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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 20-F

 

 

(Mark One)

 

 

Date of event requiring this shell company report                       

 

Commission file number: 001-35109

 

Qihoo 360 Technology Co. Ltd.

(Exact name of Registrant as specified in its charter)

N/A

(Translation of Registrant’s name into English)

Cayman Islands

(Jurisdiction of incorporation or organization)

Block 1, Area D, Huitong Times Plaza No. 71 Jianguo Road, Chaoyang District Beijing 100025, People’s Republic of China

(Address of principal executive offices)

Alex Zuoli Xu, Chief Financial Officer Block 1, Area D, Huitong Times Plaza No. 71 Jianguo Road, Chaoyang District Beijing 100025, People’s Republic of China Tel: (+86-10) 5878-1000 Fax: (+86-10) 5878-1001 E-mail: ir@360.cn

(Name, Telephone, E-mail and/or Facsimile number and Address of Company Contact Person)

 

Securities registered or to be registered pursuant to Section 12(b) of the Act:

 

 

 

Securities registered or to be registered pursuant to Section 12(g) of the Act:

 

None

(Title of Class)

 

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Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:

 

None

(Title of Class)

 

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report.

 

109,392,815 Class A ordinary shares and 69,636,436 Class B ordinary shares, par value $0.001 per share, as of December 31, 2011.

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

o Yes   x No

 

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

o Yes   x No

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x Yes   o No

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

o Yes   o No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:

 

 

*If “Other” has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow.

o Item 17   o Item 18

 

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o Yes   x No

 

(APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PAST FIVE YEARS)

 

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.

 

o Yes   o No

 

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TABLE OF CONTENTS

 

INTRODUCTION		4
PART I		5
Item 1.	IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS	5
Item 2.	OFFER STATISTICS AND EXPECTED TIMETABLE	5
Item 3.	KEY INFORMATION	5
Item 4.	INFORMATION ON THE COMPANY	28
Item 5.	OPERATING AND FINANCIAL REVIEW AND PROSPECTS	46
Item 6.	DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES	66
Item 7.	MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS	77
Item 8.	FINANCIAL INFORMATION	81
Item 9.	THE OFFER AND LISTING	82
Item 10.	ADDITIONAL INFORMATION	83
Item 11.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	90
Item 12.	DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES	91
PART II		92
Item 13.	DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES	92
Item 14.	MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS	92
Item 15.	CONTROLS AND PROCEDURES	93
Item 16A.	AUDIT COMMITTEE FINANCIAL EXPERT	94
Item 16B.	CODE OF ETHICS	94
Item 16C.	PRINCIPAL ACCOUNTANT FEES AND SERVICES	94
Item 16D.	EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES	94
Item 16E.	PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS	95
Item 16F.	CHANGE IN REGISTRANT’S CERTIFYING ACCOUNTANT	95
Item 16G.	CORPORATE GOVERNANCE	95
PART III		95
Item 17.	FINANCIAL STATEMENTS	95
Item 18.	FINANCIAL STATEMENTS	95
Item 19.	EXHIBITS	95

 

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INTRODUCTION

 

Unless the context otherwise requires, in this annual report on Form 20-F:

 

·                                          “We,” “us,” “our,” and “our company” refer to Qihoo 360 Technology Co. Ltd., its subsidiaries and consolidated entities, collectively;

 

·                                          “Qihoo 360” refers to Qihoo 360 Technology Co. Ltd.;

 

·                                          “Qizhi Software” refers to Qizhi Software (Beijing) Co., Ltd.;

 

·                                          “Shares” or “ordinary shares” refers to our ordinary shares, including Class A and Class B ordinary shares, par value $0.001 per share.

 

·                                          “ADSs” refers to our American depositary shares, every two of which represents three Class A ordinary shares;

 

·                                          “ADRs” refers to the American depository receipts, which, if issued, evidence our ADSs;

 

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

 

·                                          “RMB” or “Renminbi” refers to the legal currency of China, and “$” or “U.S. dollars” refers to the legal currency of the United States; and

 

Names of certain companies provided in this annual report are translated or transliterated from their original Chinese legal names.

 

Discrepancies in any table between the amounts identified as total amounts and the sum of the amounts listed therein are due to rounding.

 

This annual report on Form 20-F includes our audited consolidated financial statements for the years ended December 31, 2009, 2010 and 2011.

 

This annual report contains translations of certain Renminbi amounts into U.S. dollars at the rate of RMB6.2939 to $1.00, the noon buying rate in effect on December 30, 2011 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 annual report 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. See “Item 3. Key Information — D. Risk Factors — Risks Related to Doing Business in China — Fluctuation in the value of the Renminbi may have a material adverse effect on your investment.” On April 13, 2012, the noon buying rate was RMB6.3022 to $1.00.

 

We completed an initial public offering of 13,927,420 ADSs on April 4, 2011. On March 30, 2011, we listed our ADSs on the New York Stock Exchange under the symbol “QIHU.”

 

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PART I

 

Item 1.                    IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS

 

Not Applicable.

 

Item 2.                    OFFER STATISTICS AND EXPECTED TIMETABLE

 

Not Applicable.

 

Item 3.                    KEY INFORMATION

 

A.            Selected Financial Data

 

The following selected consolidated statement of operations data for the years ended December 31, 2009, 2010 and 2011 and the selected consolidated balance sheet data as of December 31, 2010 and 2011 have been derived from our audited financial statements included elsewhere in this annual report. The selected consolidated financial data should be read in conjunction with those financial statements and the accompanying notes and “Item 5. Operating and Financial Review and Prospects” 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.

 

Our selected consolidated statements of operations data for the year ended December 31, 2008 and our consolidated balance sheets as of December 31, 2008 and 2009 have been derived from our audited consolidated financial statements, which are not included in this annual report.

 

We have omitted financial information as of and for the year ended December 31, 2007 because such information is not available on a basis that is consistent with the consolidated financial information included in this annual report and cannot be prepared in accordance with U.S. GAAP without unreasonable effort or expense. Furthermore, we believe that the omission of such financial information would not have a material impact on a reader’s understanding of our financial results and condition and related trends.

 

		Year Ended December 31,
		2008		2009		2010		2011
		($ in thousands, except share and per share data)
Statement of Operations Data:
Revenues:
Internet services		5,795		16,010		53,790		166,961
Sale of third party anti-virus software		11,100		16,292		3,875		890
Total revenues		16,895		32,302		57,665		167,851
Cost of revenues:
Internet services		1,147		1,790		5,566		18,680
Sale of third party anti-virus software		7,073		6,600		1,185		238
Total cost of revenues		8,220		8,390		6,751		18,918
Subsidy income		—		—		266		151
Operating expenses:
Selling and marketing		2,732		6,256		12,603		46,836
General and administrative		1,645		2,531		5,051		19,054
Product development(1)		7,283		10,664		24,505		65,049
Total operating expenses		11,660		19,451		42,159		130,939
(Loss) income from operations		(2,985	)	4,461		9,021		18,145
Interest income		616		281		415		2,594
Interest expense		(32	)	(169	)	(98	)	(53	)
Other expense		(164	)	—		(60	)	(3	)
Exchange (loss) gain		(360	)	28		(267	)	6,294
Impairment loss on long-term investments		—		—		—		(902	)
Change in unrealized holding loss of trading securities		—		—		—		(220	)
(Loss) income before income tax benefit (expense) and loss from equity method investments		(2,925	)	4,601		9,011		25,855
Income tax benefit (expense)		179		(412	)	(463	)	(10,874	)
Loss from equity method investments		—		—		(57	)	(437	)
Net (loss) income		(2,746	)	4,189		8,491		14,544
Less: Net loss attributable to noncontrolling interest		—		—		17		1,059
Net (loss) income attributable to Qihoo 360 Technology Co. Ltd.		(2,746	)	4,189		8,508		15,603

 

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(1) We changed the “research and development expenses” to “product development expenses” in the statements of operations. This is mainly because our business has been growing rapidly and along with the development of new products, we have devoted more resources to strengthening our existing products. As such, we believe that “product development expenses” will better reflect the nature of such expenses.

 

		Year Ended December 31,
		2008		2009		2010		2011
Net (loss) income attributable to ordinary shareholders of Qihoo 360 Technology Co. Ltd.		(4,811	)	2,124		5,465		14,832
Net (loss) income per ordinary share—basic		(0.07	)	0.03		0.05		0.10
Net (loss) income per ordinary share—diluted		(0.07	)	0.03		0.05		0.09
Weighted average shares used in calculating net income per ordinary share—basic		48,969,589		51,780,932		55,568,041		137,775,752
Weighted average shares used in calculating net income per ordinary share—diluted		65,339,960		65,339,960		71,350,571		172,992,515

 

		As of December 31,
		2008			2009			2010		2011
						($ in thousands)
Balance Sheet Data:
Cash and cash equivalents		23,262			28,144			60,505		343,731
Total assets		33,943			49,589			87,808		423,958
Total current liabilities		1,987			8,489			13,924		46,560
Total liabilities		4,948			10,935			14,886		52,466
Capital stock		65			65			72		179
Total (deficit) equity		(16,175	)		(8,581		)	2,722		371,492

 

B.                                     Capitalization and Indebtedness

 

Not Applicable.

 

C.                                     Reasons for the Offer and Use of Proceeds

 

Not Applicable.

 

D.                                    Risk Factors

 

Risks Related to Our Business

 

If we fail to continue to innovate and provide attractive products and services to attract and retain users, the effectiveness of our cloud-based security technology may be adversely affected and we may lose users and customers for our revenue generating services.

 

Our success depends on our ability to continue to provide attractive products and services that enable users to have a secure and high-quality Internet experience. In order to attract and retain users and compete against our competitors, we must continue to invest significant resources in product development to enhance our Internet security technology, improve our existing products and services, introduce additional high-quality

 

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products and services and enhance user experience. We may not be able to expand our user base if our products and services do not meet the needs of our users or are not effectively or timely brought to market. If we are unable to anticipate user preferences or industry changes, or if we are unable to modify our products and services on a timely basis, our user base may not increase at the expected rate, if at all, or even decrease. The effectiveness of our cloud-based security technology increases with the size of our user cloud. If we fail to innovate and provide attractive products and services to attract and retain users, the effectiveness of our cloud-based security technology may be adversely affected. Users may not choose to use our Internet security products and Internet value-added services if our technology is ineffective, and customers may no longer choose our platform to deliver online advertising if our user base does not grow. As Internet security technology continues to develop, our competitors may be able to offer Internet security products and services that are, or are perceived to be, substantially similar to or better than our own. This may force us to expend significant resources in order to remain competitive.

 

If we fail to keep up with rapid changes in technologies and Internet-enabled devices, our business may be adversely affected.

 

The Internet industry is characterized by rapid technological changes. Our future success will depend on our ability to respond to rapidly changing technologies, adapt our services to evolving industry standards and improve the performance and reliability of our products and services. Our failure to adapt to such changes could harm our business. In addition, changes in Internet-enabled devices resulting from technological development may also adversely affect our business. For example, the number of people accessing the Internet through devices other than personal computers, including mobile phones and other hand-held devices, has increased in recent years. In 2009, we began to offer mobile security products and services in response to this market trend. In September 2011, we launched a full suite of mobile browsers supporting iPads and Android based tablets and smart phones.   However, if we are slow to develop products and services that are compatible with mobile devices, or if the products and services we develop are not widely accepted and used by mobile device users, we may not be able to capture a significant share of this increasingly important market. In addition, the widespread adoption of new Internet, networking or telecommunications technologies or other technological changes could require substantial expenditures to modify or adapt our products, services or infrastructure. If we fail to keep up with rapid technological changes to remain competitive, our future success may be adversely affected.

 

If we fail to leverage our user base to increase our revenues, our results of operations and growth prospects could be harmed.

 

We generate revenues primarily through online advertising and Internet value-added services, such as the offering of web games, remote technical support and other Internet value-added services. The attractiveness of our online advertising and Internet value-added services largely depends on our ability to maintain and expand our user base, which in turn requires us to continuously invest significant resources in providing Internet and mobile security products and services that retain and attract users. We plan to make significant investments in developing and offering Internet products and services. However, we cannot assure you that our investments will maintain or expand our user base or that our user base will successfully drive our revenue growth. If we fail to leverage our user base to promote web games or other Internet value-added services or to attract paying advertising customers, our business, results of operations and growth prospects could be seriously harmed.

 

We generate a substantial and fast-growing portion of our revenues from online advertising. If we fail to retain existing customers or attract new customers for our online advertising services, our business, results of operations and growth prospects could be seriously harmed.

 

In the three years ended December 31, 2009, 2010 and 2011, online advertising services accounted for 43.1%, 67.3% and 73.3% of our total revenues, respectively. Our online advertising customers include, among others, third-party websites who pay us for displaying their links on our 360 Personal Start-up Page and other platform products, and search engines who pay us fees for generating search queries from our 360 browsers and 360 Personal Start-up Page. Our online advertising customers may not continue to do business with us if their investments do not generate sales leads and ultimately customers. If we fail to retain existing customers or attract new customers for our online advertising services, our business, results of operations and growth prospects could be seriously harmed.

 

Legal proceedings or allegations of impropriety against us or our management could have a material adverse impact on our reputation, results of operation, financial condition and liquidity.

 

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From time to time, we have been, and may be in the future, subject to lawsuits or allegations brought by our competitors, individuals or other entities against us or our management, including claims of unfair, unethical, fraudulent or otherwise inappropriate business practices. Certain key members of our management team have also been in the past alleged to have committed wrongdoings in their current and/or prior business affiliations.  Any such lawsuit or allegation, with or without merit, or any perceived unfair, unethical, fraudulent or inappropriate business practice by us or perceived wrong doing by any key member of our management team could harm our reputation and user base and distract our management from day-to-day operations of our company. We are currently involved in several lawsuits in PRC courts where our competitors instituted proceedings or asserted counterclaims against us or we instituted proceedings or asserted counterclaims against our competitors relating to anti-trust issues, unfair competition and defamation. See “Item 8. Financial Information — A. Consolidated Statements and Other Financial Information — Legal Proceedings.” We cannot assure you that we or key members of our management team will not be subject to lawsuits or allegations of a similar nature in the future. Where we can make a reasonable estimate of the liability relating to pending litigation and determine that an adverse liability resulting from such litigation is probable, we record a related contingent liability. As additional information becomes available, we assess the potential liability and revise estimates as appropriate. In 2009, 2010 and 2011, we did not record any contingent liabilities relating to pending litigation. However, when we record or revise our estimates of contingent liabilities in the future, the amount of our estimates may be inaccurate due to the inherent uncertainties relating to litigation. In addition, the outcomes of actions we institute against our competitors may not be successful or favorable to us. These litigations and allegations may also generate negative publicity that significantly harms our reputation, which may materially and adversely affect our user base and the number of our paying customers. In addition to the related cost, managing and defending litigation and related indemnity obligations can significantly divert management’s and the board of directors’ attention from operating our business. We may also need to pay damages or settle the litigation with a substantial amount of cash. All of these could have a material adverse impact on our business, results of operation and cash flows, as well as the trading price of our ADSs.

 

Our dependence on a limited number of customers for a substantial portion of our online advertising revenues may cause significant fluctuations or declines in our revenues.

 

We depend on a limited number of customers for a substantial portion of our online advertising revenues.  Revenues from our top five online advertising customers comprised 27.8%, 35.1% and 27.9% of our total revenues in 2009, 2010 and 2011, respectively. We enter into non-exclusive, short-term agreements with our online advertising customers which are typically renewed on a quarterly or annual basis.  We anticipate that our dependence on a limited number of customers will continue for the foreseeable future. Consequently, any of the following events may cause material fluctuations or declines in our revenues:

 

·                  reduced, delayed or cancelled services required by our online advertising customers;

 

·                  our online advertising customers’ failure to pay for our services; or

 

·                  loss of one or more of our significant online advertising customers and any failure to identify and acquire additional or replacement customers.

 

If we lose the business of one or more of our top online advertising customers, our business, results of operations and growth prospects may be materially and adversely affected.

 

We face significant competition and may suffer from a loss of users and customers as a result.

 

We face significant competition from Internet security product and service providers and PRC-based Internet companies. The competitive standing of an Internet security market player in China largely depends on the technological reputation of its brand, the size of its user base, its technological expertise, the effectiveness of its security software as well as its business model. We compete in the Internet security market with established anti-virus companies such as Beijing Kingsoft Security Software Co., Ltd., and Beijing Rising Information Technology Co., Ltd. We also compete with PRC-based Internet companies that, like us, build Internet platforms to offer value-added services and online advertising services. Our primary competitor in this market is Tencent Holdings Limited, the largest Internet company in China in terms of revenue. In December 2011, Tencent’s QQ instant message software, had an active user penetration rate in China of 91.5%, while our security products had an active user penetration rate in China of 92.1%, according to iResearch. See “Item 4. Information on the Company — B. Business Overview — Competition” for description of our principal competitors in each of our product and services categories. Some of our competitors have

 

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significantly greater financial resources than we do. They also have longer operating histories and more experience in attracting and retaining users and managing customers than we do. They may use their experience and resources to compete with us in a variety of ways, including by competing more intensely for users and customers, investing more heavily in research and development and making strategic acquisitions. If any of our competitors provides better Internet security products and services than we do, our user base and user traffic could decline significantly. Any such decline could weaken our brand, result in losing users and customers and have a material adverse effect on our results of operations.

 

Furthermore, in an increasingly competitive environment, our competitors may adopt business practices or take other actions that could be harmful to us, and we may have difficulties in obtaining remedies against such actions. Any increase in competition could erode our market share, reduce our user base and customer base, and increase our marketing and product development expenditures, which could adversely materially affect our business, financial condition and operating results.

 

Our competitors may cause their products to be incompatible with ours, which may reduce our market share.

 

As two of the largest providers of user-end software in China, we and Tencent may from time to time compete for users. On November 3, 2010, Tencent issued a letter to users of Tencent QQ, Tencent’s popular instant message software, announcing its decision to disable the widely used Tencent QQ on computers that had installed our security products, effectively requiring users to either stop using Tencent QQ or uninstall our Internet security products. As a result, a significant number of users stopped using Tencent QQ, or our Internet security products, or both. Due to the large number of Internet users that were affected, this incident was extensively reported in the media and attracted government scrutiny. On November 21, 2010, the Ministry of Industry and Information Technology, or the MIIT, ordered that Tencent and we end the dispute, apologize to affected users and ensure the compatibility of products concerned. We lost some users in the first several days of this dispute before our user base quickly returned to its prior level. Since then, the MIIT has increased its regulation of competition in the Internet industry, including “Certain Provisions on the Regulation of Internet Information Service,” effective March 2012, which prevents software companies that cause product incompatibility from competing in market.  However, our competitors may continue to make their products incompatible with ours, which may reduce our market share, negatively affect our brand and reputation and materially and adversely affect our business, results of operations or financial condition.

 

If our expansion into new Internet businesses and overseas markets is not successful, our future results of operations and growth prospects may be materially and adversely affected.

 

As part of our growth strategy, we enter into new Internet businesses from time to time by leveraging our expansive user base to generate additional revenue streams. We may also expand into overseas markets through investment or strategic alliances with local market participants. Expansion into new businesses and new markets may present operating and marketing challenges that are different from those that we currently encounter. For each new business or markets we enter into, we face competition from existing leading providers in that business or market. If we cannot successfully address the new challenges and compete effectively against the existing leading players in the new businesses or markets, we may not be able to develop a sufficiently large customer and user base, recover costs incurred for marketing new businesses or developing new markets, or make a profit from these businesses or markets, and our future results of operations and growth prospects may be materially and adversely affected.

 

Our business depends on a strong brand and reputation, and if we are not able to maintain and enhance our brand or reputation or if there is negative publicity against us, our business and operating results may be harmed.

 

We believe that our “360” brand and our reputation have contributed significantly to the success of our business. We also believe that maintaining and enhancing the “360” brand and our reputation are critical to increasing our number of users and customers. As our market becomes increasingly competitive, our success in maintaining and enhancing our brand and reputation will depend largely on our ability to remain as a leading provider of Internet and mobile security products and services in China, which may become more expensive and challenging.

 

Historically, we have developed our user base primarily by word-of-mouth and incurred limited brand promotion expenses. We began enhancing marketing and brand promotion efforts in early 2010. However, we cannot assure you that our marketing and brand promotion activities in the future will achieve the expected

 

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brand promotion effect. If we fail to maintain and further promote the “360” brand or our reputation, or if we incur excessive expenses in this effort, our business and results of operations may be materially and adversely affected. In addition, historically there has been negative publicity about our company, our products and services and certain key members of our management team. Since 2011, Citron Research and certain other short-selling organizations and individuals have issued a series of reports which portrayed our business and financial position in a negative light.  Although we have vigorously rebutted the key points of these reports, they still generated significant negative publicity for our company. We cannot assure you that there will not be additional negative publicity of the similar nature in the future. Any such negative publicity, regardless of its veracity, could harm our brand image and reputation and in turn adversely affect our business, operating results and the trading price of our ADSs.

 

The success of our Internet value-added services depends on our ability to accommodate user demand and source suitable third-party products and services.

