Increasingly foreign investors are becoming more interested in choosing a joint venture (JV) structure when entering the Chinese market. In the past, foreign investors were extremely cautious to use JVs, but as the legal systems in China have developed this approach has changed.
The previous main issues were managerial complexities, vastly different cultures and business approaches, and the general difference in company strategies. Now foreign investors appear to be more open to JV’s and their benefits, this is largely due to the uncertainty in the current global business climate being volatile, uncertain, complex, and ambiguous (VUCA). These situations currently make the JV’s entry strategy in China a much more beneficial option.
As a foreign investor you can utilize the JV structure to reduce upfront investment costs, while also minimizing the risks of entering the Chinese market as you would be working with a local Chinese partner who understands the market. Being a part of a Chinese JV will lessen the learning curve and barriers to the local market.
Common Reasons for the Failure of a China Joint Ventures
Now that the China joint venture model is popular with foreign investors, it is important to understand the potential pitfalls in doing so and why Joint Ventures in China previously used to be unsuccessful and short-lived in many cases.
Here are some of the reasons why China Joint Ventures have failed in the past:
- A break down or confusion in communication between partners about their respective goals, roles, and objectives is commonplace.
- Depending on how many JV partners you have, they all have varying investment levels, interest, and input that can cause internal issues that go against your initial agreement.
- Trying to handle the varying cultural and business differences can be a real hurdle, especially when it comes to dealing with a poor understanding of the expected management and business integration.
- Failing to discuss capital increases or future fundraising to develop the business over the long term can heavily impact the JV partner’s shareholding percentages.
- There is generally no exit plan or escape route or termination mechanism if expectations are not fulfilled as agreed to previously.
- The vast majority of foreign Joint Venture failures in China are due to defects and disagreements in the Joint Venture agreement that pertains to key issues.
This is why the JV agreement and its contents are so important. It is important to set out a clear and concise agreements when taking advantage of the Joint Venture structure. The agreement needs to be legal and that detail the business relationship between the partners to avoid any potential future disputes.
Things to Pay Attention to in the MOU Stage
Some key points need to be discussed and clarified at the Memorandum of Understanding (MOU) phase before you prepare the JV agreement. Here are the MOU steps you are recommended to follow:
- List the parties’ intentions.
- List the recognition of each partner’s contributions.
- Detail the expected achievements and goals of the JV and any performance agreements.
- List the actions that will be taken if the agreements and expectations are not fulfilled.
- Figure out the potential risks and any future things that could happen and how they can be potentially managed if they arise.
You need to carefully think about these issues and discuss them with your potential partners to ensure that the formal JV agreement is true, clear, and concise.
Things to Consider when Reaching a Formal JV Agreement
The above-mentioned key points are always essential and all the JV partners are cautioned to ensure they understand the agreement before you undertake the proper legal arrangements to confirm the legal clauses in the JV agreement. Here are some additional points fo you and your JV partners to consider to protect your interests.
Ratios for Shareholding and the Capital Contributions
If you hear the term “shareholding rate”, this relates to how much weight and power each shareholder has. This can have a knock-on effect on who can pass resolutions and who the key decision-makers are for important matters.
The ratio given to shareholders is largely synonymous with the amount of capital each partner has an investment in the limited liability company. And this is usually according to PRC Company Law. Limited Liability Company shareholders should always carefully consider how much their percentage share should be of the total registered capital subscribed so the structure of the JV is correct.
If this is for a start-up company, the main core shareholder will probably ask for direct control over the entirety of the JV so they can make sensible and effective decisions. In this respect, the core shareholder will own 66.7% of the company at worse so they can make their own business decisions as and when needed.
In terms of capital contribution, this should be clearly and concisely detailed in the JV agreement so all partners and shareholders fully understand the splits, the amounts invested, the methods, and the timeline of the capital contribution so you can properly plan for operations to begin. If you check the PRC Company Law regulations, shareholders can decide the timeline and the total capital amount and even the methods of payment and contribution and so forth.
