Investment Cooperative Joint Ventures - SMART

1 CooperativeJointVentures18 January February 2005 THE CHINA BUSINESS REVIEWS ince China s World Trade Organization(WTO) entry and the PRC government s relax-ation of Investment regulations, foreigninvestors have been choosing to establish morewholly foreign -owned enterprises (WFOEs),which in the first three quarters of 2004 madeup nearly 67 percent of the value of new foreigndirect Investment projects in China (see Table).WFOEs cannot be used in every sector, however,because the PRC government requires Chinesecompany participation or control in some sec-tors. In such cases, foreign companies must con-sider a Joint venture structure. Even when theyare not required, Joint Ventures can benefit for-eign investors when a Chinese partner has cer-tain strengths such as central or localgovernment support, brand reputation, land,licenses, distribution, and access to suppliers that reduce start up costs and improve the for-eign investor s chances of success (see ).

2 In China, most Joint Ventures are equityjoint Ventures (EJVs), though some investorsestablish Cooperative (or contractual) Joint ven-tures (CJVs). CJVs and EJVs are similar in manyrespects. The PRC government approval process,approval authorities, format of agreements, taxbreaks, legal standing, and the means, laws, andauthorities for dispute resolution are general management structure and gover-nance procedures are also virtually the CJVs and EJVs differ in two importantways. First, unlike an EJV, a CJV does not needto be a separate legal person under PRC law. (ACJV that is not a separate legal person may ben-efit from lower costs, but also may expose theparties to greater liability than if they were legalPaul H. Folta,PhD, is managing director ofPaul H. Folta & Associates, LLC( ),which provides consulting ser-vices on China and Asia busi-ness development. The author would like to thankthe US-China BusinessCouncil s Business AdvisoryServices team; Rui Feng, PhD,chair and CEO, of SKNR esources Ltd.)

3 ; and severallegal, venture capital, andindustrial sources for the attractiveness of China s business andforeign Investment environment, the country is not aneasy place to do business. foreign businesses thatseek to enter the China market must consider a wide range ofstrategies and business structures each with its ownadvantages and disadvantages. CooperativeJointVenturesCooperativeJoint VenturesSavvyforeigninvestorsmaywishtoco nsiderthebenefitsofthisflexibleinvestmen tstructurePaul H. FoltaInvestmentpersons, because CJVs with legal person statusconfer limited liability on parties to the jointventure.) Second, the CJV parties profit, con-trol, and risks are divided according to negotiat-ed contract terms. In contrast, an EJV s profit,control, and risk are divided in proportion tothe equity shares invested by the disadvantagesAs is true for any Investment structure, CJVshave their drawbacks.

4 First, since all CJV con-tract details need to be negotiated, establishinga CJV can be time consuming and , CJV negotiations can derail potentialventures as parties discover that they cannotreach agreement on every detail. Second, CJVsare sometimes not the most appropriate busi-ness structure for the project. For example, aWestern automotive technology companyrecently signed a memorandum of understand-ing for a CJV with a Chinese state-ownedenterprise (SOE) for the manufacture and saleof its patented system in China. The venturedid not proceed, however, because the SOEultimately determined that it preferred an EJVso that profit sharing ratios would matchshareholdings and future changes in registeredcapital. In the end, the foreign company decid-ed to form a WFOE, but planned to maintainand develop options to work with its Chinesepartners in the choose a CJV? CJVs nevertheless can offer investors severaladvantages.

5 Compared to EJVs, Cooperative jointventures Allow access to restricted sectorsIn a CJV, Chinese partners can hold and lend assets and licenses that are forbidden toforeign investors under PRC law, or that areundesired by the foreign partner, until the ven-ture terminates or foreign ownership rules arerelaxed. Undesirable assets may include thosewith a high transfer tax, or those that are toocomplicated or costly for the foreign investor toobtain, such as land. For example, a Chinesecompany can lend its license to a CJV in avalue-added telecom network (see ). AChinese company would not be permitted totransfer such a license to an EJV because thelicense, if forbidden to foreign owners, would beconsidered part of the whole company s CJV could also allow negotiated levels ofmanagement and financial control, as well asmethods of recourse associated with equipmentleases and service contracts; in an EJV, foreigninvestors cannot always obtain such control sinceEJVs typically rely on equity levels to assign boardseats and key staff and to determine other rights.

