Doing Business In China

CHINA BACKGROUNDER: OPPORTUNITY OR PERIL?

Over the past three decades since the "Opening Up" of China, much has been said about China as a business opportunity.

On the one hand, it is difficult to ignore the country’s spectacular economic growth, which has seen it rise to become the second largest economy in the world with unprecedented speed. Poverty is on the decline, educated workers abound, and the country is hungry for business. A new middle class is emerging that is predicted to account for 20% of the worldwide consumption of luxury goods. The sheer magnitude of the Chinese economy relative to other countries is well illustrated by the map below, which was developed and published by The Economist in February 2011.

On the other hand, horror stories abound of well-known multi-nationals that have ventured into China only to run away with their tails between their legs, and their intellectual property lost to unscrupulous partners.

Of course, there are elements of truth in both opinions.

IPO PANG believes that the Chinese opportunity for many foreign companies can be real and substantial, provided prudent steps are taken to minimize risk. IPO PANG subscribes to the opinion that the failures of many foreign ventures that have occurred in China are not because China is a company-killer, but rather, because companies who venture into China unprepared are committing corporate suicide.

IMPORTANT CONSIDERATIONS FOR YOUR CHINA VENTURE

APPROPRIATE CORPORATE STRUCTURE
Foreign companies have a number of options open to them in terms of corporate structure. The optimal choice is primarily a function of which activities the company plans to undertake in China, as well as the degree of control and risk the company can manage.

Representative Office may be an appropriate first step in your China venture if you are unsure about the demand for your product and want to test the market before committing to a JV or WFOE, and if your target clients can accept the longer delivery times necessitated by the lack of local warehousing. Representative Offices have the lowest expense and regulatory burden of all corporate structures, but they are also the most restricted in the activities that can be performed.

There are two types of Joint Venture in China.

Equity Joint Venture (EJV) capital investment from one or more foreign companies with one or more Chinese companies. The foreign investment is typically a minimum of 25%, and while non-cash equity in the form of IP, technology, and equipment are legitimate sources of capital, labor is not. Non-cash capital is valuated by, and subject to the approval of the government. In EJVs, the parties jointly invest, operate, take risk, and take responsibility for profit/loss according to the ratio of their capital investments.

Cooperative (Contractual) Joint Venture (CJV) also requires capital investment from one or more foreign companies with one or more Chinese companies. The discriminating feature of a CJV is that the foreign company generally provides the majority of the capital, while the Chinese company supplies the means of production (facilities, land, etc.) A CJV can be registered in a manner similar to an EJV (ie, a single entity) or the parties may continue to operate as separate legal entities. In any event, the CJV is governed by a contract that specifies the terms of cooperation, the division of earnings, the ownership of property upon the termination of the contract, the sharing of risks and losses, and the rights and obligations of the different parties. Unlike an EJV, the division of profits and risks in a CJV is based on a contract, and does not necessarily take place according to the ratio of investment.

The Wholly Foreign-Owned Enterprise Establishment of a WFOE ("woofie") is becoming the most common corporate structure adopted by new foreign ventures in China. For good reasons, WFOEs are popular because they can perform all of the same activities as JVs, but the difference is that a WFOE "goes it alone" without a Chinese equity partner, which means less hassle fighting over control and divestiture issues. What one gains in independence one may lose in terms of local expertise and relationships (known as "guanxi" ), although often the WFOE resources the Chinese "guanxi" component through a number of consulting relationships with locals, such locals having no stake or ownership in the venture.

In many circumstances, it may be advantageous to launch a Chinese WFOE through an off-shore holding company, and this arrangement is particularly effective if one contemplates selling some or all of the venture in the future.

MARKETING

It seems obvious that before launching any new business venture, a reasonable degree of effort should be directed at basic marketing analysis, and starting a venture in China is certainly no exception. Is there a demand for your product? Are your proposed distribution channels and promotional plans appropriate for the Chinese market? As obvious as it may seem to address these issues, it is shocking how often it is overlooked. One should never assume that a popular western product will be a popular Chinese product, or that effective marketing campaigns in the west will be equally effective in China. Examples abound of products that enjoy success in the west, but not in China, or products that could have been successful in China but failed because they were delivered or promoted in a western manner that is unworkable in China. Often as not in these circumstances, enterprising Chinese will seize the opportunity to turn a loser into a winner simply by marketing the same fundamental concept in a properly localized manner.

KNOW YOUR PARTNERS

Foreign companies that partner with Chinese companies – whether in a JV or otherwise – need to be certain they know who they are dealing with. It is not unusual for Chinese companies to "embellish" their capabilities – a wholesaler masquerading as a manufacturer for example. Foreign companies that are accustomed to a high level of honesty and transparency are well advised to apply a healthy dose of skepticism to new business relationships. In all but a few cases, the need for appropriate diligence can hardly be overstated.

INTELLECTUAL PROPERTY ISSUES

Over the years, China has gained a dubious reputation for IP theft. Not only have products been blatantly copied by competitors, but it has also not been uncommon for a foreign company’s trusted partner to suddenly emerge as its main competitor.