JV Partners Inputs and Commitments
Normally, the varying shareholders might have a range of obligations to the JV. Foreign investors might be the ones providing the brand or even the technology or machinery for the company. They could also be providing advanced management skills, or experience in developing overseas markets. The Chinese investors might be responsible for exploring the local domestic markets, finding local material providers, or might be the ones running the local operations in China. This should all be listed in the JV agreement to confirm these responsibilities so they are on record, especially if they were verbal agreements that need clarifying. Clauses need to be included regarding what happens if one party or more doesn’t hit their targets and promises.
Distribution of Profits
Generating revenues and profits are the main goal of any company or business agreement. However, you need to clearly state the method in which the profits are distributed to the JV parties. Profit distribution needs to be in line with Article 34 of the PRC Company Law which sets the principle for the distribution or sharing of profits between partners. This is usually completed in a ratio of capital investment that is individual to each partner.
It is possible via Article 34 that you and the shareholders can break through this law if you have a mutual agreement in place. Generally speaking, shareholders can set out the principle that defines the distribution of profits by their own set agreements. And these agreements might go against the capital investment ratio, but as long as all partners agree, that’s all that matters.
It’s important to remember that even though the shareholders agreed to the profit-sharing ratios, the JV will still have to adhere to the profit repatriation bottom line. This means that all profits that are distributed to the shareholders can only be done after losses are taken care of and any taxes are paid.
It is possible that foreign investors might need to get a return on their investment in a timelier or flexible manner, and this could largely be due to foreign tax issues. In this eventuality, the partners might agree to some kind of income repatriation or paying some kind of royalty or agreed service fee that are in line with the JV agreement.
Rights to Voting
Shareholders get exercisable voting rights so they can participate in the management and control of the company. Voting rights are usually based on the ratio of capital contribution, but there are exceptions to this. All the shareholders can reach an agreement in the JV document that certain parties have a veto right on very important decisions. This prevents any single shareholder from being jeopardized by the others.
Alternatively, the veto right needs to be sensibly designed and used wisely or management efficiency will be impacted.
Transferring Equity and Prospective Capital Increases for Fund Raising
It is possible that all JV parties can increase their capital investment, transfer equity, and even raise new funds during business operation.In regards to a limited Liability Company whose integrity is protected by PRC Company Law routinely recommends that equity interest should be transferred between the shareholders when conditions are optimal. This means that articles of association can make certain rules pertaining to transferring equity to third parties. This essentially means you can allow for other arrangements that are drag-along, tag-along, or even other possible clauses.
If you don’t know what tag-along clause means, it’s an agreement that ensures that shareholders with minority shares can join in and possibly sell their stake if a larger shareholder sells theirs. “Drag Along” clauses are an agreement that means majority shareholders can force minor shareholders to join in if the sale of the company is imminent.
Clauses for Non-Competition
If you want to stop shareholders from starting similar businesses to your JV company and the industry, you can add a non-competition clause into the JV agreement that does not allow shareholders to jeopardize the interests of the company and the other shareholders. These clauses should define the scope that the parties are allowed to work within and the restriction of related activities in related industries and even territories. You will also have to define a time limit duration on the restrictions that are confirmed in the JV agreement.
Exit Mechanisms and Deadlocks
It is the responsibility of the partners to manage the operations, existence, and closure of the JV together if possible. Relationships can turn ugly, so the definitions need to be laid out from the start. If the relationship between the partners turns sour, the closure of the JV or a consensus might not easily be reached between all parties.
You can prevent a deadlock and any kind of dispute by taking pre-emptive actions. Ensure you add clear and concise rules in the JV agreement that covers these potential issues, especially when considering how unsteady the global economy currently is. These measures could include voting mechanisms. You could add a list of behaviours that can trigger exit mechanisms that grant flexibility to shareholders and protect their interests.
Key Points to Remember
You must collate a well-thought-out JV agreement that is clear and concise to all parties involved. Its formation is to protect the best interests of the company and its shareholders. And when you do finally reach a joint venture agreement with Chinese partners, ensure that all the key details are listed. Capital contributions, voting mechanisms, shareholder ratios, profit distribution methods, and even exit triggers are recommended.
Some of the most important things to include are who makes the most important decisions and the clear commitments of each party in the agreement. As long as everything has been included and defined, entering into a Chinese JV is a very beneficial way for foreign investors to smartly introduce themselves to Chinese markets.
