Archives: JV

Not sure why joint ventures seem to go in waves, but our China lawyers have been getting more than usual lately. I suspect it has something to do with increased flexibility on the Chinese side as a reaction to recent fears regarding China’s economy.

In any event, our recent joint venture work has gotten me to thinking about what it takes for a China joint venture to succeed. Based on both our own observations and also on what we hear from others, we view the following four things as key to achieving a China joint venture that works.

1. Make ownership and control clear. Make ownership and control of the joint venture explicit from the very start. Most managers of Chinese companies see the joint venture company as their own property. They are not sensitive to issues of control that arise from percentage ownership interests. It is important to insist that the Chinese side recognize and formally agree to any structure that will result in the foreign partner to a joint venture exercising control over the venture, particularly of day-to-day operations. The foreign party should never assume the Chinese side understands the implications of a joint venture arrangement that flows entirely from purely technical legal rules. If the Chinese side feels it has been tricked or duped into signing away its rights, it will likely take action to “correct” the situation.

2. Do not expect a 51% ownership interest in a joint venture to provide effective control. 51/49 joint ventures are generally a mistake in China. The Chinese see 51/49 joint ventures as fundamentally no different than a 50/50 joint venture and they tend to view legal control afforded by 51% ownership as unfair. As a result, in ventures between Chinese participants where one side clearly intends to exercise control over the venture, a 60/40 or a 70/30 ownership structure is typically used.

Foreign investors that use a 51/49 joint venture structure should not count on their control of the board of directors as giving them control over the joint venture company because the board actually exerts very little control over the operations of the company. The managing director/representative director and the general manager of the company have the actual power to dictate the operations of the company and can act — and usually do — with little or no supervision from the board of directors. Therefore, if the foreign party intends to exercise actual control, it must structure the joint venture so it has the power to control and appoint both the managing director and the general manager of the joint venture company. These persons must be directly responsible to the foreign partner and not to the Chinese partner. If it is not possible to exercise direct control over these positions, then control over the board of directors is of little or no benefit to the foreign partner.

3. Do not proceed with a joint venture formed on a weak or uncertain legal basis. It is very common to find business arrangements in China that are of questionable legality under Chinese law. Going forward with a joint venture in the face of potential illegality may mean that the foreign party cannot enforce its rights in the joint venture because the Chinese courts will not enforce the terms of an illegal joint venture. Because of this, it is a standard strategy for the Chinese side to convince the foreign side to go forward with such questionable ventures. For the Chinese side, there is little or no risk. If the venture fails, the Chinese side has the advantage of having received funds from the foreign venture. If the venture succeeds, the Chinese side simply takes over. If your China attorney is telling you that your joint venture is illegal and your putative joint venture partner is urging you to go ahead anyway, listen to your attorney.

4. The foreign party must actively supervise or participate in the day-today management of the joint venture. If you are not actively involved in the operations of your China joint venture, the Chinese side will likely begin to feel as though it is doing all the work with the reward going to absentee owners. This produces resentment and the desire to take action to restore the “fairness” of the arrangement. Also, when not actively supervised, the Chinese side of the JV will frequently manipulate the JV for its own benefit. Active participation in the management of the joint venture and effective supervision of senior management can prevent such issues from arising. Active day-to-day participation in the management of the joint venture company by at least one senior manager appointed and controlled by the foreign partner is usually required.

No guarantees of success if you do the above, but an almost certain guarantee of failure if you don’t.

As regular readers know, both my co-blogger (Steve Dickinson) and I have written extensively on China Joint Ventures, both here and elsewhere. This is because we find them fascinating, mostly because they are so difficult to make work. Here are some of our previous writings on joint ventures in China that focus on when to enter into a joint venture and how to make one work:

What distinguishes the joint ventures that work from those that don’t?

According to a recent McKinsey article, Avoiding blind spots in your next joint venture, “even joint ventures developed using familiar best practices can fail without cross-process discipline in planning and implementation.” According to McKinsey’s own studies, JVs succeed only around half the time, even though JV best practices are well known:

When we interviewed senior JV practitioners in 20 S&P 100 companies—with combined experience evaluating or managing more than 250 JVs—they estimated that as many as 40 to 60 percent of their completed JVs have underperformed or failed outright. Further analysis confirmed that even companies with many joint ventures struggle, even though best practices are well-known and haven’t changed for decades. In fact, most of our interviewees endorsed several that have long been the gold standard for JV planning and implementation: a clear business rationale with strong internal alignment, careful selection of partners, balanced and equitable structure, forethought regarding exit contingencies, and strong governance and decision processes.