Foreign companies can limit the risk to their IP in several ways, starting with the careful diligence of prospective partners mentioned above. In addition, legally binding safeguards and non-compete clauses for a partner’s employees and executives can be crafted.

Since entering the WTO, China has strengthened its IP rules, and there are now better mechanisms in place to enforce IP rights. In addition, foreign companies that are producing finished products or components in China in cooperation with one or more Chinese manufacturers can adopt certain strategies to ensure that no single Chinese company is ever equipped to replicate the final product.

ADMINISTRATIVE BURDEN, TAXES, LABOR, AND ENVIRONMENT

China is "open for business", but not open for any business. Certain foreign industries are not permitted to operate in China for security reasons, and to a much greater extent, heavy, polluting industries are being shunned. Gone are the days when companies could look to China as a cheap way to circumvent restrictive and expensive environmental laws.

China, with a population of 1.3 billion has a vast labor pool. China boasts over 2,000 post-secondary institutions with a typical student load of about 4.5 million. Literacy is over 90%. Salaries vary as a function of location, with top-tier cities generally having higher salaries than second or third-tier cities. Compensation is a combination of base salary plus benefits such as housing and phone allowance, New Year bonus, and so on; benefits typically amount to 50% of the base salary. Monthly base salaries range from less than 2,000 RMB (approximately USD 300) for unskilled labor (including retail clerical workers, restaurant workers, etc) to 50,000 RMB (approximately USD 7,500) for the top tier of management in a high tech company. Even as salaries rise, China’s labor costs remain competitive compared to other foreign countries, particularly given their relatively high education levels and most important of all, increasing proficiency with English. Labor laws are constantly being revised, and foreign companies that operate in China are well advised to ensure that their practices remain current and compliant.

In years gone by, China had national policies that offered tax benefits to foreign companies, but since 2007, foreign and domestic companies alike have been subject to a nominal base tax rate of 25%. That being said, national and regional governments continue to offer tax incentives in certain key industries, and in certain locations, particularly in the form of rebates on export sales.

China is governed by national, provincial, and municipal laws. Many foreign companies in China have been astonished by the vast array of permits and licenses required to operate, and particularly in years gone by, there have certainly been instances of foreign companies either being subjected to excessive administrative burden, or alternatively, suffering long delays or denial for the requisite permits. Foreign companies are well advised to get professional assistance not only to ascertain which permits are genuinely required, but also to secure them in a reasonable period of time.

HOW CAN IPO PANG HELP?

IPO PANG can directly or indirectly assist your China venture in every aspect of its operation. We can:

• counsel you on optimal corporate structure and register it accordingly
• secure licenses and permits
• negotiate with government officials
• conduct due diligence on prospective partners
• resolve disputes through negotiation, arbitration, or litigation
• work with authorities to enforce IP
• ensure that you remain compliant with prevailing tax and labor laws
• conduct market research and offer localization assistance

Checklist for Doing Business in China:

1. Which entity is the contracting party with the Chinese party?
2. Has adequate, moreover, thorough due diligence been performed on the Chinese party?
3. Has careful consideration been given to the type of corporate entity formation that will enter into contract(s) with the Chinese party?
4. Have tax considerations and "best practice" strategies been implemented to minimize tax impact?
5. Is approval (an essential criteria) from local, provincial and/or the Central government of China been well contemplated and implemented, which enables legal effect of the contractual relationship?
6. Have financial obligations and risk mitigation strategies been clearly conveyed to the foreign investor in the event of uni- or bi-lateral termination of the contractual relationship with the Chinese party?
7. Are proper and strong procedures in place to protect the foreign investor’s intellectual property rights, and, protection of trade secrets?
8. Does the foreign investor have expectations, or any awareness that under-the-table payments might be required by the Chinese side?
9. Are tactical and strategic plans contemplated to deal with such payment issues?
10. Has the foreign investor anticipated an adequate and satisfactory process for dispute resolution; and if so, in which forum(s) is it anticipated that disputes will likely be heard?
11. Does the foreign investor have local personnel on the ground that can and will continually monitor, acting as "eyes and ears" for the foreign party, relative to the regular operation of the Chinese-Counter Parties business operations, which are the subject of the contractual relationship?
12. Are proper financial auditing and controls developed to ensure that reported projections and actual numbers reflect the complete and true status of the operation?
13. If the project involves output for export, are proper QA procedures and operations clearly understood and accepted in writing by the Chinese party?
14. Is monitoring of said ongoing "procedures and operations" not only contemplated, but, does an "action plan" exist in writing to ensure general and specific compliance?

THE CHINA VENTURE IS IN DISTRESS — NOW WHAT?

Eroding sales, tight cash flows, mounting inventories and returns, erratic and urgent changes in priority – these are all symptoms of a company in distress that demand prompt and decisive action. IPO PANG operates a division called Trident China Venture Restructuring that is dedicated to helping foreign companies analyze and rectify the true causes of distress. Trident can help foreign companies whose China ventures are in distress, by:

• analyzing the root causes of distress
• formulating and implementing turnaround options, which may include:
  • marketing and distribution changes
  • installing temporary and permanent management changes
  • identifying and qualifying new partners
  • sourcing cash
  • identifying buyers for some or all of the venture
  • wind-down and dissolution