Following China opening up reforms in the 90s, investors from all over the world have rushed in the country to get a piece of cake: the market was extremely promising, with a large and totally untapped consumer base. However, laws and regulations were still very obscure and local tastes and preferences rather unknown for westerners. Considered as a convenient and cheap way to enter the Chinese market – and also because government often required foreigners to do so – foreign investors established Joint-Ventures with local partners. Two decades from then, failures have been numerous and western companies have lost a lot in the process: cash, of course, but also often intellectual property and brand image. Nowadays, foreigners’ favorite investment vehicle is the Wholly Foreign-Owned Enterprise (WFOE) which gives them full control on operations. Establishing WFOE has been a successful strategy in the most developed parts of China, where little effort was needed to adapt to local tastes. Those regions have rapidly grown western-like tastes and some kind of fanciness for western products. However, as those regions’ growth is starting to slow down to look much more like the US or Europe, investors looking for high growth potential will have to go to inner parts of the Country and, especially, Tier-2 and Tier-3 cities. But those markets are much more specific than the East Coast, with minority ethnics playing an important role in determining the local tastes and preferences. In such conditions, companies may need to ally themselves with locals again, so as to understand how those new markets work. As a consequence, it is very interesting to have a look back at past experiences and draw lessons from what happened.
Types of JV
Joint-Ventures in China can either take an Equity Joint-Venture (EJV) structure or a Contractual Joint-Venture (CJV) structure. Equity Joint-Venture consists in a new company funded by two or more partners. Liabilities and profits are proportionate to the amount of money they have invested in the first place. The initial investment can take many different forms: pure cash, staff, factories, lands or even intellectual property or trademark. Note that foreign shares shouldn’t be less than 25% though. The EJV usually have an independent life, regarding the partners’ operations. However, certain conditions, such as non-competition agreements, usually restrain partners’ activities that could harm the EJV.
Contractual Joint-Venture is a much more flexible structure, but this flexibility goes along with much more challenges. It basically reposes on a unique contract, regulating the whole relationship between the foreign and the Chinese partner. Liabilities and profits are distributed according to it, not according to equity shares. A CJV doesn’t even need to be an independent structure but can just be a contract regulating relationships between two partners. The tricky thing about CJV, though, is that nobody holds the final word on disputes unless it is written down in the agreement. So disputes can easily get out of hand, which is usually not very good for the business; this may explain why this kind of JV is still rather unused.
The difference between CJV and EJV raises a very important point: how to solve a dispute in a Joint-Venture? As a foreign investor willing to safely invest money in China, the question turns into: how do I keep control on the JV? Investing so as to get 51% of shares won’t suffice. Indeed, full legal rights on the company are ensured for the partner holding 51% of its equity. But it doesn’t mean this partner controls the company, especially in a culture that sees this principle as deeply unfair. Using the legal control with only 51% of stakes is rather seen as a ruse and some kind of betrayal. A consequence of this particular trait is that minority shareholder has the right to veto decisions emitted by the majority shareholder, according to Chinese Law.
Furthermore, the JV operations aren’t daily managed by its board. There are three levers of control in a Chinese company: the Representative Director, the General Manager and the company seals. It is a common Chinese tactic to trade a minority share of equity against the right to appoint the Representative Director and the General Manager: out of a bit of culpability, the foreign partner will agree. However, they are the only ones who see what is going on in the company every day, they are the ones supervising operations, giving direct orders to employees and appointing them. Giving away the Representative Director and the General Manager positions is like choosing to become blind: the foreign partner will never be able to be sure about what is really going on in the company.
The company seals (chops) are the ultimate approval-maker of the JV. Once apposed on a contract, it becomes valid. The employee that effectively possesses the company seals has the power to give himself a raise, transfer money from the company bank account to his personal account or approve a new selling contract with his wife’s company. On the other hand, a Director without the company seal is totally powerless. Controlling the chops is, therefore, of tremendous importance in keeping control on the Joint-Venture.
Highway to failure: one bed, two dreams
Last part was about pure, real and hard control. Those levers are only used as a last move, so as to save what can still be saved. They are not the right way to establish warm and long-standing relationships. Any foreigners that have been to China knows that relationships are keys when doing business in China. More than just being friend, it means that partners need to trust each other and, therefore, share the same long-term strategy. This is not easy: Chinese and Westerners usually pursue different objectives, because they come from different cultures and have extremely different life history. Generally speaking, the Chinese partner will look for quick profits and expansion thanks to fresh cash and technology brought by the foreign partner. On the other hand, the foreign partners want a safe and low-risk investment so as to ensure a steady growth and a long-term presence in China. A short list of what both partners are looking for is presented below:
From the very beginning of the JV negotiations, as soon as both partners meet, there should be a discussion about the JV’s long-term strategy and objectives. They should look for a common ground, assess what is possible and what is not. Divergence in partners’ long-term view for the JV will lead to catastrophe. Usually, the Chinese partner, who owns a minority equity share and therefore can’t turn its dream real, will start hidden activities with the JV. It is especially true if it owns the effective control discussed before.
So, do not underestimate the importance of relationships in China. It is all the more critical that the foreign partner won’t be backed by a strong legal system as it could be the case in the West. A contract often proves unenforceable in China.
Importance of Due Diligence
However, establishing a strong relationship with the wrong partner is losing time. So, how to determine whether a Chinese company is the right partner to start a Joint-Venture? The best way is to answer the following questions:
- Who is it? Is it a SOE/SME/local champion? Look for reputation.
- What is the business? Is it forbidden to foreign investments? Look for regulation.
- How is it done? Who are its suppliers and clients? Who are the employees? How are they linked? Look for guanxi.
- How is it financed? What does it really own? Are figures from its statements coherent? Check its finances.
These are the most basic questions to answer before entering a partnership. Most of the time, such questions can’t be asked directly to the partner. Studying its official releases, visiting its factories and offices, interviewing some of its staff can help in the process though.
Answering those questions will enable to better understand the Chinese partner’s motivations, strengths and weaknesses. The foreign entity will then be in a better position to assess whether it has an interest in working with the Chinese company or not. When it comes to negotiating the JV agreement with the partner, all the searches done will give foreign negotiators a better picture of who they are dealing with, which is often the hardest thing to achieve in China, and therefore be in a better position to sign the contract that will lead to a successful Joint-Venture.
What happens if things really go wrong? A Joint-Venture is rarely made to be permanent, as companies usually only have common interests for a rather short period of time. This doesn’t mean they are never successful; just that they can’t be always successful. As a consequence, entering a Joint-Venture shouldn’t be done without thinking about an exit strategy. If one partner doesn’t do it, the other will, at some point, and will benefit from it. First of all, the partner thinking about exiting need to assess its strategic advantages in the JV, such as being able to appoint the Representative Director or the General Manager or owning the chops. Those advantages should permit to keep control on internal operations while dispute over the partner’s exit is solved. Second thing is to ensure that leaving won’t have collateral effect. In China, politics have to be dealt with. As long as the rule of law won’t be fully in place, officials will have direct power on businesses. The answer to this is: don’t let the Chinese partner deal with guanxi alone, take part in it. But be careful about the way it is done, as a foreign company can’t ac
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