Business Structures to Overcome Obstacles in China
By Paul Folta, Folta Associates
In China, the profitability of foreign investments is growing and the business environment is improving. Yet, China is a complicated place to do business. Many companies are walking away from business opportunities, agreeing to disadvantageous business deals, or unnecessarily waiting for further government business reforms.
Knowledge of how to overcome highly challenging business situations in China alters this experience. For example, a U.S. hospital group decided not to pursue a venture in China when they concluded that they could not overcome China's restrictive regulations for foreign investment. In the same timeframe, another foreign healthcare group, who was expert in alternative business structures in China, was signing agreements with Chinese hospitals for specialized medical services and operating these ventures successfully.
Companies often make one of the following choices: decide to wait a few years for regulations to change, accept an Equity Joint Venture (EJV) structure with less control, or work with a more malleable but less attractive partner. Waiting can be wise. Waiting can also cause loss of market leadership; deals with priority partners can be lost to competitors.
Challenging Business Situations
China poses many challenging situations that often discourage foreign investors.
China's investment environment continues to improve. Relaxed regulations have encouraged an increase in Wholly Foreign-Owned Enterprises or WFOEs, making up over 62% of new ventures in China. WFOEs are not always a magic bullet. Foreign companies sometimes have no alternative but to consider a Joint Venture (JV) structure. China's government still might require Chinese company participation or control. In other cases, a Chinese partner might have capabilities (central and local government support, brand reputation, land, licenses, distribution, access to suppliers or other assets) that could reduce risk and might be critical for a foreign investor's success. Most JVs are Equity Joint Ventures (EJVs), and are well understood around the world. Yet, EJVs do not always effectively address challenging business situations.
Foreign investors have options available that are not often tapped. Savvy investors may use the Cooperative Joint Venture or Contractual Joint Venture (CJV) structure. Unfortunately, it is overlooked or little-understood by newcomers to China.
An Alternative: The Cooperative Joint Venture or Contractual Joint Venture (CJV)
In China, a CJV* is a well-accepted solution by the Chinese government, and remains untapped by many. The most important benefit of CJVs over EJVs in China is that the CJV parties' profit, control, and risks are divided according to the 'negotiated' contract terms. In contrast, an EJV's profit, control and risk are in proportion to the equity shares invested by the parties.**
CJVs and EJVs are very similar in many other respects. The formal government-required process, approving authorities, format of agreements, tax breaks, legal standing, and recourse are identical. The general management structure and governance procedures are virtually the same particularly when carefully spelled out in the JV contract.
How is a CJV Advantageous?
CJVs can have flexibility for both the foreign and Chinese parties in the following possible ways:
Examples of CJVs in China
1) operate value-added networks for application of the
smart card technology
Given the sensitivity of this sector for both the Chinese and U.S. governments, both had to apply for the necessary licenses, approvals and permits within China, and for export permission or exemption from U.S. authorities. The Chinese government has stated that certain value-added services in the restricted telecommunications sector would be approvable.
In this case and often in telecommunications, by law, ownership and operation of the technology related to interconnect with the public network must remain with the Chinese party. The legal structure of an EJV would prevent full Chinese ownership, which further confirms the importance of CJVs in sensitive sectors.
The Chinese government can be more favorably disposed to CJVs where each party owns the assets it contributes in sensitive sectors like this, and where CJVs specifically define what each party can and cannot do.
More and More Companies are Doing Business in China
Although stories of China's challenging business environment abound, foreign companies continue to be attracted to China. China has a GDP of $1.4 trillion, the sixth largest economy in the world. In 2003, foreign companies invested $57 billion in China and contracted to invest $115 billion, 39% increase over 2002. Three-quarters of 251 member firms of the American Chamber of Commerce in China claimed to be profitable in 2002. In 2002, 40% of these firms said their margins were higher in China than in their global operations.*** [Economist, 2004 & Observer, 2003]
China's laws and regulations are changing rapidly, so it is wise to obtain advice from experts with deep experience in China and who specialize in specific sectors. Starting the approval process early in the CJV formation helps to ensure that the structure is acceptable and increases the probability of the government's approval.
* Note: Contractual JVs are not unique to China, but countries' CJV regulations may not be the same.
** "Detailed Rules for the Implementation of the Law of the People's Republic of China on Sino-Foreign Cooperative Enterprises," promulgated by the Ministry of Foreign Trade and Economic Cooperation in September 1995 and amended in October 2000.
*** "A Survey of Business in China," Economist , March 20, 2004, pp. 3 and 9; "China Ahead in Foreign Direct Investment," OECD Observer , No. 237, May 2003-Published August 20, 2003.
Paul H. Folta, Ph.D., is the founder of Paul H.
Folta & Associates,
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