The JV vs. WFOE debate – Choosing between the options

March 18, 2008 Posted by China Briefing Reading Time: 5 minutes

Regulatory environment and existing partner infrastructure key decision drivers

Mar. 18 – Recent comments on our and various other sites recently have sparked debate about the suitability of Joint Ventures and Wholly Foreign Owned Enterprises (WFOEs) as investment vehicles for foreign investors in China. While such debate has ranged from the somewhat ludicrous demand to “Name ten successful JVs in China!” to the more sublime, many salient points have been missing from a constructive debate. In this piece I will try and make a sensible case for both and the main guidelines to look at when faced with a decision between the two.

Regulatory environment
In all of China’s big ticket investment area, and certainly its restricted industry sectors, having a JV partner is mandatory. There are a number of reasons for this, related mainly to political and strategic sensitivities over certain industrial sectors over which China either wants to maintain control or to keep a close eye on. These include mining, aerospace, oil and gas,, other energy production and distribution fields, education, much of the medical industry, amongst others. Much of these investments are often structured as bilateral government to government investments in any event, with the partner companies merely executing the governments wishes. Others may be more corporate to government. However, faced with such issues, when a JV partner is mandatory that is the law and if you wish to play in this industry sector, you must have a JV partner. You have no choice. We will come back to managerial aspects of such ventures later.

Asset environment
When a choice exists between a JV and a WFOE, there can be genuine reasons as to why a JV partner would make sense. Although care has to be taken when choosing a Chinese partner, it can make sense when they have certain assets to bring to the table. These include especially having an existing supply chain and relationships in place, as well as an available skilled or semi skilled workforce and production facilities to hand. Building a supplier and retail chain is from scratch is expensive, and time consuming. Your JV partner may well already have pre-negotiated volume discounts from suppliers in place, and relationships with the supply chain vendors. Obviously these need checking out, but if real, can be time effective and cost saving as the foreign investor does not then have to invest in developing these themselves. The same applies to the availability of a trained workforce familiar with your products or able to be trained in them. It is these assets I refer to as the ‘asset environment’ when looking at a potential JV partner. Otherwise a WFOE would usually be the logical way to go.

JV management issues
Faced with a JV, this now becomes a big issue. Again, the regulatory environment kicks in; some industries require the Chinese partner is in the majority. Under such circumstances, we tend to find that bilateral government relations are also involved and are mitigating against risk. Many of these JV projects are very long term and may also carry government backed guarantees of investment. If not however, then you need to mitigate against this in a variety of ways, usually involving structuring of the board and management. More of this later.

Equity and co-operative joint ventures
In much of the online debate I have seen the past two weeks not one mention has been made of the different types of JV structure, which I find telling, as they are very different. Equity JVs in essence are used in big ticket projects and are quite rigid in structure. Liabilities and dividends are released in direct accordance with the equity held by each partner, and a two tier (and detailed) management structure exists to support the project. While equity JVs can be top heavy in management, it is usually a reflection of the serious financial nature of the project that makes it so.

Co-operative JVs are perhaps the more interesting, and they offer far more variety of structure. Liabilities and dividends can be distributed in amounts that differ from the actual equity position. This can also be reflected in the management structure. Indeed, it is possible to structure a co-operative JV in such a way that although the Chinese partner may hold the majority of the equity, the foreign partner can realize the majority of the dividends, which can be a useful strategy to deploy when investing more finance but into a restricted area that requires majority Chinese equity. When faced with restricted industries, if a co-operative JV is permitted it can open up a whole new area of benefits to the foreign investor in terms of access to dividends.

Management structure
Much has been written about management structure. It’s a moot point, as each case depends so much on the quality of the partner and the proposed nature and aims of the JV. However, I find the following rules generally apply:

Minority or 50-50?
It’s a tricky one this. Personally, I prefer to see, if placed in a deal breaker situation, the Chinese side take the majority rather than have a 50-50 arrangement, as long as certain other conditions are met. I prefer the business to be able to have a decision making process and not to get into stalemate. An incorrect decision can always be turned around; stalemate can get belligerent and indefinite.

Role of the chairman
Again, there are many points of view on this. Mine is that they should act as the “ambassador” of the company in China. Who better to have than the Chinese side? It gives a lot of ‘face’ and can be used as a bargaining chip for other positions.

Role of the general manager
The GM is often legally responsible for the daily managerial and operational activities of the business, even though he may not be on the board. This position I prefer to see in the hands of the foreign investor, especially if technology transfer agreements are hand in hand as part of the JV. It would be even more preferable if the GM was a fluent Chinese speaking expat with experience of working in a China based factory.

Finance/purchasing
Back in 1997 I wrote an article entitled “The Ten Commandments of China Business”. It’s since been reprinted several times. Commandment 9 read “Thou shalt pay close attention to thy purchasing department and monitoreth them closely lest they buy from their siblings at double market rate.” The same is true today, you want people in purchasing you can trust and you need to monitor them regularly. The same applies to F&A. You need your own people in there as well as the partners.

Due diligence
It goes without saying that of course a potential desire to have a JV partner must be matched up with a good provision of on-the-ground due diligence. However, this expertise is available from established firms in China.

Summary
As mentioned, a JV may be the only option available to you if the regulatory position demands it. If so, you will need expert legal and due diligence advise from professionals familiar with the field. When faced with options, a JV can be productive if they can bring something tangible such as a supply chain or existing facility to a table. This then leads to due diligence issues, and again, expert advice. Otherwise, normally a WFOE would be the investment vehicle of choice. When considering JVs, co-operative JVs can be surprisingly flexible in terms of what they can offer the foreign investor in otherwise restricted industries.

Chris Devonshire-Ellis is the Senior Partner of Dezan Shira & Associates and has been involved with establishing foreign enterprises in China for 16 years. To contact for advice over JVs and WFOEs, please email legal@dezshira.com.

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