We sit down with Walker Wallace, managing partner of O’Melveny’s Shanghai office, to discuss how foreign tech companies should think about entering the China market. It’s worth noting that most tech start-ups should not even consider China entry in the early days, as building up tech and achieving a focused product-market fit should be the only priority, and a premature obsession over China could very well be a huge distraction. But for companies that have built up a relatively sustainable business and are looking to scale, a thoughtful, well executed China strategy could create significant value.
Today we discuss: what type of tech companies should consider entering the China market? What should their key considerations be before designing a market entry strategy? What are the different options and structures available? How do JVs work, and what is the value exchange between JV partners? Any other best practices to keep in mind?
20 Years in China
Adam: Let’s start with your story. What’s it been like over these past 20 years in China? What surprises you about what folks back home don’t understand?
Walker: I first came to China in 1990 to teach English in Guangzhou for an early wave of Chinese graduates looking to join multi-national corporations (MNEs). In 1992 I went back to the US for my law degree and worked for a few years in New York, but knew I needed to get back to China. I returned to China in 1997, this time joining O’Melveny and Myers, and have since worked on projects here and watched the development of China over that time.
So you asked the question of what people should know about China. There’s lots of things, you could write a book about it!
First of all, today’s China is not all people wearing Mao suits and riding bicycles. I know that with the foreign press these days, there’s broad recognition of how far China has come, that it's a wealthy country. But I still get a kick out of some clients who come to China and are just floored by how prosperous this place is and how well dressed people are and how fancy the restaurants are. One of my favorite spots is a corner near a place called ‘Tomorrow Square’ where you can find a Maserati dealer, a Lamborghini dealer, and a BMW dealer all at one intersection.
The second thing I would share with people is that Chinese millennials are a very different breed compared to any other generation of Chinese in living memory. They are more cosmopolitan, more interested in lifestyle issues than their parents were, more in tune to having their own culture and their own entertainment forms. It’s important to realize that they are a very different segment.
The third thing is of paramount importance – people need to get away from the image of China as just a copy cat. The Chinese are inherently very innovative. For example, take a look at the businesses that have grown out of struggle, sometimes with outright government hostility in the early years of the reform, and learned how to invent business models that work here. And if you look at almost any scientific announcement today coming out of western universities, you’ll find a Chinese name as co-author.
Adam: Right Walker, there has certainly been a number of examples of Chinese innovation and we’ve covered multiple examples on our podcasts. From your perspective as a lawyer, and given your observations over the past 20 years, can you tell us a bit more about institutional changes or policy measures that facilitate innovation and accelerate the development of new technologies?
Walker: Well for example you've seen the government actively go out to court international researchers to come and join Chinese research institutions. We see government money that's been going into specific efforts to try and innovate, including bringing semiconductor manufacturing capability to China. There are also efforts to actually encourage foreign competitors to come into this market and prod Chinese companies to get better at what they do, to launch joint ventures with Chinese companies. I think in the foreign press we tend to look at the negative side, and often don’t appreciate just how aggressively the Chinese government has worked to encourage innovation, even when sometimes these efforts hurt local companies in the short term in order to encourage long term development.
However, I would add that the government has not been as effective at picking winners and losers. In my view, so far there’s been essentially three waves of government backed venture capital firms. In China’s first wave, the government basically said “hey we’ll provide investment money to good companies”, which essentially meant that they put money behind government officials to go out and build high tech companies. That was a disaster as far as I could see and I don’t know if any of those funds that still exist today.
During the second wave, government capital figured that professors might know more about what’s best for high tech, so for a period there were a lot of funds that had university professors running fast and poking left and right. However, they oftentimes didn't know how to structure the investments or sort through the commercial terms.
The third wave has been much more effective. Essentially, it involved people who came out of the international private equity or venture capital industries. So the government said okay we’ll put some money behind these expert money managers. Despite their presence, it’s still much more of a private sector driven effort with the government providing some capital and support, rather than the government trying to do all the picking and choosing.
Adam: And beyond the VCs and investors putting in capital, what about the entrepreneurs themselves, particularly the batch of Chinese students who have gone overseas to study. Increasingly, you have Chinese entrepreneurs with a very strong science background and global perspective coming back to China start companies… how are those ventures performing?
Walker: It's mixed frankly. There's a term that people in China use to describe returnees, they call them “hai-gui”, or sea turtles. And there is a perception that if you spend too much time outside of China you really are not necessarily going to be effective within a Chinese business environment. But at the same time we have clients, Chinese who went to study in Australia or the United States, who come up with an idea or new technology and come back… and they've actually been very very successful. So I think it's really mixed.
Considerations for China Entry
Adam: Walker let’s switch gears and tackle our primary topic for today. For a company looking to enter the China market… talk us through how to think about such a step.
Walker: So I have a lot of friends who are in the consulting industry, and the old joke used to be that… the CEO of a company comes to China sees a market of 1.3 billion people and gets very excited about this opportunity because hey, if I can sell a bar soap to 1.3 billion people each, then I’d get fabulously wealthy. But then then the standard consultant analysis shows that there's 1.3 billion people but the only people with any real spending power are in the east coast cities. Okay so now maybe I'm down to two hundred million people. Well that still sounds like a pretty good market, it’s still about two thirds the size of the United States. Well, it turns out that the number of people with real spending power is actually much less. So the market opportunity gets much smaller.
In other words, there was a tendency in early years for people to not really have a realistic view of what the China market was and where it was going to go, and so there were numerous examples of companies who came to China only to have their hopes dashed.
Another thing you’ll need to ask yourself at the end of the day is: what's in it for China? Companies think about every which way a JV might be fantastic for their bottom line, but they haven’t really asked themselves what’s in it for the key local stakeholders. Many of the horror stories of JVs that failed boil down to a misalignment of incentives.
So Is the Chinese government hostile to foreign tech? Instead of worrying about that, I think foreign companies should think about how they can position themselves to become a valuable part of the Chinese fabric. For example, GE does a great job and has advertisements all over China positioning themselves as a Chinese citizen important to growth of China. This can bullet proof you against lot of concerns.
Adam: I would also add that for tech companies, if you’re at super early stage, you’re likely still trying to figure out product-market fit in your own country. So if you’re not ready, China entry can be a huge distraction. It requires a ton of effort… finding the right partner takes time, determining the right JV structure and terms takes time. At the time of the day, there must be a clear rationale for entry beyond just basic grounds for commercial opportunity.
Options for China Entry
Adam: But now assuming that your company is the right profile and has the proper strategic rationale for entering the China market… in that case what do they have to work with, Walker? What are their options?
Walker: Well there are a few text book options. Am I going to license someone else’s technology in China? Am I going to come in and set up my own wholly owned enterprise in China (WFOE)? Or will I structure a JV? There are pluses and minuses for each.
For a licensing deal, the commitment is going to be lower. But the downside is that you have less control over how that market develops, and you may end up getting just a small piece of that market.
Now, if you launch a WFOE, that’s a full time job and you need to be committed to the market. It’s a totally different game here, so you must react to the market, position and reposition, just like in your home market. There may be doors closed to you as an outsider, so you’ll need to create your own distribution channels, develop new relationships, etc.
For JVs, we see some disasters, because often soon after the JV is negotiated, both parties just step back and expect the other side to put in effort. Sometimes that can lead to paralysis, and things don’t work out the way you may expect. To properly run a JV requires 150% effort. If you choose your partner well, they can bring a ton of value. But you still need to invest heavily and manage that relationship.
Adam: Can you step us through what the value exchange looks like between JV partners? What does the foreign company provide, and what does the local partner provide?
Walker: So it’s different every time. While going into a JV, it’s very important have both parties take a hard look at what they bring to the table, and what long term value is available from this relationship. In the early days, Chinese companies didn’t have much capital or know how. Instead, they might have government connections, a dusty piece of land with a factory on it. Maybe they had a rudimentary distribution network, but these weren’t always attractive to foreign players given differences in pricing schemes and models. On the flipside, the foreign partner brought high tech, management know how, and capital. Today it’s very different, as you have very sophisticated Chinese companies with good technology, strong distribution networks, and a real good understanding of this economy they are operating in, with aspirations to build world class products.
So today, foreign start ups may come in with good technology, but they’re at a relatively early stage of their development. Unlike a well established MNE, they won’t have a hundred million dollar war chest. Their core value is tech and process know how, but the Chinese partner will do almost everything else.
Adam: It seems that the Chinese partners offer quite a bit. In that instance, how does the foreign company maintain its competitive positioning and ability to negotiate. There are stories of Chinese partners working with foreign companies, learning from them, and then eventually replicating their tech or products. How do you manage that risk?
Walker: Well first of all, the common view is that Western companies come to China and get fleeced. The reality is that this is a tough environment in general, for both foreign and local players. Companies in China move super fast, and often take advantage of a new piece of tech or insight. Western companies may have concerns on whether they can protect their tech in court, but Chinese companies have the same concerns. So they’ll protect themselves by taking proactive steps, by out-innovating their competitors. If you copy A, I’ve moved on to B. And likewise if you copy B, I’m already at C or D.
