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 

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.

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

China Business Strategy: “FOCUS!”… Don’t chase it all

Second post based on insights from an interview to David Caselli, CEO New Zealand China Direct Ltd, a New Zealand owned WFOE importing and distributing food and beverages into the Chinese market. In this post, Mr. Caselli explains how he took over a diverse business without a clear focus or scope and applied his business know-how and market insights to reformulate the strategy and establish a focused business model.

Key Message on Business Strategy:
This country is huge and there are a lot of business opportunities, but you need to focus on your best business opportunity (and sometimes on key markets) so that you can capitalize on all your business efforts, networking, channels, market insights…

Excerpts from the interview
From “Everything All Over to 3 Businesses/3 Markets”
“When I took over this project the business had been in China for 2 years. It was professing to do all type of products (timber, steel, fluffy slipers, food &beverages..) all over China. I looked at that business and saw we could not possibly succeed. So we went from everything all over the country to three businesses in three provinces.
We identified food & beverage, timber & construction and specialized manufacturing as key businesses. And we selected Shanghai, Suzhou & Hangzhou as our target markets.”
From “3 Businesses/3 Markets to 1 Business/1 Market”
“We worked the model for six months but very quickly concluded it was still too much. This is a huge country, very specialized. We narrowed from three to one business, food & beverages, and focused on one market, Shanghai.
Once you focus on that one business you start selling a lot more of food & beverages. This is a country where people create billion dollar businesses from just selling water.”
Key Lesson: Focus to Capitalize on Strengths, Efforts and Market Insights
“Focusing on one business enables us to play product by product to the strengths of the country. Some products will just be imported, bought and eaten as they are. Some products need to be imported and then processed (processed here so that they fit local taste), and then distributed. An example would be low end meat cuts (read more on this topic in his previous interview). Other products could even be imported, processed here and exported to other countries in the world.
So this focus on food &beverages allows us to do many things, and explore which ones are the winners for us to concentrate.

China Stories: Choosing the Wrong Company Formation Agent could Kill your Business!

Last week I had lunch with Andrea, who set up what was initially proving to be a successful business and saw it dying due to the wrong agent choice.

Andrea (and her business partner) learnt today’s tip the hard way… And she was kind enough to share it with us so that “beginner entrepreneurs” (as she describes herself at that time) don’t fall into the same trap.

Tip: Make sure you choose the right company formation agent.
– Get references that confirm their good work (or hire a reputed firm)
– Ensure they know your industry well

Story: “Go Nuts Healthy Gourmet Snack Bar” was an organic/healthy snack bar selling “Go Nuts” branded pre-packed products and in-store prepared food (sandwiches, granola/nut assortments, salads…). It was set to be quite a successful business. It quickly got a loyal clientele thanks to a unique offering and a good location (Jing An district in Shanghai).

But “Go Nuts” was also the best case study I’ve heard of how things can go absolutely wrong if you chose the wrong agent…. Not once, but TWICE!

1st Agent: It all started wrong. First agent was identified through a local expat magazine in Shanghai, City Weekend…. To cut the story short, the guy took the money and did nothing… Andrea describes him as an “impostor”.

2nd Agent: Here things went well… initially, but after 3 months operating the shop the local authorities came in for an inspection and were sorry to inform that “they needed to close the shop because the business scope did not allow them to run that type of activity”.
It turned out the business license only allowed them to sell pre-packed food & beverages. Most of their business was coming from the in-store prepared food. When they confronted their Chinese (first one was foreign) company formation agent the guy said:
“It is not my mistake, it is yours, because you chose me to do this job and I have never done food & beverage”
As you have already imagined the agent only gave them this piece of information after their shop had been closed with a 200.000 RMB fine.

As young entrepreneurs without a strong financial support their cash was gone (spent on licenses, rental, perishable food stock that went wasted, fines …). They felt there was too much uncertainty ahead (would they get the right agent, would the licenses be granted,…) and decided to close the shop.

