This article is authored by Jeremy Lin, Associate Director, Nexia TS Shanghai
When it comes to establishing joint ventures in China, foreign investors are often confronted with the wide array of divided opinions. Many joint ventures fail to endure due to unforeseen circumstances, and as foreign companies gain more experience, some have found it easier to establish a greenfield investment or to acquire a Chinese company outright. With loosened foreign investment restrictions and given China’s potential for growth, some Chinese companies are less interested in being acquired, which makes joint venture a more appealing option. However, the road to a joint venture, especially in China, is not an easy one. Yet, for every Wahaha-Danone bust-up, there are also examples of joint ventures in China which are operating smoothly under the radar. As such, this begs the question: How should a foreign party in a Joint Venture avoid the fate of so many of its predecessors and establish a mutually beneficial and successful joint venture?
Different Paths to Success
For foreign companies looking to enter the Chinese market, entering into a Joint Venture arrangement with local companies seems to be an intuitive way to tap into China. What better way to reach Chinese consumers than to leverage on the Chinese partner’s networks with local market knowledge? By being a party to a joint venture, the foreign company can bring about a faster time-to-market for its goods and services. Besides quicker market access, the joint venture setup also empowers the foreign company to better navigate the new business landscape through their Chinese business partners. As logic dictates, since both the foreign party and the local company have skin in the game, the stakeholders will most likely be equally committed to make the joint venture work as the best vote of confidence would be putting one’s own investments on the line. In addition to joint ventures, there are other ways to enter the Chinese market. For companies aiming to reach the end-consumer without the hassle of establishing retail points within China, they can utilise distributors within their own retail networks. Foreign players can also license or franchise their business models to Chinese partners to build a stronger brand presence in China by directly tapping on their resources for business expansion. For those who would prefer the greatest degree of control over their operations, foreign companies can consider the option of Wholly Foreign-Owned Entities (WFOE). However, a longer time-to-market and a steeper learning curve might be expected for such a mode of entry.
The Power Struggle
Should foreign firms decide to go down the joint venture route, the question of control is a thorny one –as in most business relationships, the bigger contributor is usually entitled to a larger slice of the pie. With each business partner seeking to maximise its return on investment, therefore, such a scenario bedevils many joint ventures as things are usually not as simple as they seem. In an ideal situation, most foreign investors prefer to have control over the joint venture entity. However, many go on to commit a fundamental error in assuming that a joint venture in China is run according to the Western model, whereby the leadership of the joint venture answers to a Board of Directors. As such, many foreign firms aim to obtain at least 51% ownership interest in the joint venture, thereby allowing them control of the Board, and ultimately the joint venture itself.
However, these foreign firms, being unfamiliar with the subtleties of the Chinese business scene, may unwittingly cede control over the appointment of the Legal Representative and the General Manager in a joint venture arrangement. Such a concession cedes actual power over the joint venture’s day-to-day operations. Hence, many joint ventures have been dissolved under such cloak-and-dagger tactics. With this in mind, the foreign companies must be vigilant during negotiations to avoid unforeseen setbacks.
In order to maintain effective control of the joint venture, foreign parties should aspire to control the following three aspects, namely the Legal Representative, General Manager and Company Seal of the entity. In China, the Legal Representative of a company has a substantial say over the company’s operations and it is vital that the foreign company has control over this appointment. The General Manager should be an employee of the joint venture who is accountable only to the Legal Representative. Whoever controls the Company Seal of a company has the power to enter into binding contracts as well as transact with banks and other service providers. Although this may appear to be a minor detail, it is critical to decide who ultimately controls the operations of the joint venture.
During negotiations, many Chinese parties may claim to require the control of all three aspects for the convenience of carrying out day-to-day operations. In particular, Chinese companies may assert that they cannot exercise their political and business connections if they do not control the appointment of the Legal Representative or the General Manager of the joint venture. More often than not, it is simply a smoke-screen to gain control of the joint venture. Should a foreign firm makes concessions on these three aspects, operational control over the joint venture in question will become challenging, even if the foreign party possesses a majority stake.
Conducting proper due diligence can substantially increase the chances of a successful joint venture. While Chinese parties have been known to tout their political and business connections as well as offer potential tax breaks, very often these claims should be taken with a pinch of salt. Although it is positive that a Chinese party is well-connected, such connections are a double-edged sword and can very well be used against the foreign company. Moreover, if the JV arrangement does not make financial sense without the tax breaks being offered, the foreign party might be better off not entering into a JV deal, particularly should the tax breaks prove to be a mirage in the future.
Raising and resolving as many issues as possible before the joint venture arrangement is often a wiser course of action, and more often than not, less expensive for the foreign company. These are some questions foreign investors might want to consider:
- Why does the Chinese party want to accomplish the deal? What is in it for them?
- What do I want from the JV? What are my motivations?
- What are the goals of the JV? What value does either party bring to the table and what will either party do to further the business of the JV?
- Who will be making the decisions for the JV and what are the dispute resolutions mechanisms?
- How will confidential JV information be used? Can either party have competing businesses with the JV?
- What are the exit contingencies? What if one party decides to buy the other out?
Ultimately, a successful joint venture depends on the on-going relationship between the foreign company and the local partner. The foreign company and local partner should complement each other and value-add to the growth of the business. Parties in a successful joint venture usually see value and returns on investment on an on-going basis. Should either party no longer see any value in continuing the arrangement, that joint venture is in danger of being dissolved. Signing a joint venture agreement is often just the beginning, not the end, of the journey.
For more information on our Advisory services regarding Joint Ventures in China, please contact:
Mr Jeremy Lin