The China Joint Venture Squeeze Out

Chinese companies interested in a joint ventures often claim they want to share “the upside” with you when the joint venture goes public.

Reality check — that’s probably not going to happen. Instead, your Chinese business partner is likely going to try to force you out of the joint venture once they decide they’re done with you. We call this the “China Going Public Freeze-Out.”

Our China lawyers tell every foreign partner in a Chinese JV not to transfer their ownership interest in the joint venture unless and until the money you are owed for those shares is in your home country bank account in your country’s currency. When we give this advice to our clients, they almost always reply that the Chinese side has told them that advance payment for the transfer of ownership is impossible.

The problem is that the process of transferring money from China is more complex than many companies expect. Here’s what I mean. First, the Chinese side must convert their RMB to the foreign partner’s currency and then transmit that money through a PRC foreign exchange bank. The Chinese bank will then work with the local tax and company registration authorities and report that the conversion and transfer is impossible until after all of the following are complete:

1. Conversion of the entity from a China JV to a wholly Chinese-owned entity. This process requires approval from local authorities, an independent appraisal of the entity’s values and an audit of all the company books.
2. Transfer of the ownership interest to Chinese persons.
3. Payment of all back taxes and fees of the JV entity.
4. Payment of a substantial tax on the gain realized by the foreign partner.
5. Payment of an additional withholding tax on the overseas payment.

As you can probably tell, this is a time-consuming procedure. To avoid the long process, the Chinese side will often claim to be unable to transmit its payments out of China. It will then push for the foreign party to open a Chinese bank account where it can deposit the payment funds in RMB. It then becomes the foreign partner’s responsibility to convert the RMB to dollars and then  transmit the funds from China to its home country.

The outcomes of this procedure are also uncertain. The amount of taxes and other fees you’ll be liable for depends entirely on the unconstrained decision of the local Chinese authorities. And there’s no certainty that the conversion and payment of funds to the foreign company will be approved under commercially reasonable conditions. It almost never is.

Essentially, what you are facing is not a good faith buyout. What you are facing is a joint venture squeeze out. In this scenario, the Chinese side is forcing you — the foreign party — out of the JV without providing fair compensation.

Is There a Solution?

When a client tells us the above, our response is to state that what the Chinese side has told you is that it will not buy your JV interest on reasonable terms. This means it is impossible, and so you should do nothing.

Clients will then often come back and ask for examples of where the Chinese side conducted the JV buyout on normal commercial terms, where the transfer comes after payment is received. We don’t have any such examples because that’s not how the Chinese JV system was designed to work.

The Chinese joint venture system was set up to make commercially reasonable buyouts impossible. The goal of the Chinese government was and is to force foreign companies to keep their investments in China, and the government established its JV rules and regulations to accomplish this purpose.

These situations usually play out in one of two ways:

1. The foreign party finally gives up and abandons its ownership interest in the JV entity without receiving payment.
2. The Chinese side makes a nominal payment to the foreign side using funds from outside China. This payment is usually equal to the foreign side’s investment contribution, without interest. The foreign party then abandons its ownership interest.

After the foreign party is gone, the Chinese owners skip the complicated conversion process and liquidate the entity. Normally, the entity owned by the majority Chinese side investor absorbs the JV. In rare cases, a new entity forms and takes over the JV’s physical and IP assets, most of which came from the recently removed foreign partner.

We have never seen an alternative to this scenario. The best strategy for you is to sit tight and refuse to act until after the payment has arrived in your bank account in your currency. Although that payment is rarely substantial, some payment is better than nothing.

The right position to take is that it is the Chinese side’s responsibility to figure out how to get a payment to you. Your Chinese business partner should pay you a fair price in your currency to a bank account in your home country if it genuinely wants to buy you out of your JV ownership interest. If it can’t do that, it was never really planning a buyout.

Essentially, when faced with a squeeze out, all you can really do is insist on maintaining your ownership share in the joint venture entity. There is no other alternative.

How Can You Protect Your Company in a Squeeze Out?

