at different rates, including business taxes and VATs, which effectively reduce the amount that AmazGame receives from Gamease. We cannot assure you that the PRC government will not impose restrictions on such payments or change the tax rates applicable to such payments. Any such restrictions on such payment or increases in the applicable tax rates may materially and adversely affect our ability to receive payments from Gamease or the amount of such payments, and may in turn materially and adversely affect our business, our net income and our ability to pay dividends to our shareholders and ADS holders.
We do not hold Internet publishing licenses, which are required under PRC regulations, for the games we currently operate due to temporary suspension of issuance of such licenses by the General Administration of Press and Publication, or GAPP, since our inception. If GAPP later challenges the commercial operation of our games, or if we fail to obtain or renew necessary licenses to commercially operate our games, we may be subject to various penalties, including restrictions on our operations.
Pursuant to PRC regulations issued by GAPP and MIIT relating to the regulation of online publication, an online game operator needs to obtain an Internet publishing license in order to directly make its online games publicly available in the PRC, as operating online games is deemed to be an online publishing activity. See “Regulations—Online Games and Cultural Products.” We do not hold such a license, as GAPP temporarily suspended issuance of such licenses. Prior to the transfer of all of the assets and operations relating to Sohu’s MMORPG business unit to us on December 1, 2007, our MMORPGs, TLBB and BO, were published in China under an Internet publishing license held by Beijing Sohu Internet Information Service Co., Ltd., or Sohu Internet, a VIE of Sohu, and electronic publication licenses held by third-party publishers. TLBB and BO are currently published in China as electronic publications by the same third-party publishers, but we do not have an Internet publishing license due to the temporary suspension of new issuances by GAPP. We applied for the Internet publishing licenses with respect to TLBB and BO in July 2008. The current PRC regulations are not clear as to the consequence of operating without an Internet publishing license. We have made oral inquiries with the officials at GAPP and have been informed that GAPP is aware of and does not object to such practice, so long as the applications for the Internet publishing licenses for such online games have been filed with GAPP. We cannot assure you that we will be able to obtain the Internet publishing licenses for our games. If this practice is later challenged by GAPP, we may be subject to various penalties, including fines and the discontinuation or restriction on our operations.
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 websites.
The PRC government has adopted regulations governing Internet access and the distribution of news and other information over the Internet. Under these regulations, Internet content providers and Internet publishers are prohibited from posting or displaying over the Internet any content that, among other things, violates PRC laws and regulations, impairs the national dignity of China, or is obscene, superstitious, fraudulent or defamatory. When Internet content providers and Internet publishers, including online game operators, find that information falling within the above scope is transmitted on their websites or is stored in their electronic
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bulletin service systems, they are required to terminate the transmission of such information or delete such information immediately, keep records, and report to relevant authorities. Failure to comply with these requirements could result in the revocation of our ICP license and other required licenses and the closure of our websites. Website operators may also be held liable for prohibited information displayed on, retrieved from or linked to their websites.
In addition, the MIIT has published regulations that subject website operators to potential liability for the actions of game players and others using their websites, including liability for violations of PRC laws prohibiting the dissemination of content deemed to be socially destabilizing.
As these regulations are relatively new and subject to interpretation by the relevant authorities, it may not be possible for us to determine in all cases the type of content that could result in liability for us as an MMORPG developer and operator. In addition, we may not be able to control or restrict the content of other Internet content providers linked to or accessible through our websites, or content generated or placed on our websites by our game players, despite our attempt to monitor such content. To the extent that regulatory authorities find any portion of our content objectionable, they may require us to curtail our games, which may reduce our game player base, the amount of time our games are played or the purchases of virtual items.
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 game players.
In the course of playing our games, TLBB and BO, some virtual assets, such as game player experience, skills and weaponry, are acquired and accumulated. Such virtual assets can be highly valued by game players and in some cases are traded among game players for real money or assets. In practice, virtual assets can be lost for various reasons, such as data loss caused by delay of network service by a network crash, 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 is the legal owner of virtual assets and whether the ownership of virtual assets is protected by law. In addition, it is unclear under PRC law whether an operator of online games such as us would have any liability (whether in contract, tort or otherwise) for loss of such virtual assets by game players. Based on several judgments regarding the liabilities of online game operators for loss of virtual assets by game players, the courts have generally required the online game operators to provide well-developed security systems to protect such virtual assets owned by game players. In the event of a loss of virtual assets, we may be sued by game players and may be held liable for damages.
Our 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. Recently, eight PRC government authorities, including the GAPP, the Ministry of Education and MIIT issued a 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 game players by half when those game 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. This system allows game operators to identify which game 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 game players in the future, our business could be materially and adversely affected.
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The PRC government has begun to tighten its regulation of Internet cafes, which are currently one of the primary places where our games are played. Stricter government regulation of Internet cafes could restrict our ability to maintain or increase our revenues and our game player base.
Internet cafes are one of the primary places where our games are played. In April 2001, the PRC government began tightening its regulation and supervision of Internet cafes. In particular, a large number of Internet cafes without requisite government licenses have been closed. In addition, the PRC government has imposed higher capital and facility requirements for the establishment of Internet cafes. The PRC government’s policy, which encourages the development of a limited number of national and regional Internet cafe chains and discourages the establishment of independent Internet cafes, may also slow down the growth in the number of new Internet cafes. In February 2007, several central governmental authorities jointly issued a notice suspending the issuance of new Internet cafe licenses. It is unclear when or if this suspension will be lifted. Governmental authorities may from time to time impose stricter requirements, such as the customers’ age limit and hours of operation, among others, as a result of the occurrence and perception of, and the media attention on, gang fights, arson and other incidents in or related to Internet cafes. So long as Internet cafes remain as one of the primary places for game players to play our games, any reduction in the number, or any slowdown in the growth, of Internet cafes or restrictions in their operations in China could limit our ability to maintain or increase our revenues and our game player base, thereby adversely affecting our results of operations and business prospects.
Restrictions on virtual currency may adversely affect our game operations revenues.
Our game operations revenues are collected through the sale of our prepaid game cards or online sale of game points. The Notice on the Reinforcement of the Administration of Internet Cafes and Online Games, or the Internet Cafes Notice, issued by the Ministry of Culture on February 15, 2007, directs the People’s Bank of China, or PBOC, to strengthen the administration of virtual currency in online games to avoid any adverse impact on the PRC economy and financial system. This notice provides that the total amount of virtual currency issued by online game operators and the amount purchased by individual game players should be strictly limited, with a strict and clear division between virtual transactions and real transactions carried out by way of electronic commerce. This notice also provides that virtual currency should only be used to purchase virtual items. These restrictions may result in lower sales of our prepaid game cards or game points, and could have an adverse effect on our game operations revenues.
Our business may be adversely affected by public opinion and governmental policies in China as well as in other jurisdictions where we license our MMORPGs to third parties.
Currently, most of our game players in China are young males, many of whom are students. Due to a relatively high degree of game player loyalty to MMORPGs, easy access to personal computers and Internet cafes, and the lack of other appealing forms of entertainment in China, many teenagers in China frequently play online games. This may result in these teenagers spending less time on or refraining from other activities, including education, vocational training, sports, and taking rest, which 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 operations may be adversely affected by implementation of new anti-fatigue-related regulations.” The PRC government has also begun to tighten its regulations on Internet cafes, currently one of the primary places where online games are played, including limiting the issuance of Internet cafe operating licenses and imposing higher capital and facility requirements for the establishment of Internet cafes. See “—The PRC government has begun to tighten its regulation of Internet cafes, which are currently one of the primary places where our games are played. Tightened government regulation of Internet cafes could restrict our ability to maintain or increase our revenues and our game player base.”
Adverse public opinion could discourage game players from playing our games, and could result in government regulations that impose additional limitations on the operations of online games as well as the game
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players’ access to online games, such as imposing stricter age and hour limits on Internet cafes, limiting the issuance of virtual currency by online game operators or the amount of virtual currency that can be purchased by an individual game player, or extending anti-fatigue-related regulations to adults. Such adverse public opinion and tightened government regulations could materially and adversely affect our business prospects and our ability to maintain or increase revenues.
In addition, the PRC State Administration of Taxation recently announced that it will tax game players on the income derived from the trading of virtual currencies at the rate of 20%. However, it is currently unclear how the tax will be collected or if there will be any effect on our game players or our business.
Moreover, similar adverse public reaction may arise, and similar government policies may be adopted, in other jurisdictions where we license out our games, which could materially and adversely affect our overseas licensing revenues.
The laws and regulations governing the online game industry in China are evolving and subject to future changes. We may fail to obtain or maintain all applicable permits and approvals.
The online game industry in China is highly regulated by the PRC government. Various regulatory authorities of the PRC central government, such as the State Council, the MIIT, GAPP, the Ministry of Culture and the Ministry of Public Security, are empowered to issue and implement regulations governing various aspects of the online game industry.
We are required to obtain applicable permits or approvals from different regulatory authorities in order to operate our MMORPGs. For example, as an online game operator in China, we must obtain an Online Cultural Operating Permit from the Ministry of Culture and an Internet publishing license from GAPP in order to distribute games through the Internet. If we fail to maintain any of our permits or approvals or to apply for permits and approvals on a timely basis, we may be subject to various penalties, including fines and the discontinuation or restriction of our operations.
As the online game industry is at an early stage of development in China, new laws and regulations may be adopted from time to time to require additional licenses and permits other than those we currently have, and address new issues that arise. In addition, substantial uncertainties exist regarding the interpretation and implementation of current and any future PRC laws and regulations applicable to the online game industry. We cannot assure you that we will be able to obtain timely, or at all, required licenses or any other new license required in the future. We cannot assure you that we will not be found in violation of any current PRC laws or regulations should their interpretations change, or that we will not be found in violation of any future PRC laws or regulations.
Risks Related to Our Carve-out from Sohu and
Our Continued Relationship with Sohu
We have no experience operating as a separate, stand-alone company.
Changyou was formed on August 6, 2007 as an indirect subsidiary of Sohu.com Inc. to hold and operate the MMORPG business of Sohu. Sohu transferred all of its assets, liabilities and operations relating to its MMORPG business to us on December 1, 2007. Although we had been operating as a business unit within the Sohu Group prior to the carve-out, we have had no experience in conducting our operations on a separate, stand-alone basis. Our senior management has not previously worked together to manage a separate, stand-alone company. We may encounter operational, administrative and strategic difficulties as we adjust to operating as a separate, stand-alone company, which may cause us to react slower than our competitors to industry changes, may divert our management’s attention from running our business or may otherwise harm our operations. In addition, since we are becoming a public company, our management team will need to develop the expertise
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necessary to comply with the numerous regulatory and other requirements applicable to separate, stand-alone public companies, including requirements relating to corporate governance, listing standards and securities and investor relations issues. While we were a business unit within the Sohu Group, we were indirectly subject to requirements to maintain an effective internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002. However, as a separate, stand-alone public company, our management will have to evaluate our internal control system independently with new thresholds of materiality, and to implement necessary changes to our internal control system. We cannot guarantee that we will be able to do so in a timely and effective manner.
Because we have not operated as a separate, stand-alone entity in the past, we may find that we need to acquire assets in addition to those contributed to us in connection with our carve-out. We may fail to acquire assets that prove to be important to our operations or we may not be able to integrate all of our assets.
Our ability to operate our business effectively may suffer if we do not, quickly and cost-effectively, establish our own financial, administrative and other support functions in order to operate as a separate, stand-alone company.
Historically, we have relied on financial, administrative and other resources of Sohu to operate our business. As a separate, stand-alone public company, we will need to create our own financial, administrative and other support systems or contract with third parties to replace Sohu’s systems, as well as the independent internal controls required by the Sarbanes-Oxley Act of 2002. Any failure or significant disruption to our own financial or administrative systems could have an adverse impact on our business operations, such as paying our suppliers and employees, executing foreign currency transactions or performing other administrative services, on a timely basis.
Our financial information included in this prospectus may not be representative of our results as a separate, stand-alone company.
The consolidated financial statements included in this prospectus were prepared on a carve-out basis. We made numerous estimates, assumptions and allocations in our financial information because Sohu did not account for us, and we did not operate, as a separate, stand-alone company for any period prior to December 1, 2007.
Prior to Sohu’s transfer of all the assets and operations of its MMORPG business unit to our PRC subsidiary and VIE, effective December 1, 2007, the operations of our MMORPGs were carried out by various companies owned or controlled by Sohu.com Inc. For periods both before and after December 1, 2007, our consolidated financial statements include the assets, liabilities, revenues, expenses and changes in shareholders’ equity and cash flows that were directly attributable to our MMORPG business whether held or incurred by Sohu or by Changyou. In cases involving assets and liabilities not specifically identifiable to any particular operation of Sohu, only those assets and liabilities transferred or expected to be transferred to Changyou are included in our consolidated balance sheets. With respect to costs of operations of the MMORPG business, an allocation of certain general corporate expenses of Sohu which are not directly related to the MMORPG operations and an allocation of certain advertising and other expenses provided by Sohu to Changyou were also included. These allocations are based on a variety of factors depending upon the nature of the expenses being allocated, including revenue, the number of employees and the number of servers. Our statements of operations also include the sales and marketing expenses and other costs charged from Sohu. The transactions are measured at the amount of consideration established and agreed to by the related parties. Although our management believes that the assumptions underlying our financial statements and the above allocations are reasonable, our financial statements may not necessarily reflect our results of operations, financial position and cash flows as if we had operated as a separate, stand-alone company during the periods presented. See “Our Relationship with Sohu” for our arrangements with Sohu and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Selected Consolidated Financial Data” and the notes to our consolidated financial statements
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included elsewhere in this prospectus for our historical cost allocation. In addition, in preparation for becoming a separate, stand-alone company, we have been establishing our own financial, administrative and other support systems or contracting with third parties to replace Sohu’s systems, the cost of which could be significantly different from cost allocation with Sohu for the same services. Therefore, you should not view our historical results as indicators of our future performance.
We may not be able to continue to receive the same level of support from Sohu and may not be successful in establishing our brand identity.
Sohu has been a leading Internet portal in China, and our MMORPG business has benefited significantly from Sohu’s strong Internet market position in China and its expertise in game review and editing. For example, we have benefited from marketing and advertising across Sohu’s domains (such as Sohu.com, the Sohu portal, and 17173.com, the website maintained by Sohu that is dedicated to online game information), and using Sohu’s email system and the Sohu Group’s single-user ID system, which provide Sohu’s large number of registered users easy access to our games. We also benefit from the strong brand recognition of Sohu in China, which has provided us a broad marketing reach. In addition, Sohu’s experienced game editors reviewed and critiqued our games prior to launch, improving the quality of our games upon launch.
Although we have entered into Master Transaction Agreement, Marketing Services Agreement and other related agreements with Sohu, we cannot assure you we will continue to receive the same level of support from Sohu after we become a separate, stand-alone company. In addition, as an entity that is newly separated from Sohu, Changyou as a brand name does not have the same level of recognition as Sohu in China’s Internet market. As a result, the popularity of our MMORPGs may decline as a result of lack of brand recognition. Additionally, our current customers, suppliers, and partners may react negatively to our carve-out from Sohu. We will need to expend significant time, effort and resources to continue to establish our brand name in the marketplace and our own independent identity. This effort may not be successful, which could materially and adversely affect our business. We have applied for the trademark registration of Changyou and other related trademarks in China, but we cannot assure you we will be able to obtain such trademarks, or obtain them with the scope we seek, which may materially and adversely affect our branding efforts.
Our agreements with Sohu may be less favorable to us than similar agreements negotiated between unaffiliated third parties. In particular, our Non-Competition Agreement with Sohu limits the scope of business that we are allowed to conduct.
We entered into a Master Transaction Agreement, a Non-Competition Agreement, a Marketing Services Agreement and other related agreements with Sohu prior to this offering and the terms of such agreements may be less favorable to us than would be the case if they were negotiated with unaffiliated third parties. In particular, under the Non-Competition Agreement we entered into with Sohu, we are prohibited during the non-competition period (which commences on January 1, 2009 and ends on the later of three years after Sohu no longer owns in the aggregate at least 10% of the voting power of our then outstanding voting securities and five years after the date that the registration statement of which this prospectus forms a part was first publicly filed with the SEC) from entering into any non-MMORPG businesses conducted or contemplated to be conducted by Sohu as of the date of this prospectus. Sohu currently offers casual games in addition to Internet portal, search and mobile value-added services. However, “casual games” is not defined in the Non-Competition Agreement. Such contractual limitations significantly affect our ability to diversify our revenue source and may materially and adversely impact our business and results of operations should the growth of MMORPGs in China slow down. In addition, pursuant to our Master Transaction Agreement with Sohu, we agreed to indemnify Sohu for, among other things, liabilities arising from litigation and other contingencies related to our business and assumed these liabilities as part of our carve-out from Sohu. The allocation of assets and liabilities between Sohu and our company may not reflect the allocation that would have been reached by two unaffiliated parties. Moreover, so long as Sohu continues to control us, we may not be able to bring a legal claim against Sohu in the event of
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contractual breach, notwithstanding our contractual rights under the agreements described above and other inter-company agreements entered into from time to time.
