Foreign Entrepreneurs in China

The following post compiles the complete “A Joint Venture Survival Guide” series. I´ve compiled it to help sharebility & bookmarking. If you had not read them before, I recommend it as it has got really good reviews. I hope you find it  useful.

Joint Ventures (J-V) in China can go well, and can also go very wrong. When the latter is the case, problems come up from where you less expect them. “Mike Smith” (not his real name) spent two years in rural China supervising his employer’s interest in a Chinese joint venture where they were the majority partner (deal signed before he landed there). His case falls within the second category I’ve mentioned (I would in fact say that all that could go wrong went wrong) but that has given him invaluable lessons on how to ensure things are done right. He has also met on the way a number of joint-ventures facing quite similar challenges to the ones he experienced.

We met to talk about his time representing the foreign partner and I’ve drafted “A Joint-Venture Survival Guide” based on his experiences, opinions, tips and comments (which means some of these tips will only apply only to manufacturing joint-ventures). 

Some introductory thoughts

1. China is a noble and good society… but when it comes to doing business, the value system changes. Ripping off a foreigner may be seen as a clever thing rather than a bad one.

2. Beijing, Shanghai and Guangzhou are in a universe of their own. Drive just 100 km away into central China and reality changes. It is a hardship environment and corruption is readily encountered.

3. You may have successfully set up joint-ventures and businesses in other countries. Do not assume China is going to be the same. You are lost without an expert if you are going to deal with a local partner.
“My company had successfully set up J-Vs across the world, and nowhere did they face the situations they faced here. They assumed they knew it all, and that was a big mistake”.

“The Essentials”
4. The foundations for your success will be laid before you sign the deal.
Preliminary work is essential, and I cannot stress this enough. Once you have signed you are helpless. And later on, once your million dollars are in China, you will not be able to get them out unless you exit the J-V. There is plenty of room for disaster so make sure you dig into every single hole to figure out where the problems may be.
! Tip: This is the time to get as much information as you need. You need to be able to access all books, information about operational manual, … You may hear the somewhat overused sentence “What is the problem? Don´t you trust me?”. Well it is not about trust, it is about business, and companies that have nothing to hide will share the information with you. 

5.Confidentiality and know-how protection will be difficult in a small cities. All the legal issues about this will be judged in the city in which it happens, which means that if you have a company in Shanghai and someone “copies” your product in Ningxia, the legal procedure will be carried out in Ningxia so you will be dealing with all the difficulties of operating in a place that is not a j-v business hub.
! Tip: We are a European SME. If that is also your case you canhave free brief advice from the European Chambers of Commerce. Also a free advice for intellectual property, copy right, etc in China IPR SME Helpdesk. 

6. A GOOD consultant/advisor: Priceless.
You need real in-depth expertise to pull this one off successfully:
! Tip: “J-V conflict resolution and dissolution in China is really complicated compared to other countries. Consultant/Advisor companies have an instinct for knowing the real situation” 

7.[On consultants] … But find the one suited to your size
“The reality on the ground for SMEs is quite different to that of MNCs. We don’t have their leverage and muscle power and we deal with different issues/situations. It is essential to get on board a very good consultant but I wouldn’t recommend one of the big ones. I think they are better suited for big companies.”
! Tip: MNCs are often interested in high tech, setting up R + D centres, the pharmaceutical industry, medical issues and they will find some decent protection from the Local Government. In the case of SMEs that do business outside big business hubs, protection will be very difficult to guarantee and there will be unimaginable issues unless they hire the right consultant/advisor. And believe me, consultant/advisor big names will not help you to find the back door of your J-V.

8. Sign the right “pre-nup”
You obviously don’t want your relationship to go wrong, but if things happen you need to have put in place the right “break-up” conditions.
! Tip: Always use the Chinese or Hong Kong Arbitration Court. Most companies feel more comfortable with international arbitration, but what do you do when your Chinese partner doesn’t show up or doesn’t comply with the resolution? It needs to be done in China or Hong Kong where the resolution will be mandatory and enforceable.

9. Your Potential Partner is Well Connected … Maybe Good, Maybe Bad
Experience: It is quite common to be taken on the “big tour”, introduced to the city mayor, the bank’s president, and all sorts of top-end contacts. Your partner will put especial effort into making a great impression and showing you how easy doing business in China is going to be if you deal with him.
! Tip: Do not be dazzled by your partner’s connections …They will not necessarily be used for your benefit.
The fact that your partner is well connected is good (you obviously don’t want to end up with a nobody), but it is also a fact that at times those connections are only used for their own benefit.

10. Financial Reports: “I can’t live with or without you”
Financial reports: you need them, if only because when things go wrong you will be the first one fired if you did not order a financial report. But just be aware that reports can easily be falsified, and a lot of relevant information may be missing.
Experience: I will not get into too much detail but let’s say that I have even seen the falsifying process in action. Do not believe everything you read, and be aware that there will be facts/realities that are not reflected in those reports.
! Tip: There are things you will only get the feel for if you base yourself at your potential clients´ workplace. My recommendation would be to place your trusted person (who by the way should be China-knowledgeable and understand what he/she is looking for) at the company´s site . You need to see how the factory works, how many workers there are, their accounting, their stock control ….

11. Tax Planning: “Tax Breaks. Do not believe all you hear”.
While you are negotiating the joint venture you will be promised a lot of benefits. Tax breaks are a common tool to lure you into a location that needs to be developed. A lot of companies start operations in a location partly because they have been offered corporate income tax exemptions or reduced/zero import/export duties. It is also common to find that the day you to try to apply for them, you are told that the central government has changed the regulation and they can no longer grant you the benefits they promised.
Experience: We were promised tax exemptions on all those tools and parts required for our product manufacturing. It did not happen. Not even once.
! Tip: As mentioned in tip number 5 , it is essential to get the support of a good consultancy firm. Your investment should also make sense regardless of the tax exemptions or other promised benefits.

