Volatility and uncertainty of markets drive foreign companies to do JVs in China
The impact of COVID-19 pandemic and the uncertainties regarding the future economic relations between China and the United States have driven foreign companies to do joint ventures (JV) with Chinese partners to share the risk.
When done right, these joint ventures can be a good way to share risk. But when done wrong, they increase the risk, especially for the non-Chinese company.
In general, foreign professionals prefer not to do a JV as their market-entry approach of choice due to prospective managerial complexity, different cultures and business approaches between the partners, and high risk of technology leakage.
Nevertheless, JVs are becoming more popular among start-ups and bigger companies because of the volatility and uncertainty of today’s markets and world economies.
Choosing to do a JV can be beneficial for a foreign business because it reduces the upfront investment, shares costs, and minimizes risks by working with a local partner who is familiar with the market, the culture, and local policies and practices.
International travel restrictions due to the COVID pandemic are another significant reason for a JV. Some foreigners are currently not permitted to visit China, and this forces them to rely on their local partners’ access to the local market.
It is known that in some cases, Chinese companies would make the false promise of a JV to allure a foreign firm and acquire their technology. They are convinced to contribute money, technology and know-how to the JV, while the Chinese partner is put in charge.
Instead of setting up a JV that gives the foreign company an actual ownership stake, the Chinese side takes the assets but never forms a JV. The Chinese company will then either go silent or provide fake documents of ownership. The foreign company believes it owns part of the China JV even though it does not.
Eventually, the foreign partner gets frustrated and hires a Chinese lawyer to help with the situation. This doesn’t usually happen to firms that use a qualified Chinese lawyer from the start.
In general, foreign courts don’t have jurisdiction in a case involving ownership of a Chinese company and even if they did, Chinese courts are not likely to enforce whatever judgment that court renders.
The reasons for failure in most JVs in China are related to defects in the JV agreement. When forming a JV, investors should pay close attention to certain important matters, such as shareholder ratio, capital contribution, commitments to the JV, profit distribution method, voting rights, equity transfer, capital increase, non-competition clauses, and deadlock and exit mechanism.
It is crucial that the partners communicate clearly about their respective goals and objectives when establishing the JV and contribute similar levels of investment, input, and assets (including tangible assets and intangible assets) or resources, according to the original agreement.
Different cultures, management styles, and business approaches can cause poor understanding, cooperation and integration in the real business operation. In some cases, JV partners fail to discuss the future capital increase or fund-raising approaches for business development and design the exit and termination mechanism for situations when expectations are not met.
Before being able to take advantage of the JV model, it is important that the two parties reach a clear, well-thought, and prospective agreement. This will help to conclude a business relationship professionally and avoid or at least minimize future disputes between the partners.
There are a few sensitive points that should be addressed before signing a formal JV agreement and should be included in the Memorandum of Understanding (MOU), such as set out the parties’ intentions, recognize each partner’s contribution and identify the expected achievements of the JV as well as the performance measurement approaches.
The MOU should also specify what actions can be taken if expectations are not met and how will risks and future events be managed. These points will establish the ground for the formal JV agreement.
After the MOU is negotiated, foreign companies should pay special attention to key legal clauses in the formal JV agreement to protect their own interests.
One of the first aspects to be considered should be the shareholding ratio and capital contribution. This determines how much weight each shareholder owns to pass resolutions and make decisions on significant matters.
According to Company Law in China, the shareholding ratio of a limited liability company is normally subject to the capital subscribed by each shareholder. Therefore, the shareholder of a limited liability company shall cautiously consider the percentage of the total registered capital subscribed by itself and the shareholding structure of the JV.
As to capital contribution, it should be clearly and comprehensively discussed in the JV agreement – the total subscribed amount, method, and timeline of capital contribution determines whether the JV can operate as anticipated.
The JV agreement should specify the commitments and inputs of each partner and schedule default clauses in case either party does not fulfill its promises. While the foreign investor may provide brand, technology, and advanced management experiences, the Chinese party assists in exploring the domestic market, sourcing for the materials, and running the operation locally.
The profit distribution method is another important point in the agreement. The partners can share profit in accordance with the ratio of paid-in capital contribution or they can set out a principle based on their free will, such as sharing profits in accordance with certain percentage other than subscribed capital, and such principle should be included in the JV agreement.
The shareholders and the JV still need to follow repatriation rules, meaning that the profits can only be distributed after making good on losses, contributing to the statutory surplus reserve, and paying taxes. Partners should discuss income repatriation methods.
The ultimate goal of investment is to obtain profits. Based on actual needs, shareholders may consider reaching a consensus in the JV agreement and state in the articles of association that either party has the veto right on certain important matters to prevent the interest of one shareholder being jeopardized by other shareholders. The veto right should be designed and used wisely.
The parties to the JV may transfer the equity, increase the capital, or raise fund during the operation of the business.
Non-competition clauses should be included into the JV agreement to prevent shareholders from starting similar business activities as the China JV and jeopardizing the interest of the JV and other shareholders.
Finally, establishing an exit strategy to end the relationship professionally is crucial. It is common to see things turn ugly among JV partners and the JV entering a dead end when a consensus cannot be reached.
To prevent a potential dispute, parties to the JV should take preemptive measures and state them clearly in the JV agreement. This is especially important given the current trend of the global economy.
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DISCLAIMER: All information in this article is verified to the best of our ability and is assumed to be correct at time of release; however, Woodburn Accountants & Advisors does not accept responsibility for any losses arising from reliance on the information provided within. The information provided is for general guidance and does not replace specialized advice.