Other BriefingsMitigating Hidden Risks in Various Market Entry Modes
Irrespective of which market entry mode is chosen, investors should incorporate risk mitigation measures in their market entry planning stage. While each market entry mode has unique advantages and challenges, businesses must have a clear understanding of the hidden risks that could prove costly in the long run. We discuss some typical risks and propose mitigation measures that small and medium sized enterprises can take up in their due diligence prior to setting up international business transactions, joint ventures, and M&A deals, among others. For more questions, please contact Simon Laube, Senior Associate with the International Business Advisory team at Dezan Shira & Associates’ Shanghai office.
In international transactions, hidden risks tend to be higher and more versatile than that in domestic transactions, which can be costly if not managed properly. This is especially the case for small and medium sized enterprises (SMEs) with less resources to mitigate risks.
In this article, we introduce some typical hidden risks that companies should pay attention to in various market entry modes – including product and service transactions, strategic alliances, joint ventures, and mergers and acquisitions (M&As) – and provide the risk mitigation measures that can be taken based on our on the ground experiences.
Product and service transactions
In the most common setting, especially for SMEs, international business partners have a distant relationship focused on product or service transactions. These should be based on commercial contracts, especially if the product or service is more complex. In practice, however, such transactions are often merely based on purchase orders and invoices.
Risks in such transactions are mostly associated with a lack of information and limited means of communication. Ironically, simple business relationships are often based on excessive trust, mostly because the value of the transaction is often relatively low and the costs of contract enforcement, such as litigation, might outsize the expected gains.
However, risk mitigation at this level is also rather simple and prudent business conduct can be a worthwhile investment.
For example, business partners should be concerned whether the signatory of the counterparty has the right to sign legally, and whether the stamp on documents is valid. Some errors can be detected easily, such as different names in company stamp and on business licenses. Moreover, in bilingual contracts, the wording of both languages should be independently verified, and – most importantly – contracts should be fully understood by both sides.
Another popular measure are background checks, which deliver basic information about a company, its corporate structure, and legal history.
While background checks may also provide financial data, the solvency of a business partner cannot be assessed without access to internal books. In recurring transactions, solid commercial contracts add a layer of protection, while in long-term industrial supplier relationships, audits will decrease information asymmetry.
Strategic alliances
Strategic alliance, also referred to as strategic partnership or strategic cooperation, is a commercial term to describe the flexible relationship among alliance partners to bundles resources for business improvement. Strategic alliance can take various forms and does not constitute a legal entity.
As a rather flexible method of partnership or cooperation, it favors growth potential and is less suitable for protecting businesses’ downside. Nevertheless, the scope can be extensive. Examples include patent licensing agreements and product or profit-sharing agreements, as well as entrustment agreements for processing of goods, or the authorization to use a trademark. Original equipment manufacturing (OEM) and franchising also fit into this wider category.
Among foreign enterprises in China, roughly one-third engages or intents to engage in strategic partnerships and cooperation, while engagement in joint ventures or M&A is only intended by less than five percent, respectively.
Since an alliance is rather flexible, partners should shift their risk focus towards the economic factors and structural problems that could weigh upon the commitments that partners bring to the alliance.
A common structural issue is that trust is hard to establish. Either party may be inclined to deviate from their original commitments, especially if market conditions change. Hence, economic risks, such as shifting demand and cost overruns, amplify the risk of insufficient contribution, such as limited technology upgrades and lagging customer engagement. Alliance partners likely maintain parallel strategies, which adds to the instability of the relationship.
Ultimately, trust is not just hard to build, but also easy to lose. Therefore, risk mitigation strategies should include a mechanism for rebuilding trust. Moreover, from the beginning, there should be sufficient flexibility in finding common goals. A wide range of milestones and motivational factors lessen the likelihood of diminishing common interests.
Nevertheless, a solid contractual framework is necessary to maintain clarity and vague language used in less specific agreements or memoranda must be avoided.
Joint ventures
A joint venture is a legal entity, owned by two or more investors. Due to its limited liability nature, it is more suitable to share commercial risks compared to strategic alliances.
In international business, joint ventures are often preferred when the parties lack substantial capabilities or resources to execute their expansion strategies by themselves. Key considerations when seeking a joint venture partner pertain to identifying which factors complement capacity, based on the ultimate goal of the business. A common example is an investor with capital and technology, who lacks the ability to grow and manage a local workforce and client engagements in a different cultural context. Moreover, in China, foreign ownership is capped for certain investments in restricted industries.
Since commitment to a common goal is less an issue when profits and losses are shared, joint venture partners should shift their risk focus towards controlling, management, and fraud prevention. Frequent examples are loss of control of the joint venture, random distribution of power, abuse of resources for personal enrichment, among other reasons, and technology and intellectual property theft. In addition, many joint ventures lack specified exit mechanisms, which can trap investors into extended periods of loss making.
Risk mitigation in joint ventures is complex. However, compared to strategic alliances, mitigation measures are also more specific and numerous.
Solid contracts
When reaching a joint venture agreement, investors are suggested to pay attention to certain important matters, including shareholder ratio, capital contribution, commitments to the joint venture, profit distribution method, voting rights, equity transfer, capital increase, non-competition clauses, and deadlock and exit mechanism, among others.
For example, the shareholding ratio determines how much weight each shareholder owns to pass resolutions and make decisions on significant matters. While PRC Company Law stipulates that the shareholding ratio of a limited liability company is normally subject to the capital subscribed by each shareholder, shareholders are free to decide on the total amount and the timeline. Moreover, the contribution method can be in cash or in kind if the non-cash properties can be valuated and transferred.
