Clients often ask us to review a target company’s China operations and provide a due diligence memo to help them assess where the target company is most risky and how to proceed if they want to continue the M&A deal. Sometimes this means our client intends on buying a China entity directly, and other times it means acquiring an entity in another jurisdiction that has a wholly-owned Chinese entity or Chinese operations through a representative office.
Below is a modified excerpt from a due diligence report regarding issues with a target company’s China representative office. In this case, the deal would have been an asset purchase (not a stock purchase) by a U.S. company of another U.S. company, and the China operations and employees employed by a representative office (via a Chinese third party hiring agency) were the primary valuable assets.
1. China Operations Explained
Unlike a foreign invested company, a Chinese representative office is just an extension of the U.S. entity, so the Chinese government will not permit a change of ownership of a representative office in an asset sale.
Because the representative office operations will be part of the assets sold, the seller will need to cancel the representative office and terminate its lease and its employees, and register a new China entity (a representative office or a WFOE) to continue the China operations.
This includes entering into a new lease and hiring the seller’s former employees. You may be able to negotiate with FESCO (the third-party hiring agency that currently contracts with the seller’s China office for their employment) and the landlord to assign the respective contracts to your new China entity to expedite the transfer. However, it is unlikely either FESCO or the landlord will understand and cooperate because this will be an unusual situation for them.
A stock sale could avoid the above issues. That is, if you purchase the entire ownership interest of the seller (so that the seller continues to exist as is), then the seller’s China office can continue status quo. As the buyer you will need to file with the Chinese government the change of authorized representative for the China office, but you will not likely be required to form a new China entity.
That said, we understand that you are not considering a stock sale at this moment because it would carry hidden liabilities (which is why we recommend asset purchases over stock purchases). For example, it is still unclear what activities the China office and its employees perform. If they are performing work beyond the allowable scope of activities for a representative office, then you run the risk of being flagged as a noncompliant foreign company from your first step into China. The seller may be comfortable with this risk (if they are even aware of it), but you may not be.
Assuming we move forward with the asset sale, you will either need to set up your own China representative office or a wholly foreign owned enterprise (here WFOE but also called a WOFE). We discuss the two options below in general terms. If you could let us know more what you plan to do in China (continue, expand, or diminish the seller’s current scope of operations there), we can provide further thoughts on this.
2. Representative Office
As discussed above, a Chinese representative office has no separate legal identity in China, and you can only perform limited marketing and market entry activities through a representative office. The representative office cannot enter into contracts, receive payments, or do anything resembling an actual business. All Chinese citizens working for a representative office must be hired through an employee dispatch agency (we call these PEOs (professional employer organizations) in the U.S.).
3. WFOE (Wholly Foreign Owned Enterprise)
A WFOE is a Chinese legal entity that is supposed to have the same rights and obligations as a Chinese-owned company, with one large exception: many industry sectors are off limits or severely restricted to WFOEs. But assuming a WFOE is not attempting to operate in a restricted industry (consumer goods is generally not restricted), it can engage in sales, marketing, customer support, enter into contracts with Chinese entities, send and receive payments, and much more. A WFOE can also legally hire Chinese citizens as its own employees and have direct control and oversight over those employees.
4. Making Your Decision
Neither of these options (representative office or WFOE) is cheap or quick, but that is the case generally with China matters. Your real cost savings come from being able to pay your Chinese employees less than your U.S. employees and in sourcing quality goods cheaper than you can in the U.S. And using a WFOE instead of a representative office means you will likely save money by not needing to engage an intermediary like FESCO to manage your employees.
Either way you will be looking at a major company performance gap that you can deal with in a couple of ways:
- Close the asset purchase in part by only buying the U.S. operations and having the seller keep its representative office in place until you get your representative office or WFOE established. In the meantime, you will contract with the seller to keep its employees working on your projects until you can transition the China employees to your own representative office or WFOE. You would not be able to have any direct control over any of the China employees or even communicate directly with them. Everything would need to go through the seller until the employees work for your representative office or WFOE. But keep in mind that this scenario assumes that the seller’s China employees are not exceeding the scope of what is allowable work under a representative office.
- Sign the asset purchase agreement that pushes closing out until you have your representative office or WFOE formed so that the seller keeps operating status quo until you are ready to close. The seller will probably require a significant escrow deposit from you under this option. You could start getting involved in the business as consultants (for pay or for free).
5. Negotiating with the Seller
You will need to think about the best way to approach the seller because both options are probably not what the seller is expecting. But both options have pros and cons for both sides. If the seller is keen to sell and you are comfortable moving forward, you can close soon under Option 1. But if you have your doubts and would like to have your representative office or WFOE formed before you close, then go with Option 2.
Option 1 offers the possibility to share the risk moving forward and gets you involved quickly, but it carries risks if the seller’s representative office has been exceeding its legal scope. You will also have much less control of the China employees for several months. Option 2 makes the seller carry more of the risk in exchange for your escrow deposit, but you may also be able to get immediately involved by working in the business upon signing the purchase agreement. This would show to the seller that you are invested in moving forward, even beyond merely providing an escrow deposit.
A third option could be that you go ahead with Option 2 but do not take an active role in the business until you have your representative office or WFOE formed and can close both the U.S. and China operations at the same time.
Establishing a China operation can be expensive and time consuming, but it is better to do things the right way now to avoid being found in noncompliance and having to spend a lot more time and money later. And it is always better to discover your potential seller’s China indiscretions now rather than after you have purchased the China operations.