Chapter 8

Due Diligence Guidelines –

Business Model

Appendix I – Examples of Questions Raised by Regulators in the Past to Test Business Sustainability

(a) Is the listing applicant’s optimistic view about its business viability based on realistic grounds as borne out by its historical performance?57 Does it have a loss-making history,58 net current liabilities,59 or a declining profit margin?60

(b) Where the listing applicant’s records show that it has achieved a significantly higher degree of financial success than its industry peers, are there specific and well-substantiated reasons for it?61

(c) Is the listing applicant’s historical financial success a result of factors such as:

(i) unusual sales or credit models (e.g., a high guarantee rate of return62 or extended credit term63 to customers); or

(ii) unsustainably low costs of supply64 or unusual payment terms with suppliers?

(iii) non-recurring items (e.g., revaluation gain)?65

(d) Is there a significant risk of loss or imminent discontinuation of any major revenue source (e.g., loss of key asset or termination of value-creating agreement)?66

(e) Do income items outside the ordinary course of business feature prominently in major revenue streams of the listing applicant (e.g., for a manufacturing business, interest income, administrative fee income or consultation service fee income)?67 What are their patterns of fluctuation?

(f) Will the listing applicant be able to continue as a going concern independent of connected persons? (See section 5)

(g) Does the listing applicant have proper and adequate insurance cover of the group and its directors?68

(h) Will the listing applicant have sufficient capital resources for the 12 months following publication of the listing document assuming completion of the listing?69 Does it rely heavily on borrowings to support daily working capital and what is its exposure to high borrowing costs?70

(i) What are the listing applicant’s plans on use of the proceeds of offering? How does it interact with available reserves, liabilities, working capital requirements and expenditure controls?71

(j) Are any external factors (e.g., government restrictions) adversely affecting or likely to affect the performance of the listing applicant?


57. See SFC Dual Filing Update of July 2012 where a listing applicant in the media industry, with an operating history of more than 10 years during which it had never reported any operating profit, asserted that it would be profit-making two years later assuming it managed to acquire and distribute more media products. The listing application did not proceed.

58. See SFC Dual Filing Update of July 2012 where the SFC states, “In cases where an applicant has experienced serious cash strains or continuing operating losses, the listing application materials should provide a balanced analysis of pertinent facts relating to the applicant’s business and industry environment to demonstrate that the applicant and its business can continue as a going concern.”

59. Exchange Listing Decision LD30-2012.

60. In Exchange Listing Decision LD37-2012, concerns were raised over a company’s sustainability due to a continuously declining gross profit margin the effects of which are only alleviated by extraordinary items such as foreign exchange gains on financing activities.

61. In SFC Dual Filing Update of January 2011 the SFC cited three cases where the listing applicants enjoyed significantly higher gross profit margins than their industry peers during the track record period and the explanations provided initially were either unspecific or unsubstantiated. Two of these cases did not proceed. Please see also Exchange Listing Decision LD48-2013 where the Stock Exchange demanded an explanation on what value-added services the listing applicant provided to its distributor customers to sustain its level of gross profit margin which was particularly high when compared to its peers.

62. See SFC Dual Filing Update of July 2012 where a listing applicant that managed entrusted properties in return for rental income agreed to provide very high guaranteed rates of return to its clients, the draft listing document was critiqued by the SFC for failing to disclose a meaningful analysis of the possible losses, such as a comparison of the market rent trend and the guaranteed returns for the properties under the entrustment arrangements.

63. See SFC Dual Filing Update of January 2011 where a listing applicant derived a substantial portion of its revenues from sale of car parking spaces to three individual investors who were given an extended credit term of over two years. More than a year after the sales to such individuals only 10% of the car parking spaces were leased out.

64. See SFC Dual Filing Update of August 2011 citing two cases: (i) a listing applicant would acquire an asset from a related party; the historical high profitability of the assets to be acquired had been largely attributable to the low cost of supplies sourced from the vendor at rates that the listing applicant would not be able to enjoy and the gross profit margin would have been reduced by half if the cost of supplies were to be adjusted to market price; (ii) the key raw material of a listing applicant was originally supplied at cost by a single supplier that was originally owned by a related party, which supplier was disposed of to an independent party, leading to a change in the pricing mechanism of the raw material sold to the applicant.

65. SFC Dual Filing Update of August 2011 (case 1 in note 63).

66. See SFC Dual Filing Update of August 2011 citing two cases: (i) an applicant derived all its revenue from the subleasing and management of three leased properties during the track record period, but one of the substantial properties was being demolished in phases until it was completely demolished towards the end of the period; (ii) another applicant was a value-added service provider to a major telecommunications operator on which the applicant was wholly reliant; towards the end of the track record period, the operator initiated a substantial reduction in the fees shared by the applicant because the operator decided to take a more active role in provision of the relevant service.

67. Paragraph 11 (d) of Exchange Listing Decision LD33-2012.

68. Paragraph A.1.8 in Appendix 14 to the Listing Rules.

69. Paragraph 36 in Part A of Appendix 1 to the Listing Rules.

70. In Exchange Listing Decision LD37-2012, the listing applicant relied on borrowings to support its daily working capital, and had been subject to increasingly high borrowing costs during the track record period, even after taking into account the substantial interest-free loans from its controlling shareholder. Given the low profit margin, any increase in borrowing costs in the future could easily wipe out its net profit. This, together with other factors, led to the Stock Exchange’s conclusion that the sustainability issue could not be sufficiently addressed by disclosure.

71. Paragraph 13(d) of Practice Note 21 to the Listing Rules.


HKCFEF Limited and the contributing law firms, accountants and sponsors are not offering these due diligence guidelines as legal, financial or professional advice or services and they should not be relied upon as such. These due diligence guidelines should not be used as a sole basis for any decision, action or inaction and are not meant to serve as a substitute for the advice of qualified professionals. See here for the full terms and conditions.

Examples of Questions Raised by Regulators in the Past to Test Business Sustainability

Optimistic View about Business Viability Based on Realistic Grounds

Achievement Significantly Higher Degree of Financial Success

Applicant Historical Financial Success A Result Of Unusual Credit Models, Payment Terms

Listing Applicatn Insurance Cover of Group and Directors

Applicant Plans on Use of the Proceeds of Offering

Listing Applicants Historical Financial Success

Performance of Listing Applicant

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