6 Alleviate capital contribution difficultiesThe CJV s foreign partner can contribute orlease to the Joint venture expensive Western tech-nology and equipment, such as medical diagnos-THE CHINA BUSINESS REVIEWJ anuary February 200519 China s foreign Direct Investment (Utilized FDI)2000200120022003 Jan. Sept. 2004 Total FDI ($ billion) foreign -owned enterprises (%) Joint Ventures (%) Joint Ventures (CJV, %) (%) CJV Projects (No.)1,7551,5891,5951,547996 Note: Other=Share-based enterprises with foreign Investment ; and Cooperative development vehiclesSources: PRC Ministry of Commerce, the US-China Business Council In a CJV, Chinese partners can hold and lend assets and licenses that are forbidden to foreign investors under PRC February 2005 THE CHINA BUSINESS REVIEWC ooperative Joint Venture Case Studies The following Cooperative Joint venture (CJV) cases illustrate potentially useful strategies that may apply to companies in other , toll road projects in China involveconstruction and operation of roads that havebeen classified and approved for toll collec-tion.

7 The PRC government sees toll roads as away to encourage foreign Investment in thedevelopment of China s transportation infras-tructure. CJVs are almost always used for suchinvestments because other Investment struc-tures cannot effectively address the financialrisk to investors that contribute a large amountof cash. A CJV enables such investors torecoup their Investment more quickly thanother structures, since the parties can negoti-ate how and when profits are ultimately divid-ed. Because toll roads are build-operate-transfer projects (the assets the roads will return to the government at the end of aproject s life), foreign investors are concernedabout how much time it will take to recoup theinvestment and focus on more than just thetotal Investment return by the end of the pro-ject. Since the value of cash flows declinesover time, most foreign investors measureinvestment returns by internal rate of investors typically negotiate to getmore than a proportionate share of the cashrelative to share capital in the early years.

8 Forexample, a foreign investor could negotiate toreceive up to 100 percent of the available cashfor an initial period (perhaps the first 5 to 15years). In the next 5 to 10 years, available cashcould be split to match the parties sharehold-ing. In a final period, perhaps the last 5 to 10years, the foreign party could receive a sharein the available cash less than proportionate toits shareholding. All agreements and definitionof rights should be carefully spelled out in thedetailed CJV contract. In many toll road CJVs, the foreign partyowns the majority of share capital. Most tollroad CJVs have two categories of investors:financial and local government investors may be foreign or local; forthe sake of simplicity they are called foreigninvestors here. This side contributes most ofthe needed cash. The second category of part-ners, which usually includes a subsidiary of thelocal traffic bureau, contributes licenses, con-struction, and the workforce.

9 This side, for sim-plicity s sake called local investors here, putsin assets but may also contribute cash. In one example of a toll road CJV, a pro-ject included an expressway and a Class 2road (a parallel or connecting road givingaccess to the expressway). Most of the cashwas used to build the expressway, and a less-er portion was used to repair and upgrade theClass 2 road. The foreign party maintainedmanagement control by assigning 60 percentof board seats matching its share foreign party appointed the general man-ager and the financial controller so that itwould be on top of daily operations and incharge of the material fund flows. The CJV setup checks and balances to communicateamong foreign parties, local parties, andauthorities. The CJV, a legal person with limit-ed liability, had a four-year construction periodand has a 30-year life. The parties divide prof-its based on the schedule described above. Allof this was written into the CJV toll road projects, the CJV structureshould not inhibit exit strategies.

10 Someinvestors view toll road projects as being simi-lar to a utility with a limited life. Others have astrategy to expand their projects by addingmore roads and by focusing on projects withina region or on key city-to-city projects. Thus, asuccessful exit strategy in this sector hasbeen to pool toll roads and package them intoa holding company for listing on a public stockexchange. Paul H. FoltaToday China is the world s fourth-largestgold producer. Growth in China s gold industrywas driven by domestic demand and heavygovernment Investment in the sector from the1980s to the mid-1990s. With the deregulationof China s mining laws, the nation s WorldTrade Organization (WTO) entry in December2001, and the official opening of the ShanghaiGold Exchange in October 2002, manyobservers believe the risk for foreign invest-ment in this sector has fallen. Although a for-eign investor registered in China as arepresentative office, equity Joint venture(EJV), CJV (including a nonlegal person CJV),or a wholly foreign -owned enterprise (WFOE)may apply for an exploration license, the vastmajority of foreign investments in this sectorhave been through CJVs.