 

We have derived, and expect to continue to derive, a substantial portion of our revenues from our Internet value-added services, such as offering web games developed by third parties. The success of our Internet value-added services depends on our ability to respond adequately and timely to accommodate our users’ demand for such value-added services and source suitable third-party products and services on reasonable terms. If we are unable to continue to offer a variety of suitable value-added services that attract users and generate revenue, our financial condition and operating results may be materially adversely affected.

 

If our Internet security products and services fail to detect malware or malicious websites or otherwise do not work properly, we may experience negative publicity, damage to our reputation, legal liability, declined revenues and increased expenses.

 

Our users rely on our Internet security products and services for safe access to the Internet. New malware and malicious websites are continuously being created and modified, and the detection technologies underlying our products and services may not detect all forms of malware or malicious websites that our users are exposed to. Additionally, our users may experience errors, failures, or bugs in our products that are undetected by our pre-launch testing, especially when our products and services are first introduced or when new updates are first released. Failure to detect malware or malicious websites or defects in our products may result in security breaches, disruption or damage to our users’ computers or networks and theft of confidential information or other negative consequences. Any such event may damage our brand reputation, decrease our user and customer base, require large research and development and marketing expenditures to remedy and may otherwise significantly affect our business and results of operations.

 

Furthermore, our Internet security products and services may falsely identify programs or websites as malicious or otherwise undesirable. Parties whose programs are incorrectly blocked by our products or services, or whose websites are incorrectly identified as unsafe or malicious, may seek redress against us for labeling them as malicious and interfering with their businesses. In addition, falsely identifying programs or websites as malicious may adversely affect our users’ confidence and trust in our products and decrease our user base.

 

We may not be able to manage our expanding operations effectively.

 

We have significantly expanded our operations in recent years. Since our inception in 2005, we have expanded our product offering into a comprehensive suite of Internet and mobile security products and services and have rapidly established a leading position in the Chinese Internet and mobile security service market. We expect this expansion to continue as we grow our user and customer base and explore new opportunities. To manage the further expansion of our business and growth of our operations and personnel, we need to continuously improve our operational and financial systems, procedures and controls, and expand, train, manage and maintain good relations with our growing employee base. In addition, we must maintain and expand our relationships with other websites, Internet companies and other third parties. Our current and future personnel, systems, procedures and controls may not be adequate to support our expanding operations. If we fail to manage our expansion effectively, our business, results of operations and prospects may be materially and adversely affected.

 

Our limited operating history makes it difficult to evaluate our future prospects and results of operations.

 

We have a limited operating history under our current business model upon which you can evaluate the viability and sustainability of our business. Accordingly, you should consider our future prospects in light of the

 

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risks and uncertainties experienced by early stage companies in evolving industries such as the Internet security industry in China. Some of these risks and uncertainties relate to our ability to:

 

·                  maintain our leading position in the Internet security market in China;

 

·                  continue to offer new and innovative products and services to attract and retain a larger user base;

 

·                  attract additional customers and increase spending per customer;

 

·                  increase awareness of our brand and continue to enhance user and customer loyalty;

 

·                  respond to competitive market conditions;

 

·                  respond to changes in our regulatory environment;

 

·                  manage risks associated with intellectual property rights;

 

·                  maintain effective control of our costs and expenses;

 

·                  raise sufficient capital to sustain and expand our business;

 

·                  attract, retain and motivate qualified personnel; and

 

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

 

If we are unsuccessful in addressing any of these risks and uncertainties, our business may be materially and adversely affected.

 

Interruption or failure of our own information technology and communications systems or those of third-party service providers we rely upon could impair our ability to effectively provide our products and services and protect the privacy of our users, which could damage our reputation and harm our operating results.

 

Our ability to provide our products and services depends on the continuing operation of our information technology and communications systems. Any damage to or failure of our systems could affect the performance and reliability of our Internet security products and services and directly impact our users. Service interruptions may damage our brand and reduce our user base if our products and services are perceived to be unreliable. Our systems are vulnerable to damage or interruption as a result of terrorist attacks, wars, earthquakes, floods, fires, power loss, telecommunications failures, undetected errors or “bugs” in our software, computer viruses, interruptions in access to our websites and servers through the use of “denial of service” or similar attacks, hacking or other attempts to harm our systems and similar events. Our servers, which are hosted at third-party Internet data centers, are vulnerable to break-ins, sabotage and vandalism. Additionally, the occurrence of a closure of an Internet data center by any of our third-party providers without adequate notice could result in lengthy service interruptions. The steps we take to improve the reliability of our systems will increase our cost and reduce our operating margin and may not be successful in reducing the frequency or duration of service interruptions. Furthermore, our systems may not function properly as a result of third-party action, employee error, malfeasance or otherwise, resulting in unauthorized access to our users’ data and information.  If we experience frequent or persistent system failures affecting our products and services or are unable to prevent unauthorized access to our users’ data, our reputation and brand could be severely harmed.

 

Our strategy of acquiring and investing in complementary businesses, assets and technologies may fail.

 

As part of our business strategy, we have acquired, and intend to continue to selectively acquire and invest in, businesses, assets and technologies that complement our existing business. Acquisitions and investments involve uncertainties and risks, including:

 

·                  potential ongoing financial obligations and unforeseen or hidden liabilities;

 

·                  failure to achieve the intended objectives, benefits or revenue-enhancing opportunities;

 

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

 

·                  costs and difficulties of integrating acquired technologies into our existing products and services; and

 

·                  diversion of resources and management attention.

 

Our failure to address these risks successfully may have a material adverse effect on our financial condition and results of operations. Any such acquisition or investment may require a significant amount of capital investment, which would decrease the amount of cash available for working capital or capital expenditures. In addition, if we use our equity securities to pay for acquisitions, we may dilute the value of our ADSs and the underlying Class A ordinary shares. If we borrow funds to finance acquisitions, such debt instruments may contain restrictive covenants that could, among other things, restrict us from distributing dividends. Such acquisitions may also generate significant amortization expenses related to intangible assets.

 

Our success depends on the continuing and collaborative efforts of our management team and other key personnel, and our business may be harmed if we lose their services.

 

Our future success depends heavily upon the continuing services of our management team, in particular Mr. Hongyi Zhou, our chairman and chief executive officer, and Mr. Xiangdong Qi, our director and president. If one or more of our executives or other key personnel are unable or unwilling to continue in their present positions, we may not be able to replace them easily or at all, and our business may be disrupted and our financial condition and results of operations may be materially and adversely affected. Competition for management and key personnel is intense, the pool of qualified candidates is limited, and we may not be able to retain the services of our executives or key personnel, or attract and retain experienced executives or key personnel in the future.

 

If any of our executives or other key personnel joins a competitor or forms a competing company, we may lose customers, distributors, know-how and key personnel. Each of our executive officers and key employees has entered into an employment agreement with us that contains confidentiality provisions. If any disputes arise between any of our executives or key personnel and us, we cannot assure you the extent to which any of these agreements may be enforced.

 

We rely on highly skilled personnel. If we are unable to retain or motivate them or hire additional qualified personnel, we may not be able to grow effectively.

 

Our performance and future success depend on the talents and efforts of highly skilled individuals. We will need to continue to identify, hire, develop, motivate and retain highly skilled personnel for all areas of our organization. Competition in the Internet industry for qualified employees is intense. Our continued ability to compete effectively depends on our ability to attract new employees and to retain and motivate our existing employees.

 

As competition in the Internet industry intensifies, it may be more difficult for us to hire, motivate and retain highly skilled personnel. If we do not succeed in attracting additional highly skilled personnel or retaining or motivating our existing personnel, we may be unable to grow effectively.

 

We may not be able to prevent others from unauthorized use of our intellectual property or brands, which could harm our business and competitive position.

 

We rely on a combination of copyright, trademark and trade secret laws, as well as nondisclosure agreements and other methods to protect our intellectual property rights and brands. We have registered our “Qihoo” brand and our “360” logo with relevant government authorities. The protection of intellectual property rights and brands in China may not be as effective as those in the United States or other countries. The steps we have taken may be inadequate to prevent the misappropriation of our technology or unauthorized use of our brands. Reverse engineering, unauthorized copying or other misappropriation of our technologies could enable third parties to benefit from our technologies without compensating us. Moreover, unauthorized use of our technology could enable our competitors to offer products and services that are comparable to or better than ours, which could harm our business and competitive position. From time to time, we may have to enforce our intellectual property rights and brands through litigation. Such litigation may result in substantial costs and diversion of resources and management attention.

 

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Third parties may claim that we infringe their proprietary rights, which could cause us to incur significant legal expenses and prevent us from promoting our products and services.

 

From time to time, we may receive claims that we have infringed the intellectual property rights of others. Such claims may be based on our use of trademarks, logos, technologies or other intellectual properties. Any such claim, with or without merit, could result in costly litigation and distract our management from day-to-day operations. If we fail to successfully defend such claims, we could be required to make unavailable or redesign our products and services, pay monetary amounts as damages, enter into royalty or licensing arrangements, or satisfy indemnification obligations that we have with some of our users. Any royalty or licensing arrangements that we may seek in such circumstances may not be available to us on commercially reasonable terms or at all. Also, if we acquire technology to include in our products from third parties, our exposure to infringement actions may increase because we must rely upon these third parties to verify the origin and ownership of such technology.

 

Further, we license and use technologies from third parties in our products and services. These third-party technology licenses may not continue to be available to us on acceptable terms or at all, and may expose us to additional liability. This liability, or our inability to use any of this third-party software, could result in disruptions in our business that could materially and adversely affect our operating results.

 

The successful operation of our business depends upon the performance and reliability of the Internet infrastructure in China and the safety of our network and infrastructure.

 

Our business depends on the performance and reliability of the Internet infrastructure in China. Almost all access to the Internet is maintained through state-owned telecommunication operators under the administrative control and regulatory supervision of the MIIT. A more sophisticated Internet infrastructure may not be developed in China. We may not have access to alternative networks in the event of disruptions, failures or other problems with China’s Internet infrastructure. In addition, the Internet infrastructure in China may not support the demands associated with continued growth in Internet usage.

 

Although we believe we have sufficient controls in place to prevent intentional disruptions, we expect our network and infrastructure to be targets of attacks specifically designed to impede the performance of our products and services, misappropriate proprietary information or harm our reputation. Because the techniques used by hackers to access or sabotage networks change frequently and may not be recognized until launched against a target, we may be unable to anticipate these techniques. The theft, unauthorized use or publication of our trade secrets and other confidential business information as a result of such an event could adversely affect our competitive position, brand reputation and user base, and our users and customers may assert claims against us related to resulting losses arising from security breaches. Our business could be subject to significant disruption and our results of operations may be affected.

 

If we fail to establish an effective system of internal control, we may be unable to accurately and timely report our financial results or prevent fraud, and investor confidence and the market price of our ADSs may be adversely impacted.

 

We are subject to reporting obligations under U.S. securities laws. Section 404 of the Sarbanes-Oxley Act of 2002 and related rules require a public company to include a management report on the company’s internal control over financial reporting in its annual report, which contains management’s assessment of the effectiveness of the company’s internal control over financial reporting. In addition, an independent registered public accounting firm must audit and report on the effectiveness of a public company’s internal control over financial reporting. These requirements will first apply to our annual report on Form 20-F for the fiscal year ending on December 31, 2012.

 

Prior to our initial public offering in April 2011, we have been a private company and have had limited accounting personnel and other resources with which to address our internal control over financial reporting. We and our independent registered public accounting firm, in connection with the preparation and audit of our consolidated financial statements as of and for the fiscal year ended December 31, 2011, identified one material weakness and several control deficiencies in our internal control over financial reporting. The material weakness and control deficiencies identified were identical to those identified during the audit of our consolidated financial statements as of and for the fiscal year ended December 31, 2010. A “material weakness” is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.

 

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The material weakness identified primarily related to lack of sufficient accounting personnel with appropriate knowledge of U.S. GAAP. Neither we nor our independent registered public accounting firm are required to undertake a comprehensive assessment of our internal control for purposes of identifying and reporting material weaknesses and other control deficiencies in our internal control over financial reporting for the year ended December 31, 2011. In light of the material weakness and other control deficiencies that were identified as a result of the limited procedures performed, we believe it is possible that, had we performed a formal assessment of our internal control over financial reporting or had our independent registered public accounting firm performed an audit of our internal control over financial reporting, additional control deficiencies may have been identified.

 

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

 

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

 

Our independent registered public accounting firm that issues the audit reports included in our annual reports, as auditors of companies that are traded publicly in the United States and a firm registered with the US Public Company Accounting Oversight Board (United States), or the (PCAOB), is required by the laws of the United States to undergo regular inspections by the PCAOB to assess its compliance with the laws of the United States and professional standards.  Because our auditors are located in China, a jurisdiction where the PCAOB is currently unable to conduct inspections without the approval of the Chinese authorities, our auditors are not currently inspected by the PCAOB.

 

Inspections of other firms that the PCAOB has conducted outside of China have identified deficiencies in those firms’ audit procedures and quality control procedures, which may be addressed as part of the inspection process to improve future audit quality.  This lack of PCAOB inspections in China prevents the PCAOB from regularly evaluating our auditor’s audits and its quality control procedures.  As a result, investors may be deprived of the benefits of PCAOB inspections.

 

The inability of the PCAOB to conduct inspections of auditors in China makes it more difficult to evaluate the effectiveness of our auditor’s audit procedures or quality control procedures as compared to auditors outside of China that are subject to PCAOB inspections. Investors may lose confidence in our reported financial information and procedures and the quality of our financial statements.

 

We have incurred increased costs as a result of being a public company, and we cannot predict or estimate the amount of additional future costs we may incur or the timing of such costs.

 

As a public company, we have incurred significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act and rules subsequently implemented by the SEC and the New York Stock Exchange require significantly heightened corporate governance practices for public companies.  These rules and regulations have increased our legal, accounting and financial compliance costs and made some of our corporate activities more time-consuming and costly. Also, we have incurred additional costs associated with satisfying our public company reporting requirements. We are evaluating and monitoring developments with respect to these rules and regulations, and we cannot predict or estimate the amount of additional future costs we may incur or the timing of such costs.

 

We may need additional capital, and we may be unable to obtain such capital in a timely manner or on acceptable terms, or at all. Furthermore, our future capital needs may require us to sell additional equity or debt securities that may dilute our shareholders or introduce covenants that may restrict our operations or our ability to pay dividends.

 

To grow our business and remain competitive, we may require additional capital. Our ability to obtain

 

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additional capital is subject to a variety of uncertainties, including:

 

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

 

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

 

·                  economic, political and other conditions in China and internationally.

 

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

 

Our business, financial condition and results of operations may be adversely affected by the downturn in the global or Chinese economy.

 

The global financial markets have experienced significant disruptions since 2008 and 2009. A variety of factors, including the current European sovereign debt crisis and concerns about the viability of the European Union and the Euro, could cause further disruptions to the global economy. To the extent that there have been improvements in some areas, it is uncertain whether such recovery is sustainable. China’s economy has also faced challenges. Since we derive substantially all of our revenues from China, our business and prospects may be affected by economic conditions in China.

 

Moreover, a slowdown in the global or Chinese economy or the recurrence of any financial disruptions may have a material and adverse impact on financings available to us. The weakness in the economy could erode investors’ confidence, which constitutes the basis of the equity markets. The recent financial turmoil affecting the financial markets and banking system may significantly restrict our ability to obtain financing in the capital markets or from financial institutions on commercially reasonable terms, or at all. We are uncertain about the extent to which the recent global financial and economic crisis, the European debt crisis and slowdown of the Chinese economy may impact our business in the long term. There is a risk that our business, results of operations and prospects would be materially and adversely affected by the global economic downturn and the slowdown of the Chinese economy.

 

Risks Related to Our Corporate Structure

 

In order to comply with PRC laws and regulations limiting foreign ownership of Internet businesses, we conduct our Internet businesses through our consolidated affiliated entities in China by means of contractual arrangements. If the PRC government determines that these contractual arrangements do not comply with applicable regulations, our business could be materially and adversely affected.

 

The PRC government restricts foreign investment in Internet businesses. See “Item 4. Information on the Company — B. Business Overview — Regulation — Regulations Related to Our Business —Telecommunications Regulations.” Accordingly, we conduct our business activities primarily through two of our consolidated variable interest entities, or VIEs, namely Beijing Qihu Technology Company Limited, or Beijing Qihu, and Shanghai Qitai Network Technology Company Limited, or Shanghai Qitai. See “Item 4. Information on the Company ¾ C. Organizational Structure.” We bear the economic risks and derive the economic benefits of Beijing Qihu and Shanghai Qitai as their primary beneficiary through contractual arrangements with them and their respective registered shareholders. We also entered into similar contractual arrangements with eight other VIEs that do not have significant business operations as of the date of this annual report. For a description of these contractual arrangements, see “Item 7. Major Shareholders and Related Party Transactions ¾ B. Related Party Transactions ¾Contractual Arrangements among Qizhi Software, the VIEs and the Respective Shareholders of the VIEs.”

 

Although we believe we comply with current PRC regulations, the PRC government may not agree that these operating arrangements comply with PRC licensing, registration or other regulatory requirements, with existing policies or with requirements or policies that may be adopted in the future. If the PRC government

 

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determines that our ownership structure, our contractual arrangements with our consolidated affiliated entities and their shareholders or our businesses are in violation of any existing or future PRC laws or regulations, it may revoke our business and operating licenses, require us to discontinue or restrict our operations, restrict our right to collect revenues, block our websites, require us to restructure our operations, impose additional conditions or requirements with which we may not be able to comply, impose restrictions on our business operations or on our customers or take other regulatory or enforcement actions against us that could be harmful to our business.

 

Our contractual arrangements with our VIEs and their respective shareholders may not be as effective in providing control over the entity as direct ownership.

 

We rely on contractual arrangements with our VIEs and their shareholders for the operation of our Internet business in China. These contractual arrangements may not be as effective in providing us with control over our VIEs as direct ownership in these entities. If our VIEs or their respective shareholders fail to perform their respective obligations under these contractual arrangements, we may incur substantial costs and resources to enforce these arrangements, and rely on legal remedies available under applicable PRC laws, including seeking specific performance or injunctive relief and claiming damages. In particular, if shareholders of a VIE refuse to transfer their equity interests in such VIEs to us or our designated persons when we exercise the purchase option pursuant to these contractual arrangements, we may need to initiate legal actions to compel them to fulfill their contractual obligations.

 

If the applicable PRC authorities invalidate our contractual arrangements for violation of PRC laws, rules and regulations, or any of our VIEs or their shareholders terminate the contractual arrangements or fail to perform their obligations under these contractual arrangements, our Internet and online advertising businesses in China would be materially disrupted, and the value of our ordinary shares would decrease substantially. Furthermore, if we fail to renew these contractual arrangements upon their expiration and the relevant foreign investment restrictions remain effective, we would not be able to continue our Internet business.

 

In addition, if any of our VIEs or all or part of its assets become subject to court injunctions or asset freezes or liens or rights of third-party creditors, we may be unable to continue some or all of our businesses, which could materially and adversely affect our business, financial condition and results of operations. If any of our VIEs undergoes a voluntary or involuntary liquidation proceeding, its shareholders or unrelated third-party creditors may claim rights to some or all of its assets. The occurrence of any of these events may hinder our ability to operate our Internet business, which could in turn materially harm our business and our ability to generate revenues and cause the market price of our ordinary shares to decline significantly.

 

Perfection of the pledges in our equity pledge agreements with our VIEs and their registered shareholders may be adversely affected due to failure to register these equity pledge agreements.

 

Under our equity pledge agreements with our VIEs and their registered shareholders, these registered shareholders have pledged all of their respective equity interests in the VIEs to us. The pledges under the equity pledge agreements were duly created by recording the pledges on the VIEs’ registers of shareholders in accordance with the then effective PRC Security Law and the Contract Law. The purpose of such pledges is to secure the performance of the VIEs’ obligations under the various VIE agreements, including the business operation agreements and technology development agreements. Under the then effective PRC laws and regulations, the pledge of equity in a limited liability company became effective upon recording of the pledge on the company’s register of members. However, according to the PRC Property Rights Law, which became effective on October 1, 2007, a pledge is not deemed to be validly created without registration with the relevant local administration for industry and commerce. Six of our VIEs have completed the pledge registration. We are applying to register and update the equity pledges by the shareholders of our four other VIEs with the relevant offices of the administration for industry and commerce. Although under PRC laws and regulations, the administration for industry and commerce should register a pledge immediately upon receiving a complete application, the registration process could take longer in practice. If the equity pledges are not successfully registered, they would not be deemed as validly created security interests under the PRC Property Rights Law. If our VIEs breached their obligations under the agreements with us, there is a risk that we may not be able to successfully enforce the pledges if the equity pledge agreements have not been registered with the relevant administration for industry and commerce.

 

The shareholders of our VIEs may have potential conflicts of interest with us, which may adversely affect our business.

 

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The registered shareholders of our VIEs are our directors, officers or employees. Conflicts of interest may arise between these shareholders’ duties to us and our VIEs. If such conflicts arise, these shareholders may not act in our best interests and such conflicts of interest may not be resolved in our favor. In addition, these shareholders may breach or cause our VIEs to breach or refuse to renew their existing contractual arrangements that allow us to exercise effective control over them and to receive economic benefits from them. The laws of the Cayman Islands provide that directors of a company owe a fiduciary duty to the company, which requires them to act in good faith and in the best interests of the company and not to use their positions for personal gain. If certain shareholders of our VIEs do not comply with their fiduciary duties to us as our designated directors, or if we cannot resolve any conflicts of interest or disputes between us and such shareholders or any future beneficial owners of our VIEs, we would have to rely on legal proceedings to remedy the situation, which could result in disruption of our business and substantial uncertainty as to the outcome of any such legal proceedings.

 

Our contractual arrangements with our VIEs and their respective shareholders may be subject to scrutiny by the PRC tax authorities and we could be required to pay additional taxes, which could substantially reduce our consolidated net income and the value of your investment.

 

Arrangements and transactions among related parties may be subject to audits or challenges by the PRC tax authorities. We could face material and adverse tax consequences if the PRC tax authorities determine that our contractual arrangements with VIEs are not arm’s length transactions. If this were to occur, the tax authorities could adjust our VIEs’ income in the form of a transfer pricing adjustment. A transfer pricing adjustment could, among other things, result in a reduction, for PRC tax purposes, of expense deductions recorded by our VIEs, which could in turn increase their tax liabilities. The PRC tax authorities could also impose late payment fees and other penalties on our VIEs for under-paid taxes. In addition, any challenge by the PRC tax authorities may limit the ability of our VIEs to receive any preferential tax treatments and other financial incentives. Our consolidated net income may be materially and adversely affected if our VIEs’ tax liabilities increase or if our VIEs are found to be subject to late payment fees or other penalties.

 

Risks Related to Regulation of Our Services and Products

 

We may be adversely affected by complexity, uncertainties and changes in regulation of Internet and value-added telecommunications service companies.

 

The PRC government extensively regulates the Internet industry, including foreign ownership of, and the licensing and permit requirements pertaining to, companies in the Internet industry. These Internet-related laws and regulations are relatively new and still evolving, and their interpretation and enforcement involve significant uncertainty. As a result, it may be difficult in certain circumstances to determine what actions or omissions may be deemed to be violations of applicable laws and regulations. The following illustrates some of the risks and uncertainties relating to PRC government regulation of the Internet industry:

 

·                  We only have contractual control over our websites. We do not own the websites due to the restriction of foreign investment in businesses providing value-added telecommunication services in China, including online information services.

 

·                  There are uncertainties relating to the regulation of the Internet business in China, including licensing practices that continue to evolve. This means that permits, licenses or operations at some of our companies may be subject to challenge, or we may not be able to obtain or renew certain permits or licenses. This may significantly disrupt our business, require us to compromise enforceability of related contractual arrangements, or subject us to sanctions, requirements to increase capital or other conditions or enforcement.

 

·                  New laws and regulations may be promulgated that will regulate Internet activities, including online advertising and online payment. Other aspects of our online operations may be regulated in the future. If these new laws and regulations are promulgated, additional licenses may be required for our online operations. If our operations do not comply with these new regulations at the time they become effective, or if we fail to obtain any licenses required under these new laws and regulations, we could be subject to penalties.

 

As a result of the complexity, uncertainties and constant changes in regulation in the Internet and value-added telecommunications companies, our business activities and growth may be adversely affected if we do not respond to the changes in a timely manner or are found to be in violation of the applicable laws,

 

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regulations and policies as a result of a different position from ours taken by the competent authority in the interpretation of such applicable laws, regulations and policies.

 

If we fail to obtain or maintain all required licenses, permits and approvals or if we are required to take actions that are time-consuming or costly, our business operations may be materially and adversely affected.

 

We are required to obtain applicable licenses, permits and approvals from different regulatory authorities in order to conduct our business. Over the last several years, various governmental authorities in the PRC have issued regulations regulating specific aspects of Internet content and services. Some of this legislation requires operators to obtain licenses, permits or approvals that were previously not required. The government authorities may continue to pass new rules regulating the Internet sector. They may require us to obtain additional licenses, permits or approvals so that we can continue to operate our existing businesses or otherwise prohibit our operation of the types of businesses to which the new requirements apply. In addition, new regulations or new interpretations of existing regulations may increase our costs of doing business and prevent us from efficiently delivering services and products over the Internet and through mobile operators and expose us to potential penalties and fines. These regulations may also restrict our ability to expand our customer and user base or to provide services in additional geographic areas.

 

Our security software must be examined and approved by the PRC Ministry of Public Security, or the MPS, before it may be made available to users. We believe that we have obtained the applicable permits for offering 360 Safe Guard and 360 Anti-Virus for download. However, as the upgrades of our software become more frequent and such examination and approval by the MPS may be time consuming, we may not be able to obtain such permits for all upgrades in a timely manner, which may subject us to various penalties and adversely affect our business and results of operations.

 

In addition, we have an online lottery business and also provide promotion services for a third party’s online lottery business on our platform. Under the Tentative Administrative Measures on Internet Lottery Sale promulgated by the PRC Ministry of Finance on September 26, 2010, a license is required for conducting online lottery business. Moreover, on January 18, 2012, the Implementation Rules of the Lottery Administration Regulations, or the Lottery Implementation Rules, were jointly issued by the PRC Ministry of Finance, the Civil Affairs Bureau and the State General Administration of Sport, became effective as of March 1, 2012 and explicitly stipulate that the welfare lotteries and sports lotteries sold without the Ministry of Finance’s approval and the Lottery Issuing Authority’s and Lottery Sales Office’s commission may be categorized as illegal lotteries. Therefore, in addition to Ministry of Finance’s approval, the Lottery Implementation Rules further request the lottery sales agency to obtain proper authorization from the Lottery Issuing Authority and the Lottery Sales Office to conduct lottery business. As these measures and rules are newly released, our online lottery business partner currently does not hold such license. Without such a license, an online lottery business operated by such third party may be suspended by relevant governmental authorities. We have requested our online lottery business partner to apply for such license as soon as the application procedures are available. We also plan to apply for such license for ourselves as a provider of platform for such lottery business if required under newly issued rules or regulations or by relevant government authorities. If our online lottery business partner or we are subject to regulatory penalties for lack of such license, our reputation may be harmed and our business may be adversely affected.

 

If any of our web games business activities is deemed to be in violation of law, we may have to cease or modify our web game operations, which could have a material and adverse effect on our business and results of operations.

 

All web games currently offered by our platform are licensed by, and operated with, third-party game developers. Although we have obtained licenses which we believe are sufficient for our web game offerings, the MIIT or other competent government authorities may interpret existing or promulgate and implement new laws, regulations or policies that may require us to cease or modify our web games business in order to avoid violation of any PRC laws or regulations. Any such modification to our web games business may result in disruption of our business, diversion of management attention and the incurrence of substantial costs. See also “Item 4. Information on the Company—B. Business Overview—Regulation—Regulations Relating to Our Business—Web Games and Virtual Currency.” In addition, we have requested our web game business partners to obtain and maintain all necessary licenses. However, we cannot assure you that all of our business partners have obtained or updated all necessary licenses, permits or registrations with relevant governmental authorities. If any of such business partners fails to do so, we may not continue to operate the affected web games, which may adversely affect our business and results of operations.

 

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Regulation and censorship of information disseminated over the Internet in China may adversely affect our business and subject us to liability for information displayed on or linked to our websites.

 

The MIIT has published regulations that subject website operators to potential liability for content displayed on their websites and the actions of users and others using their systems, including liability for violations of PRC laws and regulations prohibiting the dissemination of content deemed to be socially destabilizing. The Ministry of Public Security has the authority to order any local Internet service provider to block any Internet website at its sole discretion. From time to time, the Ministry of Public Security has stopped the dissemination over the Internet of information which it believes to be socially destabilizing. The State Secrecy Bureau is also authorized to block any website it deems to be leaking state secrets or failing to meet the relevant regulations relating to the protection of State secrets in the dissemination of online information. Furthermore, we are required to report any suspicious content to relevant governmental authorities, and to undergo computer security inspections. If we fail to implement the relevant safeguards against security breaches, our websites may be shut down and our business and business licenses may be revoked.

 

Although we attempt to monitor the content posted on our websites or transmitted through our services, we are not able to control or restrict the content generated or linked by the users to other Internet content providers. If the PRC regulatory authorities find any content displayed on our websites objectionable, they may require us to limit or eliminate the dissemination of such information on our websites. If third-party websites linked to or accessible through our websites operate unlawful activities, PRC regulatory authorities may require us to report such unlawful activities to competent authorities and to remove the links to such websites, or they may suspend or shut down the operation of such websites. PRC regulatory authorities may also temporarily block access to certain websites for a period of time for reasons beyond our control. Any of these actions may reduce our user traffic and adversely affect our business. In addition, we may be subject to penalties for violations of those regulations arising from information displayed on or linked to our websites, including a suspension or shutdown of our online operations.

 

Risks Related to Doing Business in China

 

Adverse changes in economic and political policies of the PRC government could negatively impact China’s overall economic growth, which could materially adversely affect our business.

 

We conduct substantially all of our operations in China. Accordingly, our business, financial condition, results of operations and prospects depend significantly on economic developments in China. China’s economy differs from the economies of most other countries in many respects, including the amount of government involvement in the economy, the general level of economic development, growth rates and government control of foreign exchange and the allocation of resources. While the PRC economy has grown significantly over the past few decades, this growth has remained uneven across different periods, regions and economic sectors.

 

The PRC government also exercises significant control over China’s economic growth by allocating resources, controlling the payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies. Between late 2003 and 2008, the PRC government implemented a number of measures, such as increasing the People’s Bank of China’s statutory deposit reserve ratio and imposing commercial bank lending guidelines, which slowed the growth of credit. In 2008 and 2009, however, in response to the global financial crisis, the PRC government loosened such requirements. Any actions and policies adopted by the PRC government could negatively impact the Chinese economy, which could materially adversely affect our business.

 

We may rely on dividends and other distributions from our subsidiaries in China to fund our cash and financing requirements, and any limitation on the ability of our subsidiaries to make payments to us could materially adversely affect our ability to conduct our business.

 

As an offshore holding company, we may rely principally on dividends from our subsidiaries in China for our cash requirements, including to pay dividends or make other distributions to our shareholders or to service our debt we may incur and to pay our operating expenses. The payment of dividends by entities organized in China is subject to limitations. In particular, the PRC regulations permit our subsidiaries to pay dividends to us only out of their accumulated profits, if any, as determined in accordance with Chinese accounting standards and regulations. In addition, each of our subsidiaries in China is required to set aside a certain amount of its after-tax profits each year, if any, to fund certain statutory reserves. These reserves are not distributable as cash dividends.

 

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If our subsidiaries in China incur debt on their own behalf, the instruments governing the debt may restrict their ability to pay dividends or make other distributions to us. Any limitation on the ability of our subsidiaries to distribute dividends or other payments to us could materially adversely limit our ability to grow, make investments or acquisitions, pay dividends and otherwise fund and conduct our business.

 

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

 

Further to the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or the New M&A Rules, the Anti-monopoly Law of the PRC, the Rules of Ministry of Commerce on Implementation of Security Review System of Mergers and Acquisitions of Domestic Enterprises by Foreign Investors promulgated by MOFCOM or the MOFCOM Security Review Rules, was issued in August 2011, which established additional procedures and requirements that are expected to make merger and acquisition activities in China by foreign investors more time-consuming and complex, including requirements in some instances that MOFCOM be notified in advance of any change of control transaction in which a foreign investor takes control of a PRC enterprise, or that the approval from MOFCOM be obtained in circumstances where overseas companies established or controlled by PRC enterprises or residents acquire affiliated domestic companies. PRC laws and regulations also require certain merger and acquisition transactions to be subject to merger control review or security review.

 

The MOFCOM Security Review Rules, effective from September 1, 2011, which implement the Notice of the General Office of the State Council on Establishing the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors promulgated on February 3, 2011, further provide that, when deciding whether a specific merger or acquisition of a domestic enterprise by foreign investors is subject to the security review by MOFCOM, the principle of substance over form should be applied and foreign investors are prohibited from bypassing the security review requirement by structuring transactions through proxies, trusts, indirect investments, leases, loans, control through contractual arrangements or offshore transactions.

 

Further, if the business of any target company that we plan to acquire falls into the scope of security review, we may not be able to successfully acquire such company either by equity or asset acquisition, capital contribution or through any contractual arrangement. We may grow our business in part by acquiring other companies operating in our industry. Complying with the requirements of the relevant regulations to complete such transactions could be time consuming, and any required approval processes, including approval from MOFCOM, may delay or inhibit our ability to complete such transactions, which could affect our ability to expand our business or maintain our market share.

 

PRC regulation of loans to, and direct investments in, PRC entities by offshore holding companies may delay or prevent us from using the proceeds of our initial public offering or other financing activities to make loans or capital contributions to our PRC operating subsidiaries, which could materially adversely affect our liquidity and ability to fund and expand our business.

 

In utilizing the proceeds we received from the 2011 initial public offering we completed in April 2011 or in other future financing activities, as an offshore holding company with PRC subsidiaries, we may transfer funds to our PRC subsidiaries or finance our PRC subsidiaries by means of shareholder’s loans or capital contributions. Any loans to our PRC subsidiaries, which are foreign-invested enterprises, cannot exceed statutory limits based on the amount of our investments in such subsidiaries, and shall be registered with the State Administration of Foreign Exchange, or SAFE, or its local counterparts. Furthermore, any capital contributions we make to our PRC subsidiaries shall be approved by the Ministry of Commerce, or MOFCOM, or its local counterparts. We may not be able to obtain these government registrations or approvals on a timely basis, if at all. If we fail to receive such registrations or approvals, our ability to provide loans or capital contributions to our PRC subsidiaries may be negatively affected, which could adversely affect our liquidity and our ability to fund and expand our business.

 

In addition, SAFE promulgated the Circular on the Relevant Operating Issues concerning Administration Improvement of Payment and Settlement of Foreign Currency Capital of Foreign-invested Enterprises, or Circular 142, on August 29, 2008. Under Circular 142, registered capital of a foreign-invested company settled in RMB converted from foreign currencies may only be used within the business scope approved by the applicable governmental authority and may not be used for equity investments in the PRC. In

 

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addition, foreign-invested companies may not change how they use such capital without SAFE’s approval, and may not in any case use such capital to repay RMB loans if they have not used the proceeds of such loans. Furthermore, SAFE promulgated a circular on November 19, 2010, or Circular 59, which requires the authenticity of settlement of net proceeds from offshore offerings to be closely examined and the net proceeds to be settled in the manner described in the offering documents. Circular 142 and Circular 59 may significantly limit our ability to transfer the net proceeds from our initial public offering to our PRC subsidiaries and convert the net proceeds into RMB, which may adversely affect our liquidity and our ability to fund and expand our business in the PRC.

 

Fluctuations in the value of the RMB may materially adversely affect your investment.

 

The value of the RMB against the U.S. dollar and other currencies may fluctuate. Exchange rates are affected by, among other things, changes in political and economic conditions and the foreign exchange policy adopted by the PRC government. On July 21, 2005, the PRC government changed its policy of pegging the value of the RMB to the U.S. dollar. Under the new policy, the RMB is permitted to fluctuate within a narrow and managed band against a basket of foreign currencies. Following the removal of the U.S. dollar peg, the RMB appreciated more than 20% against the U.S. dollar over three years. From July 2008 until June 2010, however, the RMB traded stably within a narrow range against the U.S. dollar.

 

There remains significant international pressure on the PRC government to adopt a more flexible currency policy, which could result in a further and more significant appreciation of the RMB against foreign currencies. On June 20, 2010, the People’s Bank of China announced that the PRC government would reform the RMB exchange rate regime and increase the flexibility of the exchange rate. We cannot predict how this new policy will impact the RMB exchange rate.

 

Our revenues and costs are mostly denominated in the RMB, and a significant portion of our financial assets are also denominated in the RMB. Any significant fluctuations in the exchange rate between the RMB and the U.S. dollar may materially adversely affect our cash flows, revenues, earnings and financial position, and the amount of and any dividends we may pay on our ADSs in U.S. dollars. In addition, any fluctuations in the exchange rate between the RMB and the U.S. dollar could also result in foreign currency translation losses for financial reporting purposes.

 

Governmental control of currency conversion may limit our ability to utilize our revenues effectively and affect the value of your investment.

 

The PRC government imposes controls on the convertibility of the Renminbi into foreign currencies and, in certain cases, the remittance of currency out of China. We receive substantially all of our revenues in Renminbi. Under our current corporate structure, our Cayman Islands holding company primarily relies on dividend payments from our wholly-owned PRC subsidiary in China, Qizhi Software, to fund any cash and financing requirements we may have. See “ Item 7. Major Shareholders and Related Party Transactions ¾ B. Related Party Transactions.”

 

Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and trade and service-related foreign exchange transactions, can be made in foreign currencies without prior SAFE approval by complying with certain procedural requirements. Therefore, Qizhi Software may pay dividends in foreign currency to us without pre-approval from SAFE. However, approval from or registration with competent government authorities is required where the Renminbi is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment of loans denominated in foreign currencies. With the prior approval from SAFE, cash generated from the operations of our PRC subsidiary may be used to pay off debt they owe to entities outside China in a currency other than the Renminbi. The PRC government may at its discretion restrict access to foreign currencies for current account transactions in the future. If the foreign exchange control system prevents us from obtaining sufficient foreign currencies to satisfy our foreign currency demands, we may not be able to pay dividends in foreign currencies to our shareholders, including holders of our ADSs.

 

Uncertainties in the Chinese legal system could materially adversely affect our business.

 

We conduct our business primarily through our subsidiaries and affiliated entities in China. Our operations in China are governed by PRC laws and regulations. The PRC legal system is based on written statutes. Prior court decisions may be cited for reference but have limited precedential value.

 

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In 1979, the PRC government began to promulgate a comprehensive system of laws and regulations governing economic matters in general, and forms of foreign investment (including wholly foreign-owned enterprises and joint ventures) in particular. These laws, regulations and legal requirements are relatively new and amended frequently, and their interpretation and enforcement often raise uncertainties that could limit the reliability of the legal protections available to us. In addition, the PRC legal system is based in part on government policies and internal rules (some of which are not published on a timely basis or at all) that may have a retroactive effect. As a result, we may not be aware of our violations of these policies and rules until the violations have occurred. Furthermore, any litigation in China may be protracted and result in substantial costs and diversion of resources and management’s attention. We cannot predict future developments in the PRC legal system. We may be required to procure additional permits, authorizations and approvals for our operations, which we may not be able to obtain. Our inability to obtain such permits or authorizations may materially adversely affect our business, financial condition and results of operations.

 

PRC regulations relating to the establishment of offshore SPVs by PRC residents may subject our PRC resident beneficial owners or our PRC subsidiaries to liability or penalties, limit our ability to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to increase their registered capital or distribute profits to us, or may otherwise adversely affect us.

 

SAFE has promulgated several regulations, including the Notice on Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Corporate Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles, or Circular 75, effective on November 1, 2005. These regulations require PRC residents and PRC corporate entities to register with local branches of SAFE in connection with their direct or indirect offshore investment activities. These regulations apply to our shareholders who are PRC residents and may apply to any offshore acquisitions that we make in the future.

 

Under these foreign exchange regulations, PRC residents who make or have previously made prior to the implementation of these foreign exchange regulations, direct or indirect investments in special purpose vehicles, or SPVs, will be required to register those investments. In addition, any PRC resident who is a direct or indirect shareholder of an SPV is required to update the previously filed registration with the local branch of SAFE to reflect any material change. Moreover, the PRC subsidiaries of that SPV are required to urge the PRC resident shareholders to update their registration with the local branch of SAFE. If any PRC shareholder fails to make the required registration or update the previously filed registration, the PRC subsidiaries of that SPV may be prohibited from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to their SPV parent, and the SPV may also be prohibited from injecting additional capital into its PRC subsidiaries. Moreover, failure to comply with the various foreign exchange registration requirements described above could result in liabilities for such PRC subsidiaries under PRC laws for evasion of applicable foreign exchange restrictions. Furthermore, the responsible persons and other persons in such PRC subsidiaries who are held directly liable for the violations may be subject to administrative sanctions.

 

These regulations apply to our shareholders who are PRC residents and may apply to any offshore acquisitions that we make in the future. We have notified holders of ordinary shares of our company whom we know are PRC residents to register with the local SAFE branch and update their registrations as required under the SAFE regulations described above. We are aware that Mr. Hongyi Zhou, our chairman and chief executive officer and principal shareholder and Mr. Xiangdong Qi, our director, president and principal shareholder, both of whom are PRC residents, have registered with the relevant local SAFE branch. We, however, cannot provide any assurances that all of our shareholders who are PRC residents will file all applicable registrations or update previously filed registrations as required by these SAFE regulations. If SAFE determines that any of our beneficial owners who are PRC residents fails to comply with the above SAFE rules, our PRC subsidiaries could be subject to fines and legal penalties, and SAFE could restrict our cross-border investment activities and our foreign exchange activities, including restricting our PRC subsidiaries’ ability to distribute dividends to, or obtain loans denominated in foreign currencies from, our company, or prevent us from making distributions or paying dividends. As a result, our business operations and our ability to make distributions to you could be materially and adversely affected.

 

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

 

In January 2007, SAFE issued implementing rules for the Administrative Measures of Foreign Exchange Matters for Individuals, which, among other things, specified approval requirements for certain capital account transactions such as a PRC citizen’s participation in the employee stock ownership plans or stock option plans of an overseas publicly-listed company. In March 2007, SAFE promulgated the Application

 

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Procedures of Foreign Exchange Administration for Domestic Individuals Participating in Employee Stock Ownership Plan or Stock Option Plan of Overseas-Listed Company, or Circular 78, which has been replaced by a circular 7 issued by SAFE on February 15, 2012, or Circular 7.

 

Under Circular 7, PRC residents who participate in an employee stock option plan in an overseas publicly-listed company are required to register with SAFE or its local office and complete certain other procedures. A PRC agent, which could be the PRC subsidiary of such overseas publicly-listed company, is required to retain a financial institution with stock brokerage qualification at the listing place or a qualified institution relating to the exercise or sale of share options.  We and our PRC employees, directors and senior management who receive share options became subject to these regulations upon our initial public offering in the United States. Our 2006 employee share option scheme has been filed with and approved by SAFE. However, if we or our PRC optionees fail to comply with these regulations or any of our future share incentive plans are not filed with or approved by SAFE, we or our PRC optionees may be subject to fines and other legal or administrative sanctions.

 

We may be subject to PRC taxation on our worldwide income.

 

Under the PRC Enterprise Income Tax Law, or the New EIT Law, and its implementation rules, both effective from January 1, 2008, an enterprise established outside of the PRC with “de facto management bodies” within the PRC is considered a resident enterprise and is subject to a 25% enterprise income tax on its global income. The implementation rules define the term “de facto management bodies” as establishments that carry out substantial and overall management and control over the manufacturing and business operations, personnel, accounting and properties of an enterprise. The State Administration of Taxation, or the SAT, issued the Notice Regarding the Determination of Chinese-Controlled Offshore Incorporated Enterprises as PRC Tax Resident Enterprises on the Basis of De Facto Management Bodies, or Circular 82, which sets out certain specific criteria for determining whether the “de facto management body” of a Chinese-controlled offshore incorporated enterprise is located in China.

 

In addition, the SAT issued a bulletin on August 3, 2011 to provide more guidance on the implementation of the above circular with an effective date to be September 1, 2011. The bulletin clarified resident status determination, post-determination administration, as well as competent tax authorities. It also specifies that when provided with a copy of PRC tax resident determination certificate from an offshore incorporated enterprise controlled by PRC residents, the payer should not withhold 10% income tax when paying the PRC-sourced dividends, interest, royalties, etc. to the offshore incorporated enterprise controlled by PRC residents. Although both the circular and the bulletin only apply to offshore enterprises controlled by PRC enterprises and not those by PRC individuals,  the determination criteria set forth in the circular and administration clarification made in the bulletin may reflect the SAT's general position on how the “de facto management body” test should be applied in determining the tax residency status of offshore enterprises and the administration measures should be implemented, regardless of whether they are controlled by PRC enterprises or PRC individuals.

 

While we do not believe we are considered a resident enterprise or meet the criteria under Circular 82, we cannot ensure you that the SAT will not implement Circular 82 or amend the rules in the future to the effect that such rules will apply to us or our wholly-owned subsidiaries in Hong Kong. If the PRC authorities were to subsequently determine that we should be treated as a resident enterprise, a 25% enterprise income tax will be imposed on our global income, which could significantly increase our tax burden and materially adversely affect our financial condition and results of operations.

 

Dividends we receive from our PRC subsidiaries, dividends payable by us to our foreign investors and gain on the sale of our shares may become subject to PRC withholding taxes under PRC tax laws.

 

Under the New EIT Law, dividends payable by a foreign-invested enterprise in China to its shareholders that are “non-resident enterprises” are subject to a 10% withholding tax starting from January 1, 2008, unless such shareholders’ jurisdiction of incorporation has a tax treaty with China that provides for a different arrangement. As of the date of this annual report, the Cayman Islands have not entered into any such tax treaties with the PRC. If we are considered a “non-resident enterprise” under the New EIT Law, dividends paid to us by our PRC subsidiaries will be subject to this 10% withholding tax, which would reduce our net income and adversely affect our operating results.

 

Similarly, any gain realized on the transfer of ADSs or shares by shareholders that are “non-resident enterprises” is also subject to a 10% PRC withholding tax, if such gain is regarded as income derived from sources within the PRC. If we are considered to be an “offshore-registered resident enterprise,” the dividends we pay to our shareholders that are “non-resident enterprises” with respect to our ADSs or shares would be treated as income derived from sources within the PRC and be subject to a 10% withholding tax. The gain that such shareholders realize from the transfer of our ADSs or shares may also be treated as income derived from sources within the PRC and be subject to PRC income tax if such shareholders are considered as “non-resident enterprises.”

 

Pursuant to the Notice on How to Understand and Determine the Beneficial Owners in Tax Agreement, a “beneficial owner” under China’s tax treaties and tax arrangements shall engage in substantive business activities. An agent or conduit company that is set up for the purpose of avoiding or reducing taxes or transferring or accumulating profits will not be regarded as a beneficial owner and, therefore, will not qualify for treaty benefits. We cannot assure you that any dividends to be distributed by us to our non-PRC

 

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shareholders will be entitled to the benefits under the relevant withholding arrangement set out in a tax treaty between such shareholders’ jurisdiction of incorporation and China.

 

If we are required under the New EIT Law to withhold PRC income tax on our dividends payable to our non-PRC enterprise ADS holders, or if gain from disposition of our ordinary shares or ADSs will be subject to PRC taxes, your investment in our ADSs may be materially adversely affected.

 

Any change in the preferential tax treatment we currently enjoy in the PRC may materially adversely impact our net income.

 

Pursuant to the New EIT Law, enterprises that previously enjoyed preferential treatments of low tax rates will be subject to the new enterprise income tax rate of 25% after a five-year transitional period. Moreover, tax exemption or reduction with fixed terms enjoyed by enterprises including us will continue until the expiry of the prescribed period. Our operating subsidiary, Qizhi Software, our VIE, Beijing Qihu and Beijing Star World Technology Co., Ltd, or Beijing Star World, receive preferential tax treatment in the PRC as “high and new technology enterprises.” As a result, subject to satisfaction of applicable criteria as confirmed by the competent authorities, Qizhi Software was entitled to an exemption from the 15% reduced EIT tax rate in 2008 and a 50% reduction in the 15% reduced EIT tax rate in 2009 and 2010.  Qizhi Software received a renewal of its “high and new technology enterprises” status in October 2011 and was entitled to a reduced EIT rate of 15% for 2011.  Beijing Qihu was entitled to a reduced EIT rate of 15% for 2009, 2010 and 2011. Beijing Star World received its “high and new technology enterprises” status in November 2011 and was entitled to a reduced EIT rate of 15% for 2011.  On April 21, 2010, the State Administration of Taxation issued Circular 157, which seeks to provide additional guidance on the interaction of certain preferential tax rates under the transitional rules of the New EIT Law. Prior to Circular 157, we understood that if a high and new technology enterprise was in a tax holiday period, where it was entitled to a 50% reduction in the tax rate, and it was also entitled to the 15% preferential tax rate, it would be entitled to pay tax at the rate of 7.5%. Circular 157 appears on its face to have the effect that such an entity is entitled to pay taxes at either the lower of 15% or 50% of the standard PRC tax rate. Circular 157 is newly-issued and the tax authorities may differ in explaining the rules, and there might be a risk that the competent tax authority may later decide that Qizhi Software will not be eligible for a 7.5% discounted tax rate and instead a 12.5% preferential tax rate may be applicable. Moreover, the PRC government could eliminate any of these preferential tax treatments before their scheduled expiration. Expiration, reduction or elimination of such preferential tax treatments will increase our income tax expenses and in turn decrease our net income.

 

New labor laws in the PRC may adversely affect our results of operations.

 

On June 29, 2007, the PRC government promulgated the Labor Contract Law of the PRC, or the New Labor Contract Law, which became effective on January 1, 2008. The New Labor Contract Law imposes greater liabilities on employers and significantly impacts the cost of an employer’s decision to reduce its workforce. Furthermore, the New Contract Labor Law requires certain terminations to be based upon seniority and not the merits of employees. As a result, the New Labor Contract Law could increase our operating expenses and limit our ability to significantly change or decrease our workforce.

 

Risks Related to Our ADSs

 

The market price for our ADSs has fluctuated and may be volatile.

 

The market price of our ADSs has fluctuated since we first listed our ADSs. Since our ADSs became listed on the NYSE on March 30, 2011, the trading price of our ADSs have ranged from $13.71 to $36.21 per ADS, and the last reported trading price on April 13, 2012 was $21.78 per ADS.

 

The market price for our ADSs may be highly volatile and subject to wide fluctuations in response to factors including the following:

 

·                  regulatory developments in our industry;

 

·                  actual or anticipated fluctuations in our quarterly results of operations;

 

·                  changes in financial estimates by securities research analysts;

 

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·                  negative publicity, studies or reports, including those issued by short-selling organizations;

 

·                  changes in conditions of Internet and mobile security industry;

 

·                  changes in performance and valuation of our peer or comparable companies;

 

·                  announcements by us or our competitors of new services, acquisitions, strategic relationships, joint ventures or capital commitments;

 

·                  changes in our senior management;

 

·                  fluctuations in the exchange rate between the Renminbi and the U.S. dollar; and

 

·                  sales or anticipated sales of additional ordinary shares or ADSs.

 

In addition, securities markets have experienced significant price and volume fluctuations unrelated to the operating results of any particular companies. These market fluctuations may also materially adversely affect the market price of our ADSs.

 

We may be classified as a passive foreign investment company, which could result in adverse U.S. federal income tax consequences to U.S. holders of our ADSs or ordinary shares.

 

Based on the current and anticipated value of our assets, including goodwill, and composition of our income and assets, we do not believe we were a passive foreign investment company, or PFIC, for U.S. federal income tax purposes for our taxable year ended December 31, 2011. However, the application of the PFIC rules is subject to uncertainty in several respects, and we cannot assure you that we will not be a PFIC for any taxable year. A non-U.S. corporation will be a PFIC for any taxable year if either (i) at least 75% of its gross income for such year 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 such year is attributable to assets that produce passive income or are held for the production of passive income.

 

We must make a separate determination after the close of each taxable year as to whether we were a PFIC for that year. Because the value of our assets for purposes of the PFIC test will generally be determined by reference to the market price of our ADSs and ordinary shares, fluctuations in the market price of the ADSs and ordinary shares may cause us to become a PFIC. In addition, changes in the composition of our income or assets may cause us to become a PFIC. If we are a PFIC for any taxable year during which a U.S. holder holds an ADS or ordinary share, certain adverse U.S. federal income tax consequences could apply to such U.S. holder. See “ Item 10. Additional Information — E. Taxation — United States Federal Income Taxation — Passive Foreign Investment Company.”

 

We may need additional capital, and the sale of additional ADSs or other equity securities could result in additional dilution to our shareholders.

 

We believe that our current cash and cash equivalents, anticipated cash flow from operations and the proceeds from our initial public offering will be sufficient to meet our anticipated cash needs for the foreseeable future. We may, however, require additional cash resources due to changed business conditions or other future developments, including any investments or acquisitions we may decide to pursue. If these resources are 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 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. It is uncertain whether financing will be available in amounts or on terms acceptable to us, if at all.

 

Substantial future sales of our ADSs 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 Class A ordinary shares in the public market, or the perception that these sales could occur, could cause the market price of our ADSs to decline. As of December 31, 2011, we had 179,029,251 ordinary shares outstanding, including 109,392,815 Class A ordinary shares and

 

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69,636,436 Class B ordinary shares.  The majority of our ADSs are freely transferable without restriction or additional registration under the U.S. Securities Act of 1933, as amended, or the Securities Act.

 

In addition, certain holders of our ordinary shares have the right to cause us to register the sale of those shares under the Securities Act. Registration of these shares under the Securities Act would result in these shares becoming freely tradable without restriction under the Securities Act immediately upon the effectiveness of the registration. Sales of these registered shares in the public market could cause the price of our ADSs to decline.

 

Our memorandum and articles of association contain anti-takeover provisions that could materially adversely affect the rights of holders of our ordinary shares and ADSs.

 

Our memorandum and articles of association contain provisions that could limit the ability of others to acquire control of our company or cause us to engage in change-of-control transactions. These provisions could deprive our shareholders of an opportunity to sell their shares at a premium over prevailing market prices by discouraging third parties from seeking to obtain control of our company in a tender offer or similar transaction. For example, our board of directors has the authority, without further action by our shareholders, to issue preferred shares in one or more series and to fix their designations, powers, preferences, privileges and relative participating, optional or special rights and their qualifications, limitations or restrictions. These preferred shares may include dividend rights, conversion rights, voting rights, terms of redemption and liquidation preferences, any or all of which may provide rights and preferences that holders of our ordinary shares or ADSs do not have.

 

We could issue preferred shares quickly on terms that could delay or prevent a change in control of our company or make removal of management more difficult. If we issue preferred shares, the price of our ADSs may fall and the voting and other rights of the holders of our ordinary shares and ADSs may be materially adversely affected.

 

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

 

We have a dual-class voting structure such that 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 five votes per share. We issued Class A ordinary shares represented by our ADSs in our initial public offering in April 2011. As of December 31, 2011, Global Village Associates Limited, or Global Village, a holder of our ordinary shares controlled by Mr. Hongyi Zhou, our chairman and chief executive officer, held 32,228,158 Class B ordinary shares. Young Vision Company Limited, or Young Vision, a holder of our ordinary shares controlled by Mr. Xiangdong Qi, our director and president, held 17,633,344 Class B ordinary shares. Sequoia Capital China I, L.P. and its affiliates held 14,202,219 Class B ordinary shares. As of December 31, 2011, we had a total of 109,392,815 Class A ordinary shares outstanding and 69,636,436 Class B ordinary shares outstanding. Each Class B ordinary share is convertible into one Class A ordinary share at any time by the holder thereof, while Class A ordinary shares are not convertible to Class B ordinary shares under any circumstances. Upon any sale, pledge, transfer, assignment or disposition of Class B ordinary shares by a holder thereof to any person or entity which is not an affiliate of such holder, such Class B ordinary shares shall be automatically and immediately converted into the equal number of Class A ordinary shares.

 

Due to the disparate voting powers attached to these two classes of shares, as of December 31, 2011, Mr. Hongyi Zhou, Mr. Xiangdong Qi, Sequoia and certain of our executive officers collectively owned approximately 76% of the voting power of our outstanding ordinary shares and have considerable influence over matters requiring shareholder approval, including election of directors and significant corporate transactions, such as a merger or sale of our company or our assets. This concentrated control will limit your ability to influence corporate matters and could discourage others from pursuing any potential merger, takeover or other change of control transactions that holders of our Class A ordinary shares and ADSs may view as beneficial.

 

You may not have the same voting rights as the holders of our Class A ordinary shares and may not receive voting materials in time to be able to exercise your right to vote.

 

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Except as described in this annual report and in the deposit agreement for our ADSs, holders of our ADSs are not able to exercise voting rights attaching to the Class A ordinary shares represented by our ADSs on an individual basis. Holders of our ADSs may instruct the depositary how to vote the Class A ordinary shares underlying their ADSs, and the depositary will endeavor to carry out those instructions. However, you may not receive voting materials in time to instruct the depositary to vote, and you may not have the opportunity to exercise a right to vote.

 

You may not be able to participate in rights offerings and may experience dilution of your holdings as a result.

 

We may distribute rights to our shareholders, including rights to acquire our securities. Under the deposit agreement for the ADSs, the depositary will not offer those rights to ADS holders unless both the rights and the underlying securities to be distributed to ADS holders are either registered under the Securities Act or exempt from registration under the Securities Act with respect to all holders of ADSs.

 

We are not obligated to file a registration statement with respect to any such rights or underlying securities or to endeavor to cause such a registration statement to be declared effective. In addition, we may not be able to take advantage of any exemptions from registration under the Securities Act. Accordingly, holders of our ADSs may be unable to participate in our rights offerings and may experience dilution in their holdings as a result.

 

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

 

Your ADSs are transferable on the books of the depositary. However, the depositary may close its transfer books at any time or from time to time when it deems doing so expedient in connection with the performance of its duties. In addition, the depositary may refuse to deliver, transfer or register transfers of ADSs when our books or the books of the depositary are closed, when we or the depositary deem it advisable to do so because of any requirement of law or of any government or governmental body, under any provision of the deposit agreement or for any other reason.

 

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

 

Our corporate affairs are governed by our memorandum and articles of association, the Cayman Islands Companies Law and the common law of the Cayman Islands. The rights of shareholders to take action against the directors, the rights of minority shareholders to institute actions and the fiduciary responsibilities of our directors to us 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, the latter of 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 the United States. In particular, the Cayman Islands has a less developed body of securities law than the United States. In addition, Cayman Islands companies may not have standing to initiate a shareholder derivative action before the federal courts of the United States. As a result, our public shareholders may encounter more difficulty in protecting their interests against actions taken by the management, the board of directors or the controlling shareholders of our company than they would as shareholders of a public company incorporated in the United States.

 

You may have difficulty enforcing judgments obtained against us.

 

We are a Cayman Islands company, and we conduct substantially all of our operations in the PRC. Substantially all of our assets are located outside of the United States. In addition, most of our directors and officers are nationals and residents of countries other than the United States. As a result, it may be difficult for you to effect service of process upon our directors and officers in the United States. It may also be difficult for you to enforce 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 of the United States and the substantial majority of whose assets are located outside of the United States.

 

Although there is no statutory enforcement in the Cayman Islands of judgments obtained in the federal

 

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or state courts of the United States (and the Cayman Islands are not a party to any treaties for the reciprocal enforcement or recognition of such judgments), a judgment obtained in such jurisdiction will be recognized and enforced in the courts of the Cayman Islands at common law, without any re-examination of the merits of the underlying dispute, by an action commenced on the foreign judgment debt in the Grand Court of the Cayman Islands, provided such judgment (a) is given by a foreign court of competent jurisdiction, (b) imposes on the judgment debtor a liability to pay a liquidated sum for which the judgment has been given, (c) is final, (d) is not in respect of taxes, a fine or a penalty; and (e) was not obtained in a manner and is not of a kind the enforcement of which is contrary to natural justice or the public policy of the Cayman Islands.

 

We have incurred additional costs as a result of becoming a public company, which could negatively impact our net income and liquidity.

 

We are a public company in the United States and as such, we have incurred and will continue to incur significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002 and rules and regulations implemented by the SEC and the New York Stock Exchange require significantly heightened corporate governance practices for public companies. We expect that these rules and regulations will increase our legal, accounting and financial compliance costs and will make many corporate activities more time-consuming and costly.  If we fail to comply with these rules and regulations, we could become the subject of a governmental enforcement action, investors may lose confidence in us and the market price of our ADSs could decline.

 

We are a “foreign private issuer,” and our disclosure obligations differ from those of U.S. domestic reporting companies. As a result, we may not provide you the same information as U.S. domestic reporting companies or we may provide information at different times, which may make it more difficult for you to evaluate our performance and prospects.

 

We are a foreign private issuer and, as a result, we are not subject to the same requirements as U.S. domestic issuers. Under the Exchange Act, we are subject to reporting obligations that, to some extent, are more lenient and less frequent than those of U.S. domestic reporting companies. For example, we are not required to issue quarterly reports or proxy statements. We are not required to disclose detailed individual executive compensation information. Furthermore, our directors and executive officers are not required to report equity holdings under Section 16 of the Exchange Act and are not subject to the insider short-swing profit disclosure and recovery regime.

 

As a foreign private issuer, we are also exempt from the requirements of Regulation FD (Fair Disclosure) which, generally, are meant to ensure that select groups of investors are not privy to specific information about an issuer before other investors. However, we are still subject to the anti-fraud and anti-manipulation rules of the SEC, such as Rule 10b-5 under the Exchange Act. Since many of the disclosure obligations imposed on us as a foreign private issuer differ from those imposed on U.S. domestic reporting companies, you should not expect to receive the same information about us and at the same time as the information provided by U.S. domestic reporting companies.

 

Item 4.                    INFORMATION ON THE COMPANY

 

A.            History and Development of the Company

 

We were incorporated in the Cayman Islands as an exempted limited liability company on June 9, 2005. On December 31, 2010, we changed our name from Qihoo Technology Company Limited to Qihoo 360 Technology Co. Ltd. We conduct our business operations in China through our wholly-owned subsidiaries and affiliated entities. We formed a wholly-owned subsidiary, Qizhi Software, one of our primary operating entities, in China in December 2005, and another wholly-owned subsidiary, Tianjin Qisi Technology Co. Ltd., another operating entity, in China in September 2011.

 

On March 30, 2011, we listed our ADSs on the New York Stock Exchange under the symbol “QIHU.” In April 2011, we completed our initial public offering of our ADSs.

 

Our principal executive offices are located at Block 1, Area D, Huitong Times Plaza, No. 71 Jianguo Road, Chaoyang District, Beijing 100025, People’s Republic of China. Our telephone number is +86 10 5878 1000 and our fax number is +86 10 5878 1001. Our registered address in the Cayman Islands is located at the

 

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offices of Maples Corporate Services Limited, PO Box 309, Ugland House, Grand Cayman, KY1-1104, Cayman Islands.

 

For information regarding our principal capital expenditures, see “Item 4. Information on the Company — D. Property, Plants and Equipment.”

 

Investors should contact us for any inquiries through the address and telephone number of our principal executive offices. Our corporate website address is www.360.cn. Our agent for service of process in the United States is Corporation Service Company, 1180 Avenue of the Americas, Suite 210, New York, New York 10036-8401.

 

B.            Business Overview

 

Overview

 

We are the No. 2 Internet company in China as measured by monthly active user base as of December 2011, according to iResearch. In December 2011, we had 402 million monthly active users of our products, representing a user penetration rate among all Chinese Internet users of 93.8% in China, according to iResearch.

 

Recognizing security as a fundamental need of Internet and mobile users, we offer comprehensive high-quality Internet and mobile security products free of charge. As a result, we have amassed a large and loyal user base, which we monetize primarily through offering online advertising and Internet value-added services.

 

We are the No. 1 provider of Internet and mobile security products in China as measured by user base, according to iReseach. In December 2011, we had 395 million monthly active Internet security product users, representing a user penetration rate of 92.1% in China, according to iResearch. Our core Internet and mobile security products include:

 

·                  360 Safe Guard and 360 Anti-virus, the No. 1 and No. 2 Internet security products in China, with 363 million and 352 million monthly active users in December 2011, respectively, according to iResearch; and

 

·                  360 Mobile Safe, the No. 1 mobile security product in China, was used by over 50 million smartphone users in China as of December 2011. 360 Mobile Safe had an approximately 60% share of the mobile security market as of March 2012, according to iResearch,

 

On top of our core layer of Internet and mobile security product offerings, we have further developed various platform products to meet a full spectrum of security related needs of Internet users and create trusted access points to the Internet. Our platform products include:

 

·                  360 browsers, which together had 255 million monthly active users and a user penetration rate of 59.5% in China in December 2011, according to iResearch. The user penetration rate for 360 browsers is second only to Microsoft Internet Explorer in China. We also launched 360 mobile browsers for the iOS and Android operating systems in 2011.

 

·                  360 Personal Start-up Page, the default homepage of 360 browsers and a key access point to popular Internet services and applications, had 65 million average daily unique visitors and generated 235 million average daily clicks in the fourth quarter of 2011.

 

·                  360 Application Desktop, a key Internet access point that allows users to securely obtain and manage native applications and access web applications for both personal computers and mobile devices. Since its launch in 2011, the product attracted over 50 million monthly active users as of the end of 2011 and has become a popular alternative way for users to access the Internet.

 

Our products and services are supported by our cloud-based security technology, which we believe is one of the most advanced and robust technologies in the Internet security industry. Our cloud-based security technology enables us to continuously update and enhance our capabilities to detect Internet security threats on a real-time basis. By utilizing this cloud architecture, we believe we are able to offer superior performance through reduced usage of user computing resources, particularly in comparison to traditional anti-virus software.

 

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As the effectiveness of our cloud-based security technology increases with the size of our user cloud, growth of our user base enhances our capabilities of detecting new Internet security threats, which in turn helps us to attract even more users.

 

Leveraging our large user base, we are developing open platforms on which third-party Internet product and service providers, such as web game developers, e-commerce websites and software and application developers, offer their products and services. These open platforms allow us to effectively monetize our large user base through online advertising and revenue sharing arrangements with third parties. For example, our open platform for web games enables our users to access more than 70 web games provided by over 30 developers using their 360 accounts. Our open platforms enable our users to securely access a wide variety of products and services, which in turn enhances our users’ experience and loyalty and further grows our user base.

 

We have been able to leverage our large user base and our strong brand recognition to grow our paying customer and user base. We generate revenues primarily through offering the following services:

 

·                  Online advertising.  We offer advertising services by providing marketing opportunities on 360 Personal Start-up Page and other platform products to our advertising customers. We also offer search referral services to search engine companies.

 

·                  Internet value-added services.  We offer web games developed by third parties and provide remote technical support and other Internet value-added services to users.

 

We have grown significantly since we commenced operations in 2005. Monthly active users of our products increased from 290 million in December 2010 to 402 million in December 2011. Our revenue increased from $32.3 million in 2009 to $57.7 million in 2010 and $167.9 million in 2011. We first became profitable in 2009. Our net income increased from $4.2 million in 2009 to $8.5 million in 2010 and $14.5 million in 2011.

 

Products and Services

 

Core Security Products

 

Our two core Internet security products are 360 Safe Guard and 360 Anti-Virus.

 

360 Safe Guard is our flagship Internet security product and a one-stop solution for Internet security and system optimization. 360 Anti-Virus is an anti-virus application that uses multiple scan engines to protect our users’ computers against all kinds of malware, including traditional viruses, and may operate without Internet connection. These applications protect our users’ computers against Trojan horses, viruses, worms, adware and other forms of malware.

 

These two core Internet security products collectively provide users with robust and efficient protection against virus, malware and malicious websites, protect users’ privacy by preventing unauthorized access to and control of their computer system and optimize overall computer performance by removing unnecessary processes and unused junk files, automatically detecting and fixing vulnerabilities in operating system and third-party applications, and providing other security and performance optimizing services.

 

In December 2011, according to iResearch, 360 Safe Guard ranked first among all Internet security products in China with 363 million monthly active users and a user penetration rate of 84.7% in China, and 360 Anti-Virus ranked second only to 360 Safe Guard among all Internet security products in China and first among all anti-virus products in China, with 352 million monthly active users and a user penetration rate of 82.0% in China.

 

360 Safe Guard and 360 Anti-Virus both comprise multiple integrated security products. The main components of 360 Safe Guard and 360 Anti-Virus include:

 

Cloud-based anti-malware.    We believe that our cloud-based anti-malware is one of the most advanced and robust technologies in the Internet security industry. It relies on a large user base to provide information used to detect malware. Our centralized server cloud collects data, such as samples of malware,

 

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from our user base. These samples are sent to our cloud-based analytic systems for automatic real-time detection of new malware and updating of the blacklist and whitelist on a real-time basis.

 

During on-demand scans on and real-time protection of the user’s computer or mobile device, our cloud-based anti-malware submits the unique digital fingerprints of files and web pages from a user’s computer to our cloud query engines for malware detection. Our cloud query engines compare these fingerprints against our server-side blacklist and whitelist for matches before sending match results to the client side. Any file that matches our blacklist is immediately removed, quarantined or dealt with based on the user’s instructions, while a non-match to our whitelist is presumed to be suspicious and further analyzed by our other technologies.

 

Our cloud-based anti-malware has the following advantages over traditional Internet security products:

 

·                  it ensures minimal lag time between initial discovery of new malware on a single user’s computer or mobile device and protection of all users from that malware, thus providing real-time response to new threats and robust protection to our users;

 

·                  our large user base provides large amounts of data from which we can detect many forms of newly created and variant malware, which significantly enhances our malware detection capabilities; and

 

·                  it eliminates the need for a traditional signature database stored on a user’s computer, freeing up computer resources otherwise required by traditional Internet security products.

 

The effectiveness of cloud-based anti-malware depends primarily on the size of the user cloud and the amount of information that it provides. With nearly 400 million users reporting new and potential threats, our user community contributes to its own protection.

 

360 HIPS.    360 HIPS adopts proactive defense technology and achieves real-time protection against malware by monitoring the behaviors of a program rather than its programming code signature or digital fingerprint and using predetermined rules to decide whether the program is malicious. It provides multiple levels of protection, such as monitoring file usage, processes, web browsing and removable media and preventing malware from intruding our users’ computers. In addition, 360 HIPS provides application-level protection to users against hijacking of desktop shortcuts and web browsers. Proactive defense technology takes advantage of the collective intelligence and processing power of our cloud-based security system to accurately and efficiently identify and prevent malware and is particularly effective against unknown new malware.

 

360 Automatic Vulnerability Detection and Fix.    Since most Trojan horses attack a computer through its vulnerabilities, 360 Automatic Vulnerability Detection and Fix assesses the security status of a computer and automatically identifies, downloads and installs suitable vulnerability patches. It is a user-friendly tool for users to manage and safeguard the operating system and applications on their computers.

 

360 WebShield.    360 WebShield is an application for secure Internet browsing. Using a blacklist of malicious websites compiled through our user cloud and our server side detection system, 360 WebShield effectively blocks websites that may contain automatically downloaded malware or phishing or fraudulent content and warn users against these websites. 360 WebShield also filters advertisements, restores browser settings from and protects browser settings against unauthorized modification, scans downloaded files and maintains a clean and stable browsing environment.

 

360 Privacy Protector.    360 Privacy Protector protects users’ personal information and data stored on the hard drive of their computers. By identifying the files accessed by software programs running on a user’s computer and allowing the user to decide whether to grant access, it protects our users’ private files, including chat records and online banking information, against unauthorized access. In addition, with 360 Privacy Protector, our users can monitor the status of webcams on their computers to prevent peeping, utilize a strengthened and encrypted virtual drive to store their private and sensitive files with minimized risks of data loss or leakage and clear unwanted access history or records.

 

Quick PC Health Check.    Quick PC Health Check is a user-friendly tool to quickly monitor, diagnose and rate the security status and performance of a user’s computer. It also provides a user-friendly “one-click fix” to solve identified security risks, shorten the startup time and optimize system performance.

 

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Our core mobile security product is 360 Mobile Safe. Launched in November 2009, 360 Mobile Safe is a security program for the Google Android, Apple iOS and Nokia Symbian smartphone operating systems. It scans for malware using our cloud-based security technology, blocks spam text messages, filters incoming phone calls based on user-input blacklists and whitelists, optimizes phone performance and speed and encrypts data for privacy protection in the event that the phone is lost or stolen. As of March 2012, 360 Mobile Safe had the largest share of approximately 60% in China’s mobile security market, according to iResearch.

 

Cloud Storage

 

Our Cloud Storage system offers users a space for file storage and the data backup. User data is encrypted and stored on our cloud servers in segments with at least two copies to ensure data security and integrity. Our unique segmentation redundancy technology enables users to restore a file with limited redundant data for high system reliability. Users can access and manage their files through PC software, web page and mobile platforms and enjoy the real-time synchronization among these platforms.

 

Platform Products

 

360 Browsers.    Our 360 browsers, such as 360 Safe Browser and 360 Speed Browser, are based on dual-core technologies and provide our users with a fast and secure browsing experience.  We also offer 360 Mobile Browser for the iOS and Android operating systems.  According to iResearch, in December 2011, 360 browsers had monthly active users of 255 million and user penetration rate of 59.5% in China.

 

Our 360 browsers can automatically block malicious websites, identify them among search results and scan files downloaded through the browser. Our 360 browsers also offer a “private browsing” option to allow users to surf the Internet anonymously without leaving historical access records. Furthermore, in addition to the traditional browser function of rendering web pages, our 360 browsers serve as an entrance for Internet related services, which we believe leads to greater user loyalty. For example, the microblog reminder function promptly notifies our users of new comments to and new followers of their microblogs, enabling them to better utilize social networking applications. In addition, 360 browsers’ online bookmark folders allow users to store their bookmarks in the cloud and access these bookmarks at any time in any location on PC and mobile devices with their 360 accounts.  Also, 360 browsers offer password manager to help users easily access multiple personal accounts on different online services through a secure cloud-based system. Through these additional features, we have been able to increase our users’ reliance on and loyalty to our products.

 

Officially launched in August 2011, our 360 mobile browsers’ cloud-based web page rendering may reduce up to 90% of data traffic, which helps to optimize speed and user experience.  Using 360 accounts, users can seamless synchronize bookmarks and personal settings between the Android, the iOS and PC platforms.

 

360 Personal Start-up Page.    Launched in 2009, 360 Personal Start-up Page serves as user’s start-up page aggregating popular and preferred web services and applications. As the default home page of our 360 browsers, 360 Personal Start-up Page allows users to access and utilize popular web applications from a convenient site. Eventually, it will also automatically customize the contents and design based on users’ preference and habit. In the fourth quarter of 2011, 360 Personal Start-up Page had 65 million average daily unique visitors and generated 235 million average daily clicks.

 

360 Application Desktop.    360 Application Desktop allows users to search and obtain various native applications for both personal computers and mobile devices, and access web applications through a secure and user-friendly platform. It provides an alternative way for our users to access Internet. We have established strong relationships with software and application developers to enrich the software and application offerings on 360 Application Desktop. As of December 2011, 360 Application Desktop had over 50 million monthly active users and over 180,000 third party applications.

 

Online Advertising

 

We utilize our extensive user traffic to offer online advertising services, including online marketing services and search referral services.

 

We offer online marketing services by providing links to our advertising customers’ websites or online applications on our platform products. We charge fees to our customers on a fixed, cost-per-sale or cost-per-

 

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action basis.  These fees are determined based on the effectiveness of our advertising links, which is typically measured by active users, clicks and transactions directed from our platforms.

 

We also offer search referral services to search engine companies. Our 360 browsers and their default home page, 360 Personal Start-up Page, contain default search boxes that direct search traffic to search engines such as Google.com. These search engine companies pay us a pre-determined fee for each search originated from our 360 browsers and 360 Personal Start-up Page.

 

Internet Value-added Services

 

We offer Internet value-added services, including operating web games developed by third-parties and providing remote technical support and other Internet value-added services to users.

 

We operate third-party developed web games on our game platform. We provide game players a safe and convenient gaming environment.  Our game portfolio includes role-playing, strategy, sports and simulation games. Users can play these games directly on our game platform without downloading separate software. As of December 31, 2011, we offered over 70 games and had over 30 million registered users on our game platform.  We share revenues from game operations with game developers pursuant to the terms of our cooperation agreements.

 

We also offer remote technical support. When users encounter security issues, they can request our staff to provide live technical assistance and remote troubleshooting for a service fee on a per-case basis. We also provide monthly and annual subscriptions for this service.

 

Our Technology

 

Cloud-based Technologies

 

We have developed leading cloud-based security technology, cloud computing technology and cloud storage technology.

 

Our cloud-based security technology is composed of three parts: a cloud-based database of blacklisted and whitelisted program files, the automatic scanning and analysis of potential malware and malicious websites and 360 security software installed on users’ computers. It compares the unique digital fingerprint of a program file to a blacklist of confirmed malware and malicious websites and whitelist of confirmed safe program files stored on our central servers. The blacklist and whitelist are updated by information retrieved from and submitted by our user cloud on a real-time basis. In December 2011, we scanned and analyzed an average of over 59 million suspicious file samples per day. Our blacklist contains over 1,320 million malware samples, and our whitelist contains over 30 million safe program files.

 

We believe our cloud computing technology is one of the most advanced proprietary server-side cloud computing technologies in the Internet and mobile security industry. It combines the strengths of our large-scale parallel computing technology, our mass data storage technology, our high performance inquiry and search engine technology and our QVM malware detection technology.

 

Our cloud storage system is based on our unique segmentation redundancy technology, which enables us to restore a file with limited redundant data and greatly improves the storage reliability and security for our users’ data. We possess know-how to customize servers to store greater amounts of data with lower power consumption. In addition, we have developed software for users to implement our cloud storage and data backup and restore technology, which supports automatic incremental backup of users’ designated files while ensuring the safety and confidentiality of such files.

 

Dual-core Browser

 

Our 360 browsers integrate Trident, the core browser technology of Microsoft’s Internet Explorer and Webkit, the open-source core browser technology of Google Chrome, and automatically switch between these two core technologies seamlessly to provide our users with an optimized browsing experience. Webkit increases the speed of opening web pages, while Trident improves the compatibility of our 360 browsers with online banking and video display web pages. We have also developed technologies to minimize the memory usage of

 

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our 360 browsers to prevent decreases in performance after long periods of use, and isolate individual web page crashes to prevent browser deadlocks when visiting certain pages. Our 360 browsers also incorporate multiple security features, including the Microsoft DEP/NX exploit protection mechanism, anonymous browsing and the functions of 360 WebShield and sandbox technology.

 

Qihoo Search Engine Technology

 

Qihoo search engine technology consists of our proprietary search engine technologies, including a scalable spider system for crawling web pages, a scalable parallel computing platform for processing and analyzing web pages, a massive data storage platform, a high-performance indexing system and a high-performance query engine technology. Our search engine primarily focuses on online community content. It has indexed more than 10 billion web pages and captures 20 million new web pages on a daily basis. Core components of Qihoo search engine technology are used in our cloud-based security system to augment our ability to screen massive amounts of program files and Internet content and quickly identify threats.

 

Mobile Security Technology

 

Our mobile security technology scans for malware using our cloud-based technologies, blocks spam text messages, filters incoming phone calls based on user-input blacklists and whitelists and intelligent algorithms, monitors network accessing processes, optimizes phone performance and encrypts data for privacy protection in the event that the phone is lost or stolen. It supports the Google Android, Apple iOS and Nokia Symbian smartphone operating systems.

 

QVM

 

QVM is our proprietary technology that detects malware through an artificial-intelligence algorithm capable of machine learning to recognize new forms of malware. QVM technology offers a robust model for recognizing malware characteristics using the massive amount of data that we have compiled on confirmed malware in our blacklist and verified safe programs files in our whitelist. This model is used as a basis for a detection algorithm which is automatically enhanced and updated with new malware samples submitted by our users to our servers.

 

Program files that do not appear in our blacklist and whitelist are scanned using QVM, and any “hits” returned by this technology are presumed to be malicious and removed or quarantined. As malware is constantly being created or morphing, QVM has the advantage of being able to detect threats that have not been previously identified. According to PC Security Labs, an independent security product test organization, QVM has a detection rate of 74.9% for unknown new malware, which surpasses most heuristic detection technologies.

 

360 HIPS

 

360 HIPS adopts a proactive defense technology that focuses on monitoring behaviors and actions performed by malware rather than its programming code signature or digital fingerprint. Generally, even if malware evades detection by our cloud-based security and QVM technologies, it must still perform certain actions to achieve its creator’s intentions, such as modifying system settings and accessing confidential information. 360 HIPS proactive defense technology monitors a computer’s running processes during procedures such as web browsing, downloading, software installation and data transmission and assesses these actions based on a pre-determined algorithm. If a process is deemed to be dangerous, the user is notified and information relating to that process is transmitted to our central servers for further processing. This proactive defense technology takes advantage of the collective intelligence and processing power of our cloud architecture to accurately and efficiently determine whether an action performed by a program is malicious.

 

360 Protector

 

360 Protector is a security system to provide users with protection in different processing environments, including online shopping, searches, downloads, content streaming, removable disk installation and email services. Our two proprietary proactive defense technologies, 360 HIPS and the sandbox technology, enable this system to intelligently monitor the user’s behaviors and actions and provide relevant protection through a pre-determined algorithm.  If a computing process is deemed to be suspicious, the user will be notified and such process will be isolated in a virtual environment where malicious actions can be performed without actual consequence to the user’s computer.  In December 2011, 360 Protector blocked an average of

 

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approximately 15 million Trojan horses on a daily basis, of which approximately two million originated from online downloads and 3.5 million originated from removable disk installations.

 

Malicious Web Page Detection Technology

 

Our proprietary automated detection system for malicious web pages is a core component of our cloud-based security system. It automatically tests and recognizes malicious websites with an accuracy rate of over 99%. This detection system uses a collection of techniques, including simulated vulnerability environments, search spiders, collections of suspicious websites compiled by our user base and monitoring of browser processes and actions. We have also collected large amounts of data on phishing and fraudulent websites and used this information and machine-learning technology to develop an artificially intelligent algorithm for recognition of phishing and fraudulent websites.

 

System Rescue and Recovery Technology

 

Our system rescue and recovery technology, along with our cloud-based security system, allows for the recovery of damaged systems with crucial files that have been modified by malware or user error. It is able to restore the damaged system with optimal settings and correct system files retrieved from our whitelist database on our server cloud. This technology also specifically aims to detect and remove sophisticated Trojan horses.

 

System Performance Optimizing and Power Saving Technologies

 

Our system performance optimization technology assists our users to optimize the system settings and improve the system performance of their computers. It manages hard drive, desktop, documents, Internet browsing and security settings to reduce system start-up time and increase operating speed. It also cleans the registry, recycle bin, Internet access history and system patch files, improves hard drive performance through testing and defragmentation and automatically updates and backs up system files.

 

Our hardware diagnosis and power saving technology effectively diagnoses hardware status, saves power, prevents hardware malfunctions and prolongs the battery life of a computer by closely monitoring its power consumption and the temperature of its key components. This technology can be used on desktop, notebook and other personal computers.

 

Product Development

 

To maintain and enhance our leadership position in the Internet industry, we will continue to invest in product development to enhance and increase our product offerings. Our primary product development goals are to develop security products, cloud-based services, mobile Internet products and other Internet products and services and strengthen our products and services and enhance user experience. We also aim to focus our product development efforts on expanding our other Internet-based product offerings.

 

As of December 31, 2011, our product development team consisted of 1,166 development and technical staff members, approximately 77.8% of whom held bachelor’s or more advanced degrees.

 

Our internally developed technologies include our cloud-based security system, QVM, 360 HIPS, Qihoo search engine technology, cloud storage and other technologies. See “— Our Technology.”

 

Our product development expenses include costs associated with new product development and enhancement for existing products, such as salaries and benefits, including share-based compensation expenses, costs of bandwidth and utilities, license and technical service fees, and depreciation of equipment and amortization of acquired intangible assets. Product development expenses represented 33.0%, 42.5% and 38.7% of total revenues for each of the three years ended December 31, 2009, 2010 and 2011, respectively.

 

Network Infrastructure

 

Our network infrastructure is administered by our operations department, which handles hardware, system and network operation and maintenance. Our systems are designed for scalability and reliability to support growth in our user base. We lease bandwidth from telecommunication operators such as China Telecom, China Unicom and China Mobile to connect to the national Internet backbone. We believe that our current network facilities and broadband capacity provide us with sufficient capacity to carry out our current operations.

 

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While we believe that our network infrastructure and maintenance will likely prevent network interruption resulting from attacks by hackers, there remains a possibility that such attacks could result in delays or interruptions on our network. For a further discussion, see “Item 3. Key Information — D. Risk Factors — Risks Related to Our Business — Interruption or failure of our own information technology and communications systems or those of third-party service providers we rely upon could impair our ability to effectively provide our products and services, which could affect our reputation and harm our operating results.”

 

Customers

 

Our customers primarily comprise customers for our online advertising services, such as search engines who pay us for directing search traffic and third-party websites who pay us for displaying their links on our platform products.

 

In 2009, 2010 and 2011, we had 139, 210 and 350 customers for our online advertising services. Our five largest customers accounted for approximately 27.8%, 35.1% and 27.9% of our total revenues for each of the three years ended December 31, 2009, 2010 and 2011, respectively.

 

Game Developers

 

We operate third-party developed web games on our game platform and generate revenue from selling in-game currencies online which are used by game players to purchase virtual items in these games.  We collect payments from game players in connection with the sale of in-game currencies and remit certain agreed-upon percentages of the proceeds to the game developers.

 

Suppliers

 

Our suppliers are primarily providers of servers, network equipment and bandwidth that we need to maintain our network infrastructure and operations. Our suppliers of Internet data centers, or IDC, host our servers in 58 cities across 28 provinces in China. Our primary IDC suppliers include China Telecom, China Unicom and China Mobile. Our largest supplier accounted for approximately 17.3%, 9.4% and 14.8% of our total purchases for each of the three years ended December 31, 2009, 2010 and 2011, respectively. Our five largest suppliers accounted for approximately 47.4%, 34.5% and 43.4% of our total purchases for each of the three years ended December 31, 2009, 2010 and 2011, respectively.

 

Under our agreements with IDC service providers, we lease server racks and bandwidth and the providers guarantee that the error rate, which is defined as accumulated failure time per month, will not exceed a very limited duration per calendar month. The agreements typically last for one year, some of which are automatically renewable for additional one-year terms unless terminated by either party.

 

We also purchase servers, office computers and other fixed assets for our operations, primarily from PRC suppliers.

 

Sales and Marketing

 

We have historically relied primarily on “word-of-mouth” from our large user base as a sales and marketing tool for our products and services. Trust and reliance by over 400 million users is a key driver for the growth of our business, as potential new users hearing positive feedback from their friends and colleagues are more likely to try our products and services, which in turn enhances our “360” brand. Our public relations strategy is focused on events related to our products and services, such as the launch of a new product or service, the update of existing products and services and awards and certifications we received for our products and services.

 

Since 2010, we have conducted advertising campaigns to reach a large number of potential users and customers. We also cooperate with mobile operators to promote our mobile security products.  We expect to continue to control our sales and marketing expenses in the future by focusing on advertisements that we believe will provide significant benefits to our user base and brand recognition.

 

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Intellectual Property

 

We rely on a combination of patent, copyright, trademark, software registration, non-competition and trade secret laws and agreements with our employees to establish and protect our intellectual property rights. All of our employees enter into agreements requiring them to keep confidential all proprietary and other information relating to our customers, methods, technologies, business practices and trade secrets. These agreements also stipulate that all software, inventions, trade secrets, works of authorship, developments and other processes, whether or not patentable or copyrightable, made by them during their employment are our property. Despite our precautions, it may be possible for third parties to obtain and use our intellectual property without our authorization. Furthermore, the validity, enforceability and scope of protection of intellectual property rights in the Internet and telecommunications-related industries are uncertain and still evolving. Infringement and misappropriation of our intellectual property could materially harm our business. See “Item 8. Financial Information — Legal and Administrative Proceedings.”

 

As of December 31, 2011, we had 127 registered trademarks in China and held copyrights to 124 software programs covering almost all of our products. As of December 31, 2011, we had 130 pending patent applications.

 

We have registered the domain name “360.cn” with China Internet Network Information Center. In addition to these domain names, we have registered 133 domain names with various domain name registration services as of December 31, 2011.

 

We currently license malware scanning engines and signature libraries and other security technologies from third parties, such as BitDefender SRL.

 

Competition

 

We primarily compete with Internet security product and service providers and PRC-based Internet companies.

 

The Internet security market in China is competitive among existing industry players, but contains high barriers to entry which make it difficult for new entrants to succeed, including:

 

·                  Brand.    The technological reputation of a brand is particularly important in the Internet security market, as users need to completely trust and rely on a service provider’s security software. To compete with the well-established brand of existing industry players, new entrants must commit significant resources to marketing and promotion.

 

·                  User base.    Cloud-based security technology has come to the forefront of the Internet security industry in recent years, and requires a large user cloud to be effective. It is difficult for new entrants with small user clouds that cannot detect malware effectively to attract users.

 

·                  Technology.    Cloud-based security technology requires a significant amount of technological expertise, infrastructure and resources. New entrants face significant lag time in developing their own technologies and establishing the infrastructure necessary to operate.

 

·                  Software.    Internet security software is generally mutually exclusive, meaning that an Internet user generally uses security software from a single software provider. It is difficult for new entrants to the market to capture users from existing and established brands.

 

·                  Business model.    We have established our broad user base through providing high quality pan-security products free of charge and generate revenues by leveraging that user base. New entrants into the Internet security market do not have the user base or the brand recognition to follow this business model successfully.

 

According to iResearch, in December 2011, we had 395 million monthly active users of our Internet security products, representing a user penetration rate among all Chinese Internet users of 92.1% in China. We believe that our technological know-how, large user base and established reputation in the Internet security market provide us with significant competitive advantages.

 

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We also compete with PRC-based Internet companies that build Internet platforms to offer similar value-added and online advertising services as we do. Our primary competitor in this market is Tencent, the largest Internet company in China in terms of revenue. In December 2011, Tencent’s QQ instant messaging software had an active user penetration rate in China of 91.5%, according to iResearch.

 

Regulation

 

This section sets forth a summary of the most significant regulations or requirements that affect our business activities in China or our shareholders’ right to receive dividends and other distributions from us.

 

Regulations Relating to Our Business

 

Telecommunications Regulations

 

The PRC Telecommunications Regulations implemented on September 25, 2000 sets out a regulatory framework for telecommunications services providers in China. The Telecommunications Regulations require telecommunications services providers to obtain an operating license prior to the commencement of their operations. The Telecommunications Regulations categorize telecommunications services into basic telecommunications services and value-added telecommunications services. According to the Catalogue of Telecommunications Business attached to the Telecommunications Regulations, information services provided via fixed network, mobile network and Internet belong to value-added telecommunications services.

 

Foreign direct investment in telecommunications companies in China is governed by the Regulations for the Administration of Foreign-Invested Telecommunications Enterprises promulgated in December 2001 and amended in September 2008, or the FITE Regulations. The FITE Regulations requires foreign-invested telecommunications enterprises in China to be established as Sino-foreign equity joint ventures. In addition, pursuant to the FITE Regulations and the relevant WTO agreements, foreign investors in a foreign-invested telecommunications enterprise engaging in value-added telecommunications services may hold up to 50% of the equity interest of such enterprise. The relevant rules do not impose geographic restrictions on the operations of a foreign-invested telecommunications enterprise.

 

However, for a foreign investor to acquire any equity interest in a value-added telecommunications business in China, it must satisfy a number of stringent performance and operational experience requirements, including demonstrating a track record and experience in operating a value-added telecommunications business overseas. Moreover, foreign investors that meet these requirements must obtain approvals from MIIT and MOFCOM or their authorized local counterparts, which retain considerable discretion in granting approvals.

 

In July 2006, MIIT publicly released the Notice on Strengthening the Administration of Foreign Investment in Operating Value-added Telecommunications Business, or the MIIT Notice, which reiterates certain provisions under the 2002 Administrative Rules on Foreign-invested Telecommunications Enterprises. According to the MIIT Notice, if any foreign investor intends to invest in a PRC telecommunications business, a foreign-invested telecommunications enterprise must be established and such enterprise must apply for the relevant telecommunications business licenses. Under the MIIT Notice, domestic telecommunications enterprises may not rent, transfer or sell a telecommunications license to foreign investors in any form, nor may they provide any resources, premises, facilities and other assistance in any form to foreign investors for their illegal operation of any telecommunications business in China.

 

On September 28, 2009, the PRC General Administration of Press and Publishing, or the GAPP, together with the National Copyright Administration, and National Office of Combating Pornography and Illegal Publications jointly issued a Notice on Further Strengthening on the Administration of Pre-examination and Approval of Online Game and the Examination and Approval of Imported Online Game, or the GAPP notice. The GAPP notice provides that foreign investors are not permitted to invest in online game operation businesses in China through wholly-owned joint ventures or cooperative joint venture investments and prohibits foreign investors from gaining control over or becoming domestic online game operators through indirect ways such as establishing other joint venture companies or contractual or technical arrangements. There are still substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including the MIIT circular and the GAPP notice.

 

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Internet Content Services

 

On September 25, 2000, the State Council promulgated the Administrative Measures on Internet Information Services, or the Internet Measures. According to the Internet Measures, commercial operators of Internet information services in China must obtain a value-added telecommunications license, or ICP license, from the relevant government authorities.

 

Information Security and Censorship

 

National security considerations are an important factor in the regulation of Internet content in China. According to the Decision of the Standing Committee of the National People’s Congress on Maintaining Internet Security, the following actions may be regarded as violations of laws and are subject to penalties, including criminal sanctions: (i) breaking into a computer or a system of strategic importance; (ii) disseminating politically disruptive information; (iii) leaking state secrets; (iv) spreading false commercial information; or (v) infringing intellectual property rights.

 

In addition, the MPS promulgated measures on December 16, 1997 that prohibit the use of the Internet in ways which, among other things, result in a leakage of national secrets or the distribution of socially destabilizing content. On December 13, 2005, the MPS promulgated Provisions on Technological Measures for Internet Security Protection, or the Internet Protection Measures, which require all ICPs to keep records of certain information about its users (including user registration information, log-in and log-out time, IP address, content and time of posts by users) for at least 60 days and submit the above information as required by laws and regulations. The ICPs must regularly update information security and censorship systems for their websites with local public security authorities, and must also report any public dissemination of prohibited content. If the ICPs violate these measures, the PRC government may revoke its ICP license and shut down its websites. In addition, the PRC State Secrecy Bureau has issued provisions authorizing the blocking of access to any website it deems to be leaking national secrets or failing to comply with the relevant legislation regarding the protection of state secrets.

 

Internet Privacy

 

In recent years, PRC government authorities have legislated on the use of the Internet to protect personal information from unauthorized disclosure. For example, the Internet Measures prohibits an Internet information services provider from insulting or slandering a third party or infringing upon the lawful rights and interests of a third party. Pursuant to the BBS Measures, ICPs that provide electronic messaging services shall not disclose any user’s personal information to any third party without such user’s consent, unless the disclosure is required by law. ICPs are subject to legal liability if unauthorized disclosure results in damages or losses to users. In addition, the PRC regulations authorize the relevant telecommunications authorities to demand rectification of unauthorized disclosure by ICPs.

 

The PRC laws do not prohibit ICPs from collecting and analyzing person information of their users. The PRC government, however, has the power and authority to order ICPs to submit personal information of an Internet user if such user posts any prohibited content or engages in illegal activities on the Internet.

 

Advertising Business

 

Foreign Ownership in Advertisement Business:

 

The principal regulations governing foreign ownership in advertising businesses in China include:

 

·                  The Foreign Investment Industrial Guidance Catalog;

 

·                  The Administrative Regulations on Foreign-invested Advertising Enterprises; and

 

·                  The Circular Regarding Investment in the Advertising Industry by Foreign Investors through Equity Acquisition.

 

These regulations require foreign entities that directly invest in the PRC advertising industry to have at least a two-year track record with a principal business in the advertising industry outside China. Since December 2005, foreign investors have been permitted to directly own a 100% interest in advertising companies in China, but such foreign investors are also required to have at least a three-year track record with a principal

 

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business in the advertising industry outside China. PRC laws, rules and regulations do not permit the transfer of any approvals or licenses, including business licenses containing a scope of business that permits engagement in the advertising business.

 

As a result of the current PRC laws, rules and regulations that impose substantial restrictions on foreign investment in the Internet and advertising businesses in China, we conduct this portion of our operations through a series of contractual arrangements among our PRC subsidiaries and our consolidated controlled entities. See “ Item 7. Major Shareholders and Related Party Transactions ¾ B. Related Party Transactions ¾ Contractual Arrangements among Qizhi Software, the VIEs and the Respective Shareholders of the VIEs.”

 

Competent Authority Governing Advertisement Business:

 

SAIC is responsible for regulating advertising activities in China. The principal regulations governing advertising in China, including online advertising, include:

 

·                  The Advertising Law;

 

·                  The Administration of Advertising Regulations; and

 

·                  The Implementation Rules for the Administration of Advertising Regulations.

 

These regulations stipulate that companies that engage in advertising activities in China must obtain from SAIC or its local branches a business license which specifically includes operating an advertising business within its business scope. Companies conducting advertising activities without such a license may be subject to penalties, including fines, confiscation of illegal revenues and orders to cease advertising operations. The business license of an advertising company is valid for the duration of its existence, unless the license is suspended or revoked due to a violation of any relevant law or regulation.

 

Software Products

 

According to the PRC Regulation of Computer Information System Security and the Administrative Measures on Inspection and Sales License of Security Products for Computer Information System, sale of security products for computer information system, including hardware and software products, requires approval and a sales license. A new sales license is required if an approved security product has any functional changes.

 

On March 1, 2009, MIIT issued the Administrative Measures on Software Products, or the Software Measures, to regulate software products and promote the development of the PRC software industry. The Software Measures provide for a registration and filing system for software products both made in China and imported from overseas and require registration of all software products with the competent local government authorities in charge of software industry administration. Registered software products may enjoy certain preferential treatments granted by relevant software industry regulations. Software developers or producers may sell or license their registered software products directly or through distributors. Each registration is valid for five years and renewable upon expiration.

 

Regulation of Electronic Publications and Internet Publishing

 

The Rules for the Administration of Electronic Publications, or Electronic Publication Rules, regulate the production, publishing and import of electronic publications in the PRC. In addition, under the Provisional Measures for Administration of Internet Publication promulgated, Internet publishing is broadly defined as any act of Internet information providers to select, edit and process content or programs and post such content or programs on the Internet for users to view, use or download, including books, newspapers, electronic publications and so on. Under relevant rules and measures issued by the GAPP, providing online download services of software may be deemed as Internet publishing activities, which require an Internet publishing license.

 

Web Games and Virtual Currency

 

The Provisional Regulations for the Administration of Online Culture promulgated in 2003 and as amended in 2004 and 2011 applies to entities engaging in activities related to “online cultural products,”

 

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 including music and video files, network games, animation features, audiovisual products, performed plays and artwork converted for dissemination via the Internet. Such entities are required to apply for an online culture operating permit from the relevant local branches of the Ministry of Culture, or the MOC, for engaging in any of the following types of activities:

 

·                  production, duplication, importation, wholesale, retail, leasing or broadcasting of online cultural products;

 

·                  dissemination of online cultural products on the Internet or transmission of such products to computers, fixed-line or mobile phones, radios, television sets or gaming consoles for the purpose of browsing, reading, using or downloading such products; or

 

·                  exhibition, competitions or other activities involving online cultural products.

 

Notice 35 issued by the State Commission Office for Public Sector Reform on September 17, 2009 interprets the responsibilities of relevant governmental authorities on the administration and supervision of the animation, online game and culture market. Notice 35 provides that the GAPP shall be responsible for reviewing a online game before its publication on the Internet and the MOC shall administer and supervise published online games.

 

Furthermore, the Provisional Measures for the Administration of Online Games, or the Online Game Measures, strengthens the MOC’s supervision of the development, production, online operation and issuance of online games, including web games, virtual currency. A company shall obtain the online culture operating permit in order to conduct online game operation and issuance and transaction of virtual currency. Such permit is valid for three years and renewable before its expiration. The Online Game Measures sets out detailed restrictions on online game operations, such as examination and filing of web games’ content, installment of anti-fatigue system and implementation of real-name registration. In addition, based on the Online Game Measures, the virtual currency issued by a web game operator could be only used to exchange such operator’s online game products.

 

On February 15, 2007, the MOC, the People’s Bank of China and other relevant government authorities jointly issued the Notice on Internet Cafes. The Notice on Internet Cafes authorizes the People’s Bank of China to strengthen the administration of virtual currency in web games in order to avoid any adverse impact on the economy and financial system. This notice strictly limits the total amount of virtual currency that a web game operator can issue and an individual game player can purchase. It also distinguishes virtual transactions from real transactions through electronic commerce and that specifies virtual currency should only be used to purchase virtual items.

 

Laws Relating to Intellectual Property

 

China has adopted comprehensive legislation governing intellectual property rights, including trademarks, patents and copyrights. China is a signatory to the main international conventions on intellectual property rights and has been a member of the Agreement on Trade related Aspects of Intellectual Property Rights since its accession to the WTO in December 2001.

 

Patent Law

 

In accordance with the PRC Patent Law, the State Intellectual Property Office is responsible for administering patents in the PRC. The patent administration departments of provincial, autonomous region or municipal governments are responsible for administering patents within their respective jurisdictions.

 

The Chinese patent system adopts a “first to file” principle, which means that, where more than one person files a patent application for the same invention, a patent will be granted to the person who filed the application first. To be patentable, invention or utility models must meet three conditions: novelty, inventiveness and practical applicability. A patent is valid for 20 years in the case of an invention and 10 years in the case of utility models and designs. A third-party user must obtain consent or a proper license from the patent owner to use the patent. Otherwise, the use constitutes an infringement upon patent rights.

 

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Trademark Law

 

In accordance with the PRC Trademark Law, the Trademark Office of the Administration for Industry and Commerce is responsible for the registration and administration of trademarks in China. The Administration for Industry and Commerce under the State Council has established a Trademark Review and Adjudication Board for resolving trademark disputes.

 

As with patents, China has adopted a “first-to-file” principle for trademarks. If two or more applicants apply for registration of identical or similar trademarks for the same or similar commodities, the application that was filed first will receive preliminary approval and will be publicly announced. For applications filed on the same day, the trademark that was first used will receive preliminary approval and will be publicly announced.

 

Registered trademarks are valid for ten years from the date the registration is approved. A registrant may apply to renew a registration within six months before the expiration date of the registration. If the registrant fails to apply in a timely manner, a grace period of six additional months may be granted. If the registrant fails to apply before the grace period expires, the registered trademark shall be deregistered. Renewed registrations are valid for ten years.

 

Copyright

 

The Copyright Law extends copyright protection to Internet activities, products disseminated over the Internet and software products. In addition, there is a voluntary registration system administered by the China Copyright Protection Center.

 

The Rules of Protection on Information Network Dissemination Rights address copyright issues relating to the Internet. In addition, the Interpretations on Some Issues Concerning Applicable Laws for Trial of Disputes Over Internet Copyright, or the Interpretations, establish joint liability for ICPs who knowingly infringe upon other’s copyright or refuse to remove the infringing content after receiving notice from the holder of the copyright. The Interpretations also provides that any act to circumvent the technologies designed to protect copyrights constitutes copyright infringement.

 

Regulation of Foreign Currency Exchange and Dividend Distributions

 

Foreign Currency Exchange

 

The principal regulations governing foreign currency exchange in China are the Foreign Exchange Administration Regulations, as amended in August 2008. Under the Regulations, RMB are freely convertible for current account items, including the distribution of dividends, interest payments, trade and service-related foreign exchange transactions. In order to convert RMB for capital account items, such as direct investments, loans, repatriation of investments and investments in securities outside of China, the prior approval of, and registration with, SAFE are required.

 

On August 29, 2008, SAFE promulgated Circular 142, which regulates the purposes for which foreign-invested companies may convert foreign currency into RMB. The notice requires that the registered capital of a foreign-invested company settled in RMB converted from foreign currencies may only be used within the business scope approved by the applicable governmental authority and may not be used for equity investments in the PRC. In addition, foreign-invested companies may not change how they use such capital without SAFE’s approval, and may not in any case use such capital to repay RMB loans if they have not used the proceeds of such loans. Violations of Circular 142 can result in severe penalties, including heavy fines. Furthermore, SAFE promulgated a circular on November 19, 2010, or Circular No. 59, which tightens the regulation over settlement of net proceeds from overseas offerings like our initial public offering and requires that the settlement of net proceeds must be consistent with the description in the prospectus for the offering.

 

The dividends paid by a subsidiary to its overseas shareholders are deemed income to the shareholders and are taxable in China. Pursuant to the Administration Rules of the Settlement, Sale and Payment of Foreign Exchange (1996), foreign-invested enterprises in China may purchase or remit foreign currency, subject to a cap approved by SAFE, for settlement of current account transactions without the approval of SAFE. Foreign currency transactions under the capital account are still subject to limitations and require approvals from, or registration with, SAFE and other relevant PRC governmental authorities.

 

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Dividend Distribution

 

The principal regulations governing distributions of dividends of foreign holding companies include the Foreign-invested Enterprise Law (1986), as amended, and the Administrative Rules under the Foreign-invested Enterprise Law (2001).

 

Under these regulations, foreign-invested enterprises in China may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. In addition, foreign-invested enterprises in China are required to allocate at least 10% of their respective accumulated profits each year, if any, to fund certain reserve funds unless these reserves have reached 50% of the registered capital of the enterprises. These reserves are not distributable as cash dividends.

 

Circular 75

 

SAFE issued on October 21, 2005 Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Corporate Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles, or Circular 75, which became effective on November 1, 2005, pursuant to which (i) a PRC citizen residing in the PRC or non-PRC citizen primarily residing in the PRC due to his or her economic tie to the PRC, who is referred to as a “PRC resident” in this circular, must register with the local branch of the SAFE before it establishes or controls an overseas SPV, for the purpose of overseas equity financing; (ii) when a PRC resident contributes assets of or equity interests in a domestic enterprise into an overseas SPV, or engages in overseas financing after contributing assets or equity interests into a SPV, such PRC resident must register his or her interest in the SPV and the change thereof with the local branch of the SAFE; and (iii) when the SPV undergoes a material event outside of China not involving inbound investments, such as change in share capital, creation of any security interests on its assets or merger and division, the PRC resident shall, within 30 days from the occurrence of such event, register such change with the local branch of the SAFE. To further clarify the implementation of Circular 75, the SAFE issued several regulations. These regulations require PRC residents to register with local branches of SAFE in connection with their direct or indirect offshore investment activities and PRC subsidiaries are required to coordinate and supervise such filing and registration. These regulations apply to our shareholders who are PRC residents and may apply to any offshore acquisitions that we make in the future.

 

Under these foreign exchange regulations, PRC residents who make, or have previously made prior to the implementation of these foreign exchange regulations, direct or indirect investments in SPVs will be required to register those investments. In addition, any PRC resident who is a direct or indirect shareholder of an SPV is required to update the previously filed registration with the local branch of SAFE to reflect any material change. Moreover, the PRC subsidiaries of that SPV are required to urge the PRC resident shareholders to update their registration with the local branch of SAFE. If any PRC shareholder fails to make the required registration or update the previously filed registration, the PRC subsidiaries of that SPV may be prohibited from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to their SPV parent, and the SPV may also be prohibited from injecting additional capital into its PRC subsidiaries. Moreover, failure to comply with the various foreign exchange registration requirements described above could result in liabilities for such PRC subsidiaries under PRC laws for evasion of applicable foreign exchange restrictions. Furthermore, the responsible persons and other persons in such PRC subsidiaries who are held directly liable for the violations may be subject to administrative sanctions.

 

Failure to comply with the above SAFE rules may result in restrictions on the foreign exchange activities of the onshore company, including restricting its PRC subsidiaries’ ability to pay dividends to, or obtain foreign-denominated loans from, the offshore parent, or prevent the offshore parent from making distributions or paying dividends. PRC residents who control our company from time to time are required to register with SAFE in connection with their investments in us.

 

Circular 7

 

On December 25, 2006, the People’s Bank of China issued the Administrative Measures of Foreign Exchange Matters for Individuals, and SAFE issued implementation rules on January 5, 2007, both of which became effective on February 1, 2007. Under these regulations, all foreign exchange matters involved in employee stock ownership plans, stock option plans or related plans in which onshore individuals participate require the approval of SAFE or its authorized branch. On February 15, 2012, SAFE promulgated the Application Procedure of Foreign Exchange Administration for Domestic Individuals Participating in Employee Stock Ownership Plan or Stock Option Plan of Overseas-Listed Company, or Circular 7.

 

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Under Circular 7, PRC residents who participate in an employee stock option plan in an overseas publicly-listed company are required to register with SAFE or its local office and complete certain other procedures. A PRC agent, which could be the PRC subsidiary of such overseas publicly-listed company, is required to retain a financial institution with stock brokerage qualification at the listing place or a qualified institution to handle matters relating to the exercise or sale of share options. We and our PRC employees, directors and senior management who receive share options will be subject to these regulations when we are listed in the United States. Our 2006 employee share option scheme has been filed with and approved by SAFE.  However, if we or our PRC optionees fail to comply with these regulations or any of our future share incentive plans are not filed with or approved by SAFE, we or our PRC optionees may be subject to fines and other legal or administrative sanctions.

 

New M&A Regulations and Overseas Listings

 

On August 8, 2006, six PRC regulatory agencies, including the Ministry of Commerce, the State-owned Assets Supervision and Administration Commission, the State Administration of Taxation, the State Administration for Industry and Commerce, CSRC and SAFE, jointly issued the New M&A Rules, which became effective on September 8, 2006. The New M&A Rules require offshore special purpose vehicles controlled directly or indirectly by PRC companies or individuals and formed for the purpose of listing equity interests in PRC companies on overseas exchanges to obtain CSRC approval prior to such listing.

 

On September 21, 2006, the CSRC published procedures regarding its approval of overseas listings by special purpose vehicles. The CSRC approval procedures require filing documents with the CSRC and take several months to complete. The application of this new PRC regulation remains unclear, with no consensus currently existing among leading PRC law firms regarding the scope of the CSRC approval requirement.

 

PRC laws and regulations also require certain merger and acquisition transactions to be subject to merger control review or security review. On February 3, 2011, the General Office of the State Council issued the Notice on Establishing the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, which sets out the scope, content, work mechanism and procedures of the security review. The MOFCOM Security Review Rules, effective from September 1, 2011, which implement the aforementioned Notice, further provide that, when deciding whether a specific merger or acquisition of a domestic enterprise by foreign investors is subject to the security review by MOFCOM, the principle of substance over form should be applied and foreign investors are prohibited from bypassing the security review requirement by structuring transactions through proxies, trusts, indirect investments, leases, loans, control through contractual arrangements or offshore transactions.

 

Labor Laws

 

The principal labor laws and regulations in the PRC include the PRC Labor Law, the PRC Labor Contract Law, the Implementation Rules of the PRC Labor Contract Law, the Work-related Injury Insurance Regulations, the Interim Provisions on Registration of Social Insurance and the Interim Regulations on the Collection and Payment of Social Insurance Fees. Pursuant to the PRC Labor Law and the PRC Labor Contract Law, employers must enter into written labor contracts with full-time employees in order to establish an employment relationship.

 

Employers must pay their employees wages equal to or above local minimum wage standards, establish labor safety and workplace sanitation systems, comply with state labor rules and standards and provide employees with appropriate training regarding workplace safety. Violations of the PRC Labor Contract Law and the PRC Labor Law may result in fines or other administrative sanctions or, in the case of serious violations, criminal liability.

 

C.                                     Organizational Structure

 

The following chart illustrates our corporate structure, including our principal operating subsidiaries, consolidated affiliated entities and our ownership structure, as of the date of this annual report:

 

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The following table sets out the details of our subsidiaries:

 

Name		Country of Incorporation		Ownership Interest
Qizhi Software (Beijing) Co., Ltd.		China		100	%
Tianjin Qisi Technology Co., Ltd.		China		100	%
Qiji International Development Limited		Hong Kong		100	%
360 International Development Co. Limited		Hong Kong		100	%
Qifei International Development Co. Limited		Hong Kong		100	%

 

D.                                    Property, Plant and Equipment

 

Our principal executive offices are located at Block 1, Area D, Huitong Times Plaza, No. 71 Jianguo Road, Chaoyang District, Beijing, China.  We lease approximately 30,000 square meters of office space in Beijing and other cities in China.

 

Item 4A.                                                  UNRESOLVED STAFF COMMENTS

 

None.

 

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Item 5.                                                           OPERATING AND FINANCIAL REVIEW AND PROSPECTS

 

The following discussion of our financial condition and results of operations is based upon and should be read in conjunction with our consolidated financial statements and their related notes included in this annual report. This report contains forward-looking statements. See “— F. Safe Harbor.” In evaluating our business, you should carefully consider the information provided under the caption “Item 3. Key Information — D. Risk Factors” in this annual report. We caution you that our businesses and financial performance are subject to substantial risks and uncertainties.

 

A.                                   Operating Results

 

Overview

 

We are the No. 2 Internet company in China as measured by user base. In December 2011, we had 402 million monthly active users of our products, representing a user penetration rate among all Chinese Internet users of 93.8% in China, according to iResearch.

 

We are also the No. 1 provider of Internet and mobile security products in China as measured by user base, according to iReseach. In December 2011, we had 395 million monthly active Internet security product users, representing a user penetration rate of 92.1% in China, according to iResearch. We offer all of our Internet and mobile security products free of charge and generate revenue primarily through offering the following services:

 

·              Online advertising.  We offer advertising services by providing marketing opportunities on 360 Personal Start-up Page and other platform products to our advertising customers. We also offer search referral services to search engine companies.

 

·              Internet value-added services.  We offer web games developed by third parties, provide remote technical support and other Internet value-added services to users.

 

·          Other services.  On an ad-hoc project basis, we also offer IT outsourcing and systems integration services to enterprise customers. This is not our core business and its contribution to our revenues is insignificant.

 

In addition, we also generate revenue through selling anti-virus software developed by third parties. We significantly decreased our sales of third-party anti-virus software since the fourth quarter of 2009, as we began to offer 360 Anti-Virus to users free of charge. We expect our revenues from sales of third-party anti-virus software to continue to decrease.

 

We charge customers advertising fees for providing links to their websites or online applications on our 360 Personal Start-up Page and other platform products. We charge fees to our customers on a fixed, cost-per-sale or cost-per-action basis.  These fees are determined based on the effectiveness of our advertising links, which is typically measured by active users, clicks and transactions directed from our platforms.  Our 360 browsers and their default home page, 360 Personal Start-up Page, also contain default search boxes that direct search traffic to search engines such as Google. These search engine companies pay us a pre-determined fee for each search originated from 360 browsers and 360 Personal Start-up Page.

 

We offer web games developed by third parties under revenue sharing arrangements with the game developers.

 

We have grown significantly since we commenced operations in 2005. Monthly active users of our products increased from 290 million in December 2010 to 402 million in December 2011. Our revenue increased from $32.3 million in 2009 to $57.7 million in 2010 and $167.9 million in 2011. We first became profitable in 2009. Our net income increased from $4.2 million in 2009 to $8.5 million in 2010 and $14.5 million in 2011.

 

The most significant factors that affect the financial performance and results of operations of our business are:

 

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·                  User base;

 

·                  Pricing and revenue sharing;

 

·                  Revenue mix; and

 

·                  Product development.

 

User base

 

Our success in generating revenue, especially from our online advertising and Internet value-added services, largely depends on our ability to maintain and increase the number of users of our products and services. The size of our user base drives the online traffic or transactions originated from our platform products for which we get paid by our online advertising customers. The number of users using our platform products also represents the size of the addressable market for our Internet value-added services and the potential for generating additional sources of revenues. In order to attract and retain users, we must continue to invest significant resources to provide comprehensive and effective products and services.

 

Pricing and revenue sharing

 

We charge fees to our customers on a fixed, cost-per-sale or cost-per-action basis.  These fees are determined based on the effectiveness of our advertising links, which is typically measured by active users, clicks and transactions directed from our platforms. We charge search engines a pre-determined fee for each search originated from our websites and platform products. In both cases, we have been able to increase our fee rates as our advertising platform becomes more effective as measured by the increase in Internet traffic or transactions that we are able to originate. However, our ability to increase fee rates is limited by the competitive landscape and subject to acceptance by our customers. As our web games and software sales business are based on revenue sharing arrangements with third-party developers, our revenue depends in part on our percentage share of the revenues we generate.

 

Revenue mix

 

Our revenues and costs of revenues are affected by changes in our revenue mix. In 2008 and 2009, we generated a substantial portion of our revenues from sales of third-party anti-virus software. In the second half of 2009, we started offering 360 Anti-Virus to users free of charge as we adopted the business model of offering free Internet and mobile security products to build up a large and loyal user base and generating revenues through providing Internet services, including online advertising and Internet value-added services. In the fourth quarter of 2009, we significantly decreased sales of third-party anti-virus software and focused on providing Internet services. As a result, revenues from sales of third-party anti-virus software as a percentage of total revenues decreased from 50.4% in 2009 to 6.7% in 2010, and to 0.5% in 2011. Meanwhile, revenues from online advertising increased from 43.1% in 2009 to 67.3% in 2010 and 73.3% in 2011, and revenues from Internet value-added services increased from 6.4% in 2009 to 25.7% in 2010 and 26.0% in 2011. As we further expand our business, our revenue mix may continue to change, which may affect our results of operations for future periods.

 

Product development

 

In order to attract and retain users, we have invested significant resources in developing security products, cloud-based services, mobile Internet products and other Internet products and services so as to develop and strengthen our products and services and enhance user experience. In 2009, 2010 and 2011, our product development expenses were $10.7 million, $24.5 million and $65.0 million, respectively, representing 33.0%, 42.5% and 38.7% of our revenues in the corresponding periods. We expect our product development expenses to continue to increase as we endeavor to develop attractive products and services that enable users to enjoy a more secure and a higher quality Internet experience.

 

Overview of Financial Results

 

We evaluate our business using a variety of key financial measures.

 

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Revenues

 

Our revenues increased by 78.5% from $32.3 million in 2009 to $57.7 million in 2010, and by 191.1% from $57.7 million in 2010 to $167.9 million in 2011. The following table sets forth our revenues by source both in absolute amounts and as percentages of total revenues for the periods indicated:

 

		Year Ended December 31,
		2009		%		2010		%		2011		%
		($ in thousands, except percentages)
Revenues:
Internet services		16,010		49.6		53,790		93.3		166,961		99.5
Online advertising		13,928		43.1		38,826		67.3		123,048		73.3
Internet value-added services		2,050		6.4		14,774		25.7		43,567		26.0
Other services		32		0.1		190		0.3		346		0.2
Sales of third-party anti-virus software		16,292		50.4		3,875		6.7		890		0.5
		32,302		100.0		57,665		100.0		167,851		100

 

Revenues from Internet Services.

 

Our revenues from Internet services comprise revenues from online advertising, revenues from Internet value-added services and revenues from other services.

 

Online Advertising.  Customers of our online advertising business primarily consist of third-party websites who place links on our platform products (such as 360 Personal Start-up Page) and search engines that pay us fees for generating search traffic from platform products.

 

We charge fees to our customers on a fixed, cost-per-sale or cost-per-action basis.  These fees are determined based on the effectiveness of our advertising links, which is typically measured by active users, clicks and transactions directed from our platforms.

 

For search engines, we charge a pre-determined fee for each search query that we originate, up to a pre-determined limit in certain cases. Our fee may be renegotiated if the number of referred searches exceeds the agreed limit. Our agreements with the search engines usually have a term of one year and are renewable upon both parties’ written agreement.

 

Internet Value-added Services.  Our Internet value-added services include offering web games developed by third parties, providing remote technical support and other Internet value-added services to users.

 

We select and offer popular web games developed by third-party game developers on our game platform. Our game portfolio includes role-playing, strategy, sports and simulation games. Users can play these games directly on our game platform without downloading separate software. We offered over 70 games, with a combined registered player base of over 30 million as of December 31, 2011. We share revenues from game operations with game developers according to the terms of our cooperation agreements.

 

Other Services

 

We also generate an insignificant amount of revenue from other ad-hoc services, such as IT outsourcing and system integration services to enterprise customers.

 

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Revenues from Sales of Third-party Anti-virus Software

 

We purchase software from third-party anti-virus software developers for online resale to users.

 

Cost of Revenues and Operating Expenses

 

The following table sets forth the cost of revenues and operating expenses, both in absolute amounts and as percentages of total revenues for the periods indicated:

 

		Year Ended December 31,
		2009		%		2010		%		2011		%
		($ in thousands, except percentages)
Revenues:		32,302		100.0		57,665		100.0		167,851		100.0
Cost of revenues:
Internet services		1,790		5.5		5,566		9.7		18,680		11.2
Sales of third-party anti-virus software		6,600		20.5		1,185		2.0		238		0.1
Total cost of revenues		8,390		26.0		6,751		11.7		18,918		11.3
Operating expenses
Selling and marketing		6,256		19.4		12,603		21.8		46,836		27.9
General and administrative		2,531		7.8		5,051		8.8		19,054		11.4
Product development		10,664		33.0		24,505		42.5		65,049		38.7
Total operating expenses		19,451		60.2		42,159		73.1		130,939		78.0

 

Cost of Revenues

 

Cost of revenues consists of cost of Internet services and cost of sales of third-party anti-virus software.

 

Cost of Internet services primarily consist of business tax and surcharges, payment collection costs, costs of bandwidth and utilities, depreciation of equipment and other costs. Our Internet services are subject to PRC business tax and related surcharges on our revenue. We expect our business tax and surcharges will continue to increase in line with increases in our revenues. Payment collection costs in connection with Internet services represent the fees that we pay to providers of mobile payment and online banking services for processing payments from our users. Other costs incurred in connection with Internet services primarily comprise salaries and benefits for service operation personnel and authorization fees for the operation of third-party games.

 

Cost of sales of third-party anti-virus software primarily consists of value added tax surcharges, payment collection costs and cost of purchasing third-party anti-virus software. Payment collection costs in connection with sales of third-party anti-virus software represent the fees that we pay to providers of mobile payment and online banking services for processing payments from software purchasers. We also incur costs of purchasing third-party anti-virus software that we resell.

 

Operating Expenses

 

Our selling and marketing expenses primarily consist of salaries and benefits, including share-based compensation expenses, for our sales and marketing personnel and advertising and promotion expenses. We expect to incur higher selling and marketing expenses as we intensify our efforts to build our brand and promote our products and services.

 

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Our general and administrative expenses primarily consist of salaries and benefits, including share-based compensation expenses, for our administrative personnel and fees that we pay to legal, accounting and other professional service providers. We expect to incur higher general and administrative expenses as we expand our operations.

 

Our product development expenses relate to the research, development and strengthening of our security products, cloud-based services, mobile Internet products and other Internet products and service. Our product development expenses primarily consist of salaries and benefits, including share-based compensation expenses, of our product development personnel, costs of bandwidth and utilities, license and technical service fees, depreciation of equipment and amortization of acquired intangible assets. We expect product development expenses to continue to increase as we continue to develop and enhance products and develop technologies related to the Internet, such as browser and mobile Internet technologies.

 

The table below shows the effect of the share-based compensation expenses on our operating expense line items for the periods indicated:

 

		Year Ended December 31,
		2009		2010		2011
		($ in thousands)
Share-based compensation expenses included in:
Cost of revenues		—		—		16
Selling and marketing		479		524		31,455
General and administrative		151		337		4,549
Product development		1,294		3,145		11,969
Total		1,924		4,006		47,989

 

We expect to continue to grant share options and nonvested shares under our share incentive plans and incur further share-based compensation expenses in future periods.

 

Acquisitions

 

In September 2009, we acquired the Internet business derived from The World Browser from Beijing Shengjing Wanwei Technology Co., Ltd., or Shengjing Wanwei, a China-based software developer, for $2.2 million in cash and 2,125,176 of our ordinary shares. We also granted nonvested shares to certain key employees of Shengjing Wanwei to retain their services.  In 2011, we made a total of $15.9 million in investments in small to middle sized Internet companies whose businesses complement our business.

 

Critical Accounting Policies

 

The preparation of our consolidated financial statements and related notes requires us to make judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, net sales and expenses, and related disclosure of contingent assets and liabilities. We have based our estimates on historical experience and various other assumptions that we believe 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. Our management has discussed the development, selection and disclosure of these estimates with our board of directors. Actual results may differ from these estimates under different assumptions or conditions.

 

An accounting policy is considered to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the consolidated financial statements.

 

We believe that the following critical accounting policies are the most sensitive and require more significant estimates and assumptions used in the preparation of our consolidated financial statements. You

 

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should read the following descriptions of critical accounting policies, judgments and estimates in conjunction with our consolidated financial statements and other disclosures included in this annual report.

 

Revenue Recognition

 

We generate revenue primarily through providing Internet services, consisting primarily of online advertising and Internet value-added services, and sales of third-party anti-virus software.

 

We consider revenue to be realizable and earned when all of the following criteria exist:

 

·                                          persuasive evidence of a sales arrangement exists;

 

·                                          delivery has occurred or services have been rendered;

 

·                                          the price is fixed or determinable; and

 

·                                          collectability is reasonably assured.

 

Internet Services

 

Internet services revenue includes online advertising, Internet value-added services and other services.

 

Online Advertising

 

We provide links to third-party websites or online applications on our platform products. We charge fees to our customers on a fixed, cost-per-sale or cost-per-action basis.  These fees are determined based on the effectiveness of our advertising links, which is typically measured by active users, clicks and transactions directed from our platforms. For the fixed-fee advertising contracts, we recognize revenue ratably over the period the advertising is provided. For contracts that are charged on a cost-per-sale or cost-per-action basis, the revenue is estimated based on our internal data, which is subsequently confirmed with our customers.

 

We also direct search traffic to search engines such as Google through our default search boxes on our 360 browsers and their default home page, 360 Personal Start-up Page. We receive a pre-determined fee from search engine companies based on the number of searches originated from our 360 browsers and 360 Personal Start-up Page, subject to a pre-determined limit. Our fees may be renegotiated if the number of referred searches exceeds the agreed limit. We estimate the revenue based on our monthly traffic data, which is subsequently confirmed with our search engine customers.

 

We occasionally engage in nonmonetary transactions to allow certain third parties to bundle our security products with their software products, or to grant third parties the right to provide links to our products on their websites in exchange for more downloads of our products. We recognize revenues and expenses at fair value from a nonmonetary transaction only if the fair value of the services exchanged in the transaction is determinable based on the entity’s own historical practice of receiving cash, marketable securities, or other consideration that is readily convertible to a known amount of cash for similar services from customers unrelated to the counterparty in the nonmonetary transaction. For the years ended December 31, 2009 and 2010, we engaged in certain nonmonetary transactions for which the fair value was not determinable and therefore no revenues or expenses derived from these nonmonetary transactions were recognized. In 2011, we engaged in one nonmonetary transaction for which the fair value was determinable. Other than this transaction, we engaged in nonmonetary transactions for which the fair value was not determinable and therefore no revenues or expenses derived from these nonmonetary transactions were recognized.

 

Internet Value-added Services

 

Our Internet value-added services include offering web games developed by third parties and providing remote technical support and other Internet value-added services to our users.

 

Web Games. We provide web game services and generate revenue from selling in-game currency online which will later be used by game players to purchase virtual items in web games. All of the web games are developed by third-party game developers and can be accessed and played by game players on our platforms

 

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without downloading separate software. We primarily view the game developers to be our customers and consider our responsibility under our agreements with the game developers to be promotion of the game developers’ games. We collect payments from game players in connection with the sale of in-game currencies and remit certain agreed-upon percentages of the proceeds to the game developers. Net revenue from the sale of in-game currencies is deferred until the estimated consumption date, (i.e. the estimated date that virtual items are sold within the game), which is typically within a short period of time after purchase of the in-game currency. Purchases of in-game currencies are not refundable after they have been sold unless there is unused in-game currency at the time a game is discontinued. Typically, a game will only be discontinued when the monthly revenue generated by a game is insignificant. To date, we have never been required to pay cash refunds to game players or game developers as a result of the discontinuation of a game or for any other reason.

 

Web game revenue recognition involves certain management judgments, such as determination of who is the principal in providing web game services to our users and estimating the consumption date of in-game currencies. We concluded that game developers are the principals based on the fact that the games are primarily hosted on the game developers’ servers and such developers are responsible for the maintenance of the games and determination of the prices of the virtual items used in the games. Therefore, we report such revenue on a net basis. In addition, we estimate the in-game currency consumption date based on the consumption behavior of the game players for each reporting period. The amount and timing of our web game revenues could be materially different for any period if management made different judgments or utilized different estimates.

 

Sales of Third-party Anti-virus Software

 

We purchase software from third-party software developers for online resale to users. We recognize revenue when the activation code of the software is delivered. We evaluate our software sale contracts to determine whether to recognize the revenues on a gross basis or net of costs of obtaining the associated software. The determination is based upon an assessment as to whether we act as a principal or agent when providing the sales. Most of the software revenues are accounted for on a gross basis since we act as a principal in the sales.

 

Goodwill and Intangible Assets with Indefinite Lives

 

Goodwill represents the cost of an acquired business in excess of the fair value of identifiable tangible and intangible net assets purchased. We generally seek the assistance of independent valuation firm in determining the fair value of the identifiable tangible and intangible net assets of the acquired business.

 

There are several methods that can be used to determine the fair value of assets acquired and liabilities assumed. For intangible assets, we typically use the income method. This method starts with a forecast of all of the expected future net cash flows associated with a particular intangible asset. These cash flows are then adjusted to present value by applying an appropriate discount rate that reflects the risk factors associated with the cash flow streams. Some of the more significant estimates and assumptions inherent in the income method or other methods include the amount and timing of projected future cash flows, the discount rate selected to measure the risks inherent in the future cash flows and the assessment of the asset’s economic life cycle and the competitive trends impacting the asset, including consideration of any technical, legal, regulatory or economic barriers to entry. Determining the useful life of an intangible asset also requires judgment, as different types of intangible assets will have different useful lives and certain assets may even be considered to have indefinite useful lives.

 

Goodwill is tested for impairment at the latest on December 31 of each year. Impairment is tested using a two-step process. The first step compares the fair value of each reporting unit to its carrying amount, including goodwill. We currently have one reporting unit.

 

If the fair value of each reporting unit exceeds its carrying amount, goodwill is not considered to be impaired and the second step will not be required. If the carrying amount of a reporting unit exceeds its fair value, the second step compares the implied fair value of goodwill to the carrying value of a reporting unit’s goodwill. The implied fair value of goodwill is determined in a manner similar to accounting for a business combination with the allocation of the assessed fair value determined in the first step to the assets and liabilities of the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to the assets and liabilities is the implied fair value of goodwill. An impairment loss is recognized for any excess in the carrying value of goodwill over the implied fair value of goodwill. Estimating fair value is performed by utilizing various valuation techniques, with the primary technique being the discounted cash flow method.

 

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As of December 31, 2009, 2010 and 2011, our fair value was substantially in excess of our carrying value. We did not realize any impairment loss on goodwill during the years ended December 31, 2009, 2010 and 2011.

 

An intangible asset that is not subject to amortization is tested for impairment at least annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Such impairment test consists of the fair values of assets with their carrying value amounts and an impairment loss is recognized if and when the carrying amounts exceed the fair values. The estimates of fair values of intangible assets not subject to amortization are determined using various discounted cash flow valuation methodologies. Significant assumptions are inherent in this process, including estimates of discount rates and market price. Discount rate assumptions are based on an assessment of the risk inherent in the respective intangible assets. Market prices are based on potential purchase quotes from third party.

 

Our management performs impairment assessment on intangible assets with indefinite lives on December 31 of each year or when events or changes in circumstances indicate that the assets might be impaired. Our management used the discounted cash flow method to estimate the fair value of intangible assets with indefinite lives. During the years ended December 31, 2009, 2010 and 2011, we recognized an impairment loss of $256,000, nil and nil, respectively, on our intangible assets with indefinite lives, due to the declining marketability and fair value of the intangible assets.

 

Intangible Assets with Definite Lives

 

We generally seek the assistance of an independent valuation firm to determine the fair value of the identifiable tangible and intangible net assets of an acquired business.

 

We can use several methods to determine the fair value of assets acquired and liabilities assumed. For intangible assets, we typically use the income method. This method starts with a forecast of the expected future net cash flows. We then discount these cash flows to present value by applying an appropriate discount rate that reflects the risk factors associated with the cash flow streams.

 

Estimates and assumptions used in the income method or other methods include the amount and timing of projected future cash flows, the discount rate selected to measure the risks of future cash flows, the asset’s life cycle and the competitive trends impacting the asset, including any technical, legal, regulatory or economic barriers to entry. Determining the useful life of an intangible asset also requires judgment, as different types of intangible assets have different useful lives.

 

We amortize intangible assets with determinable useful lives on a straight-line basis.

 

We evaluate intangible assets with determinable useful lives for recoverability whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. We measure recoverability of long-lived assets to be held and used as part of a cash generating unit by comparing the carrying amount of an asset to the future undiscounted net cash flows expected to be generated by the asset. If we believe the assets are impaired, the impairment will equal the amount by which the carrying value of the assets exceeds the fair value of the assets.

 

Estimates of fair value involve a complex series of judgments about future events and uncertainties and rely heavily on estimates and assumptions. Our judgments in determining an estimate of fair value can materially impact our results of operations. We base these valuations on information available as of the impairment review date and on expectations and assumptions that management deems reasonable. Any changes in key assumptions, including unanticipated events and circumstances, may affect the accuracy or validity of such estimates and could potentially result in impairment charges. During the years ended December 31, 2009, 2010 and 2011, we recognized nil, nil and $87,000 of impairment losses, respectively, on our intangible assets with definite lives.

 

Legal and Other Contingencies

 

The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be

 

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reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued, we evaluate, among other factors, the probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial statements.

 

Based on the information currently available, we were unable to make a reasonable estimate of any liability because of the uncertainty related to the outcome and the amount or range of loss. Accordingly, we did not accrue any provision for these contingencies as of December 31, 2009, 2010 and 2011.

 

Income Taxes

 

In preparing our consolidated financial statements, we must estimate our income taxes in each of the jurisdictions in which we operate. We estimate our actual tax exposure and assess temporary differences resulting from different treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which we include in our consolidated balance sheets. We must then assess the likelihood that we will recover our deferred tax assets from future taxable income. If we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance, we must include an expense within the tax provision in our statement of operations.

 

Management must exercise significant judgment to determine our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We base the valuation allowance on our estimates of taxable income in each jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. If actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance, which could materially impact our financial position and results of operations.

 

U.S. GAAP requires that the impact of an uncertain income tax position on the income tax return is recognized at the largest amount that is more likely than not to be sustained upon audit by the relevant tax authority. If we ultimately determine that the payment of these liabilities will be unnecessary, we reverse the liability and recognize a tax benefit during that period. Conversely, we record additional tax charges in a period in which we determine that a recorded tax liability is less than we expect the ultimate assessment to be. We did not recognize any significant unrecognized tax benefits during the periods presented in this annual report.

 

On April 21, 2010, the State Administration of Taxation issued Circular 157 Further Clarification on Implementation of Preferential EIT Rate during Transition Periods (Circular 157). Circular 157 seeks to provide additional guidance on the interaction of certain preferential tax rates under the transitional rules of the Enterprise Income Tax Law, or the New EIT Law. Prior to Circular 157, we interpreted the law to mean that if a high and new technology enterprise was in a tax holiday period, including “2-year exemption plus 3-year half rate”, “5-year exemption plus 5-year half rate” and other tax exemptions and reductions, where it was entitled to a 50% reduction in the tax rate and was also entitled to a 15% rate of tax due to high and new technology enterprise status under the New EIT Law, then it was entitled to pay tax at the rate of 7.5%. Circular 157 appears to have the effect that such an entity is entitled to pay tax at either the lower of 15% or 50% of the standard PRC tax rate (i.e. currently 25%). Circular 157 is unclear as to whether its effect is retrospective, but our understanding is that the State Administration of Taxation has recently taken the position that the Circular applies only to tax years commencing from January 1, 2010.  However, Qizhi Software confirmed with the relevant local tax district that entities that qualify for “three-year exemption and three-year half rate” tax holiday as HNTEs and which is registered in Experimental Area for Developing New-Technology Industries of Beijing, notwithstanding Circular 157, can still be subject to 7.5% EIT for the year ended December 31, 2010. As a consequence, Qizhi Software was entitled to a tax rate of 7.5% in 2010. Qizhi Software received a renewal of its “high and new technology enterprises” status in October 2011 and was entitled to a reduced EIT rate of 15% for 2011.

 

Uncertainties exist with respect to the application of the New EIT Law to our operations, specifically with respect to our tax residency status. The New EIT Law specifies that legal entities organized outside of the PRC will be considered residents for PRC income tax purposes if their “de facto management bodies” are located within the PRC. The New EIT Law’s implementation rules define the term “de facto management bodies” as “establishments that carry out substantial and overall management and control over the manufacturing and business operations, personnel, accounting, properties, etc. of an enterprise.”

 

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Because of the uncertainties resulted from limited PRC tax guidance on the issue, it is uncertain whether our legal entities organized outside of the PRC constitute residents under the New EIT Law. If one or more of our legal entities organized outside of the PRC were characterized as PRC tax residents, the impact would adversely affect our results of operations. See “Item 3. Key Information — D. Risk Factors — Risk Related to Doing Business in China — Dividends we receive from our PRC subsidiaries, dividends payable by us to our foreign investors and gain on the sale of our shares may become subject to PRC withholding taxes under PRC tax laws.”

 

Fair value of our common shares

 

Before our initial public offering in April 2011, we were a private company with no quoted market prices for our ordinary shares. We therefore needed to make estimates of the fair value of our ordinary shares at various dates for the purpose of:

 

·                  determining the fair value of our shares at the date of acquisition when we have acquired another entity and the consideration given includes our ordinary shares and nonvested shares.

 

·                  determining the fair value of our ordinary shares at the date of the grant of a stock based compensation award to our employees and non-employees as one of the inputs into determining the grant date fair value of the award.

 

·                  determining the fair value of our ordinary dates at the date of issuance of convertible instruments in the determination of the intrinsic value of the beneficial conversion feature, if any.

 

The following table sets forth the fair value of our ordinary share estimated since January 1, 2009.

 

Date		Class of Shares		Fair Value		Purpose of Valuation		DLOM		Discount Rate
June 30, 2009		Ordinary Shares		US$1.09		Grant of share options		34	%	24	%
September 30, 2009		Ordinary Shares		US$1.50		Issuance of ordinary shares for the acquisition of The World Browser		32	%	21	%
October 29, 2009		Ordinary Shares		US$1.53		Issuance of ordinary shares in connection with an acquisition		32	%	21	%
December 10, 2009		Ordinary Shares		US$1.60		Issuance of ordinary shares in connection with an acquisition		30	%	21	%
January 8, 2010		Ordinary Shares		US$1.86		Issuance of Series C preferred shares		29	%	20	%
June 30, 2010		Ordinary Shares		US$2.58		Grant of share options		16	%	20	%
January 1, 2011		Ordinary Shares		US$5.01		Grant of share options and nonvested shares		8	%	18	%

 

In determining the fair value of our ordinary shares in each of the grant date, we relied in part on a valuation report retrospectively prepared by an independent valuer based on data we provided. The valuation report provided us with guidelines in determining the fair value, but the determination was made by our management. We obtained a retrospective valuation instead of a contemporaneous valuation by an unrelated valuation specialist because, before January 2011, our financial and limited human resources were principally focused on our new product development efforts. We applied the income approach/ discounted cash flow, or DCF, analysis based on our projected cash flow using management’s best estimate as of the valuation date. The determination of the fair value of our ordinary shares requires complex and subjective judgments to be made regarding our projected financial and operating results, our unique business risks, the liquidity of our shares and our operating history and prospects at the time of valuation.

 

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

 

Weighted average cost of capital, or WACC:

 

The following table sets forth the WACC on each date indicated:

 

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Date		WACC
June 30, 2009		24	%
September 30, 2009		21	%
October 29, 2009		21	%
December 10, 2009		21	%
January 8, 2010		20	%
June 30, 2010		20	%
January 1, 2011		18	%

 

The WACCs were determined based on a consideration of the factors including risk-free rate, comparative industry risk, equity risk premium, company size and non systematic risk factors. The decrease in WACCs from March 2008 to January 2011 was due to the combined results of the following factors:

 

·                  The continuous growth of our business and company size. As our size increased, small company risk premium, which is a component of our WACC, decreased from 5.81% as of March 2008 to 4.5% as of January 2011.

 

·                  A longer track record for forecasting. According to the guideline prescribed by the AICPA Audit and Accounting Practice Aid, “Valuation of Privately Held Company Equity Securities Issued as Compensation,” or the Practice Aid, when an enterprise has established a solid financial history, the reliability of forecasted results is generally higher than those made at an earlier stage, and therefore the perceived risks of investing in the enterprise are generally lower than in an earlier stage. Therefore, the estimated WACC, which reflects the perceived risks of and a market participant’s expected rate of return for investing in our securities, also declined gradually from March 2008 to January 2011 as our company progressed through the earlier stages of development.

 

·                  Completion of the acquisition of realization of synergistic effects through the acquisitions of The World Browser, and two other businesses in 2009. The acquisitions strengthened our technology and security service capabilities, expanded our service offerings and hence lowered the uncertainties associated with achieving our business plan and financial forecast.

 

·                  Additional financing obtained through the issuance of preferred shares. We issued our Series C preferred shares in January 2010. This financing not only improved our capital resources, but also indicated that the uncertainty and risk perceived by investors in our business plan and our company were further reduced.

 

Comparable companies: In deriving the WACCs, which are used as the discount rates under the income approach, five publicly traded companies in China Internet and security software industry were selected for reference as our guideline companies.

 

Discount for lack of marketability, or DLOM: DLOM was quantified by the Black-Scholes option pricing model. Under this option-pricing method, the cost of the put option, which can hedge the price change before the privately held shares can be sold, was considered as a basis to determine the DLOM. This option pricing method is one of the methods commonly used in estimating DLOM as it can take into consideration factors like timing of a liquidity event (e.g., an IPO) and estimated volatility of our shares. The further the valuation date is from an expected liquidity event, the higher the put option value and thus, the higher the implied DLOM. DLOMs of range from 8% to 34% were used in our valuations between March 31, 2008 and January 1, 2011. The lower DLOM is used for the valuation, the higher is the determined fair value of the ordinary shares. Because of the proximity of the expected time of the offering, DLOM decreased from 34% for the valuation as of March 31, 2008 to 8% for the valuation as of January 1, 2011.

 

The income approach involves applying appropriate discount rates to estimated cash flows that are based on earnings forecasts. Our revenues and earnings growth rates, as well as major milestones that we have achieved, contributed significantly to the increase in the fair value of our ordinary shares from 2008 to January 2011. However, these fair values are inherently uncertain and highly subjective. The assumptions used in deriving the fair values are consistent with our business plan. These assumptions include: no material changes in the existing political, legal and economic conditions in China; our ability to retain competent management, key personnel and staff to support our ongoing operations; and no material deviation in market conditions from

 

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economic forecasts. These assumptions are inherently uncertain. The risk associated with achieving our forecasts were assessed in selecting the appropriate discount rates, which ranged from 18% to 28%.

 

The option-pricing method was used to allocate enterprise value to preferred and ordinary shares, taking into account the guidance prescribed by the AICPA Audit and Accounting Practice Aid, “Valuation of Privately-Held Company Equity Securities Issued as Compensation,” or the Practice Aid. The method treats common stock and preferred stock as call options on the enterprise’s value, with exercise prices based on the liquidation preference of the preferred stock.

 

The option-pricing method involves making estimates of the anticipated timing of a potential liquidity event, such as a sale of our company or an initial public offering, and estimates of the volatility of our equity securities. The anticipated timing is based on the plans of our board of directors and management. Estimating the volatility of the share price of a privately held company is complex because there is no readily available market for the shares. We estimated the volatility of our shares to range from 40% to 70% based on the historical volatilities of comparable publicly traded companies engaged in similar lines of business. Had we used different estimates of volatility, the allocations between preferred and ordinary shares would have been different.

 

Since our initial public offering in April 2011, the determination of the fair value of the ordinary shares is based on the market price of our ADSs, every two of which represents three ordinary shares, traded on the New York Stock Exchange.

 

Share-based Compensation

 

Our share-based payment transactions are measured based on the grant date fair value of the equity instrument we issued and recognized as compensation expense over the requisite service period, with a corresponding impact reflected in additional paid-in capital.

 

At the time of the grants, the exercise prices for options granted under our 2006 Employee Share Option Scheme were determined by CEO with inputs by management based on various objective and subjective factors, and the exercise prices for options granted under our 2011 Share Incentive Plan were determined by our compensation committee.

 

The fair values of our option awards were estimated on the date of grant using the Black-Scholes and binomial option pricing model using the following assumptions:

 

		2009		2010		2011
Weighted average risk-free interest rate		3.96	%	3.31% - 3.73%		2.74% - 3.88%
Weighted average expected term (number of years)		5.20		5.15 - 5.30		5.40 - 6.35
Weighted average expected volatility		64.87	%	62.7% - 63.64%		43.10% - 57.70%
Weighted average expected dividend yield		—		—		—

 

The risk-free rate for periods within the expected life of the option is based on the implied yield rates of U.S. dollar denominated bond issued by the Chinese government as of the valuation dates. The expected life of options represents the period of time the granted options are expected to be outstanding. As we did not grant options prior to June 2009 and no options have been exercised, no sufficient historical exercising pattern could be followed in estimating the expected life. Therefore, the expected life is estimated based on a consideration of factors including contractual term, vesting period and empirical study on early exercise behavior of employee share options. Our employees who received our stocks options are assumed to exhibit similar behavior. As we expected to grow our business with internally generated cash, we did not expect to pay dividends in the foreseeable future.

 

Before closing of our initial public offering, the estimated fair value of the ordinary shares underlying our options as of the respective grant dates was determined based on a retrospective valuation.  When estimating the fair value of the ordinary shares on the grant dates, our management has considered a number of

 

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