Why do so many joint ventures fail even when the Western company knows what it should be doing to make it succeed? Mostly a failure to follow best practices either initially or later on down the road when the company’s enthusiasm for the joint venture has waned:

Our interviewees suggest that in the rush to completion, even experienced JV managers often marginalize best practices or skip steps. In many cases, the process lacks discipline, both in end-to-end continuity and in the transitions between the five stages of development—designing the business case and internal alignment, developing the business model and structure, negotiating deal terms, designing the operating model and launch, and overseeing ongoing operations. Moreover, parent-executive involvement often declines in the later stages. Finally, many JVs struggle with insufficient planning to respond to eventual changes in risk. Such lapses, even in the early stages of planning, create blind spots that affect subsequent stages and eventually hinder implementation and ongoing operations. We’ll examine each of these issues, along with the approaches some companies are taking to deal with them.

The “rush to completion” is usually due to pressures to “get the deal done quickly.”  How can this be remedied?  “Companies must find ways to balance the pressure for speed with the demands of planning a healthy joint venture—especially allocating their time and resources in line with the potential for value and impact.”

I tend to agree.

If I look back at the China joint venture deals in which my law firm has been involved (and lets throw in the Russian joint ventures and the Vietnam joint ventures that we have drafted as well because why not?), I would say that there is a direct correlation between the time and planning and even difficulty of reaching a joint venture deal and the eventual success of the joint venture.  Put simply, the joint venture deals that were completed in one month are less likely to be standing today than those that took three months.

Why is that?

Joint ventures are incredibly complicated. Just by way of one simple example, who is going to be in charge of hiring, you the American company or the Chinese company? The quick answer is usually the Chinese company, because the Chinese company certainly knows better who to hire in Dalian or in Wuhan than you do. But then what’s to stop the Chinese company from hiring 100 of its relatives or from charging mediocre people for jobs at your joint venture? And if it does that, where do you think all of your profits are going to go? So now that you realize the importance of your having some say in hiring, what say are you going to require? Certainly you do not want to do the hiring, but do you want veto rights? Should you be limited in the number of potential employees that you have the right to decline? What about firing employees? Certainly your position will be different on managers than janitors. Speaking of janitors, are you going to want to limit the number of janitors the JV can hire? The issues on control can be endless, and this is just one of thousands of issues that joint venture partners might resolve before they ink  a deal.

Yet the more issues on which the putative joint venture partners agree before the joint venture is formed, the less room there is for arguments and disputes and wrenches being thrown in the works after the joint venture is formed.

So next time you are ready to kill someone (i.e., your China lawyer) during the third month of your trying to work out a joint venture deal, just remember that every day of delay is probably increasing your chances of the joint venture generating you money, as opposed to falling apart.

What do you think?

During the first 25 years of China’s opening up process, joint ventures were the favored vehicle for FDI in China. In 2005, the favored form of investment shifted away from JVs to direct investment through WOFEs (Wholly Foreign Owned Entities). During the last year, however, foreign SMEs have been shifting away from WFOEs and back to joint ventures. An even more dramatic shift has seen SMEs decide not to have any direct involvement in China at all. For these companies, licensed manufacturing and sales has become an attractive alternative.

The shift away from WFOEs has occurred because of the worsening environment for small private businesses in China.  Consider just the following in terms of the shift that has occurred in the last ten years:

  • Taxes: In 2003, WFOEs operated in China tax-free. WFOEs are now subject to basic income tax, VAT taxes and a host of local taxes and fees.
  • Wages: In 2003, Chinese wages were some of the lowest in the world. Now, the wage for the average worker on the coast is higher than in Mexico. In 2004, a WFOE could hire and fire workers at will and employ them for as many hours a week as the workers would tolerate. Now, employment is subject to a strict employment contract law system that makes firing workers difficult or impossible and that requires overtime for work in excess of 40 hours per week.
  • Benefits: In 2003, foreign employers could safely ignore paying benefits to their workers. Now, foreign employers are required to pay benefits to both foreign and Chinese employees that amount to almost 40% of the employee wage.
  • Rent: In 2003, rent in Chinese cities was low by world standards. Employers who located outside the major cities often negotiated free rent merely by agreeing to locate in a rural or relatively undeveloped area. Now, free rent is unheard of and rents in general are some of the highest in the world.
  • Environmental and safety regulations: In 2003, a foreign manufacturer could operate in China with minimal concern about environmental and safety regulations. Now, in virtually all jurisdictions, the Chinese authorities require compliance with relatively strict standards.

As this list of major changes shows, the business environment for foreign investors in China has changed dramatically in just one decade. However, many foreign companies that are planning operations in China assume the situation is the same as it was in 2003. It is a nasty shock to most when they evaluate their potential China operation under the current conditions.

Stated simply, many small WFOEs simply do not “pencil out.” However, because China remains an absolutely critical market for countless foreign companies, simply abandoning the China market is not feasible for many. Companies that must operate in China are starting to shift their Chinese investment plans. We are seeing two trends along these lines:

First, joint ventures are experiencing a revival. In the most basic situations, what the joint venture means is that the foreign investor is saying to its Chinese partner: we cannot make this project work by ourselves in China. We need your help. We will provide you with funding and expertise. What we want from you is management and guidance to allow the venture to earn a profit in this difficult environment.

In addition, more complex forms of joint venture are being considered. Two variations we have seen lately are:

  • The foreign company has technology but no money and no ability to manufacture or market anywhere in the world. The foreign company seeks to do a Joint Venture with a  Chinese company that will provide both necessary funding and the support needed to commercialize the product based on the technology. The structures for these China Joint Ventures are complex and are made more difficult by the antiquated and inflexible Chinese laws on joint ventures, financing and IP protection.
  • The foreign company has an existing successful product that it wants to manufacture and then market in China. Licensing is one option. The other is a complex joint venture. As above, the Chinese side of the proposed joint venture is seen not just as a source of manufacturing expertise, but also as a source of funding.
Years ago, my law firm developed a reputation for not liking joint ventures and there was some truth to that.  We did not like joint ventures that were mainly based on the Chinese side claiming that was our client’s only option.  We did not like joint ventures for joint ventures’ sake when there were other, better options for our clients.  We fully recognize that Chinese landscape has changed and whereas six or seven years ago eight out of ten joint venture proposals that crossed our desk did not make good sense, that ratio has probably completely flipped today, to the point that in the overwhelming number of instances, we make no effort to talk our clients out of their proposed joint venture.
The second trend we are seeing is companies abandoning the concept of directly investing in China and instead moving to a contractual approach. We are seeing this especially with foreign SMEs that are determining they do not have the resources to do manufacturing WFOEs in China. Basically, they are determining that Chinese owned factories are better/cheaper at manufacturing in China than foreigners. This includes multi-nationals such as Apple and HP.

In response, the current trend is to work towards purely contract manufacturing (product outsourcing), with no JV and no WFOE involved. This often involves complex IP issues and can also involve complex issues of start-up funding for the Chinese manufacturer. In connection with this trend, the foreign parties are finding that they need to work with their manufacturers to bring up their level of product quality to obtain required certifications such as HACCP and GMP.

Non-manufacturing businesses are also following this trend. In the creative industries, foreign companies are licensing their expertise to Chinese companies who then do the work on the ground. The same approach is taken even where a final product will be produced, such as a magazine or website.  I estimate that my law firm is doing at least five times this sort of work as opposed to just a few years ago and I am seeing the same sort of numbers with China joint venture deals.

This approach also requires complex contracting. In 2004, few foreign businesses had any faith in the enforceability of contracts within the Chinese legal system. This (justified) lack of faith meant that these contract-based approaches to doing business in China were not considered feasible. China’s dramatically improving legal system (at least with respect to contract enforcement where it is now ranked 19th in the world) has made it possible to shift to contract-based approaches to doing business in China. As with WFOEs, many foreign SMEs and their lawyers are not aware of this improvement in the legal system and continue to make their decisions about their China investments based on outdated, 2003 conditions.