12. Let me guess: your Chinese partner wants to contribute the land to the joint venture.
Experience: The Chinese partner always wants to contribute his own properties to the J-V. But, can he give you actual proof of the real land value? These are common situations to encounter:
- The real value of the land, does not correspond to what your partner is claiming.
- The audited value presented and paid by your Chinese partner has been (easily) falsified.
- All sorts of excuses to justify the absence of a purchase document stating the real value they paid: “Government does not give invoices. We got a good deal …” . Do not fall for them.
In our case, we got an independent valuation of the land. It was worth 30% less than what our partner claimed.
! Tip: Do not fall for excuses. A land purchase should be properly documented. Beware if is not.

Experience: We wanted to buy land for the JVC. Our Chinese partner finally presented what he deemed was the best possible location and the required size(we felt it was too big). The land value would be considered capital contribution by the partner. He presented an alleged Government document stating the land value. The document had no seal so we suspected something was wrong and requested an independent valuation. The land value estimation was 200,000 € cheaper than the value presented by our partner. Our company´s President trusted the partner so they decided to take his word on this (by that time MD was already suspicious about the partner). The land was purchased, the invoice was never seen. He showed us an ownership title and the land became his capital contribution. Later on I managed to located the real purchase documents and the deal had been sealed at a 400,000€ cheaper prize.

13. Does your land have a license to have a factory built on it?
You need to watch out for this one. Chinese companies often ignore this step. You may find sizeable companies operating (100 employees, tax bureau number, social security …) without the license to legally operate a factory/company on their land. That may not be a problem while you stay together (they will surely have their ways to ensure there are no problems). But in the event of a split you may face one of these two situations:
- You want to sell it but you can’t because there is no licence for the construction done.
- You want to operate it alone, but being a foreign company you will find the government inspection at your doorstep day one. And they will close it due to lack of permits.
! Tip: Make sure you know all the licenses the business needs to operate legally. If your partner claims to have the license for that land already, you need to see it. If licenses are pending have your expert/consultant involved in that matter.

14. Building the Factory- Oh Nightmare
This is another potential source of conflict. You will probably trust your partner to lead the factory construction works.
Experience: “…a workshop building would not progress and when I inquired I would get “We have run out of money”. Digging into the contracts details I would find a lot of irregularities like missing contracts, unsigned contracts …”
! Tip: “If your project involves building a factory, I would recommend to budget for 15% to 20% extra cost vs. agreed amounts. Timewise, I would build in an extra 40% as a buffer. Penalties should be included and quantified in your contract. And as mentioned before, always use the China or Hong Kong Arbitration Court”.

15. Check Company Operational Manuals.
Very often there is nothing written on how operations should function. When you land there and try to organise things you do not even know where to start. And what is worse, your Chinese partner is not interested in changing anything as he feels it has been working for him for years before you arrived.
! Tip: The trusted person I advise before to place in your prospective partner´s operation should check out the operational manuals and whether the company works in compliance with them. If there are no manuals in place, you should request them to record their existing processes so that you can discuss them and negotiate before the deal signature. 

16. Money Hole #1: Company employees & Social Security.
There are a couple of “black holes” that are often used to suck your money away: the stated number of employees in the company and the payments to social security. You need to get two proofs here:
- Proof of the total number of employees in the company
- Proof that they are paying Social Security forthose employees.
Do not accept their word for this.
Experience: Our partner kept swearing that the company had 74 employees. My calculation was that there were no more than 50 employees in the company. I asked them to prove their claim but there were no contracts to be seen. When I asked for the bank transactions to assess the amount of money we were investing in overheads I was told it was paid in cash. When I asked for the receipts signed by the employees they said there were none.
I was not alone in this situation. I encountered other companies facing exactly the same challenge.
! Tip: You need to check this when you are negotiating and you still have bargaining power. If you discover this when you have already invested several million dollars you will be helpless. Do not accept their word on this. In China they file Social Security online. They have a website where they can access, through their company name and password, all their social security, accounting and fiscal (tax) data. Request to have access to this while still negotiating.

17. Money Holes #2: Stock Control
Companies often do not have good stock control in place and this is another big “black hole” your money will slip through.
Experience: You are told they bought 10 units of a product and they just purchased 5. When you try to investigate in detail they tell you there are not stock control systems in place, or the switch off the computer, or they tell you it does not work …
! Tip: Make sure you have access to all the policies and procedures manuals before you sign a deal. And once you have access, make sure you assess whether the policies and procedures are really happening or not. It is also quite possible that they do not even exist
The people from the purchase department should be “your people”. If that does not sound possible it is better to create the department from scratch and hire a local purchase manager of your choice, that you can trust, to ensure proper control.

18. Money Hole #3: Accounting
How many accounting books is your partner keeping? Make sure you keep a tight accounting process.

