Retail in China (I): Choosing your Business Model

Has the Chinese retail boom lured you to consider this market for your products? You are not alone. The rapid growth of the Chinese middle class is increasing this market’s attractiveness. AmCham 2010-2011 China Business Report shows Retail performs highest in all indicators analyzed in their survey (Success, Confidence, Welcoming).

I had been wanting to write a series about retailing in China so when I met Angela López Molina, corporate lawyer at DS AVOCATS in Shanghai, I thought she would be the right expert to contribute to a series of articles on the topic.

We will divide this topic into the following 3 posts:
Retail in China (I): Choosing your Business Model (Distributor/ Agent/ Franchise)
Retail in China (II): Choosing your Business Model (Corner/ Shop / Internet)
Retail in China (III): 10 Expert Tips to Help a Successful Set Up

(*Update: this series has now been completed. Links provided at the end of this article)

And today we will kick off with Retail in China (I): Choosing your Business Model 

1. DISTRIBUTORS & AGENTS:
Selling your products through distributors or agents is the “easiest” way to penetrate the Chinese market. It does not require a high investment and it allows assessment of the Chinese consumer’s reaction to your product.
It is not free of risks, though, as you may find yourself in the middle of a chaotic distribution network that is difficult to control.

a) Distributor vs Agent: Different Roles/Responsibilities
– Distributors buy and sell the products; their profit is the difference.
– Agents act in the name and on behalf of the foreign investor; they receive commissions on sales.
– Degree of trust: The agent generally enjoys a higher degree of independence and is able to change certain conditions without the explicit consent of the principal.

b) Tips on how to deal with agents/distributors in China
– Tip #1. Licences: Ensure your distributor/agent has the required licences to retail your products.
– Tip #2.  Exclusivity: Try to reduce the exclusivity territory (you may attach a map to the contract). Generally, exclusivity for all China is a bad idea.
– Tip #3. Establish sales targets and regulate your rights in case they are not met (e.g. termination or end of exclusivity).
– Tip #4. Commissions: describe clearly the calculation basis for commissions in the agency agreement.
– Tip #5IP Rights: Define the use of IP rights, promotion and publicity materials. Do not grant property on IP rights; grant instead a licence of use.
– Tip #6.  Termination: Reasons for termination are a key issue in distribution/agency contracts. Do not forget to regulate the consequences of such termination (e.g establish sale of stock to third parties / to the foreign investor, destroy / return the promotion materials, etc.).
– Tip #7. It is quite common for entrepreneurs and SMEs to initially “test the waters” with a distributor or an agent, and once they understand the market better and how their product works, they take it to the next level.

2. FRANCHISE:
a) Franchisors: Laws & Regulations
Under applicable laws and regulations, there are certain conditions imposed on franchisors in China:
– Legal form: Having a commercial company in China (JV or WFOE) or abroad. Individuals cannot establish a franchise in China.
– Previous experience: Having at least 2 own shops operated directly by the franchisor (in China or abroad), for  more than one year.
– Business model: Having a business model and the ability to render assistance and give instructions to the franchisee, as well as technical support, training and other services.
– IP rights: Having a trademark, patent or know-how (suggestion: register your IP in China).
– Registration of confidential business information: For every signed contract, franchisors must register with the competent authorities highly detailed (and usually confidential) information, such as: original franchise contract, marketing plan, franchisee manual, etc.

b) Franchisees: Some things you should know about their rights
Your Chinese franchisee has some rights that you should be well aware of:
– Your franchisee has the right to unilaterally terminate the contract without paying an indemnity if:
1) the franchisee claims that the information supplied is incomplete or untrue.
2) after a “reflection period” the franchisee decides to back out.

c) Tips on how to deal with your potential franchisee
– Tip #1. Make the franchisee sign a receipt acknowledging that the information received is complete.
– Tip #2. Clearly define in the contract how long this “reflection period” will last and try to make it as short as possible (i.e. within 1 day from the execution of the franchise contract).
– Tip #3. Enter a non-disclosure agreement (“NDA”), as you will be sharing all your business information.

d) China Franchise: Main issues
– Lack of payment by the franchisee is common; there is not a real franchise culture in China.
– Lack of confidentiality.
– Difficulty in controlling brand image.
– Legal uncertainty due to:
a) franchisee’s right to unilaterally terminate the contract.
b) reclassification risk: if, in order to avoid the disadvantages, the franchisor has established a distribution network that works as a franchise in practice, authorities may reclassify the legal relationship and impose a penalty (RMB10,000 to RMB500,000).

e) Recommendation
– If possible, enter the market initially managing your own stores, so that you can fully understand the market before you start granting franchises.

f) Conclusion
For obvious reasons, the franchise regime is very restrictive for franchisors and inevitably favours franchisees. As a result, some companies establish a distribution network that works de facto as a franchise. As we have pointed out, there is a risk of reclassification into franchise and the consequent sanction. In addition, in the new draft of the Catalogue for Foreign Investment (which regulates which are the encouraged, permitted, restricted and prohibited activities to be carried out by foreigners in China), the franchising business is now encouraged, which make us think that in the future the regime will be less restrictive and more favourable for foreign investors.

Would you like to share your retail experience?

Update: This series has now been completed. All the links shown bellow.

* Retail in China(I): Choosing your Business Model (Distributor, Agent, Franchise)
Retail in China (II): Choosing your Business Model (Corner, Shop Lease, Internet)
Retail in China (III): 10 Expert Tips to Help a Succesful Set Up

3 comments

  1. You were starting good but then you disappointed me with this as common as wrong advice:

    “- Tip #2. Exclusivity: Try to reduce the exclusivity territory (you may attach a map to the contract). Generally, exclusivity for all China is a BAD idea.”

    Why do you believe that? Because everybody say so?
    As a matter of fact companies who chose more than 1 distributor regret it and changed their strategies later, after assessing that:

    1 – no one of the distributors was willing to advertise the brand because others distributors may enjoy the benefits as well;
    2 – no one would share the leads gained during National trade shows. A distributor based in Shanghai would collect leads of visitors from all China and you honestly believe that he is going to share those contacts?
    3 – No one will respect the territorial limits because they do not want (especially if you set sales targets);
    4 – even if the distributors are willing to respect the territorial limits they customers will not. eCommerce has no boundaries within mainland China, and retailer chains are selling all over China;
    5 – no one would feel responsible for the price control, resulting in price wars. Especially distributors located where the operating costs are lower can and will cut prices the most;

    You wrote “you may find yourself in the middle of a chaotic distribution network that is difficult to control.”
    I would rather write “you WILL find yourself in the middle of a chaotic distribution network that is difficult to control, plus a drop in price that will make your products unappealing to the retailers.. if you follow my Tip #2”