A couple of years ago, we did a post on FICEs, entitled, The China FICE — Foreign Invested Commercial Enterprise.  The reason we did that post then (and the reason we are doing this post now) was to clear up common confusions regarding FICEs, which really are nothing more than a subset of Wholly Foreign Owned Entities (WFOEs) and Joint Ventures (JVs).  In that post, we sought to explain FICEs as follows:

A FICE is a WFOE that is authorized to engage in wholesale and/or retail trade. The approval requirements for these sorts of entities tend to be stricter than for a manufacturing or service WFOE. Additionally, approval of a FICE usually must come at the provincial level, not the local level. There are some provinces that do not even accept FICE applications. Shanghai and Beijing have the authority to approve the establishment of a FICE, and for that reason, most FICE operations are formed in those two cities.

Foreign Invested Enterprises (FIEs) mostly consist of Wholly Foreign Owned Entities (WFOEs) and Joint Ventures (JVs). All Foreign Invested Enterprises must set out the nature of their business during the licensing phase of the entity registration process. There are all sorts of possible categories, including Regional Headquarters, Service, Purchasing Center, Research and Development Center, Investment/Holding Company, Service Company, Manufacturing Company and Foreign Invested Commercial Enterprise (FICE).

In the end though, a FICE is nothing more or less than a type of WFOE or JV.

With the growth of the Chinese consumer, we are dealing more and more with FICEs and I want to get out there exactly what they are even though I do not like the term FICE because it tends to lead to more confusion than clarity. A FICE is just a type of WFOE or JV that engages in certain types of business in China. So what are those “certain types of business”?  The general answer is retail and wholesaling and franchising.

That’s it.  Now forget it.

Just received an email from a friend stating/asking the following (note that I have changed some elements of the email to strip it of any even potentially identifying information):

I am heading off again to work for a few years at our China Rep Office.  My new employment contract with the head office says that [foreign country] law will apply.  Will it?  And what if there is a conflict between [the foreign country] law and China’s laws, which will control?

We get this question far too frequently and we have seen way too many employment contracts written as though U.S. law (it was actually not a U.S. company in the above instance) applies all around the world. The reality is that if you are working for a Chinese company in China (be it a Rep Office, a WFOE, a JV, or whatever), Chinese law is going to apply to your employment relationship.  I know of no country that would allow otherwise.  I mean, imagine if a United States subsidiary of a Pakistani company were to claim in a U.S. court that it should not be required to pay overtime because their contract with the employee calls for Pakistani law and Pakistani law does not provide for that, or that it can discriminate against women because there is no such law prohibiting that in Pakistan?  Even if the employee at issue were a Pakistani citizen, there is absolutely no way in the world a U.S. court would go along with any of those arguments.  In fact, the argument is so bizarre I am not even aware of anyone ever having made it.

Any employer-employee relationship between a Chinese company and an employee working in China is going to be governed by China law, no matter what the contract says.  So in China there would be no conflict of laws because Chinese law would simply apply. This is why we also advocate for drafting China employment contracts and employee manuals with Chinese as the official language.  Chinese courts and Chinese administrative bodies are the only rightful jurisdiction for China labor law disputes stemming from employment in China (yes, this is true for expats too) and so it only makes sense to have these documents in the language they are sure to understand.

Here is a more interesting/complicated related question: what would happen if a U.S. company had a contract with a U.S. citizen and that contract provided that the U.S. citizen would go work at the U.S. company’s WFOE for a few years and that contract called for application of U.S. law.  Now as I have said above, no Chinese court would apply anything but Chinese law to this relationship, but what would happen if the U.S. citizen were to flip around and sue the U.S. company in a U.S. court for failing to abide by some particular U.S. law?  I do not know the answer to this question (any U.S. employment lawyers out there), but I can tell you that if it were to benefit my client, I would argue that Chinese law applies and I think I would prevail on that.  But, I can also tell you that if it were to benefit my client, I would argue that U.S. law applies.

Anyone know how a U.S. court would rule?