Likewise, PRC Company Law sets forth the general principle of profit distribution as to sharing profit in accordance with the ratio of paid-in capital contribution. However, it allows the shareholders to break through above general principle by mutual agreement.
Since capital contributions are often not split evenly in cross-border joint ventures, investors should ensure that they receive the required shareholding ratio and dividend rights by leveraging available legal options and clearly codifying them in relevant contracts.
A less prominent example are exit mechanisms. To ensure that investors can protect their downside, exit mechanisms for specific circumstances, beyond the mandatory dissolution, can be defined in the articles of association and the shareholder agreement. These clauses should remain sufficiently practical and include unforeseeable events – to be effective.
Monitoring
While a solid contractual framework is the base for risk mitigation, this should be complemented with proper monitoring mechanisms, such as internal approval procedures or external management of seals and certificates. Financial controlling is most effective to steer a joint venture, since changes in gross profit margins, major customer accounts, and business models can be signs of irregularities. Yet, it is advisable to have mutual agreement on monitoring efforts from the outset. For example, if the partners agree on regular audits before the joint venture is in operation, such measures usually do not impact the relationship at a later stage but rather enhance trust among the partners.
M&A
A full acquisition or a merger between two entities leads to centralized ownership, meaning that risks and rewards are integrated, reducing some of the agency problems joint ventures face. Hence, the purpose of M&A is more tilted towards exploiting synergies while remaining in control. The acquisition of minority interests or shares is less common among SMEs in international transactions.
However, the major risk in M&A is that expected operational synergies may not be realized in the future.
On the one hand, if the acquisition price is too high, even realized synergies may never recover the initial investment. On the other hand, if merging entities prove to be incompatible in later stages, even an acquisition at fair value might fail to deliver on its purpose. A large body of research literature has continuously estimated the failure of M&As to be well above fifty percent. Moreover, this figure rises sharply if we consider cases which can be deemed as failures but continue operating anyway.
Risk mitigation in M&A starts with thorough financial and legal due diligence to determine the fair value of the target firm. However, investors will need to perform extensive reviews on operations, human resources, technology, compatibility of intangibles, and others, to ensure the target presents an opportunity for a sustainable future.
Financial due diligence can rectify a valuation if it uncovers irregularities. For example, improper internal control of cash, embezzlement, and off-balance sheet items, such as invisible bank accounts and off-table liabilities. Also, a target could employ diverse accounting methodologies to overestimate revenues and underestimate liabilities, which will increase its valuation.
Business context
Investors should take note of the financial risks of the wider operational context of an M&A target, such as personal relationships that the target has with its business partners, and related party transactions. For example, there may be revenues from services for which service agreements exist, but service performance was never intended. This could also extend to loan agreements, which may serve the purpose of managing revenues for the debt holder and interest expenses for the debtor. Investors could see the value of their investments being impaired if such issues surface after the transaction.
Intangible assets, especially non-monetary investment, deserve special attention in M&As, as their value could potentially not only be inflated, but also change significantly due to the nature of the transaction. A telling example is brand value, which might diminish if a brand is absorbed into the new business but continues under a different name.
Legal due diligence will obviously include all documentation of a target, such as licenses, certificates, permits and qualifications, land use rights, real estate property, and environmental assessment reports and approvals in case of manufacturing – just to name a few. However, the wider operational context matters here as well. For example, inherited risks from incomplete contracts and anonymous shareholders or shareholders with outstanding liabilities will affect the valuation.
Human capital
Human capital enters our consideration in two ways, as it is central for both the initiation and failure of many M&As.
On the one hand, investors must understand what types of employees the target has and which compensation and special conditions apply, to understand the financial implications.
On the other hand, investors should duly assess the degree to which the new corporate structure impacts the motivation and incentives of key talent and the workforce at large. A new owner can be a strong positive signal for the employees of the target. However, the integration could take a turn in the opposite direction if the new structure is perceived as unfavorable by the employees, or if corporate communication fails to deliver the right messages.
Finally, even solid due diligence and execution cannot eliminate all human factors that play an important role, especially in transactions that rely on operational integration to deliver value. Therefore, investors should prepare for effective post-merger integration well ahead of executing a deal.
Closing remarks
While each market entry mode has unique advantages and challenges, investors should have a clear understanding of the hidden risks, which might prove costly in the long run.
For basic commercial transactions, it is advisable to invest in intelligence about your business partner. In more advanced forms of cooperation, such as strategic alliances, investors should create flexible incentive mechanisms that survive market disruptions and avoid vague agreements.
While joint ventures protect against downside risks and better ensure commitment of the partners, investors need to have a solid contractual framework in place, aided by monitoring mechanisms. Eventually, in M&As, where control is centralized, investors should perform rigorous due diligence and start their post-merger integration journey before executing the deal.
About Us
China Briefing is written and produced by Dezan Shira & Associates. The practice assists foreign investors into China and has done so since 1992 through offices in Beijing, Tianjin, Dalian, Qingdao, Shanghai, Hangzhou, Ningbo, Suzhou, Guangzhou, Dongguan, Zhongshan, Shenzhen, and Hong Kong. Please contact the firm for assistance in China at china@dezshira.com.
Dezan Shira & Associates has offices in Vietnam, Indonesia, Singapore, United States, Germany, Italy, India, and Russia, in addition to our trade research facilities along the Belt & Road Initiative. We also have partner firms assisting foreign investors in The Philippines, Malaysia, Thailand, Bangladesh.
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