Chinese companies tend to operate from the same playbook, oftentimes given them by the government or their trade or industry association. Chinese companies can go years without doing XYZ and then all of a sudden, our China lawyers will see five deals in a row where the Chinese company does XYZ. We have lately been seeing a slew of Chinese companies seeking to become distributors of foreign products via joint ventures, a structure that rarely makes sense for the foreign company. See China Joint Ventures: The Tide is Out.
Our foreign company clients that have their products made in China usually start by selling their products in North or Latin America, in Europe, and/or in Australia. But as China’s consumers continue growing wealthier and more sophisticated, Chinese companies are increasingly approaching foreign companies that have their products made in China with proposals to sell the foreign company’s products within China.
When the foreign company investigates the situation, it turns out that such sales are legally far more complex than they initially imagined. To legally sell their products within China, these foreign companies usually must first export their products out of China and then sell them back into China. This typically means having to pay VAT twice — on the export and again on the import. Chinese companies will often try to entice the foreign company with elaborate schemes that purportedly avoid such double taxation. Such schemes are usually either illegal and dangerous for the foreign party and they should virtually always be avoided.
The new thing in the China-side playbook is for the Chinese side to try to convince the foreign company to enter into a complex joint venture arrangement. The Chinese side pitches these arrangements by claiming it will allow the foreign company to participate in the product distribution business in China. Almost always, the foreign company would be better served by operating via the standard distribution model used throughout the world. The foreign company should purchase its product from its China manufacturer, receive that product outside China (in an export processing zone or when shipped) and then sell that product to a qualified China distributor. The foreign company should earn its profit from that initial sale, freeing it from concerns with the financial side of the Chinese operations. The foreign company buyer can and should strictly monitor the operations of its Chinese distributor through a standard distribution agreement. See China Distribution Agreements In Real Life.
If the foreign company buyer wants to support its China distributor, it is free to offer incentives, such as the following:
- Not charging the distributor for sample product
- Reducing prices for a certain number of products
- Providing cash incentives for advertising
- Funding the cost of certifications and registrations
The foreign company should insist on a standard distribution agreement that allows the foreign company to terminate if its China distributor does not perform. This distribution agreement should also give the foreign company buyer the right to terminate the China distributor for conduct that might put the foreign company or its reputation at risk. One major defect in any kind of partnership/joint venture approach is that it is difficult to hold the Chinese side to a tight performance standard when there is a business ownership relationship. It is like a marriage: easy to get into, but hard to get out of.
Due to the need to export the product from China and then ship it back into China, the China distributor often will establish an entity in Hong Kong to handle the operations. If the foreign buyer wants to take an ownership interest in the Hong Kong distributor, it can do that, but the basic rules should remain the same: The Hong Kong distributor should be treated as an arm’s length third party, operating under a standard distribution agreement with the foreign company earning its profits from sales to the distributor (profits now), not from a share of the distributor’s future profits at some inherently uncertain later date.
A foreign company will be able to exercise more control over its “Chinese partner” by entering into a distribution agreement than by entering into a joint venture relationship. Joint ventures are nearly impossible to control by a foreign company located thousands of miles away with no right to make a quick and decisive contract termination decision.
Western companies that understand China rarely want to get involved in product distribution in such a vast and complex market like China. However, companies inexperienced with China too often fall prey to the ill-conceived concepts — like joint ventures — their Chinese counterparts pitch to them for getting their products to China’s consumers.
In assessing a business proposal from China, you should abide by the following three rules:
- You should be able to understand the proposal in a first reading.
- You should avoid a business relationship you cannot end by a simple contract termination notice, and be wary of any proposal described as a joint venture
- You should reject any proposal not supported by legitimate financial projections. A “business plan” consisting of fluff and fancy jargon that you don’t really understand does not count. If your Chinese counterpart cannot provide you with standard financial projections (hard numbers, not jargon), with each assumption clearly spelled out and supported with facts, walk away.