Less than a month ago, we wrote a post, entitled, How To Form A China Company (WFOE or JV). Hong Kong Entities. They’re Baaaaack. The gist of that post was that my law firm was now favoring the forming of Special Purpose Entities in Hong Kong to hold the soon to be formed Mainland China Wholly Foreign Owned Enterprise (WFOE) or Joint Venture (JV).  We wrote on how our position on this had changed due to China’s having recently become increasingly tough on company formations involving non-Hong Kong companies:

It is relatively easy to prove the existence and organizational structure of a Hong Kong company. The process is straightforward and the Chinese investment authorities understand the documents and readily accept them. This is not true for corporate documents from other countries. The Chinese authorities want documents that are similar to their own. They do not understand foreign company systems, and will often challenge perfectly standard documents from foreign jurisdictions that do not accord with the way they think the world should work. For example, the Chinese authorities will often demand notarized documents. When the notary is from a common law jurisdiction like the United States or England, they will object to the form of the notarization because it does not look like a Chinese or civil law country notarization.

In other cases, we have had Chinese authorities object to United States limited liability company documents because the officers’ titles do not match the equivalent terms in Chinese. For example, in most U.S. jurisdictions, a limited liability company (LLC) does not have directors and officers. Instead, the LLC is either member managed or manager managed. We have had Chinese authorities object to both forms of management because they do not understand the U.S. system. Of course, the issues can be even worse when the investor company is based in a system even more different from China, such as the Middle East, Central Europe or Africa.

All of these sorts of problems are solved if the foreign investor sets up a Hong Kong company and specifies the Hong Kong company as the shareholder of the Chinese WFOE or Joint Venture. For this reason, many of our clients will almost automatically plan to form a Hong Kong company as the first step in the China company formation process.

We received a not surprising amount of blowback to that post, both in the form of comments and in the form of a fairly large number of angry emails.  As I have written many times previously, virtually whenever we say anything that might lead anyone to believe that doing business in China involves little more than just walking in, we get push back, mostly from those whose incomes depend entirely on a smooth flow of China business. Anyway, we received plenty of communications saying or hinting that absolutely nothing had changed in China and that it was either all in our heads or due to our inability to negotiate China’s bureaucracy.

This is the “I told you so” follow-up post.

I just read a Financial Times article, entitled,  “China, India and Russia less business friendly,” on how “executives around the world” think China has become “less friendly towards business over the past three months,” as based on an FT/Economist Global Business Barometers Survey.  This survey is conducted every three months of 1,500 global senior executives.  According to the survey, of the four largest emerging market economies, only Brazil has eased up on business; China, Russia and India have gotten tougher. “The survey comes amid concerns that growth in Brazil, Russia, India and China – together known as the Brics – is slowing.” Brazil was the only one of the four Brics that more consider friendly than unfriendly towards foreign business.

I yearn for the day when China views getting “friendlier” towards foreign business as its best reaction to a slowing economy, rather than getting more “unfriendly.”

What are you seeing out there?

 

By: Steve Dickinson

When making a WFOE (Wholly Foreign Owned Enterprise) or JV (Joint Venture) investment in China, the investor must consider: who will be the shareholder in the PRC entity? Will the investor invest directly, or will the investor create a special purpose subsidiary company  (an SPV or Special Purpose Vehicle/a/k/a SPE or Special Purpose Entity) to act as shareholder. If an SPV is used, where will it be formed?  In the U.S.? In a generally recognized tax haven such as the British Virgin Islands or the Cayman Islands? Or in Hong Kong in accordance with the favorable PRC/Hong Kong tax treaty?

From a tax standpoint, the decision is complex and requires careful analysis by the primary investor. Ignoring the tax issue, however, from the standpoint of company formation, the use of a Hong Kong entity offers the advantage that it solves many of the technical problems in forming a WFOE or JV in China.

It is relatively easy to prove the existence and organizational structure of a Hong Kong company. The process is straightforward and the Chinese investment authorities understand the documents and readily accept them. This is not true for corporate documents from other countries. The Chinese authorities want documents that are similar to their own. They do not understand foreign company systems, and will often challenge perfectly standard documents from foreign jurisdictions that do not accord with the way they think the world should work. For example, the Chinese authorities will often demand notarized documents. When the notary is from a common law jurisdiction like the United States or England, they will object to the form of the notarization because it does not look like a Chinese or civil law country notarization.