So a few lessons learnt for the future:

1. Make sure you choose the right company formation agent.
– Get references that confirm their good work (or hire a reputed firm)
– Ensure they know your industry well

2. You MUST know what your license documents say… so be sure to have an English translation (even if you can’t use it for legal purposes). And please, get a good translation …don’t ask your neighbor or a friend to read it to you! Get the document from your agent or get a professional translator to do it.

Seeing is Believing…. And I mean it!

Let’s admit it, a lot of the China stories we hear around are actually funny … Once the entrepreneurs that have gone through them stop being mad, they make quite entertaining stories to tell over dinner. So, today I will share a “tip” and a comic story to illustrate it.

Tip of the day: If something does not sound right, it probably isn’t. So go and check it with your own eyes (or somebody’s you trust).

Story Setting: Entrepreneur’s very first shipment arrives. All excitement. Lamb racks arrive from New Zealand and will be showcased at a very high profile event… in 3 weeks time. All good, they just have to travel extra 10 km to the chef.

Conversation with the custom clearance agent:
Day 1. “Yes, they’re here. We are repacking them from 100kg packs into 10kg packs, so they’re easy to move.
Day 2. “They’re coming, they’re coming…”
Day 19. “They’re coming, they’re coming…”

So, entrepreneur thinks “That’s it.  I’ve had enough, surely I can go there and if I yell and scream I will be able to get my chops.” And as he is driving down in the van, he rings the warehouse company and says “I’m coming up”.
– Oh, sorry, they’re not here. They’re somewhere else.
– Where are them? ‘Cause I’m coming over.

At the second warehouse …Another surprise. No chops to be seen … in fact, freezers full of pineapple juice… and it seems they have been full of pineapple juice for months. People at this warehouse mention to him:
– Ah, no, no, this is the busiest time of the year for pineapples and the fridges are always full of pineapple juice. We could not possibly hold lamb here!!!!

So what had happened to the chops? Well, there is a happy ending because they did not disappear but:
– They had never been repacked, as this entrepreneur had been told from day 1.
– They had been sitting in a freezer in a 3rd warehouse during the whole time…
And it was only when he actually got on a van a started creating pressure that all this was discovered.

Not that unusual, is it?

China Food Industry: “Give them the Guts”

Excerpt from an interview to David Caselli, CEO New Zealand China Direct Ltd, a New Zealand owned WFOE importing and distributing food and beverages into the Chinese market.

Key Message on the Opportunities in the Food Business in China:
Although there are undeniable opportunities in the high end segment, the real breakthrough will be accessing the mass market with meat/fish & seafood derivative products and low end cuts that do not create value back home but are processed here into highly appreciated products in China.

Excerpts from the interview
“The average wage in China keeps rising and consequently massive parts of the Chinese community will be able to switch into eating more protein. It does not mean they are going to eat caviar and lobster … what they will be doing is eating more fresh meat instead of cabbage. So the biggest opportunity for us is not to sell high end lamb cuts but to sell a lamb derivative product that fits the market for the 9$ /day people… It is relatively easy to sell lamb to Western restaurants. The real challenge for us is to find out how to create products that use New Zealand lamb in Chinese dishes in Chinese restaurants. There are 20 million people in Shanghai and 400.000 foreigners. I’d rather sell to the 20 million than to the half million.

New Zealand meat industry sells some 500 million dollars a year of low end lamb cuts to China. Here it goes to a couple of provinces where they create a lamb roll (press it, add some duck fat…) which the Chinese mass eats. We have a whole lot of protein types that we don’t extract value from so the real opportunity is to unlock the value that works in China out of them.

Same holds true for other products. Seafood, for example, is there an opportunity to sell what we do not use but is appreciated here? There is also a mass market for fish frames, just heads, tails and bones. They process it and convert that into something useful.

Back in New Zealand we don’t understand the Chinese well enough to be able to identify what those products are (both in meat and fish). We need producers to get into thinking what are the uses and applications of the whole animal in China. Don’t get me wrong, they’ve probably been thinking about this for decades… what they’ve probably not done is come here and stay long enough to find the answer.”

Do you share his views?