Experience: I always used to work late. One evening I happened to walk through the accounting department and somebody had forgotten to lock away the accounting books. To my surprise, the number of accounting books was higher than what I thought our company was keeping. I did not need to be too smart to figure out what was happening. Our partner was using fake purchase orders to divert money into his own personal accounts. Our accounting team was also keeping the books for his own company, which by the way was not supposed to exist any longer but should have merged into the J-V.
! Tip: Make sure you have unrestricted access to all cabinets and locations where information is stored.
!!Tip: Keep a very strict monitoring of the accounting. All expenses must come with proof of purchase,authorised and signed by you or your team.Fa piao (we could translatefa piao as “super-receipts – receipts that are hand-stamped and recognised for tax and other purposes)”
are difficult to audit as they usually come without a description of the expense.
!!!Tip: Develop a good relationship with the CFO
!!!!Tip: Purchases should come with double signature (CFO and your representative) on set days (probably not necessary more than three times a week as purchases are planned in advance)

Other things that could go wrong
19. Technology Transfer – IP Risks
A fact you should be clear about is that your partner is likely to end up copying your technology.
Experience: Our target market was China, so our J-V was supposed to manufacture a product more sophisticated than the existing competition in China but not as technologically advanced as our products in Europe. In order to do that, we needed to transfer some know-how to our Chinese partner. I strongly suggested against it but at that time, it would have been equivalent to giving up the project and I still did not have physical evidence of what was going on.
My fears were soon proved right and I caught them copying our electronic cards … And later on I found out about them copying machinery and tooling.
!Tip: Well, you have no way to control it. Fingers crossed and good luck (do not forget we are talking “deep China” and not main business hubs). If all steps have been taken correctly things are more likely to go better.

Most business people I´ve met in China share a view that the new generation of Chinese business people who have studied abroad understand how to do business for the long term rather than for immediate and dishonest gain.

20. Company Seal- Always with You.
In China documents can be signed and stamped with the company seal. Back home contracts would not be valid unless you have signed them. Here the company seal is enough to make a contract valid … so
!Tip: Never leave your Legal Representative seal with somebody else. If you absolutely need to, be sure you can trust that person 100% as that seal is equivalent to your own signature.

21. Be ready to test your endurance
Experience: My Chinese partner was responsible for my house utilities. Once I was left without power for several days, another time I had no running water for three days. I also got internet connection discontinued.
People around me also suffered. I went through three finance managers who left the company shortly after I hired them. I remember the case of one of them who would systematically arrive at the canteen to be told there was no food for him. These are highly paid professionals who have no interest in going through that hell when they can have a nice well paid job somewhere else.
!Tip: I think when you have reached this stage, things are going really bad. In this case, it could be safest to control your house contract and utilities directly (probably through somebody you trust).

22. Beware of direct communication between your partner and your headquarters.
When you start proving to be a “damned nuisance” in your partner’s life he may try to get rid of you in different ways. He may contact your headquarters and try to make you look like inept or make them believe you complicate your life (and everybody else´s) with non-existent problems and issues.
Experience: In my case the Chinese partner kept calling my company’s president and emailing the board of directors in order to undermine their trust in me. I was very lucky because in the end I managed to get access to all sort of documents that proved we were being ripped off. But I’ve later on met other people who lost their positions due to pressure from the Chinese partner.
!Tip: Invest in “Educating your Headquarters” before you start operating in China. Headquarters don’t like to hear bad news. And some of the stories you will tell them are so unbelievable that they may end up thinking you have gone China-mad.

So what are your tips and experiences in Chinese joint ventures? You can leave a comment or contact me to share it in a longer form!

You can also subscribe for future post updates!

Your email:

 

This is the third post of the series entitled “A China Joint Venture Survival Guide” based on Mike Smith’s experiences as his company’s representative in a Chinese joint venture. If you have not read our previous posts you can read them here:
A China Joint-Venture Survival Guide (I)
A China Joint-Venture Survival Guide (II)

A Joint-Venture Survival Guide (III).(Tips 16-22)

“Watch Out for the Money Holes”
16. Money Hole #1: Company employees & Social Security.
There are a couple of “black holes” that are often used to suck your money away: the stated number of employees in the company and the payments to social security. You need to get two proofs here:
- Proof of the total number of employees in the company
- Proof that they are paying Social Security forthose employees.
Do not accept their word for this.
Experience: Our partner kept swearing that the company had 74 employees. My calculation was that there were no more than 50 employees in the company. I asked them to prove their claim but there were no contracts to be seen. When I asked for the bank transactions to assess the amount of money we were investing in overheads I was told it was paid in cash. When I asked for the receipts signed by the employees they said there were none.
I was not alone in this situation. I encountered other companies facing exactly the same challenge.
! Tip: You need to check this when you are negotiating and you still have bargaining power. If you discover this when you have already invested several million dollars you will be helpless. Do not accept their word on this. In China they file Social Security online. They have a website where they can access, through their company name and password, all their social security, accounting and fiscal (tax) data. Request to have access to this while still negotiating.

17. Money Holes #2: Stock Control
Companies often do not have good stock control in place and this is another big “black hole” your money will slip through.
Experience: You are told they bought 10 units of a product and they just purchased 5. When you try to investigate in detail they tell you there are not stock control systems in place, or the switch off the computer, or they tell you it does not work …
! Tip: Make sure you have access to all the policies and procedures manuals before you sign a deal. And once you have access, make sure you assess whether the policies and procedures are really happening or not. It is also quite possible that they do not even exist
The people from the purchase department should be “your people”. If that does not sound possible it is better to create the department from scratch and hire a local purchase manager of your choice, that you can trust, to ensure proper control.

18. Money Hole #3: Accounting
How many accounting books is your partner keeping? Make sure you keep a tight accounting process.
Experience: I always used to work late. One evening I happened to walk through the accounting department and somebody had forgotten to lock away the accounting books. To my surprise, the number of accounting books was higher than what I thought our company was keeping. I did not need to be too smart to figure out what was happening. Our partner was using fake purchase orders to divert money into his own personal accounts. Our accounting team was also keeping the books for his own company, which by the way was not supposed to exist any longer but should have merged into the J-V.
! Tip: Make sure you have unrestricted access to all cabinets and locations where information is stored.
!!Tip: Keep a very strict monitoring of the accounting. All expenses must come with proof of purchase,authorised and signed by you or your team.Fa piao (we could translatefa piao as “super-receipts – receipts that are hand-stamped and recognised for tax and other purposes) are difficult to audit as they usually come without a description of the expense.
!!!Tip: Develop a good relationship with the CFO
!!!!Tip: Purchases should come with double signature (CFO and your representative) on set days (probably not necessary more than three times a week as purchases are planned in advance)