In other cases, we have had Chinese authorities object to United States limited liability company documents because the officers’ titles do not match the equivalent terms in Chinese. For example, in most U.S. jurisdictions, a limited liability company (LLC) does not have directors and officers. Instead, the LLC is either member managed or manager managed. We have had Chinese authorities object to both forms of management because they do not understand the U.S. system. Of course, the issues can be even worse when the investor company is based in a system even more different from China, such as the Middle East, Central Europe or Africa.

All of these sorts of problems are solved if the foreign investor sets up a Hong Kong company and specifies the Hong Kong company as the shareholder of the Chinese WFOE or Joint Venture. For this reason, many of our clients will almost automatically plan to form a Hong Kong company as the first step in the China company formation process.

However, there are several important issues that must be considered before making the final decision regarding formation of a Hong Kong company.

1. The use of an SPV is in many cases prohibited by Chinese law. For many investments in the service sector, the investor must prove that the foreign shareholder has been in operation for a certain number of years. In other cases, the foreign investor must prove that it has had a certain business income for a specific period or that its capitalization meets a certain standard. Where this type of requirement exists, the standard is applied to the direct shareholder in the Chinese company. That is, it is not acceptable to say that the ultimate parent company meets the requirement. For this reason, many investors in China are required to make the investment directly and not through a SPV or other subsidiary.

2. Though establishing a Hong Kong company is relatively fast, cheap, and easy, creating a bank account in Hong Kong is not. For formation of a Chinese company, the Chinese authorities require that a Hong Kong bank account exist and they also require a letter from the Hong Kong bank stating the details of the account formation. Under Hong Kong banking and anti-money laundering rules, a bank account in Hong Kong can only be opened by a person who is personally present at the bank in Hong Kong. Moreover, the rules on who this person is are very strict.  This person must be the party the Hong Kong banking authorities determine is the person who exercises actual control over the Hong Kong company. Usually this will be the chairman of the board of directors of the Hong Kong company. Where there are multiple shareholders, this will also include a representative of each shareholder who holds more than 10% of the stock in the Hong Kong company.

For many Hong Kong companies, the shareholder will set up the Hong Kong company so that the chairman of the board is a high ranking officer in the corporate parent. For company formation purposes, this is is easily done since for company formation, only the signature of that officer is required. This then backfires when it is time to open the company bank account in Hong Kong. For this, the chairman must be physically present in Hong Kong. In addition, the chairman must also prove his or her identity using documentation that cannot be determined precisely without consultation with the bank. It is not acceptable for the chairman to designate another person such as a lower level staff person or a lawyer to act on his or her behalf. Only the chairman or similar officer of the Hong Kong company can act.

In our experience, it is the rare chairman of the investor company that has the interest in or the time to travel to Hong Kong simply to open a bank account. However, no one else will be permitted to open the account and without a funded Hong Kong bank account, it is not possible to form a company in China. Once this problem arises, it can be difficult and time consuming to fix. For this reason, consideration of how a company bank account will be opened in Hong Kong should be considered in advance, before forming the Hong Kong company. We have seen many unnecessary delays in forming a Chinese WFOE or JV that arise as a result of having to deal with bank account issues.

Having said all this, forming a WFOE that is owned through a Hong Kong company is — more often than not –generally easier these days than just forming a WFOE that is owned direct from a country like the United States.

What do you think?

Been writing a lot about China Joint Ventures of late, for many reasons.  First, I am going to be speaking in Hong Kong in mid-October on this very topic.  Second, there has been of late a sort of mini-resurgence in China JVs.  Third, others, including Rich Brubaker over at All Roads Lead to China, have been commenting on the JV uptick as well.

Brubaker came out with a really interesting (for me anyway) piece the other day, entitled, Who Is Up for Another Round of Joint Ventures?  In that post, he talked of recent announcements by Pfizer and Merck  that they have both entered into JV agreements with local firms to distribute their generic drugs in China.”  He then goes on to note how both deals have the following “characteristics” he felt “important to highlight:

  1. Both deals are structured around generics.
  2. Both deals ultimately represent a structure that plays off the strengths of each firm.  foreign brand, process, and QC … local distribution
  3. Both deals will insulate the firms from any decline in market, as well as speed up their entry to the market
  4. Both deals will insulate the firms from a number of risks, not the least of which are the legal risks brought on by the well documented business practices that take place within the industry.