Adam: it sure seems that tech advantage is a temporal advantage. For strong competitive MOATs, you improve your tech fast, or build on top of that. Let’s get to some examples… here I’ll quote something I shared via a previous blog post (Innovated in China). In 2008, Tencent successfully brought League Of Legends to China, which gave it confidence to acquire a majority stake in LoL’s maker Riot Games in 2011 and eventually complete the full acquisition in 2015. Over the years, Tencent has helped turn LoL into the world’s number one MMOG in China. So why did Riot succeed in China? Simply put, Riot retained competitive advantages that could not be easily surpassed. Typically, your basic technology leadership buys time value, but in most cases Chinese competitors are able to eventually reverse engineer and replicate. However, LoL at the time was already the world’s most popular MMOG, with a brand and fanatic user base so strong that Tencent could not possibly replicate it. Riot understood this well, and as such was able to leverage Tencent’s capabilities to distribute and localize its product, and eventually secured an exit on favorable terms.
There are plenty of other examples as well, for example LinkedIn or Uber entering China. eBay and Groupon are others. It seems that most of them entered via the JV approach. Any views on those ventures?
Walker: Some of those companies were very smart about entry and how to align themselves with Chinese interests. Uber for example sought investment from Chinese companies (Baidu). And other Chinese companies have actively coached Western companies. Tencent has strong management, I’ve worked opposite them on a number of cases, and I’ve been impressed by their efforts to look for win-win solutions and coach Western companies to ensure a sustainable relationship.
If I could make another self-serving point as a lawyer, I would emphasize that the legal structure and docs for a JV are very important, but they’re not important for the same reason as folks in the US think they are. In the US, the typical model is to get into a room, strangle each other for hours to get the right docs, and then we’ll bury some things in there and hide a couple bombs or so. In China, if you get the structure and docs right, it’s a way of aligning expectations. But if you trying to pull a fast one via legal docs, and don’t allow a certain level of generosity, then there aren’t high hopes for the JV to begin with.
For example If you go to your Chinese partner, let’s say a SOE, and tell them that oh by the way, clause D gives the foreign company exclusivity for this part of China, they’ll just say screw you. You’ll have a hard time enforcing that clause. And if you get to the point that you’re relying on the JV contract to talk to your partner, your JV is already unsuccessful. If you end up in court, who knows which way it’ll go, it’ll be a crap shoot. The JV contract is valuable to align expectations and build in some insurance, but don’t use it as a crutch for execution.
Adam: Got it. Beyond the JV, what are some lighter or more passive ways to get China exposure? For example minority investments into a Chinese company. There seem to be some good outcomes there, including Yahoo with Alibaba, and Naspers with Tencent.
Walker: We represent a lot of funds that have been doing investments in China since 2001, doing minority investments. Some of the same things apply around the alignment of interest, and making sure there are good structures in place. It used to be popular to have a ratchet, so if the round didn’t hit a certain valuation, then the investor would get more shares. But when it came time to enforce the ratchet, Chinese entrepreneurs flat out refused, so it doesn’t matter what the legal document said. Getting alignment is key. Almost all the Chinese companies that have listed in the US have minority investments from well established foreign funds and strategics. The structures are more robust and mature now, and Chinese companies and foreign investors are at least aligned on wanting to go IPO. Investors bring in a whole lot of value, including intros to investment banks, help with the IPO process, and more.
Adam: Last question – how do you look at sales rep offices as a light way to test out the China market before proper entry.
Walker: There are many different schools of thought. Actually, many of the MNEs here started off with just sales offices and sold their products via distributors. In fact, luxury brands weren’t allowed to open retailers in China, so almost the entire industry was built on local representatives. It’s a relatively low investment, light footprint to get exposure to the country. Then again, it could be more expensive in the long term… if it’s a good market they want to get more involved in, they’ll need to buy back rights or somehow get rights back.
Adam: Thanks Walker for your perspective and the valuable advice!
Walker Wallace Biography
Walker J. Wallace is a leader in O’Melveny’s China practice. He has extensive experience in international transactions and has worked with clients in a wide range of projects across Asia, from multi-nationals seeking to invest in China, to private equity funds pursuing investment strategies in Southeast Asia. In China, Walker has helped clients negotiate the complexities of investing and structuring business operations in numerous industries, including consumer products, healthcare, real estate, software, media and entertainment, retail and education.
Walker has been working in the Shanghai office since 1997. He is the former Chairman of the Legal Committee for the American Chamber of Commerce in Shanghai, and is the co-author of “Acquisitions of Companies with Chinese Assets,” “Foreign Private Equity Investment in China: Which Way to the Exit?,” “Onshore Financial Investing in China,” and “Enforcement on Defaulted Loans and Mortgage on Real Property under Chinese Law.” Walker was named as a leading lawyer by Chambers Asia 2016/2017 under the categories “China, Corporate/M&A” and “China, Private Equity: Buyouts (International Firms)”.
Walker earned his J.D. from Columbia University, and his B.A., cum laude from Williams College. He is admitted to the bar of New York.
This podcast and transcript is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or O’Melvney. Walker J. Wallace, an O'Melveny partner licensed to practice law in New York, contributed to the content. The views expressed are his except as otherwise noted.