Other things that could go wrong
19. Technology Transfer – IP Risks
A fact you should be clear about is that your partner is likely to end up copying your technology.
Experience: Our target market was China, so our J-V was supposed to manufacture a product more sophisticated than the existing competition in China but not as technologically advanced as our products in Europe. In order to do that, we needed to transfer some know-how to our Chinese partner. I strongly suggested against it but at that time, it would have been equivalent to giving up the project and I still did not have physical evidence of what was going on.
My fears were soon proved right and I caught them copying our electronic cards … And later on I found out about them copying machinery and tooling.
!Tip: Well, you have no way to control it. Fingers crossed and good luck (do not forget we are talking “deep China” and not main business hubs). If all steps have been taken correctly things are more likely to go better.
Most business people I´ve met in China share a view that the new generation of Chinese business people who have studied abroad understand how to do business for the long term rather than for immediate and dishonest gain.

20. Company Seal- Always with You.
In China documents can be signed and stamped with the company seal. Back home contracts would not be valid unless you have signed them. Here the company seal is enough to make a contract valid … so
!Tip: Never leave your Legal Representative seal with somebody else. If you absolutely need to, be sure you can trust that person 100% as that seal is equivalent to your own signature.

21. Be ready to test your endurance
Experience: My Chinese partner was responsible for my house utilities. Once I was left without power for several days, another time I had no running water for three days. I also got internet connection discontinued.
People around me also suffered. I went through three finance managers who left the company shortly after I hired them. I remember the case of one of them who would systematically arrive at the canteen to be told there was no food for him. These are highly paid professionals who have no interest in going through that hell when they can have a nice well paid job somewhere else.
!Tip: I think when you have reached this stage, things are going really bad. In this case, it could be safest to control your house contract and utilities directly (probably through somebody you trust).

22. Beware of direct communication between your partner and your headquarters.
When you start proving to be a “damned nuisance” in your partner’s life he may try to get rid of you in different ways. He may contact your headquarters and try to make you look like inept or make them believe you complicate your life (and everybody else´s) with non-existent problems and issues.
Experience: In my case the Chinese partner kept calling my company’s president and emailing the board of directors in order to undermine their trust in me. I was very lucky because in the end I managed to get access to all sort of documents that proved we were being ripped off. But I’ve later on met other people who lost their positions due to pressure from the Chinese partner.
!Tip: Invest in “Educating your Headquarters” before you start operating in China. Headquarters don’t like to hear bad news. And some of the stories you will tell them are so unbelievable that they may end up thinking you have gone China-mad.

So what are your tips and experiences in Chinese joint ventures? You can leave a comment or contact me to share it in a longer form!

You can also subscribe for future post updates.

Your email:

 

This is the second post of the series entitled “A China Joint-Venture Survival Guide” based on Mike Smith´s experiences as his company’s representative in a Chinese joint venture. If you have not read our previous post with the first set of facts and tips you can read it here:
A China Joint-Venture Survival Guide (I).

A Joint Venture Survival Guide (II).(Tips 9-15)

“The Danger Zone”
9. Your Potential Partner is Well Connected … Maybe Good, Maybe Bad
Experience: It is quite common to be taken on the “big tour”, introduced to the city mayor, the bank’s president, and all sorts of top-end contacts. Your partner will put especial effort into making a great impression and showing you how easy doing business in China is going to be if you deal with him.
! Tip: Do not be dazzled by your partner’s connections …They will not necessarily be used for your benefit.
The fact that your partner is well connected is good (you obviously don’t want to end up with a nobody), but it is also a fact that at times those connections are only used for their own benefit.

10. Financial Reports: “I can’t live with or without you”
Financial reports: you need them, if only because when things go wrong you will be the first one fired if you did not order a financial report. But just be aware that reports can easily be falsified, and a lot of relevant information may be missing.
Experience: I will not get into too much detail but let’s say that I have even seen the falsifying process in action. Do not believe everything you read, and be aware that there will be facts/realities that are not reflected in those reports.
! Tip: There are things you will only get the feel for if you base yourself at your potential clients´ workplace. My recommendation would be to place your trusted person (who by the way should be China-knowledgeable and understand what he/she is looking for) at the company´s site . You need to see how the factory works, how many workers there are, their accounting, their stock control ….

11. Tax Planning: “Tax Breaks. Do not believe all you hear”.
While you are negotiating the joint venture you will be promised a lot of benefits. Tax breaks are a common tool to lure you into a location that needs to be developed. A lot of companies start operations in a location partly because they have been offered corporate income tax exemptions or reduced/zero import/export duties. It is also common to find that the day you to try to apply for them, you are told that the central government has changed the regulation and they can no longer grant you the benefits they promised.
Experience: We were promised tax exemptions on all those tools and parts required for our product manufacturing. It did not happen. Not even once.
! Tip: As mentioned in tip number 5 , it is essential to get the support of a good consultancy firm. Your investment should also make sense regardless of the tax exemptions or other promised benefits.

12. Let me guess: your Chinese partner wants to contribute the land to the joint venture.
Experience: The Chinese partner always wants to contribute his own properties to the joint venture. But, can he give you actual proof of the real land value? These are common situations to encounter:
- The real value of the land, does not correspond to what your partner is claiming.
- The audited value presented and paid by your Chinese partner has been (easily) falsified.
- All sorts of excuses to justify the absence of a purchase document stating the real value they paid: “Government does not give invoices. We got a good deal …” . Do not fall for them.
In our case, we got an independent valuation of the land. It was worth 30% less than what our partner claimed.
! Tip: Do not fall for excuses. A land purchase should be properly documented. Beware if is not.
Experience: We wanted to buy land for the JVC. Our Chinese partner finally presented what he deemed was the best possible location and the required size(we felt it was too big). The land value would be considered capital contribution by the partner. He presented an alleged Government document stating the land value. The document had no seal so we suspected something was wrong and requested an independent valuation. The land value estimation was 200,000 € cheaper than the value presented by our partner. Our company´s President trusted the partner so they decided to take his word on this (by that time MD was already suspicious about the partner). The land was purchased, the invoice was never seen. He showed us an ownership title and the land became his capital contribution. Later on I managed to located the real purchase documents and the deal had been sealed at a 400,000€ cheaper prize.