He then goes on to say that he is seeing similar activity in “auto, insurance, and energy” where companies with whom Rich have spoken see “potential for JVs” that can “insulate [against] risk, increase speed to market, and be kept separate from other investments/products in China.

I think Rich is really on to something.  China is getting more difficult for foreign companies. It just is. It is getting more expensive, more political, and, overall just a lot less friendly to foreign businesses, from a legal, tax, and business perspective.  I am finding myself giving the following “lecture” just about every day now:

It is almost always better to fully control your business than to share your business with someone else, particularly when that someone else comes from a very different culture than you and particularly when you do not really know that someone else all that well.  But in terms of strictly business reasons, there are definitely times where a Joint Venture will be better able to compete than a WFOE.  This is particularly true in those industries where there is strong government involvement, such as banking, healthcare and the environment.  This is going to be far less true for a consumer good like clothing or toasters.

If you want to sell goods or services to China, you should be aware that there is a hierarchy of businesses in China in terms of being favored by the governments there.  Again, the strength/importance of this hierarchy is going to vary depending on the particular industry and it is going to be up to you to figure out where your industry fits.  First comes China’s own domestic companies.  They are going to be most favored. Then comes a Joint Venture.  Next comes a WFOE, followed by a Rep Office. Selling your product or service from the comforts of the United States comes last.

Not to say selling from the United States cannot work, because it can. We have clients who do quite well selling their products from the United States, but it seems that they are in industrial related businesses selling fairly high ticket items (USD$100,000 to USD$2 million) for which they are known as being at the top of the heap and for which being in China confers little to no benefit.  So really, you just need to figure out where your business fits.

Back to Pfizer and Merck. Those joint ventures seem to make good sense.  Distributing in China is tough. Really tough.  And I can only imagine it being way tougher still in the healthcare sector.  But what makes these ventures so interesting to me is their limited scope. As far as I can tell, both the Pfizer and Merck joint ventures are pretty limited in their scope. Neither involve developing or producing any product; they simply involve distribution (and marketing?). And this makes sense.  Pfizer and Merck have essentially outsourced the portion of their China business they are probably least equipped to handle as well as a local.

What’s so interesting though is that they outsourced it via a Joint Venture, which almost certainly gives them more control than if they had outsourced via a distributor relationship.  In fact, in some ways, this joint venture might be almost the opposite of the stereotypically China Joint Venture in which a Western company is brought in for the technology and the big threat is that once the Chinese side masters the technology, it will boot out the Western company.  Might Pfizer and/or Merck be positioning themselves to boot out the Chinese side once they (Pfizer/Merck) master the art of China pharma distribution.  Don’t know, of course, but this sort of deal certainly bears watching.

What do you think?

Came across a really good list of mistakes businesspeople make in China.  The list, entitled, “Top Ten Mistakes Businessmen Make in China,” was compiled by  Stanley Chao, of All In Consulting. It really is a nice collection of tips and I present them below, with my comments in italics.

