Retail in China: Choosing your Business Model & 10 Tips for a Successful Set Up

This post compiles a series I published a few months “Retail in China: Choosing your business model & 10 Tips to help a successful set up”. I´ve compiled it to help shareability and bookmarking. I have also included some valid comments from the readership. I hope you find it useful.

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.

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.

What you will find here:
(I): Choosing your Business Model (Distributor/ Agent/ Franchise/ Corner/ Shop / Internet)
(II): 10 Expert Tips to Help a Successful Set Up

 

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.

Note from Foreign Entrepreneurs in China: When I first posted this article I got a comment from a reader who strongly opposed this tip. I think he made very valid points (real life experiences) to ponder when making a decision. These were his words:

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.

- 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 #5. IP 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.

 3. CORNER

This is an individually tailored mini-shop whereby the company rents a small space in a mall. The rent has often a fixed element (based on the number of sq. m. occupied) and a variable part (that is a percentage of the sales made).

a)Laws and Regulations

- You don’t need to establish a company in China to start your business through a corner – you may do it through a local agent.

- Your agent needs to have the so-called “Tax Payer General Status” (1).

- The term of these contracts is usually from 6 months to 1 year.

- Renewal is subject to sales targets being met.

b) Advantages

It is a small investment; it allows making the products known, understanding the potential client profile and checking consumers’ reaction.

c) Tips

-Tip #1 You should be aware that many malls impose restrictive conditions in terms of the brand (e.g.it must be a reputable international brand).

-Tip #2 The tenant must ensure a minimum profit in the first months.

-Tip #3. Often the contract (which is usually short term) may be terminated unilaterally by the landlord.

4. SHOP LEASE

This could probably be, from a financial perspective, your riskier option. The main advantage, though, is the full control you have on your operation.

a) Laws & Regulations

- Shop equals Branch: So, for every shop that you open, you need to register a branch (it takes 1-2 months if branches are on the same city and 3 months when it is in a new city)

- Contract Length: 3-5 years

b) Advantages

- Not subject to specific sales targets being achieved. You pay a rent and a deposit

c) Tips on how to negotiate a shop lease

-Tip #1 Understand who is renting the space to you (i.e. the owner or a lessee) – you might be renting the space from a person who is not actually the landlord (but, for example, a tenant who is trying to sub-lease the premises). In such case, if the tenant does not manage to renew the contract with the landlord, you may be forced to leave the shop, after having invested in decoration, marketing, etc. You should therefore always ask the supposed landlord for his/her certificate of ownership of the premises.

-Tip #2. Understand what is the legal use of such premises (e.g. residential, commercial, etc.). In the certificate of ownership, you will be able to check what is the use of such premises. Please note that if the premises do not have a commercial use and, for example, they have a residential use instead, you are not supposed to locate a shop in such place- the authorities would deny the registration of this shop as a branch or as the registered office of a company. Furthermore, if you have an inspection, you will be exposed to sanctions.

-Tip #3. Try to negotiate renewal conditions in the initial lease contract (e.g. a maximum percentage rise per year) so that you don’t see a big hike in rental cost when the renewal time arrives

- Tip #4.If your shop will be in a mall that is currently under construction, we advise you to sign a letter of intention first and to negotiate the lease once the mall has the required licence.

5. INTERNET SALES

a) Recent history

Joint Ventures and WFOEs have been allowed (theoretically) to engage in retail activity through the internet since 2004. The reality has been quite different though. Central MOFCOM had to approve these activities and approvals have either been put on hold or suspended.

Foreign companies used to navigate this difficulty in two ways:

- Avoiding setting up in China: but there are a number of hassles (logistics, currency exchange …)

- Partnering with a local broker

b) Update on Law & Regulations

This type of retail activity has now seen some encouraging signs. MOFCOM issued on 19 August 2010 the ”Circular on Several Issues Concerning the Approval and Administration of Foreign Investment in Sales via the Internet and Automatic Vending Machines”. The main changes that this circular represents are:

1. For established FIEs:

Internet sales are regarded as an extension of an FIE’s regular sales activities and can be conducted without any need to obtain additional approvals.

2. For Companies trading only through the internet:

Applications for the establishment of an FIE specialising in Internet sales are to be submitted for approval to the appropriate provincial-level agency under MOFCOM instead of central MOFCOM, which has two positive implications:

-speeds up the approval process, and

-promotes competition among regional administrations to capture foreign investment.

3. Some requirements on-line businesses should meet:

-display its business license in a prominent position on its website home page or on the website where it conducts sales activities.

-establish a comprehensive system for the return or replacement of goods.

-strictly protect consumers’ personal privacy.

-abide by China’s consumer laws and regulations.

 

 

(II) 10 EXPERT TIPS TO HELP A SUCCESSFUL SET UP

Before we start operating retail activities in China, there are a few things we should know as they may affect our business success.

