The need for due diligence

Despite attempts to emphasize the “win-win” nature of mergers, acquisitions and joint venture deals, many times this type of business transaction can involve issues where the two parties’ interests are opposing. For example, in the case of acquisitions, it is in the buyer’s interest to have access to all information available about the target; this is not always in the interest of the seller. In some countries, notably in more developed markets, the buyer is generally able to conduct a comprehensive due diligence study before committing to a deal. In China however, the conflict between buyer and seller is often resolved in favor of the Chinese seller, with the foreign party not being able to have access to detailed information on the target ahead of the deal. All too often, the Chinese saying “sleeping in the same bed but having different dreams” will apply to a deal. This is one of the reasons why historically almost half of all Sino-foreign joint ventures have failed.

This success rate would no doubt improve if foreign investors took a more prudent approach to investing in China by conducting proper due diligence on partners and acquisition targets. By carefully choosing and evaluating potential acquisition targets or JV partners, the chances of a successful China deal increases dramatically.

The value of commercial due diligence

All forms of due diligence aim at finding and analyzing information. A proper understanding of a target company requires a combination of financial, legal and commercial due diligence plus environmental and other forms of due diligence depending on the industry involved in order to:

• Minimize risk by providing a thorough understanding of the company and its markets.
• Expose potential deal-breakers early on in the process to avoid unnecessary investment of resources.
• Provide an important input to valuation by forecasting potential growth, key success factors and ways to increase profit margins.
• Secure the best possible negotiating position for a buyer by enhancing his negotiation power.
• Aid post-deal integration by exposing stewardship and other issues ahead of a deal allowing for efficient integration planning.

The focus of commercial due diligence

Commercial due diligence is normally undertaken in the context of a change of shareholding in a business including acquisitions, joint ventures and managed or leveraged buy-outs. Many firms also conduct commercial due diligence in situations where there are no changes of ownership but when a company relies on another party for its business success, e.g. when looking for distributors or suppliers.

Commercial due diligence differs from legal and financial due diligence in that it focuses more heavily on future performance of the targeted company. This is because commercial due diligence aims to develop a clear understanding of the target company as a competitor in specific markets. Apart from a detailed understanding of the internal operations of a target, the buyers also needs to gain a clear understanding of the industry and specific market segments in which the target competes. As a result, commercial due diligence relies more heavily on outside sources than any other form of due diligence. Although information from the target company is important, information from secondary sources is of paramount importance. In particular, commercial due diligence relies heavily on primary research, e.g. interviews with existing customers, competitors and other industry players. Since commercial due diligence is more dependent on sources external to the target it also involves more complexity in terms of data gathering and analysis.

Chart: The Respective Roles of Legal, Financial and Commercial Due Diligence

Sources: Fiducia Management Consultants

Due diligence challenges in China

The key skills required to conduct commercial due diligence include the ability to gain access to and extract information from potential targets or JV partners and other third parties with knowledge of the target being investigated. This kind of information gathering is especially challenging in developing markets such as China. Not only is there a relative lack of accessible market data but the shelf life of the available data is also surprisingly short due to the tremendous pace with which the Chinese market is developing. Additionally, the key driver behind the performance of a Chinese company is often informal relationships that are not revealed when looking at hard data.

The only way to unearth the information necessary to properly evaluate potential targets is to talk to the right market players—including interviews up and down the target’s industry value chain—as well as talking to industry regulators. It is only by taking this kind of comprehensive approach that the “true nature” of the target is revealed.

Practical China due diligence advice

Foreign investors considering a joint venture, merger or acquisition deal in China should consider the following ten key points which are based on experience gained by Fiducia’s due diligence team:

1. Assure yourself that you are looking at the right acquisition target or potential JV partner. Many foreign companies end up initiating China deals with Chinese companies they already have a business relationship with or companies that have approached the foreign company interested in a JV. Do not assume that the company that you have present business dealings with is the ideal target. If in doubt, conduct a target / partner search to ensure that you find the best target or partner.

2. Conduct a comprehensive due diligence ahead of an M&A or JV deal in China. To only look at the financial or legal data is not enough to understand the company that you are dealing with.

3. Only do as much due diligence as you need at any given time. It is often a good idea to conduct a preliminary due diligence before proceeding with a more comprehensive “full” due diligence. A preliminary due diligence—ideally combining financial, commercial and basic legal aspects—is a cost effective way to screen potential targets before deciding whether or not to initiate a full due diligence.

4. Ensure the due diligence project scope is adequate and plan sufficient time to conclude it. Do not settle for less information than what is necessary to ordinarily make a decision whether or not to enter into a deal. Similarly, never agree to a tight time limit for the due diligence study if this will limit the scope of the study—some sellers try to impose these deadlines in the interest of speeding up the process or in the worst case to withhold potentially deal-breaking information.

5. Gain buy-in and commitment from the target ahead of the due diligence. Most Chinese companies are very reluctant to hand over information about their business or markets. It is crucial to

convince the subject of the due diligence study that the purpose of the due diligence is to facilitate not de-rail a potential deal. External specialists can provide great value by helping to reassure the target ahead of the study and by helping the client to gain access to previously withheld information.

6. Gain external information in addition to the data provided by the target and JV partner. A proper due diligence should include a significant number of interviews with suppliers, customers and competitors as well as with local government officials and financial institutions. This is why a proper commercial due diligence is essential.

7. Consider using specialists for the execution of the due diligence—conducting due diligence investigations is a specialist skill. Using specialists will also allow buyers to focus on the bigger picture while at the same time making sure that all the details are covered. Due diligence specialists if properly chosen are worth their fees if they have the relevant China experience in your industry and thoroughly understand your firm’s objectives.

Do you have questions about commercial due diligence in China?

Fiducia‘s approach to commercial due diligence is based on more than two decades worth of experience gathering, analysing and presenting market information on China. Fiducia has successfully carried out due diligence studies for a significant number of international clients with business interests in China. We have investigated businesses in most industries, including joint ventures, wholly foreign-owned enterprises and privately or state-owned Chinese enterprises. For more information please contact Thaddaues Mueller at tmueller@fiducia-china.com.

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In China your signature is not enough. For a document to be legally binding, you have to place your company chop on it. Your chop will affix your credit and your promise. It will serve as your company’s signature and it will close that final deal.  In the west a chop would be referred to as a company seal or stamp. In China it is usually a piece of solid plastic that has the company name carved in the face to imprint the Chinese characters that signify your company name.  Some western executives also have personal chops in English that spell out their personal name or company name but these chops have no legal value for the company.

What kind of chops do you need?
There is a whole range of them and standard chops in a WFOE include company chop, legal representative chop, invoice chop, customs chop, agreement chop and account number chop plus there could be more.  To obtain your three basic chops (company, legal representative, and financial), you will need:
• a business license from the SAIC
• to be registered with the local Public Security Bureau (PSB)
• PSB approval to receive chops from an appointed chop company.

Other chops such as agreement, invoice or custom chops can be obtained from the appointed chop company as well. In order to do so you will need to present your business license and your company chop. The account number chop can be obtained from your bank.

Types of chop & application

That said, a chop alone is not always enough. For some important official documents, in addition to the chop, the signature of the legal representative is required. He also has the overall responsibility for the chop’ s safekeeping. Some other facts to consider: If a company changes their name, the company chop will have to change accordingly and be approved by the Public Security Bureau. If your company ceases to exist the chop will be destroyed by the SAIC. And no chop may be duplicated - only originals are allowed.

In China chops mean business. Make sure you’ve got them in order.

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