We lawyers are known as deal-killers. Most lawyers get offended by that moniker and vehemently deny it. Me, I am more than willing to own up to it. Clients go to lawyers all excited about a deal and it is the lawyer’s job to point out the risks and to explain which of those risks can be mitigated and which cannot. I am proud of the deals I killed because my killing the deal meant I was doing right by my client. In other words, I was just doing my job

I have put the kibosh on many a China acquisition and that is what this post is about. The following is actually an amalgamation of many such potential acquisitions, but for ease of explanation and to camouflage the identities of those involved, I have amalgamated a bunch of them into one. Trust me when I say that the following is incredibly typical, including the retirement of the owner precipitating the need for the deal.

The potential deal was for a US manufacturer that had been receiving its product from the same China manufacturer for about fifteen years. The Chinese manufacturer had been providing about 90 percent of its product output to this one US manufacturer and the two companies had a “fantastic” relationship. The owner of the Chinese manufacturer had done very well over the years and he now wanted to retire and sell his China manufacturing business to the US manufacturer.

In theory, this made complete sense.

The US manufacturer told me of its plans to buy and we briefly discussed some terms and “the numbers.” They said that the Chinese company was clearing about “a million a year” but that was not why they were buying it. They were buying it because they wanted to be sure they would be able to keep getting the product.

I then told laid out the likely reality of what was to come. I told them that if they bought the Chinese manufacturing company their profits (if any) would likely be considerably lower. I proceeded to explain why this would probably be the case.

I said that there is a good chance the Chinese manufacturer is paying half of its employees completely under the table and reporting to the government only half of what it was paying the other half. I then talked of how there is also a good chance the Chinese manufacturer is underpaying its taxes and of how its rent also may be paid under the table. I then said that this sort of thing may be all well and good for Chinese companies, but that if the US manufacturer were to buy this Chinese manufacturer, it would need to do so as a WFOE and it would then immediately be on a “whole ‘nother level” with respect to China’s various tax authorities.

I then told the US manufacturer that if it were to buy the Chinese manufacturing business, it would need to bring every single employee onto the payroll and that would likely mean the payroll expenses would be close to doubled. I then gave my estimated numbers. All of the wages now being paid under the table would need to be paid above the table and that would mean that the US manufacturer would, in turn, need to pay all sorts of employer taxes, pensions, and insurance. I told the US manufacturer to figure that these items would be about 40% of all wages. So if you have an employee who is now getting $1000 a month under the table and you then report to the government that you are paying that employee $1000, you should figure on needing to pay about $400 on that to the government.

But it gets worse. Much worse.

You see, that employee who is receiving $1000 under the table is usually quite happy to be getting paid under the table. So when you tell that employee that you are now going to be reporting his or her wages/income to the government, that employee is going to demand a raise. You see, that employee has been able to avoid having to make his or her various employee contributions and to pay his or her income taxes and your now reporting his or her income will end all of that.

You should expect needing to raise employee salaries by maybe 40 percent. So now the employee who was getting $1000 is getting $1400 and you as the employer are going to need to pay an additional 40 percent on that, which equals around $560. So all of a sudden the employee that cost the Chinese manufacturer $1000 a month is going to cost you pretty close to $2000. In other words, double.

And let’s take rent. The Chinese manufacturer is probably paying the landlord under the table and the landlord is not reporting it. Heck, there is a very good chance the landlord is not even legally able to lease out the property, but for the sake of the numbers, let’s assume that the landlord is actually authorized to lease it. If you are going to buy the Chinese manufacturer’s company you are going to have to do so as a WFOE and to get a WFOE approved at all, you are going to need to have a legitimate lease. That means that before you buy this Chinese manufacturer, you are going to need to go to the landlord and tell it that you need to get your landlord-tenant relationship “on the grid” and that the landlord is going to need to register the lease with the appropriate authorities.

The landlord will likely call you an idiot (trust me on this) and initially balk. You will then need to explain that you absolutely must get on the grid and that you are prepared to cover the landlord’s increased costs to do so. Figure on this raising your rent by around 25%. Again though, this assumes that your being able to stay at this facility is even possible.

