Jack Perkowski: Staking Out Your Market Position in China: Part II

In our last post, MTD discussed ways to establish a market position in China without committing capital. Although this is certainly possible, it is very difficult to gain serious traction in the Chinese marketplace by pursuing a purely export strategy, or by contract manufacturing and selling through sales agents.

While a representative office is better than no presence at all, our advice to clients invariably is to go all the way and establish a formal legal entity in the country. That way, a company can hire employees, invoice in renminbi, conduct commercial transactions and begin gaining a first-hand understanding of the market.

Establishing a formal presence also demonstrates to potential customers a seriousness of purpose with respect to China. One of the first questions potential customers ask is whether a company is registered. The establishment of a registered legal entity, and the investment of at least a small amount of capital, denotes a level of commitment and permanence that a rep office does not.

The second question potential customers ask is whether a company has manufacturing facilities in China. To penetrate the market in any meaningful way, a company must manufacture its products and develop a proprietary sales and service staff in China. Customers want to know that the products they buy are cost-effective. They want to see the factory where they are produced, and they want to speak directly with their suppliers’ managers and engineers. They do not like the uncertainty of a long supply chain that extends across an ocean, and they want to be able to pay for their goods in the local currency.

The paragraphs that follow review the various types of legal entities that a company may establish in China. A note of caution in advance — setting up a rep office, company or joint venture in China can involve a significant amount of administrative red tape. Be prepared for a great deal of mind-numbing detail. But, China continues to welcome and encourage foreign investment, and there are many accounting, law firms and other experts that can help navigate the bureaucracy.

And, don’t be put off by all of those stories you’ve heard about a long approval process. Once a company completes all of the paperwork, obtaining regulatory approval for most investments is now relatively routine — and fast. Forming a legal entity and constructing a new workshop are relatively straightforward and will happen more quickly than in most Western countries. (Company executives are constantly amazed by how quickly buildings seem to go up in China.) Completing the legal work and building factories are the easy parts, however. Assembling a management team, training workers, setting up management systems and gaining access to customers are where a company needs to focus its efforts.

This leads to a comment or two about joint ventures. Due to well-publicized cases of disputes between Chinese and foreign partners, joint ventures have fallen out of favor in recent years. But, a joint venture provides the foreign partner with the ability to leverage the management, manufacturing and marketing infrastructure of its Chinese partner, an advantage that should not be overlooked. In some industries, I would argue, it’s nearly impossible for a foreign company to access the market on its own.

Establishing a wholly-owned company in China where a company has complete control of the decision-making process and does not have to deal with a Chinese partner can be very tempting. However, starting up a new business is difficult in any country, and China is no exception. Sometimes, it’s easier to work with and improve an existing infrastructure than it is to start from scratch. As someone who has done both, I can attest to the fact that each individual situation must be objectively analyzed before a company makes the decision to partner with a local company or to go it alone.

Wholly-Owned Foreign Enterprise (WOFE)

If a company decides to go it alone, it can establish a Wholly Foreign-Owned Enterprise (commonly referred to as a “WFOE” or “WOFE”), which is a limited liability company that is wholly-owned by a foreign company or investor. In China, WFOEs were originally conceived to facilitate the establishment of manufacturing activities that either exported products or introduced advanced technology. Since China’s entry into the World Trade Organization (WTO) in late 2001, however, WFOEs began to be used for providers of services such as consulting, software development and trading as well.

A WFOE enables a company to conduct business in China, rather than just function as a rep office. A WFOE can hire its own employees, issue invoices to customers, receive revenues in renminbi, and convert renminbi profits to another currency in order to pay dividends. As compared to a Sino-Foreign Joint Venture, a WFOE enables a company to implement its worldwide strategies without having to consider the wishes of a Chinese partner, and with only direct employees involved, a WFOE makes it easier for a company to protect its intellectual property and technology.

There are several types of WFOEs which may be formed. A manufacturing WFOE is permitted to manufacture in China and may import or export its products without the need for a special license. A consulting WFOE may engage in consulting and provide certain management services. And a trading WFOE, or Foreign-Invested Commercial Enterprise (“FICE”), is permitted to engage in trading, wholesaling, retailing, or franchising in China.

The registered capital of a WFOE is the amount that is required to run the business until it can break even, and may be as low as 100,000 renminbi. Generally, consulting or trading WFOE’s will have lower registered capital requirements than a manufacturing WFOE. Depending upon the amount of registered capital invested, the foreign shareholder may make shareholder loans to the WFOE, with payments of interest and repayment of principal not subject to profitability. Dividends may be paid to the foreign shareholder out of the cumulative net profits of the WFOE.

Setting up even a simple, non-manufacturing WFOE can be a powerful first step in China. The CEO of a company that JFP Holdings is advising told me that his company’s sales to China doubled in 2010, even though its trading WFOE was not established and a Chinese general manager not in place until mid year. JFP Holdings recommended and helped with both, and the results were predictable. The company’s focus on China and the establishment of a formal presence made a positive statement to customers, and they responded with more orders.

Sino-Foreign Equity Joint Venture

If the decision is made to partner with a local company, a Sino-Foreign Equity Joint Venture (EJV) may be structured. An EJV is a joint venture between a Chinese and a foreign company within the territory of China. It is a limited liability company that has the status of a Chinese legal person. As a limited liability company, the investors or partners in an EJV are not personally liable for the debts of the entity. Like a WFOE, an EJV is capable of invoicing customers in renminbi, purchasing land, hiring Chinese employees, constructing buildings and generally conducting its business in China.

The investment in the registered capital of the EJV by both the foreign and Chinese parties may be made in cash, intellectual property rights, technology, buildings as well as materials or equipment. In cases where the foreign partner has technology, a license agreement between the foreign partner and the EJV may be put in place. In lieu of receiving cash payments from the EJV for the technology, royalty or service fees called for in the license, the foreign partner may contribute its intellectual property in exchange for shares of the EJV. The distribution of any profits earned by the EJV is made in proportion to the respective capital contributions of the partners.

The management of an EJV is in the hands of a board of directors, consisting of at least three members, with each party either appointing the chairman or the vice-chairman. China’s Company Law gives broad powers to the board. In most cases, a majority of the board is all that is required to make key operating decisions, including the removal and appointment of managers. That is why the decision to take majority ownership in an EJV, accept a minority position, or agree to a 50/50 split of the shares is the most important decision a company will make.

The standard term for an EJV is between 30 and 50 years.

Sino-Foreign Cooperative Joint Venture

Like an EJV, a Sino-Foreign Cooperative Joint Venture (“CJV”) is a joint venture between a Chinese and a foreign company within the territory of China. The basic difference between an EJV and a CJV is that the CJV provides greater flexibility. The operation of a CJV is based on a cooperative joint venture contract that specifies the terms of cooperation, the division of earnings, the division of property upon the termination of the contract term, and the sharing of risks and losses. For example, the distribution of profits earned by a CJV may be made in a way that is determined by mutual agreement of the partners, not necessarily in proportion to the amount of capital contributed by each.

Conclusion

Despite the fact that China has amassed approximately $2.8 trillion of foreign currency reserves, and despite the stories you may be hearing about China no longer welcoming foreign direct investment (FDI), China remains very interested in receiving your investment — whether in a WFOE or an EJV.

Local officials will bend over backwards to attract your company to their city and will ensure that your company receives the most favorable policies. The officials of a small municipality recently told me that their target is to attract $80 million of FDI a year over the next few years, up from $20 million currently. If your company wants to establish a factory in their city, I can assure you that you will be welcomed with open arms.