Smaller companies going to China need to plan carefully

Excerpts from an excellent article on the China Business Review.Read the original article

There is no excuse for entering China naively today. The last 15 years of foreign investment activity has provided a wealth of experience that newcomers can draw upon. SMEs in particular, because of their unique challenges in expanding into China, need to tap this experience as they make their way into one of the most exciting but competitive markets in the world. There is gold in China—but careful planning and good execution are required to mine it profitably.

Learn from the mistakes of others

The vision of more than 1.3 billion consumers with their wallets open was intoxicating to many western executives wanting to be "first in." In their rush to enter China, however, many companies left good business judgment at the border. A review of some of the mistakes made by larger firms over the last 10-15 years yields useful lessons for SMEs.

• Perform rigorous due diligence in partner selection The PRC government offered partner companies to hungry CEOs, who often formed joint ventures without proper due diligence. These partners generally had a deficit in capabilities, a surplus in nonperforming assets, and many off-the-book liabilities.
• Base plans on more than just a "snapshot" view of the market Many companies made investments based on a current—and often inaccurate—view of the China market. The pace of change is so rapid in China that their plans were obsolete before they were fully implemented.
• Assess the competition realistically Management often underestimated the breadth and intensity of competition. Factories appeared seemingly overnight, causing excess supply and price wars. As a result, even though management forecasts were generally reasonable on a volume basis, they fell short on a value basis by as much as 30 percent.
• Be prepared for tough times When China's economy overheated in the mid- to late 1990s, western companies started to pull back, leaving their local management with few resources to sustain their China operations. Few anticipated the staying power needed to weather the market storms. China no doubt will witness periods of turbulence as its economy continues to expand.

Companies investing in China today can learn much from these painful lessons. SMEs should be aware, however, that they may face critical challenges that may differ, at least in intensity, from those facing a larger Multi National Company.

SME challenges

Given China's lack of legal protection for IP rights and track record of IP abuse, the risk that a company's "crown jewels" could be compromised is high. For an SME, this leakage could deal a fatal blow.

Another risk arises from the fact that SME management is typically thinner than that of a large, diversified company. A China initiative often requires key functional managers to dedicate substantial time and thus draws their attention away from the core business or other new projects. The CEO, top engineer, supply chain director, and other senior executives generally need to be part of the core China team and spend time in-country to get a direct sense of the opportunities and challenges. This investment of senior personnel can result in a high opportunity cost to the company.

In a similar vein, an SME likely has limited international experience and infrastructure, resulting in a steeper learning curve and a greater need to rely on third-party organizations, which can be expensive. In part because of the relatively high costs of hiring outside experts, SME management tends to prefer a "do-it-yourself" approach and may hesitate to work with third parties and to invest in the necessary outside counsel and support. This hesitation can result in management turning to unreliable and unqualified resources that present a friendly and convenient "China face" (for instance, the uncle of an assembly line worker who has "great connections" with a local vice mayor).

The financial risks of an investment in China can have more calamitous consequences for an SME than for a larger firm that can better absorb a failure or an underperforming operation. On the other hand, if management waits too long to respond to the need to go to China, it may have already compromised the company's financial health, heightening risks and limiting strategic options.

SMEs have some potential advantages over larger firms, however.

• Their decisionmaking structures are often flatter and more nimble, enabling them to move more quickly when needed.
• An SME's family-style management and organization often fit well with local Chinese management, making it easier to work together in a partnership.

To go or not to go?

In most cases, the breadth and depth of resource gaps are significantly larger among SMEs than MNCs. As a result, an SME must carefully measure its China "readiness" and be creative in addressing its organization's shortfalls. A company's readiness profile falls into one of four quadrants (see Figure).

Many SMEs have Type B profiles, in which the urgency to do something in China is high but the organization has a number of critical competency gaps that it needs to address before it can effectively respond.

A Company's China Readiness Positioning

Source: Technomic Asia

Things to consider

While certainly not a comprehensive list, the strategic principles described below will give SMEs some things to think about as they plan their future course in China.

1. Strategy before structure

Management needs to have a clear idea of its objectives in China before designing an investment structure. In many cases, a company will pursue a joint venture simply because it was approached by a local Chinese firm. But the structure a company chooses must flow from its strategy and goals. Most industries in China today face few limitations in company ownership, and the process for setting up various structures is well established. What is more challenging is to identify a valid business case for an investment in China based on the five motivations above. The right business structure will often present itself once this strategic foundation is in place.