13. Does your land have a license to have a factory built on it?
You need to watch out for this one. Chinese companies often ignore this step. You may find sizeable companies operating (100 employees, tax bureau number, social security …) without the license to legally operate a factory/company on their land. That may not be a problem while you stay together (they will surely have their ways to ensure there are no problems). But in the event of a split you may face one of these two situations:
- You want to sell it but you can’t because there is no licence for the construction done.
- You want to operate it alone, but being a foreign company you will find the government inspection at your doorstep day one. And they will close it due to lack of permits.
! Tip: Make sure you know all the licenses the business needs to operate legally. If your partner claims to have the license for that land already, you need to see it. If licenses are pending have your expert/consultant involved in that matter.

14. Building the Factory- Oh Nightmare
This is another potential source of conflict. You will probably trust your partner to lead the factory construction works.
Experience: “…a workshop building would not progress and when I inquired I would get “We have run out of money”. Digging into the contracts details I would find a lot of irregularities like missing contracts, unsigned contracts …”
! Tip: “If your project involves building a factory, I would recommend to budget for 15% to 20% extra cost vs. agreed amounts. Timewise, I would build in an extra 40% as a buffer. Penalties should be included and quantified in your contract. And as mentioned before, always use the China or Hong Kong Arbitration Court”.

15. Check Company Operational Manuals.
Very often there is nothing written on how operations should function. When you land there and try to organise things you do not even know where to start. And what is worse, your Chinese partner is not interested in changing anything as he feels it has been working for him for years before you arrived.
! Tip: The trusted person I advise before to place in your prospective partner´s operation should check out the operational manuals and whether the company works in compliance with them. If there are no manuals in place, you should request them to record their existing processes so that you can discuss them and negotiate before the deal signature.

Coming soon the final post of this series: “A Joint Venture Survival Guide (III)”. More interesting and useful tips to help you navigate a joint venture negotiation.

 Would you like to share your experience with a Chinese joint venture?

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China Law Blog has published a post about foreign companies that try to buy out their Chinese suppliers. Dan Harris makes very enjoyable reading out of a very serious topic. You can read his post entitled here: “Buying A Chinese Company. Why China Deals Don´t Get Done”

This is what you will learn from his article:
Very common practises for Chinese companies are:
-to under report employee wages to the government
-to underpay taxes
-to pay the rent under the table.
Which may be easy to get away with as a Chinese company but not as a WFOE.

So, if you are considering buying out your Chinese supplier, life will be a bit different for you. As a WFOE, your company will probably be wanting to play by the rules (and you better do it because as a foreign company you will be closely scrutinised) and the profits your supplier was making will be imposible to replicate as you will:
-end up paying double the amount your supplier was paying in wages and benefits
-pay all your income taxes
-have to increase booked rental costs

This is the short version. Read the original post here to get really interesting details and some cost estimates.

I will only add that it is indeed widely known that these practises are common. Some of these issues I will also mention in the second part of “A China Joint Venture Survival Guide” that is coming soon (Check my first post on the topic here)

Do you have any stories about buying out a Chinese company?

Joint-Ventures (J-V) in China can go well, and can also go very wrong. When the latter is the case, problems come up from where you less expect them. “Mike Smith” (not his real name) spent two years in rural China supervising his employer’s interest in a Chinese joint venture where they were the majority partner (deal signed before he landed there). His case falls within the second category I’ve mentioned (I would in fact say that all that could go wrong went wrong) but that has given him invaluable lessons on how to ensure things are done right. He has also met on the way a number of joint-ventures facing quite similar challenges to the ones he experienced.

We met to talk about his time representing the foreign partner and I’ve drafted a series entitled “A Joint-Venture Survival Guide” composed of three posts based on his experiences, opinions, tips and comments .

A Joint-Venture Survival Guide (I).(First 8 Facts and 5 Tips)

Some introductory thoughts
1. China is a noble and good society… but when it comes to doing business, the value system changes. Ripping off a foreigner may be seen as a clever thing rather than a bad one.

2. Beijing, Shanghai and Guangzhou are in a universe of their own. Drive just 100 km away into central China and reality changes. It is a hardship environment and corruption is readily encountered.

3. You may have successfully set up joint-ventures and businesses in other countries. Do not assume China is going to be the same. You are lost without an expert if you are going to deal with a local partner.
“My company had successfully set up J-Vs across the world, and nowhere did they face the situations they faced here. They assumed they knew it all, and that was a big mistake”.

“The Essentials”
4. The foundations for your success will be laid before you sign the deal.
Preliminary work is essential, and I cannot stress this enough. Once you have signed you are helpless. And later on, once your million dollars are in China, you will not be able to get them out unless you exit the J-V. There is plenty of room for disaster so make sure you dig into every single hole to figure out where the problems may be.
! Tip: This is the time to get as much information as you need. You need to be able to access all books, information about operational manual, … You may hear the somewhat overused sentence “What is the problem? Don´t you trust me?”. Well it is not about trust, it is about business, and companies that have nothing to hide will share the information with you.

