TO JV or not to JV in China

An Expert's View about Joint Ventures in China

Last updated: 11 Apr 2012

An essay on the pros and cons of investing in China through a joint venture and the safeguards and tips to ensure a successful investment and exit strategy

To JV or not to JV ? That is the Question Over the past 17 years that I have been advising clients in both Hong Kong and Shanghai on market entry to China, the question is often raised, should they enter the market in the form of a Joint Venture with a Chinese partner or take the path of establishing a Wholly Foreign Owned Enterprise. There is no stock standard answer to this question. As China has opened up, certain market sectors previously closed, have become available to 100% foreign investment however whether a wholly owned enterprise or WFOE is the right structure depends on a myriad of issues relevant to an investor, such as local market access, industry sector, labour force issues, the sharing of capital risk and R&D development costs, etc. etc. It is also worth noting the findings of a German Chamber of Commerce Survey conducted in 2007 which posed the question to German companies then operating in China, namely if they had the choice, would they now enter this market as a WFOE or as a JV? Over 75% of respondents stated that if they were to enter the market now they would do so as a WFOE. The reasons given were, a faster set up process, sole control of technology and know- how, independent decision as to when to exit the China market and last but by no means least, 100% retention of profits. The ratio of existing WFOEs to JVs who responded to the survey was 2:1 indicating that the WFOE is now the preferred investment entity. However, the JV still has its place in China, and some commentators have remarked that there may in fact be a new resurgence in the number of joint ventures, over the next few years. The reason for this is that the Chinese are slowly transitioning from a nation of exporters to a nation of consumers. Foreign companies that operate in the retail, food and beverage, or manufacturing sectors which are targeting local consumers are quick to realize that a partnership with a Chinese party, may give better access to a local large sales workforce and possible better access to government procurement contracts as JVs are seen more as domestic in nature, than foreign. In addition, there are still some industry sectors where foreign companies can only enter by JV. These industries are commonly found in the development and application of new technologies for recovery of crude oil, production and R&D of automobile electronic devises and control systems, power transmission and geothermal and nuclear power generation. While certain JVs can be successful, it is not uncommon to see failures and these often are attributable to a number of reasons. The local Chinese partner?s objectives may be different from the foreign partner, ?lying on the same bed but with different dreams?, and substantial cultural differences may lead to operational conflicts. Most importantly, the foreign partner may lose control of its intellectual property during the JV process. A successful JV in fact starts at the pre-negotiation stage. If a foreign party is introducing a new brand or trademark, this needs to be protected by registration, before negotiations commence. Too often, clients omit to register the IP prior to these negotiations and find themselves the victim of opportunistic registrations by the Chinese side. A MOU or LOI is also a common initial document drawn up between the two sides, and while often not intended to be legally binding I often recommend this be made as detailed as possible, as the more issues which are defined in the MOU or LOI, the less that is required to be negotiated when it comes to the Joint Venture Agreement, and as any company here who has been through this process will tell you, JV negotiations can be a drawn out process. In order for a foreign party to exercise effective control over a JV, it should always be mindful of keeping control over day to day management issues in the JV. This can be achieved even where the foreign partner is a minority shareholder, eg by insisting that certain key positions are made by the foreign partner, such as the CFO position or General Manager, while permitting the Chinese side to appoint the Chairman of Directors or Legal Representative. Also, where possible 51/49 splits or 50/50 splits on board or equity control should be avoided. If one looks at domestic joint ventures between two Chinese companies, one or other is always the clear majority owner, eg 70/30 or 65/35, so there is no confusion as to who controls the JV. By contrast, a 50/50 or 51/49 share is seen in Chinese business culture as a meeting of equals, rather than a clear expression of majority control, and this can lead to conflicts, where the foreign party considers its 51% ownership as giving its sway in decision making issues of the JV. Intellectual property rights that are contributed, if possible should be on a license basis only, however if this IP has to be contributed as a capital contribution of ownership to the JV, proper contractual safe guards should be put in place to ensure, that the party contributing the IP has clear rights to obtain a license back of improvements in the technology or IP or that relevant change of control clauses exist which allow for a recovery of the IP on a termination of the JV or where a local partner sells its equity in the JV. It is also worth noting, that Chinese law appears to allow a party to a JV to sell its equity to a third party simply by giving written notice to its existing partner, a fact which foreign investors often forget. It should also be clearly defined in the Joint Venture Agreement, who exactly may use the technology or IP, (eg are subcontractors or subsidiaries of the Chinese side excluded). At the management and employee level, labour contracts must clearly spell out non-compete clauses, confidentiality and non-solicitation terms. From a corporate governance perspective, staff should be made fully aware that unauthorized release of IP or technology not only adversely affects the JV, but their employment and livelihood as well. All of the above comments are simply a guide on general principles when entering into a JV. Each negotiation of a JV will have its own discrete issues, from a provincial, industry, technology and market perspective. Always be flexible in your approach to JV negotiation and also at an operational level as well and always remember, (with apologies to Longfellow), a Sino-Foreign JV is often like a child and needs to be managed as such??When they are good, they are very very good, but when they are bad they are horrid?. Richard Kimber is the Managing Partner of RHK Legal and has been advising clients in respect of their China investments for some 11 years in Shanghai. Richard also sits on the board of a number of Sino-Foreign Joint Ventures operating in China. www.rhklegal.cn
Posted: 17 March 2011, last updated 11 April 2012

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