2. Start small and simple and build on success

Companies new to China should start with a low-risk initiative and proceed in phases. When a company limits the scope of what it takes on until it establishes a successful footprint, subsequent expansion is easier and carries less risk. For instance, companies transferring some manufacturing to China should move well-established production processes and limit the number of products. Transferring an older process line—one where potential IP theft has less consequence—is also wise. Companies can also work with the prospective partner on a contract basis before establishing a joint venture to become more familiar with its capabilities and management.

3. Consider "strange bedfellows" as partners

SMEs may want to consider going to China with a key customer or supplier in North America. In this way, both parties can exploit their joint China resources as much as possible and spread the risks. Remember that these customers or suppliers are also probably working feverishly to develop their own China response. Frequently, it will be in their interest to help their partners get to China.

4. Know your costs and think "total cost"

China's cost advantage is much more than labor. To take advantage of these lower costs, a company needs to understand its own costs clearly (both variable and fixed costs) and where and how large the gaps are with Chinese competition. This insight can dramatically affect how a company sets up in China as well as with whom. For instance, if an SME finds that it simply cannot make a product at a competitive cost, it might consider finding a manufacturing partner that can do so on a contract basis while the SME maintains sales and distribution control. Often a local Chinese producer will be content to maintain a steady and predictable volume at a low margin and allow its foreign partner to control the marketing. It should also be noted that costs may not always be as low as expected after logistics costs, quality problems, time to delivery, and other factors are taken into account.

5. Control without ownership

SMEs would do well to consider creative structures like contractual joint ventures or strategic contract manufacturing relationships. In this way, companies can combine their strengths, such as technology, marketing capabilities, and offshore customers, with the China partner's strengths, such as manufacturing capabilities and local channel access, in a mutually dependent business relationship. Many companies find that they can accomplish 80 percent of their objectives without investing in a local facility.

6. Joint venture in a "clean" company

It is better to start fresh with selective assets in a new company than to purchase equity from a local partner. A new company can also help optimize tax benefits on start up. Avoid the mistakes of the 1990s, when MNCs bought into existing operations and inherited a lot of unforeseen baggage that suffocated operations.

7. Export if possible

Exporting is especially helpful if a company needs to bridge the gap until the China market matures enough to support its operation. By controlling the revenue stream, an SME can dilute the risks of the investment. This approach will also gain local government support.

8. Work closely with local government on setup

China's numerous industrial zones are aggressively competing for foreign investment to generate local jobs and tax revenue. Companies can exploit this competition to optimize benefits in tax abatement, land use costs, infrastructure support, and other areas. Be aggressive in negotiations, and compare alternatives. Experience shows that final costs after a tough negotiation process can be as low as half of the total costs from the industrial zone's initial offer—but be sure to validate these proffered benefits. In many cases, a local city government promised subsidies and benefits, such as tax breaks, to a foreign investor but in the end did not deliver because of a policy reversal at a higher government level or even a change in government officials.

9. "China-fy" your business

Simply transplanting a western business model to China operations is not the best approach. For example, some companies in the West have achieved a high level of automation in their manufacturing process. In China, however, the use of manual labor may be more cost efficient. In these cases, taking out some of the automation may make sense. In the area of value chain positioning, some companies have found that they can gain more market power (and margin) by going up- or downstream from their normal value chain positioning because of China's less developed market structure.

10. Above all, observe the "Six Ds"

Companies going to China should perform due diligence in just about every aspect of their business.

China is complex and often requires more time and expense to investigate than many companies anticipate, which means "Due Diligence, Due Diligence, Due Diligence." Companies going to China should perform due diligence in just about every aspect of their business, from potential partners, suppliers, and hires to the area in which they plan to locate. In the West, insights on a prospective partner, such as financial information, may be readily obtained. In China, however, a company may have two or even three sets of books—but the real numbers remain in the head of the owner. The right type or quality of raw material or tooling may not be available in China or obtainable only at a high cost. Even for something as simple as getting a lease in an industrial zone, one has to check carefully to ensure that the lessor has the proper land-use right certificate to the property and the authority to issue the lease under the terms promised. Read the full article

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Hat Tip : Dan Harris on China Law Blog