5.Confidentiality and know-how protection will be difficult in a small cities. All the legal issues about this will be judged in the city in which it happens, which means that if you have a company in Shanghai and someone “copies” your product in Ningxia, the legal procedure will be carried out in Ningxia so you will be dealing with all the difficulties of operating in a place that is not a business hub.
! Tip: We are a European SME. If that is also your case you canhave free brief advice from the European Chambers of Commerce. Also a free advice for intellectual property, copy right, etc in China IPR SME Helpdesk.

6. A GOOD consultant/advisor: Priceless.
You need real in-depth expertise to pull this one off successfully:
! Tip: “J-V conflict resolution and dissolution in China is really complicated compared to other countries. Consultant/Advisor companies have an instinct for knowing the real situation”

7.[On consultants] … But find the one suited to your size
“The reality on the ground for SMEs is quite different to that of MNCs. We don’t have their leverage and muscle power and we deal with different issues/situations. It is essential to get on board a very good consultant but I wouldn’t recommend one of the big ones. I think they are better suited for big companies.”
! Tip: MNCs are often interested in high tech, setting up R + D centres, the pharmaceutical industry, medical issues and they will find some decent protection from the Local Government. In the case of SMEs that do business outside big business hubs, protection will be very difficult to guarantee and there will be unimaginable issues unless they hire the right consultant/advisor. And believe me, consultant/advisor big names will not help you to find the back door of your J-V.

8. Sign the right “pre-nup”
You obviously don’t want your relationship to go wrong, but if things happen you need to have put in place the right “break-up” conditions.
! Tip: Always use the Chinese or Hong Kong Arbitration Court. Most companies feel more comfortable with international arbitration, but what do you do when your Chinese partner doesn’t show up or doesn’t comply with the resolution? It needs to be done in China or Hong Kong where the resolution will be mandatory and enforceable.

Coming soon “A Joint-Venture Survival Guide (II)” with more interesting and useful tips to help you navigate a J-V negotiation.

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If you are considering to set up a Wholly Foreign Owned Entity (WFOE) in China, the China Law Blog has just published a very good post that takes you through the basic steps that you will need to follow to form this type of entity.

I think this is a good post to recommend because a lot of foreign entrepreneurs choose to form a WFOE to stablish their presence in China. WFOEs allow you to keep full control and ownership of the operation and it also makes IP protection easier -hence it has become the preferred vehicle to enter this market.

Bellow you can read a recap of the China Law Blog recommendations and steps (you can read the complete post here, and if you still don´t subscribe to their blog I highly recommend you to do it):

1. Make sure your business is legal for foreigners.

2. Provide the required documentation: proof of the company being a duly formed and validly existing corporation or Limited Liability company in its home country.

3. Investor Documents Needed:

a) articles of incorporation or equivalent

b) business license, both national and local

c) certificate of status or a notarized copy of the Corporate Register for the investor or similar document

d) bank letter attesting to the account status of the investor company

e) description of the investor’s business activities (in Chinese)

4. Consider forming a Special Purpose Company to own the WFOE. It is common to form a Hong Kong company for this purpose and there are often tax benefits.

5. Secure Chinese Government approval.(and they remind you that in China, approval of the project by the relevant government authority is an integral part of the company registration process and you risk not being able to register if the project is not approved) . 

6. Documents to be submitted in order to achieve Chinese Government approval:

a) articles of association (which will determine issues like stablishing directors, local management, local address, special rules on scope of authority of local managers, company address, and registered capital)…
Note from Foreign Entrepreneurs in China: you need to devote special care to this part. The articles of association are one of the most important set of documents you will be preparing. The articles of association include articles like “business scope” which needs to truly reflect any type fo activity you are planning, as you will not be able to operate out of its limits.

b) feasibility study (in Chinese).

c) a lease. ( an agreement for all required leases must be provided)

7. Other documents that you will be requested: proposed personnel salary and benefit budget. And any other documentation required for the specific business proposed.

8. Approval process: 2-5 months for governmental approval, depending on the location of the project and its size and scope.

And just to finalize this post I will remind you what most entrepreneurs tell me in their interviews: “Get good advisors”. The people who help you navigate the set up of your company in China can make a huge difference.

More recommended reading: Take a look to our post entitled “Setting Up a Representative Office in China: 10 Steps and some Practical Tips”. Although it was produced with R.O.s in mind, it still provides very good tips that apply to other type of entities.

Considering setting up a Representative Office (R.O.) in China? You may need to revise your numbers.
The Notice from the State Administration for Industry and Commerce and the Ministry of Public Security “Further Strengthening the Administration on Registration of Resident Representative Offices of Foreign Enterprises” (Jan 4^th, 2010)[1] is not the only cloud on your horizon. On February 20^th 2010 the State Administration of Taxation (SAT) issued a circular announcing the new tax treatment for foreign R.O.s “Tentative Measures for the Administration of Taxation on Representative Offices of Foreign Enterprises” (Guoshuifa[2010] No.18 (Circular 18)) [2].

Two main changes are worth highlighting:

1. Exemptions
   Local tax authorities are requested to review existing tax exemptions granted under the old rules.  Till now, R.O.s’ expenses related to activities like market research, liaison and other preparatory sales and manufacturing activities for their head offices products could enjoy tax exemptions. And it is believed that often R.O.s were getting exemptions even if their expenses did not fall into these categories.
   Under the new tax treatment, exemptions will only be applicable if there is a relevant tax treaty or agreement.
   … So, reassess your situation, and if you believe you still qualify apply a.s.a.p.
2. Deemed profit rate increase from the current 10% to a minimum of 15% of the operating expenses (when using the cost-plus method/ for R.O.s that can accurately detail expenses)
   Deloitte has published in its China newsletter a very comprehensive analysis that shows that this change in the taxable income ratio will mean an increase in tax costs of no less than 24% (you can read the detailed analysis in the link at footnote # 2).
   And the most confusing part here is that this 15% that everybody is now hoping for is just “a minimum”. So one wonders how will the local tax authorities evaluate whether an R.O. ‘s profit should be deemed 15% or 50% …

These changes will definitely affect companies deciding or reassessing what legal entity best works for their China business. Ana Inchausti, from Inventta, also touched on that point when I approached her for my previous post on how SAIC’s new regulations would be affecting R.O.s. I quote bellow a summary of her comments on the tax changes:

“…To the question if we still consider R.O.s a practical approach to establish businesses in China, we would say yes, R.O.s are still an interesting approach but maybe to a more reduced group of projects than in the past. The tax increase is, in our opinion, the major change affecting the decision making process…We would advice our clients to set up a R.O when they are going to keep a small medium structure with low costs and just a few employees and overall if, after doing the math, to pay tax based on their expenses is still more interesting and competitive than to pay a profit based tax, as its compulsory to the WOFEs.”

These next two weeks are going to be very interesting. R.O.s will be submitting their quarterly EIT (Enterprise Income Tax) and BT (Business Tax) for the first time under the new regulations so there may be not-so-nice surprises. I’m planning to follow up with some R.O.s to find out what these changes have meant to them. Maybe it is time to go WFOE!

Would you like to share how the new regulations are affecting your R.O.?

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[1] Link to the State Administration for Industry & Commerce of the People’s Republic of China. Notice of changes in Registration of Foreign Representative Offices – English reference translations:
http://202.108.90.68/nd/100108143617-0.htm

[2] Deloitte Tax Analysis on the new Tax Treatment issued by SAT “Tentative Measures for the Administration of Taxation on Representative Offices of Foreign Entreprises” (Guoshuifa[2010] No.18 (Circular 18))
http://www.deloitte.com/assets/Dcom-China/Local%20Assets/Documents/Services/Tax/TaxNewsletterEN2010/cn_tax_tap1012010eng_080310.pdf

Considering setting up a Representative Office (R.O.) in China? There are a few things you should know.

R.O.s are getting a lot of attention this year, as China’s State Administration for Industry and Commerce (SAIC) issued in January new regulations that further restrict their activity[1]. These regulations are already being implemented in Shanghai and are said to be on the way for the rest of China.

I must admit that every time I read about R.O.s, commentators highlight their limitations and the hassle involved in switching to another form of legal entity, if needed later on. So consultants tend nowadays to favour the establishment of WFOEs (Wholly Foreign Owned Enterprises) as a better long term option if you are committed to a project in China.

I read about these new regulations right after I had finished interviewing Barbara Cisneros from INAEL Electrical Systems SA  on the topic of how to set up a Representative Office (R.O.) and I must admit I feared I was about to produce an “obsolete” blog post even before posting it on line. But then, I decided to go ahead with that post and further explore the new situation with Ana Inchausti, from Inventta, a consulting company specialized in internationalization projects in Asia.

Before I jump into her feedback, I will recap the main changes that these new rules mean for R.O.s:

• The foreign company must prove that they have existed for at least two years (ouch! for newly created companies that would like to operate here…)
• Registration Certificate will be valid for only one year (in the past it could extend up to three years)
• Foreign employees, who will all hold the position of “representative”, will be limited to a total of four only. This includes the Chief Representative of the office.

And I will also summarize the main advantages and limitations traditionally attributed to R.O.s:
Advantages:

• It is the fastest option to set up locally, it just takes between 2 and 3 months, once all the paperwork is ready
• It is cheaper than creating a WFOE, as you need NO capital to establish.
• It allows you a presence in China and hence better perform a series of non-profit making activities (like market intelligence, business relationships, better access to suppliers, “introducing products” (not directly selling them or invoicing) or being able to give technical support/coaching on those products).

Limitations:

• You cannot place orders or produce invoices, in a nutshell, you cannot do anything that may represent a profit making activity (all that needs to be done from headquarters)
• You cannot employ staff directly (you have to go through the government employment agency)

Interview to Ana Inchausti, from Inventta (by e-mail).

1. Do you still consider R.O.s a practical option to establish here?
   R.O.s have been traditionally the most common investment vehicles in China since foreign companies were allowed to set up legal entities in the country. During some years it’s been the best choice to enter in the market in a quick and cost-efficient way. Keeping in mind that no capital investment is required, many investors have been strongly attracted by this legal form to set up their business here.
   After the new regulation came into force in 2010, the general context has changed and to some business, R.O.s might not be the most interesting way to go; to others, it’s simply not possible to set up R.O.s because they no longer qualify to pass the approval and examination of the authorities …… The obligation to the foreign company to prove that it has existed  for more than 2 years in their countries of origin and the limitation to hire more than a certain number of foreign employees are making R.O.s a non available option to many investors, even if it was their choice in the first place.
   However, at Inventta, we analyze our clients’ investment and business plans on a case by case base; and we are still advising this kind of structure in some specific cases where all the new regulations are not having great impact . We consider all the aspects involved in a business, not only the registration or the start up periods to which many of the changes introduced apply, but we also bear in mind the future life and needs of the business.
   To the question if we still consider R.O.s a practical approach to establish businesses in China, we would say yes, R.O.s are still an interesting approach but maybe to a more reduced group of projects than in the past.
   …… We would not advice to choose a R.O.s as an investment structure to companies that may need to hire more than 4 foreign employees (which it is not allowed any more), to companies that will have great expenses (for example: rental, salaries, business trips…etc) because the tax is paid taking the monthly expenses as the tax base, and, obviously, to companies that need to issue “fa piao” (invoices) to their clients.

2. Which type of company do you recommend this approach to?
   We would advice our clients to set up a R.O when they are going to keep a small medium structure with low costs and just a few employees and overall if, after doing the math, to pay tax based on their expenses is still more interesting and competitive than to pay a profit based tax, as its compulsory to the WOFEs.

3. Do new regulations change the way you will be advising your clients?
   The new regulation came into force in January 2010 and, as in many occasions, without too much pre advice, so we all had to adapt our advising and strategy methods to make sure we are covering our clients’ needs. On the other hand, all investors had to changed their business plans to adapt their projects to the new legal frame affecting foreign corporate establishment in China.

So, now my question goes to the blog readers. Are the new regulations going to affect your activity as a Representative Office?

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[1] Link to the State Administration for Industry & Commerce of the People’s Republic of China
Notice of changes in Registration of Foreign Representative Offices – English reference translations:
http://202.108.90.68/nd/100108143617-0.htm

Other English sources for this information:
http://www.picozzimorigi.cn/main/reports.php?id=30

http://www.martindale.com/government/article_Sheppard-Mullin-Richter-Hampton-LLP_916678.htm

Considering setting up a Representative Office (R.O.) in China? Barbara Cisneros from INAEL Electrical Systems SA takes us through the steps she followed and gives us some tips based on her experience setting up in Shanghai in 2008.

1. – Obtaining the License.
Tip: Get somebody to guide you through the licensing and legal process.
Experience: There is a huge load of paperwork and you will not be able to do it on your own. In our case, we hired a Spanish law firm with an office here, as we also needed to legalize/authenticate paperwork for Spain. Once you have all the paperwork ready the process may take 2 to 3 months (at least in our case!)

2. - Designation of a Chief Representative.
In order to be able to start operating you MUST designate a Chief Representative for the R.O. This person will hold legal authority and will be legally liable. The Chief Representative will also pay taxes in China.

3. – Registering with the Tax Bureau.
As R.O.s don’t make profits, the Government has devised another way to get some money out of us. We are charged a percentage of the expenses our office incurs, including wages, rental, etc… I believe this percentage may vary depending on which city you live in, jurisdiction, municipality, district… In our case we pay 10% of our expenses.
Tip: I go back here to my first tip “get somebody to guide you”.
Experience: The law firm that navigated us through the licensing process also took care of this.

4. – Accounting.  Somebody in your Team or Outsourcing?
As soon as you get your license you must start paying taxes. You pay the income tax monthly and the office taxes every three months.
Tip: (This tip is for very small R.O.s like ours (just me and a local employee.)) Unless you have hired somebody with an accounting background who additionally, and this is very important, has good contacts at the tax bureau, then I would recommend outsourcing it to an accounting firm.
Experience: In our case I decided to hire somebody with a bit of an engineering background so that she could help with my work beyond just picking up the phone. I outsourced the accounting tasks to an accounting firm.
There are plenty of companies, both multinational and local, that can do this for you. … When you are a very small company you don’t have the budgets a big multinational may be expecting from a client… so I contacted a local firm for which I had got very good references. It is working really well for us and my contact there speaks perfect English.
Extra Tip: It will save you some money if you include the cost of the annual audit in the accounting fee.
Experience: During the first three months of each year, the R.O. is audited for the previous year activity. This is done by special companies licensed to provide this service. I was aware it would have an extra cost so I negotiated the inclusion of this cost in our accounting fee.
The auditors are very thorough. I was surprise that they devoted four hours to such a small office as ours.

5. – Recruitment.
Tip: You may choose whom you hire but you cannot complete the recruitment process directly.
Experience: One of the limitations a representative office has is its inability to recruit directly. Instead you need to use an employment agency that has a license to provide this service. When I set up the office I was told the only available option was FESCO (Foreign Enterprise Human Resource Service Co). I’ve been told that there are a few more options now.
In my case, my boss already knew a good person for the job, so I interviewed her and passed the information to FESCO so that we could complete the recruitment process through them.

6. – Opening a Bank Account.
Experience: My Chinese staff and I visited several banks. We were taken through all the relevant information, account types, processes and fees, and with all that info in hand I made my decision.

7. – Looking for an Office.
You cannot just set up a Representative Office anywhere you want. The location/building needs to have a certain type of classification. A Chinese company can set up in locations we are not allowed to.
Tip: Study carefully all services that should be included in the office tenancy agreement (building management fees, official invoice…) as they may represent an unexpected extra cost afterwards.
Experience: We were very lucky. There were offices available in the same building where our law firm was. We benchmarked with offices in some other locations in Shanghai and we realized the deal was good.

8. – Office Renovation … the office may need a bit of renovation before you move in….
Tip: Get somebody to manage it for you. Get a recommendation for somebody trustworthy! It may have an extra cost but it is the most efficient way to do it and it will pay back!
Experience: I had to travel and just couldn’t be on top of every step of the process (plumbing, wiring…). The Chamber of Commerce recommended somebody who “tailor-made” a project for me. I chose some office furniture, I even told him how I wanted the wiring, where the internet and the electricity sockets should go … and he managed everything for me.

9. – Becoming Operational_Office Services.
In our case we had to get telephone and internet installed. Usually other services like electricity and water are already provided by the office management.
Experience: The exact same internet service had different quotes depending on the source…You always feel there is something better out there, but you just need to focus on making a choice with the best information available so that you can become operational a.s.a.p.

10. – Becoming Operational_Office Supplies.
You obviously need office supplies, including computers.
Tip: Outsource anything which may distract your attention from your key tasks, especially those jobs for which specialized service is available, like information technology.
Experience: I got a contact for somebody who was doing computer maintenance/ IT support for another office.  I briefed him on what type of computer we needed, the quotes I had already got, and where I had checked them out… I requested him to take care of everything, from buying to set up. This person now provides us with IT support on demand and makes sure everything runs properly.

Have you set up a Rep. Office in China? Would you like to share your experience?