Okay, so now that I have explained how the above will eat into your numbers, let’s talk about income taxes. You are going to have to pay income taxes on the money you make, even though the Chinese manufacturer maybe never did. Figure 25% of your profits will go to income taxes. And if you are now thinking that you are not going to have any profits, let me tell you that is likely going to matter less than you think for Chinese income tax purposes. You see, if you have no profits, the Chinese tax authorities will figure that is because your Chinese WFOE is intentionally under-pricing the product it is selling to your United States operations and it will then impute a profit to your Chinese WFOE. It’s a transfer pricing thing.

You need an accountant who understands China to look over the Chinese manufacturer’s books and to run the numbers to see if this deal is going to make sense.

A few months later, I received the following (doctored) email from our US manufacturer client:

Here is where we stand:
Our accountant is in the process of re-modeling the business from a top-down perspective, in an effort to clarify what the numbers would be for our China WFOE, while complying with the rules.  We have good history on the revenue and most of the operating costs.

As you guessed, we will need to apply roughly a 2x factor to the labor costs that the Chinese manufacturer is showing, so as to properly book all of the official upcharges.

Also, as you suggested might be the case, the landlord of the factory space is not properly registered, so we will be increasing the booked rental costs as well.
The reality is that we probably will not be purchasing the Chinese manufacturing company did not sit well with its owner. He was offended when I reiterated my stance that I wouldn’t operate the business in the same manner as he has. He lost face.

A few weeks after that, I received the following email from the client (again doctored):

it is now clear that we shouldn’t consider buying [the Chinese manufacturer]. He [the owner of the Chinese manufacturer] had previously indicated that there were “a couple” more issues related to the accounting procedures. I pressed him to explain if there were any others. Of course, you know the answer to that.

In summary, it is becoming clear that we cannot be profitable in China if we follow all the rules. It is not completely clear this is really the case, since we can’t tell if [the owner of the Chinese manufacturing company] really understands the rules. What is certain is that the numbers on which we had been basing our valuations are simply not valid. The “profits” that the Chinese manufacturer was claiming to have achieved are not valid under our business model.

Amazingly enough, the US manufacturer and the Chinese manufacturer came up with a great solution which ended up working like a charm. The manager of the Chinese manufacturer bought the Chinese business and continued running it just as before and the US manufacturer and the Chinese manufacturer have maintained their “fantastic” relationship. All is well, except my law firm made a lot less money than if  the deal had gone through.

  • Dan –
    Good post but I would be careful not to overgeneralize too much regarding ethically lapses with words like “probably” and “almost certainly be”. Statistically you are probably correct , but over time, hopefully Chinese business practices will continue to evolve and prevailing stereotypes will need to evolve as well . . .
    In any case, this could still be a good deal, but this is simply a manner of doing proper due diligence with an informed legal, EHS, finance and TAX/VAT team and using “re-modeled WOFE basis” financials to construct valuations. From my experience, also be on the look out for any 3rd party “consulting agreements” or “tolling agreement” relating to import / export or permitting which could (note I didn’t say “probably”) have unrealized negative compliance issues.
    As a lawyer, I wonder if your opinion is really that the relationship is truly “working like a charm”? Now that your client has done full due diligence, he is knowingly aware of many non-compliant business practices being practiced by his value chain, probably also with a data room and paper trail to go with it.
    Can he really enjoy charmed sleep without correcting such issues?
    Regardless, a useful post. Strike one up for what I always call the DPT (Deal Prevention Team)!!

  • Kenan

    Another amazing post. It’s amazing what thousands of miles of distance can do to mask these issues. And it’s not just China, I’ve seen Japanese companies that have similar (but much less flagrant) fraudulent accounting and HR practices.

  • Geek China

    Its a Financial due diligence issue and shows why it should be conducted on Chinese suppliers and M&A.
    It also shows how China unofficially subsidizes it’s companies by being very lax on tax collection and welfare payments when foreign investors have to pay through the nose.

  • MHB

    That’s your 4th post of the year… how are you going to top that?!
    Great solution – very practical and everybody wins (except for the public funds).
    Fewer deals but more extensive due diligence – every cloud has a silver lining.

  • Marius Schutz

    Good sum-up – However, if, as is likely, the vast majority of Chinese SME operates like this, FDI by foreign SME does not make sense. Any manufacturing WFOE won’t be competitive. What do you think?

  • Joseph K. Teng

    All the more reason to get the benefit of huge Asian growth without the enormous corruption associated with China.
    My suggestion?
    Buy great South Korean companies that trade on US exchanges.

  • Brian Schwarz

    Hi Dan,
    Thank you for the great post. Keep up the excellent work.

  • Andrew

    I am a translator of a JV-to-be . What would be the impact on wages for non-management personnel like me ? PS: In the JV–to-be, the American company will be the majority shareholder.

  • DaMn

    “receiving its product from the same China manufacturer for about fifteen years.”
    and they don’t know this about their supplier or at least the possibility, at a minimum?
    China Business 101.
    amazing the extent one can go to remain ignorant of externalities.
    wake up people.
    Jeffrey says “Can he really enjoy charmed sleep without correcting such issues?”
    “Correction” is all relative. Be careful what you choose to deam “broken.”
    What’s the lesson in China Business 201? Can’t wait, hopefully.

  • Shanghai Bean Counter

    I suspect that most people know that Chinese companies don’t abide by the same standards that Western companies do. Thats why the Chinese Stock Exchanges aren’t open to foreign investment or scrutiny. What you talk about has been accepted as fact for years, and is often refered to in China as the 6D’s: Due Diligence, Due Diligence, Due Diligence.

  • muyo

    Another factor might be insurance. E.g. if the people took substandard shuttle busses to the plant before, after switching the business this may have to be changed into own company busses, hence costs. This is just a simple example.
    Or the neighbor, who supplied the steam in the past, suddenly gets Dollar (Yuan) signs in his eyes and doubles the costs for the steam…..
    Just 2 examples out of 1000+ why sometimes it is better to leave things unchanged….

  • Matt

    Your client is fortunate to have you as its legal counsel. A few years ago I bought a small Chinese company using Chinese local counsel who never told me any of this, nor did my local accountant. Once we took over, we realized how bad the numbers were and it took us years to get the business to the point we thought it was when we bought it. In hindsight, I realize that the local attorney and accountant we used were more concerned about just getting along with everyone and just getting the deal done than in giving us the straight scoop on how this all really works.

  • Great post, really informative. Unlike the first respondent I don’t have high hopes of evolutionary business practices in China any time soon. There’s simply no real demand for them within China, whilst those companies pursuing international IPO’s will have to clean up their acts, the vast majority will continue to operate within the current framework until such a time is there is a genuine need for change, which as always must originate in China and not overseas.

  • Caleb

    This is all true and the people who are getting mad at you for predicting this don’t realize that you have to figure this is the case and then determine otherwise. I have been involved in nearly ten deals for my company and there was not a single one fo them where what you said was not the case. It is not even just the dishonest Chinese company that doesn’t pay its people and its taxes: it is all of them.

  • Sam Tung

    One other issue, at least previously in the garment export business was the subsidies given by the government to the exporter. How much this is or relevant I’m not sure, being out of the manufacturing side a few years now.
    But for the garment factories they could under-price their FOB costs because they would be getting 12-15% from the government for every dollar they shipped or invoiced.
    I wonder if many people know about this subsidy scheme and if it was practiced in other industries. So it wasn’t only cheap labor, or being “tax efficient”, the government encouraged exports and under pricing by granting subsidies.
    I believe this practice is not quite as important now but I could be wrong.
    Any WOFE or foreign investment would certainly lose this privilege as well.

  • Lee

    Excellent post! Thanks for providing this valuable info.
    I agree w/ the commentator who advises buying companies that trade on the U.S. exchange.

  • Lee

    Would U.S. law firms practicing in China provide such truthful info.?

  • Jonathan

    Fantastic post. What I suspected all along, Lao Wai in China need to fight fire with fire, it’s still too early to play legit when you only have a 20% margin.

  • Karl Metzner

    A great reality check from the trenches.