  1. Take the trust factor out. All actions must be confirmed with proof.  Agreed.  We said the same thing in our post, Your China Product Supplier. Trust All You Want, But Systematize.
  2. Foreigners often complain that Chinese don’t understand their business intentions due to a lack of English. This is often wrong. The Chinese do understand your intentions, but wish not to follow or obey them. Not sure this is true and not sure this matters. I am not big on trying to figure out other people’s intent, preferring to focus more on their actions. If this is just another way of saying you need to verify, then I agree. 
  3. The Chinese will always want to rush you. Be patient, and make the Chinese understand your intentions. Agreed.  We talked about this just a few weeks ago as a typical Chinese company negotiating tactic in our post, How To Handle Chinese Negotiating Tactics.
  4. Don’t be too polite. It can sometimes be misunderstood. Be terse, direct and make your point in simple words or actions especially during negotiations. Business is Business! Sort of agree.  I think it is fine to be polite, but at the same time, you should not be so polite as to not make sure that you make your point and do so loud and clear.  
  5. Don’t do incoming inspections after the goods have landed in the U.S. It’s too late at that point. It must be done in China, preferably at the factory. Agreed.  You must do your inspections before you pay, not after.  
  6. If at all possible, have your own staff in China handling quality inspections. You don’t need many, just enough to handle the important issues. Sort of agree.  Using an outside firm for your QC can work just fine.  
  7. You are never protected by a contract. The Chinese, because of cultural and historical reasons, treat contracts differently than foreigners. They consider it a temporal agreement, subject to change as market conditions fluctuate. Disagree.  Contracts do protect you more than not having a contract. Our post, Chinese Contracts. Because They Really Do Make A Huge Difference, sets forth all the arguments why.  
  8. Don’t ever do a joint venture. This complicates matters by a factor of 3. Instead, seek distributors, licensing partners, or establish a WFOE-Wholly Foreign Owned Enterprise. Sort of disagree.  If you can do a WFOE, do that and not a Joint Venture.  But when you cannot do a WFOE because China does not allow it or because you cannot afford it or because you need assistance from a Chinese company for which a JV is required, then a Joint Venture can make sense.  For our thoughts on China Joint Ventures, check out Chinese Joint Ventures — The Information The Chinese Government Does Not Want You To Know.
  9. Have all important documents and contracts written in Chinese, with duplicates in English. Use the Chinese translations as the legal, binding document. This will eliminate misunderstandings, language problems, and disputes. Agreed and for our strong concurrence on this, check out China OEM Agreements. Why Ours Are In Chinese. Flat Out. Also, if contracts provide no protection, as implied in number 7 above, who cares in what language they are written? 
  10. You don’t think like the Chinese and vice versa. Understand what makes them different by observing them and learning the culture. You will know how to deal with them better. Agreed.  It is always good to know as much as you can about anyone with whom you are dealing.
So what do you think?

Not sure why (the bad economy?) but we have been getting a rash of China joint venture deals and possible deals over the last six months or so, many of which involve a United States company wanting to enter into a Joint Venture with their China manufacturer so as to work jointly on manufacturing and marketing and selling some combined product or products around the world.

One of the mistaken assumptions we are finding the American company is making is that it can contribute existing China-based equipment to this sort of equity joint venture (EJV) and receive “credit” for doing so.  Virtually every time, the American company is getting this wrong based on the bad advice of its putative Chinese joint venture partner.

Chinese law mandates that foreign companies doing equity joint ventures contribute a certain amount of capital to the joint venture.  Then, the voting power of each joint venture partner is proportionate to the capital each partner put into the joint venture. Since the foreign partner usually wants to control the joint venture it must contribute more than 50% of the capital to the venture. Since manufacturing operations are usually quite expensive, this means that the U.S. partner must make a significant capital contribution.

To avoid having to come up with the typically very large capital contribution required the U.S. side has been telling us: “We know the capital amount is large. But don’t worry about it, we have that part covered.” When we ask what they mean and what they will contribute as capital to the joint venture, their reply is “the equipment and molds and tooling we purchased and then placed in the XYZ China factory and have been using for the past year. XYZ acknowledges that we own these items and that we can just contribute them to the joint venture at full value. So we have the capital contribution problem already solved.”

Unfortunately, this does not solve the problem at all because China’s rule on foreign contributions to a joint venture (the same is true with respect to WFOEs as well) is that the capital contribution must come into China from outside China for the China Joint Venture.  Under Chinese law, it is very unlikely that the U.S. side has any ownership in equipment and tooling that is located in China. However, even if the U.S. side does actually own such items, they still cannot be contributed to the joint venture by the foreign partner because the foreign side of a China JV is not permitted to use RMB, cash, equipment and other goods, land or intellectual property that is located in China as its capital contribution to the JV. This is a black and white rule and there are no exceptions.

As we note above, the same rule applies to WFOEs in China. It takes an agonizingly long time to form a WFOE in China and we often get contacted by companies that have “jumped the gun” and started their China business operations before forming the WFOE. In doing that, they enter into leases and purchase equipment required for these operations. Consistently, they will want to contribute the lease payments and equipment (or the equipment costs) to the WFOE as a credit to the amount required for their capital contribution. For the same reasons discussed above, this is impossible because those contributions did not come into China from outside China for the WFOE.

For more on what it takes to succeed with a China joint venture, check out the following:

For more on what it takes to form a WFOE in China, check out the following: