This post focus on two commonly held misconceptions regarding “partnering” with Chinese companies in deals that involve foreign technology.
Due to a partnership relationship, the foreign side often wrongly believes it is somehow better protected against IP theft. The foreign side then lets down its guard, only to learn that its China partner has appropriated its core technology. This sense of partnership is most common with SMEs and technology startups, especially those companies whose owner is directly involved in the relationship with the Chinese entity.
The two primary “we are partners” myths our China lawyers see are the following:
Myth One: Our personal connection will protect us. The Chinese company will not appropriate our technology because I (the owner of the U.S. company) have a close personal relationship with Mr. Zhang (the owner of the Chinese company). Usually Our lawyers are often told something like this, followed with some bit of personal data, such as: “He came to my daughter’s wedding” or “I sponsored his son’s admission to college” or “I helped bring his family to the United States” or “He is my son’s godfather.” Trust me when I say our China attorneys have heard them all. This idea that a close personal relationship will insulate your company from China IP theft probably results in more technology transfer disasters than any other myth about China. It is a myth for two quite different reasons.
On the most basic level, personal relations are not commonly viewed in China as a barrier to committing acts of appropriation or other breaches of trust. For most Chinese business people, personal relations, such as attendance at weddings and other shows of friendship are strategic matters, done to achieve some form of business benefit. This is not always true, but it is true often enough that this possibility should not be ignored.
When the foreign party points out that this is a breach of trust, the Chinese side will often reply with something like the following: “In China, business is like warfare and contracts are like a treaty between nations. We will honor the treaty when it benefits us, and we will breach it when it benefits us. Personal matters are not relevant. As soon as we see a benefit, we will take it. The situation is really all your fault. You should not have presented me with a situation where I had the opportunity to betray you. By leaving me an opening, you forced my hand, because when an opportunity presents itself the prudent businessperson must take advantage of it.”
I have many times heard a Chinese company owner state this sort of argument with a certain amount of bitterness. They actually say: “It’s your fault. You made me do it.” They resent you for having forced them to harm the friendship in a way that was painful to them. But again, the common Chinese view is that when a foreign company provides an opportunity to seize a benefit, the Chinese company is obligated to seize it.
In many cases, the Chinese company owner has no reason to appropriate your technology, so it is safe not because of an emotional commitment but because there is no benefit from the theft. But, the technology is still stolen because it is stolen by an employee of the Chinese entity.
In fact, for technology that requires a small investment to commercialize, theft by a Chinese company employee is probably the most common way foreign technology gets appropriated. This is particularly true of software products, where no large capital investment is required. In these low barrier to entry businesses in China, senior technical employees are constantly on the look out for an opportunity to steal technology and leave their employer to start out on their own.
This is part of the aggressively entrepreneurial mindset of Chinese technical personnel. Appropriating a nice piece of foreign software is often seen as the perfect way to get a head start on forming a new company. In the same way, if an employee can make off with a full set of production molds, he or she can start up a small factory in China. So the opportunities abound and the foreign technology disappears, leaving both the Chinese owner and the foreign entity frustrated as their mutually advantageous business relationship is destroyed by a low cost Chinese competitor.
Myth Two: Our partnership is secure because of investment by the Chinese side. We hear this argument a lot and it is essentially that it is not necessary to formally protect the technology because the Chinese company plans to invest significantly in the foreign company.
This argument has two variants, both of which are false:
Variant 1: The Chinese side plans to purchase a majority ownership interest in our company. In effect the Chinese side will own the technology in the end. Since the Chinese side will eventually own it, there is little reason to try to protect it from appropriation by its future owner. In this way, the Chinese side convinces the foreign entity to transfer the important technology to the Chinese entity prior to when the investment occurs.
But, then, there are always delays in closing the investment transaction and in most cases the full investment never occurs. The Chinese side assures the foreign entity that the investment funds are on the way. In the meantime, the Chinese entity obtains all the relevant technology. Finally, the Chinese side announces that it sincerely regrets the transaction cannot be concluded. There is always some good reason. Either the bank that was to finance the investment got cold feet or the Chinese government withdrew iapproval of the transaction at the last minute. Either way, the deal is off with no liability on the part of the Chinese side. But the Chinese side got what it wanted. It obtained the key intellectual property without having to pay anything approaching market price for it.
This investment promise has become a standard technique Chinese companies use to convince foreign companies to drop their guard. The way to prevent the unfortunate result is simple. Up until the day the purchase transaction closes and the funds are in your bank account, you should treat the Chinese entity as a neutral third party. Protect your intellectual property in exactly the same way you would if dealing with an unrelated third party. The Chinese side will complain about the expense and inconvenience, and your reply should be: if you do not like it, pay us the money now.
Variant Number 2: The Chinese side will purchase a minority interest in your company, just to provide support for developing the technology. In this variant, Western companies believe protection of their intellectual property is not required because: “Why would the Chinese company harm the interests of a company in which it is a part owner?”
This argument assumes the Chinese company sees greater benefit in the earnings it will get from its minority share of the U.S. entity as compared to walking away with the American company’s technology. The U.S. side often tells us that “when we go public, the Chinese side’s share will give them a huge profit. Why would they screw things up now and prevent that public offering from ever happening?”
The Chinese side rarely sees it this way. Few Chinese companies focus on the long term. So for many, the promise of a future IPO or other monetary benefit from their minority investment means little to them. Second, when the Chinese side makes a minority investment, they do not see it as a investment in stock. They are making the payment to hire the foreign entity to do research and development work on their behalf and usually what they pay for such work (via the minority investment) is less than they would pay for an arm’s length R&D program.
The investment in this R&D work is valuable to the Chinese company, but only to the extent it can take control of the technology. So the Chinese company will invest in the foreign development efforts until it receives direct benefits in the form of the technology. The Chinese side has no intention of allowing the underfunded foreign start up to commercialize that valuable technology. Instead, the Chinese entity will transfer the technology to one of its many well funded subsidiaries for entry into the market. Normally, the Chinese entity expects the foreign start up to then simply die. They do not see this as a loss of their investment. They see themselves as having received an excellent return on their payments. It paid the money and the foreigners did the development work and the Chinese company now owns the benefits of that work. That is the end of the analysis.
The solution here is the same as the solution for Variation 1. Treat the Chinese entity like you would any third party entity. Disclose as little as possible to the Chinese entity and thoroughly protect what you disclose. If the Chinese side continues to seek access to your technology, consider carefully why it is making such requests. A normal investor does not need such information. If the Chinese side is asking you for more than a normal investor would ask, you have to ask why. The answer will almost certainly be that the Chinese company wants access to the intellectual property underlying your technology and it wants that for its own use.
If the Chinese side complains by saying something like “Don’t you trust us? We’re your partner”, this is sure sign of trouble. If the Chinese side requests access to your proprietary technical information, you have to wonder why they are making such a request? The real reason is seldom what you will want to hear.
Do not be lured into believing that the nature of your relationship with your Chinese counter-party or the structure of your deal will be enough to protect your intellectual property from being appropriated.
Be careful out there.