1. Register brands /patents as soon as you decide to enter the market

Chinese distributors often “believe” they have the right to register the brands they are marketing. This is the reason why we recommend brand or patent registration as soon as a company starts considering doing business in China, and definitely before they start contacting potential distributors. Although it is a lengthy process (at times it may take up to 2 years) the application grants priority to the first applicant. Intellectual and industrial property protection may not be easy in China, but enforcement has been improving lately.

2.- Choose carefully your brand’s Chinese name… and register it

The brand’s Chinese name should not just be a phonetic rendition of the original brand, it should also be adequate to the image we want our products to communicate. Some distributors may refuse to market our products unless they have a suitable Chinese name.

3.- Become familiar with Chinese negotiation tactics

Chinese negotiation style is quite different from the Western style to which we are so used. When negotiating a contract in China, you will often encounter situations like this (just to mention a few):

-your Chinese partner tries to re-negotiate points that have already been agreed upon

-you see yourself interacting with a number of negotiators and you are not too clear who is the real decision-maker

-a company representative is flying into China to sign an agreement and the Chinese party waits until the last day to raise important issues, so as to get them solved to their advantage (they are the masters of the “time factor”).

All this can easily generate frustration and uneasiness, but understanding the Chinese negotiation tactics will help you be better prepared. We can’t give a “negotiation course” in two lines, but we can advise the following:

3.1) Expect long negotiations (and renegotiations) – so make allowance for delays in your timelines.

3.2) Try to keep your cool.

3.3) Try to assess who is the decision maker.

3.4) Evaluate how much information you need to release (Information is Power: the other party should not be clear about your constraints or when you are reaching your final deadline …)

3.5) Brief your organisation back home about “the Chinese way” so that they are ready in case any contingencies arise.

4.- Get adequate / sufficient information about your potential distributor or partner

Get a financial report about your potential partner, so that you can verify who they really are, what are all their business lines, whether they can become competition to your business, if they have the required business licences, what their experience is … And it is always advisable to visit their offices, warehouses and/or factories (do not rely on a website, which may contain false information).

5.- Don’t rely 100% on the Chinese partner to follow all the administrative processes/steps

Often companies delegate all the administrative, legal or tax procedures to the Chinese partner. It is important not to blindly trust that all procedures and licences are in place, to avoid later surprises like product being stopped at customs, fines, tax issues, etc. …

6.- Ensure your potential partner’s alignment with your business mission

Companies need to ensure the Chinese partner or distributor understands and shares your business vision and objectives, so that all efforts are focused on achievement rather than re-discussing everything all over again.

7.- Customize your product to local demand

Before we hit the market, we should research consumer reaction to our products. A lot of international brands have adapted their products to better suit the Chinese consumer and guarantee success (e.g. MacDonalds has customised menus for its franchises around the world).

8.- Set the right price point &be conservative about it

The Chinese consumer is very price sensitive and will not pay a premium price unless there is a clear selling point / advantage (quality, brand image …). We tend to recommend avoiding very premium price points in initial stages (unless very clearly justified), to devise loyalty programs (discount cards, VIP promotions …) and to invest in marketing.

9.- Watch out for the internet response

China has the highest number of cybernauts in the world, and they are also extremely engaged in forums, blogs and other internet social networks. This also includes those forums where products and brands go under scrutiny / review. Companies should ensure that the internet is part of their marketing strategy, as a mistake in their brand positioning may affect their reputation / business.

10.- Include location as a factor in your overall China strategy

Another decision that companies need to make is where to locate their retail businesses: tier 1 cities like Shanghai, Beijing or Guangzhou, or tier 2 and 3 cities. Companies like Nike or Adidas started marketing their products in Shanghai and Beijing and have now progressed into tier 2 cities. Other brands have followed the opposite strategy, for example the Chinese brand “Peak” started by capturing the smallest municipalities and has been adding market share through medium range products.

Another example would be the Chinese brand Eno. They follow different strategies in tier 1 and 2 cities. Their objective in tier 1 cities is to improve / build brand image, while they make money in tier 2 cities where costs are lower. Quoting Eno’s founder, Renee Hartman, “look pretty in tier 1 cities, make money in tiers 2 and 3”. Their products, designed for a young urban consumer, have succeeded in that market segment and the company was selected “most innovative”company in China” by Fast Company Magazine.

 

(1) Small scale taxpayer – ordinary taxpayer
When can a company apply for qualification of VAT ordinary taxpayer?
A trading company (wholesale or retail) after its setting-up, having achieved an annual turnover of no less than RMB 800,000.
According to a circular promulgated by the State Administration of Taxation, effective as of 20 March 2010, a trading company having not obtained an annual turnover of 800 000RMB may also apply for the qualification of ordinary taxpayer if it cumulatively satisfies the two following conditions:
a) It has a fixed place of operation.
b) It can establish accounting books in accordance with the Chinese regulations on accounting, and possesses legal and valid accounting vouchers, and can present exact accounting tax documents.

 


 

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