Sohu will control the outcome of shareholder actions in our company.
Our ordinary shares are divided into Class A ordinary shares and Class B ordinary shares. Holders of Class A ordinary shares are entitled to one vote per share, while holders of Class B ordinary shares are entitled to 10 votes per share. We will issue Class A ordinary shares represented by our ADSs in this offering and Sohu holds Class B ordinary shares. Upon completion of this offering, assuming the underwriters do not exercise their over-allotment option, Sohu will hold 70.7% of the combined total of our outstanding Class A and Class B ordinary shares, and will control 81.5% of the total voting power of the combined total of our outstanding Class A and Class B ordinary shares due to the additional voting power of the Class B ordinary shares it holds. Sohu has advised us that it does not anticipate disposing of its voting control in us in the near future. Sohu’s voting power gives it the power to control actions that require shareholder approval under Cayman Islands law, our memorandum and articles of association and NASDAQ requirements, including the election and removal of any member of our board of directors, significant mergers and acquisitions and other business combinations, changes to our memorandum and articles of association, the number of shares available for issuance under share incentive plans, and the issuance of significant amounts of our ordinary shares in private placements. Due to the disparate voting powers attached to the two classes of our ordinary shares, Sohu will have sufficient voting power to determine the outcome of all matters requiring shareholder approval even if it should, at some point in the future, hold considerably less than a majority of the combined total of our outstanding Class A and Class B ordinary shares.
Sohu’s voting control may cause transactions to occur that might not be beneficial to you as a holder of ADSs, and may prevent transactions that would be beneficial to you. For example, Sohu’s voting control may prevent a transaction involving a change of control of us, including transactions in which you as a holder of our ADSs might otherwise receive a premium for your securities over the then-current market price. In addition, Sohu is not prohibited from selling a controlling interest in us to a third party and may do so without your approval and without providing for a purchase of your ADSs. If Sohu is acquired or otherwise undergoes a change of control, any acquiror or successor will be entitled to exercise the voting control and contractual rights of Sohu, and may do so in a manner that could vary significantly from that of Sohu.
We may have conflicts of interest with Sohu and, because of Sohu’s controlling ownership interest in our company, may not be able to resolve such conflicts on favorable terms for us.
Conflicts of interest may arise between Sohu and us in a number of areas relating to our past and ongoing relationships. Potential conflicts of interest that we have identified include the following:
| Ÿ | Indemnification arrangements with Sohu. We have agreed to indemnify Sohu with respect to lawsuits and other matters relating to our MMORPG business, including operations of that business when it was a business unit of Sohu prior to the carve-out transactions. These indemnification arrangements could result in our having interests that are adverse to those of Sohu, for example different interests with respect to settlement arrangements in a litigation matter. In addition, under these arrangements, we agreed to reimburse Sohu for liabilities incurred (including legal defense costs) in connection with litigation, while Sohu will be the party prosecuting or defending the litigation. |
| Ÿ | Non-competition arrangements with Sohu. We and Sohu have each agreed not to compete with the core business of each other. Sohu has agreed not to compete with us in the MMORPG business anywhere in the world. We have agreed not to compete with Sohu in the Internet portal, search, mobile value-added services, games business and any other businesses, except MMORPGs and related support services, conducted or contemplated to be conducted by Sohu as of the date of this |
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| prospectus. Sohu can continue to provide links to MMORPGs and other games, including to those of our competitors, on its 17173.com website. |
| Ÿ | Employee recruiting and retention. Because both Sohu and we operate primarily in Beijing, and both Sohu and we are engaged in online game development and operation, we may compete with Sohu in the hiring of new employees, in particular with respect to software development. We have a non-solicitation arrangement with Sohu that would restrict either Sohu or us from hiring any of the other’s employees. |
| Ÿ | Our board members or executive officers may have conflicts of interest. Dr. Charles Zhang, who will be our Chairman of the Board, is currently also serving as Sohu’s Chairman and Chief Executive Officer. Each of our board members and executive officers also owns shares, restricted share units and/or options in Sohu. Sohu may continue to grant incentive share compensation to our board members and executive officers from time to time. These relationships could create, or appear to create, conflicts of interest when these persons are faced with decisions with potentially different implications for Sohu and us. |
| Ÿ | Sale of shares in our company. Sohu may decide to sell all or a portion of our shares that it holds to a third party, including to one of our competitors, thereby giving that third party substantial influence over our business and our affairs. Such a sale could be contrary to the interests of certain of our shareholders, including our employees or our public shareholders. |
| Ÿ | Allocation of business opportunities. Business opportunities may arise that both we and Sohu find attractive, and which would complement our respective businesses. Sohu may decide to take the opportunities itself, which would prevent us from taking advantage of the opportunity ourselves. |
| Ÿ | Developing business relationships with Sohu’s competitors. So long as Sohu remains as our controlling shareholder, we may be limited in our ability to do business with its competitors, such as other Internet portals in China. This may limit the effectiveness of our online advertisement for the best interest of our company and our other shareholders. |
Although our company is a separate, stand-alone entity, we expect to operate, for as long as Sohu is our controlling shareholder, as a part of the Sohu Group. Sohu may from time to time make strategic decisions that it believes are in the best interests of its business as a whole, including our company. These decisions may be different from the decisions that we would have made on our own. Sohu’s decisions with respect to us or our business may be resolved in ways that favor Sohu and therefore Sohu’s own shareholders, which may not coincide with the interests of our other shareholders. We may not be able to resolve any potential conflicts, and even if we do so, the resolution may be less favorable to us than if we were dealing with an unaffiliated shareholder. Even if both parties seek to transact business on terms intended to approximate those that could have been achieved among unaffiliated parties, this may not succeed in practice.
Risks Related to Doing Business in China
Adverse changes in political and economic policies of the PRC government could have a material and adverse effect on the overall economic growth of China, which could reduce the demand for our products.
Most of our business operations are conducted in China and most of our revenues are generated in China. Accordingly, our business, financial condition, results of operations and prospects are affected significantly by economic, political and legal developments in China. The Chinese economy differs from the economies of most developed countries in many respects, including the amount of government involvement, the level of development, the growth rate, the control of foreign exchange, and the allocation of resources.
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
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the Chinese economy will continue to grow, or that if there is growth, such growth will be steady and uniform, or that if there is a slowdown, such slowdown will not have a negative effect on our business. For example, the Chinese economy experienced high inflation in the second half of 2007 and the first half of 2008. China’s consumer price index soared 7.9% during the six months ended June 30, 2008 as compared to the same period in 2007. To combat inflation and prevent the economy from overheating, the PRC government adopted a number of tightening macroeconomic measures and monetary policies, including increasing interest rates, raising statutory reserve rates for banks and controlling bank lending to certain industries or economic sectors. However, due in part to the impact of the global crisis in financial services and credit markets and other factors, the growth rate of China’s gross domestic product has decreased to 6.8% in the fourth quarter of 2008, down from 11.9% reached in the second quarter of 2007. As a result, beginning in September 2008, among other measures, the PRC government began to loosen macroeconomic measures and monetary policies by reducing interest rates and decreasing the statutory reserve rates for banks. In addition, in November 2008 the PRC government announced an economic stimulus package in the amount of $586 billion. We cannot assure you that the various macroeconomic measures, monetary policies and economic stimulus package adopted by the PRC government to guide economic growth and the allocation of resources will be effective in sustaining the fast growth rate of the Chinese economy. In addition, such measures, even if they benefit the overall Chinese economy in the long-term, may adversely affect us if they reduce the disposable income of our game players.
Uncertainties with respect to the Chinese legal system could have a material adverse effect on us.
We conduct substantially all of our operations through AmazGame and Gamease, companies established in the PRC. AmazGame is generally subject to laws and regulations applicable to foreign investment in China and, in particular, laws applicable to wholly foreign-owned enterprises. The PRC legal system is based on written statutes. Prior court decisions may be cited for reference but have limited precedential value. 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, the interpretations of many laws, regulations and rules are not always uniform and enforcement of these laws, regulations and rules involves uncertainties. We cannot predict the effect of future developments in the PRC legal system, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement thereof, the preemption of local regulations by national laws, or the overturn of local government’s decisions by the higher level government. These uncertainties may limit legal protections available to us. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention.
Contract drafting, interpretation and enforcement in China involves significant uncertainty.
We have entered into numerous contracts governed by PRC law, many of which are material to our business. As compared with contracts in the United States, contracts governed by PRC law 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 is not as developed as in the United States, and the result of any contract dispute 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, such as our license agreements with Louis Cha regarding our rights to develop and operate TLBB and DMD, 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.
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There are significant uncertainties under the new corporate income tax law of the PRC, or the New CIT Law, which became effective on January 1, 2008, regarding our PRC enterprise income tax liabilities, such as tax on dividends paid to us by our PRC subsidiary. The New CIT Law also contains uncertainties regarding possible PRC withholding tax on dividends we pay to our overseas shareholders and gains realized from the transfer of our shares by our overseas shareholders.
We are a holding company incorporated in the Cayman Islands, which indirectly holds, through Changyou.com HK Limited, or Changyou HK, our equity interest in AmazGame, our subsidiary in the PRC. Our business operations are principally conducted through AmazGame and Gamease, our VIE controlled by AmazGame. The New CIT Law and its implementation rules, both of which became effective on January 1, 2008, provide that China-sourced income of foreign enterprises, such as dividends paid by a PRC subsidiary to its overseas parent, will normally be subject to PRC withholding tax at a rate of 10%, unless there are applicable treaties that reduce such rate. Under a special arrangement between China and Hong Kong, such dividend withholding tax rate is reduced to 5% if a Hong Kong resident enterprise owns over 25% of the PRC company distributing the dividends. As Changyou HK is a Hong Kong company and owns 100% of AmazGame, under the aforesaid arrangement, any dividends that AmazGame pays Changyou HK will be subject to a withholding tax at the rate of 5%, provided that Changyou HK and we are not considered to be PRC tax resident enterprises as described below.
Under the New CIT Law, enterprises established under the laws of jurisdictions outside China with their “de facto management bodies” located within China may be considered to be PRC tax resident enterprises for tax purposes. A substantial majority of the members of our management team as well as the management team of Changyou HK are located in China. If we or Changyou HK is considered as a PRC tax resident enterprise under the above definition, then our global income will be subject to PRC enterprise income tax at the rate of 25%.
Furthermore, the implementation rules of the New CIT Law provide that, (i) if the enterprise that distributes dividends is domiciled in the PRC, or (ii) if gains are realized from transferring equity interests of enterprises domiciled in the PRC, then such dividends or capital gains are treated as China-sourced income. It is not clear how “domicile” may be interpreted under the New CIT Law, and it may be interpreted as the jurisdiction where the enterprise is a tax resident. Therefore, if we and Changyou HK are considered as a PRC tax resident enterprise for tax purposes, any dividends we pay to our overseas shareholders or ADS holders as well as gains realized by such shareholders or ADS holders from the transfer of our shares or ADSs may be regarded as China-sourced income and as a result be subject to PRC withholding tax at the rate up to 10%. For example, if we are considered a PRC tax resident enterprise, then, with respect to the cash dividend that we intend to declare to Sohu.com (Game) Limited in the amount of $96.8 million prior to the completion of this offering, we may be required to withhold up to $10.0 million in PRC withholding taxes. We intend to take the position that any dividends we pay to our overseas shareholders or ADS holders will not be subject to a withholding tax in the PRC.
As the New CIT Law and the implementation rules have only recently taken effect, it is uncertain as to how they will be implemented by the relevant PRC tax authorities. If dividend payments from AmazGame to Changyou HK and from Changyou HK to us are subject to PRC withholding tax, our financial condition, results of operations and the amount of dividends available to pay our shareholders may be adversely affected. If dividends we pay to our overseas shareholders or ADS holders or gains realized by such shareholders or ADS holders from the transfer of our shares or ADSs are subject to PRC withholding tax, it may materially and adversely affect your investment return and the value of your investment in us.
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Our PRC subsidiary and VIE are qualified as “software enterprises” and enjoy tax benefits under the New CIT Law. However, we cannot assure you that we will be able to continue to enjoy such tax benefits. If our status as a “software enterprise” is repealed, we may have to pay additional taxes to make up any previously unpaid tax and may be subject to a higher tax rate, which may materially and adversely affect our results of operations.
The New CIT Law, which became effective on January 1, 2008, applies a uniform statutory income tax rate of 25% to enterprises in China. The New CIT Law and implementation rules promulgated under the New CIT Law provide that “software enterprises” enjoy an income tax exemption for two years beginning with their first profitable year and a 50% tax reduction to a rate of 12.5% for the subsequent three years. Both AmazGame and Gamease have been qualified as “software enterprises” and we were informed by such bureau that both AmazGame and Gamease will be subject to 0% income tax rate for the full year 2008 and a 50% tax reduction for the following three years. In accordance with the administrative requirements of the relevant tax authorities, both AmazGame and Gamease prepaid PRC income tax at the statutory rate of 25% for the first three quarters of 2008, which amounted to $18.9 million. We were not required to prepay income tax for the fourth quarter of 2008. In January 2009, we received a full refund of such prepaid income tax from the relevant tax authorities.
As the New CIT Law and its implementation rules have only recently taken effect, there are uncertainties on their future interpretation and implementation. We cannot assure you that the qualification of AmazGame and Gamease as “software enterprises” by the relevant tax authority will not be challenged in the future by their supervising authorities and be repealed, or that there will not be future implementation rules that are inconsistent with current interpretation of the New CIT Law. If the tax benefits AmazGame and Gamease enjoy as a “software enterprises” are revoked, and we are otherwise unable to qualify AmazGame and Gamease for other income tax exemptions or reductions, our effective income tax rate will increase significantly. In addition, we may have to pay additional taxes to make up any previously unpaid tax. As a result, our results of operations could be materially and adversely affected.
To fund any cash requirements we may have, we may need to rely on dividends, loans or advances made by our PRC subsidiary, AmazGame, which are subject to limitations and possible taxation under applicable PRC laws and regulations.
We may rely on dividends and other distributions on equity, or loans and advances made by our Chinese subsidiary, AmazGame, to fund any cash requirements we may have, including the funds necessary to pay dividends and other cash distributions, if any, to our shareholders or ADS holders, and to service any debt we may incur. The distribution of dividends and the making of loans and advances by entities organized in China are subject to limitations. Regulations in the PRC currently permit payment of dividends only out of accumulated profits as determined in accordance with accounting standards and regulations in China. AmazGame is also required to set aside at least 10% of its after-tax profit based on PRC accounting standards each year to its general reserves until the cumulative amount of such reserves reaches 50% of its registered capital. These reserves are not distributable as cash dividends, loans or advances. AmazGame may also allocate a portion of its after-tax profits, as determined by its board of directors, to its staff welfare and bonus funds, which may not be distributed to us. In addition, if AmazGame incurs debt on its own behalf in the future, the instruments governing the debt may restrict its ability to pay dividends or make other distributions to us.
Furthermore, under regulations of the State Administration of Foreign Exchange, or the SAFE, the Renminbi is not convertible into foreign currencies for capital account items, such as loans, repatriation of investments and investments outside of China, unless the prior approval of the SAFE is obtained and prior registration with the SAFE is made.
In addition, there are uncertainties under the New CIT Law with regard to the PRC withholding tax on dividends paid by AmazGame to Changyou HK. See “—There are significant uncertainties under the new Enterprise Income Tax Law of the PRC, or the New CIT Law, which became effective on January 1, 2008,
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regarding our PRC enterprise income tax liabilities, such on tax on dividends paid to us by our PRC subsidiary. The New CIT Law also contains uncertainties regarding possible PRC withholding tax on dividends we pay to our overseas shareholders and gains realized from the transfer of our shares by our overseas shareholders.” Should such dividends be subject to PRC withholding tax, the amount of cash available to us for our cash needs, including for the payment of dividends to our shareholders or ADS holders, would be materially and adversely affected.
Furthermore, we control our operating entity in China, Gamease, through contractual arrangements rather than equity ownership. AmazGame entered into Technology Support and Utilization Agreement and Operation and Maintenance Agreement with Gamease, pursuant to which Gamease will pay AmazGame for the services AmazGame provides to Gamease. See “Our History and Corporate Structure.” To the extent that there is any distributable profit in Gamease, it may be difficult for Gamease to distribute such profit to AmazGame, which may further limit the amount that AmazGame can distribute to us.
We may be required to obtain prior approval of the China Securities Regulatory Commission, or CSRC, of the listing and trading of our ADSs on the NASDAQ Global Select Market.
On August 8, 2006, six PRC regulatory authorities, including the Ministry of Commerce, the State Assets Supervision and Administration Commission, the State Administration for Taxation, the State Administration for Industry and Commerce, the CSRC and the SAFE, jointly issued the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or the New M&A Rules, which became effective on September 8, 2006. This regulation, among other things, includes provisions that purport to require that an offshore special purpose vehicle formed for purposes of overseas listing of equity interests in PRC companies and controlled directly or indirectly by PRC companies or individuals obtain the approval of the CSRC prior to the listing and trading of such special purpose vehicle’s securities on an overseas stock exchange. On September 21, 2006, the CSRC published on its official website procedures regarding its approval of overseas listings by special purpose vehicles. The CSRC approval procedures require the filing of a number of documents with the CSRC and it would take several months to complete the approval process. The application of this new PRC regulation remains unclear.
Our PRC legal counsel, Commerce & Finance Law Offices, is of the opinion that prior CSRC approval for this offering is not required because (i) AmazGame was incorporated by a foreign owned enterprise, and there was no acquisition of the equity or assets of a “PRC domestic company” as such term is defined under the New M&A Rules; and (ii) there is no provision in the New M&A Rules that clearly classifies the contractual arrangements between AmazGame and Gamease as a kind of transaction falling under the New M&A Rules. As a result we did not seek prior CSRC approval for this offering. However, we cannot assure you that the relevant PRC government authorities, including the CSRC, will reach the same conclusion as our PRC legal counsel. If the CSRC or other relevant PRC government authorities subsequently determine that prior CSRC approval is required, we may face regulatory actions or other sanctions from the CSRC or other PRC regulatory authorities. These regulatory authorities may impose fines and penalties on our operations in the PRC, limit our operating privileges in the PRC, delay or restrict the repatriation of the proceeds from this offering into the PRC, or take other actions that could have a material adverse effect on our business, as well as the trading price of our ADSs. The CSRC or other PRC regulatory authorities may also take actions requiring us, or making it advisable for us, to halt this offering before settlement and delivery of the ADSs offered by this prospectus. Consequently, if you engage in market trading or other activities in anticipation of and prior to settlement and delivery, you do so at the risk that settlement and delivery may not occur.
Fluctuation in the value of the Renminbi may have a material adverse effect on your investment.
The change in value of the Renminbi against the U.S. dollar, Euro and other currencies is affected by, among other things, changes in China’s political and economic conditions. On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the Renminbi to the U.S. dollar. Under the
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policy, the Renminbi is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. This change in policy has resulted in an approximately 21.3% appreciation of the Renminbi against the U.S. dollar between July 21, 2005 and December 31, 2008. Provisions on Administration of Foreign Exchange, as amended in August 2008, further changed China’s exchange regime to a managed floating exchange rate regime based on market supply and demand. While the international reaction to the Renminbi revaluation has generally been positive, there remains significant international pressure on the PRC government to adopt an even more flexible currency policy, which could result in a further and more significant appreciation of the Renminbi against the U.S. dollar. As substantially all of our costs and expenses are denominated in Renminbi, the revision in exchange rate policy effected in July 2005 has increased, and potential future revisions could further increase, our costs and expenses in U.S. dollar terms. Our proceeds from overseas financing, such as this offering, will decrease in value if we choose not to or are unable to convert the proceeds of this offering into Renminbi and the Renminbi appreciates against the U.S. dollar, which may reduce the value of your investment.
Recent regulations relating to offshore investment activities by PRC residents may limit our ability to acquire PRC companies and could adversely affect our business.
In October 2005, SAFE promulgated Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Corporate Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles, or Circular 75, that states that if PRC residents use assets or equity interests in their PRC entities as capital contributions to establish offshore companies or inject assets or equity interests of their PRC entities into offshore companies to raise capital overseas, they must register with local SAFE branches with respect to their overseas investments in offshore companies. They must also file amendments to their registrations if their offshore companies experience material events involving capital variation, such as changes in share capital, share transfers, mergers and acquisitions, spin-off transactions, long-term equity or debt investments or uses of assets in China to guarantee offshore obligations. Under this regulation, their failure to comply with the registration procedures set forth in such regulation may result in restrictions being imposed on the foreign exchange activities of the relevant PRC entity, including the payment of dividends and other distributions to its offshore parent, as well as restrictions on the capital inflow from the offshore entity to the PRC entity.
We have requested our shareholders who are PRC residents to make the necessary applications, filings and amendments as required under Circular 75 and other related rules. We attempt to comply, and attempt to ensure that our shareholders who are subject to these rules comply, with the relevant requirements. However, we cannot provide any assurances that all of our shareholders who are PRC residents will comply with our request to make or obtain any applicable registrations or comply with other requirements required by Circular 75 or other related rules. Any future failure by any of our shareholders who is a PRC resident, or controlled by a PRC resident, to comply with relevant requirements under this regulation could subject us to fines or sanctions imposed by the PRC government, including restrictions on AmazGame’s ability to pay dividends or make distributions to us and our ability to increase our investment in AmazGame.
SAFE rules and regulations may limit our ability to transfer the net proceeds from this offering to Gamease, our VIE in the PRC, which may adversely affect the business expansion of Gamease, and we may not be able to convert the net proceeds from this offering into Renminbi to invest in or acquire any other PRC companies, or establish other VIEs in the PRC.
On August 29, 2008, SAFE promulgated Circular 142, a notice regulating the conversion by a foreign-invested company of foreign currency into Renminbi by restricting how the converted Renminbi may be used. The notice requires that the registered capital of a foreign-invested company settled in Renminbi converted from foreign currencies may only be used for purposes within the business scope approved by the applicable governmental authority and may not be used for equity investments within the PRC. In addition, SAFE strengthened its oversight of the flow and use of the registered capital of a foreign-invested company settled in Renminbi converted from foreign currencies. The use of such Renminbi capital may not be changed without SAFE’s approval, and may not in any case be used to repay Renminbi loans if the proceeds of such loans have
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not been used. Violations of Circular 142 will result in severe penalties, such as heavy fines. As a result, Circular 142 may significantly limit our ability to transfer the net proceeds from this offering to Gamease through our subsidiary in the PRC, which may adversely affect the business expansion of Gamease, and we may not be able to convert the net proceeds from this offering into Renminbi to invest in or acquire any other PRC companies, or establish other VIEs in the PRC.
We may be subject to fines and legal sanctions if we or our employees who are PRC citizens fail to comply with recent PRC regulations relating to employee stock options granted by overseas listed companies to PRC citizens.
On December 25, 2006, the PBOC issued the Administration Measures on Individual Foreign Exchange Control, and its Implementation Rules were issued by SAFE on January 5, 2007, which both have taken effect on February 1, 2007. Under these regulations, all foreign exchange matters involved in an employee stock holding plan, stock option plan or similar plan in which PRC citizens’ participation requires approval from the SAFE or its authorized branch. On March 28, 2007, SAFE promulgated the Application Procedure of Foreign Exchange Administration for Domestic Individuals Participating in Employee Stock Holding Plan or Stock Option Plan of Overseas-Listed Company, or the Stock Option Rule. Under the Stock Option Rule, PRC citizens who are granted stock options or restricted share units, or issued restricted shares by an overseas publicly listed company are required, through a PRC agent or PRC subsidiary of such overseas publicly-listed company, to complete certain other procedures and transactional foreign exchange matters upon the examination by, and approval of, SAFE. We and our employees who are PRC citizens who have been granted stock options or restricted share units, or issued restricted shares are subject to the Stock Option Rule. However, currently, SAFE does not accept applications made by non-listed companies. As a result, we have not made such application. If the relevant PRC regulatory authority determines that our PRC employees who hold such options, restricted share units or restricted shares or their PRC employer fail to comply with these regulations after our listing, such employees and their PRC employer may be subject to fines and legal sanctions.
Risks Related to Our Class A Ordinary Shares and ADSs
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, our shareholders may have less protection for their shareholder rights than they would under U.S. law.
Our corporate affairs are governed by our memorandum and articles of association, the Cayman Islands Companies Law and the common law of the Cayman Islands. The rights of shareholders to take action against our directors, actions by minority shareholders and the fiduciary responsibilities of our directors to us under Cayman Islands law are to a large extent governed by the common law of the Cayman Islands. The common law of the Cayman Islands is derived in part from comparatively limited judicial precedent in the Cayman Islands as well as from English common law, which has persuasive, but not binding, authority on a court in the Cayman Islands. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as they would be under statutes or judicial precedent in some jurisdictions in the United States. In particular, the Cayman Islands has a less developed body of securities laws.
You may have difficulty enforcing judgments obtained against us.
We are a Cayman Islands company and 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 executive officers are nationals and residents of countries other than the United States. A substantial portion of the assets of these persons are located outside the United States. As a result, it may be difficult for you to effect service of process within the United States upon these persons. It may also be difficult for you to enforce in Cayman Islands courts or PRC 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. In addition,
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there is uncertainty as to whether the courts of the Cayman Islands or the PRC would recognize or enforce judgments. See “Enforceability of Civil Liabilities.”
We will be a “controlled company” within the meaning of the NASDAQ Stock Market’s Marketplace Rules and, as a result, will rely on exemptions from certain corporate governance requirements that provide protection to shareholders of other companies.
After the completion of this offering, Sohu will own more than 50% of the total voting power of our ordinary shares and we will be a “controlled company” under the NASDAQ Stock Market’s Marketplace Rules. We intend to rely on certain exemptions that are available to controlled companies from NASDAQ corporate governance requirements, including the requirements:
| Ÿ | that a majority of our board of directors consist of independent directors; |
| Ÿ | that we have a corporate governance and nominating committee that is composed entirely of independent directors with a written charter addressing the committee’s purpose and responsibilities; |
| Ÿ | that we have a compensation committee that is composed entirely of independent directors with a written charter addressing the committee’s purpose and responsibilities; and |
| Ÿ | for an annual performance evaluation of the nominating and governance committee and compensation committee. |
We are not required to and will not voluntarily meet these requirements. As a result of our use of the “controlled company” exemptions, you will not have the same protection afforded to shareholders of companies that are subject to all of NASDAQ’s corporate governance requirements.
The market price for our ADSs may be subject to wide fluctuations and our securities may trade below the initial public offering price.
The initial public offering price of our ADSs will be determined by negotiations between Sohu, us and representatives of the underwriters, based on numerous factors we discuss under “Underwriting.” This price may not be indicative of the market price of our ADSs after this offering. We cannot assure you that you will be able to resell your ADSs at or above the initial public offering price or our net asset value. The securities of a number of Chinese companies and companies with substantial operations in China have also experienced wide fluctuations subsequent to their initial public offerings, including trading at prices substantially below the initial public offering prices. Among the factors that could affect the price of our ADSs are risk factors described in this section and other factors, including:
| Ÿ | announcements of competitive developments, including new games by our competitors; |
| Ÿ | regulatory developments in our target markets affecting us, our customers or our competitors; |
| Ÿ | actual or anticipated fluctuations in our quarterly operating results; |
| Ÿ | failure of our quarterly financial and operating results to meet market expectations or failure to meet our previously announced guidance; |
| Ÿ | changes in financial estimates by securities research analysts; |
| Ÿ | changes in the economic performance or market valuations of other Internet or online game companies; |
| Ÿ | additions or departures of our executive officers and other key personnel; |
| Ÿ | announcements regarding intellectual property litigation (or potential litigation) involving us or any of our directors and officers; |
| Ÿ | fluctuations in the exchange rates between the U.S. dollar and the Renminbi; |
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| Ÿ | release or expiration of the underwriters’ post-offering lock-up or other transfer restrictions on our outstanding ordinary shares and ADSs; and |
| Ÿ | sales or perceived sales of additional shares or ADSs. |
In addition, the securities markets have from time to time experienced significant price and volume fluctuations that are not related to the operating performance of particular industries or companies. For example, the capital and credit markets have been experiencing volatility and disruption for more than 12 months. Starting in September 2008, the volatility and disruption have reached extreme levels, developing into a global crisis. As a result, stock prices of a broad range of companies worldwide, whether or not they are related to financial services, have declined significantly. These market fluctuations may also have a material adverse effect on the market price of our ADSs.
Holders of our ADSs may be subject to limitations on transfer of their 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 or the books of the depositary are closed, or at any time if we or the depositary deem it advisable to do so because of any requirement of law or of any government or governmental body, or under any provision of the Deposit Agreement, or for any other reason.
We have considerable discretion in the use of proceeds from this offering and we may use these proceeds in ways with which you may not agree.
We intend to use the net proceeds from this offering for general corporate purposes, including capital expenditures and funding possible future acquisitions. We have not allocated the net proceeds of this offering to any particular project or acquisition. Rather, our board of directors and our management will have considerable discretion in the application of the net proceeds received by us. You will not have the opportunity, as part of your investment decision, to assess whether proceeds are being used appropriately. You must rely on the judgment of our board of directors and our management regarding the application of the net proceeds of this offering. The net proceeds may be used for corporate purposes that do not improve our efforts to maintain profitability or increase our ADS price. The net proceeds from this offering may be placed in investments that do not produce income or that lose value.
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. With the exception of the listing of our ADSs on the NASDAQ Global Select Market, our ordinary shares and ADSs will not be listed or quoted for trading on any exchange. If an active trading market for our ADSs does not develop after this offering, the market price and liquidity of our ADSs will be materially and adversely affected.
The initial public offering price for our ADSs will be determined by negotiations between Sohu, us and representatives of the underwriters and may bear no relationship to the market price for our ADSs after the initial public offering. We cannot assure you that an active trading market for our ADSs will develop or that the market price of our ADSs will not decline below the initial public offering price.
Holders of ADSs have limited voting rights and you may not receive voting materials in time to be able to exercise your right to vote.
Except as described in this prospectus and in the Deposit Agreement, holders of our ADSs will not be able to exercise voting rights attaching to the shares represented by our ADSs on an individual basis. Holders of
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our ADSs may instruct the depositary how to exercise the voting rights attaching to the shares represented by the ADSs. You may not receive voting materials in time to instruct the depositary to vote, and it is possible that you, or persons who hold their ADSs through brokers, dealers or other third parties, will not have the opportunity to exercise a right to vote. In addition, due to the different voting powers attached to the two classes of our ordinary shares, our existing shareholders, including our controlling shareholder, Sohu, our Chief Executive Officer, or CEO, Tao Wang, and certain of our directors, officers and key employees, all of which hold our Class B ordinary shares, will control 98.3% of the combined total voting power of our ordinary shares, assuming the underwriters’ over-allotment option is not exercised. As a result, your ability to affect the outcome of any matter subject to shareholder vote is very limited.
Your right to participate in any future rights offerings may be limited, which may cause dilution to your holdings and you may not receive cash dividends if it is impractical to make them available to you.
We may from time to time distribute rights to our shareholders, including rights to acquire our securities. However, we cannot make rights available to you in the United States unless we register the securities to which the rights relate under the Securities Act of 1933, or the Securities Act, or an exemption from the registration requirements is available. Also, under the Deposit Agreement, the depositary bank will not make rights available to you unless the distribution to ADS holders of both the rights and any related securities are either registered under the Securities Act or exempted from registration under the Securities Act. We are under no obligation to file a registration statement with respect to any such rights or securities or to endeavor to cause such a registration statement to be declared effective. Moreover, we may not be able to establish an exemption from registration under the Securities Act. Accordingly, you may be unable to participate in our rights offerings and may experience dilution in your holdings.
In addition, the depositary of our ADSs has agreed to pay to you the cash dividends or other distributions it or the custodian receives on our ordinary shares or other deposited securities after deducting its fees and expenses. You will receive these distributions in proportion to the number of ordinary shares your ADSs represent. However, the depositary may, at its discretion, decide that it is inequitable or impractical to make a distribution available to any holders of ADSs. For example, the depositary may determine that it is not practicable to distribute certain property through the mail, or that the value of certain distributions may be less than the cost of mailing them, or that the distribution requires certain governmental approval, such as requirement for registration or approval for currency conversion. In these cases, the depositary may decide not to distribute that property and you will not receive that distribution.
You will experience immediate and substantial dilution in the net tangible book value of ADSs purchased.
The initial public offering price per ADSs will be substantially higher than the net tangible book value per ADS prior to this offering. Consequently, when you purchase ADSs in the offering at an assumed initial public offering price of $15.00, the mid-point of the estimated range of the initial public offering price, you will incur immediate dilution of $13.90 per ADS. See “Dilution.” In addition, you may experience further dilution to the extent that additional Class A ordinary shares are issued upon settlement of restricted share units or exercise of outstanding options that we may grant from time to time. As of the date of this prospectus, there are 2,740,000 Class B restricted share units outstanding, with each such restricted share unit settleable upon vesting by the issuance of one Class B ordinary share, and 456,000 Class A restricted share units outstanding, with each such restricted share unit settleable upon vesting by the issuance of one Class A ordinary share.
We may need additional capital and may sell additional ADSs or other equity securities or incur indebtedness, which could result in additional dilution to our shareholders or increase our debt service obligations.
We may require additional cash resources due to changed business conditions or other future developments, including any investments or acquisitions we may decide to pursue. If our cash resources are
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insufficient to satisfy our cash requirements, we may seek to sell additional equity or debt securities or obtain a credit facility. The sale of additional equity securities or equity-linked debt securities could result in additional dilution to our shareholders. The incurrence of indebtedness would result in increased debt service obligations and could result in operating and financing covenants that would restrict our operations. We cannot assure you that financing will be available in amounts or on terms acceptable to us, if at all.
Substantial future sales of our ADSs or ordinary shares in the public market, or the perception that these sales could occur, could cause the price of our ADSs to decline.
Additional sales of our ADSs or ordinary shares in the public market after this offering, or the perception that these sales could occur, could cause the market price of our ADSs to decline. Upon completion of this offering, we will have 15,000,000 Class A ordinary shares and 87,500,000 Class B ordinary shares outstanding. All ADSs sold in this offering, other than ADSs held by persons deemed to be our “affiliates,” will be freely transferable without restriction under 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, subject to volume and other restrictions as applicable under Rule 144 under the Securities Act. Any or all of these shares may be released prior to expiration of the lock-up period at the discretion of the lead underwriters for this offering. As of the date of this prospectus, there are 2,740,000 Class B restricted share units outstanding, with each such restricted share unit settleable upon vesting by the issuance of one Class B ordinary share, and 456,000 Class A restricted share units outstanding, with each such restricted share unit settleable upon vesting by the issuance of one Class A ordinary share. In addition, we may grant or sell additional options, restricted shares or other share-based awards in the future under our share incentive plan to our management, employees and other persons, the settlement and sale of which may further dilute our shares and drive down the price of our ADSs.
We might be classified as a passive foreign investment company, which would result in adverse U.S. federal income tax consequences to U.S. holders of our ADSs or Class A ordinary shares.
A non-U.S. corporation will be considered a passive foreign investment company, or PFIC, for any taxable year if either (i) at least 75% of its gross income is passive income or (ii) at least 50% of the value of its assets (based on an average of the quarterly values of the assets during a taxable year) is attributable to assets that produce or are held for the production of passive income. We expect that we will not be treated as a PFIC for U.S. federal income tax purposes for our current taxable year ending December 31, 2009. Our expectation is based on our current and anticipated operations and composition of our earnings and assets (including goodwill) for the 2009 taxable year, including the current and expected valuation of our assets based on the expected price of our ADSs in the offering. However, we currently hold, and expect to continue to hold following this offering, a substantial amount of cash and the value of our other assets may be based in part on the market price of our ADSs, which is likely to fluctuate after this offering (and may fluctuate considerably given that market prices of Internet and online game companies historically have been especially volatile). Furthermore, it is not entirely clear how the contractual arrangements between us and our consolidated variable interest entity will be treated for purposes of the PFIC rules. In addition, our actual PFIC status for any taxable year will not be determinable until the close of such taxable year. Accordingly, there is no guarantee that we will not be a PFIC for any taxable year. PFIC status depends on the composition of our assets and income and the value of our assets (including, among others, a pro rata portion of the income and assets of each subsidiary in which we own, directly or indirectly, at least 25% (by value) of the equity interest) from time to time. If we were treated as a PFIC for any taxable year during which a United States holder held an ADS or a Class A ordinary share, certain adverse United States federal income tax consequences could apply to the United States holder. See “Taxation—United States Federal Income Taxation—Passive Foreign Investment Company.”
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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
We make “forward-looking statements” in the “Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business” sections and elsewhere throughout this prospectus. Whenever you read a statement that is not simply a statement of historical fact (such as when we describe what we “believe,” “expect” or “anticipate” will occur, and other similar statements), you must remember that our expectations may not be correct, even though we believe that they are reasonable. We do not guarantee that the transactions and events described in this prospectus will happen as described or that they will happen at all. You should read this prospectus completely and with the understanding that actual future results may be materially different from what we expect. The forward-looking statements made in this prospectus relate only to events as of the date on which the statements are made. We undertake no obligation, beyond that required by law, to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made, even though our situation will change in the future.
Whether actual results will conform with our expectations and predictions is subject to a number of risks and uncertainties, many of which are beyond our control, and reflect future business decisions that are subject to change. Some of the assumptions, future results and levels of performance expressed or implied in the forward-looking statements we make inevitably will not materialize, and unanticipated events may occur which will affect our results.
These forward-looking statements include:
| Ÿ | our ability to maintain and strengthen our position as a leading online game developer and operator in China; |
| Ÿ | our expected development, launch and market acceptance of additional MMORPGs; |
| Ÿ | our various initiatives to implement our business strategies to expand our business through organic growth and strategic acquisitions; |
| Ÿ | our future business development, results of operations and financial condition; |
| Ÿ | our planned use of proceeds; |
| Ÿ | the expected growth of and change in the online game industry in China; and |
| Ÿ | the PRC government policies relating to the Internet and Internet content providers, including online game developers and operators. |
This prospectus also contains data related to the online game market in China. This market data, including market data from IDC, include projections that are based on a number of assumptions. The online game market may not grow at the rates projected by the market data, or at all. The failure of the market to grow at the projected rates may materially and adversely affect our business and the market price of our ADSs. In addition, the rapidly changing nature of the online game market subjects any projections or estimates relating to the growth prospects or future condition of our market to significant uncertainties. If any one or more of the assumptions underlying the market data prove to be incorrect, actual results may differ from the projections based on these assumptions. You should not place undue reliance on these forward-looking statements.
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We estimate that we will receive net proceeds for this offering in the amount of approximately $48.3 million, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us, and based upon an assumed initial public offering price of $15.00 per ADS (the mid-point of the estimated initial public offering price range shown on the front cover of this prospectus). Assuming the number of ADSs offered by us as set forth on the cover page of this prospectus remains the same, a $1.00 increase (decrease) in the assumed initial public offering price of $15.00 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 approximately $3.5 million, 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 Class A ordinary shares for the benefit of all shareholders, retain talented employees by providing them with equity incentives and obtain additional capital. We intend to use the net proceeds from this offering for general corporate purposes, including capital expenditures and funding possible future acquisitions.
We have not yet determined all of our anticipated expenditures and therefore cannot estimate the amounts to be used for each of the purposes discussed above. The amounts and timing of any expenditure will vary depending on the amount of cash generated by our operations, and the competitiveness and growth rate of our business. Accordingly, our management will have significant flexibility in applying the net proceeds we receive from this offering. Depending on future events and other changes in the business climate, we may determine at a later time to use the net proceeds for different purposes. Pending their use, we intend to invest our net proceeds in short-term, interest-bearing debt instruments or bank deposits.
We will not receive any of the proceeds from the sale of ADSs by the selling shareholder.
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AmazGame has declared a cash dividend payable to Changyou HK in the amount of $101.8 million, which, after the deduction of a withholding tax payable to the PRC tax authorities at the rate of 5.0% of the portion of such dividend that AmazGame derived from its 2008 net income, amounted to a net of $96.8 million. The payment of this dividend to Changyou HK is subject to our receiving approval from the relevant PRC regulatory authorities. Changyou HK intends to declare this $96.8 million dividend that it will receive from AmazGame as a dividend payable to us, which amount we intend to declare prior to the completion of this offering as a dividend payable to Sohu.com (Game) Limited. We expect to pay this dividend to Sohu.com (Game) Limited as soon as practicable after we receive required PRC approvals. Our only other existing shareholder, Prominence Investments Ltd., a British Virgin Islands company beneficially owned by Tao Wang, our CEO, is not entitled to participate in this dividend, as Prominence Investments Ltd. agreed in the subscription agreement with regard to the Class B ordinary shares issued to it that it will not be entitled to participate in the distribution of any dividend declared or paid by us prior to the closing of this offering. The purchasers of the ADSs in this offering also are not entitled to participate in this dividend.
Distribution of other cash dividends, if any, will be at the discretion of our board of directors and will depend on our future operations and earnings, capital requirements and surplus, general financial conditions, shareholders’ interests, contractual restrictions and other factors as our board of directors may deem relevant. We can pay dividends only out of profits or other distributable reserves. 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, if any, on our ordinary shares will be paid in U.S. dollars. We currently intend to retain all of our available funds and any future earnings to operate and expand our business. If we are considered a PRC tax resident enterprise for tax purposes, any dividends we pay to our overseas shareholders or ADS holders may be regarded as China-sourced income and as a result may be subject to PRC withholding tax at a rate of up to 10%. See “Taxation—PRC Taxation.”
We are a holding company incorporated in the Cayman Islands. In order for us to distribute any dividends to our shareholders and ADS holders, we will rely on payments made from our VIE to AmazGame, our subsidiary in China, pursuant to contractual arrangements between them, and the distribution of such payments to us as dividends from AmazGame. Certain payments from our VIE to AmazGame are subject to PRC taxes, including business taxes and VAT. In addition, regulations in the PRC currently permit payment of dividends of a PRC company, such as AmazGame, only out of accumulated profits as determined in accordance with accounting standards and regulations in China. AmazGame is also required to set aside at least 10% of its after-tax profit based on PRC accounting standards each year to its general reserves until the cumulative amount reaches 50% of its registered capital. These reserves are not distributable as cash dividends. AmazGame may also allocate a portion of its after-tax profits, as determined by its board of directors, to its staff welfare and bonus funds which may not be distributed to us. In addition, if AmazGame incurs debt on its own behalf in the future, the instruments governing the debt may restrict its ability to pay dividends or make other distributions to us. Any dividends paid by AmazGame to its immediate holding company, Changyou HK, will be subject to a withholding tax at the rate of 5.0%, provided Changyou HK is not considered to be a PRC tax resident enterprise.
Under the laws of the Cayman Islands, the only reserve that is expressly permitted by statute to be distributable is the share premium account, which is a reserve account that represents the consideration paid on the issuance of a share that is in excess of its par value.
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The following table sets forth our capitalization, as of December 31, 2008:
| Ÿ | on an actual basis; |
| Ÿ | on a pro forma as adjusted basis to give effect to (i) our intended declaration prior to the completion of this offering of a cash dividend in the amount of $96.8 million payable to Sohu.com (Game) Limited, (ii) the conversion of 7,500,000 Class B ordinary shares held by the selling shareholder to 7,500,000 Class A ordinary shares, and (iii) the issuance and sale of 3,750,000 ADSs, representing 7,500,000 Class A ordinary shares, by us in this offering, assuming an initial public offering price of $15.00 per ADS, the mid-point of the estimated range of the initial public offering price, after deducting estimated underwriting discounts and commissions and estimated aggregate offering expenses payable by us and assuming no other change to the number of ADSs sold by us as set forth on the cover page of this prospectus. |
You should read this table together with our financial statements and the related notes included elsewhere in this prospectus and the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
| As of December 31, 2008 | ||||||
| Actual | Pro Forma as Adjusted | |||||
| ($ in thousands) | ||||||
| Shareholders’ equity(1): | ||||||
| Ordinary shares: par value $0.01 per share, 297,740,000 authorized: | ||||||
| 200,000,000 Class A ordinary shares, none of which are issued and outstanding | — | 150 | ||||
| 97,740,000 Class B ordinary shares, 95,000,000 of which are issued and outstanding | 950 | 875 | ||||
| Distribution in excess of paid-in capital, actual, and additional paid-in capital pro forma as adjusted | (4,059 | ) | 44,151 | |||
| Statutory reserves | 5,748 | 5,748 | ||||
| Receivables from shareholders | (30 | ) | (30 | ) | ||
| Retained earnings | 101,454 | 4,654 | ||||
| Accumulated other comprehensive income | 631 | 631 | ||||
| Total shareholders’ equity | 104,694 | 56,179 | ||||
| Total capitalization | 104,694 | 56,179 | ||||
| (1) | Ordinary shares outstanding do not include ordinary shares issuable upon vesting of restricted share units. |
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If you invest in our ADSs, your interest will be diluted to the extent of the difference between the initial public offering price per ADS and our net tangible book value per ADS after this offering. Dilution results from the fact that the initial public offering price per Class A ordinary share is substantially in excess of the net tangible book value per ordinary share attributable to the existing shareholders for our currently outstanding ordinary shares.
Net tangible book value represents the amount of our total consolidated tangible assets, minus the amount of our total consolidated liabilities. When we offer our ordinary shares at a price higher than our net tangible book value per ordinary share, the amount of resulting dilution is determined by subtracting net tangible book value per ordinary share from the initial public offering price per ordinary share. Our net tangible book value as of December 31, 2008 was approximately $104.6 million, or $1.10 per ordinary share and $2.20 per ADS. Our pro forma net tangible book value of approximately $7.8 million, or $0.08 per ordinary share and $0.16 per ADS as of December 31, 2008 represents our net tangible book value as of that date as adjusted to reflect the cash dividend of $96.8 million that we intend to declare prior to the completion of this offering, that will be payable solely to Sohu.com (Game) Limited as if it had been declared and payable prior to December 31, 2008. See “Dividend Policy” and Note 19 to our consolidated financial statements.
Without taking into account any other changes in our pro forma net tangible book value after December 31, 2008 other than to give effect to the issuance and sale by us in this offering of 3,750,000 ADSs, representing 7,500,000 Class A ordinary shares, assuming an initial public offering price of $15.00 per ADS, the mid-point of the estimated range of the initial public offering price, after deducting estimated underwriting discounts, commissions and estimated offering expenses payable by us, our pro forma as adjusted net tangible book value as of December 31, 2008 would be $56.1 million or $0.55 per ordinary share and $1.10 per ADS. This represents an immediate increase in pro forma net tangible book value of $0.47 per ordinary share to the existing shareholders, and an immediate dilution of $6.95 per ordinary share and $13.90 per ADS, to investors purchasing ADSs in this offering. The following table illustrates this dilution:
| Per Ordinary Share | Per ADS | |||||
| Estimated public offering price | $ | 7.50 | $ | 15.00 | ||
| Pro forma net tangible book value as of December 31, 2008 | $ | 0.08 | $ | 0.16 | ||
| Pro forma adjusted net tangible book value after giving effect to this offering | $ | 0.55 | $ | 1.10 | ||
| Amount of dilution in pro forma net tangible book value to new investors in this offering | $ | 6.95 | $ | 13.90 | ||
A $1.00 increase or decrease in the assumed initial public offering price of $15.00 per ADS would increase or decrease our adjusted net tangible book value after giving effect to this offering in each case by $3.5 million, or by $0.03 per ordinary share or $0.07 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 estimated underwriting discounts and commissions and other expenses of this offering. The adjusted information discussed above is illustrative only. Our adjusted net tangible book value following the completion of this offering is subject to adjustments 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 an as adjusted basis as of December 31, 2008, the differences between existing shareholders and the new investors with respect to the number of ordinary shares (in the form of ADSs or shares) purchased from us, the total consideration paid and the average price per ordinary share at an assumed initial public offering price of $15.00 per ADS, the mid-point of the estimated range of the initial public offering price per ADS, before deducting underwriting discounts and commissions and estimated offering expenses payable by us.
| Ordinary Shares Purchased | Total Consideration | Average Price Per Ordinary Share | Average Price Per ADS | ||||||||||||||
| Number | Percent | Amount | Percent | ||||||||||||||
| Existing shareholders | 95,000,000 | 92.7 | % | $ | 950,000 | 1.7 | % | $ | 0.01 | $ | 0.02 | ||||||
| New investors | 7,500,000 | 7.3 | % | $ | 56,250,000 | 98.3 | % | $ | 7.50 | $ | 15.00 | ||||||
| Total | 102,500,000 | 100.0 | % | $ | 57,200,000 | 100.0 | % | $ | 0.56 | $ | 1.12 | ||||||
A $1.00 increase or decrease in the assumed initial public offering price of $15.00 per ADS would increase or decrease total consideration paid by new investors, total consideration paid by all shareholders and the average price per ordinary share paid by all shareholders by $3.75 million, $3.75 million and $0.04, respectively, assuming no change in the number of ADSs sold by us as set forth on the cover page of this prospectus and without deducting underwriting discounts and commissions and other offering expenses payable by us.
The discussions and tables above also assume no vesting of any outstanding restricted share units settleable upon vesting in ordinary shares. As of December 31, 2008, there was no vesting of such restricted share units. To the extent that any such restricted share units become vested, there will be further dilution to new investors.
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Our business is primarily conducted in China and a substantial majority 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, and unless otherwise indicated, conversions of Renminbi into U.S. dollars in this prospectus are based on the noon buying rate in The City of New York for cable transfers of Renminbi as certified for customs purposes by the Federal Reserve Bank of New York on December 31, 2008. We make no representation that any Renminbi or U.S. dollar amounts could have been, or could be, converted into U.S. dollars or Renminbi, as the case may be, at any particular rate, or at all. The PRC government imposes control over its foreign currency reserves in part through direct regulation of the conversion of Renminbi into foreign exchange and through restrictions on foreign trade. On March 13, 2009, the noon buying rate was RMB6.8380 to $1.00.
The following table sets forth information concerning exchange rates between the Renminbi and the U.S. dollar for the periods indicated.
| Spot Exchange Rate | ||||||||
| Period | Period End | Average(1) | Low | High | ||||
| (RMB per $1.00) | ||||||||
| 2004 | 8.2765 | 8.2768 | 8.2774 | 8.2764 | ||||
| 2005 | 8.0702 | 8.1826 | 8.2765 | 8.0702 | ||||
| 2006 | 7.8041 | 7.9579 | 8.0702 | 7.8041 | ||||
| 2007 | 7.2946 | 7.5806 | 7.8127 | 7.2946 | ||||
| 2008 | 6.8225 | 6.9193 | 7.2946 | 6.7800 | ||||
| August | 6.8252 | 6.8462 | 6.8705 | 6.7800 | ||||
| September | 6.7899 | 6.8307 | 6.8510 | 6.7810 | ||||
| October | 6.8388 | 6.8358 | 6.8521 | 6.8171 | ||||
| November | 6.8254 | 6.8281 | 6.8373 | 6.8220 | ||||
| December | 6.8225 | 6.8539 | 6.8842 | 6.8225 | ||||
| 2009 | ||||||||
| January | 6.8392 | 6.8360 | 6.8403 | 6.8225 | ||||
| February | 6.8395 | 6.8363 | 6.8470 | 6.8241 | ||||
| March (through March 13) | 6.8380 | 6.8405 | 6.8438 | 6.8380 | ||||
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 were calculated by using the average of the daily rates during the relevant month. |
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ENFORCEABILITY OF CIVIL LIABILITIES
We are incorporated in the Cayman Islands to take advantage of certain benefits associated with being a Cayman Islands exempted company, such as political and economic stability, an effective judicial system, a favorable tax system, the absence of 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 that the Cayman Islands has a less developed body of securities laws as compared to the United States and provides significantly less protection to investors. In addition, Cayman Islands companies may not have standing to sue before the federal courts of the United States. Our constituent documents do not contain provisions requiring that disputes be submitted to arbitration, including those arising under the securities laws of the United States, between us, our officers, directors and shareholders.
Substantially all of our current operations are conducted in China, and substantially all of our assets are located in China. All of our directors and executive officers are nationals or residents of jurisdictions other than the United States and a substantial portion of their assets are located outside of the United States. As a result, it may be difficult for a shareholder to effect service of process within the United States upon us or such persons, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States.
We have appointed CT Corporation System as our agent to receive service of process with respect to any action brought against us in the United States District Court for the Southern District of New York under the federal securities laws of the United States or of any state in the United States or any action brought against us in the Supreme Court of the State of New York in the County of New York under the securities laws of the State of New York.
Campbells, our counsel as to Cayman Islands law, and Commerce & Finance 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:
| Ÿ | 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 |
| Ÿ | 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. |
Campbells has further advised us that a final and conclusive judgment in the federal or state courts of the United States under which a sum of money is payable, other than a sum payable in respect of taxes, fines, penalties or similar charges, may be subject to enforcement proceedings as debt in the courts of the Cayman Islands under the common law doctrine of obligation. Civil liability provisions of the U.S. federal and state securities law permit punitive damages against us; however, according to Campbells, the Cayman Island courts would not recognize or enforce judgments against us to the extent the judgment is punitive or penal. It is uncertain as to whether a judgment obtained from the U.S. courts under civil liability provisions of the securities law would be determined by the Cayman Islands courts as penal or punitive in nature. Such a determination has yet to be made by any Cayman Islands court.
Commerce & Finance Law Offices has advised us further that the recognition and enforcement of foreign judgments are provided for under PRC Civil Procedures Law. Courts in China may recognize and enforce foreign judgments in accordance with the requirements of PRC Civil Procedures Law based on treaties between China and the country where the judgment is made or on reciprocity between jurisdictions. As there is currently no treaty or other agreement of reciprocity between China and the United States governing the recognition of a judgment, there is uncertainty as to whether a PRC court would enforce a judgment rendered by a court in the United States.
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OUR HISTORY AND CORPORATE STRUCTURE
Our History
Our MMORPG business began operations as a business unit within the Sohu Group in 2003. In June 2003, the Sohu Group launched its first MMORPG, Knight Online, or KO, which was licensed from a Korean developer. KO had limited acceptance in the Chinese market, and its operation was discontinued in November 2006 when the license expired. In October 2004, the Sohu Group launched BO, its second MMORPG, which was licensed from a Beijing-based studio. In May 2007, the Sohu Group launched TLBB, its first in-house developed MMORPG.
Our Carve-out from Sohu
In 2007, the Sohu Group reorganized its MMORPG business, which included the establishment of the following entities:
| Ÿ | Changyou.com Limited was incorporated in the Cayman Islands on August 6, 2007 as an indirect wholly-owned subsidiary of Sohu.com Inc. to be the holding company for the MMORPG business. |
| Ÿ | Changyou.com (HK) Limited, or Changyou HK, was incorporated in Hong Kong on August 13, 2007 as a direct wholly-owned subsidiary of Changyou. Changyou HK is our intermediate offshore holding company for our MMORPG operations in China. |
| Ÿ | Beijing AmazGame Age Internet Technology Co., Ltd., or AmazGame, was incorporated in the PRC on September 26, 2007 as a WFOE and is a direct wholly-owned subsidiary of Changyou HK. |
| Ÿ | Beijing Gamease Age Digital Technology Co., Ltd., or Gamease, was incorporated in the PRC on August 23, 2007. Gamease is 60% owned by Tao Wang, our CEO, and 40% by a Changyou employee, but is controlled by AmazGame through a series of contractual arrangements. Therefore, Gamease is our variable interest entity, or VIE, and we consolidate its financial results. |
After the establishment of the above entities, Changyou.com Limited, AmazGame and Gamease entered into various agreements with Sohu, pursuant to which Sohu transferred to us, effective as of December 1, 2007, all of its assets and operations relating to its MMORPG business unit, and we assumed all of the liabilities associated with Sohu’s MMORPG business unit and paid net consideration of $9.9 million to Sohu. These agreements are summarized below:
| Ÿ | Master Transaction Agreement, between Sohu.com Inc. and Changyou.com Limited, containing key provisions relating to our carve-out from Sohu, including our assumption of the liabilities associated with Sohu’s MMORPG business unit. See “Our Relationship with Sohu—Our Relationship with Sohu Following the Offering.” |
| Ÿ | Asset Transfer Agreement, between Sohu New Era Information Technology Co., Ltd., or Sohu Era, a subsidiary of Sohu, and AmazGame, pursuant to which certain assets (primarily servers) of Sohu’s MMORPG business held by Sohu Era were transferred to AmazGame. |
| Ÿ | Asset Transfer Agreement, between Sohu Era and Gamease, pursuant to which certain assets (primarily servers) of Sohu’s MMORPG business unit held by Sohu Era were transferred to Gamease. |
| Ÿ | Technology Transfer Agreement, between Beijing Fire Fox Digital Technology Co. Ltd., or Beijing Fire Fox, and Gamease, pursuant to which Beijing Fire Fox, a subsidiary of Sohu, transferred TLBB software to Gamease. |
| Ÿ | Trademark Assignment Agreement, between Beijing Fire Fox and Gamease, pursuant to which Beijing Fire Fox transferred to Gamease trademarks and trademark rights related to TLBB. |
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| Ÿ | Services Transfer Agreement, between Sohu Era and Gamease, pursuant to which Gamease agreed to provide to TLBB game players operational and maintenance services previously provided by Sohu Era. |
Sohu made loans to us in the amount of $5.0 million and $3.5 million in September 2007 and December 2008, respectively, which we used to fund the paid-in capital of AmazGame and our U.S. dollar-denominated working capital needs.
We believe that we will realize benefits from our carve-out from Sohu, including:
| Ÿ | Sharper strategic focus. By having our own board of directors and management team, we expect to be able to make more focused strategic decisions and be in a better position to take advantage of strategic opportunities in the online game business. |
| Ÿ | Better incentives for employees and greater accountability. We will seek to motivate and retain our employees through the implementation of incentive compensation programs tied to the market performance of our ADSs and the financial results of our company. |
| Ÿ | Direct access to capital markets. As a separate, stand-alone company, we will have capital planning flexibility with direct access to the debt and equity capital markets and the opportunity to grow through acquisitions by using our shares as consideration. |
Our Corporate Structure
In order to comply with PRC laws restricting foreign ownership in the online game business in China, we operate our MMORPG operations through Gamease, our VIE, rather than through a subsidiary, and all of our revenues are earned by and paid to Gamease. Gamease holds the licenses and permits required to operate our MMORPG business, and is controlled by AmazGame, our subsidiary, through a series of contractual arrangements. AmazGame undertakes substantially all of our product development and technical support functions, which it provides to Gamease pursuant to contractual arrangements.
The equity interests in Gamease were owned 60% by Tao Wang, our Chief Executive Officer, and 40% by a Sohu employee upon its establishment on August 23, 2007. AmazGame, Gamease and the shareholders of Gamease entered into a series of agreements, which became effective on September 26, 2007 and provided AmazGame with effective control of Gamease. These agreements were subsequently amended and supplemented, and the 40% shareholder of Gamease was transferred to a Changyou employee. The following is a summary of the agreements currently in effect:
| Ÿ | Loan Agreements, between AmazGame and Gamease shareholders. These loan agreements provide for loans of $878,000 to Tao Wang and of $585,000 to the Changyou employee for them to make contributions to the registered capital of Gamease in exchange for the 60% and 40% equity interests, respectively, in Gamease. The loans are interest free and are repayable on demand, but the shareholders can only repay the loans by transferring to AmazGame of their respective equity interests in Gamease. |
| Ÿ | Equity Interest Purchase Right Agreements, among AmazGame, Gamease and Gamease shareholders. Pursuant to these agreements, AmazGame and any third party designated by AmazGame have the right, exercisable at any time during the term of the agreement, if and when it is legal to do so under PRC law, to purchase from Tao Wang or the Changyou employee, as the case may be, all or any part of his or her equity interests in Gamease at a purchase price equal to their initial contributions to the registered capital of Gamease or the respective proportion of such initial contribution in the case of a partial purchase of such equity interests in Gamease. |
| Ÿ | Equity Pledge Agreements, among AmazGame, Gamease and the shareholders of Gamease. Pursuant to these agreements, Tao Wang and the Changyou employee pledged to AmazGame their equity |
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| interests in Gamease to secure the performance of their respective obligations and Gamease’s obligations under the various VIE-related agreements. If any of the shareholders of Gamease breaches his or her respective obligations under any VIE-related agreements (Gamease’s breach of any of its obligations under the various VIE-related agreements will be treated as the shareholders’ breach of their respective obligations), including the Equity Pledge Agreement, AmazGame is entitled to exercise its rights as the beneficiary under the Equity Pledge Agreement, including all the rights such shareholder has as a shareholder of Gamease. |
| Ÿ | Business Operation Agreement, among AmazGame, Gamease and the shareholders of Gamease. This agreement sets forth the rights of AmazGame to control the actions of the shareholders of Gamease. |
| Ÿ | Powers of Attorney, executed by the shareholders of Gamease in favor of AmazGame. These powers of attorney give AmazGame the exclusive right to appoint nominees to act on behalf of each of the two Gamease shareholders in connection with all actions to be taken by Gamease. |
| Ÿ | Technology Support and Utilization Agreement, between AmazGame and Gamease. Pursuant to this agreement, AmazGame has the exclusive right to provide product development and application services and provide technology support to Gamease for a fee based on Gamease’s revenues. |
| Ÿ | Services and Maintenance Agreement, between AmazGame and Gamease. Pursuant to this agreement, AmazGame provides marketing, staffing, business operation and maintenance services to Gamease in exchange for a fee equal to the cost of providing such services plus a predetermined margin. |
In the opinion of our PRC counsel, Commerce & Finance Law Offices, the ownership structure and the contractual arrangements between AmazGame and Gamease and between AmazGame’s and Gamease’s shareholders, comply with, and immediately after this offering, will comply with, current PRC laws and regulations. There are, however, substantial uncertainties regarding the interpretation and application of current or future PRC laws and regulations. Accordingly, PRC governmental authorities may ultimately take a view that is inconsistent with the opinion of Commerce & Finance Law Offices. See “Risk Factors—Risks Related to Our Structure and Regulations.”
In January 2009, we incorporated AmazGame Entertainment (US), Inc., through which we intend to operate our planned MMORPG business in the United States.
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The following diagram illustrates our corporate structure as of the date of this prospectus(1):
| (1) | For risks relating to our current corporate structure, see “Risk Factors—Risks Related to Our Structure and Regulations.” |
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Our Relationship with Sohu
We were a business unit within the Sohu Group prior to our reorganization as a separate, indirect subsidiary of Sohu.com Inc. Sohu began reporting results of its MMORPG operations as a separate business segment for the three months ended June 30, 2007. References in this prospectus to the operations of our business, financial condition, and results of operations with respect to periods prior to December 1, 2007 are to Sohu’s MMORPG business unit. Prior to this offering, Sohu had provided us with tax, accounting, treasury, legal and human resources services, and had also provided us with the services of a number of its executives and employees. All of our current executive officers and most of our current employees formerly were employees of Sohu.
Our Relationship with Sohu Following the Offering
Upon the completion of this offering, Sohu will continue to be our controlling shareholder, with an indirect shareholding of 70.7% of the combined total of our outstanding Class A and Class B ordinary shares, and control of 81.5% of the voting power of the combined total of our outstanding Class A and Class B ordinary shares, assuming the underwriters’ over-allotment option is not exercised.
We have entered into agreements with Sohu with respect to various ongoing relationships between us. These include a Master Transaction Agreement, a Non-Competition Agreement and a Marketing Services Agreement. The following are summaries of these agreements. For the complete text of these agreements, please see the copies included as exhibits to the registration statement filed with the SEC of which this prospectus is a part.
Master Transaction Agreement
The Master Transaction Agreement contains key provisions relating to our carve-out from Sohu. The Master Transaction Agreement provides for cross-indemnities that generally will place the financial responsibility on us for all liabilities associated with the current and historical MMORPG business and operations transferred to us, and generally will place on Sohu the financial responsibility for liabilities associated with all of Sohu’s other current and historical businesses and operations, in each case regardless of the time those liabilities arise. The Master Transaction Agreement also contains indemnification provisions under which we and Sohu indemnify each other with respect to breaches of the Master Transaction Agreement or any related inter-company agreement.
In addition to our general indemnification obligations described above relating to the current and historical Sohu business and operations, we have agreed to indemnify Sohu against liabilities arising from misstatements or omissions in this prospectus or the registration statement of which it is a part, except for misstatements or omissions relating to information that Sohu provided to us specifically for inclusion in this prospectus or the registration statement of which it forms a part. We also have agreed to indemnify Sohu against liabilities arising from any misstatements or omissions in our subsequent SEC filings and from information we provide to Sohu specifically for inclusion in Sohu’s annual or quarterly reports following the completion of this offering, but only to the extent that the information pertains to us or our business or to the extent Sohu provides us prior written notice that the information will be included in its annual or quarterly reports and the liability does not result from the action or inaction of Sohu.
In addition to Sohu’s general indemnification obligations described above relating to the current and historical Sohu business and operations, Sohu will indemnify us against liabilities arising from misstatements or omissions with respect to information that Sohu provided to us specifically for inclusion in this prospectus or the registration statement of which it forms a part. Sohu will also indemnify us against liabilities arising from information Sohu provides to us specifically for inclusion in our annual or quarterly reports following the completion of this offering, but only to the extent that the information pertains to Sohu or Sohu’s business or to the extent we provide Sohu prior written notice that the information will be included in our annual or quarterly reports and the liability does not result from our action or inaction.
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For liabilities arising from events occurring on or before the date of this prospectus, the Master Transaction Agreement contains a general release. Under this provision, we release Sohu and its subsidiaries, VIEs, successors and assigns, and Sohu will release us and our subsidiaries, VIEs, successors and assigns, from any liabilities arising from events between us on the one hand, and Sohu on the other hand, occurring on or before the date of this prospectus, including in connection with the activities to implement this offering. The general release does not apply to liabilities allocated between the parties under the Master Transaction Agreement or the other inter-company agreements or to specified ongoing contractual arrangements.
Furthermore, under the Master Transaction Agreement, we have agreed to use our reasonable best efforts to use the same independent certified public accounting firm selected by Sohu and to maintain the same fiscal year as Sohu until such time as Sohu no longer owns at least a majority of our voting securities. We also have agreed to use our reasonable best efforts to complete our audit and provide Sohu with all financial and other information on a timely basis so that Sohu may meet its deadlines for its filing annual and quarterly financial statements.
Non-Competition Agreement
Under the Non-Competition Agreement, Sohu has agreed, until the later of three years after Sohu no longer owns in the aggregate at least 10% of the voting power of our then outstanding voting securities and five years after the date that the registration statement of which this prospectus is a part was first publicly filed with the SEC, or the non-competition period, that it will not compete with us in the MMORPG business anywhere in the world. We have agreed during the non-competition period not to compete with Sohu in the Internet portal, search, mobile value-added services and games business, and any other businesses, except MMORPGs and related support services, conducted or contemplated to be conducted by Sohu as of the date of this prospectus. Sohu will be entitled to continue to provide links to MMORPGs and other games, including to those of our competitors, that it provides on its 17173.com website. In addition, both parties have agreed not to solicit the employees of the other party.
Marketing Services Agreement
The Marketing Services Agreement provides that Sohu will continue to provide certain services to us, including marketing services and Sohu’s PEAK system for the distribution of our virtual prepaid game cards. The agreement further provides for the license from Sohu to us of certain domain names, permits us to co-brand our games with the Sohu name and logos, and allows us to identify ourselves as a member of the Sohu Group. The agreement will terminate upon the later of the date that is three years after the first date upon which Sohu ceases to own in the aggregate at least 10% of the voting power of the then outstanding securities of Changyou and the fifth anniversary of the date that the registration statement of which this prospectus forms a part was first publicly filed with the SEC.
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SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated statements of operations data for the years ended December 31, 2006, 2007 and 2008, and the selected consolidated balance sheet data as of December 31, 2006, 2007 and 2008, have been derived from our audited consolidated financial statements included elsewhere in this prospectus. The selected consolidated statements of operations data for the years ended December 31, 2004 and 2005, and the selected consolidated balance sheet data as of December 31, 2005 have been derived from our books and records and are unaudited. The selected consolidated financial data should be read in conjunction with those financial statements and the accompanying notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” below. Our consolidated financial statements are prepared and presented in accordance with United States generally accepted accounting principles, or U.S. GAAP. Our historical results do not necessarily indicate our results expected for any future periods.
Prior to Sohu’s transfer to our PRC subsidiary and VIE of all of the assets and liabilities of Sohu’s MMORPG business unit, effective December 1, 2007, the operations of our MMORPGs were carried out by various companies owned or controlled by Sohu.com Inc. For periods both before and after December 1, 2007, our consolidated financial statements include assets, liabilities, revenues, expenses and changes in shareholders’ equity and cash flows that were directly attributable to our MMORPG business whether held or incurred by Sohu or by Changyou. In cases involving assets and liabilities not specifically identifiable to any particular operation of Sohu, only those assets and liabilities transferred or expected to be transferred to Changyou are included in our consolidated balance sheets. With respect to costs of operations of the MMORPG business, an allocation of certain general corporate expenses of Sohu which are not directly related to the MMORPG operations and an allocation of certain advertising and other expenses provided by Sohu to Changyou were also included. These allocations are based on a variety of factors depending upon the nature of the expenses being allocated, including revenue, the number of employees and the number of servers. Our statements of operations also include the sales and marketing expenses and other costs charged by Sohu. The transactions are measured at the amount of consideration established and agreed to by the related parties.
Our consolidated financial statements have been prepared as if the current corporate structure had been in existence throughout the periods presented.
Our management believes that the assumptions underlying our financial statements and the above allocations are reasonable. Our financial statements, however, may not necessarily reflect our results of operations, financial position and cash flows as if we had operated as a stand-alone company during the periods presented. You should not view our historical results as an indicator of our future performance.
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Selected Consolidated Statements of Operations Data
| For the Year Ended December 31, | |||||||||||||||
| 2004 | 2005 | 2006 | 2007 | 2008 | |||||||||||
| ($ in thousands, except per share data) | |||||||||||||||
| Total revenues | 2,528 | 5,809 | 8,525 | 42,096 | 201,845 | ||||||||||
| Cost of revenues(1) | 2,595 | 3,284 | 3,895 | 7,317 | 14,633 | ||||||||||
| Gross (loss) profit | (67 | ) | 2,525 | 4,630 | 34,779 | 187,212 | |||||||||
| Operating expenses: | |||||||||||||||
| Product development(1) | 659 | 1,699 | 1,957 | 6,738 | 23,862 | ||||||||||
| Sales and marketing(1) | 1,328 | 1,230 | 1,798 | 19,851 | 38,917 | ||||||||||
| General and administrative(1) | 411 | 924 | 876 | 2,992 | 9,053 | ||||||||||
| Total operating expenses | 2,398 | 3,853 | 4,631 | 29,581 | 71,832 | ||||||||||
| Operating (loss) profit | (2,465 | ) | (1,328 | ) | (1 | ) | 5,198 | 115,380 | |||||||
| Investment (loss) income from an associate | (2 | ) | 102 | 151 | 9 | — | |||||||||
| Gain on disposal of investment in an associate | — | — | — | 561 | — | ||||||||||
| Interest expense | — | — | — | (61 | ) | (245 | ) | ||||||||
| Interest income and foreign currency exchange gain | 16 | 23 | 20 | 44 | 1,235 | ||||||||||
| Other expense | — | — | — | — | (278 | ) | |||||||||
| (Loss) income before income tax expense | (2,451 | ) | (1,203 | ) | 170 | 5,751 | 116,092 | ||||||||
| Income tax expense | — | — | 161 | 452 | 8,106 | ||||||||||
| Net (loss) income | (2,451 | ) | (1,203 | ) | 9 | 5,299 | 107,986 | ||||||||
| Earnings (loss) per share: | |||||||||||||||
| Basic | (0.03 | ) | (0.01 | ) | 0.00 | 0.06 | 1.14 | ||||||||
| Diluted | (0.03 | ) | (0.01 | ) | 0.00 | 0.06 | 1.14 | ||||||||
| Weighted average ordinary shares: | |||||||||||||||
| Basic | 95,000 | 95,000 | 95,000 | 95,000 | 95,000 | ||||||||||
| Diluted | 95,000 | 95,000 | 95,000 | 95,000 | 95,000 | ||||||||||
| (1) | Share-based compensation expenses are included in the following financial statements line items: |
| For the Year Ended December 31, | ||||||||||
| 2004 | 2005 | 2006 | 2007 | 2008 | ||||||
| ($ in thousands) | ||||||||||
| Cost of revenues | — | — | 74 | 38 | 14 | |||||
| Product development | — | — | 263 | 170 | 4,919 | |||||
| Sales and marketing | — | — | — | 10 | 10 | |||||
| General and administrative | — | — | 52 | 225 | 404 | |||||
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Selected Consolidated Balance Sheet Data
| As of December 31, | As of December 31, 2008 | |||||||||||
| 2005 | 2006 | 2007 | Actual | Pro Forma as Adjusted(1)(2) | ||||||||
| ($ in thousands) | ||||||||||||
| Cash and bank deposits | 522 | 1,547 | 15,419 | 134,439 | 183,641 | |||||||
| Total current assets | 605 | 1,575 | 24,386 | 166,180 | 214,465 | |||||||
| Total assets | 2,330 | 3,950 | 30,126 | 176,656 | 224,941 | |||||||
| Receipt in advance and deferred revenue | 1,528 | 1,036 | 8,173 | 20,703 | 20,703 | |||||||
| Dividend payable | — | — | — | — | 96,800 | |||||||
| Total current liabilities | 2,303 | 1,948 | 39,868 | 71,962 | (3) | 168,762 | ||||||
| Total shareholders’ equity (deficit) | 27 | 2,002 | (9,742 | ) | 104,694 | 56,179 | ||||||
| Total liabilities and shareholders’ equity | 2,330 | 3,950 | 30,126 | 176,656 | 224,941 | |||||||
| (1) | Our consolidated balance sheet data is presented on a pro forma as adjusted basis to give effect to (i) our intended declaration prior to the completion of this offering of a cash dividend in the amount of $96.8 million payable to Sohu.com (Game) Limited and (ii) the issuance and sale of 3,750,000 ADSs, representing 7,500,000 Class A ordinary shares, by us in this offering, assuming an initial public offering price of $15.00 per ADS, the mid-point of the estimated range of the initial public offering price, after deducting estimated underwriting discounts and commissions and estimated aggregate offering expenses payable by us and assuming no other change to the number of ADSs sold by us as set forth on the cover page of this prospectus. |
| (2) | The payment of the dividend referred to in footnote (1) above is subject to receipt of PRC government approvals for our indirect subsidiary in China to pay a dividend to us through our Hong Kong subsidiary, Changyou HK. Until the dividend is paid, the amount of the dividend we intend to declare will be reflected in our current liabilities. Upon our payment of the dividend to Sohu.com (Game) Limited and the PRC withholding tax described in footnote (3) below, the amount of our cash and bank deposits will be reduced by $101.8 million, and our total current liabilities will be reduced by the same amount. |
| (3) | Includes PRC withholding tax of $5.0 million in connection with the declaration by AmazGame of a dividend in the amount of $101.8 million to Changyou HK. Changyou HK intends to declare as a cash dividend the net amount of $96.8 million that it receives from AmazGame to us, which amount we intend to declare as a cash dividend to Sohu.com (Game) Limited as described in footnote (1) above. |
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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. The discussion in this section contains forward-looking statements that involve risks and uncertainties. As a result of various factors, including those set forth under “Risk Factors” and elsewhere in this prospectus, our actual future results may be materially different from what we expect.
Overview
We are a leading online game developer and operator in China as measured by the popularity of our game TLBB. TLBB, which was launched in May 2007, was ranked by IDC for 2007 as the third most popular online game overall in China and the second most popular online game in China among locally-developed online games. We engage in the development, operation and licensing of massively multi-player online role-playing games, or MMORPGs, which are interactive online games that may be played simultaneously by hundreds of thousands of game players. We currently operate two MMORPGs, TLBB, which we developed in-house, and BO, which we licensed from a third party. For the three months ended December 31, 2008, we had approximately 1.8 million active paying accounts for TLBB and approximately 159,000 active paying accounts for BO.
We have three new MMORPGs in the pipeline, including DMD, which we are developing in-house, IF and LAW, both of which we licensed from third parties. We expect to begin open beta testing of IF and DMD in the second and fourth quarters of 2009, respectively, and of LAW in early 2010.
We operate our current games under the item-based revenue model, meaning that game players can play our games for free, but may choose to pay for virtual items to enhance the game-playing experience. Game players purchase prepaid game cards or game points, which are used to purchase virtual items. We sell our prepaid game cards to approximately 100 regional distributors throughout China, who in turn sub-distribute the prepaid game cards to numerous retail outlets, including Internet cafes and various websites, news stands, software stores, book stores and retail stores.
Due to our limited operating history, our period-to-period operating history may not be meaningful. In addition, our limited operating history makes it difficult for us to have a historical basis for making certain critical accounting policies and accounting estimates. See “Risk Factors—Risks Related to Our Business and Our Industry—Our limited operating history makes evaluating our business and prospects difficult.” Furthermore, the online game industry and Internet usage in China may not continue to grow at current levels.
Our Relationship with Sohu
We are an indirect subsidiary of Sohu.com Inc., which operates a leading Internet portal, Sohu.com, in China. Prior to our reorganization as a separate, indirect subsidiary of Sohu.com Inc., we operated as a business unit within the Sohu Group. For the three months ended June 30, 2007, Sohu began reporting results of its MMORPG operations as a separate business segment and effective December 1, 2007, Sohu transferred to our Chinese subsidiary, AmazGame, and our VIE, Gamease, all of Sohu’s assets and operations relating to its MMORPG business. We also assumed all of Sohu’s liabilities relating to such business. Accordingly, references to the operations of our business, financial condition and results of operations for periods prior to December 1, 2007 are to Sohu’s MMORPG business unit.
Our consolidated financial statements included elsewhere in this prospectus have been prepared as if our current corporate structure had been in existence throughout the periods presented. For periods both before and
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after December 1, 2007, our consolidated financial statements include the assets, liabilities, revenues, expenses and changes in shareholders’ equity and cash flows that were directly attributable to our MMORPG business whether held or incurred by Sohu or by Changyou. In cases involving assets and liabilities not specifically identifiable to any particular operation of Sohu, only those assets and liabilities transferred or expected to be transferred to Changyou are included in our consolidated balance sheets. With respect to costs of operations of the MMORPG business, an allocation of certain general corporate expenses of Sohu which are not directly related to the MMORPG operations and an allocation of certain advertising and other expenses provided by Sohu to Changyou were also included. These allocations are based on a variety of factors depending upon the nature of the expenses being allocated, including revenue, the number of employees and the number of servers. Our statements of operations also include the sales and marketing expenses and other costs charged from Sohu. The transactions are measured at the amount of consideration established and agreed to by the related parties. The income tax was calculated based on a separate return basis as if we had filed a separate tax return. As the assets and liabilities relating to the operation of MMORPGs held through companies owned or controlled by Sohu historically had been under common management and control of Sohu, the assets and liabilities have been stated at historical carrying amounts.
Our management believes that the assumptions underlying our financial statements and the above allocations are reasonable. Our financial statements, however, may not necessarily reflect our results of operations, financial condition and cash flows as if we had operated as a separate, stand-alone company during the periods presented. You should not view our historical results as an indicator of our future performance.
All of our current executive officers and approximately 40% of our current employees were formerly employees of Sohu. We have invested and are continuing to invest in and expand our own administrative functions separate from Sohu’s, including our tax, accounting, treasury, legal and human resource services, which may be at a higher cost than the comparable services previously provided by Sohu. We also will incur additional costs as a public company, including but not limited to, audit, investor relations, share administration and regulatory compliance costs.
After the completion of this offering, Sohu will own approximately 70.7% of the combined total of our outstanding Class A and Class B ordinary shares and will control 81.5% of the voting power of the combined total of our outstanding Class A and Class B ordinary shares due to the additional voting power of the Class B ordinary shares that it holds, assuming the underwriters’ over-allotment option is not exercised. Sohu will continue to have the voting power to elect our entire board of directors. In addition, we will continue to have joint marketing and other commercial contractual relationships with Sohu. See “Our Relationship with Sohu—Our Relationship with Sohu Following the Offering.”
Factors Affecting Our Results of Operations
Our results of operations are affected by several key factors, including the following:
General economic conditions affecting the online game industry in China
We have benefited from general conditions typically affecting the online game industry in China, including the overall economic growth, which has resulted in increases in disposable income and discretionary consumer spending; the increasing use of the Internet with the growth of personal computers and broadband penetration; the growing popularity of online games in comparison with other forms of entertainment; and favorable demographic trends, particularly the growth of the teenage and young adult population who are typically more inclined to play online games. We cannot assure you that the Chinese economy will continue to grow, or that if there is growth, such growth will be steady and uniform and that any such growth will lead to growth in the MMORPG business, or that if there is a slowdown, such slowdown will not have a negative effect on our MMORPG business. For example, the current slowdown in China’s economic growth that resulted from the impact of the global financial crisis, appreciation of the Renminbi, the PRC government’s tightening
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macroeconomic measures implemented in 2007 and the first half of 2008 to curb inflation, and other factors may lead to decreases in the level of disposable income of our game players and negatively affect their spending on playing MMORPGs.
Our ability to develop and maintain popular online games and convert our game player base into paying customers
The popularity of our games drives the growth of our game player base, which is the key component driving the sales and consumption of our virtual items and thus our revenues. To maintain and grow the popularity of our games, we must diligently maintain the quality of the games and continually enhance the games to meet game player preferences and to incentivize game players to purchase virtual items. We solicit feedback from our game players and have a dedicated product development team that helps us to identify market trends and user preferences. For TLBB, we typically provide weekly updates and more substantial enhancements in the form of expansion packs every few months. We launch new virtual items to maintain game players’ interest. We plan the timing of our new virtual item launches to avoid over-monetizing our existing game player base. We generally only launch virtual items after we have gained a certain number of new game players. If we fail to manage the growth of our game player base and manage our sales and marketing strategies for new virtual items, our game player base may not grow and we may not be successful in selling new virtual items, which would have an adverse effect on our revenues.
The popularity and timing of the launch of new games
We currently have three new games in the pipeline, including DMD, which we are developing in-house, and IF and LAW, both of which we licensed from third parties. We expect to begin open beta testing of IF and DMD in the second and fourth quarters of 2009, respectively, and of LAW in early 2010. Our results of operations will be significantly affected by the timing of our new game launches and the popularity of such new games.
Product development and sales and marketing expenses
Developing and marketing a new MMORPG and maintaining its popularity in the market requires a commitment of significant resources, including product development and sales and marketing expenses. We typically incur such expenses several quarters before such games generate any revenues. If such games are not popular and do not generate substantial revenues, we may not be able to recover our product development and marketing expenses. In addition, because our product development strategy is to focus on a limited number of high-quality games, the failure of a small number of these games could adversely impact our growth rate.
The cost of attracting and retaining game development personnel
Competition in the online game industry in China is intense, making it increasingly costly to retain and motivate existing talent and to attract new talent necessary for the growth of our business. Many of our competitors have been aggressively hiring game development personnel. If we are unable to retain our current talent and to attract new talent, we may have difficulty developing new games or enhancements for our existing games or meeting our development schedule, which could have an adverse impact on our business, financial condition and results of operations. See “Risk Factors—Risks Related to Our Business and Our Industry—Our business may not succeed in a highly competitive market.”
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Our Revenues
The following table sets forth the revenues generated from our game operations in China and overseas licensing, both in absolute amount and as a percentage of total revenues for the periods indicated:
| For the Year Ended December 31, | |||||||||||||||
| 2006 | 2007 | 2008 | |||||||||||||
| Amount | % of Total Revenues | Amount | % of Total Revenues | Amount | % of Total Revenues | ||||||||||
| ($ in thousands except percentages) | |||||||||||||||
| Revenues: | |||||||||||||||
| Game operations revenues | 8,525 | 100.0 | % | 41,751 | 99.2 | % | 194,607 | 96.4 | % | ||||||
| Overseas licensing revenues | — | — | 345 | 0.8 | % | 7,238 | 3.6 | % | |||||||
| Total revenues | 8,525 | 100.0 | % | 42,096 | 100.0 | % | 201,845 | 100.0 | % | ||||||
Game Operations Revenues
Our current two MMORPGs, TLBB and BO, are free to play and generate revenues using the item-based revenue model through the sale of virtual items that enhance the game-playing experience. Game players can purchase virtual items, such as gems, pets, fashion items, magic medicine, riding animals, hierograms, materials, skill books and fireworks by purchasing prepaid game cards or game points. We initially operated BO under the time-based revenue model and switched to the item-based revenue model in December 2006.
We report our game operations revenues after netting business taxes, sales discounts and rebates to our distributors. See “—Revenue Collection—Game Operations.”
Tian Long Ba Bu (TLBB). TLBB is our first in-house developed MMORPG, which we started to develop in late 2004. We launched TLBB in May 2007, and since then it has contributed a substantial majority of our total revenues. For the year ended December 31, 2008, game operations revenues from TLBB generated 90.0% of our total revenues. The following table sets forth game operations revenues from TLBB in China and the related operating data for the game for the periods indicated:
| For the Three Months Ended | ||||||||||||||
| Jun. 30, 2007 | Sep. 30, 2007 | Dec. 31, 2007 | Mar. 31, 2008 | Jun. 30, 2008 | Sep. 30, 2008 | Dec. 31, 2008 | ||||||||
| TLBB Operations Revenues | 2,256 | 10,794 | 21,757 | 38,493 | 43,350 | 48,278 | 51,540 | |||||||
| Peak Concurrent Users (in thousands) | 405 | 408 | 531 | 592 | 699 | 690 | 738 | |||||||
| Average Concurrent Users (in thousands) | 181 | 216 | 278 | 306 | 380 | 387 | 411 | |||||||
| Quarterly Active Paying Accounts (in thousands) | 209 | 690 | 1,096 | 1,387 | 1,684 | 1,860 | 1,822 | |||||||
| Quarterly Average Revenue per Active Paying Account | 82 | 118 | 147 | 199 | 179 | 178 | 193 | |||||||
Average revenue per active paying account for TLBB dropped in the second quarter of 2008 as we focused on enhancing game players’ in-game experiences, converting non-paying game players into paying game
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players and reducing the number of launches of new virtual items, all with the goal of extending the lifespan of the game.
The number of active paying accounts for TLBB for the fourth quarter of 2008 decreased slightly from the prior quarter. With a strong focus on expanding our game player base, we further developed TLBB’s free-of-charge playing features in the fourth quarter of 2008. As some of the previous low-spending game players became non-paying game players due to their satisfaction with the enhanced free-of-charge playing features, the number of active paying accounts for the fourth quarter of 2008 decreased slightly.
Blade Online (BO). In October 2004, we launched BO, an MMORPG that we licensed from a third party. For the year ended December 31, 2008, game operations revenues from BO generated 6.4% of our total revenues. The following table sets forth game operations revenues from BO and the related operating data for the game in China for the periods indicated:
| For the Three Months Ended | ||||||||||||||||
| Mar. 31, 2007 | Jun. 30, 2007 | Sep. 30, 2007 | Dec. 31, 2007 | Mar. 31, 2008 | Jun. 30, 2008 | Sep. 30, 2008 | Dec. 31, 2008 | |||||||||
| BO Operations Revenues | 1,608 | 1,569 | 1,783 | 1,975 | 2,081 | 2,380 | 3,615 | 4,870 | ||||||||
| Peak Concurrent Users | 63 | 60 | 64 | 68 | 69 | 74 | 82 | 95 | ||||||||
| Average Concurrent Users | 42 | 42 | 42 | 47 | 46 | 46 | 51 | 55 | ||||||||
| Quarterly Active Paying Account | 217 | 138 | 143 | 147 | 127 | 123 | 146 | 159 | ||||||||
| Quarterly Average Revenue per Active Paying Account (in RMB) | 58 | 87 | 94 | 100 | 116 | 135 | 169 | 209 | ||||||||
Overseas Licensing Revenues
We began licensing our game TLBB to operators outside of China in 2007. We began generating overseas licensing revenues from TLBB in each of Taiwan and Hong Kong in April 2008, and Vietnam in August 2007, and we expect to begin generating revenues in Malaysia and Singapore in the second half of 2009. The licenses are for terms of either two years or three years. Under our licensing arrangements, the licensee operators pay us an initial license fee and ongoing royalties based on a percentage of revenues generated by them over the term of the license period. For the year ended December 31, 2008, our overseas licensing revenues were $7.2 million, representing 3.6% of our total revenues. We expect to expand our licensing of TLBB to additional countries and may decide to license certain of our new MMORPGs overseas after they are launched.
Revenue Collection
Game Operations
We sell virtual and physical prepaid game cards to regional distributors, who in turn sub-distribute to retail outlets, including Internet cafes, various websites, news stands, software stores, bookstores and retail stores. We typically collect payment from our distributors upon delivery of our prepaid game cards, but only recognize revenues as the virtual items are consumed. We generally offer a sales discount to our prepaid game
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card distributors based on the popularity of our games. In 2006, prior to the launch of TLBB, we offered a sales discount as high as 20.0%. Since the launch of TLBB in 2007, we offered an initial sales discount at the rate of 15.0%, which has decreased to the current rate of 11.0%, effective as of January 2009. In addition, we offer a discount of 5.0% to our game players who use Sohu’s PEAK system for direct purchases of virtual prepaid game cards and game points. The sales discount represents the difference between the price at which we sell prepaid game cards to distributors or game players, as the case may be, and the face value of the prepaid game cards or the equivalent of game points.
We also offer rebates in the form of credits on future purchases of prepaid game cards to distributors of our prepaid game cards. Distributors of prepaid game cards will receive a credit on future purchases of our prepaid game cards in an amount equal to 1.0% to 3.0% of the discounted value of our prepaid game cards, provided that the distributors meet certain preset sales conditions. Historically, most of our distributors have met the conditions required to receive these credits. Credits are in the form of free prepaid game cards. We incur transaction costs of 0.9% of the face value of the virtual prepaid game cards or the equivalent of game points by using Sohu’s PEAK system.
The current total discount and rebate rate we typically offer to all of our prepaid game card distributors is approximately 12.0% to 14.0% of the face value of our prepaid game cards. The total discount and transaction costs associated with game players’ use of Sohu’s PEAK system is 5.9% of the face value of the virtual prepaid game cards or the equivalent of game points purchased.
Overseas Licensing
Our overseas licensing revenues consist of an initial license fee and ongoing revenue-based royalties. The initial license fee includes a fixed amount payable upon signing the license agreement and additional license fees payable upon achieving certain sales targets. The ongoing revenue-based royalties are generally determined based on the amount charged to game players’ accounts in a given country or region and sales of ancillary products of the game in such country or region. We typically receive ongoing revenue-based royalties on a monthly basis.
Revenue Recognition
Game Operations
Proceeds received from sales of prepaid game cards form the basis of our revenues and are recorded initially as receipts in advance. Upon activation of the prepaid game cards, proceeds are transferred from receipts in advance to deferred revenues. Proceeds received from online sales of game points directly to game players are recorded as deferred revenues. As of December 31, 2008, we had receipts in advance from distributors and deferred revenues from our game operations of $19.9 million, compared with $8.1 million and $1.0 million as of December 31, 2007 and 2006, respectively.
We recognize revenues when virtual items purchased by game players are consumed. For consumable virtual items, including those with a predetermined expiration time, revenues are recognized as they are consumed, and for perpetual virtual items, revenues are recognized over their estimated lives. In addition, prepaid game cards will expire two years after the date of card production if they have never been activated. The proceeds from the expired game cards are recognized as revenues upon expiration of the cards. In contrast, once the prepaid game cards are activated and credited to a game player’s account, they will not expire as long as the game account remains active. We are entitled to close a game player’s account if it has been inactive for a period of 180 consecutive days. The unused balances in an inactive game player’s account are recognized as revenues when the account is closed.
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Overseas Licensing
For the initial license fees receivable under our overseas licensing agreements, we recognize revenues ratably over the remaining license period, during which we are obligated to provide post-sales services such as technical support and provision of updates or upgrades to the licensed games. Unrecognized initial license fees received are recorded as deferred revenues. As of December 31, 2008, such deferred revenues was $0.8 million, compared with $0.1 million and $nil as of December 31, 2007 and 2006, respectively. With respect to the ongoing revenue-based royalties, we recognize revenues when the revenue-based royalties are earned under the terms of the overseas licensing agreements, and the collection of such royalties is probable.
Cost of Revenues
Our cost of revenues consists primarily of salaries and benefits expenses, including share-based compensation expenses, relating to the operation of our games, revenue-based royalty payments to the game developers of BO and KO, bandwidth leasing costs, amortization of licensing fees, depreciation expenses, PRC business tax and value-added tax, or VAT, that AmazGame pays on the revenue that it derives from its contractual arrangements with Gamease. We expect our cost of revenues to increase as our revenues increase.
Revenue-Based Royalty Payments
Revenue-based royalty payments are payments made to the third-party licensors of KO and BO. Our license to KO expired in November 2006. Our obligation to make royalty payments for BO ended as of July 1, 2008. Revenue-based royalty payments constituted 6.5%, 23.9% and 60.1% of our cost of revenues for the years ended December 31, 2008, 2007 and 2006, respectively. The reduction in royalty payments as a percentage of cost of revenues for the year ended December 31, 2008 as compared to the earlier periods resulted from the expiration of our obligation to pay royalty payments for BO on July 1, 2008, and increases in cost of revenues not attributable to our operation of BO.
Salaries and Benefits Expenses
Salaries and benefits expenses primarily include employee wages and social welfare benefits, such as medical insurance, housing subsidies, unemployment insurance and pension benefits for employees involved in the operation of our games, including product maintenance, network operation and customer service. Salaries and benefits expenses constituted 35.1%, 31.0% and 23.8% of our cost of revenues for the years ended December 31, 2008, 2007 and 2006, respectively.
Bandwidth Leasing Costs
We lease communication bandwidth to connect our game operating networks to the Internet and interchange data traffic to and from our networks and our game players. Bandwidth leasing costs constituted 15.5%, 16.7% and 2.9% of our cost of revenues for the years ended December 31, 2008, 2007 and 2006, respectively.
Depreciation of Computer Equipment (Including Servers)
Depreciation expenses are for computer equipment (including servers) that are directly related to our game operations. The amount of depreciation of computer equipment (including servers) constituted 14.4%, 15.3% and 7.6% of our cost of revenues for the years ended December 31, 2008, 2007 and 2006, respectively.
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PRC Business Tax and VAT
Our cost of revenues includes business tax, at an effective rate of 5.0%, and VAT, at an effective rate of 3.0%, that AmazGame pays on the revenues that it derives from its contractual arrangements with Gamease. The amount of business tax and VAT constituted 18.3%, 6.7% and nil% of our cost of revenues for the years ended December 31, 2008, 2007 and 2006, respectively.
Gamease incurs additional business taxes and related surcharges at an effective rate of 5.5% in connection with sales of its prepaid game cards and game points. However, we present our revenues net of these taxes and related surcharges. See “—Taxation—PRC Business Tax and VAT.”
Operating Expenses
Our operating expenses consist of product development expenses, sales and marketing expenses, and general and administrative expenses, each of which includes share-based compensation expenses. We expect that our operating expenses will increase in the future as we expand our game portfolio, and enhance our product development and sales and marketing activities.
The following table sets forth our product development expenses, sales and marketing expenses and general and administrative expenses, both in absolute amount and as a percentage of total revenues for the periods indicated.
| For the Year Ended December 31, | |||||||||||||||
| 2006 | 2007 | 2008 | |||||||||||||
| Amount | % of Total Revenues | Amount | % of Total Revenues | Amount | % of Total Revenues | ||||||||||
| ($ in thousands, except percentages) | |||||||||||||||
| Product development | 1,957 | 22.9 | % | 6,738 | 16.0 | % | 23,862 | 11.8 | % | ||||||
| Sales and marketing | 1,798 | 21.1 | % | 19,851 | 47.2 | % | 38,917 | 19.3 | % | ||||||
| General and administrative | 876 | 10.3 | % | 2,992 | 7.1 | % | 9,053 | 4.5 | % | ||||||
| Total | 4,631 | 54.3 | % | 29,581 | 70.3 | % | 71,832 | 35.6 | % | ||||||
Product Development Expenses
Our product development expenses consist primarily of salaries and benefits expenses, including share-based compensation expenses, of personnel engaged in the development of our game development platform and our games, and content and license expenses relating to our games. Product development expenses increased significantly to $23.9 million for the year ended December 31, 2008 compared to $6.7 million for the year ended December 31, 2007. The increase in such expenses is primarily due to our increased expenditures to develop new MMORPGs, DMD in particular, and expansion packs for existing games. Product development expenses constituted 11.8%, 16.0% and 22.9% of our total revenues for the years ended December 31, 2008, 2007 and 2006, respectively.
Sales and Marketing Expenses
Our sales and marketing expenses consist primarily of expenses for advertisement and promotion, and salaries and benefits expenses, including share-based compensation expenses, of our sales and marketing personnel. Substantially all of the sales and marketing expenses are advertising and promotion expenses, which include online advertising, offline promotions and traditional media advertising. We typically incur sales and marketing expenses several quarters before revenue is generated in order to promote new game launches. Sales and marketing expenses increased significantly to $38.9 million for the year ended December 31, 2008 compared
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to $19.9 million for the year ended December 31, 2007. This increase was primarily a result of higher sales and marketing efforts for TLBB and BO in the year ended December 31, 2008. Sales and marketing expenses constituted 19.3%, 47.2% and 21.1% of our total revenues for the years ended December 31, 2008, 2007 and 2006, respectively. For a discussion of arrangements with Sohu to provide marketing services to us, see “Our Relationship with Sohu—Our Relationship with Sohu Following the Offering.”
General and Administrative Expenses
Our general and administrative expenses consist primarily of salaries and benefits expenses, including share-based compensation expenses, for management, finance and administrative personnel, professional service fees, audit fees, and fees for tax consultation. General and administrative expenses increased to $9.1 million for the year ended December 31, 2008 compared to $3.0 million for the year ended December 31, 2007. This increase was primarily a result of increases in salary and benefits expenses and professional fees related to our reorganization. General and administrative expenses constituted 4.5%, 7.1% and 10.3% of our total revenues for the years ended December 31, 2008, 2007 and 2006, respectively.
Share-based Compensation Expenses
Share-based compensation expenses included in our financial statements include an allocation to us of such expenses related to Sohu’s senior management who provide services for both Sohu and Changyou. Following completion of this offering, we do not expect Sohu’s management to continue to provide these services and therefore do not expect our financial statements to include such allocations in the future. We did not issue any options, restricted share units or other share-based compensation awards in Changyou.com Limited, the issuer in this offering, prior to January 1, 2008. Share-based compensation expenses included in our financial statements for periods ended prior to January 1, 2008 reflect options or restricted share units granted by Sohu to employees of Sohu who were engaged in the MMORPG business and who subsequently became our employees upon our reorganization when we became a separate, indirect subsidiary of Sohu.
In March 2005, Sohu formed an indirect subsidiary to carry out game development, and granted to Tao Wang, who at the time was an employee of Sohu, a contingent right to receive a payment equal to 25% of the value of the subsidiary upon the occurrence of certain events. Sohu later agreed with Mr. Wang that his contingent right in the subsidiary would be modified to provide Mr. Wang an equity interest in us in lieu of the contingent right.
In January 2008, we communicated to and agreed with Mr. Wang that the equity interest we granted to him would consist of 7,000,000 of our ordinary shares and 8,000,000 restricted shares. The restricted shares included, as a condition of vesting, the completion of an initial public offering by us on an internationally recognized stock exchange, and also were subject to a vesting schedule. In addition, the terms of the restricted shares provided that Mr. Wang will not be entitled to participate in any distributions by us on his ordinary shares and restricted shares until the earlier of the completion of this offering or February 2012. In April 2008, we modified the vesting conditions of the restricted shares to provide for vesting over a four-year period, subject to acceleration under certain circumstances, commencing on February 1, 2008, with no condition that an initial public offering be completed. There was no change, however, to the limitation on Mr. Wang’s right to participate in distributions declared by us prior to the completion of this offering.
On December 31, 2008, we reserved 20,000,000 of our ordinary shares to be used as incentive compensation for our executive officers and key employees from time to time under our 2008 Share Incentive Plan.
On January 15, 2009, 7,000,000 Class B ordinary shares and 8,000,000 Class B restricted shares were issued to Mr. Wang out of Sohu’s equity interest.
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The difference between the fair values, or the Incremental Fair Value, of the 7,000,000 Class B ordinary shares and 8,000,000 Class B restricted shares granted to Mr. Wang and Mr. Wang’s contingent right in the Sohu subsidiary is accounted for by us as share-based compensation. Because the terms of the issuance of the ordinary shares and restricted shares had been approved by us and were communicated to and agreed with Mr. Wang as of January 2, 2008, it was deemed as the grant date under U.S. GAAP and, accordingly, the Incremental Fair Value was determined as of that date. The portion of the Incremental Fair Value related to the 7,000,000 Class B ordinary shares, equal to $1.8 million, was recognized as share-based compensation expenses included in product development expenses for the three months ended March 31, 2008. As a result of the modification of the vesting terms of the 8,000,000 Class B restricted shares on April 21, 2008, the portion of the Incremental Fair Value related to those shares, equal to $7.0 million, was determined as of that date and is accounted for by us as share- based compensation over the vesting period starting from the date of the modification, following the accelerated basis of attribution. Share-based compensation expense relating to the 8,000,000 Class B restricted shares, which was $3.0 million for the period from April 21, 2008 to December 31, 2008, was included as share-based compensation expenses included in product development expenses. The Incremental Fair Values were determined using the discounted cash flow method.
In April 2008, our board of directors approved and we communicated to our executive officers other than the CEO and to certain employees, various grants of restricted shares and restricted share units. Pursuant to these approvals, on January 15, 2009, we issued to our executive officers other than the CEO an aggregate of 1,800,000 Class B restricted shares and we issued to certain of our key employees an aggregate of 940,000 restricted share units (settleable in Class B ordinary shares). On March 13, 2009, we exchanged the 1,800,000 Class B restricted shares held by executive officers other than the CEO for Class B restricted share units which have the same vesting and other terms as applied to the Class B restricted shares. The vesting of the restricted share units is contingent upon the completion of an initial public offering by us on an internationally recognized stock exchange, and are otherwise subject to vesting over a four-year period, subject to acceleration under certain circumstances, commencing February 1, 2008. The first vesting will occur, retroactively to the dates when they first otherwise would have vested, upon the expiration of the underwriters’ 180-day lock-up commencing on the date of this prospectus. The grant date fair value of the awards will be recognized in our consolidated statements of operations starting from the date when the vesting conditions become probable, which will occur upon the completion of this offering. The fair values of these awards were determined using the discounted cash flow method.
Share-based compensation expenses recorded under SFAS 123R for the year ended December 31, 2008 were $5.3 million compared to $0.4 million for the year ended December 31, 2007, and included share-based compensation paid by us to our executive officers and key employees, the allocated share-based compensation paid by Sohu to Sohu’s senior management who provide services to both Sohu and us, and the allocated share-based compensation paid by Sohu to certain of our employees who provide services to both Sohu and us.
Taxation
Under the current laws of the Cayman Islands, we are not subject to tax on income or capital gains. In addition, payment of dividends by us is not subject to withholding tax in the Cayman Islands.
Under the current Hong Kong Inland Revenue Ordinance, Changyou.com HK Limited is subject to 16.5% income tax on its taxable income generated from operations in Hong Kong. Additionally, payments of dividends by Changyou.com HK Limited to us are not subject to any Hong Kong withholding tax.
PRC Corporate Income Tax
Prior to January 1, 2008, our operating entities based in the PRC were governed by the Income Tax Law of the People’s Republic of China concerning Foreign Investment Enterprises and Foreign Enterprises and the Enterprise Income Regulation (“the previous income tax law and rules”). Pursuant to the previous income tax law
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and rules, PRC enterprises were generally subject to Enterprise Income Tax (“EIT”) at a statutory rate of 33% (30% state income tax plus 3% local income tax), or 15% for certain technology enterprises, on PRC taxable income. Furthermore, new technology enterprises were exempted from PRC state income tax for three years, beginning with their first year of operations, and were entitled to a 50% tax reduction, to a rate of 7.5%, for the subsequent three years and 15% thereafter. During the years ended December 31, 2005, 2006 and 2007, most of our operations in the PRC were subject to an applicable tax rate of 7.5% or were exempted from income tax as new technology enterprises.
On January 1, 2008, the newly introduced Corporate Income Tax Laws, or New CIT Law, which unify the statutory income tax rate of enterprises in China to 25%, became effective. The New CIT Law provides a five-year transitional period for those entities established before March 16, 2007, which enjoyed a favorable income tax rate of less than 25% under the previous income tax laws and rules, to gradually change their rates to 25%. On April 14, 2008, relevant governmental regulatory authorities released qualification criteria, application procedures and assessment processes for “new technology enterprises,” which will be entitled to a favorable statutory tax rate of 15%. On July 8, 2008, relevant governmental regulatory authorities further clarified that new technology enterprises previously qualified under the previous income tax laws and rules as of December 31, 2007 would be allowed to enjoy grandfather treatment for the unexpired tax holidays, on condition that they were re-approved for new technology enterprise status under the regulations released on April 14, 2008. Due to uncertainty as to whether AmazGame and Gamease will eventually be approved for new technology enterprise status, the Company had accounted for its current and deferred income tax based on the enacted statutory tax rate of 25% for the three months ended March 31, 2008.
In addition, the New CIT Law provides that “software enterprises” can enjoy an income tax exemption for two years beginning with their first profitable year and a 50% tax reduction to a rate of 12.5% for the subsequent three years. Both AmazGame and Gamease are qualified as software enterprises, and this status began to apply from January 1, 2008. In the three months ended June 30, 2008, we were informed by the relevant tax bureau that both AmazGame and Gamease will be subject to 0% income tax rate for the full year 2008 and a 50% tax reduction for the following three years. Accordingly, both AmazGame and Gamease will enjoy a tax exemption for fiscal year 2008 and a 50% income tax reduction to a rate of 12.5% from fiscal year 2009 to fiscal year 2011. Thus, as we had adopted the statutory income tax rate of 25% to account for income tax expenses for the first quarter of 2008, during the second quarter of 2008 we reversed the income tax expenses provided for in the first quarter of 2008, and we adopted a 0% tax rate for the second through the fourth quarters of 2008. Despite the fact that both AmazGame and Gamease were subject to 0% tax rate for the full year of 2008, they were still required by the relevant tax bureau to prepay income tax at the statutory rate of 25% for the first three quarters of 2008, which amounted to $18.9 million. We were not required to prepay income tax for the fourth quarter of 2008. In January 2009, we received a full refund of such prepaid income tax from the relevant tax authorities.
Gamease may be subject to withholding taxes on the initial license fees and ongoing revenue-based royalties received from our licensees in various jurisdictions outside of the PRC. We recognize such foreign withholding taxes as income tax expense when related revenue of initial license fees and ongoing revenue-based royalties are recognized. $1.0 million, $38,000 and $nil were recognized as income tax expense related to withholding taxes for the years ended December 31, 2008, 2007 and 2006, respectively.
As required by the New CIT Law, the profits of a foreign invested enterprise arising in 2008 and onwards which are distributed to its immediate holding company outside the PRC, will be subject to a withholding tax rate of 10%. A lower withholding tax rate will be applied if there is a tax treaty or arrangement between the PRC and the jurisdiction of the foreign holding company. Holding companies in Hong Kong, for example, will be subject to a 5% withholding tax rate. In the fourth quarter of 2008, in preparation for this offering, AmazGame declared a dividend to Changyou HK, its immediate parent company in Hong Kong, and we accrued a withholding tax of $5.0 million based on the 5% withholding tax rate.
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PRC Business Tax and VAT
We operate and distribute our MMORPGs via Gamease in China. Gamease is subject to PRC business tax at the rate of 5% and related surcharges of 0.5% on the revenues from game operations. Our revenues are presented net of these business tax and related surcharges.
AmazGame pays business tax and value added tax on revenues that it derives from its contractual arrangements with Gamease for its services provided or products sold to Gamease. We account for such business tax and value added tax as a component of our cost of revenues.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, appearing elsewhere in this prospectus. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe accounting for recognition of revenues, the determination of share-based compensation expense, the assessment of income tax and valuation allowances against deferred tax assets, assessment of impairment for intangible assets, fixed assets and other assets and the determination of functional currencies represent critical accounting policies that reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements.
When reviewing our financial statements, you should consider (i) our selection of critical accounting policies, (ii) the judgment and other uncertainties affecting the application of such policies and (iii) the sensitivity of reported results to changes in conditions and assumptions.
Recognition of Revenue
We earn revenues from our current MMORPG operations by providing online services to game players pursuant to the item-based revenue model. For periods prior to our upgrading and relaunching of BO in December 2006, we operated BO under the time-based revenue model, where game players are charged based on the time they spend playing the game. Under the item-based revenue model, game players play games free of charge and are charged for purchases of virtual items.
Under both the item-based and the time-based revenue models, proceeds received from sales of prepaid cards are initially recorded as receipts in advance.
Proceeds from sale of prepaid cards to distributors are deferred when received and, for the item-based revenue model, revenue is recognized over the estimated lives of the virtual items purchased or as the virtual items are consumed. For the time-based revenue model, revenue is recognized based upon the actual usage of time units by the game players. The revenues are recorded net of business tax, sales discounts and rebates to our distributors. See “—Revenue Collection—Game Operations.”
Under our item-based revenue model, game players can access our games free of charge, but may purchase consumable virtual items, including those with a predetermined expiration time, such as three months, or perpetual items, such as certain costumes that stay binded to a game player for the life of the game. Revenues in relation to consumable virtual items are recognized as they are consumed, as our services in connection with these items have been fully rendered to our game players as of that time. Revenues in relation to perpetual virtual
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items are recognized over their estimated lives. We will provide continuous online game services in connection with these perpetual virtual items until they are no longer used by our game players. We have considered the average period that game players typically play our games and other game player behavior patterns to arrive at our best estimates for the lives of these perpetual virtual items. We have also considered that the estimated lives of perpetual virtual items may be affected by various factors, including the acceptance and popularity of expansion packs, promotional events launched and market conditions. However, given the relatively short operating history of our games, and of our most popular game TLBB in particular, our estimate of the period that game players typically play our games may not accurately reflect the estimated lives of the perpetual virtual items. We have adopted a policy of assessing the estimated lives of perpetual virtual items on a quarterly basis. All paying users’ data collected since the launch of the games are used to perform the relevant assessments. Historical behavior patterns of these paying users during the period between their first log-on date and last log-on date are used to estimate the lives of perpetual virtual items. While we believe our estimates to be reasonable based on available game player information, we may revise such estimates in the future as our games’ operation periods become longer and we continue to gain more operating history and data. Any adjustments arising from changes in the estimates of the lives of perpetual virtual items would be applied prospectively on the basis that such changes are caused by new information indicating a change in the game player behavior patterns. Any changes in our estimate of lives of perpetual virtual items may result in our revenues being recognized on a basis different from prior periods’ and may cause our operating results to fluctuate.
We also derive revenues from licensing our games in other countries and territories. The licensing agreements provided for two revenue streams, an initial license fee and a monthly revenue-based royalty based on monthly revenues from the games. The initial license fee consists of both a fixed amount and additional amounts receivable upon achieving certain sales targets. Since we are required to provide when-and-if-available upgrades to the licensees during the license period, both the fixed portion and the additional portion of the initial license fee are recognized ratably as revenue over the license period. The fixed portion of the initial license fee is recognized ratably over the remaining license period from the date the game is launched, and the additional portion of the initial license fee is recognized ratably over the remaining license period from the date such additional amount is certain. The monthly usage-based royalty fee is recognized when earned, provided that collectability is reasonably assured.
Share-Based Compensation Expenses
Our financial statements reflect the adoption as of January 1, 2006, of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, or SFAS 123R, which requires all share-based payments to employees and directors, including grants of employee share options and restricted share units, to be recognized in the financial statements based on their fair values at grant date. The valuation provisions of SFAS 123R apply to new share-based awards, to share-based awards granted to employees and directors before the adoption of SFAS 123R whose related requisite services had not yet been provided, and to share-based awards which were subsequently modified or cancelled. In March 2005, the United States Securities and Exchange Commission, or the SEC, issued Staff Accounting Bulletin 107, or SAB 107, regarding the SEC’s interpretation of SFAS 123R and the valuation of share-based payments for public companies. We applied the provisions of SAB 107 in our adoption of SFAS 123R. Our share-based payments for periods prior to January 1, 2006 were accounted for in accordance with Accounting Principles Board Opinions (APB) 25, Accounting for Stock Issued to Employees, or APB 25, and complied with the disclosure provisions of SFAS 123. In general, share-based compensation expense under APB 25 was recognized based on the difference, if any, between the estimated fair value of Sohu common stock and the amount an employee was required to pay to acquire the stock, as determined on the date the option was granted. Pro forma information was disclosed to illustrate the effect on net income and net income per share if we had applied the fair value recognition provisions of SFAS 123 to share-based employee compensation for the reporting periods.
Under SFAS 123R, we apply the Black-Scholes valuation model in determining the fair value of options granted to employees and directors. Under the transition provisions of SFAS 123R, we recognized compensation
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expense on options granted by Sohu prior to the adoption of SFAS 123R on an accelerated basis over the requisite service period, which is consistent with the methods we used when preparing pro forma information under SFAS 123. Restricted share units are measured based on the fair market value of the underlying shares on the grant dates. We recognize the relevant share-based compensation expenses on an accelerated basis over the requisite service period.
Under SFAS 123R, the number of share-based awards for which the service is not expected to be rendered for the requisite period should be estimated, and the related compensation expense not recorded for that number of awards. For pro forma disclosure under SFAS 123, we accounted for the effect of forfeitures only as the forfeitures occurred. We applied the modified prospective transition method, and therefore have not restated prior years’ results.
Our management and board of directors determined the fair values as of the January 2008 and April 2008 grant dates, relying in part on a report prepared by American Appraisal China Limited, or American Appraisal China. Determining the fair value of our ordinary shares required us to make complex and subjective judgments regarding our projected financial and operating results, our unique business risks, the liquidity of our ordinary shares and our operating history and prospects at the time the grants were made.
Because at the time of the grants our MMORPG business was at a different stage of its product life cycle than that of the publicly-listed companies in our industry, we concluded that a market comparison approach would not have been meaningful in determining the fair value of our ordinary shares. As a result, we and American Appraisal China used the income approach/discounted cash flow method to derive the fair values. We applied the discounted cash flow, or DCF, analysis based on our projected cash flow using management’s best estimate as of the respective valuation dates. The projected cash flow estimate included, among other things, an analysis of projected revenue growth, gross margins, effective tax rates, capital expenditures and working capital requirements. The income approach involves applying appropriate discount rates, based on earnings forecasts, to estimated cash flows. The assumptions we used in deriving the fair value of the ordinary shares were consistent with the assumptions that we used in developing our business plan, which included no material changes in the existing political, legal, fiscal and economic conditions in China; our ability to recruit and retain competent management, key personnel and technical staff to support our ongoing operations; and no material deviation in industry trends and market conditions from economic forecasts. These assumptions are inherently uncertain and subjective. The discount rates reflect the risks our management perceived as being associated with achieving the forecasts and are based on our estimated cost of capital, which was derived by using the capital asset pricing model, after taking into account systemic risks and company-specific risks. The capital asset pricing model is a model for pricing securities that adds an assumed risk premium rate of return to an assumed risk-free rate of return. Using this method, we determined the appropriate discount rates to be 22% as of the January 2008 valuation date and 23% as of the April 2008 valuation date.
We also applied a discount for lack of marketability, or DLOM, to reflect the fact that, at the time of the grants, we were a closely-held company and there was no public market for our ordinary shares. To determine the discount for lack of marketability, we and American Appraisal China used the Black-Scholes option pricing model. Pursuant to the Black-Scholes option pricing model, we used the cost of a put option, which can be used to hedge the price change before a privately held share can be sold, as the basis to determine the discount for lack of marketability. Based on the foregoing analysis, we used a DLOM of 19% to discount the value of our ordinary share as of the January 2008 and April 2008 valuation dates. Because there was no evidence to indicate that there would be a disproportionate return between majority and minority shareholders, we did not apply a minority discount. As a result, we concluded that the fair value of our company as a going concern was $136 million as of the January 2008 valuation date and $198 million as of the April 2008 valuation date. The fair value per ordinary share and restricted share as of the date of the grants made in January 2008 was $1.36 per share. The fair value per ordinary share and restricted share, and per ordinary share underlying each restricted share unit, as of the date of the grants made in April 2008 was $1.98 per share.
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Our assumptions were based on historical experience, with consideration to developing expectations about the future. The assumptions used in calculating the fair value of share-based awards and related share-based compensation expenses represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change or different assumptions are used our share-based compensation expense could be materially different for any period. |xGv00|39b0c7c37eb72459d3c8564681b37515
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