To protect your interests and achieve your goals, structure a simple program that includes the following procedures:

1. Arrange for a trustworthy Chinese company to buy your stock at its current value in U.S. dollars. The company should wire those funds to you in the United States after deducting any applicable taxes.
2. After receiving confirmation of a successful wire transfer into your U.S. bank account, you will resign as a director at the joint venture company. You can complete and deposit this paperwork in advance with legal counsel.

This standard structure is the best way to ensure you will actually receive payment for your shares when your joint venture breaks up. A delayed payment structure or a nominee relationship would expose you to near infinite risk, which isn’t appropriate for you to deal with when your business partner is squeezing you out.

To achieve your additional goal of sharing in future stock appreciation, require the stock purchaser to make annual payments to you of an amount equal to the previous year’s increase in stock value.

If nothing else, remember this: do not give up your position in your joint until after you receive a cash payment into your own country’s bank account via wire. Remember these key points:

• If the issue is the sale price, you can set the price equal to an estimate of the growth value of the shares over some period, say five to ten years. That premium over current price would then be your compensation for agreeing to the buyout.
• You could also accept a riskier arrangement where you get annual payments reflecting the increase in stock value over the prior year.
• Do not agree to a nominee arrangement that does not involve a substantial payout to you now. Instead, use a formal shareholding trust agreement, which is possible under Chinese law.

A quick note on nominee arrangements. There is unavoidable risk involved with nominee shareholding. Over the past 15 years, for example, Asian joint venture investors from Taiwan, Korea and Hong Kong who have used nominee shareholding agreements have had generally negative experiences.

Contracts intended to get around Chinese law or that mislead the public are void, and that is what the courts usually decide when such contracts are challenged. You don’t want a lawsuit — you simply want to receive fair payment for your stock.

Licensing vs. Joint Venture

The difference between joint ventures and licensing is simple. A licensing agreement is easier and offers potentially greater reward with a lower required investment. Essentially, the company that developed the IP maintains ownership and licenses its use to other companies. In a joint venture, however, both companies own the IP.

On that note, we’ve seen a peculiar issue pop up with many American tech companies. These companies usually share the following characteristics:

1. They’ve developed a technology that’s good, but not great. Think chips, hardware, software or Internet of Things devices.
2. Although they received heavy initial funding, they only have around six months of cash left at their present burn rate.
3. They are receiving attractive offers from massive Chinese companies that want the technology. However, these companies often don’t want to pay anything upfront for it.

Chinese companies usually offer one of the following options, both of which are horrible for the American company.

Technology Licensing Deal

In a typical licensing deal, the Chinese company offers to pay the American company X percent or X dollars for every widget sold using the American company’s technology. This is usually a terrible deal for two reasons:

1. Aggressive timeline: The Chinese company is unlikely to incorporate the new tech into its product, sell the product and pay up in time to save the American company.
2. Lack of visibility: More importantly, it is usually difficult or impossible for an American company to accurately — or even close to accurately — track the sales of a Chinese company.

Licensing agreements can be tricky to navigate. Although this method may seem like a cheap way to get your product into China, we’ve seen too many licensing and joint venture agreements that heavily favor the Chinese side to say it’s a good move.

See How to License Your IP to China for more advice.

Joint Venture Arrangement

A Chinese company will often offer to form a joint venture arrangement where the American tech company gets X percent in the venture.

1. It’s unlikely that the joint venture can be formed in fewer than four to six months. Actually, it’s likely to take longer than that if the American tech company wants its technology transfer to the joint venture to count as a contribution for equity purposes.
2. It’s typically very difficult for foreign companies to accurately monitor the sales of their Chinese joint venture entities.

We’ve had so many Western companies call us for help because, although their Chinese joint venture entity seems to be thriving, they have never seen a penny.

So what should these  companies do instead?

Simple. Hold firm with the Chinese companies and require they pay a large upfront sum for licensing your technology. Nearly every time we have counseled our clients to do this, the Chinese company has backed down and paid.

The Bottom Line on China Joint Ventures

If you’re looking for a way to enter the Chinese market, you might want to consider something other than a joint venture.

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